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WINTER 2019

This is the copyright of Investec and its contents may not be re-used without Investec’s prior permission.

Contents

Welcome to Taking Stock 01

Trade wars – the new normal? Jeremy Gardiner 03

Could fixed income be the best place to be? Peter Kent and Malcolm Charles 07

Renewed focus on downside protection in these uncertain times Clyde Rossouw 11

Investing in the age of data Hannes van den Berg and Terry Seaward 21

What are the main pitfalls of bucket strategies? Jaco van Tonder 29

1

Welcome to Taking Stock

SANGEETH SEWNATHDeputy Managing Director

Chip Conley, a successful boutique hotelier who sold the company he founded and ran as CEO for 24 years, joined AirBnB at the age of 52. Not only did he have to make the transition from bricks and mortar to a Silicon Valley tech start-up, but he reports into a CEO more than two decades his junior. As he writes in his recently published book, Wisdom at Work: The Making of a Modern Elder, “Sixty may be the new 40 physically, but when it comes to power, 30 is the new 50!” What experience and age can bring, he argues, is wisdom, which he defines as the ability to see the patterns in things, something one should theoretically get better at with time (and therefore age).

I found much overlap between his views on age and wisdom and those of expert gerontologist, Sarah Harper. Sarah, who was the keynote speaker at the 2019 Nobel Prize Dialogue, presented at the Investec GlobalSelect conference we hosted in London in June. As an aside, I was pleased she could confirm that man flu is in fact a genetically justifiable phenomenon! More seriously, she guided a conversation on the impact of longevity on financial planning and whether in our lifetimes living longer by five to ten years would add to retirement years, or whether we are likely to be cognitively clear and physically strong enough to successfully work in a modern economy.

Let’s hope the markets remain supportive.

Winter 2019 | Taking Stock 2

The overarching theme of the GlobalSelect conference was Investing for a better tomorrow. Discussions were not limited to thinking about the sustainability of our clients’ futures, but also addressed how we invest sustainably. Deirdre Cooper, Portfolio Manager of our newly launched Global Environment strategy, spoke powerfully about the force of good that we can be as a significant manager of assets.

The theme was carried through to an interview with Hendrik du Toit ( joint CEO of Investec), in light of our demerger from the Investec Group and our future as an independent asset manager. In Hendrik’s words, “when you make your business smaller, you make your clients bigger.” That resonated with me personally. While we may manage more than R2 trillion globally – the equivalent of the entire SA unit trust industry – we remain close to every rand coming in or leaving from advisors. It matters to us. I encourage you to watch the highlights video of the event, which can be found at www.investecassetmanagement.com/globalselect-investment-conference-2019.

I couldn’t sign off this note without some reference to the markets. Despite a rather turbulent first six months, the SA equity market ended the period up a respectable 12%, in line with what Clyde Rossouw and his Quality team anticipated. Interestingly, the team’s overweight positions in their preferred opportunities – global equities and domestic bonds – really benefited our Investec Cautious Managed Fund, which had a strong performance uptick.

Despite this, 120% of the industry net flows* over the last quarter went into fixed income funds. Surprisingly, offshore net flows into feeder funds were negative. Either investors are going directly offshore into share portfolios, which they need to consider carefully, specifically from a tax perspective, or they are waiting on the sidelines watching the rand.

With so much focus on costs, we hear more and more about the benefits of passive investing. We would argue that you should consider whether you’re getting value for money, rather than fixating on costs. Put simply – might it be worth paying 25 to 50 basis points more if your investment is generating an additional 1% in returns ever year? Over the last 20 years, our flagship Investec Opportunity Fund has not only provided SA equity-like returns, but at almost half the volatility. In this edition, Clyde emphasises the importance of managing downside risk in the Investec Global Franchise Fund, given global growth concerns and geopolitical uncertainty.

Enjoy this edition of Taking Stock. Let’s hope the markets remain supportive for the remainder of 2019.

Sangeeth Sewnath Deputy Managing Director

*Based on our estimates using Morningstar data.

WELCOME

https://www.investecassetmanagement.com/south-africa/professional-investor/en-za/events/globalselect-investment-conference-2019/#thank-you

Taking Stock | Winter 20193

Trade wars – the new normal?

JEREMY GARDINER

The IMF warned recently that the main risk factors to the global economy currently are that further US-China tariffs, US auto tariffs, or a no-deal Brexit – could sap confidence, investment and global growth. It warned that these trade wars needed to end urgently, in order to boost confidence, investment and growth.

So, therefore, your financial fate over the next couple of years lies largely in the hands of two people, Boris Johnson and Donald Trump.

In terms of Brexit, a no-deal exit would be ‘an event’ in global financial markets, which would scare foreign investors and result in emerging markets, including South Africa, being punished. Not to mention, the UK and Europe are significant trading partners of ours, plus the UK is responsible for approximately a third of our foreign direct investment inflows.

Boris, however, does not have an easy road ahead. He must do in three months what Teresa May couldn’t achieve in three years. Although committed to leaving on 31 October without a deal if necessary, Boris realises this route carries significant risk and could be ‘bumpy’. Ideally, he would like to reach an agreement with the EU, but given that the previous deal failed repeatedly in parliament, he needs a new, improved deal. The problem is, the Europeans told Teresa May months ago that it’s not up for renegotiation, and they’re sticking to that.


VIEWPOINT

So Boris finds himself leading a government committed to a ‘no-deal’ exit, should the Europeans refuse to negotiate a new deal (which they may well do). He is up against a parliament vehemently opposed to a ‘no-deal’ Brexit, and the Tories have a parliamentary majority of one. This is very likely to result in decision-making paralysis, followed quite possibly by a vote of no confidence and fresh UK elections. Boris will obviously be hoping for a stronger mandate, but anything, including a Labour/Lib Dem coalition victory, however unlikely, is possible.

Brexit aside, I believe tariff wars are something we’re going to have to get used to, because that’s how Trump fights. The Mexicans are safe (for now), India is under pressure, and Europe, particularly the automobile industry, is next. Just as markets were enjoying a pause in the conflict over the past month, President Trump, completely disregarding the ongoing efforts of his negotiators, implemented more tariffs, by tweet. Investors panicked – again! – and world markets including emerging markets (and SA), suffered.

I’ve written before that he has a strategy, that analysts believe that he is deliberately stoking global tensions in order to get the Chinese to stimulate more and the US Federal Reserve to cut more. Then, when he eventually does a deal with the Chinese, the US economy and stock markets will crescendo, peaking just in time for the US elections. The result? A booming economy should ensure his re-election next year. Apparently, that’s how the US works. A strong economy equals almost certain re-election for an incumbent president. It seems the economy is all that counts, all other negativity is just ‘noise’.

I’ve been told that this theory gives too much credit to Trump, that he is irrational and acts impulsively with little thought of the consequences. If this is the case, we better hold on tight because there’s a very real chance that the global economy is going into recession.

The risk to his strategy is that the Chinese understand how much he needs a strong economy for re-election and may well play hardball in order to try and strike a better deal with a Democrat president. Also, Jerome Powell, Chair of the US Federal Reserve, is not yielding to Trump’s pressure to accelerate rate cuts, infuriating Trump and unsettling markets.

I’m pretty sure his strategy is to get re-elected. If that is the case, and he manages to artificially stimulate the US economy (and therefore also the global economy), the result will be a ‘risk-on’ environment which would be very positive for emerging markets, including SA.

And my goodness, at the moment we need every bit of help we can get.

6

A ‘risk-on’ environment will be very positive for emerging markets, including SA.


With the SARB firmly focused on inflation, could fixed income be the best place to be?

Amid all the risks facing our fixed income market, it may be hard for investors to see a silver lining. While the risks are well documented – Eskom, a Moody’s credit rating downgrade, a deterioration in the fiscus and politicians tinkering with property rights – low inflation has been a welcome fillip. In this article, we explore why we believe fixed income could be the best place to be.

As had been widely anticipated by the market, the South African Reserve Bank (SARB) cut interest rates by 25 basis points in July. This is in line with our long-held view that the South African economy is experiencing sustained disinflation, driven by the lack of demand in the economy and the SARB’s determination to get inflation to the middle of the target band at 4.5%.

Indeed, the cyclical elements of inflation – traditionally a function of supply and demand – are running very low at closer to 2-3%. The only drivers of inflation in the economy are administered prices (such as electricity tariffs and tax hikes), combined with periods of higher oil prices and episodes of rand depreciation.

PETER KENT Co-Head of SA & Africa Fixed Income

MALCOLM CHARLES Portfolio Manager, Fixed Income


The SARB has long maintained that the impediments to growth are structural rather than cyclical, and that South Africa needs reforms rather than rate cuts. While this view holds true, it appears that the Bank is finally acknowledging that there may be a cyclical element to the growth slowdown too, and has accordingly responded by easing policy.

SARB reluctant to cut aggressively, despite poor growth prospects

There’s no denying that the growth picture in South Africa is ugly, with commentators bemoaning the lack of investment in the economy. But a recent research note from the SARB makes the point that for the period 2010-2016, “South Africa’s investment rate has actually remained above its long-term average.”1 What has happened is that the public sector has been crowding out the private sector, with state-owned enterprises (SOEs) becoming a much bigger investor in the economy. It is not surprising that from 2010 onwards, capital spending has become less productive. For every rand that has been invested in the economy, we are not getting the kind of return that is needed. Eskom’s two new power stations, Kusile and Medupi, are key examples of this kind of unproductive investing. In the same research note, the Bank makes the point that the “misallocation of capital” flowing from “patronage spending” and “self-enrichment” has contributed to the drop-off in investment efficiency, which in turn has curtailed “the country’s long-term growth potential.”

The SARB cut its forecast for GDP growth in 2019 from 1% to 0.6%. We believe the Bank’s growth forecast for 2020 and 2021, is still too optimistic. There is a strong argument from a cyclical perspective to cut interest rates further. However, South Africa’s structural problems mean that the extent to which the SARB can ease has a floor – in our view at between 50 and 75 basis points overall. More than that would require a meaningful improvement in the structural impediments to growth. For now, we are simply too dependent on foreign capital to fund our fiscal and current account deficits.

Investors well rewarded for taking on risk

While the SARB has welcomed the continued downward trend in inflation, it is concerned that the financing needs of SOEs could impact the value of the rand and push long-term interest rates higher. The Bank’s strong focus on anchoring “inflation expectations near the mid-point of the inflation target range”, has meant that fixed income investors have been well rewarded for taking on South African bond market risk. While bond yields have risen to reflect heightened risks, the SARB’s cautious stance on rate cuts and sustained disinflation have provided investors with attractive real (above inflation) yields. These are much needed in an environment where South Africans’ incomes have been eroded by ever-increasing taxes, and higher electricity and water tariffs.

1South African Reserve Bank, Occasional Bulletin of Economic Notes, July 2019, What happened to the cycle? Reflection on a perennial negative output gap, Theo Janse van Rensburg, David Fowkes and Erik Visser.

VIEWPOINT | FIXED INCOME


Investec Diversified Income – where to from here?

Domestic bonds have had an exceptional – if bumpy – 12 months, with the All Bond Index returning almost 11.5% to the end of June. We have participated in this upside and continue to have a constructive view on domestic bonds, as we believe they are a better expression of this disinflation theme than listed property. With our portfolio yielding above 8.5% and inflation running at 4.5%, fixed income provides a meaningful real return. In addition, we believe there is further capital uplift to come from bonds.

We maintain a prudent allocation to government bonds, taking advantage of disinflation, high real yields and attractive valuations. The portfolio also has a meaningful exposure to investment-grade corporate bonds. This has been a high-conviction call over the last two years and the portfolio benefited from it materially. The yields are still good but not as compelling as they have been in the past.

The global environment has become more supportive of emerging markets such as South Africa. Uncertainty sparked by President Trump’s trade policies and global growth concerns moved the US Federal Reserve to cut the federal funds rate at the end of July. The European Central Bank will likely ease key interest rates in September and introduce other support measures, given persistently low inflation in the euro zone and a gloomy growth outlook.

While the global environment has provided some breathing room for South African markets, we remain mindful of the risks, outlined above. There has been constant negative news flow about a potential credit rating downgrade by Moody’s. A close examination of the methodology that Moody’s uses to assess and rate the quality of a country’s sovereign debt, leads us to believe that a rating downgrade in November is unlikely. But without targeted government intervention to stabilise Eskom and our fiscal situation, we could see the ratings agency move the outlook to negative.

Risks and uncertainties abound, but on a risk-adjusted basis we believe fixed income could be the best place to be. Valuations, together with our offshore allocation, provide some protection against the multitude of risks locally and globally.

We believe there is further capital uplift to come from bonds.

VIEWPOINT | FIXED INCOME


Renewed focus on downside protection in these uncertain times

We’re in the later stages of the longest bull run in developed market equity history, which has exceeded ten years. Over this period, there has been a material increase in the market share of passive global equity market strategies. For instance, the market share of active US equity funds was 51.3% at the end of last year, versus 48.7% for their passive counterparts.1 In 2009, the split was 73% (active) versus 27% (passive).2 And while investors have enjoyed the tide of rising markets, managing downside risks have been less of a focus. But global growth concerns and geopolitical uncertainty are creating a challenging investment environment, with downside risks on the increase. Investors face a raft of issue that include:

• Rising debt burdens across governments, corporates and households

• Central bank policy beginning to shift away from the huge quantitative easing experiment that has supported asset prices over the last ten years

• Volatility spikes in equities, bonds, currencies and commodities, which serve as an important reminder of the latent risk in markets at these levels

• Technological change severely disrupting a variety of companies and industries, causing earnings forecast downgrades in many cases

1 Morningstar Direct data, as at 31.12.18, https://www.morningstar.com/blog/2019/01/28/us-fund-flows-trends.html.

2Morningstar Fund Flows and Investment Trends, 2009.

CLYDE ROSSOUW Co-Head of Quality

https://www.morningstar.com/blog/2019/01/28/us-fund-flows-trends.html

https://www.morningstar.com/blog/2019/01/28/us-fund-flows-trends.html


We believe avoiding capital losses is just as important as achieving capital gains when it comes to generating sustainable long-term returns. This is where the value of good active management truly comes to the fore. Index-tracking passive strategies expect investors to put their faith in a basket of equities, regardless of their characteristics and inherent risks.

Quantitative metrics have flaws

We don’t believe a quantitative passive approach is able to fully capture mispriced opportunities that will generate sustainable outperformance (alpha) for long-term investors. As active managers, we believe that in-depth bottom-up qualitative research is essential to fully evaluate the sustainability of a company’s competitive advantage and profitability. Quantitative metrics may not reveal, for example:

• The true strength of a company’s competitive positioning and market share

• The impact of short-term currency movements

• Its dependence on the economic cycle

• Its relationships with key stakeholders

• Business tail risks, such as regulatory/political risk or over-reliance on a single product, market or customer

Aggressive accounting and financial engineering can also give a false picture of the actual health of a company. This can distort earnings-based metrics on which quantitative passive strategies rely. Even accurately reported figures can be misleading. For example, high margins may reflect under-investment rather than pricing power or cost efficiency. Overall, different levels of disclosure, accounting treatments and calculation methodologies, as well as corporate activity leading to one-off gains or losses, all make cross-company comparisons difficult using a solely quantitative based approach.

In addition, quantitative strategies struggle to take advantage of forward-looking themes and trends, such as technological disruption, and social, environmental, political and demographic change. We believe in-depth proprietary qualitative research can exploit the long-term pricing inefficiencies not captured by a purely passive or quantitative approach.

Our Beiersdorf case study helps to further illustrate these points.

VIEWPOINT | QUALITY


Case study – Beiersdorf

Beiersdorf, the German consumer goods company behind the Nivea brand, and a recent addition to our Global Franchise portfolio, is a good example of the pitfalls of following a quantitative only approach. This is explained below:

• The company has a large net cash position on its balance sheet which results from holding the dividend flat for several years, in anticipation of future merger and acquisition opportunities. At current prices the cash balance of more than €4 billion equates to approximately 18% of Beiersdorf’s true market capitalisation. The large cash balance has a secondary effect of reducing the company’s overall headline return on invested capital (approximately 15%) which, on an operational basis, is greater than 70%.

• Even if the cash balance is correctly reflected in the valuation, other issues persist. Beiersdorf’s market capitalisation is incorrectly reported by a number of data vendors who include shares held in treasury (approximately 10% of the share count). This means that even if an investor attempts to adjust for the large cash balance using an enterprise value to earnings before interest and taxes (EV/EBIT) multiple, the market cap used to calculate the EV is 10% too high.

• Beiersdorf’s historical growth rates do not reflect the true underlying growth due to the company’s decision to re-position the Nivea brand by pulling away from certain adjacent personal care categories. This has constrained reported growth since 2012 but is now complete, with the company well positioned to grow from here.

• Moreover, Beiersdorf’s treatment of sales in hyperinflationary countries means that even if you compare recent organic growth rates with peers, they are not comparable. For example, many European staples still account for Argentina at ‘constant exchange rates’ and have only recently dropped Venezuela from the calculation. Beiersdorf, in contrast, calculates its organic growth in these countries using the actual exchange rates – a more prudent approach.

• The company’s margins are low relative to peers due to the active decision to invest heavily in advertising and promotion. At approximately 25% of sales within its Consumer division, it appears to us as though a normalisation of this cost line could represent a long-term opportunity within Beiersdorf’s profit and loss statement. Such insight can only be obtained by analysing the disclosures in the annual report and speaking with the company.

VIEWPOINT | QUALITY


A high conviction portfolio

Concentrated portfolios allow portfolio managers to make high conviction allocations to their best investment ideas. We believe active management is most effective when conviction is at its highest. A portfolio investing in a high number of stocks can dilute the impact of a portfolio manager’s best risk/return ideas, particularly in broadly efficient markets where alpha opportunities are scarce.

Our Quality investment team scours a global universe of over 20 000 listed equities from which we select only 25-40 stocks for the Investec Global Franchise Fund. This translates into the fund having an active share of more than 90%, versus the MSCI All Country World Index (MSCI ACWI).3 Compared to the MSCI ACWI Quality Index, the fund’s active share remains a very high 80%. Clearly, we aren’t benchmark or index huggers and we follow a differentiated approach to stock selection.

Table 1

TOP HOLDINGS %

Visa Inc 9.1

Microsoft Corp 7.2

Verisign Inc 6.4

Booking Holdings Inc 5.5

Moody's Corp 5.3

Nestlé SA 4.6

Johnson & Johnson 4.2

Roche Holding AG 3.9

Beiersdorf 3.8

Philip Morris International 3.8

TOTAL 53.8

Number of equity holdings 29

Source: Investec Asset Management, as at 30.06.19.

3Active share is the fraction of the fund’s portfolio holdings that deviate from the benchmark index – Investopedia.

VIEWPOINT | QUALITY


How do we define quality?

Fundamental research helps us to uncover what best reflects our definition of high quality franchise companies. We seek businesses that have the following key attributes:

These exceptional qualities create barriers to entry against competitive threats and high switching costs for customers. The resulting pricing power, together with capital-light business models and financial strength, have enabled franchise companies to sustain high levels of profitability over the long term, far beyond market expectations.

Focus on sustainability

Because we invest for the long term, we have a strong focus on the future sustainability of companies. Our active approach allows us to gain an understanding of companies’ resilience to disruptive forces and whether they have taken steps to ‘future-proof’ their businesses. So, we pick companies with enduring qualities, and consequently, we have a low portfolio turnover. Since inception, the portfolio turnover for the Global Franchise Fund is only around 50%. This helps to minimise the investment cost drag on investment returns, which can prove meaningful over the long term.

Delivering long-term sustainable returns to our investors (durable alpha) requires ongoing analysis and engagement with companies and their stakeholders. We engage regularly with management teams and evaluate companies’ impact on their various stakeholders. Our active investment approach enables us to carefully assess the environmental, social and governmental (ESG) risk and opportunities that can affect the sustainability of a company’s business model; the quality of its accounting policies; and governance issues such as capital allocation, risk management, board composition, audit, remuneration, and shareholder rights.

VIEWPOINT | QUALITY

Hard-to-replicate enduring competitive

advantages

Dominant market positions in

stable growing industries

Low sensitivity to the economic and market cycle

Healthy balance sheets and low capital intensity

Sustainable cash generation and effective capital

allocation


Differentiated alpha

The Investec Global Franchise Fund has a long-term track record of delivering durable, defensive returns to investors, thanks to our differentiated, active investment approach (Figure 1 and Table 2).

Figure 1: Cumulative performance in US dollars since inception*

Table 2: Annualised returns in US dollars

1 YEAR 3 YEARS P.A. 5 YEARS P.A. 10 YEARS P.A.SINCE

INCEPTION P.A.*

Investec Global Franchise A Acc

10.7% 10.1% 8.1% 11.0% 7.0%

MSCI AC World NR** 5.7% 11.6% 6.2% 10.1% 4.5%

Quartile ranking 1 2 1 1 1

Past performance is not a reliable indicator of future results, losses may be made. Source: Morningstar, dates to 30.06.19, NAV based, inclusive of all annual management fees but excluding any initial charges, gross income reinvested, in US dollars. **The comparative index changed to the MSCI AC World Index from 1 October 2011. Highest and lowest returns achieved during a rolling 12-month period (since inception): Feb-10: 54.4%, and Feb-09: -38.7% – Investec Global Franchise A Acc share class. *Launch simulation date: 10.04.07. Quartile ranking within the GIFS Global Large-Cap Blend Equity.

While Quality indices are still very overweight consumer staples, we have reduced our exposure to consumer staples over last few years, in favour of interesting defensive growth opportunities. Technology, which is now our highest sector exposure, has contributed materially to our alpha generation. Furthermore, our active bottom-up stock picking has also added alpha. This means that our differentiated approach to quality stocks is not replicable by investing in the market, or even in a quality index.

Investec Global Franchise A Acc MSCI AC World NDR (pre Oct-11, MSCI World NDR)

Per

cent

age

(%)

119.7%

68.6%

-60

-40

-20

0

20

40

60

80

100

120

140

Apr 07 Dec 08 Aug 10 Apr 12 Dec 13 Aug 15 Apr 17 Dec 18 Jun 19

VIEWPOINT | QUALITY


Managing risk

Avoiding capital losses is just as important as achieving gains when it comes to generating sustainable long-term returns. So, we seek companies which have defensive characteristics. We typically like companies that have recurring revenue streams, enduring competitive advantages, strong management teams, low debt levels and healthy balance sheets. This helps to reduce our investors’ exposure to operational, business and financial risks. On top of that, we manage valuation risk by investing in quality companies at reasonable prices.

Importantly, the Investec Global Franchise Fund’s outperformance against the comparison index – the MSCI ACWI – has been achieved with lower risk, both in terms of drawdowns and volatility.

Figure 2: Outperformance with low volatility – risk vs. return in US dollars

Past performance is not a reliable indicator of future results, losses may be made. Source: Morningstar, 30.04.07 to 30.06.19. Performance for the fund is NAV based, inclusive of all annual management fees but excluding any initial charges, gross income reinvested, in US dollars. *The comparative index changed to the MSCI AC World Index from 1 October 2011.

Avoiding capital losses is just as important as achieving gains when it comes to generating sustainable long-term returns.

Annualised volatility (%)

Investec Global Franchise A Acc

MSCI ACWI*

0

1

2

3

4

5

6

7

8

10 11 12 13 14 15 16 17 18 19 20

Ann

ualis

ed p

erfo

rman

ce (%

)

VIEWPOINT | QUALITY


The portfolio has shown its mettle during severe market corrections, such as when the global financial crisis hit investors. For instance, over the period May 2007 to March 2009, the Investec Global Franchise strategy’s drawdown was 20.5% while the MSCI ACWI lost 37.7%. The quality stocks in our portfolio have also proven to be more defensive than the MSCI ACWI Quality Index during falling markets.

Figure 3: Average rolling 12-month performance in US dollars

Per

cent

age

(%)

Investec Global Franchise A Acc MSCI AC World Quality NDRMSCI AC World NDR (pre Oct-11, MSCI World NDR)

16.0

8.0

-4.3

20.1

9.1

- 7.4

19.7

5.5

- 13.2-20

-15

-10

-5

0

5

10

15

20

25

Strong markets63 months

MSCI > 10%

Moderate markets28 months

0% < MSCI < 10%

Falling markets44 monthsMSCI < 0%

Past performance is not a reliable indicator of future results, losses may be made. Source: Morningstar, 30.06.19. Performance for the fund is NAV based, inclusive of all annual management fees but excluding any initial charges, gross income reinvested, in US dollars. Rolling 12-month periods. MSCI ACWI Quality index launched 18.12.12 – synthesised performance history prior to that date.

Conclusion

There are clear risk and return arguments that support an active approach to quality equity investing. As active investors, we have the ability to manage downside risks, while still participating in up markets. This should provide some comfort to investors in these uncertain times where global growth concerns and geopolitical uncertainty are creating a challenging investment environment.

The Investec Global Franchise Fund has a long-term track-record of delivering durable, defensive and differentiated returns. Our portfolio companies have been less sensitive to the economic and market cycle and have offered an attractive combination of resilience and long-term structural growth – much needed attributes in this uncertain environment.

VIEWPOINT | QUALITY

20

The portfolio has shown its mettle during severe market corrections.


JACO VAN TONDER Advisory Services Director

JACO VAN TONDER Advisory Services Director

Investing in the age of data

According to IBM, we create 2.5 quintillion bytes of data every day, with 90% of the world’s data having been produced in the last two years alone.1 While individuals may at times suffer from information overload, businesses across the spectrum, from social media and entertainment to banking and investments, have recognised the benefits of harnessing big data.

The use of machine learning to supplement human intelligence demands innovation across industries. A systems view is imperative for leaders who want to lead their respective organisations into the future.

Advances in technology and big data have resulted in data screening tools (quantitative analysis) gaining a strong foothold in the investment management industry. When it comes to finding good companies in which to invest, information and timing are key. This requires the ability to speedily process huge volumes of information from multiple sources.

While quantitative analysis focuses exclusively on the numbers behind data sets, fundamental analysis also incorporates judgement (qualitative analysis) such as company forecasts, industry dynamics and the quality of strategy and management. In this article, we take a closer look at these two approaches and how we combine them in the Investec Equity Fund to optimise idea generation and the risk-return profile of the fund.

1IBM, 10 Key Marketing Trends for 2017.

HANNES VAN DEN BERG Co-Head of SA Equity & Multi-Asset, 4Factor

TERRY SEAWARD Portfolio Manager, 4Factor


VIEWPOINT | QUALITY


Investec Equity: fundamental research is key to what we do

In our search to find good companies in which to invest, our investment team analyses financial statements; the overall health of companies; the management and strategy of the businesses; and industry and economic conditions that impact operations. Fundamental analysis typically entails determining a company’s earnings potential as well as assessing if these fundamentals are reasonably valued. Essentially, fundamental analysts do a ‘deep dive’. Besides critically assessing financial statements, our team visits companies, engages with management, board members, competitors and industry experts, and researches firms’ products and services to identify good investments. A qualitative approach should also include behavioural analysis, which considers investor sentiment to determine share price direction.

As active owners we focus on sustainability of earnings, which includes environmental, social and governance (ESG) principles, which we integrate into our fundamental analysis. Since businesses can circumvent rules, good governance requires strong leadership and sound judgment. Better governance can foster trust in leadership and provide greater confidence in forecasting company earnings. In turn, good corporate governance should lead to better corporate performance and shareholder value over the long term.

Combining fundamental analysis with a quantitative investment approach

A quantitative approach uses mathematical and statistical modelling that collects immense volumes of data at lightning speed to help identify good investment ideas and assess portfolio risks. To put it in perspective, more than 16 million discrete pieces of information feed into constructing a portfolio from a 4000-stock universe. Quant analysts are often described as data analysts working in finance, as they need to be highly skilled in maths, statistics, computer science and finance.

Our Investec Equity quant team’s focus is on mining company-relevant data far and wide, as opposed to considering intangibles such as brand value and intellectual property rights. Such qualitative factors are typically the domain of our fundamental analysts. Quant analysts adopt a disciplined, evidence-based approach to investing and they are not influenced by human emotion or behavioural biases. They rely purely on numbers and data to identify good investment ideas that help to reduce and manage risk.

Public debate tends to pit humans against machines, reinforcing the stereotype of an ‘us versus them’ scenario.

VIEWPOINT | EQUITY


Figure 1: Harnessing human insight and technology

When it comes to big data and machine learning, public debate tends to pit humans against machines, reinforcing the stereotype of an ‘us versus them’ scenario, rather than entertaining a ‘marriage of two minds’. Even within the asset management industry, it is common to find that active equity managers only employ quantitative analysis as an initial screening tool to identify good investment ideas based on a specific set of criteria. So, quants is often used as a filter to narrow a large investment universe, after which fundamental analysts do a deep dive on these stock ideas.

However, in our view, each approach (quantitative and fundamental analysis) has key strengths and weaknesses. To put it into perspective: quants is ‘a mile wide, but an inch deep’, while fundamental research is a ‘mile deep, but an inch wide’.

Table 1: Both approaches have strengths and weaknesses

STRENGTHS WEAKNESSES

Quantitativeresearch

Discipline, repeatability, objectivity and efficiency

Slow to adapt to changing trends

Breadth: the ability to analyse a vast amount of data in a short period of time

Based on historical information

Good at portfolio construction and risk management: the ability to optimise correlations and co-variances of all possible combinations of holdings

Fundamentalresearch

Judgement, insight and experience Emotional bias

Depth: the ability to assess many different aspects of a company in detail and to consider multiple angles using the same data

Inconsistent

Ability to communicate, debate portfolio positioning and express a view

Slow – a finite amount of time to analyse available data

Flexibility and the ability to adapt to new situations/breaking news

VIEWPOINT | EQUITY

Speed andobjectivity

Judgementand intuition


Idea generation – finding the right balance

Over the last eight years we have refined our investment process, blending fundamental insight with quantitative analysis to produce more consistent investment returns for our investors. We employ a two-fold process to generate ideas:

01. Qualitative: bottom-up fundamental research from our experienced team of analysts, where the best investment ideas are identified based on fundamental company research. For instance, our analysts will examine the market’s earnings forecasts for a company. The aim is to determine whether a company is likely to have higher (or lower) earnings than other market participants expect. When profit forecasts are revised upwards or downwards, we believe it can have a material impact on a company’s share price.

02. Quantitative: a stock screen process which identifies the best investment ideas, based on very specific data-driven, fundamental criteria. This screening includes finding companies, based on fundamental investment data, with favourable dynamics (earnings/profit expectations) and reasonable valuations.

Figure 2: Idea generation in the Investec Equity Fund

It is important to note that our quantitative stock screen research and fundamental analysis run parallel to each other, so the one process isn’t relegated to a supporting act: both have a star billing. The investment ideas that are identified by both our quantitative and fundamental analysts typically represent our high conviction stock picks in the Investec Equity Fund. For example, Anglo American and BHP Billiton came up as top picks based on our quantitative and fundamental research. These stocks currently both represent a material holding in the Investec Equity Fund.

Bottom-up fundamental

research

Fundamentalstock screen

Highconviction

ideas

Qu

antitative analysis

Qualitative analysis

VIEWPOINT | EQUITY


A difference of opinion can be healthy

As these two research processes run independently, one may identify a stock as a good or bad investment idea, which might not be supported by the other. For example, Naspers scores poorly on our quant-based metrics (valuation). But a more detailed fundamental analysis reveals that Naspers represents reasonable value, when valuing each business within the internet and media giant separately. Both processes may fuel debate, highlighting the need for further analysis of an investment idea.

This integrated approach reduces the risk of ‘over-confidence’, which can be a pitfall where idea-generation favours only one of these two research processes. Essentially, we capitalise on the best attributes of both. Quantitative screening offers discipline, repeatability, objectivity and efficiency, while bottom-up fundamental research provides depth, human insight and judgement.

Portfolio construction – more than implementing your best investment ideas

Investments may result in financial losses, which is why it’s so important to manage the tension between investment conviction and risk. Portfolio construction and risk management are complex processes for humans. Constructing a simple 30-stock portfolio requires managing hundreds of pieces of expected return, risk and related information, easy for a machine but difficult for a human. Some asset managers will try and manage risk by limiting the weighting of an individual stock or by imposing sector-specific exposures. We believe these measures are a blunt way of managing risk as they constrain potential outperformance and do not consider the multiple correlations between stocks and sectors.2

Having quant expertise within our Investec Equity investment team has enabled us to develop an extensive risk and portfolio management process over years to address these challenges. Proprietary quant tools allow us to combine key risk and return metrics to optimise our portfolio and maximise diversification. Our internally developed system provides crucial information to us on a pre-trade basis. As an example: before we implement a trade to reduce the allocation to one stock in favour of another, the system tells us how it will impact the overall portfolio risk.

Investments may result in financial losses, which is why it’s so important to manage the tension between investment conviction and risk.

2Correlation measures how assets and markets move in relation to each other, and can be used to manage risk – Investopedia.

VIEWPOINT | EQUITY


While our proprietary models have greatly enhanced the risk management and portfolio construction process, human insight and common sense remain crucial. Fundamental analysts are best placed to interpret breaking company news, market dynamics, regulatory or tax changes, and ESG issues. For instance, fundamental analysis allowed us to assess the risks to Sasol’s earnings when carbon taxes were introduced this year. Given deteriorating fundamentals, we reduced our position in Sasol. When governance issues hit Glencore last year, we took the decision to exit our position.

Figure 3: Investec Equity Fund

In conclusion

In our view, fundamental analysis and quantitative analysis have strengths and weaknesses. We believe both these approaches have an important role to play in finding good stock ideas, as well as constructing a portfolio and managing risk. Over the last eight years we have refined our investment process, blending quantitative analysis with fundamental insight to produce more consistent investment returns for our investors.

PurposeDeliver consistent

returns

PhilosophyUpward earnings revisions

at reasonable value

ProcessHumans harnessing

technology

VIEWPOINT | EQUITY

28

Quantitative screening offers discipline, repeatability, objectivity and efficiency, while bottom-up fundamental research provides depth, human insight and judgement.

29

What are the main pitfalls of bucket strategies?

This article is a follow-up to our ongoing series on living annuities, which focuses on how to maximise a pensioner’s chances of drawing an inflation-hedged income for life.

One of the key discussion points emanating from our advisor engagements on this topic has been the use of so-called bucket strategies in managing the asset allocation of living annuities. In our May 2019 article, we reviewed bucket strategies and some academic material published on this topic. We would encourage you to review this article for background. One of the key conclusions from our article was that bucket strategies introduce portfolio management risk, and advisors using these strategies should actively guard against these pitfalls. This article unpacks the above conclusion.

Bucket strategies introduce portfolio management risk.

JACO VAN TONDER Advisor Services Director


VIEWPOINT

What are the key investment risks for a living annuity portfolio?

In our earlier research work on designing investment portfolios for living annuities,1 we concluded the following:

• For a given level of starting income, the success probability of a living annuity is strongly driven by the real return of the portfolio.

• The real return of a portfolio is, in turn, strongly driven by the asset allocation and the manager alpha (outperformance of the benchmark).

• Contrary to popular thinking, the biggest asset allocation risk for an annuity is underexposure to growth assets (such as local and offshore equities), as you need growth assets to provide an inflation-protected income over a 30-year term.

• Once an annuity portfolio has the correct asset allocation, reduce volatility as much as possible through diversification and selecting investment managers/strategies with an inherently low volatility signature.

With these four conclusions as background, how can the investment strategy for a living annuity go wrong? Broadly speaking, the following are the three most common mistakes made:

• Selecting an incorrect long-term strategic asset allocation (typically maintaining too low an average equity exposure in the annuity);

• An unintended tactical asset allocation trap (basically falling in the classic ‘buy high and sell low’ trap under pressure); and

• Incorporating unnecessary volatility in the portfolio.

How prone is a bucket strategy to these investment pitfalls?

Let us investigate the implementation of bucket strategies against these common pitfalls.

01. Selecting the appropriate long-term strategic asset allocation

This is a critical area to get right, and arguably where bucket strategies are most prone to errors and present some risk to advisors and pensioners.

A bucket strategy’s behavioural advantage could lead to a poor investment outcome. The focus is on securing the next three or four years’ income in fixed income instruments to manage the pensioner’s emotions and behaviours. But this makes a bucket strategy prone to overexposure to fixed income assets.

1www.investecassetmanagement.com/living-annuity-series

https://www.investecassetmanagement.com/south-africa/professional-investor/en-za/insight/living-annuity-an-active-solution/


The table below gives an example of how this can easily happen in practice. It highlights an initial asset allocation for a 5% initial income living annuity where the first year’s income is in the money market and the next three years’ income is in multi-asset income funds. The remainder of the assets are invested in multi-asset high equity funds.

Table 1: Initial asset allocation for a typical bucket strategy

PORTFOLIO ALLOCATION

AVERAGE ASSET ALLOCATION

DOMESTIC FIXED INCOME SA EQUITY

OFFSHORE EQUITY

Money market 5% 100% 0% 0%

Multi-asset income 15% 100% 0% 0%

Multi-asset high equity 80% 40% 40% 20%

Total net exposure 52% 32% 16%

From the table you can see the problem quite clearly. Although at first glance this portfolio appears acceptable (80% invested in balanced-style funds), on a look-through basis this living annuity only has 48% exposure to local and offshore growth assets. This contrasts with what our living annuity research suggests for a 5% initial income annuity, which is closer to 70% equity exposure. Such a strategy introduces risk to the pensioner and advisor, as it materially increases the failure probability of this annuity.

Advisor tip: Always run a look-through asset allocation analysis on a bucket portfolio’s long-term asset allocation!

This is an important discipline that will quickly highlight if a portfolio suffers from ‘fixed income drift’.

02. Rebalancing a bucket portfolio regularly

One of the implications of using a bucket strategy is that the annuity income is only drawn from the fixed income assets in the portfolio. The fixed income assets therefore need to be replenished periodically by selling equity assets and purchasing fixed income assets with the proceeds.

A lot of material has been published in international financial planning journals about various rebalancing strategies, but this article is not about the merits of different strategies. However, we would like to highlight that, unless rebalancing is done in a systematic way (i.e. at fixed, regular intervals), it effectively becomes a type of tactical asset allocation and can jeopardise the success probabilities of an annuity portfolio.

VIEWPOINT


The typical trap with rebalancing is when:

01. You delay switching growth assets into fixed income assets after the equity market has run hard (greed); or

02. After a market crash you switch more growth assets into fixed income assets than is required to fund the income (fear).

As with the normal ‘fear/greed’ trading cycle, this type of behaviour destroys value for a pensioner and should be avoided at all cost.

Figure 1: A typical rebalancing trap

Advisor tip: Pick a portfolio rebalancing strategy that automatically rebalances a portfolio at least annually and is not influenced by market fear/greed. And stick to it!

03. Avoiding short-term asset allocation mistakes

At first glance it appears that tactical asset allocation is one area where bucket strategies should do very well. After all, they are designed to temper investor emotions and they are very effective at nudging the pensioner to ‘stay the course’ with their asset allocation, and not get distracted by short-term market noise.

However, there are situations where an advisor would knowingly tilt the asset allocation of an annuity away from the ideal long-term strategic asset allocation. A classic example of this is when the investment is originally made for a new pensioner client. The negative implications of a market correction early on in an annuity’s lifetime (known as sequence of return risk) are well documented. An early market correction significantly reduces the future success prospects of an annuity, and it dents the pensioner’s confidence in their new financial advisor, possibly leading to a severing of the advice relationship.

Switching delays due to greed Switching too much due to fear

Growthassets Growth

assets

Fixed incomeassets

Fixed incomeassets

VIEWPOINT


VIEWPOINT

The most effective way to deal with both issues of pensioner trust, as well as sequence of return risk, is to phase in the investment at inception. This involves deliberately investing an annuity into a fixed income-heavy portfolio at inception, to protect against an early market crash. The pensioner’s retirement capital is then phased into the target asset allocation at regular intervals over a period of twelve to thirty-six months.

Figure 2: A typical phasing-in strategy

The risk with this strategy, however, is that the phasing-in strategy is ignored or significantly delayed. This is a real possibility when market conditions are choppy and there is apprehension to phasing into growth assets. This could leave a pensioner overexposed to fixed income assets for a number of years.

Advisor tip: Use phasing-in to manage sequence of return risk. However, set up the phasing instructions on the administration platform of the annuity provider at inception and stick to them!

04. Avoiding unnecessary portfolio volatility

On face value, bucket strategies don’t appear to deal directly with portfolio volatility. However, bucket strategies are often implemented using specialist mandate funds (i.e. single asset class mandates) as opposed to multi-asset funds, which makes them prone to not achieving maximum diversification.

A common example is with offshore exposure in annuity portfolios. In our earlier research work on living annuities, we identified offshore equity exposure as a key piece of the diversification puzzle. Including an offshore exposure of between 25% and 35% makes a significant difference to the portfolio’s volatility signature and improves the success rate of an annuity. Ignoring offshore assets and investing a living annuity 100% in South African assets increases portfolio volatility unnecessarily and reduces the annuity’s success probabilities.

Advisor tip: Always evaluate a bucket portfolio for opportunities to reduce volatility. Pay specific attention to a bucket portfolio’s net offshore equity exposure and for opportunities to use funds with an inherently lower volatility style.

Inception12 – 36months

Target asset allocationFixed income assets


VIEWPOINT

Conclusion

Bucket strategies are frequently used by advisors because of their behavioural finance benefits. They do, however, come with some portfolio construction risks that an advisor should recognise and manage proactively.

The key points for advisors using bucket strategies are:

• Always run a look-through asset allocation report on a bucket portfolio to verify that the net asset allocation makes sense.

• Use a structured portfolio rebalancing algorithm that is immune to market emotions to avoid falling into a market-timing trap.

• Phase-ins are very useful tools when investing the retirement capital of a new pensioner client during uncertain market conditions. But remember to stick to the phase-in plan and do not get distracted by market events.

• Always search for opportunities to reduce portfolio volatility. In particular, look for opportunities to use funds with lower volatility styles and do not forget the diversification benefits of offshore exposure in living annuities.

36

Always search for opportunities to reduce portfolio volatility.


Core fund range

Note: [ ] indicates maximum in equities. *As an internal limit, the Fund will normally invest no more than 40% of its value in the shares of companies. The Investec Global Multi-Asset Income, Investec Global Strategic Managed and Investec Global Franchise Funds are available as ZAR feeders. The Investec Global Strategic Managed and Investec Global Franchise Funds are available in hedged GBP classes.

Diversified Income

Global Strategic Managed(USD/GBP/ZAR)

[75%]

Opportunity[75%]

Global Franchise(USD/GBP/ZAR)

[100%]

Equity[100%]

Cautious Managed[40%]

Global Multi-Asset Income (USD/ZAR) [40%]*

Exp

ecte

d r

etur

n

Expected risk (volatility)

GROWTHINCOME

International

Local

Note: [ ] indicates maximum in equities

WorldwideFlexible

[100%]

INVESTEC FUNDS

Investec Asset Management and Investec Investment Management Services (IMS) are authorised fi nancial services providers.

Unit Trusts Offshore Investing Tax Free Investing Retirement Solutions

Globally recognised investment manager

Range of local & global funds & solutions

Proud of our South African roots

28 years of helping our clients

An offshore investment gives you access to opportunities across different countries, industries, companies and currencies, exposing your portfolio to more possibilities, while diversifying risk. Investec GlobalSelect offers offshore investment solutions into a range of foreign-domiciled funds in euros, pounds or dollars. Create your own blend of global funds from leading asset managers in one place – on our integrated IMS investment platform.

Stay local. Seize global opportunities.www.investecassetmanagement.com/offshore

investments, simplifi ed.A world of offshore

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CONTACT INFORMATION

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Important information

All information provided is product related, and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. Investec Investment Management Services (Pty) Ltd and Investec Asset Management (Pty) Ltd (“Investec”) are authorised financial services providers. A feeder fund is a fund that, apart from assets in liquid form, consists solely of units in a single fund of a collective investment scheme which levies its own charges which could then result in a higher fee structure for the feeder fund. The fund is a sub-fund in the Investec Global Strategy Fund, 49 Avenue J.F. Kennedy, L-1855 Luxembourg, Grand Duchy of Luxembourg, and is approved under the Collective Investment Schemes Control Act.

This document is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Issued by Investec Asset Management, August 2019.

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