Excess long-term returns

The strategy behind the Investec Value Fund


This year, helped by a record rally in gold mining stocks, the Investec Value Fund posted a return of 68%. This performance is consistent with its long-term track record under fund manager John Biccard, who took it over in 2001, when it had a value of R50 million. Since then, it has outperformed the index by about 4% per annum, an exceptional performance recognised by a Raging Bull award for top outright performance over three years by a South African equity general fund. We spoke to Biccard about the strategy behind these achievements.

It all begins with a blank sheet of paper … “We don't consider the index at all,” says Biccard. “We don't start by saying that a share is 20% per index: we start by saying ‘I want the cheapest 20 shares on the market.’ All the stocks are selected on a bottom-up basis with no consideration of the benchmark, and all of them will be very cheap. We could choose two groups of shares, the one being an annuity-earning business like Mr. Price, with quite a steady stream of earnings, and then we just look at the traditional valuations—PEs, EVEs, with traditional dividend yields.

If it is cheap on that basis, we will look at it, and as is the case at the moment, we may invest in resources when the earnings are quite low. Then we use price to book, price to replace cost, and price to sales, to determine when shares are cheap.

“So the first important thing is that everything we have in the portfolio would have significantly underperformed over a medium- to long-term period and it will be very cheap, either on the first basis of PEs, or on the second basis of price to book.

“The second part is we will go through and attempt to uncover what will unlock the value. In doing that, we pay a lot of attention to macroeconomic changes, because it is quite easy to work out what's cheap but it’s a bit harder to work out what will have to change to unlock the value.

So we take quite a long time to work out what needs to change and, very importantly, whether this is possible to change.

Nine times out of ten, it reverts to the mean, and nine times out of ten something will change to unlock the value, but we spend a lot of time working on whether something is a permanent change in an industry, or whether that means that the return to the mean is not possible.”

The now-defunct former industry giant Kodak is a case in point. “A few years ago, our offshore component nearly bought Kodak because it was unbelievably cheap, but it soon transpired that their business model was permanently impaired.

There is no point buying something cheap that is doomed to fail: we steer clear of stocks that are permanently impaired.”

The next step is to look at the balance sheet. “When we know that everything is cheap from a bottom up point of view, we go on to spend a lot of time looking at the balance sheet to make sure the share can survive while we wait for the macroeconomic changes to come.

“Then we ask whether there is any permanent change in the world which would mean that this industry is just a dead-end sunset industry. Of the work we do, maybe 10 or 20% is on valuation and 80% is on trying to work out if this industry will actually survive. It is relatively easy to work out that something is cheap but harder to work out why it is cheap and whether those industry changes are permanent.

“The net effect is that we generally buy sectors that are massively out of favour and we often have to wait for stocks that are massively out of favour. We generally pile them too early and have to wait a number of years for the idea to mature, but then it does come right and we make a lot of money. We tend to make very little and then we make a lot because the value is then unlocked.”

Deep value convictions

Sticking out the long-term position takes a certain amount of conviction and guts.

“The thing is that we have no regard for what the rest of the market think,” says Biccard, “so we will buy things that are out of favour, but we when we buy something, we can’t see what the catalyst to change it will be. We know what needs to change, but we can't see exactly what will make it change. If we saw it, everyone would see it, so often we have to wait quite a long period of time. Effectively, Biccard will buy “when people are in the depths of despair”. “For example, our biggest position in the fund is platinum, which has been going down for ten years; we have done all the work on that, and my view is that platinum, palladium and rhodium prices will go up because there is a shortage. We have been waiting for two to three years and it hasn't happened up to now, but in the last 16 years, there have been a number of times we have been waiting for four or five years but we make nothing; then in that year the share triples or it goes up four or five times, and that is how we make the returns. “Let's say Impala Platinum started buying at 100 and finished buying at 25; in the year that we recovered, the share went from 25 to 70, but because we kept buying all the way down, in that recovery year we more than made up for all the loss. We stuck to our guns and it came through in that period because we had the maximum of Impala that we could have when it was R25 and then one year it just tripled.

“What we are looking for is the recovery from shares that are down 95% and we have the ability to triple. But it means you have to do the work to start even if it takes three to four, five years. Ultimately, it’s clear that this strategy works, because over the 16-year period, the value fund has beaten every other unit trust on the market.”

Attention to detail

A good example of the difference between Biccard’s viewpoint and the market is the mining sector. This is where attention to macro-economic detail comes into play. “We now have a lot of platinum, and the market's view is that electric vehicles will rule the world, so there will be no more use for platinum in combustion engines,” he explains.” We've done all the work on that, and although there is indeed a massive move towards electric vehicles, we can't see the whole world rushing to use electric vehicles all at once. As a result, even under a very successful adoption of electric vehicles, we still see the demand for platinum. And because there isn't enough platinum around, we still see a deficit.

“In other words, even though electric vehicles don’t need platinum, we have done all the work on what electric vehicles actually mean in terms of supply and demand, and we still find platinum very attractive. Even with the trend going against us, there is still a big opportunity to make money, because the shares have fallen 95% from the all-time high.

“Another historical example is that over the last 16 years, we have made a lot of money on Sappi. Eight years ago, you might have said that there's a business that's dead in the water, but the shares have gone up seven or eight times because we bought it cheap enough. There too, the trend was against us, but we still made a lot of money.”

This macro-economic perspective has informed the fund’s positioning.

“Our positioning has been the same for the past four years and it started working in the last 18 months. The positioning is 20% gold, 25% platinum and 30% offshore, with the remainder, in mid-cap shares which undervalued in smaller cap shares. We don’t really overlap with the index. We have a big overweight in gold and platinum, and then we run an offshore value fund which buys these sorts of shares internationally. But we don't have any of the go-go stocks in South Africa. The one share that has really hurt us is Naspers, which has a massive following index, which we haven’t held for 10 years. You won't see the normal shares like British American Tobacco and Naspers and Aspen and banks, because we don't see any value in it.

“Our top five shares are Impala Platinum, Anglo Plats, Anglo Gold, and African Rainbow Minerals, which probably comprise 50% of the fund. The platinum shares are 90% off their all-time high and Anglo Gold is 70% off its all-time high. African Rainbow is 60% off its all-time high.

Investor stamina

Some investors might be a bit cagey about a fund that underperforms for extended periods only to peak from time to time. What sort of investors does this fund actually suit?

“I think that's a good question. The first thing point is you need a longer time horizon. Investors need to stomach the X years of poor performance because the long-term track record, which is the best in the industry, shows that this is the most lucrative way to run money over the long term. It’s no good if your time horizon is one, two years, even three years, because you could be on the downside of these ideas and not make anything.

“The second point is even during our periods of underperformance generally, we don't lose money for investors. Admittedly, we don't make them anything in markets that are going up strongly; for example, in the last four years, everyone has been buying tech stock and we are in shares doing nothing. So in the four bad years from 2011 to 2015, the fund basically went sideways while other markets went up massively. “If you are worried about how other people are doing, then it is not the fund for you. You have got to be able to say I'm not making any money, but in years two and three I'm going to make a lot of money. If you need the money in the next two or three years, maybe you shouldn't put the money in, because I can't tell you if these ideas will mature in a year or in five years.

The returns are lumpy and the investors need to know that. It’s the nature of the beast.

“We make an excess return because it is uncomfortable to be away from where everyone else is and it is uncomfortable to go through those periods of underperformance. You need a reward for that, and the reward is the excess returns you make out of the long term.”

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Issue 72