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Clyde Rossouw explains how his Investec Opportunity Fund is beating the market

Money manager Clyde Rossouw supports the theory that investors improve with age. Having run the Investec Opportunity unit trust for over a decade, he has been enjoying a purple patch over the past couple years, comfortably beating the market – and competitors.

In this fascinating interview with Biznews.com’s Alec Hogg, he explains why his fund is still staying away from resources stocks (unpacking why Assore is the obvious one exception) and giving the rationale behind the apparently contradictory view of his heavy offshore holdings but also owning a chunk of South African bonds.

Joining Alec Hogg from Cape Town is Clyde Rossouw the portfolio manager of the Investec Opportunity Fund. Clyde, it’s good to talk to you again after quite some time. We’ve got a history that goes back a long way but from your perspective how did you get into money management in the first place?

Hello Alec. Yes, I was always fascinated more by the investment side of things and ironically at the time I remember applying for a job in the investment department at Sanlam and they let me in, not on the basis of my background but actually more on the basis of the fact that I could do a bit of stats. I transferred to the investment department on that side and I just kind of built a career from there.

Then you took over the Opportunity Fund, which has a proud record.

Yes, we’ve been pleased by what we’ve seen in terms of performance over, not just three or five years, but through at least a couple of market cycles, which I think that at the end of the day it is quite important when one considers long term investment management because there are cycles and there are changes in market environments.

I think one has to be able to at least navigate those different waters, with a reasonable degree of clarity.

Many people forget that actually it was the place where Piet Viljoen started.

Yes, that’s true. Piet ran the fund from 1997 until 2002, so yes I’d like to think that the fund has definitely moved on in terms of its positioning and certainly it’s done quite well, I think, in the last 12 or 13 years. Yes, we’ve been pleased with the performance over that period.

Read also: Piet Viljoen – the ultimate value investor: Darkest before dawn?

That’s been under your guidance that period. How long have you been running it for Clyde?

Correct, yes, so I’ve run it since February 2003, so this will be my 13th year.

You seem to be really hitting your straps lately. You had a fabulous 2015, and so far 2016 has been pretty good as well. Why would that be? Are conditions just maybe suiting you?

I think when you think about what’s required to outperform in the market conditions I think there are two things. The first one is you do require differentiated views, which might be stating the obvious, but you also have to be correct. Often what people do is they take differentiated views and they turn out to be wrong.

Then the investment outcome is not great, so I think fortunately for us 2015 was a year where we didn’t back the consensus positioning that we saw in the market and a lot of the things that we believed in came through very strongly. Our offshore holdings, which the Rand was weak but I think we did very well in our offshore equities as well.

Then certainly, so far this year it’s been a choppy environment but, on the SA side a lot of our stock hauls have come through very strongly, so I think getting a couple of differentiated positions right worked really well for us.

I think it is also fair to say that we didn’t have a great 2014, where we were a little bit disappointed by our performance but it’s always good to make up, more so in tough markets then possibly giving away in difficult circumstances. That’s always been the way we’ve run the fund over the last 13 years.

Yes but the big call last year, and I guess for any value investor, has been to stay away from resources. Why did you make or how did you actually rationalise that to yourself?

Well look, we did quite a lot of work in the resource sector in the last couple of years, and we’ve gone through all of the companies trying to make, because we’re obviously interested in stocks where the market unilaterally failed. I think the key call for us was that we felt that people overestimated the degree to which resource prices and in fact the margins for many of these businesses would normalise.

I think many managers out there had the view that margins would normalise to some sort of high level, which was kind of the average of what we saw during the boom period, where China was rapidly industrialising from about 2002 to 2007.

We didn’t agree with that. We thought that the end game would be far lower levels of profitability and because I think we spotted that, even thought the share prices were depressed, we still felt that in many cases there was more downside.

I think, to be fair, we were proven correct. We looked at all the companies but we didn’t want to invest anywhere barring one or two holdings, within the resource space. I think that has definitely helped us and avoiding the diversified mining companies, BHP Billiton, and Anglo American I think was definitely the right strategy.

Read also: After decade’s underperformance, Value Investing coming back, led by banks

What about now?

I think for us, if you look at this year, there’s been a significant turnaround in terms of expectations with regards to market and many of those diversified mining companies have certainly seen their share price improve. I think in many cases, well ahead of what the actual underlying fundamentals have improved by.

If you look at commodity price uplift – it’s not spectacular. We think that, ironically given the performance we’ve seen in the short term, many of these shares are ahead of themselves. I still would be a little bit cautious around making huge allocations to, particularly the diversified mining sector.

I think you’re better off picking your weightings on individual commodity counters and trying to make a bit of sense as to where the money can be made on that fund. I think for us the key issue here is that balance sheets in the resource sector are still not in great shape.

A lot of the companies have a lot of debt and currently the strategy is to get everybody to reduce their costs but if everybody in the industry is reducing costs, then there’s no reason for commodity prices to increase because they just tend to drift lower to that percentile of cost.

For us, the bottom up strategy, what makes sense for individual companies does not necessarily suit the aggregate industry. In general terms we still think that these commodity markets are very well supplied. There’s no evidence that we’ve run out of these precious commodities, which I think was the view in 2006/2007.

There’s always exceptions aren’t there and Des Sacco’s company, Assore is quite a big holding in your portfolio. Tell us about that.

Yes, it’s true. I think for us we’ve had a very good journey with that investment over many, many years and its added cumulatively even during the downturn of 2013/2014 significantly, to our client’s portfolios, over a 13 year period. We’ve always liked the business because its family controlled. Their CAPS allocation decisions have been very good.

They typically don’t care very much about short term investor’s interests, where most of the mining sector is motivated by satisfying analysts that want certain things to happen. They’ve resolute their long term strategy. When they’ve built new projects, for example when they expanded into iron ore, it was well timed, it was below cost, and it was below budget.

More recently they’ve divested of some of the Ferrochrome Smelters that they had in South Africa because electricity costs are too high.

They’ve moved those to Malaysia. That again was a good strategy. They’ve signed some good power contracts from that fund, so we just like the way the business is managed for the long term, and I think it’s somewhat of a rarity.

Then most importantly, it’s a business that’s always had what we call a lazy balance sheet or surplus cash and when you have cash on your balance sheet and times are tough, you have the strategic optionality of not having to work for the bankers or for the bond markets. You can make the correct decisions to build your business in long term, and I think those are a few of the things that impressed us about the company.

Read also: Investec AM heads $670m Emerging Africa Infrastructure Fund

I guess also if you sell those shares, because they are fairly tightly held, it might not be that easy to get a position back.

Yes, that’s also true. We’ve been a consistent owner of about five to 6% of the company through many years and obviously it’s a relative opportunity. If we could find an equivalent asset, which is similarly run on equivalent valuation, clearly we would enter into the logic of possibly owning that but so far, we’ve struggled to find as good a business as this one elsewhere.

It is called the Opportunity Fund, so you have to have those very opportunities wherever you can find them. What has been interesting Clyde is the way that you have invested abroad, not just directly where you’ve got a big slug of foreign investments, but also in the South African shares that you hold in your portfolio or JSE listed shares in your portfolio. I’m thinking there of BAT, Medi Clinic, which is now big overseas, of course Steinhoff as well. What kind of thinking is shaping that strategy?

I think there’s a couple of things firstly, we’ve been concerned the last couple of years about the slowing trend rate of growth in the South African economy and the number of issues that have conspired against us. Firstly, commodity (albeit in markets) are generally not very good to provide a background for growth in South Africa, and we’ve seen overall growth declining.

We’ve seen significant Rand weakness and those sorts of key factors have caused us some concern around where we’re going to get long term earnings growth from. With that in mind we’ve wanted to have an increased exposure to offshore assets.

By regulation 28, which ultimately governs the positioning of the Opportunity Fund, we can’t hold more than 25% in foreign assets so to supplement that exposure we thought it would be useful to own some of the offshore earning businesses, so British American Tobacco is clearly one of the key businesses on that front.

The MediClinic’s journey has been spectacular, where they’ve built themselves up from being essentially a domestic only heath care company to having operations in Dubai, Switzerland and a minority holding or an associate in the UK now as well, so we’ve been impressed by that.

Similarly, Steinhoff’s journey has been to focus on expanding their retail footprint to, and largely in Europe and yes, these businesses we’ve journeyed with and we like their strategy that they’ve followed over time and it’s kind of given us some of the exposure to additional opportunities and a higher growth rate in what we possibly would have had, had we just focussed our portfolio on some of the cheaper, but obviously more locally or into businesses.

Read also: Jessica Spira: Catapulting MediClinic into FTSE 100 – the deals which transformed it

On the other hand it sounds a little contradictory that you also like South African Bonds.

Yes, it’s true. Our bond holding is important to understand because remember when you run a multi asset fund you have to have different assets that perform differently at different times.

One of the mistakes that we think people make, when they construct a balanced fund, but have different assets. They want all those assets to perform at the same time, so when things go well they go really well but when they go badly they go really badly. For us, we’ve had big holdings both in physical gold and with Gold ETFs, we’ve held physical platinum and we have bonds.

These assets behave very differently to the rest of our portfolio. Particularly on SA Bonds, well if you look at the opportunity today, the yields on the long end are nine-and-a-half percent roughly. In our minds we know that there’s nothing good to be said about South Africa’s credit rating. We know we are facing an imminent downgrade to sub-investment grade but we think that’s in the price. We’ve had significant Rand weakness.

We’ve got this downgrade, which is priced in, and we’ve got a peak and inflation, which is probably six months away. With that in mind, people are ignoring the good news and you are currently getting just over 2% real, based on the current inflation numbers, out of owning, let’s say bonds where we think that the equity markets, broadly in South Africa are probably only priced to give you 1% dividend inflation, so twice the real return.

Half the risk, with potentially some optionality if things get better, so I kind of think it’s a differentiated asset and if nothing happens you at least get nine-and-a-half percent per year, which is not a bad return to start with.

Do you go for the coupon or do you go for inflation linked bonds?

We’ve got a mix. We have more nominal conventional government bonds, which are fairly liquid but we do have some inflation linkers. I think inflation linked bonds at the moment have been doing quite well because of their rising in trend and in headline inflation but, as I said, when you get close to the peak of that by the end of this year, beginning of next year. I think you’d probably want to reallocate.

Now, we’ve also had some fun together at the Berkshire Hathaway Annual General Meeting. I know that you’re a staunch follower of Warren Buffett. He is not that keen on banks but many value investors around the world are starting to CAP into banks again. Are you seeing them as an opportunity?

No, for us I think strategically the business model of banking has become incredibly difficult, so if you look at either the pre 2007 year, where banks had license to print money. They could entertain at almost any level of leverage within their balance sheet. They’re required to hold very low levels of capital.

I think the rules have changes, so subsequent to the financial crisis the Regulator is making life incredibly tough for banks, particularly in Europe and in the US but ultimately in South Africa as well. Its making life very difficult for them to produce at exceptional returns, so what we’ve seen happen to the banking sector is leverage has come down.

Margins have been eroding and capital has become a key feature. We don’t think those issues are going to go away any time soon, so the best way to think about banks is that they’re probably going to become more akin to being regulatory utilities, rather than being full profit organisations, in our mind, and that does, somewhat diminish the value proposition.

We know the shares trade in expensively, both on price earnings, multiples priced to books dividend yield, so they conceptually interesting but I do think one needs to bear in mind the regulatory environment is not going to get easy any time soon. Therefore, your upside is probably somewhat limited.

Treat them like utilities and maybe look for special situations?

That would be our view, so many cases, like I said, in South Africa if you look at some of the domestic focussed banks like Absa, which is being sold off by its parent. There is potentially a special situation developing although we think it’s going to be tough for Absa to grow their earnings into 2016, given the adverse economic environment.

We think you may still want to wait a little bit longer and just see where earnings rebase, certainly for the next 12 to 18 months. Slow growth, higher inflation, and higher interest rates – I know that not all of those combinations is negative, necessarily but I think people underestimate the degree to which the bad debt environment is going to deteriorate and we have some concerns around that in the short term. Yes, I think sort of going into 2018 maybe, but a little bit more careful in the short term.

To summarise then, you’re still staying away from resources, which some of your competitors have been climbing into and continue to do so. You remain well invested outside of South Africa because of the concern of the economic picture but also looking at South African listed stocks that can give you this offshore taste, and maybe all the bad news or too much bad news is in South African Bonds.

Yes, I think that’s fair. The one share that we do own in the resource space, well it’s technically not a resource stock anymore, is Sasol, so that is one stock where we do agree that the valuation is too low and the market probably is too sceptical about the ability to pull off a large capital project in the US, where they’re building an ethane cracker.

Now, of course the jury is out on that one but I think that there at least you are being paid a reasonable amount while you wait for that to come on board. In the mean time oil prices looks like probably, a slightly better performing commodity than most, given the supply and demand on that it makes it look a little bit more attractive for energy, so there we would make an exception.

Read also: Investec defies weak rand. Profits up, shares down.

Clyde, just to close off with, an interesting stock that you have in your portfolio, Santam, the short term insurer. We know around the world that because of negative interest rates or very low interest rates at best that the reinsurance and the insurance companies have lost a lot of their shine. Is the Santam holding a reflection of maybe higher interest rates in South Africa, where your float becomes more valuable? Just explain to us why you like this one.

Yes absolutely. I think that’s a very important point that you touch on. You’re right. Most short term insurance companies, typically, don’t make underwriting profits. In other words, they don’t make any money out of their basic insurance business. Their claims pretty much match their premium income.

Whereas in South Africa Santam has typically always made a decent underwriting margin and in fact, it’s been superior to the tradition industry over many years. We know that some of the newer players in the direct insurance space have typically also done quite well, so if you think about an OUTsurance.

If you look at a business with a great track record of underwriting margins, you’re right, they are absolutely pedantic about managing that float, so they focus on the cash generation of the business.

Then the other thing, which has also been impressive, is the way they’ve actually ran their net asset value, so the shareholder funds, typically it’s been incredibly well managed, with a great CAP allocation. If you look at the returns that this business has generated. They’ve typically been around the mid-30, which for a financial services business is incredible.

We think people have underestimated the quality of the asset and if you look at their track record over many years, they’ve paid many special dividends. They still probably have a little bit too much capital.

At the moment there’s probably room for another special dividend again, so we find it incredibly cash generative and you do get quite a lot of that cash they’ve generated back in, in the form of dividends. We think the combination is attractive.

You’re still loving your job Clyde I can hear that from the way we’re talking about these individual stocks. Tap dancing to work, as Buffett would put it.

Yes Alec, I think that clearly investment environments are ever changing. I’ve been in the markets for long enough, and sometimes I still feel like… I mean, I learn every day and for me, I can’t think of anything better to do than what I’m doing at the moment. Yes, for people hoping to get rid of me, I don’t think that’s going to happen any time soon.

Clyde Rossouw is the portfolio manager of the Investec Opportunity Fund.

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