Predicting Rain Doesn’t Protect Your capital, Building An Ark Does

It has been a very benign period for global financial markets, something of an endless summer. Every time there has been any threat of rain or stormy weather, one or more central banker has come to the rescue with accommodative words or policy and the clouds have swiftly disappeared. This has made it especially difficult for economic forecasters, but also for value-conscious stock pickers such as ourselves. The sunny skies have resulted in elevated levels of complacency and with it equity valuations.

We are in no position to predict what will bring an end to this golden patch, although the most obvious potential threat is an increase in US interest rates, especially for vulnerable emerging markets such as South Africa. What we can do is make sure that client portfolios have the ability to withstand any future storms. While our portfolios are built from the bottom up, one stock at a time, they are likely to be well protected should we experience more adverse conditions at any stage. Broadly speaking our portfolios are positioned as follows:

• Sizeable cash and preference share balances until valuations improve
• Preference for well-priced global shares over expensive local shares
• Avoidance of shares that are reliant on easy money or
• Avoidance of expensive shares that are a large beneficiary of momentum investors (especially foreigners)
• Limited overlap with the index

While it has not been a good idea to look different to the index for some time, the last few weeks have highlighted that this is not always the case. While one month is of little relevance, we are of the view that the ability of active managers to outperform going forward is significant for those brave enough to look different.

When constructing portfolios we are looking for shares that offer an asymmetrical investment profile. If our thesis is right we will make a lot of money, but if it is not we will not lose any money. Heads we win, tails we don’t lose! The key to this type of an investment profile is usually some combination of the quality of the business and the price at which it is purchased. What is clear is that there is currently a strong link between the generous prices being applied to some businesses, and the generous cost of money (i.e. zero interest rates). A cornerstone of our strategy is not to be overly generous (i.e. skeptical) and to own assets that can withstand a more normal environment.

One way of doing this is to buy companies that have already been through their own storm. Because they have experienced tough times already, it is likely that much of the bad news is already in the price. It is also likely that the weak holders of the company (i.e. short-term focused investors) have already exited, thus providing a more stable long-term investor base.

American Express

A good example of this is American Express. American Express is a great global company, albeit not quite of the same quality as Mastercard or Visa. The company is currently going through its own little storm as they are ending a key partnership with Costco, which, together with a strong dollar, is putting pressure on short-term earnings. This mini- storm has resulted in fairly significant share price weakness in a buoyant overall market. We have been buyers of American Express for appropriate accounts as we believe that the long-term fundamentals remain sound for this business. At a reasonable starting valuation, should management achieve anywhere near their targeted long-term targets of 12-15% growth in earnings and greater than 25% Return on Equity, we are likely to achieve very solid shareholder returns.

Bowler Metcalf

On the local market we have recently purchased shares in relatively unknown Bowler Metcalf for clients. Bowler Metcalf is a niche Cape Town based packaging company. It fits very well into the category of share that we believe offers us an advantage over large institutions who cannot buy it, as it has a market capitalization of less than R700 million. Bowler Metcalf was once an excellent company that generated high returns on capital and shareholder returns followed. In recent years it lost its way by getting involved in the extremely competitive beverage business (Bowler’s Quality Beverages owns the Jive brand which has done reasonably well in the Cape, but less so in Gauteng). This, together with intense competition in packaging, has resulted in dismal returns for shareholders.

Share Price of Bowler Metcalf over the last 5 Years

Last year Bowler Metcalf announced their intention to sell the beverages business and merge it with another beverage business (SoftBev), in which Bowler Metcalf will have a 43% interest. This transaction has resulted in a cleaner business and what we believe is now an asymmetrical investment opportunity.

The investment thesis can be summarised as follows:

• The niche packaging business has renewed focus
• Management are conservative, focused and large co-shareholders
• The balance sheet is very strong with over 15% of our initial purchase price in net cash
• The share is just too cheap – 8 PE on relatively low earnings, which is perhaps overstated by cash and an underperforming beverage business
• Starting dividend yield of nearly 5%
• Free option on any success in the newly merged beverage entity, which management has stated they would ultimately like to list

We have made a long-term investment in Bowler Metcalf as we believe that over our investment horizon (5-7 years) it is very likely to generate significant returns for shareholders. We do not know when these returns will be realised, but we are very comfortable that the likelihood of losing money in this investment is very low. Again, heads we win, tails we don’t lose.

Summary

We have no idea when the balmy conditions will end, but we do know that this cycle is now extended and that a disciplined approach to capital allocation is required. As custodians of our clients’ capital we sleep well at night knowing that should we at any stage experience a market storm, we may get wet, but we will not drown!