Stable Fund – Outlook for the year ahead

Dave Foord is the CIO of Foord Asset Management and one of four multi-counsellor Portfolio Manager for the Nedgroup Investments Stable Fund. The Fund has been shooting the lights out for over ten years and is currently number one over one year and, since its inception 13 years ago, is also number one relative to peers over that time period. In a Q&A format, Dave discusses his prospects for the current global environment, the outlook for the year ahead and what impact that might have on financial markets.

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What are the key components of the Foord investment approach that enabled the team to produce the Fund’s category topping numbers?
It’s a combination of looking forward to anticipate where the risks are and manage them as well as looking at what sectors are likely to produce the better returns. A lot of the extra performance we got in 2020 came from experience and understanding what was happening.

What helped/hindered the portfolio’s performance in 2020?
Property and SA equity, which make up about 10% of the portfolio, did not contribute and in fact contributed a small negative at -1.4% and -1.3%, so the weighting in those areas was correct. We had a good contribution from SA Bonds where we have a 40% allocation, in particular from the R186. We’ve been saying for some time that the R186 is offering value because there is not too much credit risk on the SA Treasury because it’s shorter dated and they are offering CPI plus 5%. The lower interest rates will, with time, bring the R186 down the yield curve, so you get the waterfall effect with a likely return of about 9% and a possible return of over 10%. With the Fund trying to get CPI plus 4%, locking in over 5% for about 36% of the Fund looked like a good thing to do. With interest rates coming down in 2020, the R186 gave us 15.9%, so over the 3-year period has given us 12.5%, which is well above the benchmark. The lesson in that is that you need to take a longer-term view on asset class choices, which we’ve been doing for the last 3 or more years with investors only getting their reward for that now.

At the end of 2020, the Rand was very strong and we have a very weak Rand bias in our portfolio. Despite the stronger than expected Rand, the portfolio did particularly well. The reason for this is that we had a strong view on global equities, which contributed about 8% of the return. We’ve learned that we need to pay up for quality stocks even if the price is above what we intended to pay. This thinking has been encouraged by low interest rates, which means that cap rates need to be higher. If you have a 2% US 10-year treasury, then the equity markets should be on 50 PE if the upside from growth is equal to the risk of not making the earnings. Obviously the risk becomes a lot more the higher the market goes. While this is an extreme view, it does reinforce the fact that market PE’s of 25 and 30 are actually too cheap. But, we followed that theme and paid up for shares that would previously have got away from us.

With so many people buying ETFs and index funds, the large cap stocks are not that expensive, but are being pushed, which is leaving a gap for the less followed stocks that are actually cheaper relative to the rest of the market. We’ve been finding quite a few stocks, which are giving us great returns and that’s where our alpha came from in 2020. But, we did miss a few things. We put hedges on, which cost us about $50 million. This money was not wasted because it enabled us to hold onto the stocks rather than going into cash to protect the portfolio. If we hadn’t spent the $50 million, our returns would have been a lot higher. Our areas of success have been where we’ve got stocks in tech, lens, sensor and photo companies and also some micro stocks in the biotech space where we’ve been getting 2-3 times for our investment in a short space of time.

Our main compounders, which have done well for us are Roche and Nestle. Stocks that we did buy and where we are now on round 2 include Microsoft and Google. We have a nice balance in the portfolio. I’m very excited about what’s happening in the global equity fund. We did well in materials, 3-4 baggers in gold stocks, silver, copper and lithium stocks. Another theme we’ve been playing is agriculture. We think this sector is big for the future and we’ve got about four stocks in that space, which are not only performing well, but we expect to continue to perform well.

We’ve already got 2.5% alpha for the Fund in January this year and I’m really excited about the stocks we hold. We have nice diversification in good quality companies that we want to hold for quite some time and which we’ll get good returns from.

What are your thoughts on the evolution of Covid over the last few months, the impending introduction of vaccines and were your biotech holdings influenced by the pandemic?
The pandemic has been a lot worse than we originally expected both in deaths and duration. The impact of the government’s stupidity and short sightedness, making huge decisions, which are collapsing little businesses that can’t come back has been significant. I think the cure has been worse than the disease. It’s uncertain how long the pandemic will last and how effective the vaccine will be. So do we take advantage of it? We have Johnson & Johnson and Aspen in the portfolio, but the amount of money they are likely to be allowed or able to make from distributing or making the vaccines won’t be material to their earnings. We looked at Mediclinic who operate in the Middle East, Switzerland and SA. If they go flat out and get huge market share for the vaccine, the impact on their share price will only be about 2%.

It’s far more important to work out the bigger changes in the world resulting from Covid. In our view a lot of change was already underway and a lot of change was needed. We were in some of the biotech stocks before Covid and were going for the stocks which assist rather than stocks that have a blockbuster drug that may or may not work. We’ve therefore been going for stocks that facilitate the transport, storage etc. of drugs, which has served us really well.

Continued polarisation is one trend that is nowhere more evident than what we’ve seen in the US. Are there any other region or country specific events in 2021 that you’re keeping an eye on or that investors should be aware of?
I’m a great worrier and investors should always be worried. I don’t think events in the US were purely related to Trump and will continue in different ways. China is definitely becoming more emboldened in some ways and that is something to be concerned about. The biggest thing is inflation. Inflation hasn’t come through yet and it may still come through. We have a democratic president coming though and he’s putting in the old guard so your inner circle are all socialist democrats in the establishment. Janet Yellen and Treasury is something you need to watch. I expect her to encourage the politicians to spend and worry about paying the money back later. That trend is a big concern for me. Initially, it’s going to be good for the markets but later it’s going to be bad.

Value vs growth performance divergence
Value has been getting a bad rap even though it’ been doing pretty well. Value indices are not value indices as we understand value. Value is buying a great company in terms of future earnings at a good price. The so called value indices aren’t actually made up of stocks that we would call value, but the market sees them and they continue to underperform because they are bad stocks. It’s a clear example of misguidance and people not paying attention to what’s in the indices.

The outlook for local and global equities
Locally, we’ve got a cyclical run happening on the materials side, which we haven’t taken full advantage of. On the SA Inc side it’s difficult to understand where the earnings are going to be going forward. In terms of valuations, I don’t know if the market is cheap or expensive because I don’t know what level of confidence to put on the earnings five years out. Global equities, in terms of the framework I mentioned earlier of low interest rates for longer, are cheap and are the main game in town in terms of asset allocation. But, that comes with a rider. We’ve seen lots of down drafts in the past and we’re like to see another one especially with a new term president. With Yellen and Powell, there’s just too much money coming into that market so valuations are cheap. You need to pick your punches because certain industries are dinosaur industries and you can’t just buy anything and everything. It’s very much a stock pickers market going forward, which is what we love. It won’t be an easy ride and 2020 was a warning that things are going to be volatile in 2021.

Portfolio positioning 
We still want the majority of the 60% of the portfolio that we can’t put in equities to be in short-dated SA bonds (35%). The R186’s are getting near the end of their use by time and we need to go further out the yield curve and play in the waterfall and we need to get that timing right. On the international side, we’ve got 28% in global equities and about 8% in local equities. We want to be in those global equities, but want to start putting hedges on because there could be some major down drafts. We started buying puts last week. We have a small hedge on local and international equities at the moment, but will expand that by the end of January.

Emerging markets haven’t been able to shore up their economies like the major economies have and will take longer to recover. The Chinese economy is still doing well and we expect good growth from that sphere. We don’t want to be in bonds in case inflation comes in and the interest rates jump so we have return-free risk in global bonds. We’re very selective and careful when it comes to SA property. We have about 13% in cash in case there’s a disconnect in the market and something sells off and becomes cheap as we saw in our own bonds in March last year. The lesson of investing is that when you’ve got cash and no one else has you can get bargains.

Inflation and interest rates in South Africa
Inflation locally is going to be pushed up by food prices. Agriculture prices around the world are moving up, which will push up some numbers on short-term inflation and could have a greater knock-on effect than in previous times. I think the SARB should cut interest rates by 50bps, but think they will do nothing.

Stable Fund vs universe of ‘stable funds’
We’re very proud of the fact that we’re the number one stable fund and have outperformed both the low equity and flexible income fund peer group. The big enemy is inflation and that’s why the benchmark is CPI plus 4. And we’ve achieved this after fees and in a period with lower interest rates and poor equity markets. There is competition out there in other sectors. The Stable Fund is outperforming flexible income funds, which you would expect given that flexible income funds can only put 30% in equities compared to our allocation of 40%. We would expect relative outperformance in those two sectors to continue to hold.

Some final insights
More and more we want to be green and look after the planet and fully support the drive in ESG analysis. In the past, it’s been better to make the extra money, but increasingly we’re getting to the stage where the future returns from the coal and oil industries will not be that good. We’re moving to the point where we actually don’t want to be in them, partly for the benefit of the planet and because it will be better for our investors in the future. The French oil company Total is soon going to be a very green business and is another lesson that you can’t put things in boxes and expect the label to be accurate.