At PSG Asset Management, we construct our portfolios using a bottom-up approach

We do not attempt to forecast political or economic events, because even if we could do this accurately, we wouldn’t have conviction about the ultimate impact of these events on the market.

Acquiring quality assets at the right price

Over the past 18 months we have written extensively about the divergence in valuations we have observed between cyclical and defensive companies.

In many cases, valuations of companies whose earnings are (perceived to be) more cyclical or uncertain than their defensive counterparts, have been trading at relative multi-decade lows, providing us with excellent investment opportunities. At the same time, those companies that had performed well over the last few years, or whose earnings streams are of a more defensive nature, had been significantly overvalued.

With US bond yields inflecting during mid-2016, coupled with an expected increase in global growth and inflation, we have witnessed a significant recovery in the share prices of companies that had previously underperformed, such as the portfolio’s global bank holdings or more cyclical industrial companies.

Some of the best investments are made in times of distress

To provide some context, JP Morgan, one of the world’s largest and oldest banks with a corporate history dating back to 1799 has been a long-term, high-conviction holding in the portfolio. As recently as 2012, after the ‘London whale’ incident, the company’s share price was $31 and it was trading at a price to earnings (P/E) ratio of 6.5 times and a price to tangible book ratio of 0.94. Fast forward to March 2017 and after recovering by 63% from its 12-month low, its share price traded at $94, at a P/E ratio of 15 times and a price to tangible book ratio of 1.8. The fact that the share price of JP Morgan trebled from a point of deep pessimism in a space of five years, illustrates that some of the best investments are made in times of distress. A similar tale can be told about the portfolio’s other global bank holdings and industrial counters such as Union Pacific, Colfax and Glencore which appreciated significantly ahead of the market over the past year.

Investing with a margin of safety

You are by now aware of our 3M investment philosophy, with the third M referring to a margin of safety. A rising share price in isolation is not necessarily an indicator of a reduced margin of safety. Our emphasis is always on the price we pay compared to the intrinsic value of the underlying security. We have, however, taken the opportunity to increase our allocation to cash. Market sentiment, especially in the US, continues to be one of greed. This has resulted in a reduced margin of safety in several holdings. We need to stress that all the stocks we mention above continue to trade well below intrinsic value despite recent share price moves.

Increased cash allocation The portfolio’s cash holding increased to 30% at the end of March 2017. This is an increase from 24% in cash at the end of 2016 and 8% during the February 2016 lows, where the portfolio had 92% of its assets invested in equities. We are willing to hold cash because it effectively expands our opportunity set from risk assets at today’s prices to the prices that will become available for risk assets in the future.

Cyclical companies continue to offer value

We continue to hold the view that many high quality, defensive companies are trading at valuations that put investors' capital at risk or, at best, offer poor prospects of positive returns. Several more cyclically-exposed companies continue to offer good value. But, in most cases, their margin of safety and prospective returns are lower than they were 12 months ago.

Global opportunities exist

Long-term investors with PSG Asset Management know that we tend to find our best investment opportunities in times when fear or uncertainty permeate the marketplace. While global investors have been welcoming the increase in global growth recently, we think it is coupled with an elevated level of complacency given the geopolitical backdrop. In our view, the best hunting grounds for opportunities driven by fear and uncertainty currently exist in the UK - where Brexit-related fears have depressed the valuations of several domestically-focused companies – and among selected emerging market companies, Japanese industrials and in agricultural commodity-producing companies.

We are high-conviction managers and while well-diversified, we tend to have relatively concentrated portfolios. Fortunately, we are still able to find excellent opportunities and Brookfield Asset Management currently leads the charge as the portfolio’s largest position. This company, which dates to 1899 and where management has around $7 billion of personal exposure, remains an outstanding, unique investment opportunity that we expect to compound at well-above-average market rates for many years to come.

While both the short and medium term will likely be characterised by uncertainty, we continue to stick to our 3M process and only invest in opportunities that we believe are likely to deliver attractive risk-adjusted returns.

Current context

Given the backdrop of elevated market valuations, global stocks continued their strong performance during the second quarter, with the MSCI World Index delivering a positive return of 9.43% (11.01% including dividends) year to date. The tech-heavy Nasdaq index outperformed comfortably (+14.67%), while an acceleration in European growth, coupled with a market-friendly election outcome in France and dollar weakness, drove European stocks 15.91% higher. Emerging markets also ended two years of underperformance and returned 18.55% year to date. (All returns quoted in US dollars.)

This does not necessarily mean that all markets and all market sectors had an easy year. Value stocks, which outperformed last year on the back of higher growth, inflation and interest rate expectations post Donald Trump’s election, underperformed the broader market as the likelihood of effective policies to drive US growth diminished significantly. Continued threats of disruption (both perceived and real) by online retailers and lower-cost competitors have also driven the prices of US retailers down by 7% at an index level. In addition, while most emerging markets have seen their currencies and stock markets appreciate considerably this year, countries such as Brazil and South Africa continue to excel at scoring political own goals. Markets in both these countries have underperformed both emerging and global market peers.

Our perspective

We inherently like to buy high-quality companies with attractive growth prospects, at attractive valuations. We do not consider very expensive stocks that are deemed to be defensive as low-risk investment opportunities, and we expect muted long-term performance from such stocks. Rather, we think the risk is lower (and the opportunity better) in quality assets that are currently out of favour, yet offer excellent long-term prospects. This is reflected in the construction of the portfolio.

In fact, the divergence in valuations between the most expensive parts of the markets relative to the cheapest is still as extreme as it was during the dot-com bubble (as shown in the charts below). This warrants caution, but also presents stock-picking opportunities away from the popular crowd.

Portfolio positioning

Our portfolios are constructed from the bottom up and are diversified across regions, industries and currencies. We continue to have strong conviction in our large portfolio holdings, namely Brookfield Asset Management, Cisco Systems, Yahoo Japan and AIA Group. We are also well exposed to some high-quality cyclical companies on low levels of earnings. Finally, while cognisant of the risks, we are finding great opportunities in the United Kingdom, emerging markets and areas such as agricultural commodity producers.

Complacency and significant amounts of greed in some parts of the market have allowed us to reallocate capital out of securities where valuations have approached or exceeded our estimates of intrinsic value, into investment opportunities where fear and uncertainty have driven prices to attractive valuation levels. We have exited or significantly reduced our positions in Apple, Mastercard, Microsoft, Sainsbury’s and J.P. Morgan, while allocating capital to companies such as Discovery (an outstanding global opportunity in our view), The Mosaic Company (the world’s largest potash and phosphate producer) and Babcock International (the UK’s leading defence and engineering outsourcer).

A backdrop of rising asset prices and expensive valuations for the world’s best companies informs our relatively high levels of cash. At the end of June, the PSG Global Flexible Fund had 29% of the fund in cash.

The world remains an uncertain place, with the impacts of US policy changes, balance sheet normalisation by central banks, geopolitical tensions and many other factors, yet unknown. The securities in the fund are trading at a significant margin of safety and we are ready to deploy large amounts of firepower once further investment opportunities that satisfy our strict criteria become available.

- 2016 experienced a strong market rotation from defensives to cyclicals which benefitted the portfolio's performance.
- The average stock on global markets returned 8.2%. (incl. dividends) in US Dollars.
- MSCI emerging markets rose by 11.3% with Brazil (+67%) and Russia (+56%) being standouts.
- High quality defensive equities underperformed but continue to be very expensive.
- Quality cyclical companies performed strongly but are still attractively priced.
- The stocks in the portfolio offer attractive return profiles at current share price levels.

2016 in review

2016 turned out to be very different to the way it started. After one of the worst starts on record, (MSCI World fell by 12% to mid-Feb), global equity indices staged a recovery and returned 8.2% in 2016.
The path was by no means smooth and was heavily influenced by geopolitical events, such as Brexit, Trump and impeachments of multiple presidents. Furthermore, the introduction of fiscal stimulus in Japan is likely a sign of what's to come in other developed nations as the effects of loose monetary policies lose steam.
Even though emerging markets as an asset class outperformed their developed market counterparts, performances within this group were divergent. Brazil and Russia were up 67% and 56% respectively while Turkish stocks declined 8% (all in US dollars).

After a number of years of outperformance, well-loved, high quality defensive companies started what could well be a multi-year underperformance trend. High quality companies which we have previously held in the funds when they could be bought at a margin of safety, such as Unilever (-3.7% total return), Reckitt Benckiser (-7.2%), Nestle (-1.6%) and Roche (-15%) materially underperformed the average company. We have written about our cautious stance on these types of companies in previous commentaries and continue to hold this view today as these staple, bond like equities are expensive in absolute terms and relative to their own histories.

The standout performance in 2016 and especially over the 2nd half of the year came from cyclical stocks with energy, materials and financials delivering strong returns.
Given this backdrop the PSG Global Equity Fund delivered a return of 19% in 2016 (vs MSCI World total return of +8.2%) and 5% in the 4th quarter (vs MSCI World +2%).
In last year's commentary we wrote about some of the fund's detractors where cyclical pressures (which generally do not impact intrinsic values) weighed on earnings and sentiment in the short term. In 2016 most of these names recovered strongly with Glencore, Colfax Corp., Anglo American and Capital One being the fund's top contributors to performance (note: we sold Anglo American in April 2016). The only material detractor was Sainsbury which we continue to view as an extremely attractive and asymmetric investment opportunity and it thus remains one of our highest conviction holdings.

The 4th quarter witnessed some unexpected political events such as the election of Donald Trump and a 'NO' vote in the Italian referendum on constitutional reform. As referred to in our Q3 commentary, as part of our investment process we do not try and forecast uncertain political outcomes and always select stocks in a bottom up fashion based on our 3Ms (Moat, Management, Margin of Safety).

During Q4 of 2016, rising bond yields and inflation expectations after the election of Donald Trump led to an acceleration in the rotation from defensives to cyclicals. This specifically benefitted US banks holdings in the fund (Capital One +22.1%, JPMorgan +30.5% and Wells Fargo +25.5% in the quarter), as well as cyclically exposed companies Glencore (+24.4%), Colfax Corp. (+14.3%) and Union Pacific (+7%). The fund's largest position at the end of Q3, Berkshire Hathaway, returned 12.8% in the quarter and therefore materially contributed to performance.

While fund returns were strong in Q4, detractors to performance included National Grid (-15.7%), Brookfield Asset Management (-5.5%) and US tech stocks Qualcomm (-4%) and Cisco Systems (-3.9%).

Portfolio positioning and outlook

As mentioned above, the 4th quarter saw some sharp upward moves in share prices and over the latter part of the quarter we reduced the funds exposure to global bank holdings after the significant re-rating they enjoyed since the US election. This is because they are now starting to price in both more normalised interest rates and a continued favourable bad debt environment. At a price/book ratio of 1.2 times however, the bank holdings in the fund continue to offer good long term value and account for 13.5% of the fund.

Another notable change in the portfolio is a reduction in the fund's exposure to Berkshire Hathaway, which has been the fund's largest position throughout 2016, as the recent share price increase narrowed its discount to intrinsic value.

Fortunately, stocks across the globe are not perfectly correlated and we continue to find good opportunities to re-deploy profits. We increased the fund's exposure to Brookfield Asset Management, which has been under pressure in the latest yield sell off, even though its exposure to 'real' assets should be beneficial in an environment of higher inflation and bond yields.

Apple is now in the Top 10 as we are increasingly of the view that the company's software platform is lifting barriers to exit, while its cheap valuation and mountain of foreign-held cash should get a boost from lower repatriation taxes and more than offset any potential headwinds from higher tariffs or added supply chain complexities in the Trump era.

We also continued to increase exposure to Yahoo Japan, now the fund's 6th largest position and added Hong Kong listed AIA Group to the portfolio. AIA Group is South East Asia's largest life insurer with a market cap of $69bn and operates in 17 countries across the region. Founded in 1919, the company was spun out of AIG in 2010 and continues to enjoy a long runway of growth. Rising populations, urbanisation and spending power coupled with structurally low social welfare payments and low private cover should continue to provide long term tailwinds to this best in class insurer.

Even though many high quality defensive companies sold off in the 2nd half of the year they continue to trade at expensive valuation multiples and do not offer an adequate margin of safety. The fund therefore has limited exposure to this part of the market.

While the market as a whole is at relatively elevated levels with the MSCI World trading at a PE ratio of 22 times we continue to find good opportunities within the market which should generate attractive returns from current levels. The Price Earnings ratio of the fund of 14.9 times compares well to the market.
We are still encouraged about the outlook from the equity holdings in the fund:
o They are attractively priced relative to history and the market in general;
o They are generally on low levels of earnings;
o Many are on high sustainable dividend or total payout yields;
o They are generally of above-average quality.

While the year ahead will likely continue to be marked by known and unknown (political) uncertainty, we will continue to focus on finding undervalued contrarian opportunities which an unpredictable world will likely present.