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Can Your Investment Ride Out The Storm?

It pays to choose your fund manager wisely. Ask the right questions and expect clear answers.

One of the most common mistakes that investors make is to choose a fund manager purely on the grounds of good returns. Even a long track record by an award-winning fund can hide a multitude of sins. While you need to take risk to produce inflation-beating returns, you want to be sure that your fund manager takes no undue risk, invests in a sound mix of high-quality (sometimes lower-yielding) counters and lower-quality (but higher-yielding) counters, and that you are sufficiently compensated for the risk in your portfolio.

The proverbial cyclone does not hit the investment landscape every year, but when it does and the debris settles, it soon becomes clear who invested in quality and who didn’t.

It starts with the right advice  

Time in the market is important, particularly where an equity or property investment is concerned. When the equity market corrects, very few share prices remain unscathed. Defensive portfolios normally experience a lower-than-market-average drop in value, but it could take several months – even years – for an investor who invested just before a crash to get his money back, let alone show a real return. Investors who don’t have the time to mend their sails should rather choose the safe harbour of more conservative investments.

A good financial adviser will steer a conservative, short-term investor away from higher-risk, higher-return investments, which require patience and a longer-term commitment to realise their full value. Such a recommendation is by no means a reflection on the quality of the portfolio. The expected volatility (or market risk) of an equity portfolio is simply too high for, say, a two-year investment term. A sound investment is therefore first and foremost an appropriate investment – one that is right for the specific investor’s needs and investment horizon.

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Diversification for a robust portfolio 

Diversification is the backbone of a portfolio, irrespective of whether you are investing in equity, property or fixed interest. Should one issuer or company collapse, there should be enough other counters in your portfolio to sustain investment performance.

Chris Hamman, Head of Fixed Interest at Sanlam Investments, believes that fixed interest portfolios should not have more than 10% exposure to any counterparty, unless that party is one of the four big banks or debt guaranteed by the SA government, and no more than 5% exposure to any one SA company. ‘You want a balance of high- and low-quality counters.’

Quality in the fixed interest space 

In the fixed interest space, the same issuer can issue several instruments, all with different levels of quality, for example, senior debt, subordinated debt, mezzanine debt, preference shares and other types of shares.

Should an issuer fail, as happened with African Bank recently, the holders of senior debt are first in line for capital repayments. Chris points out that senior unsecured debt is of the highest quality because it gives the claimant a claim over the entire balance sheet of the company.

Chris recommends that investors make sure that:

They understand where the money to service the interest and repay the interest is coming from

Their fund managers are accurately and transparently marking to market (valuating) the investment and able to explain their methodology in  simple terms

The fund manager takes no undue credit concentration risk, that is, the portfolio is well-diversified

They have no undue exposure to low-quality instruments.

A high-quality fixed-interest portfolio will be one where the individual counterparties have strong balance sheets and where there is very little concentration risk. One needs to distinguish between necessary and unnecessary risk. ‘We do not believe that you are compensated for concentration risk and we therefore minimise this type of (unnecessary) risk,’ Chris stresses, ‘but clients with a higher risk appetite or who need growth, will need a (lower quality) higher credit risk portfolio.’ Credit risk is a function of the strength of the balance sheets of the counterparties to whom you lend.

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Is sticking to the Collective Investment Schemes Control Act (Cisca) guidelines good enough? 

It’s possible to lose a significant amount of money while obeying the Cisca guidelines for unit trust investments. Chris therefore imposes stricter rules for managing credit concentration risk. He believes that the framework his team follows, if applied correctly, should minimise the need to write off more value than the excess performance relative to benchmark over a one- to two-year period, after a single credit event.

The problem with credit ratings

Credit rating agencies provide credit ratings in return for a fee, which means they are inherently conflicted. They are also often hesitant to announce a downgrade, as that may precipitate a crisis. An important downgrade therefore sometimes happens only after a credit event, which doesn’t help fund managers much. Sanlam Investments therefore uses its own credit analysts and its own internal credit ratings, and only depends on external ratings agencies when clients specifically request this.

High-quality equity portfolios 

As far as equity investments are concerned, Patrice Rassou, Head of Equities at Sanlam Investments, and his team assess the following to determine the quality of a company:

• The past financial returns of the company, using as much financial history as they can obtain

• The track record of company management with respect to capital allocation

• The level of corporate governance within the company, by interacting with the boards of the companies they invest in.

Investing in people with integrity

As far as his criteria for company management is concerned, Patrice favours shrewd CEOs who will exit value-destroying lines of business early and allocate capital only to value-accretive opportunities.

‘We look for managers who, like us, focus on the long term and who do not take shortcuts to achieve their goals. We first and foremost make sure that we invest our clients’ money in companies run by people with integrity. We appreciate management who are open and prepared to interact with our team, sometimes three or four times a year. Experience has taught me that good managers are very hands-on and they focus on running their company – not on their share price.’

Lessons from the past

After more than two decades in financial services, Patrice can recall many poignant failures of SA companies. He points out, ‘It is no surprise that African Bank, Unifer and Saambou were all victims of exuberant lending in the unsecured market, which led to bad debts and eventually the bank’s inability to service its liabilities. This shows that industries focused on growth often assume too much risk when the environment is benign, only to pay the price when economic growth slows.’

Value investors welcome varying quality

The JSE has been on a bull run since 2008 and the share prices of quality-listed companies have been bid up by investors looking for growth opportunities. Value managers, such as Sanlam Investments, invest in high-quality companies if their share prices are offering value, but also invest in lower-quality stocks if there is a sufficient margin of safety built into the purchase price. Often such opportunities are ignored by market participants who prefer to invest in the fad of the moment.

Patrice reminds investors that resource companies are often seen as low quality because they are cyclical, require high capex and are dependent on commodity prices. ‘So, after the global financial crisis, we were able to accumulate a large position in resources stocks when they were heavily sold off.’

With the constant stress testing of portfolios and clear expectation management by fund managers and intermediaries, the next storm should bring no surprises.

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