• Covid-19 stalls global economy and causes indiscriminate sell-off.
• Our portfolios suffer given pro-growth positioning coming into 2020.
• Valuations and trajectory of virus support the addition of risk.

We consult our previous commentary when putting quarterlies together. This helps to frame our current thinking, to see how our views have evolved, and to communicate those changes to you. But scanning our Q4 2019 commentary now, it reads like it was written in a different century.

The quarter began brightly, with global growth indicators picking up across the board. Our thesis of a strong global consumer forcing manufacturers to restock global supply chains looked intact. Then news began to seep into our digital feeds of a contagious virus born in an exotic food market within a little-known Chinese city.

The realisation that no country would be spared infection, and that containment efforts would severely hamper growth, began to take hold in the collective psyche. And then fear cranked up exponentially, manifesting as indiscriminate selling across the global financial market.

To make matters worse, developed market equities – which heavily influence the asset class – entered 2020 with excessive valuations after a powerful run in 2019. That run was premised on an expectation that 2020 earnings would be strong. If you want a market crash, the simple recipe is elevated valuations and an evaporation of earnings.

We say the selling was indiscriminate because even assets that had valuation support – swaths of domestic and other emerging market assets – got crushed. In hindsight none of this is surprising given the magnitude of the global economic shutdown we’re experiencing, demonstrated in our first chart.

Source: Bloomberg, March 2020

The illustration above shows that China’s industrial production (think manufacturing output) has fallen back to the same level seen in 2014, wiping out 6-years of expansion. A contraction of this magnitude in the world’s second largest (and fastest growing) economy is testament to how dangerous the Chinese authorities perceived Covid-19 to be.

As we pen this quarterly in our new world, the central banks that can ‘afford’ to have pledged unfathomable amounts of money to try and float their economies across the abyss they currently face. This may have provided some sort of floor in asset prices for now, but volatility remains because no one knows how long this virus will remain a threat to economic activity.

When you’re positioned for one outcome and the exact opposite scenario unfolds then performance is unfortunately going to suffer.

Our analysis of the macroeconomic environment plays a large role in our portfolio construction. We will get those calls wrong from time to time. That is why we emphasise having a valuation underpin for every investment we make – if our macro view is wrong, we have valuation support to limit downside.

But when selling is indiscriminate and furious, valuation, on a relative or absolute basis, doesn’t provide protection. Nowhere is this dynamic more evident than in the behaviour of emerging market bonds during the recent depths of the crisis.

With real yields superior to anything in the developed market and inflation pressures collapsing, they still sold off aggressively. This while their developed market counterparts saw their yields compress further into nothing territory.

Our multi asset funds held a material portion of long duration SA government bonds going into the crisis. The yield curve steepened sharply – illustrated in the chart below – capital losses resulting.

Source: INet, Obsidian Capital, March 2020

The equity we held in our portfolios was also domiciled predominantly in emerging markets; these are the assets that generally perform best when global manufacturing re-accelerates, our view entering the new year.

We acknowledged that earnings growth from our domestic consumer facing businesses looked worrisome even before the crisis hit and therefore preferred resources exposure on our local market. But with global growth collapsing on the back of theCovid-19 containment efforts, commodity prices that support our resource plays also jumped off a cliff.

In the main, our equity exposure was spread across South Africa, Russia, and Mexico. All three markets collapsed during the quarter, despite their relatively attractive valuation metrics when compared to developed market equity.

To illustrate how expensive the US market was after 2019, consider the following chart which plots the valuation of the S&P 500 using price/dividends (in red) and our economic indicator (in blue). This is part of the reason we preferred emerging market equity.

Source: INet, Obsidian Capital, March 2020

But in having the majority of our offshore component domiciled in emerging, rather than the likes of the S&P 500, we didn’t benefit from the 20% weakness of the rand against the US dollar.

It was a horrible quarter for us, and we’ve had plenty time to reflect on our performance and whether we could have done things differently. This is an ongoing introspection. The two questions we’d ask ourselves (if we were outside investors) are as follows:

1. Why didn’t you use your smaller size to move quickly and reduce equity exposure when news of the Covid-19 broke?

Naturally, we’ll be the first to admit that we underestimated the measures governments would take to contain the virus. Global economic lock-downs were not on our radar. Many of the assets we held in our portfolios had attractive valuation on their side, and as they fell, that valuation only looked better. At the same time, we took the stance that this was not a crisis that would result in long-term economic damage that would take years to recover from, but rather a sharp burst of short-term pain. And although we were taking perhaps more than our share of the pain given our very pro-growth positioning, locking in those losses by selling felt like fear-driven capitulation, something that experience has taught us not to do.

2. Why did your hedge funds not do a better job of protecting capital?

Our multi asset hedge fund has never had a negative calendar year return in its 12-year history. It’ll be a miraculous recovery if we’re to keep that record in place. The past success of this fund has come from the relative outperformance of our long versus short positions over time, the secret sauce for any mentionable hedge fund. But when a fund has a long bias, which ours did at the time given our pro-growth view, and everything falls in a heap, the concept and effectiveness of relative performance disappears. Under this environment, the gearing – owning more of the long positions funded by your short selling – worked against us.

There is a diversity of views within our team about how Covid-19 progresses and what the economic implications will be. Both these questions are impossible to get certainty on. But in working with what we have, building a mosaic using the concept we refer to as multiple confirmations, we are starting to get consensus on a few key decisions.

The first is that our next move is likely to be an increasing of risk across our portfolios. A large chunk of global equity now exhibits very attractive valuations. And we know that markets are forward looking, and that unlocking that value will happen once the market gets visibility, rather than evidence, of recovering economic activity.

With China seemingly over its first wave of infections, and Italy and Spain showing promising signs that they’re reaching their respective peaks, we are not expecting a scenario where the lock-downs cause the global economy to enter a period of prolonged malaise. This thesis is bolstered by the very substantial stimulus packages that many developed nations have cobbled together.

The second piece of the puzzle is which equity will we look to add. It’s easy to make the case that the cheapest businesses can be found on our doorstep. Using Standard Bank as a proxy for our domestic shares (see the next chart) the value is clear.

Source: INet, Obsidian Capital, March 2020

On a PE basis (light-blue dotted line) Standard Bank was last this cheap in 1985 (Rubicon speech). The divergence of the black line (actual share price) from the fair value (solid red line) can be interpreted as follows: the market believes that Standard Bank’s earnings/dividends will contract by between 40-50% by the next financial year end. For a host of reasons, we think the magnitude of this predicted contraction is overdone. There is a large margin of safety baked in, and when the market realises this, these shares will re-rate.

Does this mean we’re ready to fill our boots with SA Inc. type equity and ride off into the sunset with them? Our answer is a resounding no. The re-rating opportunity in these shares is real and can provide excellent returns. But once that gap between the red and the black line closes, things get less exciting very quickly.

The fair value (in red) can only rise – which then allows for share price appreciation – if Standard Bank can generate good earnings growth. This looks highly unlikely in the short-medium term given the challenges our economy is going to face when it emerges from this crisis. So, we will look to take advantage of this short-term dynamic, but it’s unlikely that SA Inc. shares become foundational, buy-and-hold investments in our portfolios.

As the global economy starts to tick again, we do see a place for domestic resource counters in our portfolios, particularly from their current depressed levels. It’s important to highlight at this juncture that any business that has excessive debt is not being entertained by the team. The SA property sector looks particularly vulnerable in this regard.

With the above in mind, most of the equity we’d look to add will likely be domiciled offshore. For the first time in a while, US equity is in our sights. To be sure, the greenback still looks expensive to us (the main reason we’ve had limited exposure to the S&P 500 since 2016) and we still believe there’s a chance that it weakens once the Covid-19 fear starts to dissipate. But combine the obvious value with the growth potential (after the earnings base reset) and the risk of a weakening dollar neutralising equity returns from the S&P 500 is diluted.

The third and final asset class we have a measure of comfort with is SA bonds. We have been calling for Moody’s to downgrade us to junk to remove the uncertainty that was stopping investors from moving into this very attractive asset class. We’ve spoken about our parallels with Brazil before; if our yields behave anything like theirs post downgrade, it’ll be a good investment from here.

Source: INet, Obsidian Capital, March 2020

The first quarter of 2020 will be one we remember forever. And as gut-wrenching as it has been, it’s also gifted us with an invaluable learning opportunity that will make us stronger in the long-run.
Our funds have suffered a material blow and, as our own capital is invested in these funds, we share the anxiety you must rightfully be experiencing.

To be sure, we don’t expect the world to go back to the way it was before. Much has changed. But we do believe that the meltdown we have seen across a broad spectrum of financial assets is providing an enticing entry point for investors willing to look forward 6-12 months. We are proponents of such a philosophy and are readying ourselves for that eventuality.

We have always preached an open door policy, so please, if you have any questions or concerns, don’t hesitate to contact us. Lastly, and perhaps most importantly, we hope that you and your loved ones remain safe during these challenging times.