This recession, do not be afraid

South Africa’s financial and wealth advisers and financial planners are being encouraged to replace their fears about current market uncertainty with optimism for long-term equity return prospects. One of South Africa’s largest asset managers argues that plenty of opportunities will present as today’s market distortions unwind. “The benefit of being in the market for a long time is that you experience periods of significant fear and pessimism and learn to identify the opportunities that such periods create,” said Shaun le Roux, portfolio manager at PSG Asset Management, who has managed the PSG Equity Fund for more than 20-years

The unwound future

The 2022 PSG Asset Management Winter Outlook presentation was bullish on return prospects for a number of carefully selected domestic and offshore companies. Le Roux explained: “We are incredibly bullish right now; we have a track record of looking through the fear and uncertainty and taking a long-term view”. He suggested that global financial market performances have been plagued by various aberrations or distortions going back more than a decade, and that asset classes are primed to respond as these distortions unwind. More importantly, the best thing you can do to deliver on your clients’ return objectives, is to ensure that they are invested in the asset classes, and opportunities within these classes, that align with this ‘unwound’ future. 

The presentation coincided with the emergence of a new investment focus or short-term theme, namely that the rising interest rates on the back of 40-year high global inflation could result in recession. “The headlines we are reading at the moment are all about recession; we are being warned that global recession is on the cards whether it is in Europe or the United States,” said Le Roux. One need only look to global stock market returns to appreciate the growing fear over developed market recession and stagflation, with US markets delivering their worst first half performance in over 50 years. And tour clients are already responding… According to Le Roux, “It is pretty bleak out there, and [we hear that your clients] are asking you to get them out of the markets, into cash”. 

He observed that your clients’ concerns were evident among global fund managers too, with many institutional asset managers reportedly the most bearish they have been since the 2008-9 Global Financial Crisis (GFC). Their response, as expected, has been to position their portfolios overweight cash and underweight equities. The hope these fund managers hold is to time their return to the equity markets to coincide with the point of greatest pessimism, which must surely be just around the corner. The trick, said Le Roux, is to reflect on asset allocation and share selection based on a three-, five- or 10-year view rather than obsessing over what might happen over the next month or two. 

Four market distortions to be aware of

The long-term potential in various asset classes is closely correlated with four distortionary factors, and more specifically, how these factors resolve or unwind. The first distortionary factor was free money; a consequence of the massive sums of cash pumped into financial institutions post-GFC, and the monetary support given to businesses and households during the 2020-21 COVID-19 pandemic. “The cost of capital to businesses has been incredibly low and the environment for taking risk in certain asset classes has been very, very favourable; [free money] has pushed the prices of certain assets to record levels,” said Le Roux. Among the consequences of the resulting sky-high valuation of tech-heavy growth stocks, was that passive equity investors ended up chasing yesterday’s winners. 

The second financial market distortion relates to how allocators of capital are responding to environmental, social and governance (ESG) concerns. Le Roux observed that although ESG was embedded in PSG’s processes, “the way in which ESG has been adopted in recent years, borders on insanity”. His was a brave and refreshing comment on the ongoing pressure being brought on asset managers, banks and insurers to drop everything to do with fossil fuels and other out-of-favour sectors regardless of the long-term consequences. Factor three centres on the multi-year and still ongoing flight of investor capital from South Africa and other emerging markets. “Some of the [capital flight] trends that we have observed in recent years have bordered on panic, giving rise to very interesting developments on asset prices,” Le Roux said. 

Misdirected fiscal interventions

Misdirected fiscal interventions were singled out as the fourth factor causing a distortionary effect on financial markets. As the globe struggled with COVID-19, most governments opted to dish out cash to struggling businesses and citizens… This stimulus affected financial markets differently to, for example, the post-Second World War stimulus which was entirely directed towards infrastructure. “The direct impact [of these distortions] is that risk has been mispriced, and people have been incentivised to take risk in areas of the market that are the beneficiaries of these distortions,” said Le Roux. Thus, by paying cash directly to its citizenry, Western governments played a direct role in both the excessive market valuations towards end-November 2021 and today’s inflation bubble. 

Of greater concern is that this abundant cheap capital has found its way to new, tech-heavy growth stocks at the expense of the old, productive parts of the economy. The question becomes: How can you use this distortionary backdrop to position a portfolio, and to select shares, that will deliver return over the long-term? PSG is excited because of the significant valuation differences between the still expensive beneficiaries of these financial market distortions, and the “as cheap as they ever get” companies that struggled due to the distortions. “If you are prepared to differentiate; to look outside the winners of the past; to accept some of the inevitable volatility that comes with the unwind of these distortions; and be very firmly focused on paying the right price … then we think that big things are going to happen,” noted Le Roux. 

Moats, management and margin

Distortions or not, PSG Asset Management is sticking to its 3M share selection methodology, seeking out companies that have a protective moat against competitors; have exceptional management; and offer shareholders a significant margin of safety. “The current market conditions are very conducive to finding under-appreciated quality that arises when [an unexpected crisis] suppresses profits in a number of sectors, industries and companies [forcing the market to] takes a pessimistic view of companies’ future profitability,” concluded Le Roux, adding that the focus should be on long-term profitability rather than what a company might achieve in the next six- to 12-months. 

Writer’s thoughts:
Today’s article focused on some of the distortions that are affecting financial market valuations circa 2022; but the PSG Asset Management presentation also spent some time on the price-to-earnings (PE) and dividend yield ‘attractiveness’ of many local and offshore shares. What do you prefer from an asset manager presentation? Would you rather they spoke about themes and trends; individual company valuations; or both? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.