How a focus on valuations helps to drive long-term returns

Anet Ahern, CEO at PSG Asset Management

Ask any shopper if they prefer to buy an item at a premium, fair value or a discount, and you’d expect they’d (logically) opt for the discounted price. But in markets, investors don’t behave in a similar way. At times, investors are willing to pay a premium for shares, and at other times seem reluctant to invest, even when the discounts are steep. The graph below shows price to book ratio for a selection of markets, with the most popular markets at the highest valuations on this measure.

In short, while there are sometimes good reasons for markdowns, markets often misprice assets – and we believe this offers opportunities to patient investors. Just like in the real world, paying less to acquire a quality asset makes sense. But unlike with real-world consumer goods, we aim to buy shares that increase in value over time, rather than depreciate due to wear and tear!

As bottom-up investors, we believe there are advantages to be had by buying quality companies at a discount to fair value. That is why our 3M investment process is grounded in thorough research and an in-depth understanding of the return drivers of each company we invest in. We understand that many quality companies are adept at creating returns even under harsh conditions. In fact, our process, which includes a focus on the moat (barriers to entry and business model) and quality of management, helps us identify businesses that can compete and take market share from competitors, even if opportunities in their existing markets are slim. This is especially relevant in the local market, where business conditions are notoriously tough. However, from a broader perspective, our 3M process also means we are fundamentally ‘valuation cognisant’. In our view, ‘investing at any cost’ thinking is more likely to result in long-term disappointment than a more value-conscious approach.

How a bottom-up approach helps us to look beyond prevailing narratives

Given poor fundamentals and overwhelmingly negative sentiment about the SA market, many would be tempted to write off local investments altogether. And yet, the prevailing narrative obscures the fact that economic growth (good or bad) does not equate directly to company performance. What might hold true at the aggregate level, does not always hold true at the individual company level, as management can be skilled at exploiting as yet untapped opportunities, increasing efficiencies, or taking market share from weaker rivals. Conversely, in an abundant growth environment, companies may channel funds into less productive areas, that do not translate into bigger company profits. Who would have thought that on a
1-year view, SA industrials would lead the pack with a return of 32.0% (for the period ended 30 April 2023), even ahead of the return earned by global equities (in rand) at 19.3%?

Selected outperforming industrial shares in PSG Asset Management portfolios

The point is that there are dangers to assuming a low-growth environment equals a dearth of investment opportunities, or conversely that every ‘high growth’ investment will pay off. We have recently made similar arguments about investing in the Japanese market: despite the well-worn story of economic malaise, we have been able to identify a few selected investment opportunities which we believe will serve our clients well into the future. By extension, we believe that investors wanting to enter markets that are expensively valued, should always apply a due level of caution that they are not paying a premium for assets that may be due for a reversion closer to the mean, therefore putting their investments on the backfoot from a long-term return perspective.

We focus on each company’s business model, and ensure that we buy into companies at a decent ‘margin of safety’ (discount) that allows us to improve the odds of our clients’ long-term investment success. By doing so, we believe we are able to deliver on our clients’ need for real wealth generation in the long term. The success of our long-term strategy was recently affirmed when PSG Asset Management was named as the South African Manager of the Year at this year’s Raging Bull awards.