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A two stock investment strategy

14 February 2012 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

Imagine if you could reduce your share selection strategy to consider just two types of companies. We discovered this “keep it simple stupid” technique at a recent presentation by PSG Asset Management. The company has used its share picking prowess to eme

We discussed the group’s five-step share picking methodology in a previous newsletter, but it is worth repeating here. The first step is to adopt a patient, value-based approach. This ensures that companies are only purchased when offering a deep discount to their intrinsic value… In layman’s terms the group likes getting R2 in value for every R1 invested. Step two is to be contrarian. A contrarian investor looks for opportunities that go against the grain of the current market trend. Essentially fund managers will be active buyers when the markets are falling sharply, and reduce shareholdings when they rise. PSG Asset Managers illustrates this technique by comparing cash holdings in a particular fund to market valuations, as measured by the market price-to-earnings (PE) ratio. The graph clearly shows lower cash holdings in the fund as market valuations drop (falling market).

Compounding return on the menu

Steps three through five are more philosophical. Three is to make sure you understand the company you are investing in – four, to challenge your investment thesis frequently – and five, to learn from your mistakes. With the basics out of the way we can take a more detailed look at the two share universes this value fund manager “fishes” in.

In their 1 February 2012 presentation, titled Managing Money in an Uncertain World, PSG Asset Management identified the first pool of shares as Phenomenal Compounders. “A Compounder generates progressively more free cash flow which is used for dividends, reinvestment in the company or share buybacks,” observed Paul Bosman, a fund manager at the group. He said that South Africa was an incubator for this type of company due to its historic isolation (due to Apartheid-busting sanctions), geographic location (at the southern tip of Africa) and abundance of monopolies and oligopolies. He offered up a number of shares that exhibit phenomenal growth performances thanks to their free cash flow and return on capital over time.

South Africa’s clothing retailers are among the most attractive Compounders on offer. Companies such as Truworths (JSE: TRU) and Mr Price (JSE: MPC) expose shareholders to a rapidly growing stream of cash. The former boasts a 32% compound annual growth rate and the latter a staggering 35%! A similar situation exhibits in the private healthcare space where the likes of Netcare (JSE: NTC), Life Heatlhcare (JSE: LHG) and Medi-Clinic (JSE: MDC) produce consistent return on capital going back many years. “There are many opportunities to invest in local companies that offer consistent rapid growth,” concluded Bosman. The trick is not to overpay for these shares – and not to fall in love with them!

Taking advantage of mean reversion

The second pool of shares was identified by Shaun le Roux, manager of the PSG Equity Fund, as Mean Reverters. FAnews likes to think of these shares as having fallen on hard times, but ready to recover when economic growth picks up. But Le Roux has a better description: “These are generally lower quality businesses where the margin of safety more than compensates for this – we want to buy companies worth a rand for 50 cents.” He singled out Anglo American (JSE: AGL) as one such company.

“Anglo today is very different to Anglo 10-years ago,” said Le Roux. The group has plans to be in the lowest half of the cost curve in the seven metal categories it operates in. So – for example – they aim to have 65% of their copper produced in the lower half of the cost curve by 2015. “This is very important to us in terms of the quality of the asset – and a good reflection of where management is going strategically,” he said. The key success factor is to buy the asset at a sensible price. PSG has been buying the share at a price-to-book ratio of just 1.35 times, indicating the share is trading at just two thirds of its historic value. In conclusion: “We are quite confident that Anglo will exceed its cost of capital, which means there’s quite a lot of upside!”

Le Roux said there were two forces at play on the global economic stage. On the one hand investors must consider the excessive debt situation dominating the developed world. On the other they must be cognisant of the cheap money on offer due to governments’ accommodative monetary policy. Central banks are quite happy to add liquidity to the financial markets when required. Some of the heat has gone out of the markets in recent months and it looks like the investment return battle lines will be drawn between defensive and cyclical stocks over the next couple of years. PSG Asset Management’s equity fund managers will adopt a wait-and-see approach through 2012. They expect to sit on slightly higher levels of cash and watch carefully for opportunities to scoop up local and offshore “blue chip” shares at below intrinsic value.

Editor’s thoughts: PSG Asset Management introduces a number of key concepts for equity investing. Most important among these is to invest for the long-term and to assess new opportunities from both a return and value perspective. Do you pay much attention to fund manager philosophy before selecting equity funds for your clients? Please add your comment below, or send it to

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