Dear Fellow Investor,
In a matter of months, the COVID-19 pandemic has altered the world as we know it. The one common thread about crises is that they create fear, anxiety, panic, and uncertainty. With this in mind, we believe that it is important to keep the lines of communication open to reassure you that we are alive to the risks in front of us and to demonstrate that we are acting in accordance with our stated investment process, in order to protect and grow your capital. In this letter, we would like to articulate our current views on the COVID-19 pandemic, describe the actions we have taken to date, and look at the initial results of our strategy.
The COVID-19 Pandemic
We are not going to go into the clinical details of the virus in this letter, as there are now many sources of publicly available information about this topic. Instead, we will focus more specifically on the manner in which COVID-19 has impacted markets and describe the course of events that led us to the realisation that swift action was required. This is the first time since the Spanish flu, approximately 100 years ago, that the world has faced a pandemic of this nature. Many changes occur in the world over 100 years and as such, neither governments nor fund managers, have a playbook describing how to handle a situation like this. We all had to figure out what to do, largely from scratch.
It is important to recognise that COVID-19 was a mathematics problem before it became a public health problem, due entirely to its rapid exponential growth. Assessing the rate of growth of the virus that occurred in China was an early red flag that COVID-19 had the potential to be a high impact event that could severely affect the health of the world’s population. After identifying this risk in mid-February, our entire team was tasked to conduct as much research as possible to understand the potential impact that COVID-19 may have on healthcare systems, economies, and human behaviour. The pro-active research we performed highlighted that the pandemic was likely to have a much greater impact on human life and the global economy than what world leaders and market participants anticipated at that time. When some Western leaders and media sources dismissed the seriousness of COVID-19 or simply ignored it, our team concluded that cases were likely to rise into the millions and that the world could be facing a true human tragedy with severe economic consequences.
A favourite quote by Howard Marks from Oaktree Capital Management is that “you can’t predict, but you can prepare”. The initial research that we performed led us to conclude that there was a high risk the world would be a very different place for the foreseeable future and this meant that the way we built our portfolios would have to change materially. We crafted a clear plan to act in a manner that was aggressive and decisive to protect our portfolios so that they could withstand short term losses. This course of action meant that we were well-positioned to buy shares we like if market prices happened to fall.
A few key decisions taken over the past six weeks were as follows:
At the outset, we urgently needed to protect the portfolios from the possibility of a severe market sell-off, which seemed increasingly likely to occur as the economic picture became clearer to policymakers and market participants. To facilitate this, we bought more insurance to protect the portfolios than we have ever done previously, in the form of index put options;
It was also imperative to avoid any company with a large amount of debt on its balance sheet. Severe lockdowns that are required to contain the virus means that most businesses are likely to face an immense shock to their revenues, and companies with little or no debt are much more likely to survive this period of stress;
As the sell-off gained momentum, we were buyers of shares. High-quality businesses that have excess cash on their balance sheets are our preferred businesses to own over the longer term and are the safest businesses to own during a recession. These shares are typically very expensive, but during the early phases of the panic the entire market collapsed and there were great opportunities to buy these companies at attractive prices. We also used this sell-off as an opportunity to switch some existing positions into these high-quality businesses, thereby upgrading portfolio quality. We believe these actions have allowed us to reduce the risk in the portfolios while maintaining our ability to generate strong returns when markets eventually bounce back;
While we were buyers of shares generally, we prioritised adding exposure to companies outside of South Africa. The South African government’s response to the crisis has been exceptional to date, and we applaud the leadership for taking aggressive early measures to contain the virus. Despite this, our country entered this crisis with too much government debt and the ability to support the local economy with employee incentives, tax breaks, and low-interest loans will be significantly less than what is possible in more developed countries with stronger financial positions. It will be far more difficult for emerging market economies to bounce back from this shock than it will be for more developed nations;
During periods of market panic, we try to look for shares where there are forced sellers due to excessive leverage or panic in markets. We have taken advantage of two such situations thus far and hope to see more of these opportunities in the weeks and months ahead. Keeping a cool head while others are losing theirs is a vital part of delivering long term outperformance for clients.
There are rare occasions when circumstances change so dramatically that you cannot hold on to pre-existing views. You simply have to accept that the world has changed. As a result of this, we were extremely active in local and global markets during the last 6 weeks of the first quarter. This activity was a combination of implementing market hedges, selling existing positions and replacing them with new positions better suited to the current environment, adding new shorts and taking advantage of opportunistic miss-pricings. We don’t foresee being this active in the long run, but our rapid analysis of the evolving situation and the willingness to drastically alter the portfolios has added tremendous value to the performance of our funds. It shows the benefit of being nimble, and not losing flexibility by having excessive assets under management or bureaucratic decision-making protocols.
In the table below, you can see how our different mandates have performed versus peers and the overall market during Q1 2020. Our team has worked tirelessly to rationally assess the impact of this once in a lifetime event and while there are always things we could have done better or sooner, we are very pleased with the decisions that we have taken, and the speed of our execution. Our actions have resulted in one of our best relative quarters in the past 15 years.
During the last three months, the world has faced a one in a hundred year event, and we are extremely proud of the fact that our Pure Hedge Fund ended the quarter in positive territory, even during this time, highlighting the ability of this fund to preserve capital for investors. The Dynamic Alpha Fund, a close derivative of the Pure Hedge Fund, has also performed admirably during this volatile time.
Our High Growth Fund inherently has more overall market exposure and ended down for the quarter because of this. While we always prefer showing positive returns, this kind of performance is exactly what we would expect, and aim for, in a quarter that was as bad as this. Our goal is to be down substantially less than the market during a market collapse, with the aim to then generate strong performance as things recover. The High Growth Fund outperformed the market by 20% and peers by 7% during this quarter, which we are highly pleased with. The fund has maintained 10% out-performance of the JSE Capped SWIX Index over both 5 and 10 year periods.
We believe that our portfolios are positioned in a manner that reflects a good balance of optimism and caution. We stand ready to take advantage of further market weakness with a very clear plan, a healthy team and a good dose of sober courage. To be clear, we believe that share prices of companies we own are very attractive and offer a great margin of safety. Our portfolio composition is well suited for the current environment, setting the foundation for strong returns for those investors focused on the long term. Answers about the duration of the crisis and the shape of the recovery remain opaque but we continue to read widely and debate these concepts vigorously to calibrate our response. The next 6 to 12 months are likely to remain a volatile time in the markets as the world continues to battle this pandemic, so one shouldn’t expect a smooth trajectory from here. However, for investors sitting on excess cash, we believe this is a good time to deploy that capital in a cautious and measured manner.
Thank you for your continued support. We hope that you and your families are safe and healthy!
Please contact us if you have any questions or comments.
Jacques Conradie, Managing Director & David Fraser, Executive Director
The First Quarter 2020 Investor Letter contains all the information and disclosures as required by the Financial Sector Conduct Authority (FSCA).[/vc_column_text][/vc_column][/vc_row]