This article was first published in the first-quarter 2015 edition of Personal Finance magazine.
A unit trust fund that confines itself to a narrower mandate than its peers and yet out-performs funds in the same sector is often an interesting find. The ClucasGray Future Titans Prescient Fund, managed by Brendon Hubbard, is one such fund.
The fund invests across the asset classes in South African markets without any constraints on its asset-class allocations and, as such, falls in the South African multi-asset flexible collective investment sub-category.
In terms of the PlexCrown Ratings, the ClucasGray fund was the top performer on a risk-adjusted basis in the broad South African multi-asset unit trust sector over periods up to five years to the end of September last year – in other words, it obtained the highest PlexCrown rating out of all the funds in the South African multi-asset flexible, multi-asset high-equity, multi-asset low-equity and multi-asset medium-equity sub-categories.
On straight performance, the fund was the second-best performer in its sub-category over three years and the third-best over five years, with average annual returns of 26.77 percent and 21.63 percent a year respectively to September 30, 2014.
Funds in the multi-asset flexible sub-category, of which there are 77, have a relatively wide mandate. They must invest at least 70 percent of their assets in South Africa. Of the remainder, 25 percent of assets can be invested offshore in countries other than Africa, and five percent can be invested in Africa excluding South Africa.
Multi-asset flexible funds are unconstrained in what asset classes they may invest in – be they equities, bonds, money markets or property – and they aim to maximise total returns (capital and income growth) over the long term.
Many of the 77 funds in the South African multi-asset flexible sub-category are the flagship funds of the asset managers they represent, because the sub-category’s relative lack of constraints provides little room for excuses and offers a platform for a manager’s best ideas. Fund managers cannot blame poor bond markets, poor equity markets or, to a lesser extent, the poor performance of a particular geographic region, for the under-performance of their funds.
The sub-category is also often the sector of choice for hedge fund managers wanting to create a retail presence. These managers must observe the rules of the Collective Investment Schemes Control Act when managing unit trust funds. They may not, for example, borrow money to invest, and their investments must comply with the requirements and limits set in terms of the Act.
One of the benefits of having an experienced hedge fund manager managing a flexible unit trust fund is that hedge fund managers tend to have an absolute-return focus: they aim to beat an inflation-based target regardless of what is happening in investment markets.
Fund managers who focus on performance relative to a benchmark or that of their peers will happily announce that their fund was the best in the sub-category even when all of the funds in the sub-category produced a negative average return.
Retirement funds may not invest in South African multi-asset flexible funds, because they are considered too risky. As a result, the total value of the sector is only about R39 billion, according to ProfileData, compared with the South African multi-asset high-equity category (the most popular sub-category among retirement funds), which has total assets of about R470 billion.
Investors in funds in the multi-asset flexible sub-category tend have money to invest over and above what they have in a regulated retirement fund and want to add a little risk to their total portfolio.
Most funds in the sub-category invest freely across the range of asset classes. There are, however, a few exceptions. The Marriott Property Equity Fund, for example, has a self-imposed mandate to invest in JSE-listed property shares, property trusts and property loan stock, and the Anchor BCI Flexible Fund focuses on interest-bearing investments, listed property and preference shares.
The ClucasGray Future Titans Prescient Fund has chosen to narrow the focus of its equity component to small- and mid-cap shares on the JSE.
Hubbard explains the fund’s mandate choice and investment philosophy.
Personal Finance: Why did you choose the narrower equity mandate for the fund?
Hubbard: We decided to narrow the focus of the equity component to small- and mid-cap shares, or those that fall outside the top 40 companies on the JSE, because these shares tend to be under-researched. With this focus, we increased the chances that a smaller firm like ours would be able to add value through our selection of equities. This gives us a potential competitive advantage.
Also, we run a high-conviction fund and we believe that the single most important ingredient of any business is its people, and more particularly, the management team. We believe that if we go out of our way to find those good managers, we will identify good businesses.
What is the risk of this leading to the fund under-performing, if, for example, investment conditions favour larger companies?
You have to look at the factors that have led to favourable conditions for particular companies. If there is a weak rand, for example, and rand-hedge companies (which have offshore earnings or operations) are doing well, we would look for the small and medium shares that do well in a weakening rand environment. One of our favoured shares right now, for example, is Nampak, a packaging company that derives about 40 percent of its profits from selling products to other African countries. It is not only the larger companies that can be positioned to take advantage of particular conditions, in this case a weak rand- trading environment.
It is a commonly held view that investing in small caps is risky, and however much research you do, there is always the chance of one or two of your carefully researched companies blowing up unexpectedly. How do avoid these landmines?
We take a long-term view of our investments; we take a long time to do thorough research. If we find one good company a year, we are happy. When we identify and invest in our chosen companies, our approach is similar to that of a private equity firm: we buy a stake in the business with the intention of holding on until certain events unlock value, or predicted trading conditions come to pass, enhancing the value of the company concerned. We generally devise a three- to five-year battle plan; we slowly accumulate shares, and then, when the anticipated situation has been realised, slowly sell them at our targeted exit price.
Mid- and small-cap shares are historically more volatile than their large-cap counterparts. The mandate of this fund requires us to hold other asset classes, which provide the necessary counterfoil to small-cap volatility and enable us to pursue those opportunities that will deliver long-term inflation-beating growth.
It must be very frustrating if you are forced to sell your carefully selected companies to pay out investors. How do you protect your investments during volatile markets when some of your clients want to sell their units?
As a multi-asset fund, the fund holds other asset classes that are generally easier to sell than equities. Second, we have learnt over the years not to take money from institutional fund-of-funds investors. These investors can play havoc with carefully laid plans if they decide to exit your fund quickly. We at ClucasGray have a close relationship with our individual clients and are always available to answer questions. Individual clients are less likely to act in concert and this helps to build the sustainability of the fund.
As of October 2014, the top three shares held by the fund were Hulamin, Sirius Real Estate and Interwaste. Why do you like these companies?
Hulamin is an aluminium rolling operation based in Pietermaritzburg, and it is set to benefit from the recently introduced aluminium beverage can. The cans will be manufactured by Nampak, with SABMiller buying over 90 percent of cans produced. The significant growth in 440ml can demand has been driven by young people not wanting to share their beers, as has been the norm in the past with a glass quart bottle. In addition, shebeen owners prefer cans to bottles, because empty glass bottles can be dangerous, whereas empty aluminium cans are harmless.
Hulamin benefits from the huge increase of scrap aluminium in circulation, which lowers their input costs. Aluminium is easily recycled, with a low melting point and resultant lower energy costs. Currently, 80 percent of Hulamin’s production is exported, with Tesla Motors in California its biggest export customer.
Sirius Real Estate, a German company listed on the JSE, is the leading operator of branded business parks, which provide flexible workspace to the German small- and medium-enterprise market. In 2007, the firm raised money and acquired 30 business parks. Since then, the managers have worked hard to unify the network of business parks under the Sirius brand, upgrading and reconfiguring the space where necessary. You must remember that property values in the developed world took a big knock during the financial crisis, and many property companies subsequently traded at discounts of as much as 30 percent.
Sirius listed on the JSE on December 5, 2014, with South Africans owning over 40 percent of the shares on issue.
Interwaste is an interesting company. It was simply a trucking company that moved into waste management. After eight years of waiting for a licence from provincial authorities, the company finally got permission to open a waste facility in Midrand. Interwaste have six environmental impact assessments under way to open further waste facilities in Southern Africa, which will add enormous value to the potential scale of the company. The licence for the Midrand dumpsite was the last to be issued in Gauteng, effectively providing Interwaste with an advantage over its competitors.
Where do you find your investment ideas?
I read. Everything that I can get hold of. I am a voracious reader of newspapers and specialist publications, both local and foreign. The ClucasGray team consists of 12 investment professionals with 230 years of financial markets experience, which provides great support to the fund.
How would you describe your investment philosophy?
We follow the “growth at a reasonable price” philosophy. This is a blend of buying the value (lower price relative to earnings or valuation) and the growth (consistent earnings growth above those of the market) prospects of a company, as indicated by the price of the security and our own fundamental analysis. We believe that growth is a product of earnings and price.
The fund has a good risk profile on a wide range of risk measurements. Do you manage your fund so as to reflect well on these scores?
No. The fund is a high conviction fund and our focus is on the companies in which we invest.
A quick analysis of the weightings of the fund’s underlying equity and property holdings shows that it is very rare for you to have an exposure to any particular entity higher than five percent. Is this how you control risk?
Yes, that is deliberate, as a fund that is mandated to invest in small- and mid-cap shares, it would be foolish to have too large a weighting, regardless of the conviction level, because of the high volatility of mid and small caps. We are mindful of the liquidity constraints of these shares, and with some companies we take a longer-term approach, as you would with private equity.
The fund’s sector and asset allocation have changed fairly dramatically over the past two years. Why is that?
Nothing should be read into these changes. Macro-economic changes and trends do not inform our portfolio construction. The fund’s assets are simply invested where we see good opportunities.
Your exposure to bonds is very low.
I prefer to invest in the Prescient Yield QuantsPlus Fund, a proxy money market fund, as opposed to cash or bonds. The ClucasGray Future Titans Prescient Fund is primarily invested in property and equity, and the function of holding cash is really just to earn a decent return while keeping the gunpowder dry and ready and available for the moment when property and equity opportunities present themselves.
The fund launched in September 2009 and has comfortably beaten the benchmark (the average return of funds in the multi-asset flexible sub-category). Why, however, did the fund deliver a relatively lean performance about a year after the fund was launched?
The small- and mid-cap equity space is largely driven by news flow, and we do experience periods of relative under-performance. But, as Warren Buffett says, “I’d be a bum on the street with a tin cup if markets were always efficient.”
Your fund has assets under management of R550 million, while the largest fund in this sector, the PSG Flexible Fund, has assets of just over R5.4 billion. Given your success over the past five years, are you disappointed that the fund has not become more popular?
Not at all. Our fund is not really scalable in the way that some funds in the sector are because of the focus on small- and medium-cap companies. We have turned away money from some of the institutional fund-of-fund managers. We are actually thinking of closing the fund to new investments when we get to R600 million.
The fund has an unusual fee structure. Please explain it.
We give investors a choice of fee structures. They can either pay a fixed rate of 1.3 percent plus VAT, which works out to 1.48 percent, or they can choose the performance fee structure, which is 0.5 percent fixed plus 10 percent of performance above six percent, the upper limit of the South African Reserve Bank’s target inflation band.
You are a military historian in your spare time. Are there any aspects of this interest that help you to understand the demands of fund management better?
Portfolio management is much like planning a battle. The fund manager must know the macro-economic environment, as a general would know the terrain and weather. Both parties must plan and have strategies that take advantage of opportunities. Importantly, you forward plan what events are likely to happen in the future and you position the portfolio to benefit from this.