Responsible Investing Hypocrisy

Socially responsible investing (SRI) continues to gather momentum in the investment industry, and is becoming increasingly popular amongst private investors. The idea is that investors allocate their capital to socially responsible businesses. There is some subjectivity as to what constitutes social responsibility, though ESG scoring (environmental, social, governance) is one widely accepted approach. Consideration can also be given to broad themes such as investing in renewable energy or electric cars for example, or not investing in certain industries such as tobacco, oil & gas, defense, etc.

Since we manage individual portfolios, we engage with our clients individually in this regard, whilst taking an overarching view on the long-term viability of any specific business that we invest in. This is fairly straightforward and for us it makes more sense than taking a one-size-fits-all approach.

But underlying this SRI movement is an incredible hypocrisy. We have an industry that for decades has peddled opaque, complicated, unnecessarily expensive products, riddled with conflicts of interest, now preaching social responsibility to its clients. Many in the investment industry even see SRI as a marketing hook to sell more of the same products:

Fee pressure behind ‘push on ESG’ – FT Adviser (8 Jun 2020)

Firms see embrace of ESG as way to garner more fees – P&I (24 Feb 2020)

There’s also the issue of ESG window dressing to consider – a topic for another day perhaps.


At Bellwood, responsible investing starts at home with the way we treat our clients. There are three major areas where we differentiate ourselves from the rest of the industry: Transparency, cost-effectiveness and alignment of interests. Unless the rest of the industry addresses these issues properly, SRI will be just another marketing smokescreen.

Let’s examine each of these areas and provide practical examples of how they apply in day-to-day business:

Transparency: How many layers are there between you and your money?

For a South African, a typical foreign investment starts with your financial advisor placing your funds on a local platform that invests in a global feeder fund that invests in an offshore fund, very often a fund-of-funds, which invests in several other offshore funds, which finally invest in various stocks, bonds, etc. That puts four or five layers between you and your underlying investments. There are variations on this often featuring asset swaps, endowments, wrappers and other financial products. The result is complexity, lack of transparency, inflexibility, limited access to your funds, and excessive costs.

Here are some questions to ponder: Do you know what your underlying investments are? Do you understand the underlying investment strategy? Does your adviser? Can you speak to the person who actually makes investment decisions? Are you able to access all of your funds anywhere at any time? Do you know what fees you’re paying through all the layers, or do you just see the top layer? Is it necessary to have all these layers between you and your money? Do they add value?

More often than not, many of these layers are sold with only the supposed benefits in mind, and with no consideration of the added costs – call it cost-benefit analysis. When you apply cost-benefit analysis more layers always make sense. It figures.

So how do we do things differently?

For starters we do proper cost-benefit analysis for every potential layer between you and your underlying investments. As a result, we’ve generally found that fewer layers are better. For example: Does it make sense for a private investor to work through a local platform to make a global investment? It limits your investment options significantly, it means that you can only access your funds from South Africa, the platform charges an extra fee, and it automatically adds another layer for the global feeder fund. On the ‘upside’, it means you don’t have to go through the minimal admin of moving your funds offshore, and it provides your adviser with a convenience in terms of reporting, switching funds, charging fees, etc. It really makes more sense for the adviser than the client.

At Bellwood, our clients have their own direct offshore accounts. They can login and view detailed statements of exactly what their underlying holdings are, what transactions/trades have occurred, and so on. They can pick up the phone and speak to or send an email directly to the person who manages their portfolio, who can explain our process in detail (which is also part of our client take-on process), the rationale behind specific investments and transactions, etc. Our clients control access to their own funds without restriction. Our clients pay a management fee to Bellwood, and negligible trading costs to the underlying broker. Simple, transparent, flexible and cost-effective.

 Cost-Effectiveness: Do you know what fees you’re actually paying?

 Transparency and cost-effectiveness go hand-in-hand. Where there are more layers between you and your money, you will be paying more fees, and often you won’t know about them beyond the top layer because the underlying fees are simply lumped into the daily unit trust prices. With the platform-feeder fund setup described above, it’s common-place to pay anything between 3% and 5% per year once you add the fees for each layer, whereas a more transparent solution should result in fees of around 1% p.a. for a reasonably sized investment. These differences in fees are not insignificant! The following graph shows what $1m dollars invested in the S&P 500 20 years ago would be worth now depending on the fee being charged:

So how do investors wind up paying such exorbitant fees? Often it’s just that the numbers sound small – “0.5% p.a. here, 1% there, 2% for the fund, oh the platform only takes 0.25%” – so nobody really thinks about the impact that these fees make over long periods of time. Often investors don’t know – their advisor charges 50-100bps and they think that’s it.

Sometimes it’s a deliberate marketing strategy, usually in the area of supposed tax benefits (or deferral). This is a trap that catches so many investors and advisors alike because they don’t do the math properly! The tax numbers are big (often overstated) and applied once-off, or simply deferred more often than not. The costs are usually smaller numbers compounded over time, and because they’re small they’re often only mentioned in the paperwork. The headline numbers make for an easy sale. The reality is that in most cases, any supposed tax benefits are far outweighed by the additional costs involved, and they usually come with the added bonus of complexity, limited investment options and restricted access to your money.

We’re not saying there isn’t a place for these types of products, but that all too often these products are sold to investors that don’t need them.

At Bellwood, we do the math. Most of the time the math says the costs outweigh the benefits. But this is something we can assess properly on a case-by-case basis, with due consideration for other benefits and drawbacks, rather than touting some convenient headline numbers to sell a product.

Alignment of Interests: Make sure you’re not being sold!

“Show me the incentive and I will show you the outcome.” – Charlie Munger

The reason there is so little transparency and so much unnecessary expense is because the investment industry is riddled with conflicts of interest. The grotesque reality is that wealthy investors are a huge cash cow around which an enormous industry has been built to collectively milk it. So how do you guard against this? Understand the incentives of the people you appoint to manage your investments.

Here are three common practices to avoid:

1) Commission-based advice: Trusted advisers are the gatekeepers of their clients’ wealth. This puts them in a potentially lucrative position, especially when they have different ways to earn additional fees. Many advisers make their money through upfront and referral fees. If they were government officials it would be called bribery, but in the investment management industry it is fully disclosed and therefor legal and accepted practice. Many product providers will pay advisers large upfront or ongoing commissions (taken from their clients’ investments no less, and disclosed – it’s all above-board) for bringing clients their way. Others will add a small fee on top of their own fee to pay the adviser for the referral. Is this of ‘advice’ independent? Is it any wonder that advisers are all for selling more products and putting more layers between clients and their money?

2) The broker-manager: Stockbrokers generally make their money from brokerage and management fees. They are often given discretion to manage client portfolios as they see fit, and they charge a management fee for that, but they also make money every time they trade for the account. While all will profess to be honest and most probably are, the reality is that such a perverse incentive naturally makes honest people see more opportunities to trade than would otherwise be the case. More trading means more brokerage, which is more cost to the client, but more money for the broker. The number that gets put on the white board at the end of each day is brokerage generated – that’s the target. Portfolio performance is secondary. This arrangement is not in the best interests of the client.

3) Performance fees: Asset managers often tout performance fees as a way of aligning their interests with their clients’. The reality is very different. Performance fees are first and foremost an additional way to make more money – an added fee. Second, because they are generally asymmetrical (if we win we make way more money, if we lose we still make our normal fees anyway) they create an incentive for asset managers to take greater risks that have potential for huge payoffs, but also greater risk of loss. This creates a conflict of interest, not alignment.


What makes us different?

So how to we deal with these institutionalized conflicts of interest at Bellwood? We only charge a management fee and nothing else. We don’t accept referral fees, commissions, upfront fees, brokerage fees or charge performance fees. If you make more money, we make more money. If you make less money, we make less money. This incentivizes us to look for cost-effective solutions for our clients that maximize their wealth instead of looking for product providers that give us the best ‘rebate’. It also incentivizes us to focus on our investment process and generate real returns for our clients. We also invest substantial portions of our own wealth alongside our clients.

Simple, transparent, cost-effective and as aligned as it is possible to be with our clients’ interests – these principles should form the foundation of any credible responsible investing initiative.

Our clients and regular readers will recognize that we’ve invested a great deal into our investment process. We trust that you will recognize that as highly as we prize our professional capabilities, we esteem the value of our reputation and integrity even more highly.

“Lose money for the firm, and I will be understanding. Lose a shred of reputation for the firm, and I will be ruthless.” – Warren Buffett

Difficult Investments

NetEnt and Evolution Gaming have been two of our most successful investments to date. Both are Swedish companies operating in the online gaming industry (i.e. casino/betting systems). Since we acquired them through 2018/19, they have returned 120% and 370% respectively. As of March however, the performance of these two stocks couldn’t have been more divergent. Evolution held up well through the first quarter. Even at its lowest point in March it had nearly tripled since our original acquisition. NetEnt on the other hand lost nearly 40% during the first quarter, reaching a new low in March, down more than 50% from where we’d bought it.

Despite the dismal share price performance of NetEnt up to March, our process indicated that the stock was priced for better long-term returns than before. We continued to buy shares through the first quarter (though not quite at the low), making it our second largest holding by the end of March. In the three months between 19 March and 23 June, NetEnt rallied more than 250%. (It became apparent to the market that their US expansion strategy was starting to bear fruit). By May, NetEnt had become the largest position we’ve ever held in our portfolios. As we didn’t deem it expensive we decided to maintain our full exposure.

On 24 June, Evolution Gaming announced an all-stock deal to acquire NetEnt. The deal priced NetEnt at a sizeable premium and sent the shares 30% higher on the day. Because of the large position size, NetEnt has made a significant contribution to our performance during the quarter. NetEnt is a good reminder of how quickly things can change in financial markets. We need to be patient when things don’t immediately go our way, and ready to respond when rapid changes do occur.

Difficult investments require discipline

There are some valuable lessons to be learned from NetEnt about how successful investments can play out over time. On the one hand you can have a company like Evolution. Evolution moved sideways for a little while after we bought it, and then just climbed higher and higher. Evolution has been an ‘easy’ investment in the sense that we’ve only ever experienced success from the get-go.

NetEnt on the other hand has been a difficult investment. After two years of investing more and more into the stock, we found ourselves 50% down. Three months later we’re up 120%. Successful equity investments seldom deliver nice consistent return streams like Evolution. Most successful investments involve long periods of volatility – like NetEnt.

What is interesting about these difficult investments is that we often make more money out of them than the easy ones. We may have ‘only’ made 120% on NetEnt (vs 370% for Evolution), but we actually made more money out of NetEnt than Evolution. How? We kept adding to our position as the price came down and prospective returns increased. To do so required emotional detachment and discipline.

Why is discipline so important? Because without a disciplined investment process, our judgement can easily be clouded by emotion. Emotional investment decisions generally lead investors to buy when stock prices are high, and to sell when stock prices are low.

Ownership leads to emotional bias

An investor’s emotional perception of a stock depends on two things: 1) What the share price has done, and more importantly 2) whether or not he owns it. Take NetEnt as an example. In the two years before we bought it, the share price had dropped by more than 50%. We were excited by the opportunity to buy a good business cheaply. We didn’t feel those losses. But then two years later, we were down 50% on our investment – and we weren’t happy about it. The fundamentals hadn’t really changed, but our emotional perception of them had. Why? Because we owned it. If we’d been driven purely by emotions we might have resisted buying more shares, or worse, thrown in the towel and sold out.

Our natural emotional perception of a stock is highly dependent on whether or not we own it, yet this has no impact on the future of the business. These perceptions shouldn’t enter the equation. Let’s imagine for a moment that we held off buying NetEnt two years ago, and we didn’t own the stock in March. We’d probably have been just as excited, if not more excited about the prospects of this investment than we were two years before. We’d be emotionally detached from the losses suffered by NetEnt investors over the preceding four years. That’s how we needed to think about NetEnt in March, even though we did own it and had suffered through some of those losses.

No investment process can stop us from feeling these emotional biases, but a great investment process needs to override them in our decision making and enforce discipline. We need to make decisions as though we don’t own the stocks. We need to ignore the emotional impact that ownership brings to the table. Every time we look at a stock that we already own, we need to look at it through the same emotionally detached eyes that we had before we bought it. That’s what our process does for us.

Red Flags Analysis: Wirecard, Alibaba

At Bellwood, we follow a quantitative process that ignores popular narratives and makes decisions based on underlying fundamentals like profitability, financial strength and valuation. One of the things that differentiates us from other quants-oriented asset managers is that we subject our portfolios to a more qualitative ‘red flags analysis’ before implementation. So the numbers always tell us why we should buy something. We never buy something for qualitative reasons where the numbers don’t stack up. But while we never buy something that the numbers don’t support, we will at times not buy something that the numbers say we should because of qualitative red flags. For us, the biggest red flags are serious questions around a company’s accounting practices, from credible sources.


We saw a very clear example of this play out in the last quarter. We’ve had Wirecard AG (a German internet payments company) on our watchlist for some time, based purely on the numbers. In May it came onto our shortlist and we discussed Wirecard’s merits: It was profitable, had high growth, a decent valuation, strong cash flows and modest debt – the numbers looked good. So we decided to put it through our red flags analysis. Even a cursory glance through their news history reveals that there have been serious questions around their accounting practices, from credible sources, for some time. As a result, we didn’t invest – an easy decision.

In June, Wirecard announced a $2 billion hole in their accounts. The stock price has since fallen 98%. This type of qualitative red flags analysis is simple and we believe it adds significant value to our process. It’s by no means a guaranteed system, but it does a good job of managing the risk associated with fraud, among other things.


To be clear, we didn’t predict the Wirecard fraud, nor did we know that it would play out so quickly after our discussion. But we did see the potential and we avoided it. There are other examples where there is good reason to be suspicious of a company’s accounting where so far nothing has happened. A good example would be Alibaba. Alibaba has been under a cloud of suspicion since its listing in 2014, though it is making new highs as we speak.

We recognized the ‘numbers’ return potential for Alibaba in 2016, but decided not to invest because of their accounting practices. We would make the same decision today. Time will tell if there is substance to these allegations or not. It’s worth noting that between 2009 and 2018, Wirecard’s share price had increased 50x – but now the price is lower than in 2009.

We sleep easier knowing that the companies we hold aren’t under a cloud of fraud suspicion that might implode at any time. We trust that our clients do too.

Keep Doing the Basics Well

What a quarter it has been. COVID-19 has abruptly reminded us of the many frailties in our global society. The world seems almost paralyzed by the shock. As bad as the reaction in financial markets has been, it pales in comparison to the magnitude of the real economic pain this virus is causing across the globe, not to mention the widespread fear and the impact felt by those who are directly affected by the illness.

Remember that the world is, and always has been, a scary place. This is not the first time something bad has happened, though every crisis has its nuances. It won’t be the last time either. The nature of the risks we face may change over time, but “do not let us begin by exaggerating the novelty of our situation.”CS Lewis.


We entered the first quarter well-positioned for a pullback in the market (generally speaking – we certainly didn’t foresee the COVID-19 crisis) with ~20% in cash and strong balance sheets across our portfolios. These are the two things you want going into a bear market. We are ready to deploy cash as we see the right opportunities to do so.

It’s at times like these that we need to remind ourselves of the basics and keep doing them well. We’ve highlighted 4 principles that we think are especially relevant to a crisis like this:

Basic Principle #1: Be proactive about asset allocation

To the extent that it is possible, keep enough cash aside to meet near-term liabilities and contingent liabilities. You don’t want to be forced to liquidate large portions of your stock portfolio or other assets in the middle of a liquidity crisis. A focus on asset allocation also reduces the urge to engage in speculations about which way the market will head next, which are seldom profitable.

Basic Principle #2: Beware of leverage

The sustainable return of businesses across the board is going to take a knock during this economic crisis, with a few exceptions. A major factor that will determine which of those recover and which don’t is leverage. A strong balance sheet is the most valuable asset a business can have during a crisis. Overleveraged companies are likely to become distressed and may be forced to raise capital at the worst possible time, permanently impairing the equity of existing shareholders. Financially sound businesses are more likely to ride out the storm and recover.

This has always been a major focus in our investment process. Our portfolios are well-positioned in this regard.

Basic Principle #3: Diversify

This crisis has affected the travel industry more than any other, and it seems unlikely that this will recover in a hurry. Grocery production, medical, pharmaceutical and certain technology companies have been relatively unaffected. Some countries have also suffered worse outcomes than others. Geographic and industry diversification remains a cornerstone of financial risk management.

It is important, however, not to buy overvalued or low-quality businesses for the sake of diversification. Diversify within the constraints of quality and valuation.

Our portfolios are well-diversified on both an industry and geographic basis.

Basic Principle #4: Keep your discipline

The reality is that it’s probably too late to address the first 3 points. They needed to be in place before the crisis hit us. Without a doubt the most important thing to do through the crisis is to keep your discipline. Emotional decisions are seldom good decisions, yet emotion drives markets more than anything else in times like these. Stick to your financial plan. We are sticking to our investment process.

Remember that the shares you own are not merely pieces of paper and numbers on a screen. These shares represent ownership of very real businesses providing very real goods and services. These businesses are more substantial and secure than most of our own private businesses, yet because we are made aware of their market value on a tick-by-tick basis, and because we are detached from their reality, we are more inclined to worry about them and react impulsively.

Traditional economics assumes that we are all rational thinkers, therefore more information makes us better decision makers, but this simply isn’t true. Because we are not always rational, more information can feed our irrationality and make us worse decision makers. This is especially true of financial markets where we are constantly bombarded with information and live prices. Perhaps this even applies to the situation we find ourselves in with COVID-19. Don’t let the deluge of negative information distract you from doing the basics well.

When patience doesn’t pay

Last quarter we wrote about active share and how our portfolios are very different from the index. The strength (both relative and absolute) that we saw in September continued through the end of the year, as our portfolios rose 13.1% in aggregate during the last quarter, bringing our total net USD return for 2019 to 23.5%, while holding roughly 15% in cash.

If in the previous quarter we were reminded of the importance of active share, then this quarter we were reminded of something equally important: Equity returns don’t come smoothly! As of end-August our year-to-date return was only 3.5%.

It’s very easy to lose patience with a stock, an investment strategy or even the whole stock market when returns don’t quickly materialize. So how do we counter this? Is it simply a matter of being patient in every instance? Turns out there’s more to it than that.

Lesson #1: Patience doesn’t pay when you invest in a bad business.

Let’s consider a tale of two stocks – Johnson & Johnson (JNJ) and Ford – two American heavyweights. Between 2002 and 2012, JNJ’s share price changed by… 0%. A decade of no real return. The same was true for Ford. Since 2012 JNJ’s share price has more than doubled, while Ford’s has languished for almost another decade. Following those 10 years of no return, how could an investor distinguish between these two companies? The answer is to break down those returns into their components: Sustainable return and revaluation. Sustainable return is a persistent source of return, while revaluation tends to cancel itself out over long periods of time.

Between 2002 and 2012, JNJ’s real sustainable return was 165%, while its valuation had dropped 60%. Ford on the other hand had delivered negative sustainable return, and its valuation had more than doubled over the same period. To an investor looking back at 10 year total returns in 2012, these two stocks would have looked the same. To an investor looking at sustainable returns and valuations, these two stocks couldn’t have been more different. JNJ is a high quality business with a proven track record of profitability and a healthy balance sheet, both of which drive strong sustainable return. Ford has always been the opposite.

Lesson #2: Patience doesn’t pay when you overpay, even for a good business.

So now we know we must invest in good businesses. But 10 years is a very long time to earn nothing from a good business like JNJ. So how can we avoid waiting 10 years to earn a positive return? Don’t overpay! In 2002, JNJ was on a 32x PE ratio. In 2012 it was 13.7x. Once you’ve determined that something is a good business, you still need to pay a good price for it to ensure good returns.

There are countless examples of high quality businesses that have delivered fantastic sustainable returns since 2000, but have only recently reached breakeven for their investors that were paying ridiculous prices during the tech bubble. It took 15 years for Microsoft investors (who paid 70x PE in 2000) to breakeven, despite the business delivering 430% real sustainable return over the same period.

Interestingly, Ford has traded on a single-digit PE for most of the last 20 years. Valuation on its own isn’t enough – you still need to buy a good business – remember lesson #1.


But what about the medium term? In 2010, JNJ traded on a 14x PE. It was cheap, it was a good business, but two years later it had delivered no return. This is when patience is required. This is when patience pays.


How can we apply these lessons today?

So let’s come back to 2020 and see how things are set up: The US stock market continues to make new highs. Over the last 10 years the S&P 500 has returned 256%. Why not simply buy the S&P 500 today and be patient?

If we adjust for the abnormally low margins of 2009/10 the S&P 500 traded at a PE of 13.5x a decade ago, vs 22x today. Roughly half of the total return of the last decade has come from revaluation from historical lows to the highest PE since the tech bubble – a non-persistent source of return. If valuations revert to anything near their long-term averages, and sustainable returns remain roughly the same for the next decade, this implies low-single-digit real returns from the S&P 500. Furthermore, these returns aren’t likely to come smoothly! Don’t expect the last decade to repeat itself. Remember lesson #2.

We’re far more comfortable holding a globally diversified portfolio of high quality businesses trading at historically low valuations, with 95% active share relative to the global benchmark index.

Dare to be Different

Investment managers are generally split into two categories: Active and passive. Active managers aim to outperform a certain benchmark index by being different from it. Passive investors seek to replicate an index. Both have their proponents and their detractors. Recently there has been a strong trend towards passive investment following a number of studies which show that the average passive fund has outperformed the average active fund after costs.

Active managers are not all the same though, and it’s a mistake to lump them all together. One of the most important differentiators of an active manager is active share. Active share is a measure of how different a portfolio is from a benchmark index. Active share is calculated by summing all the absolute differences between a portfolio’s position weightings and the benchmark’s position weightings, and dividing by two (because you’re double counting). A portfolio with an active share of 0% is replicating the index exactly – i.e. passive investing. A portfolio with an active share of 100% has absolutely nothing in common with the benchmark index. The higher the active share the more different a portfolio is from the benchmark – the more active it is.

Why is Active Share so Important?

Much of the active management industry purports to be active, charging active fees, but delivering portfolios with low active shares (i.e. <60%). These funds are closet indexers. They are a major reason why active management as a whole has lagged passive. If you hold a closet index fund, your gross return will be roughly the same as the index, but your costs will be higher than an index fund. This all but guarantees underperformance. There really isn’t any good reason to hold a closet index fund.

In contrast, truly active funds (those with active shares >80%) have outperformed their benchmarks in aggregate over long periods of time. This was demonstrated by Antti Petajisto in his paper Active Share and Mutual Fund Performance. There is a very real place for true active management – investment which demonstrates genuine conviction. Why is this so? Perhaps the most skillful investors are more likely to have conviction in their processes, so they tend to have higher active shares.

Unfortunately there isn’t much of this type of active management about. Between 1980 and 2009, the proportion of truly active US mutual fund assets dropped from 60% to less than 20%. According to a 2016 Morningstar paper, less than a quarter of actively managed European equity funds fell into this category. Only 2.4% had an active share of more than 90%. Why?

If high active share tends to outperform over time and closet indexing does the opposite, why has true active management shrunk over time? Because, in the short-term, high active share is a double-edged sword. Short-term returns are highly random. High active share guarantees periods of significant underperformance, even for the most skillful investor.

These periods are difficult for investors and investment managers to deal with. There are all kinds of emotional biases that mistakenly attribute randomness to skill or lack thereof. Despite the fact that closet indexing practically guarantees long-term underperformance, investors are far more likely to give up on an outlier in the short-term – i.e. a truly active manager.

Avoid the Middle

Far too much attention is given to outliers by advisors, investors and the media every quarter and every year, both on the downside and the upside.  There is simply no acknowledgement of the role that randomness plays in short-term outcomes, especially where active share is high. Distracted by the outliers, they ignore those hiding in the middle. Closet indexing is an easy way to survive as a fund manager once you’ve built up a sizeable fund. It ensures you’ll be consistently in the middle of the pack. Sadly, it is this group as a whole that adds no value to the end investors. This issue deserves far more attention, from advisors in particular. Charging active management fees for tracking an index is a great disservice to investors.

One indication of closet indexing (other than low active share) is a portfolio of household names that tends to track the market. There are 1 000s of relatively unknown, but still significant businesses listed around the world. One shouldn’t expect a sound active process to yield only familiar names.

For us there is simply no point in being a closet indexer. Passive investing delivers the same result before costs, but at lower cost. Closet indexing, while comfortable for some, is obsolete. What makes sense is to either be a true active investor, a passive investor, or to combine products at either end of the active share spectrum.

Analyzing our Active Share

Bellwood Capital’s active share is 95% relative to the MSCI World Index. We hold 49 different shares across all of our portfolios, vs roughly 1 600 in the benchmark. 20 of the shares we hold, comprising 43% of our portfolios, are not in the benchmark. The other 29 shares / 57% of our portfolios contribute just 6.5% to the MSCI World Index. Our portfolios are truly different from the index on an individual stock level. The returns they generate will also be different from the index. This is a good thing (though it might not always feel like it).

So why are we so different from the index? Are we being different just for the sake of it, or does being different add value? While Petajisto demonstrates that being different does add value on average over time, high active share isn’t a panacea that can stand in place of a sound investment process. High active share should be the result of a good process. It is important to get the cause and the effect the right way around.

Our approach is to build diversified portfolios of our best ideas from the available opportunity set. To achieve diversification doesn’t require much more than 30 – 50 stocks, provided they aren’t all exposed to the same industries and geographies (more on this lower down). Within this framework, we maximize exposure to our best ideas in terms of profitability, financial strength and valuation – the three causal drivers of return. The end result is likely to be very different from the benchmark. This is true active investment management, demonstrating a high level of conviction in our process.

Midcap vs Megacap

One theme seems to stand out when we examine the nature of the differences between our portfolios and the benchmark: Market capitalization. More than half of the index is invested in about 200 companies each with a market cap of more than $50 bn. Only a quarter of our portfolios is invested in a dozen of these 200 stocks. Further, we have a very significant weighting (about 40%) in midcap companies with a market cap of less than $10 bn. These are still very significant businesses. The index has less than 10% in these stocks. While we don’t generally prefer midcap companies, we do see more abundant opportunities among these stocks than the megacap stocks, as they are currently priced.

This comes as the trend towards passive has accelerated in the last few years. It is expected that assets invested in passive US equity funds will surpass their actively managed counterparts for the first time ever in 2019. In 1995, less than 5% of US equity assets were passively invested. The tidal wave of money flowing from active to passive in the last few years, and to the S&P 500 in particular, has meant that the megacap companies on which passive investing is generally focused have been bought indiscriminately at the expense of midcaps that don’t feature in the popular passive indices. This doesn’t make these businesses inferior investments, but it does mean that many are a lot cheaper than they’ve been in the past, especially relative to the megacap stocks.

Mind the Valuation Gap

Our portfolios are currently trading at their 5th percentile of historic valuations relative to the MSCI World Index. The valuation gap between the index and the stocks we currently hold is as wide as it’s ever been. This is a good reason to be different from the index, because valuation is a key causal driver of long-term returns.

By our estimates, the popular passive indices are not priced for good long-term returns, and no wonder given the massive indiscriminate flows in their direction the last few years. We’re quite happy to be different in this regard.

Applying Active Share to Diversification

While 49 stocks is undoubtedly diversified on an individual company basis, it doesn’t help if these are all in one or two industries or countries. There is another way to apply active share that helps to assess whether we are adequately diversified in this regard, or whether we are taking large industry or geographic bets*. We generally avoid these because they don’t have strong causal links to return.

The way to measure this is to calculate active share in terms of industry groupings and geographic groupings relative to a diversified index (like the MSCI World Index). Lower active shares on these measures indicate greater diversification. Ideally we would want our portfolios to exhibit high active share on the individual stock level, but low active shares at the industry and geographic levels. Our active shares are 33% and 29% respectively at the industry and geographic levels. This indicates high levels of diversification. Combined with an active share of 95% at the stock level, these measures put us right at the business end of well-diversified active investing.

* Side note: Whilst identifying the desirability of high active share at the stock level, Petajisto also demonstrated how these types of “factor bets” haven’t added value to investors over time, though he measured this using tracking error. Our tracking error is between 5% and 6% – on the lower end of the spectrum – which is consistent with our industry/geographic active share measures.

Dare to be Different

True active investing is about consistently applying a sound process to build a diversified best-ideas portfolio. It is not supposed to track the market, and if it does there’s something wrong. This type of investing adds real value over time, but it isn’t always easy. Bellwood Capital is a truly active global investor. Our active share demonstrates this. In an environment of generally high equity valuations, driven by indiscriminate passive flows towards the major index constituents, we’re far more comfortable being different from the market than following it.

Too Much Information

The conventional wisdom in investing is that more information is better than less. In the past Peter and I have sometimes questioned whether we have an informational deficit, but over time we’ve realized that it is not quantity of information that counts, but knowing which information is important and analyzing it correctly. In fact, to the extent that too much information leads to overconfidence and emotional bias, more information can become a stumbling block.

Last year we wrote an article in which we compared insurance to investing. The focus was around diversification: How insurers are in the business of selling diversification for a profit. We feel there is a lot that investors can learn from the way insurers go about their business, which in many ways is very similar to the business of investing.

This time our focus is around information, and how that relates to the selection side of the process.

Focus on key variables and aggregate outcomes

Insurance is about aggregate outcomes. You isolate a few key variables – age, gender, smoking, family history and other health markers (for life insurance) – which largely explain variations in aggregate claims (or base rates). These variables are readily determined at low cost and can be applied broadly. This is called underwriting, the insurance equivalent of selection.

Further variations in individual claims are treated as random, either because they are random, or because the cost of collecting and assessing further information that might explain these variations outweighs any potential benefit of doing so.

Your life insurer probably won’t send someone out to interview you and find out about your life. The conclusions would likely be unreliable, especially to the extent that they differ from what the key variables are suggesting. Apart from the added expense, your insurer wouldn’t disregard the base rates in favour of a compelling story when setting your premium.

Your life insurer also won’t waste too much time second-guessing its underwriting process for every random deviation from the average, as long as the aggregates are in line. Claims are expected.

What is important about this approach to selection is that it is logical, business-like, and reasonably free from emotional bias. And it works.

The informational deficit mirage

In contrast, the investment world is obsessed with specific outcomes and individual stories. There are huge stakes attached to correctly predicting big winners and losers, which drives the investment community to generate and consume as much information as possible – as though this would somehow enable us to see the future.

The idea is that more information leads to more accurate predictions. This seems intuitive. The reality is that more information leads to greater confidence in forecasting, but not greater accuracy. This information-driven overconfidence causes investors to take big bets on specific outcomes without the required accuracy.

 Stories appeal to our emotions

The obsession with individual stories creates another problem: Investors are far more likely to allow emotional biases to bypass logical reasoning when stories are involved. In their paper On the Psychology of Prediction, Kahneman and Tversky demonstrate how compelling, but ultimately irrelevant information, can cause people to disregard prior base rates when making predictions, leading to systematic prediction error.

This sort of thing happens all the time in investing. Overconfident from all the information we have about a company, we fall in love with the story and often lose sight of the few key variables that determine aggregate outcomes.

It is staggering to see how different the approaches of the insurance and investment industries are, considering how similar their businesses are.

What are the key variables in investing?

Perhaps one reason why investors consume so much information is because there isn’t broad understanding of what the key variables in investing are. Understanding the causality of investment returns helps to isolate which variables are important. There are only three broad variables that really matter:

Higher profitability is associated with higher reward and lower risk. Higher leverage is associated with higher reward and higher risk. Higher prices are associated with lower reward and higher risk.

These are the three key variables that drive aggregate outcomes in the stock market. Every bit of information that you consume should be directed at trying to understand these three aspects of a business. Every bit of information that draws your attention away from these variables is probably impairing your judgement. The investment community generates far more of the latter.

Let’s do an example, then add a story to make it interesting…

You have the opportunity to invest in a persistently loss-making business that is operating in one of the most competitive and capital-intensive industries in the world. The company is highly geared, issues a lot of new shares every year, and burns through cash. The industry is cyclical. If the company was as profitable as its competitors, it would be trading at a PE of 30x – 40x.

Loss-making, leveraged, expensive… What do you think the base rates of return look like for a group of companies with these characteristics? Would you invest? Maybe this one is an exception.

What if I told you the company is a fast-growing, high-flying, tech company that is disrupting one of the most established industries in the world. The CEO is a billionaire genius who has successfully grown several startups into multibillion-dollar businesses.

How about now? The story tells you little about profitability, leverage or price, but it is representative of a mental model of success. Would you disregard the prior base rates in favour of the story? The market does this every day.

Investing like an insurer

We’ve always preferred a more actuarial approach to investing. The idea is to drill down to the key variables, and to ignore marginal information when it is no longer useful, or when it is introducing emotional bias that might cause us to lose sight of the key variables.

Though we often talk about individual companies, we always think in terms of base rates and try to build a portfolio of highly profitable businesses, with prudent leverage at attractive prices. It makes it difficult to keep portfolio updates interesting when the reasons we bought company X are always the same.

Finally, in investing as in insurance, there are always claims. Some periods are worse than others. High base rates combined with small samples can be dangerous. This is why diversification and time horizon remain critical to achieving investment success.

SA Foie Gras

AfrAsia’s latest South Africa Wealth Report found that wealthy South Africans have 83% of their assets invested locally. According to the report, their asset class breakdown between South Africa and the rest of the world is:

Let’s exclude properties, businesses and alternatives, which tend to be illiquid and might correlate with where you live or work. Let’s focus on the 44% made up of local and foreign stocks and fixed income – the liquid, more readily investible assets where investors have greater flexibility. The splits within this category are consistent with traditional asset allocations in terms of both asset allocation and global allocation:

The split between stocks and fixed income might be justifiable. The split between local fixed income and foreign fixed income might also make sense to the extent that local cash is needed to meet short-term liquidity requirements.

Too much invested in local stocks

What doesn’t make any sense is investing twice as much in local stocks as in foreign stocks, when:

  • More than half of your wealth is already tied up in illiquid local assets;
  • You have enough local cash to meet your short-term liquidity needs;
  • The local stock market is <1% of the world.

The purpose of investing in the stock market is to grow wealth and match long-term liabilities like retirement or leaving an inheritance. Surely investors in this position should be aiming to diversify their risk, which is very concentrated in South Africa, and to take advantage of the widest opportunity set possible. This means investing as much of your stock portfolio as possible in the global markets.

This doesn’t necessarily mean excluding the local market (though you probably already have exposure through your retirement annuity/pension). It means that local stocks should have to justify their place in your overall portfolio on more than the fact that they are listed where you live. They should compete on merit with every other stock in the world.


So why do so many South African investors and their advisors still seem to favour local, despite the obvious risks associated with such concentration?

“No one-size-fits-all”

I think it’s time to retire this line. We know that every investor has unique circumstances, and of course everybody doesn’t have the average allocation in the AfrAsia report. But when the averages are so skewed towards local, we can’t keep pretending that this is the perfect end-product of every individual’s unique financial plan. We also can’t keep using this line to avoid debating this important issue.

Isn’t the JSE Internationally Diversified?

“More than half of the JSE’s revenues come from outside of South Africa.” – another line often used to justify local market bias. But those revenues come from a handful of stocks – Naspers alone is more than 20% of the local market, with the top 4 companies making up half the index.

You cannot build a diversified global portfolio with a handful of stocks. There’s simply no benefit to limiting your options like this.

Ask yourself the following question: If these stocks weren’t listed in South Africa, how much of your global portfolio would you invest in them?

Where are your liabilities?

Ideally you want your assets structured in such a way that they match your liabilities. If you’re living in South Africa, it stands to reason that most of your liabilities will be local.

As far as your short-term liabilities are concerned, it makes sense to have sufficient local fixed income exposure to meet these liabilities. The primary goal here is low volatility in Rand terms.

Once you start talking about building wealth and matching your long-term liabilities, you should be less concerned by volatility and you’re probably investing in the stock market.

You might think that adding currency volatility can interfere with your long-term asset-liability matching, or with your dividend flows, but different sources of volatility are often offsetting rather than additive. Stocks are already volatile. Dividends are also volatile in times of crisis. Adding currency volatility doesn’t make them more so, especially since the Rand tends to weaken during times of crisis.

In 2008 the JSE Top 40 index lost 26%. The MSCI World index lost 21% in ZAR. The following year JSE Top 40 dividends fell by 37%, while MSCI World dividends fell by 24% in ZAR terms. Currency volatility in the stock market is a bit of a red herring. If anything, it reduces overall portfolio and dividend stream volatility.

A globally diversified portfolio of your best investment ideas chosen from the widest possible opportunity set is far more likely to meet your long-term goals than a locally concentrated portfolio. The risks are also lower.

Strong Rand keeping you up at night?

Every debate about local vs offshore seems to devolve into a discussion about whether South Africa or offshore will do better. Apparently South Africans worry that South Africa might do well – that Rand strength might somehow make us poorer. They are worried about the possibility that 99% of the world might underperform 1% of the world, despite the fact that they already have 83% invested here. This is insane.

First, this argument ignores the fact that there are many more cheap assets outside of South Africa than inside. Simple Bayesian inference.

Second, it’s not about which will do better, it’s about risk management and where your exposure is. When you are 83% invested in one small country where you happen to live, return expectations become secondary to risk management.

If Turkey, an economy twice the size of South Africa’s, was your best investment idea in the world, would you invest two-thirds of your stock portfolio there, on top of your property and your business?

We need to stop mis-framing this issue as a return issue when it is in fact a risk issue. We can’t keep dangling far-from-certain return potential as a carrot to force-feed local investors something they already have too much of. As advisors and asset managers, is our job to sell SA, or to represent our clients’ best interests?

If you’re anything like the average SA investor, you are already hopelessly overinvested in South Africa. If South Africa recovers and the Rand strengthens, you’ll benefit more than 99% of the rest of the world. Your business, your properties, your local cash will all be worth more in real terms. This is a good thing. You will survive a strong Rand.

Be more concerned about what might happen if, heaven forbid, South Africa and the Rand don’t do so well.

Consistent Profitability

Return = Yield + Growth + Revaluation = Sustainable Return + Revaluation

This understanding of return is central to our investment philosophy and process. We’ve written about this on numerous occasions. Those who have followed our writing will recall that revaluation, though dominant in the short-term, tends to cancel itself out over long periods of time.

The result is that over very long periods of time, Return Sustainable Return.

This makes sustainable return incredibly important as it is the underlying fundamental source of value creation to all investors in aggregate. Businesses with low or negative sustainable returns might deliver high returns at times when revaluation is strong, but because this isn’t a persistent source of return, these businesses ultimately fail to create value for their shareholders over time.

Revaluation acts as a transfer of wealth between investors, rather than wealth generated by the business itself. This doesn’t mean that revaluation isn’t worth pursuing, but because of its unpredictability it makes sense to own strong businesses that are likely to generate high sustainable returns, and to approach revaluation more opportunistically over and above this.

What causes high sustainable return?

So, what causes sustainable return to be better for some companies than others? The most important factor is profitability. If a business makes a profit it can reinvest it in the business to drive growth, or it can return it to shareholders as yield. Since Sustainable Return = Yield + Growth, it stands to reason that the base rates for sustainable return of consistently profitable businesses should be superior.

To demonstrate the fundamental relationship, we calculated the annualized sustainable returns of nearly 1 200 of the largest US-listed companies with at least 10 years of financial data history (as of June 2018), and categorized them by consistency of profits:

The base rates for those that were profitable 10 years out of 10 were significantly higher, whether measured in terms of earnings, sales or book value. Less consistent profitability was associated with lower annualized sustainable return, as we would expect from the causal relationship.

While this is quite a simplistic way of assessing profitability (because it doesn’t account for capital employed, cash flow, leverage or cyclicality), it nevertheless demonstrates just how powerful consistent profitability is in driving the base rates for long-term sustainable returns.

Don’t let the Rand dictate your portfolio

For many South African investors, the Rand exchange rate is the single most important variable they consider when deciding whether to invest money offshore. It crowds out every other consideration. We think this is a mistake.
If you’re thinking about investing globally, but you’re worried about timing the Rand, ask yourself the following questions:

1) How much of your wealth is focused in South Africa?

This is probably the most important consideration: If you’re overexposed and something goes seriously wrong here, your wealth could be permanently impaired.

This is an emotive topic for many investors and advisors who have strong views about what will happen one way or the other, ranging from doomsayers and fearmongers to the fervent “we’ve always recovered in the past” crowd.

We fall into neither camp, preferring a more probabilistic approach to risk management. Risk events have two elements: 1) Probability of occurring, and 2) magnitude of loss. A failed state is generally a low probability event, but the magnitude of loss is very high. Low probability, high magnitude risks are risks worth managing. This is the reason young, healthy people buy life cover. We think about country risk the same way. Global diversification is a form of country insurance.

Depending on where the Rand is trading, country insurance may be free, cheap or expensive. Free insurance is a no-brainer. Whether or not you decide to pay for country insurance should depend on two factors: 1) Price, and 2) how much insurance do you already have?

So how much of your wealth is focused in South Africa?

If, like many South African investors, you have a local business, a house, a pension and/or retirement annuity, chances are high that most of your wealth is focused in South Africa. If most of your liquid, discretionary assets are also invested locally, paying a fair premium for some country insurance might not be such a bad idea.

If, on the other hand, you are a global investor with very limited exposure to South Africa, your mindset is totally different. You have become the insurer, and for you it may make sense to be moving in the other direction, collecting premiums in exchange for bearing country risk as part of your globally diversified portfolio. This is a good position to be in.

Discussions about how cheap South Africa and the Rand are should be framed within the context of your global asset allocation and the size of the currency premium, if any. The higher your country risk exposure, the more it makes sense to pay a reasonable premium to manage it. The lower your exposure, the more you can afford to be opportunistic.

2) Is the Rand cheap or expensive?

In December 2001, the USDZAR reached a high of 12.45, 80% above the “fair” value based on inflation differentials and long-term trends. The premium for country insurance at this point was extreme. The perceived risks did not play out, and within 3 years the exchange rate had halved. The short-term pain was compounded by the simultaneous popping of the tech bubble.

Long-term investors who bought the S&P 500 in December 2001, and held on until March 2019, would be up 321% in ZAR, or 8.7% p.a. – not great, but not as bad as one might expect for the worst timed investment of the last 20 years. Also bear in mind that things might have played out differently. We only see what did happen in hindsight making it seem like the only possibility, but the reality is that the future is uncertain.

More recently the 2016 USDZAR high of 16.87 was about 40% above our estimation of fair, still very high, but nowhere near the extremes of 2001. We estimate today’s premium at roughly 15%. For a long-term investor, this premium could easily be a lesser consideration when weighed against other factors.

The “always recovered” commentators often use 2001 as a warning against rushing for the exits when the Rand is cheap. But cheap and expensive aren’t black and white. The current exchange rate premium is much closer to fair than it is to 2001 levels.

Your context may be one of 100% exposure to South Africa, in which case you may be happy to pay the current premium to get some global exposure. A global investor’s context may be one of only 1% exposure to South Africa, in which case the premium may warrant further investment in the country.

Within the context of your exposure to South Africa, is this a reasonable premium or not?

3) Cheap relative to what?

So, the Rand is fairly cheap. But relative to what? The US Dollar? Ironically, we tease Americans about their perceived lack of awareness when it comes to the diversity of “Africa”, but many of us make the same mistake when investing “Offshore”. There is a whole world out there that isn’t pegged to the US Dollar. There’s also more to global equity markets than the S&P 500.

By our estimation Sterling, Yen, Euros, Canadian Dollars and the Swedish Krona are also cheap relative to the US Dollar. You aren’t paying much of a currency premium to invest in these places.

The relative valuations of other currencies should also be factored into your decision to invest globally.

4) Are Rand-based assets cheap or expensive? What about other countries?

One of the major benefits of a global portfolio is having access to a very broad opportunity set. This allows you to make better investments and achieve a greater degree of diversification. You might find very cheap assets in a country where the currency isn’t as cheap. Think of Hong Kong, where the currency is pegged to USD. One of our portfolio holdings is a Singaporean company, listed in Hong Kong, which does business globally. It reports and trades in HKD, but how relevant is HKD really in this equation? Should the strong HKD put us off investing here? No.

The same applies to many companies listed on major exchanges around the globe, as well as our own local exchange. Some advisors say that investors should invest locally because a) the Rand is cheap and Rand-based assets are cheap, and b) because some of our prominent local listings like BAT, Naspers and Richemont have nothing to do with the local economy. These two points are contradictory. The fact that these companies are priced in Rands on our local exchange means nothing if they earn almost nothing in Rands. These companies stand to benefit no more from a domestic recovery than Altria, Tencent and LVMH.

There are also companies listed in the US that are cheap despite the strength of the USD.

The valuation of an asset’s trading and/or reporting currency is less important than where the company does business. It is also less important than the overall valuation of the asset, where currency effects are but one factor.

In the global investment opportunity set where South Africa represents less than 1%, it is highly unlikely that our local assets are the only cheap assets in the world. Shunning the rest of the world’s investment opportunities because “the Rand is weak” makes no sense.