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04 Apr 2024

Performance Review — Light at the End of the Tunnel

The Foord International Fund is known for its resilience during market weakness. It is much more likely to lag in bull markets — and last year was no exception. In this article, Managing Director Paul Cluer discusses why the Foord global funds underperformed last year, when and how we expect them to recover, and how the Foord South African funds are positioned to generate inflation-beating returns in the year ahead.

The two Foord global funds heavily underperformed their benchmarks — for different reasons — last year after having delivered stellar returns in the big drawdown year of 2022, when global interest rates were first rising. We understand that the magnitude of the underperformance over this short period is hard to endure for investors. But there is light at the end of the tunnel.

FOORD INTERNATIONAL FUND

Foord’s popular 26-year-old Foord International Fund is a conservative, absolute return product. Given the choice between chasing investment returns and protecting capital in this product, the managers are always going to choose to protect capital. They did this well when the dotcom bubble burst at the turn of the century, well enough over the 2008 Global Financial Crisis, and again well during the heavy COVID-drawdowns of 2020, as well as in 2022 when global share and bond markets plunged 18% in US dollars. Limiting losses when risks are high is a hallmark of this fund.

But in worrying about the risks of loss, the fund missed out on the (short-lived) stimulus rally of 2021 and the AI-sparked rally of 2023, which has driven key western markets to all-time highs this year. Protecting against market drawdowns comes at a cost, especially if markets surge higher.

In 2023, the fund was down 4% in US dollars when tech-heavy global share markets rose an eye-popping 24%. The trend continued the first two months of 2024, with a reprieve in March. There are three primary reasons for these poor returns.

Inherent Conservatism and Cost of Hedges

First, the fund’s inherent conservatism detracted from returns through a combination of holding a smaller portion of the fund in shares, and the direct costs of hedging the fund’s equity exposure. Hedging refers to the practice of using derivatives to protect against falling markets. Hedges add value if markets fall — as was the case in 2022 — but are costly if markets rise. Had we not hedged the risks building in US equities, Foord International Fund’s performance would have been 3.8% better last year.

So why did we put these hedges in place? If we cast our minds back to mid-2023, we were confronted with US inflation around 7%, wages increasing by nearly 5%, and jobs market data — whether payrolls or job openings — that exceeded even the highest expectations. The US economy was in full swing. It seemed to us that the US central bank would not soon start to cut interest rates — even if the market was expecting just that and trading at ever higher valuations.

We expected that peak US profitability, elevated inflation and multi-decade high interest rates would crimp corporate investment and weigh on earnings. It was conceivable to us that a US recession was possible and quite likely, which would be negative for stock markets. While earnings growth did slow materially — especially after inflation — the correction was less than we would have thought. As a result, the expected impact on the share prices of US companies has not come to fruition. Or at least, not yet.

Chinese Investments

Second, the fund’s investment in Chinese equities was negative for the year. Although accounting for less than 15% of fund assets, the negative investor sentiment pressuring all Chinese shares cost the fund 3% last year after Chinese bourses fell by double-digit returns — compared to the double-digit gains achieved by US share markets. Chinese markets are down further in 2024 but appear to have now troughed.

Foord is an earnings-driven investment firm. We hold a well-tested belief that if we properly forecast earnings, share prices will follow. While the earnings for nearly all our Chinese investments grew during 2023 — many at robust rates — prices fell on poor western sentiment towards China. We believe this is a timing issue and that share prices will recover in time, and probably sooner than most expect (refer Investing in China — Risks and Opportunities for our thesis on why we don’t believe that China is not investible).

Low Weighting to Expensive US Technology Shares

Finally, the fund’s relatively modest investment in the ‘Magnificent Seven’ grouping of mega-sized US technology companies weighed heavily on performance relative to global markets. This group seven-handedly accounted for more than 40% of global share market returns last year. Many shares outside of the Magnificent Seven performed poorly, with low single-digit — or even negative — returns. The opportunity set outside of the expensive big tech shares was constrained.

We are acutely aware that diligent application of our investment philosophy has  — in this period, at least — caused, rather than prevented, losses in the fund: sticking to our valuation discipline was painful through our lower weight to expensive, large-cap US technology firms that rallied heavily; our keen focus on earnings and valuations did not alleviate the sentiment-driven declines of our quality Chinese investments, while hedging strategies — paradoxically implemented to mitigate market drawdowns — themselves compounded losses in the fund.

FOORD GLOBAL EQUITY FUND

The Foord Global Equity Fund has a much longer time horizon than its conservative stablemate. It is appropriate for investors who can tolerate much more risk. Last year was also a disappointing year, with the fund returning 7.6% in US dollars. While positive, this was well below the benchmark return of 22%.

The reasons for the underperformance mirror those of the Foord International Fund, although this fund did not use hedging strategies. As an equity-only product, the effects of the underweight position in US technology stocks and the overweight position in Chinese investments were, however, more acute.

The US Magnificent Seven, along with the balance of the information technology sector, now comprise 40% of the US S&P 500 Index, which tracks the 500 most valuable companies listed on US stock exchanges. These seven stocks returned (on average) 80% in 2023, nearly seven times that of the 12% return achieved (on average) by the 493 companies that are not included in the Magnificent Seven.

While sticking to our valuation discipline can be painful in the short run, often over our forty-plus year history we have been reminded that security prices do follow earnings and that paying a reasonable — not excessive — valuation for those earnings is of utmost importance in generating sound, risk-adjusted, long-term returns. We may yet be proven correct regarding tech valuations.

The Foord Global Equity Fund has about a fifth of its portfolio invested in quality Chinese consumer and technology companies. These companies have attractive business models and are growing their earnings at appreciable rates. However, they sold off on sentiment as already noted. We have strong conviction in our philosophical view that earnings fundamentals drive share prices over time, as well as in our current portfolio holdings and positioning.

FOORD’S SOUTH AFRICAN PORTFOLIOS

The Foord Equity Fund is showing its stripes, outperforming its FTSE/JSE Capped All Share Index for the year and for the last three years — as well as most of its peer group. That said, it has only delivered low single-digit returns for the last 12 months when the JSE has been negative. The opportunity set in South Africa has mostly been in the fixed-income asset classes. Foord’s suite of fixed-income products has delivered returns of 7% to 10% in the last year, mandate dependent.

Foord’s South African multi-asset portfolios — the Foord Conservative, Balanced and Flexible Funds — invest variously between 35% and 65% of their assets into the Foord global funds. As a result of the poor returns on the Foord global funds and the constrained South African opportunity set, the returns on these multi-asset funds since the start of 2023 have been in the low single digits. We are acutely aware that the funds have not kept pace with inflation in this period.

LOOKING AHEAD

How do we see this situation changing to again deliver long-term, inflation-beating returns to investors in these products?

Firstly, we expect — for the reasons set out in the accompanying article by portfolio manager JC Xue — that Chinese equities will recover well, on even just the smallest improvement in economic fundamentals or sentiment. The Foord SA multi-asset funds have from 6% to 11% effective exposure (mandate dependent) to this region on a look-through basis and we should see a meaningful performance fillip when this occurs.

Second, while inflation here and abroad is proving stickier than many have believed, it is well off its 2023 highs. South African and developed market interest rates are still at recent peaks. Interest-bearing investments — cash, money market instruments, as well as corporate and government bonds — are generally delivering inflation-beating yields.

The Foord funds are mostly invested in fixed income instruments that have low risk of loss, even if interest rates rise. Within bonds, we favour inflation-linked bonds for their better risk-reward profile. The funds have between 20% and 45% (mandate dependent) invested in interest-bearing investments that should deliver an inflation-beating return over the medium term.

Investments in South African equities are split between ‘SA Inc.’ shares that are directly exposed to the fortunes of the SA economy, and locally listed shares that earn most or all their revenue in hard currencies. As we’ve discussed in other forums, the SA Inc. shares are trading cheaply — some for very cogent reasons. Nevertheless, there are scenarios where the better-quality stocks will achieve attractive earnings and share price growth. We have a low weighting to cyclical resources stocks that have dramatically underperformed the market in the last 18 months.

The rand faces continued headwinds against hard currencies. The economy remains structurally constrained, and the country’s terms of trade are weak. Political and energy risks remain high. Rand weakness should buoy all investments with foreign currency earnings — whether listed locally or abroad. Ditto the gold bullion investments, which are in the portfolios at levels up to 5% of fund.

We note that there are certainly risks in global shares, with US, European and Japanese stock markets recently achieving all-time highs. They are primed for retracement if corporate earnings disappoint or recessions bite. That said, the Foord global funds are less exposed to the most expensive areas of the global market and the Foord International Fund specifically has hedges in place against market declines. In a risk-off scenario, rand weakness should help pare market losses.

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