Glenn Freeman: I'm Glenn Freeman for Morningstar. I'm talking today with David Pace from Greencape Capital. He is talking about a few different areas in terms of how they construct their portfolios in terms of following a bottom-up process rather than taking sector tilts, remuneration structure and how that plays into both the way they select companies and also within their own business and also, speaking about active share and his thoughts on active share targets and how it plays into the way that these fund managers operate.

David Pace: Yeah, Glenn, I think, ultimately, it's the numbers that differentiate one manager from the next. And we've managed to outperform over all time periods since inception which was September 2006. But when you drill down a bit further what's behind those numbers, it's decisions like capacity-constraining our business to make sure that we can sustain the returns over time. It's the fact that we spend so much in the field doing company visitation and we typically do about 1,500 each year. But thirdly, I think, it's the unique culture at Greencape and that really stems from the fact that we are such a niche and clean business and the fact that our remuneration structures are super clean. And that just strips away any politics and bureaucracy and keeps the team very aligned on the common goal of generating alpha year-in and year-out.

You can kid yourself, you can sit at your machine and say all these pretty numbers that's been around green and red, hopefully more green than red, but it's talking to people who are running businesses in the real world that really deliver you the proprietary insights that can make a real impact to the portfolio and the returns for the client base.

It's a really interesting question because it's not something that we have typically managed to. But I did look at our active share over time very recently and what was really reinforcing to me is that our active share increased through short-term periods of underperformance. And I love saying that because that says if you've got faith in the portfolio that you own today and it's underperforming, you should be buying more of it. And that's, I think, one of the key ingredients to our ability to generate quantum alpha.

We are trying to build a portfolio full of better-than-average people running better-than-average businesses. Right now, that sounds like a very simplistic sort of notion, but there are a lot of qualitative and quantitative calls made in the process. But sure, when we are backing in good people, we want those people also to be driven by the right outcomes. So, again, we know how powerful those (room) structures are in our own business. So, we spend a lot of time thinking about and looking at the (room) structures of the target entities that we are looking at. Are they acceptable to us? Is there an alignment with the shareholder base? But also, what are they telling us about the likely behavior of that management and their board, are they going to be pro-growth or are they going to be more conservative than that? Are they striving to survive or are they striving to excel?

And also, the other thing I'd say is, we are really looking for businesses that can generate economic returns through a cycle, so you are above the cost of capital. And that might not happen at all points in the cycle, but on average, we need to get there. And so, that typically takes us towards businesses with structural competitive advantages over the business level or within the context of the industry.

The other thing I will say is that when it comes to valuation, we do as much valuation work as the next house. But we take a pretty liberal approach to it, right. So, whilst we discretely forecast cash flows over the forecast period and find a net present value for that, we think about the inherent optionality from a valuation perspective in having a good management team and having a good business. So, for example, Computershare bought a business called Equatex last year. The market doesn't see that coming until it's there. That's a good deal. And so, that gets priced on day one. So, you need to think about what that optionality is and find some way of incorporating that into your thinking.

Another really good example would be CSL. And thinking about their ability to add meaningful value through research and development spend to bring specialty products to the market that are made discarded fractions of plasma today. So, they throw them away today. They find those, and they bring them to market as specialty product. Again, that's not known to the market until it is, but you need to think about ways of incorporating that into your valuation and your thinking.

We don't really approach the market that way. We are very much a bottom-up house and investment nirvana for us is to have a portfolio full of very compelling bottom-up stories such that we don't have to think about the macro and the top-down. That's been near impossible since our inception date. So, what we typically do is pick stocks, stand back from those and think about where our effective biases and tilts might be. Well, make sure we identify those, and either be willing to assume those or find ways of sort of controlling them. But if you look at the portfolio today, Glenn, we are roughly market-weight resources, we are underweight banks and have been so for some time and the rest is stock picking.

 

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