The world continues to navigate a period in modern history where “black swan” events seem to recur with unprecedented frequency. Brexit, COVID-19, the war in Ukraine and the threat of runaway inflation have all occurred in short succession, stoking fear, anxiety, and a general sense of uncertainty. Higher interest rates and lower global growth will most likely result in a lower-return environment for equity and debt markets, where “buy and hold strategies” offer greater risk than return.
Investors are faced with the choice of staying invested in typical long only strategies, or seeking out alternative investment vehicles that
offer downside protection and the prospect of higher returns. While it would be misleading to claim that all hedge funds offer these outcomes, it is worth highlighting the unique tools that hedge funds have at their disposal that allow them to navigate unchartered and choppy waters:
– The capture of outperformance without taking on market risk through “pair trades”.
– The prospect of generating positive returns despite negative price movements through the practice of “short selling”.
– Buying “put option” insurance or using other derivative instruments to hedge against uncertain tail events and
– Adopting flexible mandates that are not beholden to “benchmarking” behaviour.
We have written extensively in the past about the use of pair trades, put options and short selling that can be employed to contend with the fear that grips investors during more volatile times. It is also worth describing a specific Peregrine Capital example that highlights the value of flexible mandates and the absolute return mindset that this enables.
In June 2021, Anglo American unbundled a significant stake in Thungela Resources to its shareholders. Anglo undertook this action primarily as a means of divesting from “dirty energy”, which would (rather cynically) improve their ESG rating. Unbundling transactions are a great source of interest for the Peregrine Capital team because most investors simply do not conduct the bottom-up research required to form proprietary views about a “new” company. At the time of unbundling, Thungela represented less than 1% of the market capitalisation of Anglo American, its size in the benchmark resources index was negligible, and a 5% position in Anglo for the most bullish fund manager would yield a 0.05% position in Thungela post the unbundling. There was no incentive to understand such a small part of one’s portfolio or the market, and it was far simpler to sell the shares that you received rather than do the work required to value the business.
Rather than shunning Thungela, we set out to do the bottom-up research required to figure out whether Thungela was an investable opportunity. After pouring through the prospectus, our team engaged extensively with the Thungela management team to better understand the business and we met with competitors to improve our knowledge of the market. We also spoke to Transnet management to assess their operating capacity after many years of “state capture” and interrogated the capability of the Richards Bay Coal Terminal, which is a “private” terminal owned by the coal companies themselves. We extensively interrogated the market’s ESG concerns to determine whether the investment into a coal producer was justifiable for our investors. Finally, we built detailed models and scenario analyses to understand what the business was worth.
The question of ESG as relates to a coal company is highly contentious if taken at face value, but is equally ambiguous and worth explaining further. Shutting down coal fired power plants and the mines that serve them is positive for the environment, but such actions have several direct and indirect negative social ramifications. Directly, workers at the power plants and mines would lose their jobs (each of whom support 5-7 dependants), exacerbating the dire state of unemployment in South Africa. Indirectly, shutting down coal and nuclear energy plants in Europe has contributed to Russia’s dominance as an energy supplier in that region, the funds from which continue to finance the brutal murder of innocent civilians in Ukraine. The path toward a sustainable future is critical for the world but cannot be pursued at the expense the individual freedoms, security, and the right to life.
Thungela is playing an important role in weaning Europe off Russian energy, which is critical to ending the war in Ukraine and saving lives. They are also likely to pay many billions of Rands in taxes and royalties to the South African government, which if used wisely, can support the just energy transition we all seek. Dr Chrispian Olver, Executive Director of the Presidential Climate Commission, noted at his climate change presentation hosted at the JSE on the 26th of April 2022, that simply exiting an investment in a fossil fuel mining company was “too easy”. He encouraged investors to rather stay the course to ensure that companies like Thungela incorporate the repurposing of skills into their social and labour plans, and adequately capitalise their rehabilitation funds.
An investment in Thungela has proved to be a fantastic hedge against the war in Ukraine, preserving and growing the purchasing power of investors. It also clearly demonstrates the value of maintaining an absolute return mindset that is not reliant on “benchmark” thinking. For the most part, this characteristic is unique to hedge funds, facilitated by their broad and flexible mandates. If the future is characterised by markets that move sideways at best and downwards at worst, simply earning market return from “buy and hold” long only strategies is likely to yield suboptimal investment outcomes. We believe that selective hedge fund products should play an increasingly important role for South African investors in an increasingly volatile market environment.