RYK VAN NIEKERK: Welcome to this market commentator podcast: my weekly podcast where I speak to leading investment professionals. My guest today is Jean Pierre Verster. He is the manager and the fund manager behind Protea Capital Management – and he is, of course, the individual who famously shorted Steinhoff as well as African Bank. Jean Pierre, thank you for joining me.

You shorted those shares a few years ago. Currently, what are you shorting?

JEAN PIERRE VERSTER: Well Ryk, for my sins in the last year, I’ve had some small shorts in the gold and platinum sector, which hurt, so that just shows that no manager gets all the calls right all of the time. But importantly, as a hedge fund manager, one’s focus is actually more on risk management than it is on generating returns and therefore, when you do get things wrong, you need to make sure you don’t get hurt too much so that the times that you get things right – as happened with Steinhoff and African Bank – can work for you and then, through a full cycle, you can generate above-average returns.

RYK VAN NIEKERK: Of course, you need to analyse every single detail of the financials of those companies. Do you look differently – to a specific company, when you analyse it for possible long investments – as opposed to a short investment?

JEAN PIERRE VERSTER: It’s the same process. We call our process a ‘quantamental process’. So we combine the normal traditional fundamental way of looking at companies, reading the small print in the notes to the financial statements, meeting the management team and understanding who the people are involved in the business. That is very important, understanding the competitors, suppliers, the customers. But we combine that as well with strong quantitative analysis techniques. And that is a lot of automation and the use of algorithms to automatically forecast financial statements on a line-by-line basis.

And that means that we have both depth and breadth in our process.

So we can look at more shares at the same time than most other hedge fund managers can. But we also believe that we don’t just look at them superficially, we look at them in detail. And we do the same for the longs and the short. And through that process, we then can have highly diversified portfolios both on the long side and on the short side.

RYK VAN NIEKERK: So you have a very complex Excel spreadsheet in which you put in the financials and then there’s one block that tells you to buy, sell or hold.

JEAN PIERRE VERSTER: In simplistic terms, you are absolutely correct. The key is when that block says buy, hold or sell, do you believe and follow the model, what the Excel spreadsheet tells you, or do you combine that with real-world experience? And quite often your real-world experience tells you that the spreadsheet doesn’t have the answer and you maybe should do something differently. And that is why we combine both the spreadsheet and the real-world experience in our process.

RYK VAN NIEKERK: How accurate is the spreadsheet?

JEAN PIERRE VERSTER: What I would say is, on a statistical basis, which means you need to have a lot of positions, it is. And it has been shown to be quite accurate in our experience, and you can see that also by the above-average performance that our funds have generated – that it has been quite accurate – but it doesn’t mean it’s accurate all the time.

And that’s the important thing. If you have a highly concentrated portfolio with only a handful of positions, then the times that you are wrong can really hurt you.

But by using a diversified approach, you actually allow [for] the statistics of our process being right more often than being wrong through the help of these spreadsheets to generate above-average returns.

RYK VAN NIEKERK: Is that not an indexing model?

JEAN PIERRE VERSTER: Well, I would call it a high diversified model and in that sense, it’s quite similar to an index, yes. But importantly we don’t just use, call it one-factor market cap, to design our portfolios, which is effectively what an index fund does. We use more factors and look at a company holistically and then have a diversified portfolio. So we are actually strong proponents of indexing passive investment strategies if it is highly diversified because in that sense, I agree with the passive index proponents, and that is that highly diversified portfolios tend to do better on average, but we think that our diversified portfolios are better than an index’s portfolio.

RYK VAN NIEKERK: Of course, you manage hedge funds, three of them, you say it very diversified. How many short positions do you have relative to long positions?

JEAN PIERRE VERSTER: So in the South African fund that we manage, the Protea South African Retail Hedge Fund, we have roughly 50 long positions and 40 short positions, which speaks to how diversified this portfolio really is. And in the Protea Global Fund, it’s even more diversified, where we have roughly 70 long positions and 50 short positions, so 120 positions. And that means that our third fund, which is effectively just the combination of our Protea South Africa and Protea global funds, which we call the Protea Worldwide Flexible Fund as it [has] over 200 positions because it effectively mirrors both the Protea South Africa fund and the Protea global fund. And therefore that, which is our flagship fund, is the most diversified in our range.

RYK VAN NIEKERK: Do you actually look at the performance of all your short positions relative to your long positions? Jean Pierre is nodding his head, so the next question is: which one performs the best?

JEAN PIERRE VERSTER: Okay. So yes, for our attribution analysis – which we do specifically for our institutional investors that want more detail regarding how that we generate the returns of the past – we have shown that our longs outperformed the market on average, not by a lot in the last three years at least, but was shorted …

RYK VAN NIEKERK: Local and international?

JEAN PIERRE VERSTER: Local and international, but our shorts have effectively done substantially worse than the market, which means we made money because we shorted the right shares, which really underperformed the market. And we believe that this type of attribution is specific to the last three years where it was important to get the shorts right.

And admittedly the reason why we didn’t outperform on our long book versus the index in the South African fund is that we were not long gold and platinum shares. So we know the reason why our performance looks the way it does. It’s still above average. And even though we made most of our differential return, if we want to call it that – the difference between our return versus the market from shorts in the last three years – that doesn’t necessarily mean that will be the case for the next three years. And quite often through a full market cycle, a bull and bear market, you would make your shorts, [make] most of your money from shorting one period, but most of your money from longs in a different period.

RYK VAN NIEKERK: Let’s look at the individual funds. Let’s start with the South African hedge fund. The performance over two years is close to 24% as opposed to the market of around 1%, but over one year it’s slightly worse, or 5.7% over one year, as opposed to the market doing 7%. Of course, these are after fees, performances and you have a pretty high total expense ratio of close to 5% – just talk us through those numbers.

JEAN PIERRE VERSTER: Sure. So I’ll focus on the two-year numbers. I do believe that on a one-year basis if you invest in equities like our funds do, both long and short, a one-year period is too short a period to really look at causation. I will just briefly say that the reason why we are now slightly lower than the market over a one-year basis is that we were not long gold and platinum shares.

RYK VAN NIEKERK: Were you short with gold and platinum shares?

JEAN PIERRE VERSTER: I was but thankfully through good risk management they didn’t hurt me too much because, as you mentioned in the numbers you quoted, we are less than 2% behind the market over the last one year. So it hurt us but not too much.

Over the last two years we have done substantially better than the market – roughly 25%, where the market has given you nothing after fees – and we are pleased with that. And we do tell our bases that they should focus on longer periods; two, three, four years and more when it comes to the TR [total return] ratio.

The reason why it is so high is because of our performance. So on two years’ performance of 25% after the fees, if I work backwards and I use our 20% performance fee in rough terms, we actually did over 30% gross return and then, as the hedge fund manager, to align our interests with our investors, we’d take a 20% performance fee. So if you take 20% of, call it 30-odd percent, it means you will have a 5-6% performance fee, and that is exactly what has happened over the last two years. So investors got 24-25% and we as the investment manager got a performance fee of roughly 5% due to our performance fee structure. Importantly, there’s a high water mark so we can’t charge again on the same performance, if we, for instance, give a negative return in the coming 12 months.

RYK VAN NIEKERK: How do you calculate that expense ratio – you do it over a period of two years, or is it a running 12-month performance? Is it a fixed 12-month performance? How do you calculate?

JEAN PIERRE VERSTER: Actually, very interesting point because the TR ratio is set by two different, if you want to call them, ‘regulators’. The one is Cisca, the Collective Investment Schemes Control Act, and the other one is Asisa, the Association for Savings and Investment South Africa. And there’s actually a contradiction in how they want one to determine the TR ratio. The one says it should be over one year and the other regulator says it should be over three years. So ours effectively, because our fund, the South African fund, is not yet three years old, is effectively measured on a since-inception basis until we get to the three-year period.

RYK VAN NIEKERK: Interesting. Let’s look at your global hedge fund. It performed significantly better – over one year, 25% higher; over two years, 27% – and that is better than the [inaudible]. But the MSCI world index performed better: 33% over one year and 40% over two years. Talk us through this performance.

JEAN PIERRE VERSTER: So I think firstly, as with most hedge funds, one should consider the net exposure of the hedge fund. Our Protea Global Fund over the last two years as on average had a net equity exposure of 50%, so in simple terms I can say we’ve delivered two thirds of the MSCI World’s return at only half of the equity exposure.

Also keep in mind that the last two years has being a raging bull market in world equity markets, so for a hedge fund to give you two thirds of the upside is admirable. It’s acceptable. And the key will be when we get to the end of the global bull market. If we can – as we tell our investors we should – protect value on the downside, we can significantly outperform from the end of the current bull market. And that means over a full bull-and-bear market cycle, we will attempt to outperform the MSCI World [Index] even though the fund has got an absolute focus of generating returns in both bull and bear markets.

RYK VAN NIEKERK: You said 50% exposure to equities. Of course that means it’s less risky than to be 100% in equities. In what did you invest the other 50%?

JEAN PIERRE VERSTER: So that is the net exposure of the fund. So to put it differently, if I look at the gross exposure of the fund, if you look at the Protea Global Fund: for every R100 that investors invested in the fund, in rough terms, you can say that R120 of long exposure was bought with R100 of capital and R70 of short positions were entered with that R100. So if you take R120 of long positions and you minus the R70 short positions, you get the net exposure of the fund of only R50 or 50%. So the gross exposure is the 120 plus 70 – is 190% – and the net exposure is only 50%.

What that means is [that] if I pick the right shares, you are quite right – it decreases the risk because I’m both long and short shares. So when markets rise, I won’t capture the full upside, but when markets fall I also won’t incur the full downside. But at the same time, it must be admitted that this hedge fund, as others do, takes leverage and does have more than a 100% exposure. In this case, 190% exposure. And as a final reminder, the collective scheme control act says that retail hedge funds can only have a maximum gross exposure of 200% to make sure that the leverage doesn’t become too high to become too risky.

RYK VAN NIEKERK: Let’s talk about risk. How risky are these funds compared to, say, a straightforward exchange-traded fund investment in the MSCI world?

JEAN PIERRE VERSTER: It’s difficult to speak about all hedge funds because hedge funds as a category are not a homogenous group of funds.

RYK VAN NIEKERK: But your fund?

JEAN PIERRE VERSTER: My fund – we see our fund, the way we manage money, as being less risky because our net exposure is at most times between 35% and 70% and, like I mentioned, at the moment roughly 50%. The latest actually in the global fund is at the lower end of our bound, closer to 30%, because of our, let’s say, estimation that variations are now quite full. So we believe that our funds – you could look at the past volatility of the fund, the way we manage the fund – the fact that our net exposure is, call it medium, is less risky than [the] 100% equity alternative, especially if you take the deep drawdowns into account that the typical market and a typical 100% equity fund can experience when you have a deep market correction.

RYK VAN NIEKERK: The fact sheets are interesting. You don’t list the exact investments – [the] companies you are invested in – like normal unit trusts are forced to do. Why don’t you list your underlying investments?

JEAN PIERRE VERSTER: Correct. So what we do is we list the sector exposure and we also disclose the asset class exposure between, for instance, South African equities, options and other instruments, and on a sector exposure basis. They should still give you a good feel regarding the type of exposure we have, but we do not mention the exact names of the shares and that’s mostly because of the sensitivity in the market. Still, regarding short positions, a lot of management teams of companies don’t like it when hedge fund managers disclose publicly that they are short their shares. Most management companies obviously are remunerated quite closely to their share price performance and they feel that if a hedge fund manager is short their shares they are betting against the company and therefore the interests are metrically opposed to the management team. Now it shouldn’t be that way.

RYK VAN NIEKERK: No, definitely not.

JEAN PIERRE VERSTER: Correct. It shouldn’t be that way because a hedge fund manager being short the share most often is only a call on valuation, not on the quality of the management team. But because there’s still a sensitivity in the South African market regarding short positions, we have elected not to disclose our individual holdings including our individual short positions.

RYK VAN NIEKERK: But internationally you do in certain markets see that short positions are disclosed?

JEAN PIERRE VERSTER: Yes. What you would see is – and the JSE has actually now aligned their requirements as well to do the same – that the moment a hedge fund shorts more than half a percent of a company’s outstanding shares, it must be reported to the exchange. And there are certain other thresholds where, if they are exceeded, there must be a public announcement regarding the short position that a specific hedge fund might have in a public listed share.

RYK VAN NIEKERK: Just lastly, we are seeing a lot of volatility in world markets. A lot of uncertainty. We have Donald Trump on the one side [which] seems to be very positive for markets in China. We are currently seeing the coronavirus which is creating a lot of uncertainty, we’ve seen some pressure on markets there. How do you see the current market valuations and where do you think is the risk on the upside or the downside?

JEAN PIERRE VERSTER: We are not top-down investors, we are bottom-up investors in terms of the fact that we look at businesses individually, but through our quantamental process, we have an estimation of the fair value of a lot of shares. And if we weigh those fair values relative to the market gap, we have an estimation of, call it the return, that certain global indices might give us in the next four years. And based on that quantamental process, currently our estimation is that prices are expensive, that valuations are full. And that is why in our Protea Global Fund and actually our Protea South African Fund, our net exposure is closer to the lower end of the bound that it has been historically. So I’m nervous at the moment, but not because I read the news and I read what Trump says, but rather because my quantamental process from a bottom-up perspective tells me that most valuations are quite full at the moment.

RYK VAN NIEKERK: What does your spreadsheet say?

JEAN PIERRE VERSTER: Spreadsheet says sell.

RYK VAN NIEKERK: Well, Jean Pierre, thank you so much for joining me. It’s a very interesting fund you are managing, and good luck.


RYK VAN NIEKERK: That was John Pierre Verster. He is the hedge fund manager at Protea Capital Management.