KEY TAKEOUTS

• Over a five-year period, despite a recent rally, the FTSE/JSE All Property Index (ALPI) has provided a flat total return compared to a greater than 60% total return from the All Share Index.
• The Old Mutual Quoted Property Fund has managed to hold its own during a challenging period, outperforming its benchmark after fees.
• The fund considers ESG and governance in its investment process, an approach that continues to provide it with a safety net during more volatile market conditions, particularly when it comes to sifting out poor governance practices within its investment universe.
• A key risk that we are mindful of in our holdings is conflicts of interest, but rather than avoiding these shares altogether when we have these concerns, we rather consider them actively.

Listed property prices rallied over 20% since their low in October last year, mostly in the last quarter of 2023. As a result, the sector has tipped over into a positive nominal total return since its pre-Covid level at the end of December 2019. This is despite the market having migrated to a less positive outlook for interest rate cuts from that which prevailed some months ago.

This long-awaited comeback, after a tepid preceding five years, meant listed property pipped most other asset classes for 2023.  However, over a five-year period, despite the recent rally, the FTSE/JSE All Property Index (ALPI) has provided a flat total return compared to a greater than 60% total return from the All Share Index.

The Old Mutual Quoted Property Fund has managed to hold its own during a challenging period, outperforming its benchmark after fees over 12 months and five years. This is after it remained positioned conservatively for economic and consumer stress, avoided high gearing, financing and operational risk and held some quality companies.

Sifting out ESG concerns

However, there exists an additional potential performance driver that could give the fund an edge over its competitors. The fund factors an environmental, social and governance (ESG) screen to its investment process, an approach that continues to provide it with leverage during more volatile market conditions, particularly when it comes to sifting out poor governance practices within its investment universe.

The listed property sector has historically had a poor reputation for its corporate governance. While property gets a bad rap, this may have reflected the composition of the sector rather than anything specific to property itself. There were (and are) many small property companies increasing the probability of maleficence in any one company. Some property counters were listed and controlled by a founder shareholder with an intrinsic conflict of interest. This was during an era where regulations around this were more lax and small company governance standards were often inferior to that of large companies.

Over the past decade governance standards have improved significantly in the property sector as funds have grown, non-executive directors with strong governance credentials were appointed and management has professionalised. There has been fruitful open engagement with stewardship-minded shareholders such as Old Mutual Investment Group, allowing for improved governance of the sector, but also clearing the way for increasingly attractive investment prospects.

Governance plays a key role in our investment process, holdings and interaction. Our stewardship team spends considerable time engaging with companies and boards to improve their ESG risk management as well as opportunities for green growth. There has been a special focus on the property sector given that it screened weakest on governance and held promise for improvement in environmental impact; however, we have found management in the sector very open to upping their game in this regard.

Our investment process utilises both ‘hard’ ESG measurement and our judgement based on what we know from our experience and networks, which cannot be reflected in often narrow formalised scoring mechanisms. These factors go into determining our assessment of the desirability and position size of our property holdings.

We believe that it is better to sacrifice potential upside than to risk more substantial value destruction. We have avoided or greatly reduced our portfolio’s exposure to some corporate disasters by keeping governance concerns front of mind. This has held our portfolios in good stead over time, even if it has meant missing out on some very cheap companies that have subsequently performed well to our portfolio’s detriment. In the longer run, we remain confident that our decision to avoid these companies is the right one.

Spotlight on conflicts of interest

One factor that we are very sensitive to, and that is often not appropriately accounted for or calibrated in standard ESG scores is conflicts of interest. In most cases the issue is not a concern that management may act illegally, but rather that management, related parties or the controlling shareholder will act legally (even if marginally so) in a way that benefits themselves at the expense of ordinary shareholders.

Humans have cognitive biases, and when self-interest is involved in management, related parties or controlling shareholders may have convinced themselves that their action is both entirely ethical and purely in the interests of the company rather than themselves, and indeed take umbrage at any suggestion otherwise. The situation is even muddier as the conflicts of interest can often be more subtle, such as the risk taken on, where capital is allocated, with whom business is conducted or the financial metrics utilised and the outlook on which decisions are taken.

When issues as a result of such conflict-of-interests arise, they often arise years later and are precipitated by a change in the financial environment (e.g. higher interest rates, lower property values or liquidity becoming a priority) from what was done at the time.

The issues are structural, not personal. Current management may be paragons of virtue, but new management/ owners may inherit these conflicts and they may act differently. If a legal entity has the legal right to act in a way that is to their benefit (even if this happens to be at the expense of ordinary shareholders) why should they not exercise this? It would be irrational during the course of business for them not to do so and consequently this should be the base case.

What we therefore prize is avoiding these concerns altogether. This requires alignment of interests between management or controlling shareholders and ordinary shareholders. Each must have the same financial interests in the cash flow of the entity. No external management company should have its own financial objectives.

In assessing the appropriateness of remuneration structures, our focus is similarly on alignment. If management creates genuine value for the risks they have taken on behalf of the company they should be rewarded. We don’t want to see returns floundering, with management doing well due to a misaligned remuneration policy. This has occurred all too frequently.

Active consideration and increasing the bar

We don’t necessarily avoid any shares in our portfolios where we have conflicts of interest or alignment concerns. The listed property universe in South Africa is not large enough to afford this luxury and every case is different. Rather, when we have these concerns, we consider them actively, increase the bar of what is required to be in the portfolio, focus on the potential downside and hold less of that share than would otherwise have been the case.