It’s been a tough time for South African investors, with the country having slipped into recession and political and economic uncertainty turning market sentiment. This may make investing uncomfortable, as fear of an uncertain future elevates concerns about risk.
Falling share and bond prices hit investors right in the stomach, particularly when (and this is normally the case) these prices are accompanied by uncertain outlooks and terrifying newspaper headlines. Over several periods in the past (for example in 2003, 2009, 2011 and 2015), investors have felt this pain. Current conditions are no different and make short-term investment decisions difficult. The political environment (not only in SA but also abroad) is unpredictable and can result in binary outcomes.
Recent events have shown that even if you correctly predict an outcome (for example, Donald Trump winning the US election), you may not necessarily get the market impact right (in this case, the US stock market rallying). In addition, high levels of global stock markets have given rise to some complacency, as illustrated by very low levels on the VIX volatility index.
However, these very same conditions, and the diverse equity market valuations that have resulted, mean this is a good environment for making long-term investment decisions.
US fund manager Howard Marks talks about taking the temperature of the market. This means gauging where it is hot (where confidence and expectations are high and the chances of finding good bargains are low) or cold (where prices are generally low and chances of finding bargains are high).
We characterise significant parts of the markets as hot, while smaller, less obvious parts of the market are cold. There is a large divergence globally between shares with the highest and lowest market valuations as measured by their price-to-book ratios (which give an indication of what the market would pay for the underlying net assets of a business).
In fact, the divergence between these parts of the markets is as extreme as it was during the dotcom bubble. The more expensive companies are those deemed to be bond-like, characterised by stable and growing earnings. In contrast, cyclical companies are cheaper.
In SA, large parts of the market are deeply out of favour due to political uncertainty, recessionary conditions and aggressive foreign selling. Investors can, therefore, buy quality companies at a widening margin of safety (a greater discount to what they’re inherently worth). Many of the firms are cyclical and more exposed to the South African economy, such as banks and midcap industrials.
What the market is potentially missing is that earnings are depressed for many of them. We expect earnings to improve for most of our South African investments despite the recessionary conditions and the combination of low earnings and low valuations supports strong long-term investment returns.
Perceptions of risk tend to be informed by recent share price movements.
It is also worth noting that the moats (competitive advantages) of quality South African firms improve in tough times. In fact, this is one of the main reasons that the JSE generates such good long-term returns: because SA has not been viewed as an attractive place to do business, this has meant less competition.
A great example is Santam, which has compounded its share price at 18% (excluding dividends) from the beginning of 1985. Over this period, SA witnessed the Rubicon speech, avoided a civil war, weathered four recessions and suffered through 86 months in which the year-on-year decline in the rand was more than 20%. Despite all this, Santam’s moat has gone from strength to strength.
Perceptions of risk tend to be informed by recent share price movements. Market participants often perceive risk to be low when stocks are high (as they generally are now, globally). Investors should not view expensive stocks that are considered defensive as low-risk investment opportunities. These include some of the megacap nonresource rand hedges on the JSE, such as Naspers, Richemont and British American Tobacco. From their current valuation levels, we expect muted long-term investment returns. Using Mark’s analogy, the temperature in this part of the market has increased from hot to red-hot.
While this is not the perception of the general market, we consider parts of the market where share prices are low (such as the out-of-favour domestic counters) as low-risk. With a long-term mind-set and the ability to keep your emotions in check, there is value to be found for the patient investor.
• Hopkins is chief investment officer at PSG Asset Management.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.