The trend is no longer the investor’s friend

By Clyde Rossouw, portfolio manager, Investec Asset Management

Investors have definitely benefited from the equity bull market that has prevailed for the last five years, but we believe the trend may no longer be the investor’s friend. In the current environment, it is crucial to place a greater emphasis on capital preservation.

We have seen a significant recovery in equities since 2009 when the JSE All Share Index (Alsi) touched a low of 18 000 and was trading on a price earnings (PE) ration of only 8x. Since the global financial crisis the Alsi has powered ahead to its recent levels in excess of 50 000.

Market moving sideways with more volatility

However, over the past 24 months we have become increasingly concerned about the overall valuation level of the market. While excess liquidity and investor exuberance have driven domestic equities higher, the market has struggled to gain further upside traction over the past six months. We have seen sideways moves with increased volatility.

On a historical PE of 17x, the equity market as a whole is not cheap. Current prices are being driven by investors willing to pay up for anything with a hint of growth. While nobody can predict when the ‘music will stop’, we remain very cautious about the possibility of capital loss from these market levels. Therefore, we are deploying investors’ capital in relatively defensive opportunities. We have reduced our exposure to South Africa equities, but we have maintained our maximum offshore allocation.

What returns can investors expect?

Looking at the overall domestic market and the returns likely to be achieved, the South African stock market looks to be fully priced. In our view, a real return of no more than 1.4% p.a. is likely for the next five years, which is not an exciting outcome. High valuations, uncertainty about global growth, the prospects for commodities and the direction of interest rates, are all factors that will challenge investors seeking to earn real returns. Selective stock picking will become increasingly important to seek out those opportunities that could continue to provide dependable real returns with less downside risk. Our preference is for shares with a high cash flow, high dividend yields and a diversified earnings base.

While the returns for the overall market are expected to be disappointing, we still think the stocks we own within our Opportunity and Cautious Managed Funds are priced for better returns. The local equity portion of our portfolios is trading on a PE of 14.5x, which is at a significant discount to the rest of the market.

The best opportunities are still in high-quality developed market equities

We continue to make full use of our offshore allocation as we believe the best opportunities remain in high-quality developed market equities. We are finding more high-quality businesses offshore at more attractive prices than locally. While Naspers and SABMiller are good businesses, we believe their shares are currently too expensive. Our focus on capital preservation steers us away from Naspers, and towards opportunities such as Twenty-First Century Fox and eBay. These companies should benefit from the same underlying growth drivers as Naspers, but they are trading at much lower multiples (PEs).

Our offshore holdings continue to make a strong contribution to portfolio returns. We are avoiding most financials, mining companies and utilities given our reluctance to invest in some of the more capital-intensive parts of the market, and we have no interest in highly leveraged companies. We have a material exposure to the consumer staples sector, while we are also seeing some attractive opportunities in information technology and healthcare. Our holdings include Imperial Tobacco, Johnson & Johnson, Moody’s and Roche. Our portfolios also have exposure to international property, as the asset class offers attractive yields in the form of high dividends.

South African bonds are providing a superior return to cash

Over the past year, we increased our bond exposure, predominantly purchasing long-dated instruments which offer investors significant value over cash. South African bonds are benefiting from slower-than-expected local economic growth; falling inflation expectations driven by a lower petrol price; a switch away from Russian sovereign debt into safer emerging markets; and a general reduction in global yields as growth remains uncertain. Given the level of yield available on government bonds compared to the growth prospects for property rentals in South Africa, we believe local bonds offer greater security and certainty of return than property, i.e. a superior risk-adjusted return.

We are at the bottom of the interest rate cycle in South Africa, but we do not foresee substantial interest rate hikes driving the prices of long-dated bonds lower. The local economy can ill afford higher interest rates, and any hikes in sympathy with the US Federal Reserve will be short-lived. In fact, we expect that any increases in US rates will be minor given an already strong dollar, weak global growth, and signs of disappointing US numbers