After three years of disappointing equity returns, the JSE has come back in 2017 to return nearly 20% to the end of October on a total return basis with dividends included.

• Market’s slow-motion crash provided a perfect opportunity to buy cheap high-value shares

After three years of disappointing equity returns, the JSE has come back in 2017 to return nearly 20% to the end of October on a total return basis with dividends included. This strong performance, particularly over the past three months, appears to have caught many investors by surprise.

I wrote previously how we observed many investors moving their savings from equity unit trusts to money market funds. Even conservative multiasset portfolios with exposure to South African equities did not escape these outflows: statistics from the Association for Savings and Investment SA show its multiasset low-equity category suffered higher outflows than any other category for the first three-quarters of 2017.

This was clearly a knee-jerk reaction by investors in response to lower short-term returns delivered by equity funds up to the middle of 2017.

In line with single-digit returns from the JSE, equity funds generally underperformed money market funds over the preceding three years and had not beaten inflation in the past two years.

Indeed, the average general equity unit trust returned -1.1% for one year and +1.7% per annum over three years (both after fees to end-June 2017), far less than the average money market fund return of 8.7% per annum and 7.3% per annum respectively (also after fees).

Sadly but predictably, investors who made this switch in the first half of 2017 have missed an exceptional period of performance over the third quarter. Previously, we made the case for sticking to a longterm investment strategy and for not switching from equitybased growth portfolios in response to the subdued returns from this asset class over the short term.

We also made the point that strong performance from equity markets is known to be lumpy and is never delivered in a straight line. This is the nature of the game.

At Prudential we began increasing the South African equity exposure in our multiasset funds, such as the Prudential Balanced and Inflation Plus Funds, in December 2016 and into the beginning of 2017.

While this change proved prescient, it was not the result of gazing into a crystal ball. Rather, we observed at the end of 2016 that the valuation of South African equities was starting to appear attractive. This is generally the case after a market correction: investors might not realise it, but we have experienced a market crash — except it happened over 2015, 2016 and the first half of 2017. It was a crash in slow motion.

This “correction” was somewhat unusual because of its long duration and because it did not entail a precipitous collapse in share prices. From the second quarter of 2015 to mid-2017, the price level of the all share index moved in a relatively narrow corridor of about 49,000 to 55,000 points — barely a 10% range. This sideways movement is shown by the red line in the top graph. But this is not the complete picture — observing only the price level of the market tells you nothing about the valuation thereof. In the words of Warren Buffet, “Price is what you pay, value is what you get.”

When the earnings level of the market (the total annual profits of the companies that make up the all share) is brought into consideration, one can begin to observe how the valuation of the market changed. This was the result of a very gradual improvement in corporate earnings, as depicted by the black line in the top graph.

In the bottom graph we plot the price:earnings (p:e) ratio of the all share as a measure of value using the consensus expectations for profit to be reported in the next 12-month period (also called forward earnings). This highlights how the market’s valuation had fallen by about 21%, from a high p:e ratio of 17.3 times in April 2015 to a recent low of 13.6 times in June 2017. This happened while the market’s price was oscillating in a narrow range. Put differently, investors were being asked to pay the same price for a gradually improving stream of profit. This means the equity market gradually became cheaper over this period.

Had such a drop taken place over only one or two quarters, it would have been called a crash (at worse) or correction (at best). Because it took place slowly, over more than two years, it was barely commented on.

This correction gave investors who were focused on valuation, such as Prudential, an opportunity to buy South African equities at an attractive valuation compared to their longterm fair value.

The all-share index has subsequently rallied to 61,500, so buying South African equities proved the right thing to do. Moving to cash, solely in response to disappointing shortterm performance, was not.