Local investing: balancing caution and optimism
Investing is cyclical: there will always be a degree of uncertainty and we will have to respond to unprecedented challenges
Due to overwhelmingly negative market sentiment, many solid, resilient, wellmanaged companies are being derated. As a result, their valuations are low and dividend yields are high, offering investors an opportunity to generate healthy returns.
However, despite the recent uptick, absolute returns have remained disappointing over the medium term — only marginally ahead of inflation over five years. That said, as we look ahead, we are cautiously optimistic about our ability to generate returns for our clients from the local market and believe the outlook for returns from South African assets is quite good at present.
The FTSE/JSE all share index (Alsi) and capped Swix are the two most commonly used broad market indices in South Africa, but have had large differences in composition and in performance from time to time. Over the 12 months to endSeptember, the Alsi returned 18% compared with the capped Swix’s return of only 12%. A major contributor to this difference was the strong performance of Richemont, which had a larger weight in the Alsi.
The Richemont share price has been on a strong run — in line with the performance of other luxury goods businesses. We continue to believe that the share is overvalued, with margins and earnings at record levels in what has historically been a cyclical business. The Richemont share price has given up some of its strong performance recently, declining 28% over the third quarter.
A Richemont corporate action in April 2023 led to a reduction in the share’s weight in the Alsi. Richemont constitutes a similar, much smaller weight in the capped Swix as well. The only remaining big difference between the two indices is the larger weight of Anglo American in the Alsi. When you compare stock market performance over numerous decades, the JSE is still one of the best-performing in the world. However, the local market has underperformed the world index over the last decade, although this has begun to turn over the past two years.
To avoid overlooking opportunities in the local market and to contextualise the prevailing sentiment, it is important to compare South Africa with its emerging market peers. It is not the only country in this basket that is grappling with challenges around funding government debt, less foreign ownership and negative sentiment. Emerging markets have underperformed the world index over the past decade, largely as a result of the stellar performance of the US stock market.
Bond yields and exchange rates are often good barometers of how well or badly a country is doing, and we have seen South Africa’s 10-year bond yield rise steadily over the past eight years as the currency has deteriorated. This can also be seen in the percentage of non-residents holding South African government bonds, which has come down significantly since 2018.
Given the higher yields, one could ask why we don’t put the bulk of our funds in South African government bonds and lock in high returns. But these returns are not risk-free. For example, higher inflation remains persistent globally and there is a risk it could erode the real returns from government bonds, should it rise further.
Considering this risk, we prefer investing in well-managed South African businesses as they are able to adjust their prices in response to inflation, offering investors some protection. Investors should also remember that these higher yields are a good indicator that buying government debt is accompanied by meaningful risk. We should not be blind to this. Cash is also an appealing option. South African oneyear deposits are yielding rates as high as 9.5% — the highest seen since 2009.
When putting together a portfolio, we identify investments that offer the highest expected returns but also weigh up the associated risks and the diversification benefits of uncorrelated returns.
An important decision is whether to prefer “South Africa Inc” shares (companies operating primarily in the local economy) or “rand-hedge” shares (companies that operate offshore and benefit from a weaker rand). The very low valuations of South Africa Inc shares offer more potential upside if the economy recovers, but these are also the businesses facing the brunt of the challenges of operating in South Africa. There are diversification benefits to holding well-priced shares from both categories.
In addition to the direct offshore allocation we hold in our portfolios, we believe that the true offshore exposure in our equity and balanced portfolios is closer to 60% on a look-through basis. This takes into account the earnings many JSE-listed companies generated offshore.
One of the things we have learnt over the last five decades is that investing is cyclical: there will always be a degree of uncertainty and we will have to respond to unprecedented challenges. To deliver the best possible outcomes for our clients we need to remain diligent, carefully weigh up the risks and potential rewards and construct our portfolios from the bottom up. We pay close attention to the asset allocation of our funds and aim to maximise the returns for our clients without unduly risking capital loss. Although this approach may make us look a little foolish when markets are overly exuberant or overly pessimistic, we know that looking beyond prevailing sentiment and doing our own in-depth analysis to inform our decisionmaking has successfully built wealth for our clients over the long term.