When there is more upside
The future is inherently unpredictable. This uncertainty, and the fear that accompanies it, creates a risk premium: higher potential returns to compensate investors for taking on higher risk (the reason that equities tend to outperform over the long term).
As risk and return are inherently linked, it is important to understand the risk-return trade-off to invest successfully.
If you invest in growth assets (those with higher risk premiums) for long periods, you significantly improve the odds of retiring comfortably. And if you buy quality securities at good prices, you improve the odds of earning higher returns at lower levels of risk.
Expensive assets can deliver good returns, but only if growth rates exceed expectations or buyers push prices up further. Instead of trying to forecast shortterm earnings or wondering whether the average investor is likely to be a buyer or seller in the months ahead, investors should focus on the expectations they believe are embedded in the price.
When the expectations that are discounted into a share price are very low, downside is limited even if the outlook worsens. But returns should be acceptable if conditions remain the same, and excellent if they improve – thereby creating positive asymmetry. Negative asymmetry is likely when confidence levels are high.
High expectations are factored into the prices of many financial assets. Developed market bonds and credit remain expensive. Similarly, we are cautious of crowded developed market stocks, especially the FAANGs (Facebook, Apple, Amazon, Netflix and Google); the darlings of the market.
This suggests that returns from these assets are likely to disappoint and negative asymmetry may be at play. There is a difference between a great company and a great investment.
Worryingly, the prices of popular stocks have continued to rise this year despite a ramp-up in reasons to temper expectations. These include the threat of trade wars, tightening US monetary policy, and potentially unsustainable levels of profitability that have been boosted by favourable economic conditions, record margins and low tax rates. It is clear that a significant proportion of equity market participants – and notably passive products – is not price sensitive, or risk averse.
Many South African companies continue to find themselves out of favour. This has presented the opportunity to accumulate several attractively priced shares where valuations are underpinned by strong free cash flow.
These can be viewed as asymmetrical opportunities, because while it is possible that conditions may get worse and the shares may get cheaper, this would probably be temporary.
Shaun le Roux is a fund manager at PSG Asset Management