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Investment views

Sowing seeds for future growth

14 February 2019

Last year was a bruising year for investors, with negative returns across a broad set of markets and asset classes. Developed market equities, emerging market equities, commodities and global credit, to mention a few, generated negative US dollar returns. Back home, we had to contend with yet another year of disappointing equity returns, with only cash and bonds providing positive returns.

Watch the full interview with Clyde Rossouw.

In an interview with Deputy Managing Director Sangeeth Sewnath, Co-Head of Quality, Clyde Rossouw, reflects on the sustainability of returns for the SA bond market given that it has run hard, and whether there is still opportunity offshore.

We had a strong start to 2018, but the SA equity market fell sharply towards the end of the year. Even if we look back over the last five years, our biggest growth engine – SA equities – barely kept pace with inflation. Where to from here for investors?

During 2018, we expressed our concerns about the lack of liquidity. It was a difficult year for markets due to a challenging geopolitical environment in which politics took centre stage, and tighter monetary policy put pressure on liquidity.

While it is heartening to think that a new year brings a new market direction, it’s important for investors to recognise that when you are investing for the longer term there will always be asset classes and opportunities that can be exploited. So, for us, if you look at the Investec Opportunity Fund, we still believe that the growth drivers for our portfolio for the next 2-5 years will come from global equities. We have already seen a rebound occurring in January, particularly in the offshore markets. Looking at fixed income, SA bonds had a reasonably good year in 2018. We believe there is more upside as disinflation takes hold in 2019.

So, we would encourage long-term investors not to become despondent. I know we have had three years of very muted returns and investors may be tempted to turn to cash. We believe it is a good time to sow the seeds for future returns from growth assets.

I can see the temptation – cash is giving investors a return of 7-8%, which is above inflation. Do you think cash will remain king?

It’s important to understand the context of those real returns. SA growth has decelerated significantly over the past year and the retail trading updates show the sector is under pressure. Across the board, there has been a massive slowdown in December, which will only feed through to the GDP numbers that will be released in February/March. Typically, in the six months leading up to an election, people tend to put off any big spending decisions and businesses tend to pull back on capital expenditure, due to political uncertainty. We believe sluggish growth will move the Reserve Bank to cut rates.

Cash is unlikely to give you the same level of return as last year. Depending on how the year unfolds from a liquidity perspective, cash could be a lot more disappointing compared to other asset classes. In SA, listed property, bonds and equities, both the locally-oriented and the rand-hedge shares, are now starting to offer some material value.

Let’s look at SA bonds. How do you view this asset class?

Our holdings in SA bonds reflect our view that significant real value exists, particularly at the long end of the curve. You have a 9% yield in an environment where inflation has peaked at 4.5% and is on a downward trajectory, so that is a substantial real return in anyone’s books. Last year, bonds gave us a high single-digit return from the long end of the curve, while SA equities were strongly negative. That tells us that we need a reset to occur in financial markets.

We believe that without a significant rally in bonds, the SA equity market is not going to perform because there is no strong driver of earnings in the near term. Both locally-oriented and internationally-oriented equities are struggling to grow their earnings.
Without a re-rating that comes from lower interest rates, we are not going to get massive returns from stock markets, particularly on the domestic front.

So, we’d first need to see lower bond yields fuelled by lower inflation. Of course, there are fiscal and political dynamics at play, which could have an impact on the valuations of bonds. But these factors should ebb during 2019, potentially offering an opportunity to switch some of our bond holdings into equities.

Listed property took a knock of 25% over the year. Do you see some opportunities emerging?

We’ve had very little exposure to listed property, and some of the concerns we had about the sector have played out. For the first time again in many years, the absolute dividend yields in the property sector are now starting to get closer to the levels offered by the long end of the bond market.

While the relative value has started to improve, investors need to bear in mind that the guaranteed rental growth rate that everyone has been banking on is no longer there. We see distribution growth probably around the 3% mark for the sector this year, with some companies producing sub-zero growth. In other words, the distributions will go backwards, and I think that is important to bear in mind.

Another key consideration is that the dividend yields in the property sector are in many cases supported by continuous issuance, either companies tapping into the bond market or, issuing units by virtue of scrip dividends or placements. So, while the true dividend yield is becoming more attractive, you cannot take it at face value. Adjusting for the underlying free cash flows, we still think a 100-basis point increase is needed to attract more investment into listed property. So, 2019 could see us increasing our weightings to the sector, subject to bonds re-rating and listed property yields offering an additional 1%.

Do you still view offshore equities as a key growth driver?

Our high-quality offshore equities again did well for us last year, providing attractive returns. Rand depreciation over the course of 2018 further bolstered returns for SA rand investors. We are not expecting much action from the currency in terms of driving returns in 2019, but we believe our offshore equities are still priced to deliver attractive returns. There has been a significant reset in offshore equity prices and the valuations of our offshore equities have improved substantially. The business fundamentals remain positive and corporate earnings still appear to be strong.

Are you concerned about the valuations of global quality stocks?

The global quality equities in our portfolio are typically priced for outperformance because of their superior earnings growth. Their outperformance in 2018 can largely be attributed to better drawdown-risk characteristics than the broader market. Our stocks are less exposed to economic cycles, so their better earnings dynamics in a slowing growth environment have also been favourable for investors. We believe our stocks remain attractively priced, given their potential to outperform the market over the medium term in terms of earnings growth and free cash-flow growth.

What are your views on SA equities now that valuations are more attractive?

Across the board, a lot of stocks are now trading on high single-digit multiples, which is a refreshing change from where we were a couple of years ago. We started voicing our valuation concerns in 2014/2015, warning investors of the high likelihood of low single-digit returns from the equity market based on the starting valuation levels. This has now played out. The valuations are looking much better. Overall, the FTSE/JSE All Share Index is now trading at around 12.5x this year’s earnings, which is lower than its long-term average; so that is encouraging.

We have a very low weighting in financial and domestic industrial stocks, some exposure to resources and no holdings in retailers. Unfavourable trading conditions have resulted in retailers performing poorly. We saw large downward movements in their share prices in December and January as the market reset its expectations. We are getting closer to the point where we can consider sowing seeds for future growth.

Equity opportunities will emerge this year, but we are not going to jump in and ‘catch the falling knives’. Should earnings reach a trough within the first half of 2019, and we have a positive interest rate environment, we could see a re-rating in stocks. Hence, we anticipate that in a few months’ time the environment may be more favourable to proactively allocate capital to companies that are offering good value.

2018 was a very difficult year, but the Investec Opportunity Fund showed resilience thanks to your quality style of investing. Where to from here?

While the Investec Opportunity Fund’s relative performance was gratifying, the absolute performance was slightly negative. Nevertheless, we were pleased with our capital preservation efforts given the broad-based market sell-off. The Investec Opportunity Fund preserved more capital than the average fund in its sector, validating our investment approach. What’s encouraging for us is that the investment environment has become more favourable to pursue attractive real returns over the long term. To summarise: we still like SA bonds; we’re seeing much better value in local equities; and we expect continued growth opportunities offshore. So, from an asset allocation perspective, we have identified several drivers of returns that should help us to deliver inflation-beating returns over the long term.

Clyde Rossouw
Clyde RossouwPortfolio Manager

Important information

All information provided is product related and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The TER of the Investec Opportunity Fund (A) class is 1.50%. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA).

This document is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Investec Asset Management (Pty) Ltd is an authorised financial services provider. Issued, February 2019.

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