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2019 Investment Views

Sowing the seeds

28 November 2018
Authors: Clyde RossouwPortfolio Manager, Rob ForsythHead of Quality Research

Rob Forsyth and Clyde Rossouw discuss Quality investing in the coming year.


Rob: Clyde, I think the burning question out there is we haven’t really earned returns for the risk that we have had to take. So, in other words, if you look over the last 3 years, bonds have delivered marginally more than cash but equities have delivered less than cash. So I think everyone is saying why shouldn’t we put our hard hats on and go into full defence mode and put all of our money into the bank, for argument’s sake, but I think there is a balance of risks out there. So how do you see building a portfolio and how much defence you should take versus how much attack?

Clyde: Yeah, sure, Rob. I think the key point here is if you sort of wind the clock back a couple of years, 2014/15 we had extraordinarily high equity valuations on the local market and were on the tail end of a pretty strong rally that started in 2009 and we were warning about some concerns that we were developing in terms of an absence of the continuation of the commodity super-cycle. Obviously, the leadership in the market was becoming narrower and narrower and there were pockets of extreme excess in terms of valuations of different parts of the market and, in aggregate, the market looked like it was priced for mediocre low to mid-single digit returns.

Now that that has effectively transpired the last 3 or 4 years, when we said that 3 or 4 years ago, people used to say well, it can’t be because we are coming off the back of these extraordinarily big numbers. So now we are seeing and rolling in numbers which are mid-single digit, the question then, of course, becomes have we had enough of a valuation reset in terms of the key asset classes to the point at which we can, from this point going forward on a 3-5 year basis, be confident in knowing that the future returns are going to be better?

What is important when you sort of trying to answer that question is to look at what the face value numbers are telling you in terms of yield. So bond yields on the long end of the South African curve are yielding more than 10% and we know, statistically and factually, that is a pretty good starting point in terms of knowing what your returns are going to be for the next couple of years in the absence of yields moving higher because the environment gets worse. In terms of equities, there are a lot of stocks in the local market that are now derating to sort of 9, 10, 11 times earnings mark and the market index in total has derated to sort of 15 times earnings.

So when you look at that and you say to yourself well, if the growth is going to come through even though we are at a period of hiatus, it does start asking the question whether we are – at what point in time can we start getting a little more front foot in terms of allocating more capital and we have been slowly over time whittling down some of that cash with a view of actually starting to invest for the next harvest. Markets move through cycles not dissimilar to agriculture. There are periods where you harvest and there are periods in which you sow and we are going into a phase now where it is closer to sowing time than harvesting time.

Rob: But I think it is quite unusual from a global perspective. Just to put it into context, I mean if we have got inflation that is printing at round about 5% at the moment and we can get, as you say, close to 10 at the long end of the curve, that is 5% real-

Clyde: Sure.

Rob: -which is pretty extraordinary, given that, even if you look in the context of the risk that you want to put in South Africa, is that sort of why we can get quite excited about bonds being, you know, a really good balance to performance?

Clyde: Yeah. Look, I mean it is hard to get excited about bonds in absolute bonds because bonds don’t really resonate with anybody. It’s not really an emotional investment that people can make but the reality is, as you point out, because yields are very high, the order of events that we would see, things have to fall in place in order for us to see the pathway to recovery.

We know that interest rates are too high in South Africa. We are still dealing with a world where – I mean in the developed world, apart from the US where rates are moving up, there has been very little movement in interest rates in Europe or in the UK and, obviously, Japan for that measure whereas emerging markets in general and South Africa in particular have got an extraordinarily high term structure of interest rates.

So the way we look at it is to say well, why would you want to take on risk when corporates are struggling with pricing power? Why not just take the yield that is on offer and wait for the whole term structure of interest rates to decline as the market becomes used to the lower inflation environment? When I talk about low inflation environment, I am not talking about a sort of move between 4.5 and 5 and then back down to 4.5. It is not that kind of – the debate is if you have a 10% yield, the market implicitly believes that inflation is going to be on the outside end of the Reserve Bank’s target band and, if you listen to them in terms of conversation, they are pretty committed to the discipline which is going to take us back into the band.

So either you believe that we don’t – and South Africa for a long period of time has had a credibility gap on the government’s side in terms of financial institutions. So if the Reserve Bank is an adult in the room, you now have a decent Finance Minister in charge even although it is our fifth Finance Minister in 6 years but you now actually have some stability on that front, it actually starts paving the way for more confidence to come through in the market and we do think that is a precursor, you know, in order to get equity valuations to unlock that opportunities will come in the equity market. That is going to come with a lag. The first start of the rally is going to come from bonds.

Rob: Like it did in 1998 actually, obviously in that peak time. I think we have got to be quite careful with our equity selection as well because, if you look at – I think you mentioned the point about pricing power but the oligopolistic structure of the SA market has slowly been dissipating and you look at the return profiles of some of the sectors have actually changed quite a bit. Obviously, property has had its own problems but it needs a very strong funding cycle to be able to continue to generate returns. That is down over 3 years now.

We have got new entrants into different sectors where we didn’t have before. So we had the big 4 banks – well, now guess what? – it’s the big 5 banks. You have got Capitec as well. That is excluding Investec. Discovery Bank is about to launch. Michael Jordaan is launching a bank as well. Then you have got insurance. You have got Firstrand going more into insurance. You have got H&M and Cotton On coming into the apparel markets. You have got Massmart as a bigger player in food distribution and retail. So all of this means you have to be quite careful about your asset selection still. It is not – we are not in a scenario where we can just push a big green button and start adding to equities.

Clyde: Yeah, it is true. Rob, just on that, where do you see pricing power in the economy? If I sort of throw the question back around to you, you have spoken about the oligopoly structures but I mean, if companies want to grow earnings going forward in an environment where there is no GDP growth, where is the growth going to come from? Is it volume; is it price; and how do they actually get the price mechanism through?

Rob: Yeah, it is going to be really tough. I think it is more about the position of the companies and ability to take market share because at the moment the market is not really growing. So we are reverting back to the global business model. Take, you know, an example of Vodacom – so earned fantastic returns over a period of time but now pricing for data is starting to come down and it is very difficult to get away from that pricing paradigm. So I think we have got that in a number of industries so we have to be very careful about the equity selection.

You might argue that there are some elements of pricing in food retail. You might say there is some in insurance. There are regulated pricing environments in some of the hospitals and medical areas of the marketplace but, once again, you are taking on different types of risk then as well. So I think we are saying you have got to do your homework and you have got to really try and stick to looking at those individual equities.

Clyde: Yeah, look, that is definitely a key point. Then if you look at our way we constructed our portfolios, you know people sort of draw the conclusion that it means that you should sell all your equities because actually there is no hope here. I think it is important to think about the sort of axis of growth that we are looking for.

In our portfolios, we have – you know, there is a perception that we just back rand hedges because we are perennial rand bears. I mean that is not necessarily the case because, if you look at the rand at somewhere between R14.50 and R15.00 to the dollar, it is arguably on the weaker end of where it needs to be. So it is not exactly like it is priced for perfection. It is priced for a lot of risk, it is priced for a lot of uncertainty and it is priced for a low growth environment.

So when we look at our portfolios, even though we have a skew towards the offshore earners, it is not because we specifically have a bad call on the currency or a call that the currency is going to weaken. It is we want to gain access to businesses that have some competitive advantage that they have been able to export internationally, so think about a Richemont that clearly is a major player in the luxury goods space or if you think about some of the other offshore earners, BAT – tobacco has not been liked by many people. Tobacco stocks are cheap across the board. That is a business that we think should do a lot better going forward.

Then if you think about some of the mining assets we own, the one area of extraordinarily large deposits that we think is going to be a big area of growth for the SA economy going forward is in the area of manganese. I mean if you look at South Africa’s commodity endowment historically, initially gold was the area where a lot of money was made but that has been a sunset industry for many years now. Platinum has got a number of challenges and there are very few assets that have a growth trajectory in terms of volume. Iron ore looks okay but it looks relatively mature but manganese, we have got 120 years of high grade manganese sitting in the Kalahari and that looks like an opportunity that can be exploited over a multi-year time horizon as long as we get the infrastructure in place.

So if you look at some of the assets we own, like Assore, it is well-plugged into sort of monetising those sort of growth opportunities but, if you sit and think about that, where else are we going to get the growth from from an equity perspective?

Rob: Well, I think we are lucky that obviously we are a multi-asset environment. You can go and look for companies that are best of breed outside of South Africa as well, which gives you a lot of growth optionality because these are companies that are very, very strong in their industries and they can continue to invest and there is a very, very long runway for them to be able to potentially grow into the future.

Hopefully, that is one area where we can still ballast the returns from maybe the risk in the local SA market. You know, it is very, very difficult for companies to make that jump from local champions to offshore champions and that is why you have probably got to do it in a more purer form than the offshore equity selection bucket of the component.

Clyde: Do you think you are paying for that offshore if you look at the prices for global assets versus local assets? I mean is there a premium that demands that you have to believe in the growth or do you think it is reasonable?

Rob: No, we think it is reasonable. You know we still have got a situation where we have got great companies that convert 100% of their cash flows into earnings, that are trading on close to 5% free cash flow yield. Just to put that into context with US bonds, just call it 3% just to make a nice rounding, 5% you are getting a premium over bonds and we think they can grow their cash flows high single digit close to 10%.

So we still think you can get very good returns from that and, if you put that in the context of even South African stocks, the best of breed here, we still don’t think that risk-return is quite commensurate with the risk that you are taking on, particularly as these are global companies that can produce returns in dollars rather than in rands and are a bit less captive to the SA market. So we think that the valuation trade-off still looks pretty good for those companies in terms of generating good returns.

Clyde: And if you sort of think about it, a lot of people try and box our South African funds. They sort of say well, these are quality funds and then because – you know, how do you structure your portfolio if you are looking to make quality investments? I mean is it fair to say that there is a difference between what we will own in SA versus what we own offshore?

Rob: I think the important thing is we obviously put the whole portfolio together. So we try and get a continuum of quality in the portfolio and try to make sure that we can get the best risk-return for the portfolio in each of the buckets. I mean, clearly, the hurdle rate for investing in pure SA equity counters has got to be lower than the global counters because, you know, in high jump parlance terms, you are not going to find too many people that jump 2.40 metres to quality for the Olympics in the South African stock market. So we do have to have a slightly broader philosophy when it comes to the quality companies but that is about constructing the total portfolio and making sure we get the aggregate return mix for the entire equity component of the portfolio.

Clyde: Sure, Then, just lastly, if you sort of think about returns, I mean we obviously are not in a position to make any promises or anything around – we can’t make promises. I mean you have no idea what the future holds so it is completely an idiosyncratic question but I mean what should investors sort of think about if they are kind of considering their variety of different options? They can obviously sit in cash, where they might earn 5-6% in SA; they could invest offshore and the offshore return numbers are looking quite strong at the moment, particularly for the investments that we have made on their behalf on our offshore assets; then local equities have been disappointing so far this year, but I mean, if you were to kind of think about what markets could deliver or in terms of what outcomes could come, how would you answer that question?

Rob: Well, I think you have always got to look on a longer term. You can’t look on a year because you have no chance of predicting the next year. You know we talked about – the interlude was when will equities basically deliver the risk premium that they are meant to deliver on cash and it looks as though we are getting closer towards that period: So you would normally expect a good risk premium of 5-6%.

So in the medium term, if we can deliver a 5% risk premium over cash, we are talking about round about a 12% return, a little bit of rerating from bonds because you are already getting a 4% real return, you should be able to start getting towards double digit returns on an asset allocation fund over a 5 year period we would believe but it is not going to happen necessarily in year 1. You have got to hold on and we think the risk is dissipating, not increasing, at this point in time.

Clyde: Okay, great, thanks.

Clyde Rossouw
Clyde Rossouw Portfolio Manager
Rob Forsyth
Rob Forsyth Head of Quality Research

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