Feb 12, 2020
People are trying to be smart – all I am trying to do is not to be idiotic, but it’s harder than most people think.
As we start a new decade it's typical for market pundits to dust off their crystal balls and make optimistic forecasts about the future. While a long-term approach to investing is a cornerstone of our investment philosophy within the Quality capability, we are mindful that not all clients have the luxury of time when assessing the attractiveness of investment opportunities. In situations where investors are either post-retirement or have short-term investment goals, one needs to think carefully about the risk of capital loss, especially when an investor does not have the time to recover from short-term market corrections.
Growth assets (equities, property and commodities) need to deliver superior returns relative to income assets (bonds and cash) to compensate investors for the higher risk embedded in these asset classes. Unfortunately, this outcome is not guaranteed, especially over the short to medium term. South African equities and property delivered poor returns over the last five years, significantly underperforming both inflation and local income assets.
Figure 1: Market returns dominated by global equities (in rands)
Source: Ninety One SA (Pty) Ltd, 31.12.19.
Looking forward, the environment is incredibly uncertain and questions that would be top of mind for many financial advisors include:
As the future is never certain, these are not simple questions to answer. It is important that investors understand probability distributions around forward return expectations, especially when the distribution around the forecasts is quite wide. Research suggests that people are too confident in their own abilities and predictions. As a result, they tend to predict outcome ranges that are too narrow. If they are wrong in those predictions and forecasts are too optimistic, the downside risks to portfolios can be significant. If time is not on your side, you need to insist on defensive investing to avoid such pitfalls. However, if you are too defensive, you potentially miss out on attractive investment opportunities to meet your investment goals. A balanced approach to risk management is thus key when weighing up the potential risk-adjusted returns from available investment opportunities.
The current consensus view is that global equities are expensive, especially because of the strong performance over the last five years. Given a high-level macro view with only a focus on overall index levels, we are sympathetic to that assessment. We, however, remain optimistic on the prospects for the concentrated collection of high-quality global stocks we own in our Cautious Managed portfolio. These stocks trade on similar valuation levels as the overall market (All Country World Index), but they are vastly superior in terms of both is quality and growth outlook. We believe the market has consistently underpriced these quality companies and their ability to compound over time. The range of expected returns around our forecasts is reasonably narrow for the businesses we own, given their growth outlook is less dependent on macroeconomic cycles. We are, however, mindful of the risks to global markets and have catered for these risks through prudent asset allocation and position sizing of individual holdings.
We believe the best local opportunity remains government bonds. They provide a real return in excess of 4%, which is attractive relative to historical real return expectations for bonds of 1-3%.1 Local bonds also provide a natural hedge against the volatility of the South African rand and bring stability to the portfolio, given our exposure to offshore equities. Based on our forecasts, we think local bonds provide an asymmetric payoff profile (i.e. more upside risk than downside risk). We believe the market has largely priced in the potential Moody’s downgrade to junk status.
We appreciate the risks to the fiscus, and as a result, still hold a significant portion of the portfolio in cash. The current real returns of approximately 3% are attractive relative to historical real return expectations of 0-1%.1 Our large cash holding also gives us the flexibility to remain disciplined and only deploy capital when attractive investment opportunities become available.
We have been quite bearish on the outlook for local equities and property for some time. Given the poor performance of these asset classes over the last five years, we are often asked when we are likely to become more optimistic on their prospects. While valuations are more attractive than they have been for some time, the prospects for many ‘SA Inc’ businesses are still dependent on an economic recovery. Unfortunately, the timing of this recovery is incredibly difficult to forecast given the ongoing challenges at Eskom, continued job losses, regulatory uncertainty, and low business and consumer confidence. Current valuations of many of these businesses incorporate some level of recovery. But if the expected recovery does not happen, we believe investors will once again be disappointed with returns. Based on our scenario analysis, the range of future expectations is quite wide and thus we have low conviction in our ability to call the bottom. It is therefore important to be selective and disciplined around security selection on local growth assets.
Diversification, active asset allocation and disciplined portfolio construction are important tools in managing downside risk. The critical role played by financial advisors is understanding the risk profile of clients and ensuring you allocate to solutions which match both the return and risk profiles of underlying investors. We believe the Cautious Managed portfolio can offer investors defensively positioned growth assets which provide inflation-beating returns. At the same time, investors have a significant exposure to income-generating assets, which provide both yield and downside protection. In an increasingly uncertain world, we believe this is the prudent approach investors should be adopting.
1 South African Savings Institute