Aug 25, 2021
For the greater part of five years, being sceptical of SA equities has been understandable; equity investors have battled to beat inflation consistently and South African asset classes generally have struggled. SA investors have earned higher real returns from global equities.
Domestic equity investors have had to put up with high volatility and poor returns. Over this period, SA equities have lagged SA bonds and barely outperformed cash. The SA market was seen as expensive, and a lacklustre domestic and global growth environment meant that the prospects for many local stocks were unfavourable.
Behavioural economist, Dr Shahram Heshmat wrote in ‘Psychology Today’: “Once we have formed a view, we embrace information that confirms that view, while ignoring, or rejecting, information that casts doubts on it. Confirmation bias suggests that we don’t perceive circumstances objectively. We pick out those bits of data that makes us feel good because they confirm our prejudices. Thus, we may become prisoners of our assumptions.”1
Most people stick to one newspaper, news channel or political website, and few of these present a balanced picture. Thus, most people hear a version of the news that is totally unlike the one heard by those on the other side of the debate. When all the facts and opinions you hear confirm your own beliefs, mental life is very relaxed but not very enriching. We believe that cognitive biases can greatly influence investors’ ability to accurately evaluate investment opportunities. Even when market conditions or the prospects for businesses change, market participants may stick to views that are no longer accurate or reflect the current situation.
Most market participants currently have established views about the unprecedented (or at least exceptional) developments in a few areas: the COVID-19 pandemic and its economic impact, disruption to labour and supply chains, central bank stimulus, government intervention and structural changes to consumer spending. We guard against behavioural biases when making investment decisions. It is important to look through noise and emotions in order to identify structural changes in trends, sectors and markets.
The investment picture has changed considerably since the arrival of the pandemic. Last year’s COVID-19 market crash saw our market losing around a third of its value, in line with global markets. The speed of the market recovery caught many investors by surprise. Roughly a year after the pandemic struck, the SA market gained a staggering 54% (12 months to end March). The latest 12-month figure is a very healthy 27% (as at end July).
Figure 1: SA asset class returns (12 months to 31 July 2021)
Source: Bloomberg to 31 July 2021.
Since the onset of the pandemic, fiscal and monetary stimulus measures have bolstered local and global markets. During 2008, a lot of liquidity was pumped into the banking system to alleviate financial stress. One of the differences between the recent fiscal and monetary intervention and the measures employed in 2008, is that the current stimulus has been channeled directly into the bank accounts of consumers. The SA market is inextricably linked to the fortunes of the global economy and global markets. So, it’s important to consider where we are in the global cycle.
While markets have enjoyed a strong rebound from the COVID-19 lows, we are now approaching the middle of the cycle where global economic growth is more moderate and broader equity market returns are typically more modest. Over the last few months, market exuberance has shifted to worries about higher inflation, slower growth, and ‘peak’ liquidity. Inflation is rising across the world, largely due to the low base effects of 2020, as well as labour and supply chain disruption caused by the COVID-19 economic shocks. And as per usual, markets climb the wall of worry… When inflation is too low, markets worry about it because companies have no pricing power and when inflation is too high, the concern is that bond yields may spike or become disorderly, putting pressure on equity markets.
When you go back in history, global equity markets tend to do well when inflation is within the 1-3% range. At these levels, companies that have pricing power can push through inflationary increases. We are therefore seeking out those companies that have the ability to carefully manage their costs, maintain their margins and increase their prices where needed.
Investors are also fretting about policy makers cutting back liquidity. The US Federal Reserve (the Fed) could start reducing its massive monetary support to the US economy by the end of this year or early next year by trimming its bond purchases. But there is no clear timeline yet on when the Fed’s tapering will commence. US interest rate hikes are widely expected to ‘lift off’ in 2023. We believe that in an environment where inflation is controlled, tapering is transparent, orderly and well telegraphed, and interest rates go up for the right reasons, equity markets should do reasonably well. It is also important to note that while global growth is slowing, it remains at or above trend, which is positive for equities.
We construct our portfolio using intensive fundamental research and bottom-up stock selection. Our investment philosophy allocates capital to stocks where expected future earnings are being revised upwards, and we like to buy these at reasonable valuations. We believe that what moves the share price for a particular stock from its current level is the market’s change in earnings expectations – if these are revised upwards, it drives the share price higher, and similarly, if these are revised downwards, the share is likely to underperform.
While we have seen a broad-based recovery in earnings across SA equity sectors, we are likely to see more significant differentiation over the next few months. Valuation and earnings dispersions within sectors are creating compelling investment opportunities for stock pickers.
Since the third quarter of last year, SA cyclical stocks have rallied strongly thanks to a material improvement in their earnings prospects, with many beating consensus forecasts, leading to improving sentiment towards these sectors. In terms of our domestic-oriented (SA Inc.) holdings, we continue to see earnings upgrades, which we believe are likely to keep exceeding analysts’ expectations. Our SA Inc. holdings include apparel retailers Foschini and Truworths, and SA banks Absa, FirstRand and Capitec Bank. Despite material upgrades over the last six months, we see further upside to banks’ earnings. The COVID-19 economic shocks meant that SA banks had to make substantial provisions for bad debts last year and we believe many of those provisions are overly conservative.
Figure 2: Earnings revisions profile across industries (Jan 2020 = 100)
Source: Bloomberg, Ninety One, as at 5 July 2021.
Resource stocks have benefited substantially from improving global growth expectations, led by positive vaccine developments and a rebound in manufacturing and economic activity. Higher commodity prices have pushed resource companies’ earnings higher, resulting in earnings upgrades. The higher spot prices in iron ore, copper and platinum group metals (PGMs) were not fully reflected in earnings expectations, and we continue to see an upward revision of these expectations, although momentum has slowed. We have exposure to diversified miners Anglo American, BHP Group and African Rainbow Minerals. Slower supply and tight commodity markets with low inventory levels have bolstered these companies. While we have trimmed some of our positions in the mining sector, we still have a healthy allocation to diversified miners and PGM miners. We favour companies with potential for earnings upgrades where supply-demand dynamics are favourable.
Figure 3: Robust earnings revisions but varying prospects for resources
Average earnings revisions of the general and platinum miners (Jan 2020 = 100)
Source: Bloomberg, Ninety One, as at 5 July 2021.
The defensive stocks in our portfolio are an important diversifier, as these holdings are less sensitive to economic cycles. Almost a third of the SA equity portion of the portfolio consists of defensive stocks. We recently initiated positions in the healthcare sector, investing in Aspen Pharmacare and Life Healthcare. Both trade at multiples that do not yet incorporate the operational recovery we expect in future. Portfolio holdings such as Naspers, Prosus, Richemont and Bidcorp, provide protection against potential rand depreciation. Overall, the portfolio still has a pro-cyclical tilt.
We remain positive on global equity markets as we transition into a mid-cycle growth and expansion environment. The global growth backdrop should still be supportive for emerging markets such as South Africa.
The recent civil unrest in our country was very unfortunate and we could see some impact on GDP growth this year. However, the disruption to business was very region-specific (mainly KwaZulu Natal and Gauteng). In terms of our portfolio holdings, the impact on earnings and revenue is limited; these listed businesses are also fully insured. What is heartening is that there has been a cohesive effort from business and civil society to support communities that have borne the brunt of the unrest.
In terms of the medium- to longer-term outlook, there are some positive signs of structural reform in South Africa. Examples include recent initiatives to increase the self-generation energy capacity for companies to 100 megawatts (from just 1MW) and the part-privatisation of the beleaguered South African Airways. We are encouraged by the meaningful overhaul of leadership in critical bodies (the Special Investigating Unit, the National Prosecuting Authority and the South African Revenue Service), significant progress on the corruption clampdown, and the recent cabinet changes.
We believe the appealing valuations and a strong earnings recovery profile in the banking, retail, and resources sectors should drive attractive returns for SA equity investors over the medium term. The portfolio is actively managed with exposure adjusted to tap into those opportunities where earnings expectations as well as sentiment are improving, which allows us to keep our clients in the game.
1 What is confirmation bias? Psychology Today, 23 April, 2015.
Co-Head of Quality, Clyde Rossouw, has had a fascinating career in investments, having witnessed several market crises such as the dotcom bubble, the Great Financial Crisis and more recently, the COVID-19 market crash. Clyde shares some of the key investment lessons he has learnt.