In pursuit of potential

DUNCAN ARTUS, Chief Investment Officer, Allan Gray

The most important determinant of investment success is the price you pay for an asset, and valuations for many quality companies are the cheapest they have been for a long time.

Absolute returns from SA equities have been low. The market has underperformed inflation over three and five years and is flat since 2014, and from 2006 when measured in US dollars. This is despite the extraordinary performance of Naspers.

The yield on our 10-year government bond is a transparent barometer on how we are doing financially as a country. After the large sell-off in the first quarter to over 12%, the yield has settled back at 9.2%. This is still a very high cost of borrowing if we consider inflation is around 3%. In other words, markets are only willing to lend to South Africa at a real interest rate of 6%. This is a very high cost of capital, partially due to our rapidly deteriorating financial position, which has been exacerbated by the fiscal response to the pandemic and collapsing tax revenues. We expect the fiscal deficit to be over R700bn in 2021. Put simply, South Africa cannot afford it over the medium term. We need strong economic growth that requires strong, sensible leadership to get out of this hole.

Significant disparity in global markets

There is significant disparity in global markets, and a disconnect between fundamentals and the level of equities. This will only be known for sure with hindsight, but what we do know, is that central bank balance sheets have expanded rapidly. This excess liquidity often finds its way into asset prices. The US Federal Reserve’s balance sheet has increased from US$4tn to US$7tn in response to the pandemic.

The disparity can be seen by comparing the performance of US equities to the rest of the world. US markets have hugely outperformed and, in fact, the MSCI All Country World Index, excluding the US, is lower than it was in 2007.

While the US market has outperformed, like the ALSI, it has also been driven by a small number of shares. The so-called FAAANM shares (Facebook, Amazon, Apple, Alphabet, Netflix, Microsoft) are up four times (January 2015-July 2020), while the rest of the market is only up 26%. We believe that while they are great businesses, the valuations look stretched. Any kind of mean reversion could result in strong outperformance of the Index.

Pessimism presents opportunities

It is in times of great pessimism that great value is found. For example, we have done a lot of work on the downside risks and balance sheets of our banking sector. Given their pivotal role in an economy, we know that problems and weakness are going to show up in their loan books. We believe this is more than discounted into the current level of share prices. Our banking system earns higher returns on capital than most developed market banks, which gives our banks a greater ability to absorb increased bad debts. We believe bad debts would have to be three to four times higher than those during the great financial crises of 2009 before wiping out their excess capital buffers.

Cognisant of the risks

The levels of disparity in global equity markets are extreme by historical standards. Unfortunately, this knowledge does not tell when it is going to change. We are excited by the positioning of our portfolio but are aware of the extraordinary times we as investors and ordinary people find ourselves in. This means that thinking about and managing risk is as important as thinking about returns.