2006 was yet another triumphant year for the optimists. Our optimistic prediction at the beginning of the year of a 25% return from SA equities proved still too conservative, as the market delivered yet another massive 40% plus return. And this, despite what was not the most perfect of years: 2006 saw a war in the Middle East, four rate hikes, more chaos in Iraq, more HIV/AIDS, more crime, more corruption, rape trials, further deterioration in Zimbabwe and the first blows in the fight for presidential succession.
So what fuelled the 41% return enjoyed by equity investors last year?
Firstly, the Chinese/Indian scramble for resources in Africa continued, with the resources sector up 44%.
Secondly, financials and industrials, which were relatively underpriced, finally received the attention they deserved, returning 36% and 42% respectively.
In line with global developments, and fuelled by some very attractive valuations, the wave of private equity investors scouring our market has resulted in a substantial rerating of a number of our listed companies. While some have since delisted, having been bought out by both local and foreign investors, others have rallied strongly in anticipation of very attractive cash offers.
Thirdly, despite a brief mid-year collapse in confidence, global sentiment towards emerging markets remained positive.
The Rand, predictably, continued its gradual decline, ending down roughly 9% against the US Dollar (although it was typically volatile, shedding roughly 22% at one stage) and oil returned to more benign levels.
So what then can we expect from 2007?
From an interest rate perspective, we are either at the peak, or almost there. While another 50bps up is possible, it becomes less and less likely if oil stays at current levels.
Which it should. A variety of factors have contributed to the weakness in the oil price, including a milder than expected hurricane season, a warmer than expected winter in the Northern hemisphere, less speculative activity, additional capacity and declining geo-political tensions. A democratically run US Congress should also ease (as opposed to fuel) further tensions.
Once again, expect a gradually declining currency, and given the weaker oil price, you should see inflation peaking in the second quarter.
What are the risks for 2007?
The two main risks for 2007 are:
* US housing market: 2007 will see the US housing market under renewed pressure.
A soft landing will see house prices drift sideways to slightly off going forward, putting the heavily over-geared US consumer under pressure but unlikely to make them stop spending completely or panic.
A hard/crash landing, however, would see prices correct fairly significantly, panic from consumers, and spending would dry up completely. The question then would be whether the Asian consumer can take over from the US consumer, in which case the world would slow but not stall.
We believe the softer landing to be the more likely outcome.
The extent to which the US (and hence the global economy) slows, will dictate Chinese/Indian growth, which in turn will affect demand for our commodities, which in turn affects our currency, our economic growth and the performance of the JSE.
* Presidential succession will play itself out continuously throughout the year. There will be rumours, denials and lots or rhetoric. Some candidates will be market-friendly and others not. Hopefully sanity prevails over emotions. Watch this space.
So what should investors be doing?
Remain diversified equities arent cheap and a correction at any stage is entirely possible. However, equities are not in dangerous territory, as is evidenced by the fact that there are equity funds on PEs of approximately 12x, with dividend yields of up to 4%. This year should once again see equities outperforming bonds, although by a lot less than the past few years, which will make portfolio diversification more palatable. Barring any abnormal events, 2007 should see equity returns comfortably outpacing inflation, bonds returning roughly 8% and cash approximately 9%.
By Jeremy Gardiner, Director, Investec Asset Management
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Portfolio manager commentary on top performing funds:
Investec Value Fund - John Biccard, portfolio manager
(Top-performing equity fund across all categories over five years and first in its category over the quarter and second over the year, with a return of 41.56%* over the year.)
December brought to a close what has been a very rewarding quarter for the Value Fund, with Decembers 7% return bringing the quarterly return up to a substantial 21.59% - well ahead of the All Share Indexs return of 11.8% and sufficient to place the fund as the top performing Value unit trust over the quarter. After a disappointing second quarter of the year, the strong finish to the year enabled the fund to end the year as the second best value unit trust with a return of 41.56% - in line with the All Share Indexs return of 41.2% and a good result when one considers that at mid year the fund was around 10% behind the index. Investors should also note that 2006s return was sufficient to place the fund in position 6 out of 54 funds if the fund is to be compared to funds in the General Equity sector. Over five years the fund remains the best performing equity fund across all sectors with a 41.8% compound return.
Performance over the last quarter of the year was driven by the funds large positions in banks (+24% over the quarter), general retailers (+28%) and mobile telecoms (+35%), as well as our small positions in the underperforming areas of oil and gas (+3%), general mining (+3%) and life insurance (+4%). The strong run up in domestic interest rate stocks over the last quarter was the main feature of the quarter and reflected the combination of a deeply oversold position at mid year together with a moderation in the markets panic with respect to rising inflation and interest rates (which in turn was due to rapidly falling commodity prices especially oil as well as the Reserve Banks slightly less hawkish comments at the back end of 2006). The rapid fall in commodities had a double whammy positive impact on your portfolio, as it not only assisted in the rally in domestic interest rate sensitive stocks (although we will argue that the sub 10 PEs that were applicable on a number of these stocks also assisted the rally), but it also prompted profit taking in resources in which we remain underweight.
Over the month we added to our holdings in Steinhoff, Ellerine, JD Group, and Foschini and introduced a small holding in DRD Gold and took profits in Bidvest and Naspers. In addition, given the massive run up in share prices and valuations over the last quarter, we have made the decision to up the cash holding in the fund to around 10% and as a result we sold out our holdings entirely in four stocks which had reached our price targets, namely MTN, Telkom, Illovo and Barloworld.
Looking ahead, importantly we emphasise that, given the funds more than 40% compound return over the last five years, that returns over the next few years are expected to be substantially lower. That said, the fair value of our holdings remains above current share prices and for the portfolio as a whole, we estimate approximately 15% upside to full valuations. It should also be noted that there is a very real possibility that the market overshoots fair value and so our advice is for unit holders to hold on but with tempered expectations. The average PE of the top 10 stocks (which make up nearly 60% of the portfolio) is still only 12 times a 25% discount to the market and a reasonably low absolute level given the quality of the top ten holdings. With respect to stock selection, despite the strong outperformance of financial and industrial stocks over the last quarter of 2006, we are not tempted to switch into resources as all that has in fact happened is that financial and industrial stocks have recouped the ground they lost over the first half of 2006. Given that resource stocks are not trading at a discount to the 12 PE of our top ten holdings and that dollar resource prices are falling (thus resulting in some question marks with respect to resources 2007s earnings) - in contrast to our conviction that the financial and industrial stocks we hold will continue to grow, we stick to our financial and industrial overweight and resource underweight. Note that these good fundamentals for financials and industrial stocks are further enhanced by the rash of private equity buy outs (which are currently focussed on the FINDI sector) as well as the fact that the 2010 soccer World Cup and its associated euphoria is now only three years away.
Investec Commodity Fund - Daniel Sacks, Portfolio Manager
(top-performing fund in its sector over 1 year, 2 years, 3 years and 10 years, with a return over the year of 50.37%* and the top-performing fund overall over 2 and 10 years)
The Investec Commodity Fund appreciated by 10.8% over the last quarter, handsomely out-performing its benchmark, the JSE Resources Index, which rose by 4.5%. The quarter saw a weakness in most commodity prices. The bellweather copper price, in particular, fell 17%, as demand side concerns (slowdown in US housing starts, a decrease in Chinese imports, and substitution in some applications) and increased supply from scrap, led to a rise in inventory levels and the resulting sell-off. We held the (correct) view that the copper price would fall and halved our holdings in Anglo and BHP Billton, thereby greatly benefiting fund performance, particularly in the face of the sell-off during the last two months of 2006. While sector performance was flat over the final quarter of the year, the Investec Commodity Fund rose 2.9%.
The fund also benefited from large holdings in platinum shares and the steel sector (industrial metals), a position we have maintained throughout 2006. We also held less Sasol, which came under pressure due to lower energy prices.
Looking ahead, the market is focussing on demand side concerns (particularly for copper), and the possibility of a large surplus of copper during 2007. Copper sentiment is also influencing the other metals markets. We are still, however, positive on metal prices on a medium to long term.
Given the markets greater concern over risk and volatility, we like BHPBilliton for its bulk commodity exposure (iron-ore and coal are 36% of the portfolio), since prices for these commodities are contracted for the next twelve months and are therefore not subject to terminal market volatility. BHPBilliton is not expensive, trading at 7.5x FY07 earnings, with very strong cashflow and likely more capital management to come.
In contrast, Anglo is trading on a more expensive forward multiple of 11.6x, even allowing for stronger precious metals prices. The market is probably already stripping out a soon to be sold Mondi and Anglogold from Anglos valuation but, even so, Anglo then trades on a 9.7x multiple. We fail to see why Anglo attracts a 30% premium to BHPBilliton when both businesses are equally exposed to the jitter inducing copper price and have overlapping portfolios in terms of met coal, steam coal and iron-ore. We also fail to believe that Anglo is a target for a buy-out given its rich valuation too high market capitalisation.
For the year ahead, we are more bullish on precious metals than base. We believe that a weakening dollar, strong supply versus demand fundamentals, and diversification benefits should support precious metals prices. Within precious metals equities we currently prefer platinum to gold. The current forward P/E ratio for the platinum sector is in the order of 15x. This indicates that this sector still offers markedly less risk than the gold sector, priced at over 20x.
Furthermore, given increased PGM prices and an expected increase in output, dividend yields for the Platinum stocks exceed 5%, representing good absolute value. While we favour the sector in general, we believe Angloplatss relatively higher gearing to the metal prices will drive its outperformance.
Investec Worldwide Fund - James Hand, co-ordinator of Four Factor team
(top-performing fund in its category over 6 months, 1 year, 2 years and 3 years, with a return of 38.3%* over the year to end 2006)
The MSCI World finished 2006 on an extremely strong note, rising 8.5% in US dollar terms. In rand terms this was significantly worse as the rand strengthened after its weakness in the third quarter. However, the overall year stayed in good shape with the MSCI World Index up an impressive 33% for South African investors.
The strength in the markets was broad-based with most sectors posting good US dollar returns. The strong performers were Materials and Telecoms with strong metal prices driving the former and solid free cashflow generation the latter. On the negative side Healthcare continued its poor performance (it was the second worst performer over the year after IT) as large companies such as Pfizer and AstraZeneca continued to face disappointments in their drug pipelines. With generic pharmaceutical companies continuing to challenge the patents of large companies the outlook for the pharma sector remains tough.
The Fund had a strong quarter outperforming the benchmark by 2.98%. This caps a very good year for the Fund which was well ahead of target outperformance. Performance for the period was driven by two key sectors Materials and Steel. Within the materials sector a takeover of Phelps Dodge by Freeport-McMoran and strong performance from all of our metals names drove performance. Steel names also benefited as investors became increasingly confident that the US Federal Reserve has engineered a soft landing for the US economy, meaning that global steel demand should remain strong.
World equity markets still look appealing on valuation grounds, despite our concerns over accelerating momentum. The continued high level of overall liquidity creation and strong merger & acquisition activity, particularly from private equity funds, provides support for current price levels though the rising level of new equity issuance, especially from China, does give some concern particularly as the quality of the companies offered in the new issues market does seem to be deteriorating.
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