Dr Saville’s prescription for unhealthy markets
An overwhelmingly negative mood is weighing heavily on investors and equity markets. However, for Cannon Asset Managers, this is nirvana.
Global markets are depressed
This January saw the worst ever start to a year on world equity markets with developed markets off 8% and emerging markets down 12%, in US dollar terms. The sub-prime crisis represents the greatest credit excess in US financial history, a result of unwarranted risk taking and inflated asset prices, with housing markets leading the charge.
To get a sense of the extent of January’s equity market selloff, the value that was lost is equivalent to 40% of the US economy or almost 20 times the South African GDP. Moreover, there have been few places to hide: investors have run for cover, switching assets into bonds or hedge funds, but the HFRI (Hedge Fund Return Index) lost 2.1% in January 2008 and a further 2.5% in March 2008. The panic has seen US Treasury yields driven down to just 1.6% (with price inflation at 4.0%) as investors have rushed for the safety of government bonds.
Central banks have responded to this environment by slashing interest rates and pumping liquidity into the system. Sadly, this liquidity has not reached its intended targets, but has rather been pouring into commodity markets, with the result that prices of both hard and soft commodities have scaled new heights in 2008. Moreover, commodity fund inflows so far this year have already exceeded the flows seen in each of 2003, 2004 and 2005.
At home, the picture also looks bleak
In South Africa, sentiment is being dragged down by uncertainty regarding the political transition within the ANC, crime, load shedding and the skills shortage, amongst other things. The mood has been aggravated by sharply rising inflation, driven by uncontrollable food and fuel price movements, which has led to higher interest rates and sagging retail sales. Further interest rate hikes are on the cards, with another 50 basis point increase likely in June.
The South African equity market has responded to the despair with even greater volatility than other emerging markets. In part, this has been exacerbated by the decline in the rand: the South African currency has been the worst performing currency in the world relative to the US dollar for the year to date.
As usual, however, markets have overreacted to the gloom. The economic outlook is, in fact, significantly brighter than markets are pricing.
Things are not as bad as they may seem
On the global front, the 20% slump in equity values has resulted in US large cap stocks being cheaper than at any point in last 70 years. Although earnings engines have been set back, they have not been permanently damaged. Some 80 million people are added to the world population each year, representing growing markets for consumer goods. While some of the developed economies are seeing more modest growth, China (the world’s fourth largest economy) and India (the 12th largest) are still seeing growth in the region of 8%-10%.
Closer to home, the sub-Saharan African region is the third-fastest growing region in the world, recording growth better than 6% in 2007. Further, whilst the Zimbabwe situation is clouding the outlook for southern Africa, if we exclude Zimbabwe, the SADC countries are performing admirably. Since 2000, the Namibian economy has doubled in size and Botswana has the highest per capita GDP in US dollar terms on the continent. Angola now ranks as one of the fastest growing countries in the world.
Considering South Africa, the decade of uninterrupted growth in the economy is set to continue. The investment drought is long over, with investment spending now close to the 25% of GDP target as government and the private sector are massively expanding infrastructural capacity. The country has seen 15 years of structural adjustment with sound fiscal and monetary policy in place. Last year saw the first budgeted surplus ever and exchange control for the vast majority of the population has been all but abolished.
On the currency front, the rand looks falsely weak as its correlation with commodity prices has broken down but this is likely to revert in the medium term. Using purchasing power parity as a guideline, around R6.00 to the US dollar looks close to fair value for the Rand.
This means that there are great opportunities
By stripping emotion out of the investment decision, Cannon Asset Managers are taking advantage of exceptional opportunities on offer. Investors are all too often blinded by either optimism or pessimism: they tend to overlook all the evidence which doesn’t fit their current belief.
Equities are the top-performing asset class over the long term. To move out of this class at precisely the time when they are offering such value would be to give up the potential to earn substantial returns.
Cannon Asset Managers’ recipe for success
Buy assets that are mispriced
Forget market timing, it doesn’t work
Buy quality
Buy to hold (with minimum expense and without leverage)
Engage a philosophy that works and stick to it: buy value
Based on the S&P 500 over the period 1980 to 2007, the probability of a capital loss when holding equities for 10 years falls to zero, while the average annualised return of a ten-year holding period from 1980 to 2007 rose to 15.6%.
Cannon Asset Managers epitomises the “buy to hold” strategy with the lowest turnover of South African asset managers and one of the lowest in the world. This gives the investment house one of the lowest expense ratios in the industry. In turn, this factor converts in an important additive in driving investment returns. On this front, it is interesting to note that since 2000, the flagship Cannon All Equities portfolio has returned 720% versus the market’s 410%, and this has been done with lower-than-market volatility, reflecting the dual emphasis that Cannon Asset Managers places on quality and value in their investment process.
Adrian Saville (pictured above right) is CIO of Cannon Asset Managers and holds a Visiting Professorship in Economics and Finance at the Gordon Institute of Business Science.
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