Fund managers take strain as local equities remain expensive

Gareth Stokes, FAnews Online Editor

If you thought lacklustre returns from local equities were a thing of the past, then think again. A quick look at the JSE All Share return year-to-date suggests the average equity investment is going backwards. And it gets worse. Sam Houlie, a fund manager at Investec Asset Management, says that valuations are very stretched throughout emerging markets – including South Africa. “Local equities are overvalued and the absolute value offered by such investments is not compelling,” says Houlie. He was presenting to a group of financial intermediaries to introduce the Discovery Life Best Ideas Fund, which will be managed by Investec.

An entry-level valuation ‘tool’ used by analysts is the price-to-earnings ration (PE). South Africa’s average PE going back to 1960 is just 12 times. The average going back to 1989 is slightly higher, at 14.1 times… But today we’re trading nearer 17 times! In order for the market to move closer to its long-term average either share prices fall or earnings go up. Right now the latter seems unlikely! This dilemma isn’t limited to the JSE only. The United States cycle-adjusted price-to-earnings ratio is at 19.7 times against its long-term average of just 15 times. As we plough through Q2 2011 we’re faced with a domestic equity market that’s over-valued and over-bought. “The index trackers may struggle, but we anticipate a great environment for stock picking,” says Houlie.

Selecting winning shares more difficult than ever...

As economies JM Keynes once observed: The central principle of investment is to go contrary to the general opinion. A fund manager cannot simply position a portfolio based on momentum or capital flows. “Portions of the market are almost directly related to the rand because it is flow driven – while flows explain what’s happening they don’t justify what’s happening..! Someone who invests on flows is extremely vulnerable to sudden shift in sentiment,” says Houlie. Had you followed capital flows you would have loaded up on commodity shares at the end of Q1 2008 – moments before the sector collapsed in a heap. Houlie says those fund managers who topped up their Anglo American holdings at R550 per share are still deep in the red three year’s later… The share is changing hands at around R330 today. So how do you ‘pick’ the winning share? It’s not an easy task.

“Very few local stocks exhibit the desirable combination of low valuation and low earnings expectations,” says Houlie, describing the shares he typically favours. We’ve therefore been forced to shift our focus to opportunities offshore. The Dow Jones Global Titans – a collection of top international firms – are inexpensive, higher quality and offer better free cash flows than local equities...

Where is the smart money going?

Investec is buying quality and under-valued stocks – particularly companies with resilient, depressed or below-average profit margins. The asset manager is also positioning for rand weakness… Houlie notes that defensive positions are critical given the ongoing threat of sovereign debt and slowdowns in both emerging and global economies. And the Discovery Life Best Ideas Fund has been designed for such turbulent investing conditions. “The fund is free to exploit global equity (or equity-type) opportunities with a total return bias, without being constrained by the restrictions imposed on a regulated fund,” notes Houlie. There’s no equity minimum, freedom to roam geographically without offshore limits and he can invest in capital structures or financial instruments if necessary.

If you want to get a feel for fund managers’ favourite shares you can do worse than consider the top 10 holdings in their respective portfolios. At 30 April 2011 Houlie was still 47.3% in cash. “The best idea is to be in cash right now – yes returns may be lower – but when the time is right we’re always liquid enough to commit to an opportunity,” he says. The fund’s top five holdings include NewGold Issuer Limited (4.2%), SuperValu Inc (2.2%), Reckitt Benckiser (2.1%), MTN Group (1.9%) and Alliance One (1.7%). The fund has also invested small amounts in the likes of Kelloggs, British American Tobacco, Nestlé, Yamaha and Nintendo! The fund is only a few months old so there’s no way to measure its performance just yet.

Value in South Africa

To get an idea of the ‘value’ opportunities in South Africa we consider the Discovery Equity Fund, also managed by Investec. This fund is currently invested in an interesting mix of value and growth opportunities. A big surprise is the fund’s heavy weighting to telecoms stocks, with MTN Group (at 10.5% the single biggest fund investment) and Telkom SA (2.9%). Commodities also make a strong showing, though the fund has more gold mining exposure than many of its peers. An impressive 4% of fund assets are invested in Harmony Gold and 3% in Goldfields. Diversified mining company Anglo American (2.9%) also makes a showing.

There’s a little something for everyone… The group hopes to rake in returns on the back of the consumer recovery through JD Group (2.8%) and Steinhoff (4.9%) And the stalwarts of many portfolios Sasol (5%) and British American Tobacco are there to round things out nicely. The company has also recently upped its stake in Standard Bank (4.4%)

Editor’s thoughts: As we sat through the presentation our only concern with the Discovery Best Ideas Fund was its positioning in the Life stable… Surely a fund of this nature would serve consumers better as a unit trust product under the Discovery Invest brand. Nevertheless it looks as if Houlie is ready to bring his years of asset management expertise to the Best Ideas fund – which means the fund’s performance should be up their in the top quartile of its peers. Are you impressed with a fund manager prepared to hold so much cash in these ‘cash is trash’ times? Please add your comment below, or send it to gareth@fanews.co.za