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Investors should move cautiously on equity markets

17 September 2007 Nedgroup Investments

Equity investors will have to become far more selective in finding those shares that will give them reasonable growth in the short-term, says Neil Brown, manager of the Nedgroup Investments Growth Fund.

"On the other hand, South African investors who are in invested in the markets for the long-term will just have to sit tight and ride out the volatility in local and global markets."

Speaking at a Nedgroup Investments seminar, Brown said several important indicators showed that the local equity market is now at a high level: "For instance, the average operating margins of industrial shares on the JSE has risen from about 8% to just under 14% in 2007. The same is true for the return on equity of local industrial shares from +10% in 2001 and is now above 25%."

The price/earnings ratio of the FTSE/JSE All Share Index has also increased from around eight times in at the beginning of 2003 to just over 15 times in 2007. "I expect the local equities market to move sideways for the next 12 months."

"In terms of our current portfolio position, we favour high quality, mid-sized industrial companies as well as local banks. In the next couple of months we will also be looking for higher levels of safety margins in our valuations of companies."

Brown said the Nedgroup Investments Growth Fund was continuously investing in companies with better quality business models supported by high levels of pricing power and cash generation. "We also favour defensive and less cyclical shares that meet these criteria, such as Standard Bank, Remgro, Pick n Pay, Naspers and Liberty International."

Speaking at the same investment seminar, Larry Jones, chief investment officer at Nedgroup Investments UK and manager of the Nedgroup Investments International Target Return Fund, said the turbulent markets of the past two months was particularly stressful for investors in individual hedge funds, where some major losses occurred.

This again emphasised the importance of investing in hedge funds that focused on preserving capital in times of extreme volatility, such as a fund-of-hedge funds.

"Volatile markets create inefficiencies in markets and these can be exploited by skilled hedge fund managers to create that extra return for investors, also known as alpha. Investors would be in a better position if they invest with managers of fund-of-hedge funds who focus on generating alpha returns (the risk-adjusted returns due to skill which cannot be easily replicated), instead of managers who focus on beta returns (the return provided by exposure to market risk factors which can be replicated through for instance, index tracking funds).

Jones pointed out that the US sub-prime mortgage crisis acted as a catalyst for the pullback in global markets and that "more delinquencies" will follow. "The crisis has not played itself out yet and there are still problems ahead."

He said South African investors would feel the impact through a general market pullback. "It has led to a widening in credit spreads in emerging market bonds and greater risk aversion."

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