Making sense of volatile equity markets

Gareth Stokes, FAnews Online Editor

Volatility is an indicator of investor fear. In recent months, whether measured by the US VIX or South African SAVI index, volatility has leapt off the charts. It seems investors are petrified the European Union will be unable to handle the sovereign debt crisis playing out in Greece and other Euro-zone economies. The VIX index visited 40-plus territory in September and October 2011, its highest level since May last year. (US market volatility was measured at 79.13 points in October 2008 at the height of the sub-prime crisis). Why are investors so fearful? And why are share prices jumping all over the place?

Alwyn van der Merwe, Director of Investments at Sanlam Private Investments (SPI) provided some of the answers at the group’s Q3 2011 media briefing held in Johannesburg, 26 October 2011. He says that aside from general economic uncertainty, the current bout of volatility is due to an over reliance by investment decision makers on short-term news flows. This knee-jerk investment approach stems from the 2007/8 financial crisis when investors were forced to rely on short-term sentiment indicators rather than long term market views simply because the outlook was so cloudy. We can expect more market volatility until these investors realise 2008 and 2011 are fundamentally different. 2008 was a liquidity crisis while 2011 is fast becoming a confidence crisis. Fear and uncertainty are dictating prices rather than fundamental value and long-term earnings prospects.

Asset allocation for Q4 2011

What should investors do? Local asset managers have always advocated investing for the longer term… Investors should consider the opportunities available to them at a given point in time, structure their portfolios accordingly, and sit back to allow time to do its work. According to Van der Merwe the ideal balanced portfolio, as we enter the final quarter of 2011, would be invested in equities (60% or more), corporate bonds, hedge funds (as an alternative to cash) and listed property (up to 10%).

A heavy equity weighting is a non-negotiable due to compelling valuations both locally and offshore. Van der Merwe illustrated the concept by comparing the yield on a basket of US Treasuries (with durations of one to 10 years) with the dividend yield on US equities. The former produced a mere 0.89% per annum, in stark contrast to the 2.8% dividend yield on US equities! If you take a long-term view there is simply no debate: You want carry your maximum possible equity weighting because you’ll benefit from better immediate yield, from the likely growth in annual dividend, and from significant capital appreciation over time. The preference for corporate bonds over government bonds is easily explained too – corporate bonds simply offer a better yield at present. We were surprised to hear a pro-hedge fund argument, but SPI believes these investment vehicles are sensible alternatives to cash, especially when the return on cash dries up.

What about offshore? Craig Massey, SPI’s Director of Stock broking says that investors should consider increasing their offshore investment exposure to take advantage of opportunities in global markets. “South African equities have performed extremely well over the past decade, but now we believe there may be better value offshore,” he says. The easiest way for retail investors to gain offshore exposure is through rand-denominated offshore unit trusts or one of the many foreign currency denominated funds with Financial Services Board approval. Those who prefer to invest directly in offshore markets should probably consider passive investments such as exchange traded funds, because actively managed bespoke solutions (structured and managed portfolios) typically require an investment of around $500. 000.

On the banks and four shares for the brave

There are plenty of compelling cases for local equities. SPI spent some time discussing prospects in the banking sector, as well as looking at some of their favourite portfolio shares. Van der Merwe says that South Africa’s banking shares have flat-lined since April 2007. But the outlook for the sector could be changing for the better. He likes banking shares because investors have largely written the sector off – always a good sign of an imminent turnaround. Other pro-bank motivations include that their bad debt situations are improving, loan books are starting to show conservative growth and they are well capitalised. The sector’s attractive dividend yield cannot be scoffed at either. The pick of the country’s large retail banks include the conservative Standard Bank (JSE: SBK) and the innovative First Rand Limited (JSE: FSR). More adventurous investors can consider Capitec (JSE: CPI). The share is quite expensive, trading at a price-to-book of five times versus the 1.7 times sector average, but you’re paying for its growth prospects. Capitec is adding around 100, 000 accounts each month and is rapidly expanding its unsecured lending book.

We don’t often get down to the specifics of investing in this newsletter, but SPI offered up some thoughts on solid shares to invest in during Q4 2011. They like Anglo American (JSE: AGL), Old Mutual (JSE: OML) and Astral Foods (JSE: ARL). Anglo’s boasts a one year forward price-to-earnings (PE) ratio of 5.9 times and most analysts have already accounted for the likely drop in earnings due to softer resources prices. Old Mutual is trading at a significant discount to its embedded value and is a different prospect to a decade ago. Astral offers better value than its defensive food producing peers.

Van der Merwe reckons each of these companies has good prospects over the next 12 months. For the very brave he suggests Wilson Bayly Holmes Ovcon (JSE: WBO). This share offers a less volatile earnings stream – is one of a few construction shares that prices risk into its tenders – and knows how to win and conduct business in Africa. The share should “come good” over five years.

Editor’s thoughts: When it comes to asset allocation and share picking it seems the best policy is to leave decisions up to the asset and fund managers. Companies such as Sanlam Private Investments have the infrastructure to research the asset classes and pursue those opportunities most likely to match or exceed the chosen benchmark. Do your clients ever ask about the merits of individual shares listed on the JSE or abroad? Please add your comment below, or send it to gareth@fanews.co.za