JC Louw, chief executive officer and fund manager at Contego Asset Management.
The investment market is a dynamic environment in its own right, but taking into consideration picking the right adviser for your needs, the constant development of new products on offer, various solutions and platforms for these products (and emotions playing a much bigger part in the decision-making process than we care to admit) and you end up with a very confusing mix of available alternatives. Believe it or not, life would actually be simpler if the before-mentioned “how?” questions were the only ones to consider… they are merely one side of the coin. A far tougher set of questions are in store with the “what?” or the “when?” with investments. Specifically, “what is the risk profile and how much risk can the investor take on board?” followed by “what asset class do I use to satisfy this need at a stated risk?” Only then do we get to “at what price or valuation?”… Surely a question this late in the chain of events cannot really be that important, right? This is where most investors would miss the bus completely!
So, where do we as investors get it wrong the most? Is it buying the right asset class at the wrong time or just blindly following history and assuming it is the correct thing to do? Probably a bit of both and a bit of a third culprit, as the risk profile dictates the required action and experience take the lead from there, but relying on experience only is just where it all falls apart! New investment strategies and portfolios like protected equity as opposed to general equity portfolios are prime examples of the recent changes investment managers should be aware of. Protected equity will not only reduce the risk of the equity portion of the total investment, but can also in many instances enhance the stability of investment returns, as most portfolios are run on an ‘absolute-return’ basis.
Without going into too much detail, what is a protected equity portfolio? It is merely adding derivatives, mostly put options to an existing general equity portfolio to reduce the volatility and downside in the case of a decline in the market. A put option (if you own it) is easily comparable to ‘insurance’ against a fall, meaning it should return some of the value lost when the investment declines or even just add value during extreme volatility, as options are ‘priced’ or ‘valued’ in volatility. In the same way goods or services are valued in rand terms, portfolio managers price or trade the option in volatility and the same old ‘buy low’ and ‘sell high’ principle applies here as well... So, as the volatility increases or spikes in the market, you could expect a pickup in the price of the option due to the ‘increased value’ of the currency (volatility) of the option. Protected equity is definitely one of those areas where knowledge is not necessarily power, but rather how you use it and that is why Contego Asset Management decided more than decade ago to focus on the protection aspect of investments and approach the management of risk with the clients’ needs in mind!
So, why would it be important to consider protected equity in the current market environment? South Africa experienced a major financial crisis around five years ago, after which a staggering amount of liquidity was forced into the markets, resulting in an unprecedented bull rally. Similar to the ill-fated frog in the slow-heating pot of water, you may argue not much has changed in the past year and a half and that is where the pot gets close to boiling point! The international central banks have already started the ‘tapering’ process (printing less money) and interest rates are slowly rising due to threatening inflation worldwide. Yet, growth is coming through too slowly and defaults in countries like Argentina and Portugal may even spur the volatility in its own right. However, realising the risk of sounding like ‘Rupert the Bear’, I am going to keep the current risks to three main points, namely geopolitical risks, equity valuations and corporate actions.
Geopolitical risks
I am neither a politician nor an economist, so I’ll keep this short. The geopolitical environment leaves very little for the imagination, with Ukraine and Russia rattling sabres daily and the US (and, more recently, the UK) following the ‘soapy’ with great anticipation and regularly chips in with sanctions for good measure. The passenger jet being shot down did not help the tension with the long in the domestic dispute drama turning into a ‘who-done-it’ mystery. The events around Iraq and the war in Gaza all add to the political headache, already experienced in places like the White House, as both parties involved refuse to stick to the humanitarian cease fire agreements.
Equity valuations
When looking at current valuations, you can expand exponentially. Basically, when you refer to the South African market (FTSE/JSE All Share Index), you should notice that most of the last year’s gains (~35% return) came from rerating, meaning the markets moved higher without the earnings following suite, resulting in the Price/Earnings (P/E) ratio climbing to dangerous heights. To put it mildly, during the past 19 years, South African has only spent around 5.4% of the time at P/E levels exceeding 18x and, if you dig even deeper and exclude the past 12 month’s moves, where SA spent most of its time above it, you would have seen a mere 2.6% of the time above 18x during the past 19 years! This means, South Africa is in the midst of a rare occurrence, and something’s got to give. Volatility (see graph 1), on the other hand, is as cheap as can be at the moment and although it should not be used as a directional indicator, it can very easily be used as a measure of complacency.
Graph 1: FTSE/JSE All Share Index versus 30-day historic volatility
What the volatility shows is that less people are looking to ‘protect’ and buy options and the market is so ‘nice and warm’ that investors are not really worried about the downside in the markets. Declines are also swift and short due to the enormous amounts of cash on the side-lines due to the stimulus worldwide.
History is a great tool when you want to drive home a point and this will be no exception. In the past, when the SA market spent time in the ‘greater-than-18x P/E zone’ (see graph 2), upon its exit (the cycle dipping below 18x P/E), the average P/E of the market, 12 months later, was around 15.2x.
Graph 2: FTSE/JSE All Share Index P/E levels
For the market to change from the current elevated levels into the 15.2x P/E levels would require the earning (E) to improve by around 18% to 20% to get the P/E lower, should the price (P) remain unchanged for now. Basically, the market is saying the 18x P/E is ok as long as SA grows earnings by more than 18% in the next twelve months. Keep in mind, however, during this very same 19-year period, the average earnings growth of the FTSE/JSE All Share Index, according to I-Net Bridge, was around 12%. If you believe SA can grow its earnings at 1.5 times the average or at 150% of the pace it did in the past, taking the current environment where interest rates are increasing into consideration, un-protected equity is probably for you…
Corporate actions
If I have not lost or confused you completely by now, I will try hard in the final point where we look at what the companies are doing with the stimulus they receive so cheaply? When you look at graph 3 of the S&P500 Index it becomes clear where the stimulus money is going.
Graph 3: S&P500 Index versus company share buybacks
People always make fun of it and say things like ‘if you cannot make money in a ZERO interest rate environment (like in the US at the moment), you should change jobs…’ Well, by the looks of it, companies in the S&P500 are buying back shares at a rate last seen in 2007, just before the crisis. Now for all the non-accountants out there, what happens when you buy back your own company shares? You merely improve the ‘per-share’ valuation by buying back shares from the market, pushing up the price due to unnatural demand being added as well as the perceived improved valuation. However, while the ‘per-share’ valuation improves, the company applies cash (at zero interest) to make the business ‘look better’ as opposed to spending it on buying growth for the future. This strategy as you can imagine works well for a finite period, then ‘growth’ (or the lack thereof) catches up to you…
I did mention the various points listed above might make you want to run for the hills and that is most certainly not my idea with this note, I merely want to point out that there are great risks in the current market that are not being priced into the 18x P/Es or SA’s volatility at the moment. We all know equities deliver the best returns over time and we also know that we need equities to construct a sensible long-term investment portfolio but what not many people are aware of is that you can make use of protected equity as well. You need to be careful when selecting your specific protected portfolio, as there is no real ‘benchmark’ for the expected returns in this category, but rather a return profile on a fund-by-fund basis.
Protected equity should be just that, a fully invested equity portfolio with a protective strategy or overlay in place, all the time. I can only quote the Contego B5 MET Protected Equity Fund’s typical characteristics of being invested more than 90% in equities, at all times with permanent protection in place at around current market levels. What you can expect in return, during normal market conditions, is a typical participation rate of around 70% of the upside and around half the risk of that of the All Share Index, measured in volatility. As explained earlier, it is even possible to receive better returns should volatility play in your favour (making use of the insurance at ideal moments to add value) while it should be noted that the ‘insurance cost’ could also work against the portfolio during low volatility, low-event risk periods like SA experienced between 2009 and 2013.
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