Are we done yet? - Cannon Asset Managers assesses the investment environment

With a global economic environment that has been in turmoil for a large part of the 21st century, many analysts are wondering when the financial and economic pain in the advanced world will come to an end. Sadly, our assessment is that the end of tough t

We refer to this listless economic state of the advance economic world as a “PAFTOTY scenario”, where the rude, but pointed, acronym stands for “pissing around for ten or twenty years”. The PAFTOTY scenario borrows directly from Japan’s experience of the last twenty years, which has seen furious stimulatory policy efforts on numerous occasions, including their government borrowing rising by $10trillion over the period to fund spending and an aggressive zero interest rate policy (ZIRP) adopted during the noughties decade. Despite these substantial initiatives, Japan’s economy is the same size today as it was in 1990. Aside from misguided policy, other factors have served to drag Japan’s economic welfare lower, most notably demographic decay, with the median age of the population rising from 38 years to 45 years between 1990 and today. This triple cocktail of vast indebtedness, demographic decay and policy inadequacy is a sad result for the Japanese. But, because Japan’s economic stagnation is explained by the same factors that appear in many other advanced economies today, it also is a clear warning to policy makers in other advanced economies: if they want to avoid the Japanese experience they will need to break away from the policy path that Japan pursued. Sadly, the mould has not been broken.

Already the US and Europe have experienced economic stagnation since 2007, but they now are burdened with additional debt of $11trillion. Rock-bottom interest rates also have not translated into a surge in economic activity. Instead, the additional debt has been used to fund ineffective government spending programmes and ultra-loose monetary policy has helped prop up stressed household balance sheets. The futility of policy – and the sad social outcomes – is evidenced by soaring unemployment in European economies where in the case of Greece, for instance, the unemployment rate amongst the youth is in excess of 40%.

Guided by the evidence of Japan’s experience and that of other advanced economies over the past five years, we expect the developed world, in aggregate, to spend the next decade or two drifting listlessly as they cast around for quick solutions to long-term, structural problems.

The things that matter

However, while the economic prospects of the developed world are poor, many other economies have seen swift growth since 2007. China and India – the clear drivers of the emerging economies – have grown by 60%and 45%, respectively, over the last five years. Other emerging champions, such as Nigeria and the Philippines, have grown by similar amounts. At this rate of growth, these economies are doubling in size every decade. This dynamism in emerging markets gives rise to a second scenario of “SINFOOH”, where the acronym stands for “the sky is not falling on our heads”.

More to the point, in spite of the gloom surrounding many of the advanced economies in 2012, there is a raft of countries which boast excellent fundamentals in six factors which correlate highly with improving socio-economic welfare over broad sweeps of time, namely:

1. Access to savings that fund productive investments which, in turn, lead to economic growth;
2. A favourable demographic structure with more people entering the workforce than leaving the productive sector;
3. An improvement in the nation’s relative physical health and healthcare infrastructure, which leads to enhancements in socio-economic welfare;
4. Rising education levels which support healthcare, bolster labour productivity and give rise to a higher rate of economic growth and better quality of life;
5. Sensible national policy including transparent policy making and policy stability; and
6. Country “openness” which fosters the free movement of goods, people, services, capital, information and ideas that collectively contribute to better economic growth and higher standards of living.

As already noted, the rich countries of the developed world are failing on at least three counts, namely dis-savings, represented by extremely elevated levels of debt; demographic decline which has more people moving out of the workforce than into the workforce; and questionable macroeconomic policies, including social welfare benefits and spending promises that are simply unaffordable. Whilst this result is sobering, there is reason for hope and optimism, which finds root in the fact that there is a raft of countries that are rich in the six factors identified. Notably, this is about much more than the usual suspects of China and India. All five of the BRICS – Brazil, Russia, India, China and South Africa – which represent a combined population of three billion people, are rich in different ways in the six factors. However, there are others countries, like Peru, Chile, the Philippines, Vietnam, Iraq, Egypt, and, more recently, Mongolia that also are able to tick the six boxes with rising confidence and conviction. What this means is that, with a wealth of success factors and proper engagement of these factors, these countries are positioned to do well.

Early evidence of the implications of this shifting world economic order is readily available. The cumulative economic growth of the BRICS over the past decade totals $12 trillion, equivalent to the size of the US economy. Assuming the same growth rates hold for the next ten years, the BRICS economies would replace Italy ten times over or Greece 40 times over in the next decade. As an aside, the Chinese economy builds the equivalent of the South African economy every 241 days. In short, whilst the advanced world is in a quagmire, the sky is not falling on our heads.

South Africa: a foot in the PAFTOTY world with an arm around the SINFOOH drivers

In terms of the implications for South Africa, the structural headwinds facing the advanced world have a direct implication for our economy in the form of, inter alia, weakened trading partners, softer tourism markets, and lower commodity prices. Yet, the challenges at home have encouraged companies located in the advanced world to look at investment destinations, such as South Africa, with new eyes. Over the past three years South African firms have enjoyed high levels of interest from their developed world counterparts: in 2010 US retail giant Walmart acquired control of Massmart; in 2011 Japan’s NTT acquired Dimension Data; and in 2012 the acquisition of O-Line Holdings by Germany’s OBO Bettermann was announced as well as a major investment into Litha Healthcare by Paladin Labs Inc of Canada.

In the same breath, South Africa has many “SINFOOH positives” going for it. The country has a successful tourism industry, superb fiscal and monetary policy discipline and a potential massive stimulus from the R1 trillion infrastructure spending pipeline which will boost jobs and skills. In addition, many positive prospects are right on our doorstep, giving South Africa vibrant neighbours. Angola has enjoyed the highest rate of economic growth in the world over the past decade; Mozambique is amongst the fastest-growing non-oil economies in the world; and since the time of Botswana’s independence in the 1960s, it is the fastest growing economy in the world. This wide opportunity in our neighbourhood has seen South Africa’s eight mainline retailers establish more than 500 stores in sub-Saharan Africa. Other examples of rising economic integration abound, including listed transport and logistics company Grindrod seeking to triple the coal handling capacity of its Maputo harbour facility to 20 million tons per annum; and South African building and construction firms growing their order books with great success in neighbouring countries. As the SINFOOH countries go from strength to strength, we expect this to contribute to South Africa’s prosperity.

Perspective reveals a reality with four key investment drivers

By stepping back and giving ourselves a clear perspective on this PAFTOTY and SINFOOH world, we are equipped to effectively interpret the fast-changing information being thrown up by the new world order; find opportunities that others are missing; and take sound investment decisions.

The landscape painted above points to four key investment arguments.

First, in any setting, tactical asset allocation has a fundamental bearing on investment outcomes. However, the uncertainty of the shifting world economic order has disrupted asset markets; in places the disruption has been dramatic. Importantly, then, successful tactical asset allocation is not just about selecting the correct asset classes, but also about identifying areas within the asset classes that are well priced – witness the seduction presented by Greek government bonds which recently offered a yield of more than 200% just weeks before Greece defaulted. To this end, our assessment of the different asset classes suggests that, whilst government bonds have performed exceptionally well over the last year, from a global perspective, gilts are expensive and risky. Equally, whilst the dynamic markets present exceptional business growth opportunities, this is already in the price of the underlying shares. Investors will need to navigate this environment carefully. By drawing on tools such as cyclically-adjusted price-earnings (CAPE) ratios and through-the-cycle yields, Cannon Asset Managers has built a successful global and domestic asset allocation track record. The Cannon Allocator Portfolio, for instance, has matched equity market returns over the last three years but with half of equity market volatility. This toolkit, and our experience, equips us well to deal with the challenging environment.

Second, whilst bad news has brought about risk aversion, bad news does not render equities an ineffectual investment; this is especially the case in PAFTOTY markets. With price inflation likely to feature in the coming years, and yields likely to stay “lower for longer”, investors will need to look away from cash and bonds to achieve and protect acceptable income yields. Critically, given the turbid setting, investors need to look for sustainable yield, not just high yield. As noted, traditional savings accounts and government bonds offer poor opportunities in this environment, with ultra-low yields or interest rates and a high chance of capital losses because of deep government indebtedness, rising price inflation and tax-hungry governments. As intimated, equities present the potential for investors to earn a healthy, sustainable income yield. A good example of this is Deutsche Post DHL. The well-established German firm offers investors an attractive and stable dividend yield, currently equal to 4.8%; the business is financially robust and has good business growth prospects. Notably, Deutsche Post DHL is just one of twenty-five companies that make up the Cannon Global High Yield Portfolio, each of which satisfies the strict criteria we lay down in terms of quality and value in our search for yield. Currently the portfolio offers a total dividend yield of 6.5%, underpinned by high quality and, as in the case of Deutsche Post DHL, the potential for capital growth.

Third, excellent opportunity is offered in the form of PAFTOTY assets that have SINFOOH exposure. True to form, because of poor economic growth prospects, most investors are neglecting the PAFTOTY areas while having chased assets in the SINFOOH regions. As a result, many SINFOOH assets have become overpriced, making them poor investments that carry a high risk of capital loss. By contrast, we find a number of assets that are priced for recession but that are exposed to high economic growth drivers. For example, luxury motor firm BMW is on a price-earnings ratio of 7.5 times and trades at a modest multiple to net asset value with a substantial cash pool on its balance sheet. Yet, BMW has considerable exposure to the rapid growth of new, dynamic economies. As such, BMW represents a fine opportunity. As evidence of its health, the company enjoyed its best year ever in 2011 in terms of units sold and bottom line profit. BMW expects this trend to continue, helped by Asia becoming its largest market within the next two years.

Fourth, and drawing attention close to home, with most capital having been directed to growth and large stocks over the last three years, there are some investment gems that have been overlooked and that offer remarkable prospects. Metair, trading on a price-earnings ratio of 8.3 times is such an example. But it’s not just about being attractively priced. Metair is a high quality business as evidenced by exceptional balance sheet metrics, property that is understated by three times, and a neat vote of confidence in the form of 106 of the last 120 directors’ corporate actions being share purchases. Metair is held in all of our domestic portfolios, including our SuperDogs portfolio, which has the enviable result of having outperformed the FTSE-JSE All Share Index over the last three years, but with less volatility. This has been achieved through our relentless pursuit of companies that have excellent prospects but that are out of favour or out of fashion. This result points to the outcomes that investors can enjoy when combining good quality firms bought at the right price.

Things are not key-hole shaped after all

The concept of SINFOOH investing in a PAFTOTY world captures the challenges that face investors in a world with mixed fortunes and rapidly shifting economic plates. Notably, whilst the landscape is changing rapidly, the factors that govern socio-economic advance and the rules that stand behind successful investing remain unchanged. This perspective equips investors with the ability to make effective decisions in a fast-changing world.