Context slaps down the SA Inc argument, most times
There is no better place for your client’s money than South African equities, which are looking absurdly cheap as we power into the final quarter of 2022. This opening statement, which is loosely informed by the “SA Inc companies are dirt cheap” view shared at countless asset manager presentations during 2022, carries two disclaimers. First, nothing in the opening statement, nor the remainder of today’s newsletter, constitutes financial advice. And second, one cannot simply regurgitate a pro SA equity view without context.
Local equities look great, assuming that is all you consider
The first step in assessing today’s opening one-liner is to reflect on the context in which asset managers make their positive value observations re local equities. Magnus Heystek, an independent financial adviser and director at Brenthurst Wealth Management is critical of these managers for ‘talking up their products’ and trying to sketch a domestic situation that is more favourable than it actually is. In an interview with the Centre for Risk Analysis (CRA) he contrasted the upbeat asset manager views shared between January and April this year with the 22% dollar decline in SA-listed shares year-to-date October 2022. “We had a flurry of fund managers saying that local was the place to be, and that there was so much value in the JSE, but low and behold our market is down 22% [in dollars],” he said.
Another important consideration is that equities are usually cheap for a reason, and that few asset managers would scoop up a share just because it meets some or other value criteria. For the most part, asset managers accept the price-to-earnings (PE) ratio often used to make a value call as a backward-looking measure that does not factor in the country’s economic, political and social realities. “You can say shares on the JSE are cheap based on the historical metrics … but you cannot take it out of context; the macroeconomic environment is extremely poor currently versus two decade go,” said Heystek. Of course, an asset manager running an SA-focused equity or multi-asset fund could be excused for declaring that SA equities represent the best return option within their funds’ mandates, because they may have nowhere else to go!
It was refreshing to attend a panel discussion at the 2022 Morningstar Investment Conference during which a team of respected portfolio managers were quizzed about the outlook for local equities. Sean Neethling, Portfolio Manager at Morningstar Investment Management, steered the conversation with an opening question about whether South African listed companies would be able to support current valuations by compounding their earning over the next few years, and thereby building long-term wealth for clients. “There is massive negative sentiment built into the valuation of local equities at the moment,” said Piet Viljoen, Portfolio Manager at Counterpoint Asset Management. “Businesses are struggling to compound earnings because of the fundamentals, but the prices are low enough to compensate for that”. In short, he felt that local shares were cheap, but with good reason.
Low valuations could be ‘fair’ given faltering economy
Gail Daniel, a Fund Manager at Ninety One agreed that select local companies were cheap but noted that it was difficult to know what constituted sustainable growth in the challenging macroeconomic environment. Although not participating in the panel, Heystek’s view is worth sharing here. He certainly agreed with the second conclusion that Daniel reached, telling the CRA audience that he did not buy the argument that the JSE was cheap because of concerns over earnings growth: “you cannot convince me that companies listed on the JSE can make meaningful profit growth in the current environment”. One of the difficulties that local asset managers face is to figure out whether companies’ apparently low valuations fully discount the tough and worsening trading conditions. It turns out that local companies are struggling to grow earnings and revenues in a domestic economy beset by high unemployment and slow economic growth. And their various attempts to diversify revenues offshore by acquisitions in Australia and Europe or expanding into Africa have proven less than optimal.
Evan Walker, part of the investment team at 36ONE Asset Management, reminded the audience that the JSE offered unique exposure to dollar-based revenues. “Remember that around 70% of company earnings from the large cap JSE-listed firms are in dollars,” he said. “It is possible for us to secure 100% US dollar earnings based in South Africa, and we know more about investing in these local businesses”. From his perspective, local asset managers benefited from the trifecta of reasonable visibility on earnings; cheap valuations; and a domestic banking sector that was likely to grow by 10-15% per annum over the next two years. The bottom line: asset managers can have their pick of solid banks and insurers and a “plethora of very good industrial businesses that have both offshore dollar earnings and domestic earnings”. The trick though, is to avoid counters that are too exposed to domestic economic uncertainties.
Forget patriotism, your clients’ returns are at stake
Asset managers and investors cannot afford to be patriotic given the importance of diversification in delivering risk-adjusted returns. As Walker pointed out, “you would be crazy to invest in the 60 to 70 investible South African businesses in perpetuity when you have another 10 000 or so on the world stage”. Most large asset managers consider these firms as the building block for liability-matched portfolios for South Africa domiciled clients. “We have to take advantage of this cycle of high rates and low equity prices to put more money to work offshore,” he added. This means that most funds will gradually increase offshore exposures to the maximum allowed under regulation 28.
Neethling asked whether recent changes in the regulation affected how asset managers thought about managing risk. “We are going to come under pressure with regulation 28 to invest more on the infrastructure side; this is concerning, because you could get a whole bull market going without visibility on what you own and do not own,” said Daniel, who was also concerned about high and non-transparent costs in the infrastructure ‘class’. The most important message that financial advisers can take from the Morningstar panel discussion is that the diversification on offer offshore renders the domestic value debate moot.
So, how much of South Africa should you hold?
When asked how much of their optimal portfolio they would invest in South African equities, the assembled portfolio managers were rather subdued. Walker said he would have no more than 15-20% exposure to domestic equities. And Daniel was even less enthusiastic, dropping the bar to 10-15%. “I quite like Remgro right now,” she enthused, before quickly disclaiming “but you should never say that on stage, because as soon as you walk out there is a profit warning and you want to change your mind”.
Viljoen, who incidentally has often clashed with Heystek on the offshore / onshore debate, said his opinion echoed his fund’s asset allocation approach. “We manage a worldwide flexible fund that can invest in any asset class, anywhere in the world, and that fund currently has 33% in South Africa,” he said. Just over half of this allocation was to long-dated government bonds, with some exposure to inflation-linked and nominal bonds, and around 11% in equity. “The long-term returns for investing in developed markets will underperform that of emerging markets because of the way capital is priced in the two different markets,” added Viljoen. “This year, emerging markets have outperformed global markets despite a strong dollar and despite a global economy heading into recession”.
The optimal solution, according to Viljoen, is to run a well-diversified portfolio, with a ‘tilt’ towards asset classes and stocks that you think will do better. “It turns out that fund size is a structural edge in the South African market; a small fund size helps you diversify appropriately because there are a lot of smaller companies in this market, good smaller companies which you cannot access through larger funds,” he concluded.
Writer’s thoughts:
There is an old English idiom that holds ‘the proof of the pudding is in the eating’. So, the best way to solve the offshore / onshore debate should be to sample portfolio returns! Based on recent performance, are you concerned with the returns that your clients are receiving from their regulation 28 compliant retirement fund investments? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].
