Category Investments

Keeping perspective in times of fear

09 April 2020 Anet Ahern, CEO at PSG Asset Management

The evidence is clear: starting valuations are a very important predictor of long-term returns.

However, this insight gets lost in times of market panic when all the attention goes to reducing portfolio risk. The lowest risk way of achieving satisfactory long-term outcomes, is to buy assets at attractive valuations. Ironically, this is often an uncomfortable approach.

The COVID-19 market panic has seen indiscriminate selling as investors scramble to reduce risk and raise liquidity

Very few stocks or asset classes have escaped the bloodbath and even some of the traditional safe havens, like gold stocks, have been punished. The stocks in our portfolios have not escaped this brutal sell-off either despite their low starting valuations and in some cases are now cheaper than they were during the Global Financial Crisis (GFC) – an extraordinary situation.

There is no denying that locking down countries and self-isolating within society has a brutal impact on both economic demand and supply. Many industries are suffering significant drops in demand, especially in discretionary consumer-facing sectors, as well as supply disruptions. Company profits will be hit hard. It will also put significant pressure on the flow of credit and liquidity from the banking sector to distressed corporates and some casualties are likely. The impact on employment and society will be equally severe. To cushion the impact, central banks and governments around the world have embarked on aggressive interventions to both stabilise and stimulate their economies, and more is sure to follow.

The low share prices that follow aggressive market declines may well sow the seeds of the next bull market

We are often asked: what would give rise to cheap stocks outperforming expensive stocks in the future, or put differently, for the value approach to work again? Growth shares have outperformed value stocks for 12 consecutive years, supported by factors like extraordinarily low interest rate levels, long-term growth in sectors like tech and the massive flow out of active into passive (which allocates money into what is expensive and has been winning at the expense of what is cheap and has been under-performing). We think we have quite possibly seen the peak in relative performance by expensive stocks: their valuations have reached levels last seen in the dotcom bubble while value has been languishing at GFC levels. Furthermore, the impact of a coordinated global fiscal response has traditionally been very supportive of multi-year outperformance by value stocks. The dramatic drop-off in capacity in various sectors will ultimately give rise to strong pricing power as operations cease and competition reduces. The mining sector offers some good examples of where this has happened in the past.

On the domestic front, we expect a very challenging year for the economy. Notwithstanding short-term price volatility, we expect our portfolios to be partially protected by the very attractive starting valuations that the stocks found themselves on at the start of this year. There will however be sharp drops in earnings across the board on the JSE, and in some cases, companies will incur losses as revenues plummet and fixed costs bite. We think it is appropriate to be especially cautious of highly leveraged businesses that could see dramatic declines in turnover.

Falling prey to fear and selling at these low levels also mean realising what are currently paper losses. Although it is extremely difficult to do so, we believe that now is the time to stand back, review your overall asset allocation and ensure that your exposure to risky assets is judiciously replenished over a period of time to ensure the appropriate long-term asset allocation. This approach helps to take emotion out of the picture and refocuses attention on the longer-term objectives and actions needed to work towards that goal. This is more constructive than reacting to the wide range of predictions that are out there at present, most of which will likely turn out to be wrong, and some of which will turn out to be reflected in asset prices already. The key assumption here is to target a suitable long-term portfolio construction across the asset classes for your situation.

There is fertile ground for long-term returns from this point

There are many good businesses in South Africa and abroad. They will get through the tough times. In fact, many can be expected to expand market share and cost bases have been cut aggressively in recent times. This, in conjunction with their extraordinarily low share prices, provides fertile ground for long-term returns from this point.

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