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Opportunities for countercyclical investors

10 October 2019 Dirk Jooste, fund manager at PSG Asset Management

Recent statistics from the Association for Savings and Investment South Africa (ASISA) show that South African Interest Bearing portfolios attracted the bulk of net annual industry inflows for the year ended June 2019, followed by Money Market portfolios. On the flipside, the South African Equity – General category recorded net outflows.

Heightened risk aversion from local investors has resulted in increased demand for fixed income funds, while equity funds have lost much of their appeal. Local investors are opting for fixed income over equity, in a bid to play it safe.

Shifts in demand have impacted asset prices

The demand for fixed income funds from investors has spurred demand for fixed income instruments from fund managers.

This has resulted in corporate bonds and other credit instruments starting to trade at lower yields. In contrast, as equities have become less popular, the decline in prices has resulted in attractive dividend yields.

Bank securities present a good case study. Credit spreads on both floating and particularly fixed-rate negotiable certificates of deposit (NCDs) from local banks have narrowed i.e. yields on these instruments are lower and closer to those offered by government bonds of the same maturities (for fixed-rate NCDs) or corresponding JIBAR (short-term interbank) rates (for floating-rate NCDs). In contrast, dividend yields on bank shares have gone up.

Graph: Spreads on bank NCDs have narrowed, while dividend yields on bank shares have increased

Sources: PSG Asset Management, Bloomberg

Narrowing credit spreads have reinforced the importance of a solid credit process

Buying with a sufficient margin of safety – ensuring that yields compensate for the associated risk taken – is a cornerstone of our fixed income philosophy.

Recent credit spread movements such as those in bank NCDs have prompted us to re-evaluate exposures to the credit market, to ensure that both fund holdings and position sizes remain appropriate.

Where we are no longer comfortable that the margin of safety offered is adequate, we are taking advantage of current market appetite to sell into strength.

We are applying some of this capital into high-quality local shares that have come through our investment process and are offering attractive dividend yields. In the prevailing environment of fear, these shares are available at low prices, providing a wide margin of safety to their intrinsic values.

We also expect steady growth in their dividends in future, implying both an attractive current yield and protection against future inflation. This is a rare combination.

Investing countercyclically allows long-term investors to capitalise on shifts in sentiment

Large moves in sentiment that drive broad-based changes in investor behaviour pose risks as well as opportunities. What becomes popular also becomes more expensive (and offers a lower margin of safety). What gets left behind may appear unappealing but in fact offer misidentified value.

Bank NCDs are traditionally considered to be very low-risk investments, but with their spreads narrowing this may not currently be the case. On the other hand, many domestic equities – part of an asset class considered to be high-risk – are priced with such a wide margin of safety that they actually present a low-risk opportunity.

Anomalies such as these create attractive prospects for long-term investors.

 

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