Safety in stocks might not be where you think it is

Linda Eedes, senior analyst at value asset manager RECM.

Investing in popular shares without regard to the price you pay for them can make investing in a safe company a risky investment. Focussing on quality assets only when these are selling cheaply however provides capital protection and delivers good real returns through the full market cycle.

‘Industrial shares started 2014 at very expensive levels and then went on to get even more expensive,’ says Linda Eedes, senior analyst at value asset manager RECM. ‘This supported the ALSI to end the year up just over 10%, but this performance shouldn’t be taken as being representative of the SA stock market as a whole.’

Eedes points out that almost half of the ALSI’s performance in 2014 was generated by only two shares – Naspers and SABMiller. ‘More than one third of the shares in the ALSI actually delivered a negative return. The ALSI return of late tells you very little about what is actually going on in the underlying universe of stocks – it tells you more about what is going on with the big stocks. The market’s fixation with large capitalisation industrial shares – seen as being safe because of perceived earnings certainty – has supported the run in the ALSI. However, shares of companies seen as more ‘risky’ because they’re going through challenging times continue to be shunned but represent the better return/risk proposition.’

Resources shares started 2014 at very inexpensive levels and went on to become even cheaper, says Eedes, commenting that the relative valuation between resources and industrials is reaching extreme levels. ‘At the height of the commodity super cycle bubble in early 2008, the resources sector was trading at about twice the historical average relative valuation to the industrial sector. That situation has flipped around and industrials are now even more expensive on the same basis as resources were during the greatest resources bubble since the mid-1980s.’

According to Eedes, the paradox in the markets at the moment is that the shares that seem ‘safest’ to invest in – the current market darlings – have a high risk of capital loss due to their high valuations. ‘Resources stocks are broadly viewed as more risky since they’re cyclical businesses going through challenging times, but these actually may be less risky in terms of capital loss from this point onwards. A portfolio that shuns the pricey market darlings and invests instead in cheap quality assets actually creates a much lower risk portfolio by shifting away from the risks inherent in an overvalued market.’

Despite the overvaluation in the market, RECM still sees plenty of opportunities, says Eedes. ‘We continue to identify new investment ideas that meet our value criteria both locally and internationally. These ideas are fairly evenly split between local and offshore shares and across sectors such as packaging, retail, banking, energy and base metals. We’ve also increased our exposure to several existing holdings where opportunities have become even more compelling.’

Value portfolios may lag the market when markets are running due to expensive stocks becoming more expensive, but they’ve proven over time to still deliver good real returns through the full market cycle. ‘More importantly,’ says Eedes, ‘they protect capital in down markets, precisely because they don’t hold the stocks that take the market to its highs and which are then the most vulnerable to correction. This protects investors’ capital in the downturns that inevitably follow, and capital protection is a critical element of generating good long-term real returns.’