Watch for risk hidden in offshore returns, warns RECM

Linda Eedes, RECM Senior Analyst.

The significant weakening of the rand against major currencies over the past three years has been a big driver of returns for South African investors invested offshore, and may even have masked poor investment allocation. Now that the rand is close to fair value, if not slightly undervalued, the performance of the underlying offshore assets will be far more important for future returns. Further, with international markets now looking expensive, offshore exposure should be carefully managed.

This is according to RECM Senior Analyst Linda Eedes, who says that over the past three years having money invested in hard currencies has paid off for local investors, thanks in large part to the translation of hard currencies back into rands, rather than solely due to the performance of the underlying investments themselves. “Moving assets into other currencies was a no-brainer three years ago when the rand was so clearly overvalued. With the rand depreciating 35% over the last three years, it didn’t matter as much where you put your money, you would have in all likelihood seen a strong return in rand terms. Even if your investment actually lost 10% over the period in the underlying investment, you made 25% thanks to the depreciation of the currency alone.”

But with the rand now having fallen far closer to fair value, future returns will likely be more dependent on the performance of the underlying investment offshore, says Eedes. “On a long-term purchase power parity basis the rand is actually slightly undervalued right now, but not significantly so. There’s likely to be short-term volatility in the rand, but there’s no longer the strong swing factor of a currency set to weaken significantly. This means that offshore returns from this point are more dependent on how the money has been invested than has recently been the case.”

According to Eedes, another challenge to prospective returns is the high current valuations of major international markets at the aggregate level. “Given strong returns from global indices, many investors may be considering a passive index-tracking fund. But this approach is backward-looking – now is precisely the time to actively select global investments that still offer value and omit those investments which are now expensive and represent risk.”

A number of indicators suggest that international markets are overvalued, says Eedes. “While price-to-earnings ratios of the major markets are sitting at the top end of their historical range, there are several other indicators also pointing to significant overvaluation. Prices are high compared to ten-year average earnings and share buybacks have decreased significantly, which often indicates that management feel their own shares may be overvalued. IPOs are on the rise, which tends to show the same thing.”

“We’re not calling the top of the market. We have no idea what the market will do at the aggregate level, but then neither does anyone else. Equally, we don’t know where the rand will go in the short-term,” warns Eedes. “However, it’s fair to say that the rand at current levels is unlikely to give the same boost to returns of offshore assets over the next three years as it gave over the past three years. And with international markets looking pricey, investors need to think very carefully about where their money is invested offshore. Ideally, they should be in assets that can give them real capital growth over the long-term while protecting against the risk of significant capital loss.”

RECM believes the best way to achieve this is through taking a bottom-up, value-oriented approach, wherever in the world you invest. “We don’t pretend to know what’s going to happen next with global markets or the rand. Our approach is to focus on building in a margin of safety by buying good businesses when these are trading below our assessment of what they’re worth. By doing so, we not only stack the odds of generating real returns in the favour of the investor, but also reduce the risk of significant capital loss should markets correct.”