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Invest(ing) in the other 99%

10 July 2019

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by Darryl Hannington, Portfolio Management

Investing on the JSE has been extremely rewarding in the long run. SA was, after all, the best-performing market in the world from 1900 to the end of 2016, delivering an average annual return of inflation plus 7.2%. This according to the 2017 edition of Credit Suisse’s Global Investment Returns Yearbook. The publication compared returns of various asset class over the period in 21 countries with a continuous investment history. In addition, until a few years ago, equity investors on the JSE were handsomely rewarded over a 10-year period with a compound annual return of 18%, which included the global financial crisis (GFC) market crash of 2008/09!

We often get asked by clients “… how is this possible – everything we read and see … suggests economic conditions over the past 15 years have done nothing but deteriorate in SA; just look at how the rand has depreciated?!” The answer is quite simple – due to the construct of the JSE it has been a fantastic hedge for local investors against poor economic conditions in the country. We are spoilt compared to many of our EM peers by the fact that c. 50% of earnings from companies listed locally are earned offshore. These revenue streams, and the companies that earn them, are aptly named rand hedges. It is worthwhile pointing out that not all rand hedges are made equal – many of these firms are selling their goods and services in other EMs and therefore generating revenue in those (possibly weaker) currencies. Over time, there has been a strong correlation between EM economic conditions and currency movements. Added to this, a number of these “dirty” rand hedges have debt issued in DMs, resulting in a negative mismatch in an environment where EM currencies (including the rand) are depreciating against their DM counterparts. This is clearly not positive for corporate earnings and, by extension, for share price returns. Two recent examples are British American Tobacco and AB InBev. Nevertheless, despite all of this, investing in equities on the JSE has been a great strategy over any extended time period.

However, the past five years have been a lot leaner from a return perspective and the JSE has underperformed most global markets in US dollar terms (albeit not severely over that period). JSE investors are in unchartered territory – there are very few periods in living memory when the local index has underperformed almost every other asset class. Even more concerning is that returns being generated are barely beating inflation in what has arguably been a low inflationary environment! In addition, you are receiving your pay-out in rand, which is crucial when viewed in a global investment context – the rand has depreciated by 5% p.a. over the past 10 and 15 years.

As both investors and investment managers, we are faced daily with severe equity market fatigue as we ask ourselves “why take equity market risk for the low returns being generated?” While this is an obvious question, as the custodians of our clients’ financial destinies, our responsibility is to make sure that hasty decisions, which could impede our clients from reaching their long-term financial goals are avoided at all costs. This conversation is also made far more difficult both in times of tough market conditions and in periods of equity market exuberance.

Now is not the time to raise the white flag on SA equities – our market is cheap on a relative basis, both when compared with its own history and to most other global markets. However, one could (and should) argue that our market is cheap for a reason – local economic conditions are about as bad as they have been since the GFC. Despite this, sentiment is an extremely powerful driving force both for asset prices and, more importantly, for long-term economic growth. In addition, share prices move quickly as was clearly shown in what has become known as the “Ramaphoria trade” early last year. After a somewhat surprising win for now-President Cyril Ramaphosa at the ANC Elective Conference in December 2017, market participants cheered the outcome as prospects of a new economic dawn were in sight. The result was that, over the next two months, there were certain sectors on the JSE (such as banks and retailers) that were up over 20%! Unfortunately, a shocking 1Q18 GDP print and continued deteriorating economic conditions as the year progressed all but poured cold water on the rally as most of these gains had reversed by early this year.

While investor sentiment often drives share price performance in the short term, economic growth drives corporate earnings and long-term shareholder returns. For this reason, we were not anticipating Ramaphoria 2.0 after the recent election result – investors are likely to remain weary and will look for improvements in the macroeconomic backdrop. Should this start to transpire, we could well have one of those classic Aha! moments, where we realise that our market is too cheap and, as mentioned, assets are likely to reprice quickly to reflect the improved outlook, which makes trying to time it impossible.

Regardless of what the future holds for the local equity market, the JSE has always been a concentrated market and a combination of corporate failures and poor capital allocation by several of our corporate management teams has meant that the list of investable shares has shrunk even more over the last few years. SA is less than 1% of the total investable universe globally, which begs the question as to why we are willing to put so many of our eggs into such a small basket?

Home bias is not a SA phenomenon – investors worldwide feel more comfortable investing in companies they know well and, generally, these are more likely to be local. If you add the common misperception that it is difficult to get approval for transferring money out of SA, it makes the whole process of global diversification seem daunting for investors.

This is often a strong enough deterrent to prevent us from getting out of the starting block. Invariably, we are happy to settle for those rand-hedge shares the JSE has to offer. The reality though is that, provided your tax affairs are in order, it is a relatively painless process to get approval to transfer up to R11mn per adult p.a. offshore – a significant investment amount for even the wealthiest investor.

As equity investors with an unconstrained global mandate, we often ask ourselves “how many JSE-listed shares would we include in this portfolio?” Sadly, the answer right now is not many. Does this mean that we think SA companies are bad investments? Not at all, but the reality is that our choices become so much vaster the moment we embark on a global diversification strategy. We have access to the highest quality, most exciting companies listed anywhere in the world, where even the biggest investment managers (by assets under management) aren’t constrained by the same liquidity issues facing investment managers here. Bizarrely, most SA investors would likely recognise more of the shares in the offshore Anchor High Street Equity Portfolio than they would in our local equity mandate. The fact that we are exposed to most of these companies in some way or form every day of our lives eases the home bias considerably.

So, why not sell up everything and invest it all overseas? There are investment professionals out there that would advise clients to do just that. Our answer lies in the fact that most us still need to eat, breathe and sleep in rand. Asset allocation is probably the most important aspect for an investor to consider when setting financial goals for their investments. Naturally, deciding which asset classes to invest in, and on what continent, is a crucial step in this consideration process. Our advice to clients is to try and ensure that they have provided for their rand expenses both before and during retirement primarily with local investments. Thereafter, if for no other reason than the sheer choice that offshore markets offer, it makes sense to invest most of your remaining assets abroad. Still, a measured approach is key to externalising funds offshore. In the fullness of time, we think you should have 60%-75% of your investable assets offshore, but here timing is very important.

The positive news for investors is that the relative attractiveness of our local asset classes, other than equities, is very good. Our bond market offers amongst the best inflation-adjusted yields in the world. This gives us a great chance of achieving the goal set out earlier – cater for rand expenses primarily with the lower-risk, higher-yielding portion of our asset allocation, while looking for long-term capital growth abroad. It goes without saying but seeking out quality investment advice in planning your investment journey is of paramount importance.

Investing is not a proposal and implementation thereof, but rather an ongoing journey. Our approach is to set a strategic asset allocation over time, but not fall into the trap of externalising money at extreme exchange rates, which is probably where we are at currently. So, a measured approach to externalising funds (and the timing of doing so) is key. We work hard to scour the globe for unique investment opportunities, and we will present these to our clients as they arise. While part of us might feel like economic traitors for suggesting what we have above, the reality is that we are proud South Africans but with a choice and, for now, we choose to live in the sun and (where appropriate) invest in the shade.

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