returns than other asset classes. Despite the dot com bubble and the financial crisis, which had devastating effects on
A WORD FROM OUR CIO The art and science of investing in global equities
Adriaan Pask CIO PSG Wealth
In unpredictable times when asset prices appear to ignore valuations, choosing an asset class to secure a reasonable return has become a bit of an art form. Although investment decisions should always be underpinned by science, or objective quantitative assessment, allocations do depend on what the investment is required to do, and the amount of risk an investor is prepared to take.
Equities have historically delivered better returns than other asset classes Despite the dot com bubble and the financial crisis, which had devastating effects on the stockmarket, the case for investing in equities over the long term remains strong. This is because the impact of these short-term market downturns diminishes when staying invested for 10 years or more. Data shows that equities have offered the best real returns over the past 5-, 10-, 20- and 48-year periods.
Unfortunately, there is a perception that equity is the highest risk investment While cash will grow at a steady pace, investments in equities managed by active managers can reduce one’s longevity risk. Investors are rewarded with a premium for their uncertainty,
since equities are the most volatile asset class. Investors often get fixated with characteristics of investments that are beyond their control, such as market volatility. We, however, believe that paying careful attention to sound investment principles could be of far greater value. Regardless of our preference for global equities we must caution that equities should form part of a well-diversified portfolio, along with other asset classes.
Two graphs inform our strategic decisions about global equities Domestic equity is overvalued by 38% Our assessment of the data shown in the graphs is that domestic equity is now roughly overvalued by 38% relative to its historic yield. Some expensive pockets remain in the market and investors should expect continued volatility at current levels.
Premiums and discounts in various global and domestic asset classes Current earnings yields versus long-term averages – premiums and discounts 79.3%
80% 70% 60% 50%
49.0% 38.0%
40% 30% 19.6%
20%
24.0%
24.3%
Domestic bonds
Domestic property
19.3% 13.3%
10% 0 Global cash
Global bonds
Global property
Global equities
Domestic cash
Domestic equities
% Premium (+)/Discount (-) Source: PSG Wealth investment division THIRD QUARTER 2016
A WORD FROM OUR CIO
Current earnings yields versus long-term averages 14 11.8
12
11.7
11.4
11.7
12.1
9.5
9.2
10 8.2
8
9.0
8.2
8.0 6.9
7.1
6 4.2
4 2 0
4.5 3.6
2.4
4.9
6.4
7.0
8.0
8.1
7.7
6.2 4.3
4.0
3.5 2.5
1.2 Global cash
0.9 Global Global Global Domestic Domestic Domestic Domestic Domestic Domestic Domestic Domestic Domestic Domestic Domestic bonds property equities cash bonds property equities industrials resources financials bonds bonds bonds bonds 1-3 3-7 7-12 12+ Average
Current
Source: PSG Wealth investment division
Listed property is also overvalued by 24% Based on our assessment of fair value, domestic listed property is now overvalued by roughly 24% relative to its historic yield. In addition, we believe that the interest rate cycle will affect domestic economic strength, affordability and sentiment. These are headwinds for capital growth in the listed property sector. We therefore expect property yields to normalise on the back of capital value pressure. However, as always, there are some exceptions. Selected listed property shares are experiencing growing yields, which may present some opportunities. Although broad-based property exposure is not appropriate now, we do believe there are some listed property shares that are able to make a contribution to a diversified portfolio. Domestic bonds are overvalued by 24% The aggregate yield of the BEASSA All Bond Index shows that this asset class remains generally overvalued. The implied premium is roughly 24%. With money market assets starting to offer some value, demand for bonds may decline in light of the increased risk of holding them. The relative risk-adjusted returns of bonds are also being compromised by higher interest rates on the horizon. Until recently, the gross real yield on most short-dated money market assets was nearly zero; and on an
after-cost, after-tax basis, there was very little to be excited about. We do, however, expect this to change over the coming months, as rate hikes are anticipated. Cash should form part of a diversified portfolio and even in an increasing interest rate cycle, should not be used in isolation. Relative to our valuations, global equity, although trading at a slight premium of 19.3%, therefore remains the most attractive asset class.
The art of investing offshore As professional investment managers, we are comfortable with determining the intrinsic value or risk associated with each asset class. But the days when valuations provided the main insight into potential value or risk are long gone. Today, investors understand that investment potential is also determined by management, macroeconomic conditions and the political landscape. In essence, the environment in which earnings must be generated plays an increasingly important role in how we assess investment potential and risk.
THIRD QUARTER 2016
A WORD FROM OUR CIO
Market review Market indicators Index Local equities
Local bonds
Local cash
International equities
Quarter-end value
1 month
3 months
6 months
1 year
3 years
5 years
ALSI
52 733.12
0.27%
-1.63%
8.43%
8.63%
11.00%
14.66%
Industrials
79 456.69
1.92%
-2.05%
7.16%
12.75%
15.76%
22.41%
Resources
17 658.81
-0.85%
0.89%
15.69%
-5.39%
-10.05%
-5.66%
Financials
40 303.92
-3.23%
-2.57%
6.15%
-3.93%
14.98%
18.34%
Listed Property
634.78
-4.89%
-0.65%
7.05%
3.49%
16.63%
17.10%
ALBI
516.22
-1.77%
4.48%
7.61%
4.46%
7.14%
6.94%
ALBI 1-3 Years
400.19
0.06%
2.38%
5.06%
7.24%
6.70%
6.41%
ALBI 3-7 Years
492.92
-0.64%
3.85%
6.94%
7.32%
7.55%
7.12%
ALBI 7-12 Years
566.85
-1.67%
4.55%
7.20%
4.88%
6.76%
7.10%
ALBI 12+ Years
563.97
-2.19%
5.37%
8.78%
3.25%
7.61%
6.97%
GOVI
514.63
-1.61%
4.40%
7.44%
4.88%
7.08%
6.83%
OTHI
525.75
-2.22%
4.63%
7.97%
3.24%
7.55%
7.58%
STeFI 3 Month
339.53
0.60%
1.77%
3.50%
6.70%
6.01%
5.71%
Volatility Index
13.42
13.06%
-5.43%
-34.70%
-52.80%
-7.60%
-15.75%
S&P 500
2 170.95
0.14%
4.10%
13.60%
12.55%
12.30%
14.69%
Euro Stoxx
3 023.13
1.15%
-0.83%
5.07%
-4.79%
6.44%
8.85%
Nikkei
16 887.40
1.92%
-2.02%
5.37%
-10.60%
8.05%
13.53%
Hang Seng
22 976.88
4.96%
10.39%
20.22%
6.03%
1.88%
2.27%
973.72
2.22%
3.12%
11.59%
4.09%
10.14%
13.50%
MSCI World
1 719.52
-0.13%
2.68%
11.14%
4.50%
5.59%
8.39%
MSCI World ex US
1 686.99
-0.17%
1.27%
8.86%
-2.27%
-0.43%
1.56%
FTSE 100
6 781.51
0.85%
8.84%
11.23%
8.54%
1.92%
5.14%
Dax
Performance reported in base currency, using total return Sources: I-Net, PSG Wealth investment division As at 31 August 2016
THIRD QUARTER 2016
A WORD FROM OUR CIO
Businesses and their earnings must be sustainable
The science behind finding value in global equities
When we analyse global stocks, we look at the sustainability of the business and its earnings. Businesses should generate a lot of cash, with strong corporate profits and a lean balance sheet with little debt. This enables the business to absorb macroeconomic shocks. Only once we have a sense of comfort about this will we start considering valuations and other quantitative measures. Having sight of the bigger picture enables us to make sound investment decisions. We also focus on selecting fund managers who actively analyse shares according to these criteria.
The S&P 500 generated a return of 13.60% over the past six months, which brings the five-year historic annualised return for the S&P 500 to 14.69% in dollar terms. The FTSE 100 generated returns of 8.84% for the past three months and 11.23% for the past six months – in other words, it continued to generate positive returns despite the unexpected Brexit vote in June. The US has, however, been the primary driver of global stockmarket returns, as the S&P 500 was the only major global index that grew by more than 10% over the past year.
There is a wider opportunity set offshore
Combined with the weakness in the rand over the same period, this has resulted in phenomenal returns for investors who diversified offshore.
We prefer global stocks to domestic shares because generally offshore shares provide more opportunities. There is a greater probability of us finding a good business at an attractive price. Part of the art of investing in offshore equities is the ability to stay the course and not be tempted to chop and change your decisions. This art form has, however, always been informed by our science or quantitative analysis.
Wage growth/consumer spending/corporate earnings wheel
Wage growth
Corporate earnings
Consumer spending
Source: PSG Wealth investment division
THIRD QUARTER 2016
A WORD FROM OUR CIO
Tactical asset allocation preferences
EMERGING
DEVELOPED
South Africa
Global
Strategic asset allocation Tactical asset allocation Changes this month Overweight: Tactical recommendation to hold more of the asset class than specified in the strategic asset allocation
Neutral: Tactical recommendation to hold the asset class in line with its weight in the strategic asset allocation
Underweight: Tactical recommendation to hold less of the asset class than specified in the strategic asset allocation
Source: PSG Wealth investment division
THIRD QUARTER 2016
A WORD FROM OUR CIO
Multi-nationals provide geographical and currency diversification
Low wage growth in the US is a concern but corporates are healthy
In addition to promising long-term returns, global equities also provide global exposure and therefore diversification. South Africa contributes 1% to global GDP and a similar percentage of corporate earnings. Yet most investors focus only on local investment opportunities. By investing in multi-national companies, investors can reap the rewards of global economic growth, without making any regional specific allocations. In addition, investing in a business that is geographically diversified usually diminishes specific foreign exchange rate risks.
A potential headwind to investing in global equities is the stagnant growth in US wages. Although data shows that more Americans are being employed, this has not led to the expected increase in consumer spending. The reason is that the wages received by most of these workers are not sufficient to enable excessive spending to support faster economic growth.
We prefer investing in multi-nationals: • with strong balance sheets who adjust their investments to emerging and developed markets as their business strategy informs • who are diversified geographically as well as across various industries
There are ways in which to manage the impact of rand volatility The biggest near-term risk for South African investors is volatility in the rand. However, there are ways in which professional investment managers can manage this risk effectively. Our investment managers, for example, have the required access and expertise to use currency-hedge instruments to manage the rand’s volatility. Having said that, the rand is now trading at a discount of greater than three standard deviations to purchasing power parity (PPP). We can make two key observations from this: • The rand is trading well above the long-term PPP benchmark, which appears to be excessive. Although a sovereign debt downgrade would result in additional short-term volatility, we are focused on the long-term outlook. • The margin at which the rand is currently trading indicates that further weakness is unlikely. In fact, the rand may even strengthen from these levels.
However, the balance sheets of corporates in the US are healthy. We expect the wage growth/consumer spending/corporate earnings wheel to start spinning once corporates start to use their higher-than-normal cash positions to hire more employees or to invest in their businesses. This could lead to more money in workers’ pockets, increased spending and better economic growth, which leads to corporate earnings growth.
We are overweight developed market equities In tough economic conditions we prefer to be overweight in defensive shares that offer some protection in volatile market conditions. We do, however, consider cyclical shares when underlying valuations are sound.
Global equities remain the most attractive long-term asset class Although global equities are trading at a premium, this asset class remains the most attractive asset class for long-term investors. The underlying valuations are still less stressed than most of the other asset classes and there are many quality firms to choose from.
THIRD QUARTER 2016
