especially if we consider the strength of the US market and the fact that ... Graph 1: The S&P 500 outperformed the
Finding positive asymmetry in uncertain times
Shaun le Roux
Shaun has managed the PSG Equity Fund since 2002 and the PSG Flexible Fund since 2016. He is a CA(SA) and a CFA charterholder.
Risk and return go hand in hand The future is inherently unpredictable. This uncertainty – and the fear that goes with it – creates a risk premium: higher potential returns to compensate investors for taking on higher risk (the reason that equities tend to outperform over the long term). As risk and return are inherently linked, it is important to understand the risk/return trade-off to invest successfully. Investing in growth assets at attractive prices improves the odds of favourable outcomes If you invest in growth assets (those with higher risk premiums) for long periods, you significantly improve the odds of retiring comfortably. And if you buy quality securities at good prices, you improve the odds of earning higher returns at lower levels of risk. Expensive assets can deliver good returns, but usually only if growth rates exceed expectations or buyers push prices up even further. We focus on the expectations embedded in the price Instead of trying to forecast short-term earnings or whether the average investor is likely to be a buyer or seller in the months ahead, we focus on the expectations we believe are embedded in the price. When the expectations that are discounted into a share price are very low, downside is limited even if the outlook worsens. But returns should be acceptable if conditions remain the same, and excellent if they improve – thereby creating positive asymmetry. Negative asymmetry is more likely when confidence levels are high Conversely, when expectations for a share or asset class are high and the valuation is stretched, the investment outcome is unfavourably skewed. If expectations aren’t met, negative asymmetry means the downside can be sizeable. High expectations are currently factored into the prices of many financial assets. Developed market bonds and credit remain expensive. Similarly, we are cautious of crowded developed market stocks, particularly in the US and especially the ‘FAANGs’ (Facebook, Apple, Amazon, Netflix and Google); the darlings of the market. This suggests that returns from these assets are likely to disappoint and negative asymmetry may be at play. There is a difference between a great company and a great investment. Prices of popular stocks continue to rise despite risks Worryingly, the prices of popular stocks have continued to rise this year despite a ramp-up in reasons to temper expectations. These include the threat of trade wars, tightening
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US monetary policy, and potentially unsustainable levels of profitability that have been boosted by favourable economic conditions, record margins and low tax rates. It is clear to us that a significant proportion of equity market participants – and notably passive products – is not price sensitive (or risk averse). There are still parts of the markets for which expectations are low Low confidence levels create pockets of positive asymmetry. This means that investors who are prepared to invest in less popular asset classes stand to be rewarded with sound longterm returns. Within these parts of the markets, we continue to find good opportunities in South African shares in particular, and in uncrowded global stocks and local government bonds. Over recent years, South African equity returns have disappointed Over the last four years, returns on the JSE (at an index level) have barely kept pace with inflation. When expressed in dollars, the local market is down 1% due to rand weakness. Furthermore, half of the FTSE/JSE All Share Index’s (ALSI) performance has come from one share – Naspers. This has unsurprisingly left many investors disappointed, especially if we consider the strength of the US market and the fact that the rand has weakened substantially since 2011 (with more than 60% of the JSE Top 40 comprising rand-hedge shares). It would have been far better to invest in the S&P 500, which returned 11.2% in dollars and 18.5% in rands over this period (as shown in Graph 1). Poor emerging market sentiment and political uncertainty have weighed on the local market As South African financial assets tend to follow the fortunes of global markets, asset prices are less influenced by domestic developments. However, the political woes of the past few years have stalled the South African economy, which has weighed heavily on the profitability of domestic shares. This has acted as an additional drag on market returns. It is important to note that other emerging markets have also struggled over this time. The MSCI Emerging Markets ETF (exchange-traded fund) is down in dollar terms and we have seen a rollercoaster ride in emerging market equities. The 40% decline into 2016 was followed by a 90% rise into early 2018. This has been followed by a drop of 19% from year-to-date highs amid sharply deteriorating sentiment towards assets and economies that investors perceive to be risky.
Total index returns in rand or dollar (June 2014 = 100)
Graph 1: The S&P 500 outperformed the ALSI from June 2014 to June 2018 210 190 170 150 130 110 90 70 50 JUN '14
SEP '14
DEC '14
MAR '15
JUN '15
SEP '15
S&P 500 (rands)
DEC '15
MAR '16
JUN '16
S&P 500 (dollars)
SEP '16
DEC '16
ALSI (rands)
MAR '17
JUN '17
SEP '17
DEC '17
MAR '18
JUN '18
ALSI (dollars)
Compound annual four-year total returns S&P 500 (rands)
18.5%
S&P 500 (dollars)
11.2%
ALSI (rands)
5.7%
ALSI (dollars)
-1.0%
Sources: PSG Asset Management, Bloomberg
Elevated valuations of popular shares gave rise to negative asymmetry Several large-cap JSE shares have delivered negative returns over the past four years, largely due to extended starting valuations. For example, Aspen, Woolworths and Life Healthcare are all Top 40 shares that have lost investors money. Four years ago, Aspen traded at a price-earnings (P/E) ratio of 30 times, and Woolworths and Life Healthcare at P/E ratios of 24 times each – all starting valuations that priced in high expectations of future growth. When those expectations weren’t met, shareholders endured disappointing outcomes, demonstrating negative asymmetry at work. Less popular shares present compelling opportunities Many domestic-facing South African companies continue to find themselves out of favour. This has presented the opportunity to accumulate several attractively priced shares where valuations are underpinned by strong free cash flow. We view these as asymmetrical opportunities, because while it is possible that conditions may get worse and the shares may get cheaper, we expect that this would be temporary. Our assessment of what
we think these companies are worth indicates material upside for long-term investors. We continue to mine the global equity universe for uncrowded stocks We have identified some good long-term opportunities despite the generally elevated valuation levels in developed market equities. (Philipp Wörz sets our global process on page 4 and Dirk Jooste writes more about the opportunity in Japanese financials on page 7.) We encourage investors to stay the course to benefit from our long-term approach Our search for positive asymmetry means that our funds tend to look different to the indices and many of our peers. This means that investors can expect them to perform differently from others. In fact, they may often underperform over the short term. We view this as one of the costs of investing in uncrowded areas. However, the asymmetrical nature of our investment ideas should provide investors with long-term returns to compensate.
SECOND QUARTER 2018 | 3
