South African investors often make the mistake of thinking that day to day movement in the rand or local bonds and equities are a function of domestic economic and political developments.
“The reality is that, over time, capital flows to and from South Africa tend to be much more driven by global trends including levels of interest rates, commodity prices and risk appetite,” says Shaun le Roux, fund manager at PSG Asset Management.
Speaking recently at an investment seminar in Cape Town, le Roux said that investors are focused on the likelihood of a sovereign credit downgrade for South African government bonds. “However, we believe that a sovereign downgrade is already priced into SA bonds,” he said.
Instead of trying to guess what will happen, it’s more fruitful to try to determine what has been priced into assets and whether one can buy high quality assets at a margin of safety, le Roux said.
“The risk that concerns us most in local politics would be a successful attack on the independence of the Treasury and Reserve Bank. We are monitoring developments very closely as a change in the status quo would have a material impact on financial markets and the price of the rand.”
Overpriced asset classes
Another challenge faced by investors when making investment decisions in the current climate is assessing the impact that very low global bond yields is having on asset prices. “We are clearly living in a time of peculiar and distorted asset prices,” le Roux said. “It is apparent that artificially low yields and high prices imply a very poor outlook for long-term returns. “
Le Roux said PSG Asset Management was also cautious of other assets, including a portion of the equity market, that are trading off the global bond curve and where there are also valuations at very elevated levels. This is particularly the case for those global equities that are perceived to have the most stable, bond-like cash flows or the most visible and robust growth trajectories.
The market-cap weighted indices in South Africa are dominated by many companies that trade at very elevated valuation levels. This is especially the case for some large-cap industrial companies, most of whom have rewarded rand investors handsomely over recent years.
Looking at the Indi25 index (large cap industrials) whose collective value comprises 62% of the FTSE/JSE All Share index, a passive investor in the All Share should be aware that he or she is allocating 62% of their capital to shares trading at 28 times earnings on a weighted average basis. The valuations are stretched and le Roux believes there are better opportunities to be found at more acceptable levels of risk.
“Cool heads are required in these times of turbulence and noise. Investors need to ensure they don’t let macro and political developments throw them off course and end up selling low or buying high.” Le Roux said PSG Asset Management is “actively grabbing opportunities that arise simply because of poor sentiment.” A diversified portfolio and a longer time horizon will help investors achieve their objectives without taking on excessive risk.