Top-performing asset managers are less concerned about global events than they are about the high valuations of shares on the local stock market.
Prudential Fund Managers and PSG Asset Management say valuations, as measured by the price-to-earnings ratio (P:E) of the JSE, will be the factor that most influences the returns you earn in future.
Michael Moyle, the manager of Prudential Investment Managers’ top-performing Inflation Plus Fund and the head of real return, says the FTSE/JSE All Share Index (Alsi) is on a forward P:E of 16, whereas the long-term average historic P:E of the JSE is 12.5.
The P:E measures how expensive the price of shares are relative to their expected profits or earnings (a forward P:E) or their past earnings (historic P:E).
Moyle says that, given the high P:E of local equities, and the fact that valuations are the biggest driver of returns, you should not expect the same good returns you earned from local shares, particularly because earnings have not been good.
He says that, in an environment of low economic growth, the performance of equities is driven by the growth in company earnings, but earnings forecasts are being downgraded.
His warning of lower returns is echoed by Shaun le Roux, the equity manager at PSG Asset Management. Le Roux says the current economic conditions are tough, and pockets of the market are expensive.
Returns in recent years have been driven by rising P:Es, and many market indices are trading as high as they have been in decades, Le Roux says. This is unlikely to persist, because company earnings growth is unlikely to be robust, he says.
Parts of the market are expensive because of a high demand for the shares of higher-quality companies – particularly in the financial and industrial sector, he says.
Investors in local equity funds have enjoyed average returns of more than 15 percent over the past five years, but the average one-year return for these funds dropped to just 5.62 percent to the end of June, according to figures from ProfileData.
South African equity funds invested in financial shares had one of the best average returns over the year to the end of June, delivering average returns of 18.38 percent, while industrial funds returned on average 13.43 percent.
The average returns of most sub-categories for funds that invest in global markets were above 10 percent, while most sub-categories for South African funds produced average returns below 10 percent.
Global equity funds produced average returns of 14.03 percent for the year to the end of June.
Moyle says the 4.79-percent increase in the Alsi over the past year, combined with an actual decline in expected future earnings, means the market is getting more expensive.
Forecasts by economists of a recession for South Africa are less of a concern than the valuations, because many local companies make their profits from offshore markets, he says.
Le Roux says the risks to the local equity market are high, because it seems that both the United States and South Africa are about to start a cycle of hiking interest rates.
Moyle agrees an interest rate increase in the US combined with the current high valuations is a risk. The local market reacted negatively when the US announced in 2013 that it would begin tapering off the easy monetary policy it embarked on after the 2008 global financial crisis.
Le Roux says the key to success in the current market is to pick shares with exceptional management teams.
The good news for investors is that asset managers are likely to find opportunities for those who are patient and have longer-term investment horizons in “unloved” sectors of the market.
Le Roux says it is a good time to look for companies with strong balance sheets among cyclical stocks that are deeply out of favour, including the construction, manufacturing and resources sectors.
Commodity markets are deeply distressed, and there will be some meaningful consequences, so investors need to be wary of companies with weak balance sheets.
But it is an environment in which the strong will get stronger, he says.
Resource shares, such as Glencor and Anglo American, or industrial share Imperial, can be bought cheaply and could deliver for the patient, disciplined investor with a three- to five-year investment horizon, he says.
The possibility of rising interest rates creates a little more uncertainty, but good companies bought at good share prices don’t require very low interest rates to do well, Le Roux says.
He says PSG’s equity portfolios currently have relatively high levels of cash as the manager waits for good investment opportunities.
In its multi-asset funds, Prudential has sold some expensive equities and listed property and has moved into cash, Moyle says.
In funds with offshore exposure, Prudential is choosing to maximise exposure to global equity markets rather than invest locally, because the P:Es of global markets, particularly in Europe, are more attractive.
It remains neutral on government bonds, which it believes are offering fair value, but is staying away from global bonds, where yields are low.