Interest rate jitters spark flight to quality

An investor looks at a screen displaying stock information at a brokerage house in Hefei, Anhui province October 13, 2008. China's stock market rebounded from early losses on Monday to close sharply higher, led by bank shares after U.S. and European policy makers said they would take fresh steps to try to resolve the financial crisis. REUTERS/Stringer (CHINA). CHINA OUT. NO COMMERCIAL OR EDITORIAL SALES IN CHINA.

An investor looks at a screen displaying stock information at a brokerage house in Hefei, Anhui province October 13, 2008. China's stock market rebounded from early losses on Monday to close sharply higher, led by bank shares after U.S. and European policy makers said they would take fresh steps to try to resolve the financial crisis. REUTERS/Stringer (CHINA). CHINA OUT. NO COMMERCIAL OR EDITORIAL SALES IN CHINA.

Published Apr 25, 2015

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The best defence against the threat of rising interest rates in the United States and locally is to invest in quality companies – and the demand for these companies’ shares has never been higher, asset managers say.

Rising interest rates in the US could result in the sale of foreign investment holdings in South African equities, listed property and bonds, which is likely to result in prices in these sectors falling.

William Fraser, a director at Foord Asset Management, says that when valuations are high, as they are in the local share market, you should be in quality companies with strong balance sheets that can withstand a change in the liquidity in the market and can produce goods and/or services at low cost.

If the factors that are buoying the market unwind when the US Federal Reserve starts to increase interest rates, these companies will continue to make a profit, and they may take market share from companies that produce at higher cost.

Foord continues to focus on future company earnings when analysing investment opportunities.

Fraser says if the share price of a company that has strong and consistent earnings falls because of external factors, such as a change in investor sentiment, the price will eventually correct to follow the company’s earnings.

Clyde Rossouw, the multi-asset portfolio manager at Investec Asset Management (IAM), says Investec also prefers high-quality businesses that have strong cash flows and trade at reasonable price-to-earnings (PE) multiples. These businesses are relatively defensive (they can maintain profitability despite tough economic conditions), and IAM believes they will protect investors if there is a correction in equity markets, he says.

Paul Bosman, a multi-asset fund manager at PSG, says PSG likes quality companies that are mispriced (the share is priced below the intrinsic value of the company), because it gives the manager a margin of safety when it invests.

PSG bought shares in Steinhoff (which makes, sources and sells furniture and household goods in Europe, Africa and Australasia) when it was undervalued. It also held AVI (owner of a number of food and beverage brands), which regularly pays out almost 100 percent of its earnings and still grows its earnings at 20 percent a year.

However, opportunities are more limited than they were in the past, because many industrial shares are expensive, as evidenced by the FTSE/JSE Industrial Index, which is very expensive relative to its expected future earnings (it is trading on a very high PE ratio), and the companies in the index have been reporting high profits. There is a risk that these companies’ profits and share prices could come down, he says.

In the absence of sufficient opportunities in the market, PSG will hold high cash reserves and wait for a market correction to deliver shares that are mispriced.

Bosman says PSG has started to buy “unloved” resource and construction shares, but only those that it believes will be able to make a profit even if the global demand for resources stays low and weak economic growth depresses the demand for construction.

If you buy the right companies, with diverse business activities and good management, you can do well, but PSG will not have a blanket buy on construction and resource shares, because not all of them are good quality, Bosman says.

He says that, in the fixed-interest sector, PSG’s multi-asset funds bought Capitec bonds when these were sold down as a result of negative sentiment during the demise of African Bank.

PSG has also invested in cash instruments, such as NCDs with longer durations, because these are offering real (after-inflation) yields of two to three percent a year.

Bosman says, as typically happens when prices in a sector are rising steadily, there have been a number of new listings in the listed property sector. However, the shares in the FTSE/JSE SA Listed Property Index are now, on average, trading at a premium of about 40 percent to their net asset value.

Like PSG, Foord has trimmed its exposure to local equities and is also stashing cash to buy quality companies when share markets fall during periods of volatility.

Fraser says Foord started to invest in local bonds last year, when yields were higher, but when the oil price resulted in lower inflation expectations, bond yields fell too far, and real return expectations became unattractive.

Fraser says Foord is patient and will gradually increase the allocation to bonds. He believes a combination of higher interest rates on US Treasuries (government bonds) and higher domestic short-term interest rates will result in higher yields on local longer-dated bonds.

Fraser says that when you consider the out-performance of listed property relative to other asset classes, it is clear that asset managers made the wrong calls on this sector over the past year.

However, the fall in listed property yields does not reflect the future outlook for growth in distributions; instead, it is driven by very low global interest rates. The sector has also benefited from foreign inflows, and prices are not realistic.

Listed property shares may continue to do well as long as offshore money is looking for higher yields, but there is a huge risk in investing in this sector now, because share prices are out of kilter with the companies’ net asset values.

Offshore equities have done well, because company earnings have reflected the improvement in economic conditions, Fraser says. The end of the upward economic cycle is not close and there is room for more economic expansion, because no central banks have started to raise interest rates, he says.

The improvement in economic conditions in the US and a sharply weaker euro have resulted in exporters in Europe showing significantly better earnings.

What may change the outlook for equity markets is a prolonged rise in global interest rates. Although the upward cycle may continue, there will be much greater volatility in equity markets, Fraser says.

He says Foord is not overly concerned by the slowdown in the growth rates of emerging market economies; instead, it will focus on long-term themes in sectors that will grow at a faster pace than overall economic activity. For example, Foord will seek companies that will benefit from ageing populations in both emerging markets and developed markets.

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