It has been yet another great year for South African general equity funds: performance data for the quarter to June 30 shows that more than 50 funds returned in excess of 30 percent for the year.
Over the three- and five-year periods to the end of June, the top-performing South African general equity funds returned, on average, in excess of 20 percent, the results from ProfileData show.
South African industrial funds produced the highest returns of all the unit trust sub-categories over three and five years, with average annual returns of 27.29 percent and 27.14 percent respectively.
Whenever markets have run as well as they have over the past five years, there are words of caution from fund managers.
Herman van Papendorp, the head of macro research and asset allocation and the co-portfolio manager of balanced funds at Momentum Asset Management, says that, as a result of strong returns since the market low in 2009, valuations – share prices relative to their expected earnings – are looking extremely expensive relative to other emerging markets and the local market’s history. South Africa is therefore trading like a developed equity market, without the corresponding developed-market fundamentals behind it, he says.
Instead, the local economy is facing rising inflation and interest rates, which are expected to affect economic growth and company profits, and, in turn, equities, bonds and property, Van Papendorp says.
Rian le Roux, the chief economist at Old Mutual Investment Group, says there has been a deterioration in the outlook for South Africa’s economic growth, and forecasts for the year have generally been cut to two percent or less, from three percent earlier this year.
He says weaker growth will put further pressure on the government’s finances, and raises the risk of a ratings downgrade during the second half of the year.
Van Papendorp says the rise in the South African equity market, without the underlying economic fundamentals, is problematic for investors, because it removes the margin of safety in the asset class.
Investors should seek opportunities where the risk-reward trade-off is skewed in their favour. In South Africa, equities are expensive, which means that the good returns are compromised relative to the risk that is being taken.
Mark Cliff, the head of marketing at PSG Asset Management, says now is not the time to be taking unnecessary risk.
Over five years to the end of April, the FTSE/JSE All Share Index (Alsi) has delivered an annual average return of 22.2 percent (with dividends reinvested), which is more than 16 percentage points a year above inflation, he says. By comparison, the Alsi’s long-term average total return has been about 13.5 percent, Cliff says.
Minimise risk
The key to investing in the current market is to minimise the risk of losing value on your investments, so that when markets fall, you are likely to experience smaller losses than the market, he says.
A manager who loses less of your investments will also recover faster when markets turn, and for this reason you need to have the capacity to remain invested for long enough to recover from any falls, Cliff says. This is why PSG considers how much the prices of its shares and other securities in which its funds invest could fall if the market were to fall, he says.
“We define risk as the probability of incurring a capital loss over an appropriate time horizon. For the PSG Stable Fund, this would be a two-year horizon; for the PSG Balanced Fund, it would be a three-year horizon; for the PSG Equity Fund, it would be a five-year horizon; and so on,” Cliff says.
Although taking greater risks increases the return you could possibly earn, it also increases the losses you could incur from a fall, and the greater the climb after the fall (and the more time it will take) to return to the original point of departure, he says.
After a fall, the climb is always double the fall, Cliff says. If an investment declines by 50 percent in value, it has to increase in value by 100 percent to return to its peak.
The key is not to expose portfolios to expensive assets, but to ensure that there is a suitable margin of safety between the price paid for the share and its intrinsic value as calculated by the fund manager.
“We do not know if or when the price of that share will rise when we buy it. However, we do know that if the price should decline, the degree of fall is likely to be much less than if we had bought or held the share when it was trading at a premium to its intrinsic value,” he says.
Cliff says that at the end of May 2008, the price-to-earnings ratio (P:E) – the price of a share relative to the share’s earnings – of the Alsi was 15.9 times, while the P:E of the shares in the PSG Flexible Fund was 11.3 times (or about 29 percent cheaper). When the market correction occurred later that year, the P:E of the Alsi fell to 8.2 times by the end of February 2009 (a decline of 48 percent), while the P:E of the shares in the Flexible Fund fell by 10 percent less to seven times (a decline of 38 percent).
As a result of this relatively smaller fall, the Flexible Fund reached a new high by August 2009 and powered onto gains. By the time the Alsi returned to its pre-correction level – more than a year later than the Flexible Fund – the fund had already out-performed the Alsi by a significant margin of more than 35 percent, Cliff says.
Long-term focus
Karl Leinberger and Duane Cable, portfolio managers at Coronation Fund Managers, say markets “continue to grind higher with very little regard for the underlying risks facing the real economy – the eventual withdrawal of accommodative monetary policy and concerns over a slowdown in China”.
Leinberger and Cable also focus on valuations as a measure of safety, and are investing for the long term.
They say Coronation continues to favour quality global stocks that happen to be domiciled in South Africa, such as MTN, British American Tobacco, Naspers, Richemont and SABMiller. Although these shares have performed extremely well relative to the broader market, they remain attractive relative to what Coronation regards as their intrinsic value, as well as relative to businesses that are purely domestic, Leinberger and Cable say.
Coronation has, however, taken healthy profits on some of these counters to fund recent purchases.
Leinberger and Cable say they own very few domestic businesses, particularly those that are consumer-facing, because the valuations were not attractive, and they are concerned about the ability of these companies to defend their earnings base. However, these shares now have fair to attractive valuations and provide an adequate margin of safety, they say.