Thoughts on investment strategy in the current market

In this blog, I want share with you some of my thinking on how I would position an investment portfolio in the current market.

Central banks

The current market in South Africa and globally is influenced by a number of factors. What stands out for me however is the role of central bankers in trying to stimulate growth through ultra-easy monetary policy, i.e. keeping interest rates artificially low, in fact even negative in real terms. These low rates ultimately influence asset prices by inflating their value. This can be observed in the high relative valuations (price earnings ratios) in the market.

Arguably, any sign that interest rates (globally) will normalise, will quickly result in asset prices being lowered significantly. We witnessed the turbulence in the markets when the US Federal Reserve stopped its quantitative easing programme and started raising interest rates (albeit very cautiously). The challenge for investors, however is that it is very hard to predict how central bankers will act. The complexity is further compounded because central bankers are not a homogenous group and do not act as one. When the US Federal Reserve raised interest rates, the European and Japanese central banks in fact decreased interest rates. This resulted in some whipsawing in the markets. By the way: the relevance for South Africa is that cheap money looks for assets anywhere in the world, including South African assets, thus also impacting South African asset prices.

South Africa

For South African investors, additional complexities arise: an ANC government that is split along factional lines, the scourge of corruption in the country, insufficient growth to meet the needs of job seekers and to meet government expenditure requirements, the potential for a sovereign credit ratings downgrade; etc. But perhaps the biggest problem facing the country is that failure of government policy in stimulating growth, creating jobs, reducing high levels of inequality and making South Africa a globally competitive business environment. Entrepreneurial, professional, technical and artisanal skills are not being sufficiently developed to give South Africans coming into the job market a better chance of getting meaningful employment and to make South Africa a stable and globally competitive environment.

Overvalued Market?

We can see from the picture below, obtained from an article by Steve Blumenthal in www.valuewalk.com that looking at it from a historical basis, the current market is overvalued and that returns are likely to be on the lower end if one is investing broadly in the market at these levels. The picture shows the valuation and subsequent 10-years returns.

The JSE ALSI is trading at a PE of approximately 21.5. This is also at an aggregate level, in expensive territory. So, if you want to invest, you need to be much more discerning, making decisions very hard for investors.

What to do?

The first question to ask then is:

“Is there any positives amongst all this doom and gloom?”

The doom and gloom should not be ignored, but one also should not be carried away by it. So, my first recommendation would be to be more risk averse in the current market. As a guideline, I would suggest that holding some cash that can be deployed when more favourable investment opportunities present themselves would not be such a bad idea.

The problem however, is that one does not know how long the current circumstances will last. As the saying goes: “nobody rings the bell at the top or the bottom of the market”, so one does have to retain some investments in the market. In a previous blog, on growth at a fair price, I discussed how you need to choose key sectoral themes and identify businesses that will take advantage of those themes.

Some of the themes that I think may play out over the next few years are depicted in the diagram below:

If these are the themes that will play out over the next 3-10 years, then one should be looking at those businesses that can take advantage of these trends. So, a second strategy that I would adopt is to have approximately 25%-35% of one’s investment portfolio offshore as the businesses that will benefit from some of these trends are listed in offshore markets and there may be very limited opportunities in the South African market.

Let’s take a few examples: businesses like Apple, Google, Amazon, and Facebook cut across a number of themes:

• Changing preferences of millennials
• Aging Populations in developed markets
• Pace of technological breakthrough
• Rapid urbanisation with megacities

There really are no equivalent businesses in the South African market that are in a similar league, yet most people are users of one or more of those companies services in South Africa. So, to get exposure to those businesses, one has to have offshore exposure. Warning: I am not necessarily suggesting that you buy into these businesses, as you would still need to conduct a valuation analysis to determine if the price is less than its intrinsic value before you invest in them. However, I do recommend that you do at least have a closer look at whether you should invest in these businesses if you accept the themes in the diagram above.

Now, one would have some cash, some offshore exposure, but there is still a large chunk of one’s portfolio left. Let’s assume that you are looking for equity exposure with the rest. Where would you look to find opportunities?

World Class South African Businesses

South Africa is home to a number of world class businesses.

Another one of my favourite businesses in South Africa is Discovery. Discovery is owner-managed, i.e. the owners have a large stake in the business. It is highly innovative, continuously seeking out new products, continuously analysing data so that it can be more efficient, price sharper, identify fraud, etc. It has the ability to attract great talent. Its Vitality loyalty programme is one of the best in the world, and it is continuously seeking opportunities in other markets. On the negative side, some of their products and ventures have not been as successful as expected and project costs have been higher than planned.

Discovery plays into the themes of:

• Rising African Middle Class
• Changing preferences of millennials
• Aging Populations in developed markets
• Pace of technological breakthrough

The share price is down by more than 25% since its peak of R155.77 per share, but still trading at a historical price earnings ratio of approximately 20. Still a bit expensive in my book, but if it manages to ride the waves of the sectoral trends, it may yet be a great investment even at these price levels.

Other South African world-class businesses that are globally competitive and provide opportunities for investors, include FirstRand, Standard Bank, Sanlam, PSG, Capitec, Mediclinic, Shoprite, Aspen to name a few. However, if there is a correction in the market, in all likelihood, these companies’ share prices will also probably come down, offering better entry points for investors. Some prices have already come down (perhaps not sufficiently) as we see with Discovery. So, if one does not have these quality businesses in one’s portfolio, a strategy could be to start slowly building up stakes in these businesses, with a view to be more fully invested over a few months or even a year or two, depending on the price entry points. One should also take advantage when prices are down, bearing in mind that sentiment will probably very low at that time. This is when your conviction is severely tested.

Conclusion

In summary, my view is that the markets are expensive at the moment and very difficult to predict as a result of central bank and government actions. Having some cash in one’s portfolio to take advantage when markets weaken is not a bad strategy. Similarly, my view is that approximately 25-35% on one’s portfolio should be in offshore assets. Lastly, if you haven’t already started, then begin building positions in great South African businesses that are likely to take advantage of key demographic trends.

Finally, I would also not recommend that anyone invests for a single outcome, e.g. Rand weakening or Rand strengthening. Invest with a view to manage the risks if your view/s do not pan out. The market is not always rational, especially in the short term.

Sabir