Uncertainty is a fact of life, and ever present in investing. There are times, however, when uncertainty seems to dominate sentiment and news flow – and arguably we are in one of those periods. Tamryn Lamb draws on some of the points discussed at the 2021 Allan Gray Investment Summit to answer five key questions that advisers and many clients are asking.
As we emerge from this pandemic, and grapple with the aftermath of both the health crisis and the responses by government to combat it, it feels increasingly difficult for investors to connect the dots between what has happened and how to invest now for what the future may hold. If this describes you, then you are by no means alone.
We are privileged to be able to meet and interact with many independent financial advisers and investors across the country. In these discussions, common themes have emerged from frequently asked questions. We have aimed to give our take on five of these important questions:
- South Africa’s macroeconomic situation seems dire – are there any green shoots of hope?
- Are there great investment opportunities to be found in South Africa, given all the risks we face?
- How should we be structuring portfolios to protect against some of these risks?
- Where are the best opportunities to invest offshore?
- How do you incorporate ESG thinking into your portfolios locally?
1. South Africa’s macroeconomic situation seems dire – are there any green shoots of hope?
The most common question we receive, and what feels top of mind for almost every South African, is: How bad is the economic situation?
There is no shortage of negative news to feed fears and sentiment, and it is difficult to filter through the daily noise. I asked our senior portfolio manager and economist, Sandy McGregor, to share his thoughts. These are captured below.
The South African economy is gradually recovering from the pandemic. It had a setback in June/July as a consequence of the third COVID-19 wave and the unrest in KwaZulu-Natal and Gauteng, but the recovery is now back on track. The past year has seen a remarkable commodity boom, with mining and agriculture prospering as never before. For the first time since 1994, we have enjoyed a substantial current account surplus. While export revenues will now contract following a sudden slowdown in China – which has triggered a dramatic decline in iron ore and platinum group metal prices – the global economy should be fairly buoyant over the next year as the pandemic recedes.
South Africa’s economy has always been leveraged off its exports, so despite the Chinese slowdown, the necessary conditions for stronger growth are in place. It seems that the desire to travel has survived the pandemic and, as the remaining restrictions are lifted, the tourism sector, which has been decimated by shutdowns, will also recover.
The principal cause of the prevailing gloom about South Africa’s future has been the failure of the Ramaphosa administration to reverse the economic stagnation of the Zuma years. Government lacks the skills to do this. The ANC has sunk into chaos and has been unable to provide the necessary political leadership. It appears that only the private sector has the skills and resources to fix things.
There have been tentative steps to get greater involvement of private business in activities previously reserved for the state. For example, the leadership of both Eskom and Transnet now say that the private sector must play a greater role in both electricity generation and transport. This change of attitude is partly due to South Africa’s fiscal crisis caused by a bloated public sector wage bill, which rapidly compounded to unsustainable levels under former president Zuma. Government borrowing now absorbs most of SA’s savings, leaving little for investment by business.
However, in the past year, tax collections have surprised on the upside, mainly due to the mining boom, and the government has been trying to contain its spending. The deficit is still too large, but it is declining.
Stanley Lewis, the entrepreneur who created the modern Foschini Group, was fond of saying that “things are never as good as you think, and they are never as bad as you think”. This is true of South Africa today. Conditions are improving, and businesses will take advantage of this. The consequent economic recovery will happen despite and not because of the government.
2. Are there great investment opportunities to be found in South Africa, given all the risks we face?
As investors, we shouldn’t pretend we operate in a vacuum that is nicely insulated from macroeconomic and political trends. However, as Rory Kutisker-Jacobson, one of our portfolio managers, explained at our recent Investment Summit, it is equally important to distinguish between the economic environment and the prices you are paying for assets in that environment. While the underlying value of the assets we invest in can be impacted by tough economic conditions, if sentiment is low and those assets are already pricing in a poor economic outcome, they can still generate healthy investment returns. If changes in price and sentiment are more volatile than changes in value, there could be great opportunities on offer for patient, long-term investors.
As both Sandy and Rory note, we are not bulls on the South African economy, and it is incredibly hard to predict the future. We don’t have a crystal ball that tells us what South Africa will look like 10 or 15 years from now. However, while we don’t believe in making long-term economic forecasts, we can make inferences based on history and what we see prevailing today. Based on this, and on a balance of probabilities, we would expect that South Africa will experience more of the same: relatively muted growth and scoring the odd own goal.
However, within this context, we believe it is possible to find a number of companies that are either positioned to do well despite a poor macro backdrop, or pricing in a sufficiently dire outlook in today’s share price, so that even if the economy continues to be dire, the investment returns from that company can be very healthy.
One area where we are finding value is the domestic banks, whose share prices remain below where they were at the end of 2019. Our biggest exposure is to Standard Bank, which has an excellent long-term track record and trades well below historic multiples. At today’s share price, Standard Bank can deliver muted earnings growth and still generate good investment returns.
Meanwhile, there are a number of companies that are listed on the JSE, but whose fortunes are completely divorced from the state of the domestic economy – either because they are multinational corporations, which happen to be listed here, or because they derive the majority of their income from exports or services supplied in offshore jurisdictions.
One example is Glencore, which we believe is out of favour with the market given its large exposure to coal production. However, Glencore is also a major producer of copper, nickel, cobalt and zinc, among other commodities. These commodities are heavily used in wind, solar and battery technology and, as a result, are well positioned to benefit from the growing demand of renewable energy. Over time, the contribution from coal will decline and the contribution from these other commodities will increase. Today, you can buy Glencore for less than 10 times our estimate of normal earnings.
As always, it is a question of price: How much am I paying? How large is my margin of safety? And to what degree am I being compensated for the downside risks? Currently, on the JSE, we believe you can find a number of companies whose prices are sufficiently low that the odds are skewed in your favour.
3. How should we be structuring portfolios to protect against some of these risks?
There are a number of factors that obscure the view of how global markets may play out over the next 10 years – not least of which are the unprecedented monetary and fiscal interventions by developed market governments. We believe it is important that investors be mindful of the risks that abound globally, but also aim to position their portfolios for a range of potential future outcomes, rather than taking a big bet on one scenario prevailing.
As our chief investment officer, Duncan Artus, recently outlined at the Summit and in an article, we should also be careful to believe that what has worked since the global financial crisis will continue to do so. History shows us that these themes can last for a number of years, until they don’t. In a world that feels dominated by big trends riding the wave of popular opinion, we believe independent thinking is going to be increasingly important, with detailed, bottom-up research key to identifying good-quality opportunities that don’t rely on the status quo continuing to prevail.
With this in mind, Duncan noted that when it comes to asset allocation in our portfolios today, we prefer the following:
- Very little or no exposure to developed market sovereign bonds and high-yield instruments whose spreads are compressed relative to history and their intrinsic risk factors
- To be underweight technology stocks where valuations have outpaced fundamentals
- Exposure to producers of metals used in the energy transition, such as Glencore
- Exposure to precious metals and precious metal suppliers (this is a good potential hedge against inflation)
- To use our bottom-up process to find those idiosyncratic ideas that don’t rely on the big things discussed above, e.g. the opportunity presented through omnichannel retailers like Country Road, or low-value retailers, which can capture some of the beneficiaries of additional government spending, e.g. Pepkor
- To look beyond the “big five” of Naspers, Prosus, Richemont, BHP and Anglo, which all have meaningful exposure to China, towards other opportunities, e.g. British American Tobacco, which has zero exposure to China, or AB InBev, which has great potential
- To focus on all aspects of environmental, social and governance (ESG) factors and search beyond the best ESG companies that everyone is buying for the companies that are improving their ESG the most
4. Where are the best opportunities to invest offshore?
When it comes to decision frameworks around offshore versus local investing, South African investors seem to routinely fall into the trap of making panic-stricken moves offshore in response to deteriorating local sentiment and rand weakness. We believe that investing offshore should always form part of an investor’s investment strategy, but it should be done with clear objectives in mind and a long-term focus, and be in keeping with your individual circumstances, risk tolerance and goals.
So where is the long-term global opportunity?
Knowing when to invest is, of course, a different question than knowing where to invest. The global opportunity set is not without risk. Developed markets have had an extremely long period of low rates and abundant liquidity, which have created distortions in bond markets and supported equity valuations overall. In particular, investors have flocked to businesses that have demonstrated high levels of growth, causing the prices of those businesses to surge, which, in turn, has been exacerbated by tracker funds being forced to hold larger stakes in these companies to replicate the index, as Orbis discusses in a recent piece on their website.
Meanwhile, the companies that have been deemed by the market to be unexciting or risky have languished – such that the gap between the most expensive and the cheapest companies in the market has widened to unusual levels. Investors are faced with a tough choice: remain invested in the most expensive parts of the market in the hope that recent trends will continue, or start diversifying into other areas where the bad news may already be priced in.
With this backdrop in mind, Graeme Forster, from Orbis, shared some interesting insights at the Summit. He discussed that it is natural to be fascinated by exciting and emerging technologies such as artificial intelligence, quantum computing, blockchains, virtual reality and gene editing, to name just a few, as these innovations have the potential to change the world in ways that we can’t begin to imagine, but that the world changes in more subtle ways too: Even the most mundane businesses can also produce exciting investment opportunities. This is where Orbis prefers to look for long-term opportunities – and commodities – despite their seemingly “old-school” reputation.
According to Graeme, companies, governments and, most importantly, consumers are starting to care a lot more about how and where products are sourced. Whether it’s the beans used to make coffee or the materials used to build cars or iPhones, it is a trend that is here to stay and will likely intensify. Secondly, and just as important, technology is making it easier than ever to reliably track goods back to their origin.
Orbis believes that the combination of these two developments – a greater desire to identify the origin of what we consume and the ability to do so with precision – will lead to both structurally higher prices for certain commodities such as aluminium and greater price differentiation.
Shares of commodity producers have been one of the few investments to lose money over the last two decades. Almost everything else has been in a long-term bull market as liquidity has sloshed around the system. More recently, commodity producer earnings started to recover strongly off a very low base. This is partly due to economies starting to open up in the wake of the pandemic, but Orbis also sees clear evidence of subdued supply response as externalities are driving up costs.
Most interestingly, the market does not appear to believe that these earnings will be sustained. Valuations in the sector remain very low, with free cash flow yields in the teens for many producers. Sustainable positive change coupled with deep scepticism is typically a very favourable combination for investors.
5. How do you incorporate ESG thinking into your portfolios locally?
Environmental, social and governance (ESG) issues have dominated headlines for the last few years and are front of mind for many investors as they start to think more critically about the environmental and social impacts of companies in which they invest and demand more purpose-driven, sustainable and stakeholder-centric behaviour.
Although integrating ESG factors into our research has always been an intrinsic part of our investment philosophy, we work on improvements to our ESG approach, research and engagement processes year-on-year. As Raine Naudé, one of our ESG analysts, explained at our recent Summit, as long-term investors, we spend a lot of time trying to understand what a company’s sustainable free cash flow will be. In our view, companies that operate unethically or do not appropriately manage their social or environmental externalities face a greater risk of cash flow erosion over the long term. This can manifest in multiple ways, including regulatory fines, loss of an environmental permit or social licence to operate, or reduced demand for products due to reputational damage or shifting societal preferences.
Because ESG factors can be material to the investment case, our investment analysts are responsible for ESG research in relation to the stocks they cover. However, we also have three ESG analysts who assist with monitoring individual companies and conduct thematic and detailed company-specific research. We focus our research and engagement efforts on ESG issues that are most material to each company, rather than applying a cookie-cutter approach. Every company research report we write includes an ESG section and, when material, we try to quantify ESG risks or opportunities in our fundamental valuations. We may also limit the size of our holding in a company, or choose not to invest in it, if the ESG risks are significant.
We further integrate ESG into our engagement with company boards and management teams and by making carefully considered proxy voting recommendations to our clients. Our portfolio managers are ultimately accountable for managing the ESG risks in our clients’ portfolios, but we also report to our board of directors biannually.
Of course, it is easy for us, and other managers, to explain how we incorporate ESG factors into our analysis and process; it is harder to apply this consistently over time. We would caution against investors taking undue notice of attention-grabbing headlines, which tend to oversimplify what is a multilayered issue.
There are many ways in which ESG, as a growing global theme, could impact future stockpicking and our clients’ portfolios. As outlined above, an accelerated global energy transition could increase the demand for certain metals, while single-use plastic bans could dampen demand for oil and alter demand for certain packaging materials. In addition, the ESG theme has the potential to materially impact investment flows. For example, the Net Zero Asset Managers initiative – recently launched internationally to commit to investment portfolios aligned with net-zero greenhouse gas emissions by 2050 or sooner – could impact flows into both low- and high-carbon emitting industries.
In this debate, however, the intersection of the environmental and social pillars should be appropriately weighed up. As Raine noted, so far, environmental considerations have been in the driving seat; however, reducing the E has an impact on the S, and the COVID-19 pandemic has further accentuated deep inequalities in many countries, with potentially severe consequences, as the July riots and looting in South Africa showed. Overlooking the social aspect of ESG is as much of a global risk as failure to act on environmental issues.
The role of the investment industry and overcoming challenges
As an investment industry, we must be honest about what we are and what we are not. For example, we are not experienced policymakers. Many of these complex problems require coherent policy and regulatory development and enforcement, far above investor engagement, to be effectively addressed. This would also avoid unintended consequences.
An example here has been the growth in asset owners announcing divestments from fossil fuels, particularly thermal coal. As a result, many listed companies have rushed to unbundle or privatise these assets. But once sold, they remain in operation and in fact often increase production. The climate is no better off, while lesser disclosure requirements mean that society generally has less insight into the site’s environmental management than before.
ESG factors are also often still lightly or inconsistently reported by issuers, particularly in less developed stock markets, making meaningful evaluation and comparability difficult. At Allan Gray, we try to address this by engaging with issuers on a case-by-case basis to improve their disclosures and by using multiple sources for ESG research: Apart from company reporting, we look at non-governmental organisations and academic, regulatory and news reports.
ESG is further complicated by the fact that we tend to view these matters through the lens of our own personal value set. The EU is leading the way in regulation attempting to address some of the interpretation issues, and regulators elsewhere, including here in South Africa, are watching closely.
At Allan Gray, we participate proactively in industry initiatives that bring more regulatory clarity to ESG. This includes providing detailed feedback to industry consultations, such as on National Treasury’s draft Green Finance Taxonomy and the revised Code for Responsible Investing in South Africa (CRISA) earlier this year.
Don’t forget about the G
Finally, we pay particularly close attention to the governance pillar. This is because, as shareholders on behalf of our clients, we are not involved in the day-to-day running of companies and therefore rely on executive management and boards to act responsibly. We assess management’s alignment with long-term shareholders by evaluating how they are incentivised through executive remuneration schemes. We also consider the board’s expertise and independence to be able to provide effective oversight. Finally, studies show that stronger governance is generally associated with stronger company environmental and social performance.
Need more detail?
Our recent Allan Gray Investment Summit offered independent financial advisers and investors a rare glimpse into the minds of top fund managers and forward-thinking thought leaders. Our aim was to share a range of perspectives to help make sense of the noise and connect the dots between the challenges we face today and the opportunities that lie ahead.
Many of the questions raised during the event have been dealt with briefly in this article; if you would like more detail, you can view a selection of presentations from the Summit on the event portal.
Of course, as an individual investor, it is important to remember that there is no one-size-fits-all when it comes to structuring your investment portfolio. For personalised advice, we recommend you speak to a good, independent financial adviser.