When it comes to investing, the single most important variable is the price you pay. Sentiment can drive valuations to extremes, and even great companies can be poor investments if you pay too high a price at inception. Negative sentiment can have the opposite effect, pushing prices so low that even assets with a relatively poor outlook can be very attractive investments. That is where we find ourselves in South Africa today. In this 26-minute webinar recording, Rory Kutisker-Jacobson looks at the positioning of the Allan Gray portfolios in light of this dichotomy; his key takeouts are summarised below.
Even before the COVID-19 crisis, South Africa had experienced a deteriorating fiscal environment with consistently low growth, structurally high unemployment, and a growing budget deficit. Our response to the pandemic has exacerbated these trends, with the budget deficit now forecast to be in excess of R760bn this year, and an ongoing deficit of around R500bn per annum expected over the next few years. Debt to GDP is now forecast to exceed 90% in the latter half of this decade.
Negativity priced in
However, a lot of this negative outlook is already priced into South African assets. The yield on government debt is significantly more attractive than it has been for some time, with the yield on 10-year debt now over 9% in nominal terms and offering a real yield greater than 5%. This is significantly more attractive than developed market bonds, which are trading close to zero, and more attractive than comparative peer countries like Brazil and Turkey on an inflation-adjusted basis.
Similarly, after a decade of disappointing returns on the JSE for the dollar investor, the valuations on offer from a number of JSE-listed companies are looking very attractive. This is particularly true when you consider that the total return of the index has been concentrated in only a handful of stocks, with Anglo American, BHP, Naspers (including Prosus) and Richemont now constituting more than 40% of the index overall. Strip out the performance of those large shares, and the average stock on the JSE has declined in nominal terms over the last five years. The disparity in valuations between the popular and unpopular stocks is the widest we have seen for some time, and this makes us excited about the opportunities we are finding.
Offshore exposure is essential
Despite our optimism about potential returns on the JSE, we still think it makes sense to have maximum offshore exposure where our funds’ mandates allow (the Allan Gray Equity, Balanced and Stable funds). The reasoning for this is twofold: Our long-term concerns about funding South Africa’s ongoing deficit have not gone away and, more importantly, we are finding as many, if not more, opportunities in global markets through our offshore partner Orbis, who is seeing similar disparities in valuations and opportunities in world markets.
Positioning portfolios for multiple outcomes
We are also taking a prudent approach to portfolio positioning. Risk means that more things can happen than will happen. Given the heightened level of uncertainty prevailing in global markets, and that nobody knows for sure when or how the world will emerge from the COVID-19 crisis, we have positioned our portfolios for a wide variety of outcomes, rather than taking a big bet on one particular scenario prevailing.
An example of this is how we have positioned the domestic equity portion of our flagship funds. If we place our equity positions into broad buckets, you will see a couple of competing themes emerging:
In the first broad bucket, we are invested in a number of shares that will continue to perform well irrespective of the prevailing economic environment in South Africa and how long it takes the world economy to recover from the pandemic. Examples here include Naspers and British American Tobacco.
We are invested in a number of commodity shares in the second bucket. These are trading on attractive valuations and will do disproportionately well in a scenario where the rand weakens for domestic-focused reasons. The largest exposure here is to Glencore.
The final bucket includes shares that are cyclically depressed, and domestic-focused businesses whose fortunes are more directly tied to the South African economy. The current environment is very challenging for these businesses, and many of their valuations have been punished. However, valuations could re-rate materially if sentiment improves, or if the economic environment recovers faster than expected. So, while the risks are arguably higher for these businesses, the upside is too, and many of the negative expectations are already more than priced in. Volumes and profitability do not need to recover to pre-COVID-19 levels for these to be attractive investments. The domestic banks, such as Standard Bank, fall into this category.
The common thread across these buckets is that we are finding compelling value trading at a significant discount to our estimate of fair value. As a result, overall, we are cautiously optimistic on the returns available in our funds today.