The market had a volatile first quarter with positive sentiment towards South African equities continuing against a backdrop of volatile international markets. Investment strategies, such as risk parity and being short volatility, which few investors question in an up-trending market, are now being tested. As we saw in February, these strategies can affect markets with little apparent change in fundamentals.
With the significant repricing of certain local equities that are geared to the local economy, such as banks and retailers, we reduced our exposure to these sectors. In our view, many domestic shares are pricing in a positive step change in the growth rate of sales and loans, which we are not yet certain will obviously materialise.
We have therefore increased our research effort on locally listed international businesses that have underperformed and offer better relative value than a year ago. An example is British American Tobacco (BAT), which is now trading under 14x its expected earnings to December 2018. While BAT generates just under half its profits in the US, where the tobacco industry faces regulatory headwinds, we believe this is more than discounted in the current price.
We are also finding value in shares that have underperformed within domestic sectors that have rallied, such as Investec and Woolworths.
Investec is trading at less than 11x our estimate of earnings, which we don’t believe are high. In addition Investec earns around 65% of its profit from South Africa, so it should benefit from a better local economy.
Woolworths has significantly lagged the retail sector given market concerns over its Australian operations, where it over paid when acquiring department store chain David Jones. The South African woman’s clothing division has also underperformed its peers recently. The dramatic change in sentiment towards Woolworths has resulted in the share trading at just over 15x earnings that are not high, in our view. The jury remains out on the ability of management to turnaround David Jones, but the lower entry price provides some compensation for assuming the risk.
The Equity Fund’s offshore holdings have increased to 29% of Fund in line with the new prudential limits of 30% announced in the Budget. While the ALSI expressed in US dollars remains well off its 2010 / 2011 highs when measured against the World Index, we believe this increased offshore allocation will allow the Fund to further diversify on both a geographical and sectoral basis. In particular it gives the portfolio more ability to benefit from businesses using technology to drive structural change, which can only really be accessed through Naspers on the ALSI.
The biggest changes in the Fund over the quarter include the selling of shares in domestic consumer-facing sectors and an increase in shares with offshore operations, such as BAT.