Local investing

How to invest in challenging times

A braai over the weekend inevitably reminds us of the significant challenges our country faces – there is lots of negative news to talk about. An unemployment rate of 29%, combined with youth unemployment of 58%, means that most citizens are still not being included in the economy and cannot help the government to raise further tax revenue to address high and increasing debt levels (61% of GDP, currently). Our government bailout of Eskom alone will add R50bn to debt (1% of GDP) in 2020. Even an optimist would struggle to see a financial way out for the public monopoly as a result of poorly maintained infrastructure and new stations that may never operate economically as a result of significant design flaws.

The good news for investors is that asset prices compensate investors for risks, and various options are available to mitigate bad outcomes for the country. Government bonds may be seen as risky given the backdrop mentioned above, but the yield on 10-year government bonds at 9% is 4.1% higher than the average consumer inflation rate over the past five years. This has only been the case 23% of the time since 1974.

Our stock market is also unusually cheap relative to inflation, with a dividend yield of 3.6%, only 1.3% below inflation. The average of the dividend yield on stocks and yield on 10-year bonds is 1.4% higher than inflation. This has only been true 3% of the time since 1974. What is also comforting is that subsequent five-year returns of stocks and bonds averaged 14% a year ahead of inflation when they were this cheap or cheaper, since pessimism on earnings growth does not always materialise and investors typically enjoy a re-rating on top of the above-average yield when assets are this cheap.

Protecting capital is key

Having said this, given the risks, one would be wise to look for opportunities that protect capital in a bad outcome for the country. Having a well-diversified portfolio is key. You can create a well-diversified portfolio yourself, or you can invest in a balanced fund and allow investment professionals to do the asset allocation for you.

Money market instruments carry low risk of default and capital loss in a scenario where inflation increases. In the Allan Gray Balanced Fund (the Fund), these make up 3.3% of the Fund and yield 7.2%, currently. Bonds make up 9.5% of the Fund, yield 9.2% on average and are skewed towards corporates. Cheaply priced domestic shares that don’t depend on South Africa – such as Naspers, British American Tobacco and Glencore, which are in the Fund’s top 10 – are another option that we are fortunate to have. The average dividend yield of these three shares is 4.5% and there is a strong case to be made that this basket of companies will grow faster than the South African economy in most scenarios through a combination of secular growth (Naspers), organic price growth of strong brands (British American Tobacco) and strong commodity fundamentals combined with share buybacks at low prices (Glencore).

Owning domestic shares that trade at a meaningful discount to fair value helps to protect against a bad outcome as companies can pass on inflation to consumers. Shares from the Fund’s top 10 like Standard Bank, Old Mutual, Investec and Woolworths trade at an average dividend yield of 5.3% and at a discount to our estimate of intrinsic value. In a scenario where the economy starts growing again, these shares would offer further upside.

Finally, a diversified portfolio of global shares and fixed income securities provides protection in a scenario where the rand weakens materially. In the case of the Balanced Fund, these are selected by our offshore partner Orbis.

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