In recent years, South Africa’s numerous, well-known economic challenges have fuelled declining investor sentiment and led many to doubt the local market’s potential to deliver meaningful returns. Through our contrarian lens, Tim Acker discusses the risks as well as the opportunities for investors who are willing to grapple with the fundamentals and stay the course over the long term.
When investors consider the current state of the South African economy and the number of uncertainties in the environment, it is easy to forget that despite its recent performance, the JSE has proved resilient through uncertainty for well over 100 years. From the sanctions in 1986 and the first democratic elections in 1994, to the dotcom bubble in 2000 and the global financial crisis in 2008, the market has weathered many bouts of overwhelmingly negative sentiment and rewarded long-term investors handsomely. Allan Gray’s flagship Balanced, Equity and Stable funds have outperformed the market over the long term, with most of this outperformance generated during down markets. Tough times often create opportunities to add value.
Uncertainty and opportunity often go hand in hand
Despite the negative news flow, local market returns have been relatively high over the last year. Over the 12 months to the end of July 2023, our flagship funds have delivered double digit returns and outperformed their benchmarks. Understandably, at face value, this may be difficult to reconcile with the current difficult macroeconomic environment. There are various reasons for this divergence in the economy and the market, including the fact that SA market valuations are generally quite cheap.
We spend a significant amount of time engaging with the management teams of individual companies, who tell us about the real challenges of operating a business facing loadshedding and consumers under pressure. As we examine the fundamentals of many of these businesses, we are still finding solid, resilient, well-managed companies. However, due to overwhelmingly negative market sentiment, many of these businesses are being derated. As a result, their valuations are low and dividend yields are high, offering investors an opportunity to generate healthy returns.
However, despite the recent uptick, absolute returns have remained disappointing over the medium term – only marginally ahead of inflation over five years. That said, as we look ahead, we are cautiously optimistic about our ability to generate returns for our clients from the local market and believe that the outlook for returns from South African assets is actually quite good at present.
South Africa versus the world
When you compare stock market performance over numerous decades, the JSE is still one of the best-performing stock markets in the world. However, the local market has underperformed the World Index over the last decade, although this has begun to turn over the last two years.
To avoid overlooking opportunities in the local market and to contextualise the prevailing sentiment, it is important to compare South Africa to its emerging market peers. South Africa is not the only country in this basket that is grappling with challenges around funding government debt, less foreign ownership and negative sentiment. Emerging markets more broadly have underperformed the World Index over the past decade, largely as a result of the stellar performance of the US stock market.
Bond yields and exchange rates are often good barometers of how well or badly a country is doing, and we have seen South Africa’s 10-year bond yield rise steadily over the last eight years as the currency has deteriorated. This can also be seen in the percentage of non-residents holding South African government bonds, which has come down significantly since 2018.
Given the higher yields, one may suggest that we should put the bulk of our funds in South African government bonds and lock in high returns. These returns are not risk-free though. For example, higher inflation remains persistent globally and there is a risk that it could erode the real returns from government bonds, should it rise further. In light of this risk, we prefer investing in well-managed South African businesses, as they are able to adjust their prices in response to inflation, offering investors some protection. Investors should also remember that these higher yields are a good indicator that buying South African government debt is accompanied by significant risk. We should not be blind to this. Cash is also an appealing option. South African one-year deposits are yielding rates as high as 9.5% – the highest rates we have seen since 2009.
Is offshore the answer?
In search of a safe haven from South Africa’s woes, in recent years there has been an uptick in investors enquiring about moving their money offshore to protect their long-term wealth. Offshore exposure is one way to diversify a portfolio and mitigate the risks local investors face, and we receive many questions about whether we believe we have adequate offshore exposure in our funds.
The JSE is more offshore than you may think. In fact, many of the large shares in the local index are multinational businesses that generate large proportions of their income outside of South Africa. These include the likes of Naspers/Prosus, Richemont and British American Tobacco. Many of these businesses are dual listed. In most cases they have little exposure to South Africa’s risks. Roughly half the value of companies listed on the JSE is attributable to offshore businesses. In addition to the direct offshore allocation we hold in our portfolios, we believe that the true offshore exposure in our Equity and Balanced portfolios is closer to 60% on a look-through basis.
Consistency remains key
One of the things that we have learnt over the last five decades is that investing is cyclical: There will always be a degree of uncertainty, and we will have to respond to unprecedented challenges. To deliver the best possible outcomes for our clients, we need to remain diligent, carefully weigh up the various risks and potential rewards and continue to construct our portfolios from the bottom up. We pay close attention to the asset allocation of our funds and aim to maximise the returns for our clients without unduly risking capital loss.
Although this approach may make us look a little foolish when markets are overly exuberant or overly pessimistic, we know that looking beyond prevailing sentiment and doing our own in-depth analysis to inform our decision-making has successfully built wealth for our clients over the long term.