Excess returns from the FTSE/JSE All Share Index (ALSI) relative to cash have disappointed over the last five years, with cash now outperforming, on average. The good news is that, historically, this has often been followed by stronger periods from equities relative to cash. Strong dollar returns have also proved elusive globally over the past 11 years, especially if one excludes the US market, and within the US market itself, a few sectors. Over 20 years, local equities produced strong dollar returns but the starting point in 1998 was the Asian crisis, which produced low valuations.
The above suggests that there should be increasing value to be found. We believe this is the case locally, but we are more cautious offshore, given the large expansion of central bank balance sheets and historically low interest rates. Both of these factors are changing and remain a significant tail risk.
Last year’s price decline in the stocks making up the World Index was deep and very broad when measured against peak prices in dollars during the year. There were few places to hide in offshore equities.
The local market looks similar when using the ALSI 40 as a proxy, with drawdowns approaching historically high levels. Over the last two years the main task for local managers has been to avoid as many of the big mistakes as possible. We were able to avoid the vast majority of high-profile share collapses through diligent research and some luck. The net equity exposure of the Allan Gray Balanced and Stable Funds is currently above their average exposure since inception.
One of the largest detractors from performance over the past year was our holding in British American Tobacco (BAT), which dropped significantly and underperformed in a falling market – which is unusual. BAT looks optically cheap on a price-to-earnings multiple of 8.5 and a dividend yield of 7.5%. While the company has significant debt following its acquisition of Reynolds in the US, even on an EV/EBITDA basis the valuation looks attractive. However, the risks are not to be downplayed: Declining volumes and regulatory risk, including a potential ban on menthol cigarettes, will decrease intrinsic value.
On a positive note, local fixed income is currently offering real returns with yields above inflation. This has not always been the case and is a positive for the Stable Fund. Listed property, itself often seen as a fixed income proxy, but with real growth potential, has significantly de-rated. A number of concerns we have had regarding the sector all played out during the year and we have increased our research effort as well as our exposure. However, we remain underweight relative to most of our competitors.
The offshore portion of the portfolio had a difficult year in absolute terms, as discussed above, but also on a relative basis, with our offshore partner Orbis underperforming its benchmarks. Historically times like this have typically been attractive periods to invest, as discussed in detail by William Gray in our latest Quarterly Commentary.
Two areas Orbis is finding attractive are the Chinese Internet and gaming sector and selected US biopharmaceutical stocks.
Netease, Tencent and Naspers provide attractive exposure to the large online gaming market and all three shares also have other areas of business which we believe the market is undervaluing. Meanwhile, the biopharmaceutical stocks are trading on reasonable valuations and have a pipeline of new products which are attractively valued, in our view.
We believe from these levels the prospect for relative returns from local assets is reasonable. Local shares are flat in dollar terms since 2006. Offshore markets corrected meaningfully in the last quarter of 2018 and many global shares are already in bear markets. This should mean more opportunities when combined with a potential reversion to mean in Orbis’s alpha.