CAPE TOWN – The FTSE/JSE All Share Index is currently trading on a price-to-earnings (PE) multiple of of around 21 times. This is very high by historic standards and the sort of level that preceded the big downturns in 1998 and 1987.
The market’s long-term average PE multiple is closer to 15. That gives some idea of how stretched valuations appear.
In this environment, many multi asset funds are holding large amounts of cash because the risk of investing at this point appears high. Historically, investing at these kinds of levels lead to poor returns.
However South Africa’s largest multi asset fund, the Allan Gray Balanced Fund, has been increasing its exposure to local equities over the last six months. The weighting it gives to local stocks is still well below all-time highs, but it has been creeping upwards towards 50%.
This might seem unusual, particularly given the asset manager’s reputation as a contrarian investor.
With the All Share Index where it is, why would Allan Gray be putting in money now?
The answer, according to chief investment officer Andrew Lapping, is that there is more to the JSE than what one might see at first glance.
“We are not buying the market,” Lapping explains. “We are buying specific companies that we feel are undervalued. Following what happened in December with Nenegate we are finding more companies trading at a discount and we are buying those companies.”
He points out that the All Share Index has become dominated by just two stocks – Naspers and SABMiller. Together they currently make up just over 25% of the entire Index. Over the last five years the share prices of these two stocks have grown exponentially, and they have become progressively more expensive.
Since May 2011, Naspers has gained 470%. It is currently trading on a PE multiple of around 53 times.
Over the same period, SABMiller’s share price has climbed 290%. It’s PE ratio is now around 37 times.
If you remove just these two stocks from the Index, you get a very different picture of how the average counter on the JSE has done over the last few years.
In dollar terms, without the contribution of Naspers and SABMiller, the JSE would be trading close to 2005 levels.
That being the case, Lapping believes that while certain parts of the market are undoubtedly expensive, there are others that are attractive.
“We are finding pockets of value in the South African market,” he says. “And we are buying those undervalued assets.”
He is however quick to point out that this doesn’t mean that these shares will necessarily produce stellar returns in the next six months or a year. However they do present a lower risk investment option.
“This is how we protect capital,” he says. “Not by any clever strategy, but by buying undervalued assets.”
Lapping explains that when investing in these stocks, they take into account the potential for a number of different outcomes, particularly over the short term. And this includes a worst case scenario of a market crash.
If this were to happen, he argues that it is the undervalued stocks that will best protect investor capital, because they have already been discounted. It is the expensive stocks that represent the highest risk in this case, as they will be more aggressively de-rated.
“If you hold a stock that is trading at 80% of its valuation and it is de-rated to 70% of its valuation, you haven’t lost much,” he says. “But if the stock is trading at 160% of its valuation and it is sold off to 80% of its valuation, you’ve lost half of your money.”
This is critical because he points out that, over the long term, a fund can generate out-performance just be ensuring that it out-performs in down markets. Even if it lags when times are bullish, reducing draw downs when markets turn produces long term gains.
“And investing is a long-term undertaking,” Lapping says. “It’s not a three, six, nine or 12 month thing. It’s a ten year, or even multiple decade thing.”