It may surprise some investors to know that resources have outperformed the JSE by about 5% per annum over the last three years and that deep-value funds like the Investec Value Fund, RECM’s Equity Fund and the Element Earth Equity SCI Fund, unloved for the last 10 years, have outperformed – relative to their general equity peers – by about 6% per annum over the same period.
However, if one looks at general equities, measured by the JSE All Share Index (Alsi), it is clear that equities have performed poorly over the last five years. So much so that cash, as measured by the short-term fixed interest rate index (Stefi), has outperformed the Alsi every year, rolling, for the last five years to October 2018.
Based on various valuation methodologies, the S&P 500 is at its second most expensive level since 1900, says Shamier Khan, portfolio manager at Element Investment Managers. Edgy investors were made more nervous in October when the S&P 500 fell by over 8%, its sharpest drop since the 2008 -2009 financial crises.
FAANGs lose their bite
The sell-off was more extreme at the tech-heavy Nasdaq exchange, home to Apple, Alphabet, Amazon, and others. The FAANGs, which have led the extraordinary bull market are showing signs of weakness. Since July Facebook has fallen 39.5%, Apple 19.9%, Amazon 25.9%, Netflix 35.3%, and Google 20.1%. “A company’s competitive advantage is normally eroded by competition, regulation or technology,” says Khan. “Once growth stops, gravity tends to play its role.”
The investment team at Element Investment Managers is inherently value-oriented, but believes in capitalising on the different stages of the economic cycle with sector rotation. This sector rotation is driven by valuation considerations. The strategy sees the firm shifting its investments from one sector to another to take advantage of cyclical trends in the economy.
“The last 10 years have seen the rise of ETFs [exchange-traded funds] and passive investment strategies; you could not go wrong with a passive strategy,” says Terence Craig, CIO at Element. “Passive does well in an upwardly trending or momentum market.”
The extended bull market hurt value fund managers who underestimated the length of time the market would exhibit this buoyancy – fuelled as it was by quantitative easing.
However, passive strategies do not perform as well when stock prices start to fall. Falling prices create a virtuous cycle where investors sell their ETFs, forcing ETF managers to sell the underlying shares, reducing support for the share. “We think market dynamics are in place for active to outperform passive,” says Craig. “When the market leaders – and these are indisputably the FAANGs – start to roll over it’s the end of the easy times.”
The environment now favours active managers, he says.
And perhaps value will continue to have its day?
“Few have noticed that value has been performing,” says Craig. “It has been by stealth. South African investors have spent 2018 watching the performance of Naspers, which has an outsized impact on the JSE’s performance.”
Overall, the All Share index is down 12% for the year. At a sector level the Financial 15, Industrial 25, Small Cap and Mid Cap indices are all down for the year. This has perhaps masked the fact that the Resource 10 index is up 10% for the year, providing a platform for the return of the value fund manager.
Sector rotation is all about valuation and, as a fund manager, one must be willing to rotate in and out of sectors as dictated by the stage of the cycle and valuation differentials. “A lot of fund managers will not own resource shares,” says Khan. “We are saying you have to be sector-agnostic. Play the cards you are dealt, not the ones you want. In other words, don’t hold the shares you are comfortable with if the valuation metrics and cycle does not favour them.”
Thus Element is underweight trendy tech stocks such as Naspers, global luxury like Richemont and diversified resource plays like Anglo American. It is overweight commodity plays like AngloGold and Glencore, companies that provide essential products like Afrox, and is watching platinum closely.
“Platinum shares were priced for a bust,” says Craig. “Yes, there was the VW emissions scandal in Europe and the trend is moving away from diesel, so we don’t want to catch the falling knife, but the fundamentals for platinum are not inherently bad. The diesel market in Europe will be consuming platinum for years to come, and petrol cars in China are driving palladium demand.
“The platinum margin has turned, but the share price is not reflecting this.”
While the cycle may be turning, Element is not saying that investors need to abandon their investment strategies to dive into deep value. “We think investors should apportion an amount to value – how much depends on one’s ability to stomach a degree of volatility,” says Khan. “Financial advisors have not had to think about this.”