Last year was one of the worst since the Great Depression, and the South African market has not been spared from this global market turmoil. South African investors have basically moved sideways over the last five years. Just to keep investors on their toes, ‘Mr Market’ compensated investors in the kick off to 2019 with positive returns in January and February.
Worst performance figures (US market, S&P 500)
The question is where to from here, and what to do with your investments?
There is no doubt that we have some serious challenges ahead of us including getting some resolution on state capture, Eskom, land reform through expropriation without compensation and, on the global stage, Brexit and the threat of global trade wars. However, it remains important to objectively assess the investment environment because some of the best opportunities are often found during times of uncertainty. Markets are currently fairly valued, with most valuation metrics – price-to-earnings and price-to-book ratios, and dividend yields – reflecting this.
The market opportunity is clearly evident by looking at returns during previous periods of uncertainty and ‘depressed’ market valuations, with the market on average returning 24.3% after five years of ‘flat’ returns. This is also reflected in the expected real returns from investment managers, with real returns ranging from ‘fair’ to Investec Asset Management expecting real returns of 9% (nominal returns of 15%) from local and international equities. This is significantly higher than the long term real returns for equities.
There is no ‘magic formula’ here – it is a result of markets becoming so ‘cheap’ at times that investors reassess the available investment opportunities and re-enter equity markets. Think about that ‘25% markdown sale’ that you could not help but go and buy. From an investment perspective, the current dividend yields of 3.5% in South Africa start looking very attractive relative to after-tax money in the bank.
At some stage Mr Market offers quality companies at prices that cannot be ignored and, as investors return to the market, the markets revalue, compensating the patient and savvy investor. Sadly, most investors miss out as these revaluations get lost in the noise and negative sentiment.
Where should you invest?
1. Invest in the whole investment toolbox
For long-term investors, it is worth considering a flexible fund. The fund’s mandate allows for freedom to invest across asset classes and countries. This gives the investment professional the freedom to move between equities and cash and to invest up to 30% internationally. Examples are the PSG Flexible Fund and the Old Mutual Flexible fund.
A current market opportunity is clearly reflected in the price-to-book ratio of the underlying equities within the portfolio of the PSG Flexible Fund – currently at 1.43 compared to a long-term average of 2.3.
The price-to-book ratio has long been favoured by value investors as a metric for assessing the value of a company relative to its market cap.
A further example of market opportunity is the Old Mutual Flexible Fund, the forward price:earnings ratio of the underlying equities is 9.8, well below the market and attractive compared to history. On a bottom up basis the analyst fair value of the portfolio gives upside of 15%, which is underpinned by a dividend yield of just over 4%. As a rule of thumb, portfolio manager Peter Brooke believes a price:earnings ratio below 10 is good value.
2. Hold a diversified portfolio of active and passive balanced funds
We do believe in holding a diversified portfolio of balanced funds, including allocation to a low-cost balanced passive fund. Passive funds ensure market-related returns without paying an arm and leg. For these types of funds investors should not pay more than 0.25% (excluding Vat) per annum.
We also believe in including a ‘supertanker’ – one of the well-known and reputable balanced funds from, among others, Allan Gray, Coronation and Investec – in our clients’ portfolios
It is then worthwhile to add something different to the portfolio as a diversifier. A good example of this is the PSG Flexible Fund mentioned above or the Bridge Stable Fund for an income-oriented investor. These funds don’t fish in the same pond as the supertankers and have meaningful exposure to small and medium-sized companies, providing a different return profile.
3. If the heat is too much, you don’t have to get out of the kitchen
Smoothed bonus funds have attracted a lot of criticism in the past, and even though we are not yet comfortable with the level of disclosure of these funds, they do offer a solution to investors who cannot stomach any volatility (in other words, investors who need growth assets but cannot stomach their portfolio losing 5% or 10% due to short-term market fluctuations).
These funds are similar to traditional balanced funds, where the investment manager invests into a diversified portfolio of asset classes and countries. They can also invest into alternative assets, which provides an additional source of diversification not currently available to unit trusts. The returns of these funds are ‘smoothed’ – meaning that in times of good performance, returns are held back by the manager to compensate for the lean or negative years, thus providing a smoother client experience.
4. Use your tax exemptions to your advantage
More conservative investors may find it worthwhile to consider using their interest exemptions to their advantage, either for discretionary investments or in order to benefit from the tax-efficient status of, for example, living annuities. It is possible to generate a real return of 2-3% without taking on too much risk. This can be achieved by investing a portion of assets into multi-asset income funds where the portfolio manager is looking at the best interest-yielding investments for investors.
With interest exemptions of R23 800 (under 65) and R34 500 (over 65), and historic returns of around 8.5%, investors older than 65 can invest up to R400 000 into these investments without attracting tax. This should however form part of a broader investment strategy with some more growth assets.
Wynand Gouws is a certified financial planner with an advanced postgraduate diploma in investments and estate planning from the University of the Free State.
The views and opinions shared in this article belong to their author, cannot be construed as financial advice, and do not necessarily mirror the views and opinions of Moneyweb.