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JOHANNESBURG — As South Africa’s economic situation worsens amid rating downgrades and sluggish growth, the world of investing is becoming more complex for local citizens. But there are interesting opportunities emerging, which include offshore options as well as South African bonds. Sumesh Chetty, a portfolio manager at Investec Asset Management, explores some of these options and the factors to consider. – Gareth van Zyl
This special podcast is brought to you by Investec Asset Management and with me on the line from Cape Town I have Sumesh Chetty, who is a portfolio manager at Investec Asset Management. Sumesh, thanks for chatting to me. Do the best opportunities for SA investors lie offshore at the moment? And if so, what type of options should South Africans be looking at?
Hi Gareth, thanks for having me on the call. Right now, we think that the absolute best opportunity does lie offshore. If you look at equities, both globally and locally, what you’re looking for are those businesses that have diverse geographical exposure to economies that are growing at a much faster rate than our economy. SA GDP growth is now forecast to be below 1% for 2017, and mostly for 2018 as well. As a result of that if you’re looking for businesses that are able to grow their top-line and not just businesses that are looking to cut costs, you have to have that geographical diversity in your portfolio.
When we think about the world today, clearly there’s a lot of concern around the levels at which equity markets are trading. So, if you look at the SA market it’s trading on a PE of approximately 19 times versus an historic average, going back to 1990, of approximately 14 times. S&P is trading on a multiple of 25 times. Most investors, a lot of commentators, are saying, ‘be careful – there are a lot of risks out there.’ We’re saying, be careful because the environment is still incredibly simulative – equity markets could go further but we appreciate the building risks. As a result of that when you look for those global businesses, we’re saying be careful of the degree of economic sensitivity that you’re assuming.
So, what we would prefer investors included in their portfolio, what we are buying for our investors in the portfolios that they hold with us, are those businesses that have the lowest economic sensitivity. Historically it’s been things like consumer staples but ultimately you want businesses that almost come hell or high water, and which will continue to pay you solid dividends or continue to generate solid cash flow.
Are there any particular countries that you are honing in on, like the US or Europe?
No, we don’t look at businesses on a top-down view and I appreciate that there are a lot of investors who do that and who are very successful at doing that. But we really are focusing on the fundamentals of each of the individual businesses and our primary measure is really the economic value that a management team is able to create. We measure the return on the invested capital that their management team has generated. We compare that to the cost of capital – the capital that they have available to them, and we want to see that they’re able to generate return on invested capital that’s sustainably in excess of that cost of capital. By focusing on that type of metric, it is really a bottom-up approach. When you talk about that geographic diversification, the businesses with the greatest chance of success, from a bottom-up point of view, are exhibiting the characteristics that I’ve described.
It’s very interesting that you mention that bottom-up approach. So, you’re obviously looking at each possible investment on a case-by-case basis then?
Correct, it’s a very large universe. We’ve got 6 000 stocks. We are obviously very qualitative in our approach. There’s a lot of fundamental analysis, but what we do is we do reduce the universe by screening for certain factors to make things more manageable.
And among your clients, are you seeing more appetite for offshore investments, especially in the current climate that we’re in right now?
Very much so. It might not be an appropriate reason for wanting that offshore exposure but given the political and policy uncertainty that we are currently experiencing in SA, a lot of clients are taking a, ‘let me run now approach.’ Clearly, on the institution side, Pension Funds are constrained by Regulation 28. They can only have 25% of their capital offshore and most of the clients are sitting at that maximum either because they want it or their consultants are choosing that level, or because the asset manager, like ourselves, in a discretionary portfolio is actually saying look, ‘this is the best investment opportunity.’ On the retail side of the equation – where investors obviously aren’t limited by this 25% – the demand is high for foreign exposure. I think it’s very much along the lines of what we saw back in 1994, and what we saw back in, I think it was 2001. The periods when the Rand actually weakened quite materially because there was a negative sentiment towards the country.
Treasury has just held its biggest auction yet of currency debt. What is your take on where SA bonds stand at the moment? Do they possibly offer attractive risk-adjusted returns maybe?
Very attractive risk-adjusted returns. But you’ve got to be careful when you look at SA assets. Individuals are too quick to compare the equity market in SA versus the bond market in SA but the equity market in SA is no longer a SA equity market. If you look at the top 40, in excess the 70% of the earnings actually comes from offshore and you’ve got some very large, global businesses that are listed in SA, for whatever reason so, the likes of BTI, Anheuser-Busch, and Richemont. When you look at the SA assets you really have to compare true SA businesses with SA bonds. On that basis among all of the SA assets, SA bonds actually represent the best risk adjusted opportunity. If you think about our 10-year bond right now, it’s generating a return or an expected yield over the next 10 years of approximately 9.5%. The SA Reserve Bank interest rate is at 6.75%. Let’s say you think inflation is going to be 5.5% on average, over the next 5 – 10 years, that’s a 4% real yield. Bonds have one-third the risk of equities and volatility of prices. So, when you think about it that way, it’s fantastic risk adjusted returns.
But the concern around the bond market of course is the fact that investors have a lot of uncertainty around who’s going to be in charge of the country? What National Treasury is going to look like? What revenue is going to do in this country, given the lack of growth or tax collection? Ultimately, what happens to our debt to GDP ratio? That uncertainty is keeping those yields at elevated levels but if you look at the risk premium that’s built into the yields and so many investors are looking at the risk premium relative to US bonds and we keep saying that’s inappropriate. There are very few investors in the world who say, ‘I’m buying Donald Trump or I’m buying Zuma.’ They’re effectively saying, ‘I have this global ability to allocate amongst multiple asset classes.’ Typically, what you’ll find from foreign investors is, ‘I’m playing in emerging markets and a portion of the portfolio, or in global markets and a portion of the portfolio.’ So, those investors who buy SA bonds typically, those global investors, will be thinking, ‘do I buy Putin, do I buy Erdogan, or do I buy Zuma?’ So, you actually have to compare SA to other emerging markets.
Emerging market bonds have done incredibly well over the last year or two. Yields have come in quite a bit but SA yields are not coming in at the same extent. As a result of that, very large risk premiums now make themselves available to investors who want to assume the risk. Now, having said that they offer a great opportunity, there are risks and we would never say to an investor, construct a portfolio that is 100% in bonds. We’re saying, you’re actually sitting with a fantastic opportunity. Your best opportunity is actually offshore and your second-best opportunity is bonds because it’s the best opportunity in SA. They actually offset really well in a portfolio. They are negatively correlated because of the way the Rand moves relative to our bond yields. As a result of that, you can actually create a portfolio today with far better risk characteristics than you’ve been able to do in the recent past.
What if that risk comes to the fore and there’s a collapse of sorts? You’ve mentioned the debt to GDP ratio in the recent mini-budget that was forecast to top over 60% in forthcoming years. What does an investor have to bear in mind regarding that?
This is the point: You cannot put 100% of your capital into bonds. You have to have an appropriately diverse portfolio and if you have focused on the best opportunity first, and then you’ve bought SA bonds as the second best overall opportunity, you will actually still do very well if the worst were to happen in SA, whatever you think that worst case scenario is. This is because the Rand will depreciate and provide you with natural cover against the potential losses in bonds. The other thing is a lot of investors forget that even though their potential short-term losses in bonds as yields move up, you still have a very strong underpin coming from the coupon, that 8% coupon that you’re receiving a year. So, the concern ultimately then has to become does the government default?
Well, I appreciate that concern when you think about the US Dollar to a nominated debt because with the depreciating Rand it becomes much harder for government to cover that liability. But with local denominated debt the risk ultimately is that the government just inflates the problem away in terms of the printing presses. It prints more money to make investors whole again but that higher inflation will obviously translate into more negative sentiment, a weaker Rand, and ultimately, once again, that offshore component in your portfolio will protect you.
I thought it was quite interesting how you said that investors typically would compare SA to the US 10-year bonds, but if we look at the spread that’s relative to other emerging markets, how do we compare there?
Just to add a little bit of colour. If you go back through time (and I’ve only got the answer going back to about 2002) – if you compare SA bond yields, our 10-year bond yield, less the average of the emerging markets, the average spread was 1.7%. If you think in normal times foreign investors demand an additional 1.7% to invest in SA versus the peer group. When Minister Nene was removed in December 2015, that spread shot up from the average of 1.7 to a level of approximately 3.2% – 3.3%. When Minister Gordhan was brought back that spread compressed slightly but it didn’t ever return to the 1.7% level. Then we saw it drift up again when Minister Gordhan was removed and drift up yet again when the Public Protector made the comment she did around the SARB mandate, when she issued her report on Absa. They drifted up again on the medium-term budget policy statement so, we’re currently sitting at levels of approximately 3.6% or 3.7%. That’s materially above the 1.7% average we’ve seen and that says two things. Firstly, the market is pricing in the risk that exists in SA today, and secondly, the part of the risk that’s been priced in is that we are going to be downgraded to junk because that additional premium actually puts us in line with some of our lower credit rating brethren like Turkey and Brazil. So, a lot is already built into our bond market. Not to say that yields won’t tape up further but a lot has been priced in already.
What about SA equities, the JSE, it’s recently hit record highs? Are you steering clear of that?
No, we think that it’s still appropriate for an investor to hold locally listed equities but, again, it comes down to the selection. We can’t really get behind retailers. We do have some exposure to the banks. The focus of the businesses that we’re buying locally really are those global names that are listed locally. So, the names that we’re finding and, effectively, they have more appropriate valuations in the market as a whole, and I appreciate a lot of that is being driven by Naspers. You’ve got to be very careful because when you look at the market excluding Naspers it’s on far more reasonable valuations. The market as a whole is, I think, on 19 times and without Naspers it’s only on about 16 times: it’s still above its long-term average. But ultimately, what you’re seeing is that local businesses are trading on far more attractive valuations but we don’t think investors have appropriately capitulated on the local economy given what’s going on.
We think that retailers, for example, should be trading at far better valuations, far lower prices because the SA consumer is in such trouble right now. Unemployment is back to 2003/2004 levels at 27.7%. It’s been creeping up steadily. Furthermore, the lack of economic growth, the decline in consumption is going to further impact those businesses that are purely local. You can also appreciate that in the actions of management teams recently, who have chosen to purchase businesses offshore, good or bad, just to get the diversification and the Rand hedge.
The big elephant in the room is the macroeconomic situation in SA. How does Investec view this picture over the next 12 months? Is the situation going to worsen or improve?
I don’t think the situation is going to improve. Effectively, what we’re seeing is a declining economy of the back of an inability to create jobs, and I don’t think employment is going to reverse, in other words improve, unless we see investment in this country. The local businesses are not investing in this country while you have this uncertainty. So, you need political and policy clarity before there’s going to be any investment and, therefore, before there’s any job creation and improvement in the country. Now, December is the binary event and you could argue that even if December is out of the way a particular party winning might still result in uncertainty all the way up until April 2019.
So, short-term, even if there’s good news in December I can’t see how even someone turning the taps on, on investments in this country in let’s say, January or February 2018 actually, is strong enough or significant enough to turn around economic fortunes of our country in 2018. So, there’s potentially positive sentiment that can come to the fore and that may drive asset prices up but I don’t think you will see an immediate rebound in the economy. That’s still a while off and there’s still a lot of things for us to get through in terms of policy, and even if political uncertainty is taken out of the picture.
Sumesh Chetty, thanks for giving us this brilliant overview of what’s happening in these markets.
Thank you, Gareth.
This special podcast is brought to you by Investec Asset Management.