Wednesday, April 28, 2010

Road to recovery or another bad trip?

By Laura du Preez, Personal Finance, 24 April 2010

Following a strong recovery on global and local equity markets, asset managers are having a hard time finding investment opportunities for you. Some say local traditional asset classes are priced fairly or are overpriced, making them risky. Others see potential for shares' earnings to grow. Some foresee bubbles in favoured offshore and emerging markets, while others see a more sustainable recovery. We asked some asset managers for their views.

Better to be safe than sorry

It is very difficult to know where to place your money at the moment and you need to be careful that you do not unwittingly take on risk, Simon Pearse, the chief executive officer of Marriott Asset Management, says.

He says listed property, bonds and equities all look expensive once you consider the returns you are likely to earn. "The recovery from the recession may take longer than is generally expected, and investors should err on the conservative when anticipating levels of return from the various asset classes."

Pearse says the recession has cost 870 000 jobs, and has resulted in a 10-percent cut in tax revenue, a fiscal deficit, a huge rise in government debt and an expected cut of four percent in corporate earnings. Household debt remains at an all-time high and, without the ability to borrow more, consumer spending will remain subdued.

In addition, inflation is unlikely to stay within the three to six percent band due to rising labour costs, a rising rand petrol price and massive electricity price hikes.

Pearse says the total return you will earn on any investment can be estimated from the starting income yield (the income earned divided by the security's price) plus the growth in that income, plus or minus any change in the price of the security.

Marriott estimates that 25 percent of your total return from equities will come from the starting dividend yield.

The current dividend yield (the dividend earnings divided by the price) of the All Share index (representing the equity market) is 2.2 percent - below the long-term average of four percent, Pearse says.

Growth in dividends is likely to be subdued in light of economic conditions, and there is great potential for a down-rating of share prices, which would bring the dividend yield more in line with its long-term average, he says.

Marriott's research shows that half the return you earn on listed property comes from the starting yield. The current yield on South African listed property is 7.8 percent, which, in Pearse's view, is too low.

He says expected returns from this base will be modest, and there is too great a risk of capital loss if investors decide to down-rate listed property in light of these low anticipated earnings.

Bonds have enjoyed an 11-and-a-half-year bull market, but, Pearse says, this trend is unsustainable as a result of ballooning government debt, which is likely to be funded by bonds, and the risk of rising inflation.

The current yield of 8.8 percent on government bonds is below the long-term average of 13 percent, Pearse says. Marriott has scaled back on its investments in listed property, equities and government bonds in its funds, and has instead invested in preference shares and inflation-linked bonds. Preference shares are yielding eight percent tax-free.

Inflation-linked bonds are yielding 3.3 percent but could provide capital growth of about six percent once inflation rises and demand for these bonds increases, Pearse says.

Local equities still offer the best returns

You are faced with difficult investment choices, but on local markets equities are still likely to give you the best real return, Prudential Portfolio Managers says. On a three- to five-year view, Prudential expects a total return of 13 to 17 percent a year from local equities, Bernard Fick, Prudential's chief executive officer, says.

Fick says a dividend yield of about three percent and earnings growth of about 10 to 14 percent will provide this return.

The current dividend yield of the All Share index (Alsi) is about two percent, but Fick says this is low by historical standards.

Earnings are expected to grow because they are coming off a low base - earnings declined some 20 percent during the recession, but consensus forecasts are that earnings are likely to rebound strongly this year (36 percent) and next year (25 percent), he says.

While there will be short-term share price movements, Fick says Prudential does not expect the returns you will earn from local equities to be affected by any long-term re-rating of shares over the next five years, because the Alsi appears to be fairly priced considering the expected rebound in future earnings.

Prudential has invested its equity portfolios in defensive shares from companies that offer essential goods and services that consumers continue to use despite tough economic times.

Prudential is expecting inflation for the next three to five years to be about 5.5 percent a year - at the upper end of the inflation target band - as the Reserve Bank adopts a more flexible approach that will support economic growth.

Staying defensive

Allan Gray, one of the country's largest managers, says current equity market valuations create more scope for disappointment than pleasant surprises.

Allan Gray has reduced the equity exposure of its domestic asset allocation Balanced Fund to 66.6 percent. In addition, it has sold some index futures to hedge its equity exposure to an effective 56.3 percent, it says. The manager says that with the FTSE/JSE All Share index up 40 percent, it is no surprise that its value-based approach has led it to lower its equity exposure.

Allan Grays says its domestic Equity Fund has a large exposure to high-quality businesses with sustainable profits and attractive prices.

Time to look offshore

The choice of where to invest is tricky at this stage, Jeremy Gardiner, a director at Investec Asset Management, says.

Gardiner says future returns depend enormously on how much you pay for your assets, and currently nothing is particularly cheap. "Although equities are more attractive than cash, potential equity returns are not that appealing and do carry risk."

However, Gardiner says, one area that South Africans should be considering is offshore diversification. He says the rand has run hard and is not expected to maintain its current strength for much longer after the World Cup. Although the rand is impossible to call, you can probably rely on some weakness at some stage in the future that will boost offshore investment returns, he says.

Gardiner says most South African investors have a "jaundiced" view of offshore investing, after 10 years during which United States equities have had on average an annual return of zero percent.

John Biccard, Investec's value fund manager, says the lack of yield on cash is driving investors to riskier investments, such as emerging market equities and debt, commodities and the rand.

Biccard says we should remember the advice of one of the world's best-known value investors, Jeremy Grantham, who says: "The real trap here, and a very old one at that, is to be seduced into buying equities because cash is so painful. Equity markets almost always peak when rates are low, so moving in desperation away from low rates into substantially overpriced equities always ends badly."

Two new bubbles are forming

At least two new asset bubbles are forming, and investors need to be wary of these markets, Adrian Saville, the chief investment officer of Cannon Asset Managers, warns.

After the credit crisis, policymakers in advanced economies threw money at their problems, hoping they would disappear, but instead debt is now bubbling over, Saville says.

Tax revenues in these countries are proving to be woefully inadequate to repay the debt and reduce the fiscal deficits, he says. While governments could reduce spending and wait for economic growth to play catch-up, countries have resorted to printing money.

"This is clearly another bubble in the making and a sharp rise in price inflation is a likely result. Another likely implication is that advanced economy currencies will become engaged in a race to the bottom. This substantially complicates the risk of investing in these markets."

Saville says that investors should avoid government debt - especially in advanced economies - until pricing excess has unwound.

He says another bubble is forming in China. While the Chinese economy has succeeded beyond all expectations, it would be a mistake to equate economic growth with investment success, he says.

In the past 20 years, China has been flooded with capital. This has led to over-investment and a collapse in returns on capital, Saville says.

But investors are mesmerised by China, with still more capital further squeezing returns.

Saville says evidence of a bubble can be seen in the price-to-earnings ratio of 50 times. This is more than three times the "fair" ratio of 15 times.

Saville says Cannon has no direct exposure to China, nor does it hold any advanced economy government bonds. He says Cannon prefers underpriced Japanese shares and also sees opportunities in South Africa, as pessimism abounds but fiscal policy supports the economy.

Recovery will be sustained

The explanation for the improved market sentiment is simply that the world is recovering, Ashburton says.

Tristan Hanson, Ashburton's manager for asset allocation and strategy, says it is not surprising that, in the aftermath of the greatest financial crisis in decades, most commentators have remained highly cautious. Few, if any, are truly optimistic for the future and most have been surprised by the strength of recent economic data, especially out of the United States, he says.

However, Ashburton is of the view that the US economy is transitioning from a "stimulus-led" recovery to one that is sustainable, driven by income growth and business spending.

Weak credit creation and a depressed housing market remain headwinds, but consumer spending typically recovers prior to credit growth, Hanson says.

An improving economic backdrop will support growth in corporate profits and this should support both equities and corporate bonds.

Hanson says there will be bumps in the equity road ahead, and risks remain - most obviously those in the hands of policymakers. But, he says, investors would do well to remember that it is never a bad thing to treat short-term "noise" in financial markets with a healthy scepticism.

Health Warning: Fund managers' views on the markets should help you to understand what returns you can expect from your investments. They should not stop you investing, or induce you to try to time the markets or cause you to abandon a well-structured investment portfolio. Such a portfolio should be diversified across markets and asset classes to reduce risk. Then leave the decisions on how to make the most of market opportunities to your professional fund manager.

Allan Gray still king of the castle

April 24, 2010

By Laura du Preez, Personal Finance

Allan Gray remained the top domestic investment house in the PlexCrown survey of unit trust management companies for the periods to the end of March.

Since Allan Gray first qualified for an overall rating in the management company rankings, this is the eighth quarter out of the past nine that it has occupied the top position.

PlexCrown Fund Ratings determines the leading unit trust fund manager from an overall rating calculated on the basis of the PlexCrown ratings a manager achieves for all its qualifying funds. Each fund is awarded a single rating of between one and five based on four different measures of risk-adjusted returns over periods up to five years.

For the periods to the end of March, Allan Gray had six funds that qualified for PlexCrown ratings. Allan Gray's Balanced Fund (A), Stable Fund (A), Orbis Global Equity Feeder Fund (A) and Orbis Global Fund of Funds (A) all scored the highest ranking of five PlexCrowns each, according to Rickus Ferreira, an analyst at PlexCrown Fund Ratings. Allan Gray's Bond Fund (A) and Equity Fund (A) achieved four PlexCrowns each.

Average ratings in various domestic and foreign unit trust sectors are determined, and the average of these ratings is used to calculate an average total domestic and an average total foreign score. The domestic score is accorded a weighting of 75 percent and the foreign score a weighting of 25 percent when the overall score is calculated.

According to Ferreira, Allan Gray's individual fund ratings gave it an overall average PlexCrown rating of 4.500 - the highest score achieved by qualifying fund managers for the periods to the end of March.

Prudential, with a rating of 3.792, was the runner-up in the management company rankings for the quarter to the end of March this year, Ferreira says.

Prudential has six funds that received a PlexCrown rating. Prudential's Dividend Maximiser Fund (A) and Equity Fund (A) achieved five PlexCrowns each. Two funds achieved four PlexCrowns each and two funds were awarded three PlexCrowns each.

Coronation, with an overall rating of 3.583, climbed back up the rankings to be among the top three companies, Ferreira says. It ousted Nedgroup Investments, which had to settle for fourth position, with an overall rating of 3.563. Coronation's Balanced Defensive Fund (A), Balanced Plus Fund (A) and Equity Fund (A) achieved five PlexCrowns each. Among its other funds, five achieved four PlexCrowns each, five achieved three PlexCrowns each and two scored only two PlexCrowns each.

Offshore ratings

With a score of 4.250, Orbis, Allan Gray's offshore sister company, achieved the top spot based on the average PlexCrown ratings among offshore managers that are registered with the Financial Services Board and can be marketed in South Africa, Ferreira says. The good performance of Orbis's equity and fixed-interest funds helped it to achieve this position, he says.

Investec, with a rating of 3.722, was placed second among the offshore managers. It did well in global asset allocation, total equity and total fixed interest.

Ashburton was rated third in the offshore management company rankings. It scored well in global asset allocation and total equity, Ferreira says.

Monday, April 12, 2010

Insuring your investment portfolio

This is a verbatim copy of GrayIssue no. 104 from Allan Gray. It is an interesting look at insurance, specifically insurance against risks of investment losses.

Sun International, a long-term holding in our clients’ portfolios, recently reported their financial results. These revealed tough operating conditions in their markets and notably the temporary closure of their rapidly growing Chilean operation due to the recent earthquake in that country. As an unexpected event, no analyst could have forecast this.

On further investigation, we found that Chile experienced many large earthquakes over the last century and is a known ‘earthquake zone’. Fortunately, Sun International considered this and had earthquake insurance for both property and loss of profit. Insurance premiums well spent in hindsight.

Balancing the risk of losing money with the risk of missing out on future returns

This example has interesting parallels with our current view of local investment markets. Our December GrayIssue (issue no. 99) discussed the two basic and opposing risks that investors need to balance: the risk of losing money and the risk of missing future returns. In our asset allocation funds we try to manage the trade-offs that naturally occur when navigating between these two extremes for our clients. Readers of our recent commentaries would know that we currently focus a larger part of our attention on managing the risk of loss.

We have been early movers and the market has continued to rise

It is fair to say we have unfortunately been an early mover as the overall market has continued to rise, though in a less linear fashion. If we take a fresh look at valuations, as at 12 March 2010, we find that:

• The FTSE/JSE All Share Index (ALSI) price/earnings ratio is 18.8 compared to its long-term average of 11.5

• The ALSI dividend yield is 2.1% compared to its long-term average of 4.5%

• The earnings of the overall market are not obviously low by historical standards

We believe the market is already discounting a strong and sustained earnings recovery

This is confirmed by our bottom-up research, with many shares discounting a strong and sustained recovery in earnings next year. Some shares are arguably pricing something even better. If the earnings recovery matches expectations, it is tough to see why investors should expect to achieve returns in line with historical averages, given that many current values have already discounted future strong and sustainable earnings.

What if the future turns out differently? What if an unexpected event occurs, the financial equivalent of the earthquake in our Sun International story? There is little margin of safety in current valuations to absorb or ‘insure’ against an event like this.

Expecting the unexpected

An observer of financial history would know that unexpected adverse events have occurred on many occasions in markets, just as earthquakes have always occurred in Chile. While forewarned with such knowledge, we cannot predict their timing or even if such events will indeed occur at all.

Our fixed income weighting is our insurance

We do however have the choice, just as if we ran a casino in an earthquake zone, to ‘buy’ some insurance for our portfolios when values reach levels that have historically suggested a high probability of risk of loss. One can consider the above average weighting that we currently hold in fixed income (cash and bonds) as our insurance.

This insurance has a short-term price, but we believe it is worth it in the long run

Of course, insurance is not free, and there are trade-offs in all decisions. The recent lower returns of our funds relative to other managers reflect the ‘cost’ of our insurance. This is due to our high weighting to fixed income compared with a portfolio that has had higher exposure to equities.

If no ‘earthquake’ happens and the future earnings environment that the market is discounting materialises, the approximate 7% yield on the fixed income portion of our asset allocation funds provide compensation for our insurance. Insurance is expensive to buy when risk of loss is obvious and unfolding. We hope our early move towards investing in some insurance against risk of loss in equities will prove to be prudent should the market experience any aftershocks.

9 April 2010