By Alwyn van der Merwe, 29 July 2013
Long bond yields also corrected aggressively in June as investors feared the so-called tapering off of the Quantative Easing programme by the USA Federal Reserve Board. No matter what the reasons for these price swings were, it simply demonstrates uncertainty, indecision and of course big swings in investors’ sentiment as they focus on short term news flow and try to make sense of it.
Short term uncertainty is not uncommon. The natural way for investors to deal with uncertainty is to work harder at understanding current trends and to find comfort in forecasting future events. Although Sanlam Private Investments (SPI) tries to understand the macro context, we also understand that most forecasts need to be interpreted with a fair amount of caution. Since the financial crisis of 2007/8 we have witnessed increased involvement by politicians and economic policy makers in economic activities. Because we see bigger involvement of politicians in the economy, there is a higher probability of a policy mistake and therefore higher forecast risk. In addition, investment analysts have demonstrated over time that they are too optimistic in their forecasts and the extreme uncertainty in the short term requires a different approach when we focus on the longer term investment outcome.
Our focus is unashamedly longer term. At SPI our analysis starts with the only “known” in the equation to understand future investment performance and that is the price of the asset or valuation. There is a clear historic relationship between price levels and future earnings. When asset prices are high there is a very high statistical probability that the longer term (defined as 10 years in our study) returns are likely to be below average. The opposite is also true. When the price starting point is low, one would expect a high likelihood of above average 10-year returns. Following a very strong performance from bonds and equities from 1998 and 2003 respectively, South African investors would be very unrealistic to expect a repeat of a 4% p.a. real return from bonds and an almost 15% p.a. real return from equities. In fact, given very realistic growth assumptions, we believe local government bonds will provide a pedestrian real return of 2% p.a. for the next 10 years while local equities are expected to yield a marginally better return of approximately 4% p.a. for the next ten years.
South African equities represent a very diversified basket of shares. Within this basket industrial shares are expensive relative to their long term history, resource counters are also marginally expensive on longer term trend earnings but financial shares look fairly valued. These relative valuations need careful consideration when crafting an investment portfolio.
Within this context it is easy to make a case for active management to enhance future investment performance. Continued uncertainty and volatility in price movements of the respective asset classes would allow investors to amend the asset class mix without losing sight of their longer term investment objectives. Within asset classes, history has also taught us that some assets are likely to outperform their peers in the same basket. If our view of the longer term picture unfolds, it is essential for investors to enhance investment performance by discovering those assets that will provide so-called alpha or outperformance.