The broader South African investor base has become pessimistic, and with good reason. Slow structural reforms and anaemic economic growth, corruption, high unemployment, and an unsustainable debt burden are only a few of the many issues that South Africa is facing. Returns from domestic equities have also been disappointing, not only compared to equity returns from our emerging market peers but also from the developed world, especially in the US.
They say bad things happen in threes, and this has evidently been the case with domestic equities. Firstly, foreigners have been multi-year sellers, secondly, institutions have dramatically reduced their weightings to multi-decade lows, and thirdly, retail investors have fled into cash and offshore investments. This has given rise to extremely depressed prices, especially during the crisis of last year.
Has the opportunity set changed and could we look forward to a period of better returns?
Panic selling of stocks by both locals and foreigners during last year’s crisis gave rise to a rarely seen buying opportunity. The biggest opportunity arose in the stocks that were already cheap coming into the crisis: unloved cyclical industries and out-of-favour geographies like emerging markets and the UK were severely punished.
Even though we have seen early signs of a recovery in valuations since the sell-off in March 2020, it is worthwhile to note that the base was extremely low coupled with severely depressed earnings levels. We believe that valuations are currently still reflective of a poor backdrop as well as low sentiment and remain attractive relative to emerging market and developed market peers.
Financials, in particular, is an area that we see opportunity in and that has lagged the recent recovery. This continues to be the most attractive sector in the local market, largely driven by a strong yield component as companies resume the payment of dividends (and share buybacks) and a strong valuation underpin. Resources has been the standout sector recently from a performance perspective, however, we believe current valuations are still attractive given the favourable supply/demand backdrop for major commodities.
Couple low prices, low earnings and just a slight uptick in investor sentiment and you have a powerful combination for returns to be generated.
The bigger picture
Now that we have established that there are some green shoots from a valuation perspective, it is also important to look at the bigger picture. South Africa is part of an emerging market basket that has been deeply out of favour for the past decade or so. What the graph below shows you is the performance of a commodity basket (i.e. a proxy for emerging markets) compared to the performance of the broader US market.
The large valuation divergence is evident because of the extraordinary levels of crowding into past winners and the capitulation out of what had not worked. What we have witnessed is the start of a rotation into cheaper, more cyclical parts of the market since the end of 2020.
Usually, when a rotation like this occurs, it is a multi-year event but not a linear one. This is a very interesting development and a positive one if you think South Africa will get its natural slice of the emerging market pie.
Source: Bloomberg, Torsten Dennin, Lynkeus Capital, Incrementum AG. Data as at February 2020. Past performance is not an indication of future returns.
Conclusion
When constructing portfolios for clients, the investment team at Morningstar Investment Management applies their expertise in asset allocation, manager selection and portfolio construction to create investment strategies for investors. We follow a disciplined bottom-up process to ensure that we allocate money to the most attractive parts of the market and avoid areas that we deem to be expensive without taking unintentional bets.
While we strongly support portfolio diversification and favour healthy offshore exposure, we question the wisdom of the ongoing panic to reduce cheap domestic equities in favour of expensive global stocks or domestic cash. We encourage investors not to look only at past winners when making investment decisions, but to remember that investing is more often than not counterintuitive – “Investing in what is comfortable is rarely profitable.” — Robert Arnott. K
Risk Warnings
This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.
This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.
Morningstar Investment Management South Africa Disclosure
The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.
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