Investors face tricky risk-return decisions
Since the start of 2022, investors have been confronted with rising global investment risks and higher uncertainty on the back of persistently higher inflation, more aggressive interest rate hikes and downward revisions to growth forecasts. The possibility of stagflation and recession in the US and Europe has also grown. As a commodity producer, South Africa’s financial markets were not initially hit as badly as many others, but this trend changed more recently as we have felt the full impact of global interest rate hikes, falling metals prices and investor pessimism, as well as slowing growth prospects.
It has been a tricky period for investors given the highly volatile market conditions. Yes, asset valuations have become more attractive given the sharp falls across both equity and nominal bond markets – both globally and locally – but risks to economic growth, and therefore to corporate earnings, have risen. Credit risk has also deteriorated for some bond issuers. In our view, buying signals have only been strong enough to implement marginal changes to our portfolios – in other words, many valuations have not yet fallen far enough to be considered sufficiently cheap to compensate for the elevated risk.
As such, rather than being more aggressive and adding risk to our portfolios at this point, we believe that to be successful in the current conditions, investors need to be more cautious and selective in their portfolio choices, but without tilting them to overtly defensive positioning.
Managing a delicate balance
We have managed this delicate balancing act between return and risk in a number of ways as the investment environment deteriorated, based on fundamental asset valuations. Globally, we have been underweight equity and bonds and overweight cash for some time now. Within global bonds, we took advantage of the sharp selloff and reduced our underweight in developed market bonds, adding some US Treasuries and diversified global bonds. We are still underweight, however, and have a preference for bond markets where the real yields are high and the currency is trading at fair-to-cheap levels.
As for local equities, even though we took marginal profits earlier in the year, we held on to our overweight positioning as the market became even cheaper, with the FTSE/JSE Capped SWIX P/E de-rating from around 9.6X to around 8.0X. Corporate earnings expectations have started to roll over, but they have not fallen as much as share prices, and in our view are not yet reflecting global recession risks. Later in Q2 we also added more SA nominal bonds to our overweight positioning to take advantage of their very attractive longer-dated yields of around 11.0%.
Another way we are managing portfolio risk-return balance is through a broad diversification of equity risk across both global and local markets. In the SA market, we have been cautious about the sustainability of Resources earnings, given their very high levels of profit margins and cash flows on the back of high commodity prices. As such, we had opted for underweight exposure to the Basic Resources sector in favour of Oil and Chemicals, positioning that has protected portfolio downside. Equally, faced with increasing pressure on household incomes due to worsening inflation and higher interest rates, earlier this year we cut our exposure to the Retail sector, opting to hold only select retailers who, on top of attractive valuations, are capable of passing on price rises to consumers and therefore have a resilient earnings outlook.
British American Tobacco (BAT) is a stock we prefer. It is offering an exceptionally attractive dividend yield of 7%, which we expect to grow by around 10% per year for the next five years, despite the risks that tobacco companies face. We think that BAT can continue to grow profits while helping its customers switch to much less harmful products. The company has been a strong relative performer over the last year, as the market has recognised its defensive cash flows.
In contrast with this more defensive holding, we increased our already-overweight position in Naspers and Prosus as their valuations fell. The Group’s primary asset, Tencent, is a high-quality company with a market-leading position in China, giving it a very strong competitive advantage and significant growth potential. In our view it has been trading on an undemanding valuation. Additionally, we think that the very substantial discount at which both Naspers and Prosus trade, even following their sharp share price rebound in June, provides a significant margin of safety. We also expect longer-term outperformance from the group for the reasons above.
In conclusion, as valuation-based investors, we would always like to take advantage of cheap asset valuations. However, amid the current global sell-off we remain cautious and selective in our choices. Global bonds remain at risk of higher-than-expected inflation and interest rates, and many global equity markets are still relatively expensive. Locally, asset valuations are attractive, but risks have risen. Rather than moving to overtly defensive positioning, we believe it best to keep reassessing valuations, focussing on the fundamentals and staying well diversified.