26 October 2023
Local investments are super cheap.
We all know that the last decade in South Africa has been a period characterised by increasing disruption to our lives, as a combination of toxic politics and rampant corruption in both government and the civil service, have gradually eroded the capability of the State to deliver even the most basic of services to its citizens.
It’s no wonder that the people of South Africa have sought refuge for their money from this rising government risk factor, by transferring huge amounts of capital, both human and financial, to other places in the world perceived to be less risky.
Under these deteriorating conditions, why would anyone in their right mind even consider investing in South Africa, when they can freely invest in other regions of the world that suffer from fewer obvious risks? The answer to this question is nuanced and not absolute because every region of the world has their own unique problems and challenges. It is however an indisputable fact that those that have allocated more capital offshore in recent years have done better than those with full South African exposure, when measured in US dollars.
Warren Buffett was once quoted as saying, “Price is what you pay, value is what you get.” This investment theorem is timeless and remains true. Starting valuations always determine the terminal return generated. Highly priced assets, using price/earnings, price book, dividend yield or any other valuation metric, will deliver investors lower returns than cheaper assets for a given level of growth.
South Africa has an abundance of cheap assets, as the rising pessimism about the country’s economic prospects, failing infrastructure and concerns relating to the upcoming national elections in 2024, have created a persistent flow of capital abroad from individuals, companies, and retirement funds. Falling demand for local equites, property (except in the Western Cape) and government bonds, have made them priced extremely cheaply, creating a generational opportunity to acquire these assets at very low valuations.
Many of the cheapest listed assets in the world are to be found in the mid- and small capitalisation sectors of the JSE. Local investment specialists with the correct knowledge of these assets and who possess the necessary skill and flexibility to own the right companies in the right proportions, are likely to enjoy outsized returns looking forward over the next decade.
This outcome is very likely, despite the unstable politics and will commence when global interest rates start to fall, and the financial impact of load shedding becomes less harmful to the economy.
The importance of global diversification
South Africa makes up a small portion of the global investment opportunity set, with our equity and bond markets representing less than 1% of the total global market value in these asset classes.
Additionally, there are businesses and industries that one simply cannot access in South Africa because they either do not operate here in a meaningful way, or they are not publicly listed and investible here. Artificial Intelligence, oil, big tech, pharmaceuticals, and microprocessors are all examples of global growth industries that are not available to investors on the JSE in any meaningful way.
Spreading one’s capital across markets and geographies is an important concept as this action, performed correctly, improves the risk, and return characteristics of a portfolio of assets. Adding to the complexity, currency allocations matter. The relative value of the SA rand has deteriorated against most developed market currencies over the last few decades. Conversely, interest rate differentials between South Africa and the developed world have meant that over the last twenty years, an investment in SA cash has outperformed an investment made into US dollar cash despite the local currency losing value against the dollar at a rate of approximately 5.2% per annum over this time.
Putting all the individual pieces of this complex puzzle together is not simple and requires knowledge, skill, insight and sometimes a little luck. As already described, SA equity and bond assets are historically cheap, but the risk of SA becoming a failed state justifies some of this discount. Global equity assets are more fully priced (some are even highly priced) and the risks to global growth due to higher interest rates and persistent inflation indicate these assets may be trading on quite lofty valuations.
South African domiciled fund managers have a potential advantage over their global counterparts. But perhaps not for the reasons you think.
All investment houses use services like Bloomberg, FactSet, Refinitiv (and others) to gather investment data. We all receive the financial data on any listed company, government debt instrument or economic update simultaneously. In the age of the webinar, companies do investor calls to all investors these days, not just a select few. There is no geographic advantage to being in New York, Tokyo, Singapore, or London anymore. Investment return data unequivocally illustrates that active global fund managers are on average no better than SA fund managers. There are winners and losers on both sides.
Our advantage is a mental toughness, a “can do” mindset that is required to survive in South Africa and other less developed countries. We have a better understanding of the real “on the ground” conditions and issues in emerging markets. Emerging markets are going to be the major return driver over the next decade, simply because these markets are generally where growth is happening, and the assets are generally cheap.
Finally, and most importantly, we are close to our clients and can regularly meet them in person while with global managers it’s almost always going to be a written report or an online engagement.
Paul Stewart, Managing Director – Merchant West Investments
