Alphen Asset Management Asset Class View: Long offshore, long cash and on-weight equities

Neels van Schaik of Alphen Asset Management writes that despite the bumpy ride we experienced early in 2009, market valuation levels in the market towards the end of the first quarter in 2009 were low enough to arrest the implosion in equity prices that started in mid-2008. As a value investor one therefore should not have had any problems purchasing high quality companies at exceptionally good prices.

Investors have entered 2010 on a completely different tone though with a state of relief and optimism prevalent. The global media is swamped with positive news about the synchronised global recovery and the resultant uplift in earnings - the complete opposite of 2009 when gloom and doom reigned. Not dissimilar to the euphoria that prevailed in early 2008, China is once again leading the way on the commodities front with its almost insatiable demand for raw materials and consequently, commodity currencies and commodity markets are firmly in vogue. By extension, emerging financial markets have continued with their star performances relative to their developed peers as their economies are in much better shape and likely to stay that way for quite some time.

What concerns us this year as against last year, however, are the high valuation levels of various markets across the globe. Companies are no longer priced for Armageddon as was the case in late 2008-early 2009, which made stock selection much easier. Earnings yields of many companies are not looking that attractively priced relative to bond yields and cash yields anymore. In 2008, we found companies that we purchased at or below the value of their net assets. Now many of these same companies trade at almost double those levels. Our view is that the margin of safety in equities for most of the market has largely disappeared. With this in mind, we firmly believe that once investors start paying for growth, the risk of capital loss increases significantly.

Capital preservation is for us a key component of our investment philosophy and we therefore deem it prudent to take money off the table as the market moves higher.

We believe offshore is a comfortable space to invest in. The rand remains vulnerable to exogenous economic shocks. We are concerned about the very tight relationships that have existed for the last couple of years between the Rand's performance and global stock markets and commodity prices. In a nutshell, the Rand has been a major beneficiary of the increased risk appetite.

Synchronised trades carry serious risk, and at times we have witnessed the reverse of commodity fortunes leading to serious currency volatility. Based on the extent of re-inflated asset levels in certain markets and the degree to which this has been driven by short term capital flows, we feel that volatility and risk is likely to change in the months ahead. Whilst we fully appreciate that a sustained recovery in global stock markets and commodity prices does bode well for the exchange rate in the short term, we feel that the risk of significant depreciation is increasing. We are mindful that it is impossible to predict currency moves in the short-term, but we are very comfortable to maintain our investors' high offshore exposure simply because we deem many assets abroad to offer more value than most of those in South Africa. We thus consider the potential for rand weakness at some future date as added optionality which further justifies our positioning.

Bonds are fairly priced given the level of interest rates in South Africa. A lot has been said about a potential adjustment of the South African Reserve Bank's inflation-targeting mandate, to incorporate other economic factors as well. Thus far it has only been speculation and given the status quo, we maintain our view that interest rates are likely to stay on hold for at least six months, before they start moving up again. The impact of the very aggressive rate cuts between 2008 and 2009 will start impacting the real economy positively in the first half of this year and based on this could act against the performance of longer dated SA bonds.

We favour cash over bonds and also believe that domestic inflation continues to pose a long term structural risk through sticky administered prices. Contrary to the consensus view, we also believe that any inflation threat is likely to come from emerging markets such as China and not as a result of rising money supply in developed markets. Although inflation globally thus far has largely been an asset price phenomenon, the most likely inflation risk which South Africa faces could in fact again emerge from soft or agricultural commodities.

Alphen is on-weight equities and have taken money off the table from our aggressive equity weightings at the beginning of 2009. We think the potential return from the stocks we do own, still outweighs the risk of permanent capital loss, given the companies' positions within their industries, cash flows and expected return on capital. We are cautious, on the market in general though, as very aggressive growth and recovery expectations are being discounted. With that said, markets can however certainly move higher in 2010. The extreme stimulus measures that have been implemented in recent years by Central Banks across the globe are likely to overstay their welcome and will be supportive of equity prices. The more realistic growth paths for individual countries though will unfortunately only be witnessed with hind sight, once these artificial stimuli disappear.

Our objective as always is to own the right stocks for the right reasons and at the right valuations, and to keep some powder dry when mouth watering opportunities come to the fore again; and they will.