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Investing is an Olympic Marathon, not a 100 m sprint

04 May 12          

Mohamed Shafee Loonat of Element Fund Managers writes that for the first quarter of 2012, stock markets seem to have taken their cue from the fact that this is an Olympic year and they are off to the races. With such a vast array of events on show at the global event, the one that captures the most interest is undoubtedly the one that is also the shortest – the 100m sprint. When it comes to the markets, investors also seem to think that we are in a short sprint to the finish, when in fact this is a marathon.

If we start too quickly and too early we will certainly struggle, much like the hare against the  tortoise.

The first quarter of 2012 saw the FTSE/JSE All Share Index (ALSI) gain 6.0% in ZAR terms and 11.8% in US$ terms. Almost all of the return was earned in the first month, which saw a rise of 5.7%, while February was slower at 1.7% and March saw a slight decline of -1.4%. The US stockmarket, as represented by the S&P 500, recorded its best opening quarter (+12.0%) since 1998 and, together with the preceding three months, it experienced its strongest six month gain (+24.5%) since 1997.

Those of us with long enough memories will recognise 1997 as the period when Russia and Asia were going through their financial crises. On 15 March 2012, the S&P 500 closed above 1400 for the first time in 951 trading days, having gained 107% from its post Global Financial Crisis (“GFC”) low in 2009. The rise in the opening quarter of 2012 was more than double that in the opening quarter of 2011, but volumes were 23.5% lower, which gives us some concern about the sustainability of the rally. We remind our fellow investors that after a decent opening quarter to 2011, the S&P 500 ended the year down -1% and we fear that history may repeat itself.

The pain in Spain…

The recent run may seem justified on the back of stronger corporate balance sheets, higher earnings and cheaper valuations. All time low global interest rates, together with other forms of stimulus have certainly helped the corporate world, but we argue that these are not sustainable. Developed markets still make up two thirds of the global economy, and their sovereign debt problems have not gone away nor been resolved – despite the protestations (and wishes) of the politicians. We have finally seen Greece actually being declared in default (on 9 March 2012) with private investors losing an effective 76% of their investment by the end of March 2012.

The Greeks started the Olympics, with its motto being “Citius, Altius, Fortius”. These three Latin words mean “Swifter, Higher, Stronger” – something the Greeks can only dream about when it comes to economic growth. The “new” Greek bonds that were issued in exchange for the “old” defaulted bonds were expected to yield 9% but started trading at 14% and have already risen to over 20% (a reminder that bond prices plummet when yields rise dramatically). Clearly, this is not a sign that all is well and indicates that we have not heard the last of the Greek story just yet.

We still see  Europe as a material risk to global economic growth and systemic risk, with Spain being worst positioned in terms of size relative to Greece (Spain is the world’s twelfth largest economy according to the World Bank). At the time of writing, Spanish bond auctions failed to meet targets and Spanish bond yields had started another upward trend with the Credit Default Swap (“CDS”) rates also rising materially (effectively the cost of insuring against a Spanish default).

We continue to see the macro headwinds as being sufficiently material to warrant caution on the part of investors. Risks include softening US economic data, deterioration in Europe, and a harder landing in China amongst others – none of which appears to be factored into share prices based on 1Q2012’s performance.

Diverging ratings offer different investment opportunities

The GFC highlighted that emerging markets have not completely decoupled and a continued slowdown in the developed world will most likely result in a drag on growth in emerging markets as well. Emerging market valuation multiples are now above their 10 year averages. The South African market also breeched new highs in the last quarter, but we caution investors that earnings levels for the market as a whole, and certain sectors in particular, are materially above their long term trend lines and are likely to correct at some point going forward.

The resource sector has seen material declines in a number of its sectors and shares. The gold and platinum sectors, in particular have been hardest hit during the six months ending March 2012 with relative total return underperformances to the ALSI of –25% and –17%, respectively. The resource heavyweights of Anglos and BHP Billiton have fallen materially from last year’s highs with Anglos down -29% and BHP Billiton down -22% since their respective February 2011 relative peaks compared with the ALSI.

What this highlights is that those shares that have taken the ALSI to its recent highs appear more expensive than ever and, in our opinion, offer poor relative value on a three- to five-year view, as most of the gains appear to have been driven by higher ratings rather than underlying earnings and cash flow growth.

By way of illustration, we have highlighted the PE relative graph of SABMiller (SAB – an industrial heavyweight) against Anglo American (Anglos – a resource heavyweight) in the graph below. The graph covers close to a 20-year period and we have highlighted the mean and approximate deviation lines on the graph. Over the last 20 years, SAB has traded at a 50% higher PE, on average, than Anglos. In other words, if Anglos was on a 10 PE, SAB would trade on a 15 PE – on average.

There are many factors that can account for SAB’s superior rating to Anglos over time, but this is likely to be largely attributed to SAB having more predictable earnings and cash flow than Anglos, with much lower volatility.

However, as can be seen from the graph, SAB is now trading on a PE multiple more than 230% higher than Anglos or more than 2.2 times its long-term average rating differential. The graph is also almost at its highest rating differential ever over the last 20 years – a position that seldom holds for a material length of time before correcting – as can be seen from the peaks and troughs over the last few years from mid-2008. While we have owned SAB for our clients many times in the past, it currently looks expensive. Its rating differentials, as shown below, lead us to conclude that there may be better long-term value elsewhere in our stock market.

In addition, the food and clothing retail sectors look expensive and vulnerable to a potential de-rating. Earnings and operating margins are at, or close to, all-time highs with relative PE multiples materially above long-term trends. The competitive environment in the retail space looks to be increasing significantly with Walmart, Zara and Gap being three international names already in the country with expansion plans in the offing, and more international names likely to follow.

It is also likely that Edcon (holding company of Edgars) may re-list, providing another material listed  alternative in the retail space. In our opinion, inflation is likely to surprise on the upside and consumer disposable income will be impacted by rising fuel and food costs, as well as the impact of a weaker rand being felt in the second half of 2012.

Notably, our interest rates and our interest rate cycle also move closer to the point where they will start to rise.

Our portfolios continue to favour shares with good long-term earnings and cash flow track records that may be out of favour currently (and trading on low PEs) and often with depressed earnings. These shares stand to benefit from both earnings growth and a re-rating when earnings normalise over time. We are avoiding shares where earnings, margins and ratings are at peak levels – usually these are the current hottest sectors for those with a 100m-sprint philosophy, but the ones that are likely to generate sub-optimal returns over the investment marathon time horizon. As long-term investors, we are in the investing marathon over the long haul and are confident that our proven philosophy, process and track record will result in both superior returns and superior risk-adjusted returns going forward.

We wish our SA athletes well in their respective Olympic events (starting late July 2012) and hopefully they can bring some gold back to its rightful home.

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