Investing is usually most rewarding when it’s most difficult to do
The premise of investing is simple: buy low, sell high and, by doing so, earn an investment return. In practice, however, it’s far more difficult. How we’re wired as humans makes it hard for us to set aside emotions as investors. This applies both to buying when security prices are low due to pervasive pessimism (which goes against our inherent preference to play it safe) and to selling when markets are rising, when we’re tempted to hold out for even greater gains. In fact, most investors end up doing the exact opposite, by exiting their investments at market lows in a bid for safety and reinvesting once markets have already run. Not only does this crystallise losses, but it also means missing out on market recoveries. We’ve written about how uncomfortable investing can get and why this means that most investors underperform the markets before. However, given the prolonged and heightened uncertainty investors are currently facing, it’s useful to take a step back and re-evaluate the rare opportunity set current conditions are presenting.
A flight to perceived safety is evident locally and abroad
Statistics released by the Association for Savings and Investment South Africa (ASISA) for the quarter and year ended June 2019 show that South African Interest Bearing portfolios (Short Term and Variable Term) attracted the bulk of net annual industry inflows, followed by Money Market portfolios. South African Multi Asset – Income portfolios were also popular with investors. On the flipside, equities have lost much of their appeal, with the South African Equity – General category recording net outflows. ASISA notes that “… investors continue to favour the perceived safety of interest bearing portfolios, which is not surprising given the market volatility and political uncertainty over the past year.”
In markets such as the US, the ‘flight to safety’ has been into the market darlings, with investors chasing strong performance from growth stocks and technology counters despite high valuation levels.
While it may feel uncomfortable, markets are presenting the potential to buy low
As we have noted over recent months, markets globally continue to be characterised by wide divergences: valuations of higher-quality, defensive companies are generally elevated, while valuations in parts of the markets characterised by fear and uncertainty are depressed. Locally, while the FTSE/JSE All Share Index (ALSI) has delivered a total return of 4% year to date (to 26 August), this has been driven by a handful of counters (primarily mining shares and large-cap rand hedges). In fact, we estimate that over 80% of ALSI stocks are in a bear market, i.e. trading at more than 20% below their five-year highs. Globally, US investment management firm Pzena notes in its latest quarterly commentary that the valuation dispersion between the cheapest and most expensive developed market stocks surpasses 99% of the monthly observations in the 45-year history of its data.
Starting valuations are critical to long-term investment outcomes
Such extreme valuation divergences are rare and present risks as well as opportunities. Investors seeking a smoother ride by switching to cash or buying high-quality counters at any cost may find that this ‘fail safe’ proves to be the opposite over the longer term. Missing out on the gains from a market recovery can dramatically erode an investment outcome. Similarly, buying securities at lofty valuations underpinned by high growth expectations may result in losses if expectations prove to be unsustainable.
In contrast, areas in which valuations have been driven lower due to fear and uncertainty present the potential for mispricing. Where prices fall across the board – an entire sector or geography, for example – quality securities become available cheaply, along with the rest. Tainted by pessimism, their earnings potential is easily overlooked. While it may take time for the market to realise mispriced value, investors who can ride out the storm stand to generate outsized returns from such attractive entry points.
We continue to find good opportunities in unloved areas
Pzena notes the following in its newsletter: “We believe the world is facing one of those rare points when fear has reached an extreme, and a tremendous number of overlooked but good companies are available at fire-sale prices.” It’s a sentiment we share. We believe that this is true within emerging markets generally and South Africa in particular, as well as in Japan (especially Japanese financials), the UK and the retail and agricultural sectors. To capitalise on the available opportunities without taking undue risk, we apply our process consistently and with discipline to guard against emotional triggers. We also interrogate valuations critically through our team-based approach and will only invest in securities we believe offer a margin of safety (i.e. which are trading below what we deem to be fair value). Finally, we ensure that portfolios are well diversified to perform under a range of possible future scenarios. After all, while it’s seldom comfortable to buy low, it’s a necessary precursor to selling high – and opportunity usually shines brightest in the gloom.
Return numbers quoted from Bloomberg.
Anet Ahern is the CEO of PSG Asset Management.