Adapting to a new reality
23 Nov, 2022

Adapting to a new reality

Many investors are hiding in cash waiting for market conditions to improve. Attractive entry points are emerging for those who have a long-term investment horizon.

Clyde Rossouw, Co-Head of Quality at Ninety One

The fast view:

Financial assets have adjusted materially to central banks withdrawing liquidity and raising interest rates aggressively.
This has created attractive opportunities for long-term investors.
Global equities still provide the best prospect for growth for Ninety One Opportunity Fund investors.
Bonds are the best local opportunity on an expected risk-adjusted return basis. SA cash has become more attractive but is still not generating a real return.
SA equities appear cheaper, but the cheapest shares carry the highest earnings risk.

Investors are having a painful year. Financial assets have been punished across the board, with equity and bond investors feeling the weight of a significant drawdown on capital. Markets have become obsessed with global inflation and whether we’re nearing a peak. With central banks fighting inflation by withdrawing liquidity and raising interest rates, the cost of capital has rocketed. Essentially, we’ve gone from a decade-plus of ‘free’ money to a more normal environment, where money now has a cost attached to it.

Markets need to adjust to this ‘new’ reality, by pricing in the increased cost of capital. While this process should leave financial markets in better shape in the long term, investors have endured massive short-term pain as stocks, bonds and other assets have sold off to account for the increased cost of capital. This in turn, has put major downward pressure on capital values.

Positive signals on the global inflation front

While inflation is still uncomfortably high in the US, we’ve seen disinflationary forces emerge on the global front. Oil prices have come down dramatically from their highs, and copper, fertiliser and food prices have also moderated. All the big inflationary push factors have worked their way through the system, and we will reach a point where these factors will be reflected in lower inflation numbers. The US Federal Reserve is determined to put out the inflation fire, so we can expect interest rates to keep on increasing until price stability is restored.

Figure 1: Brent crude oil price (YTD 2022)

The sharp rise in interest rates is weighing on economies around the world.

Global growth is another key focus for markets. The sharp rise in interest rates is weighing on economies around the world, with recession fears dominating investor sentiment. As economies slow, many companies will find their ability to grow earnings (profits) constrained. This is a worry for equity investors, so picking companies with earnings resilience will be key.

A mindset change

Many investors are hiding in cash, biding their time until market conditions improve. There’s close to $5 trillion stashed in US money market funds alone while the investment environment remains uncertain. It is very hard to call the peak in interest rates, and when markets and economies will bottom out. Trying to forecast these key inflection points is largely an effort in futility. It is important for investors to recognise that assets have already repriced materially in the face of a withdrawal of liquidity and aggressively higher interest rates.

Markets should remain choppy in the short term.

Investors need to appreciate the magnitude of the events that have occurred this year. Markets should remain choppy in the short term but instead of looking for reasons to exit, investors should focus on the meaningful opportunities that exist. You cannot time the market consistently – you need to allocate to risk assets for long-term growth.

Attractive entry points

As investment managers, our job is to make intelligent allocations of capital to businesses where we think the fundamentals are sound. We would rather invest in businesses that are poised to grow over the next few years than sit on the sidelines, relying on perfectly timing the markets. On a bottom-up basis, there are healthy return opportunities for investors who have a reasonable time frame and aren’t speculating on short-term price movements based on news flow.

Resilient earnings are going to become increasingly important as liquidity reduces and growth becomes scarce. The businesses in our portfolio also have compelling inflation protection attributes given their pricing power, strong balance sheets and low capital intensity. We continue to favour high-quality, global businesses as our preferred asset class within the Ninety One Opportunity Fund.

This year’s market carnage has provided the opportunity to buy great businesses at better prices. Both the valuation and return expectation of the businesses we own have improved meaningfully since the start of the year. In fact, the global stocks we own now have an expected rate of return of over 10% per annum in US dollars on average (5-year view). We have been increasing our exposure to select global equity holdings and building new positions, with the allure of defensive assets decidedly fading.

Verisign – pricing power and healthy cash flows

Verisign, one of our top ten global equity holdings in the Ninety One Opportunity Fund, has been a key contributor to performance for the portfolio. It is a global provider of domain name registry services and internet infrastructure. The company’s operations are essential for the proper functioning of the internet. Besides domain name registration, Verisign maintains the security, stability and resiliency of key internet infrastructure and services. It provides these services to the .com and .net top-level domains, which support most global e‑commerce businesses.

Verisign’s monopoly position and recent agreements struck with the regulatory oversight body mean it also enjoys pricing power. Specifically, a regulatory agreement permits automatic renewals, allowing for annual price increases of approximately 5%, while domain growth has remained stable. Verisign’s global reach, strong brand and a 20-year uninterrupted track record for seamless operation, translate into significant competitive advantages. The business has seen a steady increase in its domain name base and enjoys double-digit, long-term free cash-flow growth.

Figure 2: Domain name base at 174.2 million names (up 1.2% Y/Y)

SA bonds – best local opportunity on a risk-adjusted basis

Despite domestic growth concerns and inflationary pressures, our large holding in SA bonds reflects our view that significant real value exists, particularly in the belly of the curve. South Africa’s 10-year government bonds offer real (above inflation) yields of more than 4%. We also have exposure to inflation-linked bonds to further guard against the ravages of inflation.

We have low conviction on companies reliant on the SA economy/consumer.

While SA equity valuations are more attractive, in many cases they are not an accurate reflection of companies’ underlying fundamentals. We have low conviction on companies reliant on the SA economy/consumer, preferring businesses that enjoy dominant market share, and derive their earnings from global markets.

In addition, we maintain a healthy weight in cash – both locally and offshore. It provides a cushion against risk and allows us to take advantage of opportunities as they arise.

In conclusion

Our asset allocation decisions reflect our 5-year outlook for the different asset classes that make up the portfolio. Investors should, therefore, not expect sweeping short-term changes based on the news of the day. We continue to find compelling investment ideas to generate long-term wealth for clients. We remain confident that our quality style of investing will equip us to navigate the inflationary environment and be resilient during periods of market weakness.


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