South African balanced funds have generally underperformed their targets over the last two years. How likely are these funds to achieve inflation +5% over the next two years, and what are their drivers?
This was the topic of a panel discussion I took part in at this week’s Investment Forum, and may be a concern shared by investors in these funds. However, we believe that a diversified portfolio of undervalued shares, high-yielding bonds and attractive cash instruments will offer a good chance of benchmark-beating returns over appropriate time periods – especially given the favourable inflation outlook.
Balanced funds are generally medium- to long-term investments
It is important to emphasise that although the Investment Forum focused on a rolling four-year period, balanced funds are best suited to investors with an investment horizon of at least five years. As we have often cautioned, there is a risk to making long-term decisions on the back of short-term movements.
It seems the Reserve Bank has a strong intent to reduce the nominal hurdle
The South African Reserve Bank has built credibility in inflation targeting, and CPI has averaged 5.8% (within the 3% to 6% target range) since the introduction of the policy framework in 2000. However, there are indications that the bank is targeting lower inflation still. It has stated that a key objective of current monetary policy settings is to lower inflation ‘… so that it is securely anchored nearer the midpoint of the inflation target range …’*. Maintaining structurally high interest rates even though inflation is currently low is further evidence of this commitment.
Potentially, a target of inflation +5% therefore means a total return of 9.5%. To account for the impact of management fees (using a ballpark fee of 1.5% excluding VAT), a fund will need to deliver at least 11%.
A diversified portfolio of undervalued securities is key to achieving required returns
Think of a fund’s long-term performance as a container vessel on an ocean crossing. In this analogy, the vessel is fitted with a reliable but unpredictable engine system: the portfolio manager has several motors at his or her disposal, but no way of knowing which will fire when, or how often. It is therefore critical that there are enough motors, that they are all in good condition and that there is fuel in the tank. And then you wait. Investing is all about patience.
At PSG Asset Management, we do this by constructing well-diversified portfolios of securities with one common denominator: the market underappreciates their true value. When it ultimately drives the price of a security towards this true value, one of our motors kicks in. But as history has shown, these movements are impossible to time or predict: they can happen in a matter of days, months or years.
What are the ‘performance engines’ in the PSG Balanced Fund?
Stocks with long growth runways (local and global)
These are stocks such as Brookfield, Discovery and AIA. While they might not appear attractively priced at first glance, we believe the market underappreciates their growth opportunities. In all three cases, management teams have shareholdings that amount to large personal exposures. They are in it for the long haul.
South African industrial stocks
We currently hold a number of domestic industrial stocks that are on low multiples of low profits. These profits were generated in a time when South Africa’s gross fixed-capital formation was back at 2004 levels, in nominal terms. As profits normalise, we expect the market to regain excitement about the quality of these franchises and rerate their share prices.
South African banks
Banks represent a doubly leveraged (financial and operational) tolling booth on South African economic activity. If there are several pockets of GDP recovery and the industry’s competitive landscape remains reasonably undisturbed, aggregate bank profits could grow handsomely, especially if we consider how well they managed to tread water in the recent slow years. We are especially interested in banks with high-performing management and share prices that offer attractive entry levels. Nedbank is one such example.
The weighted average price earnings (P/E) ratio of the local stocks in the PSG Balanced Fund is currently 12.9, while that of the global stocks is slightly higher at 14.5. Combined, the earnings yield of the equity component (62% of the overall portfolio) is currently 7.5%. Even if these were average businesses growing only by inflation, they could potentially deliver somewhere in the region of 12% to 14% (earnings yield plus inflation). However, we believe the return could be higher, as these are above-average companies at below-average valuations.
The bond component of the portfolio (24.3%) is currently yielding 9.1% – an attractive real return, especially if average inflation could be in the vicinity of 4.5%. We are of the view that this real yield is too attractive to be sustained. Should the market push yields lower (and bond prices higher), the total return (from the price movement plus the receivable coupon) could be well in excess of inflation plus 5%.
The fund’s domestic cash and equivalents holding (money market instruments and NCDs) currently amounts to 12.9% of total assets. This portfolio of highly liquid instruments is currently yielding 8.7%, which comfortably exceeds expected inflation. Most of these holdings consist of NCDs with terms of between one and five years, implying that we’ve secured attractive yields for our clients even if interest rates drop. Of course, to us cash represents firepower to be applied when the market presents compelling buying opportunities, from which we could expect a much higher total return than 8.7%.
We believe the odds are in our clients’ favour, as long as they stick around for the long term
There are plenty of motors fitted to the PSG Balanced Fund, and while we cannot control when they will fire, it is likely that our long-term investors will benefit when they do. A number of shares might rerate, government bonds could rally or our cash might be deployed into bargain security prices. These movements could be gentle and orderly, but there might also be lulls when nothing is firing and there is an outside chance of all motors firing simultaneously. While we cannot control the timing or the speed, we believe we have a steady hand on the direction. This is a long-term approach to investing, and to benefit from our process we suggest that our clients stay the course with us.
*South African Reserve Bank Monetary Policy Review, October 2017
The PSG Balanced Fund was recently named Best Aggressive Allocation Fund at the 2018 Morningstar Awards, for the second year running. To learn more about the fund, download the latest fund fact sheet here.
Paul Bosman is the Fund Manager of the PSG Balanced and PSG Stable funds.
This article is reproduced here courtsey of The PSG Angle. The PSG Angle is an electronic newsletter of PSG Asset Management.
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