As any parent of young children will attest, the need to know “why” and “when” is a natural human tendency. It is also the mainstay of daily market commentary and investment articles. Human beings believe that if we know why something happened, it will help us make sense of it and form a better basis for future decisions. We want a thread of causality – and, if at all possible, a linear one with a timeline.
Investors are sceptical about South Africa
When considering an investment that is in any way connected to what happens in South Africa (notably in SA Inc.-related shares and local government bonds), investors are sceptical. They ask why the investment case will materialise, why the value the buyer sees will be recognised by the market and why low valuations will improve. Investors want a checklist that states what needs to be in place for the thesis to be proven right, and by when.
Checklists can be useful in investment decision making. They help keep emotions out of decisions and often highlight risks. But even when used well, checklists come with no guarantees. Although they can help to assess and determine the investment case and the quality of the investment, they don’t tell us when a revaluation will happen.
The build-up to a bubble or market crisis is usually insidious, and its full impact is only felt later. This was the case with both the global financial crisis and state capture in South Africa. Both took years to develop and while (with hindsight) the signs were there that an unhealthy situation was evolving, the depth of the damage was only known and reflected in asset prices much later.
Looking to economic data to identify the ideal buying opportunity is a hit-or-miss strategy
Over the past 90 years, the US economy has had 14 recessions. However, not every end of a recession coincided with a long-term buying opportunity. Where a recession did provide a buying opportunity, a big stock price move often took place before the economic picture improved. The best example of this was the sharp market recovery from early March 2009 – which was three months before the recession ended. The market was up some 20% by the time the recession officially ended, and by even more by the time the associated economic data came out. A sell strategy based on the absence of economic growth can be risky.
Starting valuations are more reliable indicators of future return potential
So, if forecasting, checklists and even economic data don’t always help, what does? One of the best indicators of future returns is the starting valuation. When considering the cyclically-adjusted price/earnings ratio of the S&P 500 over the past 20 years, for example, low starting valuations have historically preceded the highest annualised returns over the subsequent 10 years (and vice-versa). Even when a market is not cheap, you greatly improve the chances of good future returns if you can construct a portfolio of shares that trade at attractive valuations.
The outlook for SA investors
We acknowledge the seriousness of the issues in South Africa and look out for developments that we believe will improve the general structural health of the environment. Far from a timeline or definitive list, this approach is about acknowledging steps in the right direction, rather than arriving at a neat conclusion. The Ramaphosa administration’s approach to addressing some of its most pressing challenges in coming months will be informative.
In the meantime, we continue to seek out compelling long-term valuations and to focus on diligently understanding each investment in the funds and its associated risks. We believe that this allows us to plant the seeds for good long-term returns regardless of whether we are presented with obvious evidence that it is time to buy.