Have your portfolios considered some of the most extreme financial markets ever?
The multi-year outperformance of growth over value stocks is well documented and has been amplified by the Covid-19 pandemic. In fact, cheap (value) stocks have underperformed by the biggest margin seen in over a century. Hence, it should not come as a surprise to find that the investing public has given up on value stocks and value funds. The effect of this capitulation out of cheap and unloved stocks has been profound. It has given rise to some of the widest discrepancies in relative valuations and some of the highest levels of crowding in growth (particularly technology) stocks on record.
Growth investors are highly convicted in the relative attractiveness of secular growth companies in a low growth world. Little attention is given to the price paid for future growth and the fact that the largest part of investment returns has come from multiple expansion in recent years. The backdrop of low valuations and a post-Covid-19 economic recovery could result in a more constructive view on the merits of investing in undervalued businesses.
Are South African assets value traps?
South African assets are deeply unloved by both foreigners and locals. Foreigners have consistently reduced exposure to SA equities over the past several years and have aggressively sold domestic bonds in 2020. Local investors may have been big buyers of local bonds, but they have turned their backs on domestic equities. Pension funds have their lowest exposure to domestic equities since the 1980s, and fixed income unit trusts have enjoyed mammoth inflows over the past two years while equity and balanced funds have seen large outflows. South African investors have heavily tilted portfolios to cash, bonds and offshore assets at a time when domestic shares trade at very low valuations in both absolute and relative terms. Our equities are among the cheapest in the emerging market universe at a time when emerging markets are already very cheap relative to developed markets. By their positioning, both foreign and domestic investors are expressing high conviction that South African assets, and particularly domestic stocks, will continue to underperform.
Furthermore, the 2020 recession is testing an already fragile domestic fiscal position and reducing government debt levels will be a significant challenge. Understandably, this is receiving a lot of attention from market participants with many expressing a view that a sovereign debt default scenario is insurmountable. What get less attention at times of heightened fear are the mitigating factors that necessitate a more balanced approach to local investing. These include the structure of our sovereign debt maturity profile; deep sophisticated local financial markets; the diversified nature of many of the opportunities on the JSE; building evidence of economic reform implementation and the tackling of corruption; and the reasonable likelihood of an emerging market growth cycle off a low base.
Most market participants seem committed to their views, and they are positioned for extreme conditions to persist. While they may do so, it implies that if the truth lies somewhere in between the extremes (as it usually does) it is possible to foresee a dramatic reversal in performance.
There are ample examples of extreme conditions in markets:
Highest levels of passive (index) investing on record
Extremely high levels of concentration within indices
Extremely crowded positions among active managers
Very extreme valuation discrepancies between what is being crowded into (growth and tech) and what is out of favour (value and emerging markets)
Sovereign debt has ballooned, yet interest rates in developed markets are at multi-century lows
An explosion in money supply
The most expensive stocks have become the ‘safe-havens’
The market thinks it is unlikely that the future will look different to the recent past
This is effectively an all-in bet that a handful of companies will continue to be priced for multi-year domination, that the global economic recovery is anaemic, and that South Africa will become a failed state. Any outcome other than what is embedded in expectations, will likely give rise to extreme reversals and rotations.
This environment is providing a remarkable opportunity to build a portfolio of well-diversified, quality businesses at exceptional valuations. These can be expected to generate excellent long- term returns at just the time that most portfolios are heavily weighted in stocks that could disappoint elevated expectations.