In Allan Gray’s latest Quarterly Commentary, Tamryn Lamb, Allan Gray’s head of retail distribution, distilled some of the points discussed at the asset manager’s 2021 Investment Summit to answer the five key questions that financial advisers and their clients are asking.
1. South Africa’s macroeconomic situation seems dire – are there any green shoots of hope?
Lamb drew attention to the following points made by Allan Gray senior portfolio manager and economist Sandy McGregor:
- The economic recovery is back on track after the setback in June/July as a result of the third Covid-19 wave and the unrest in KwaZulu-Natal and Gauteng.
- Mining and agriculture are prospering as never before.
- For the first time since 1994, South Africa has enjoyed a substantial current account surplus.
- While export revenues will now contract following a sudden slowdown in China – which has triggered a dramatic decline in iron ore and platinum group metal prices – the global economy should be fairly buoyant over the next year as the pandemic recedes.
- South Africa’s economy has always been leveraged off its exports, so despite the Chinese slowdown, the necessary conditions for stronger growth are in place.
- As the remaining travel restrictions are lifted, the tourism sector will recover.
- The main reason for the prevailing gloom about South Africa’s future has been the failure of the Ramaphosa administration to reverse the economic stagnation of the Zuma years.
- There have been tentative steps to get greater involvement of private business in activities previously reserved for the state. For example, the leadership of both Eskom and Transnet now say that the private sector must play a greater role in both electricity generation and transport. This change of attitude is partly due to South Africa’s fiscal crisis caused by a bloated public sector wage bill, which rapidly compounded to unsustainable levels under former president Zuma. Government borrowing now absorbs most of SA’s savings, leaving little for investment by business.
- However, in the past year, tax collections have surprised on the upside, mainly due to the mining boom, and the government has been trying to contain its spending. The deficit is still too large, but it is declining.
- Conditions are improving, and businesses will take advantage of this. The consequent economic recovery will happen despite, not because of, the government.
2. Are there great investment opportunities in South Africa, given all the risks we face?
Lamb said Allan Gray is not bullish on the South African economy, and it is incredibly hard to predict the future. However, we can make inferences based on history and what we see prevailing today. “Based on this, and on a balance of probabilities, we would expect that South Africa will experience more of the same: relatively muted growth and scoring the odd own goal.”
Within this context, Allan Gray believes it is possible to find a number of companies that are either positioned to do well despite a poor macro backdrop or are pricing in a sufficiently dire outlook, so that even if the economy continues to be dire, the returns will be healthy, Lamb said.
The areas that Allan Gray is finding attractive include:
- Domestic banks, whose share prices remain below where they were at the end of 2019. “Allan Gray’s biggest exposure is to Standard Bank, which has an excellent long-term track record and trades well below historic multiples. At today’s share price, Standard Bank can deliver muted earnings growth and still generate good returns.”
- JSE-listed companies whose fortunes are completely divorced from the state of the domestic economy – either because they are multinational corporations, which happen to be listed here, or because they derive the majority of their income from exports or services supplied in offshore jurisdictions. An example is Glencore, which Allan Gray believes is out of favour with the market because of its large exposure to coal production.
“However, Glencore is also a major producer of copper, nickel, cobalt and zinc, among other commodities. These commodities are heavily used in wind, solar and battery technology and, as a result, are well positioned to benefit from the growing demand of renewable energy. Over time, the contribution from coal will decline and the contribution from these other commodities will increase. Today, you can buy Glencore for less than 10 times our estimate of normal earnings.”
As always, Lamb said, it is a question of price: How much am I paying? How large is my margin of safety? And to what degree am I being compensated for the downside risks? “Allan Gray believes investors can find a number of companies on the JSE whose prices are sufficiently low that the odds are skewed in your favour.”
3. How should we structure portfolios to protect against some of these risks?
There are a number of factors that obscure the view of how global markets may play out over the next 10 years – not least of which are the unprecedented monetary and fiscal interventions by developed market governments, Lamb said.
Allan Gray believes it is important that investors be mindful of the risks that abound globally, but also position their portfolios for a range of potential future outcomes, rather than taking a big bet on one scenario prevailing.
Allan Gray chief investment officer Duncan Artus told the Investment Summit that investors should be careful to believe that what has worked since the global financial crisis will continue to do so. History shows us that these themes can last for a number of years, until they don’t.
Artus said Allan Gray currently prefers the following approach when deciding on the asset allocation of its portfolios:
- Very little or no exposure to developed market sovereign bonds and high-yield instruments whose spreads are compressed relative to history and their intrinsic risk factors.
- To be underweight in technology stocks where valuations have outpaced fundamentals.
- Exposure to producers of metals used in the energy transition, such as Glencore.
- Exposure to precious metals and precious metal suppliers (this is a good potential hedge against inflation).
- To use its bottom-up process to find those idiosyncratic ideas that don’t rely on the big things discussed above – for example, the opportunity presented through omnichannel retailers such as Country Road, or low-value retailers that can capture some of the beneficiaries of additional government spending – for example, Pepkor.
- To look beyond the “big five” of Naspers, Prosus, Richemont, BHP and Anglo, which have meaningful exposure to China, towards other opportunities – for example, British American Tobacco, which has zero exposure to China, or AB InBev, which has great potential.
- To focus on all aspects of environmental, social and governance (ESG) factors and search beyond the best ESG companies that everyone is buying for the companies that are improving their ESG the most.
4. Where are the best opportunities to invest offshore?
The global opportunity set is not without risk. Developed markets have had an extremely long period of low rates and abundant liquidity, which have created distortions in bond markets and supported equity valuations overall. In particular, investors have flocked to businesses that have demonstrated high levels of growth, causing the prices of those businesses to surge, which, in turn, has been exacerbated by tracker funds being forced to hold larger stakes in these companies to replicate the index.
Meanwhile, the companies that have been deemed by the market to be unexciting or risky have languished – such that the gap between the most expensive and the cheapest companies in the market has widened to unusual levels.
Investors are faced with a tough choice: remain invested in the most expensive parts of the market in the hope that recent trends will continue, or start diversifying into other areas where the bad news may already be priced in.
Graeme Forster, from Orbis, told the Investment Summit that it is natural to be fascinated by exciting and emerging technologies such as artificial intelligence, quantum computing, blockchains, virtual reality and gene editing, as these innovations have the potential to change the world in ways that we can’t begin to imagine.
But the world changes in more subtle ways too: even the most mundane businesses can produce exciting investment opportunities. This is where Orbis prefers to look for long-term opportunities – and commodities – despite their seemingly “old-school” reputation.
According to Forster, companies, governments and, most importantly, consumers are starting to care a lot more about how and where products are sourced. Second, and just as important, technology is making it easier to reliably track goods back to their origin.
Orbis believes that the combination of these two developments – a greater desire to identify the origin of what we consume and the ability to do so with precision – will lead to both structurally higher prices for certain commodities, such as aluminium, and greater price differentiation.
Lamb said shares of commodity producers have been one of the few investments to lose money over the past two decades. “More recently, commodity producer earnings started to recover strongly off a very low base. This is partly due to economies starting to open up in the wake of the pandemic, but Orbis also sees clear evidence of subdued supply response as externalities are driving up costs.”
The market does not appear to believe that these earnings will be sustained, Lamb said.
“Valuations in the sector remain very low, with free cash flow yields in the teens for many producers. Sustainable positive change coupled with deep scepticism is typically a very favourable combination for investors.”
5. How does Allan Gray incorporate ESG thinking into its portfolios locally?
Raine Naudé, one of Allan Gray’s ESG analysts, told the Investment Summit that the asset manager spends considerable time trying to understand what a company’s sustainable free cash flow will be.
“In our view, companies that operate unethically or do not appropriately manage their social or environmental externalities face a greater risk of cash flow erosion over the long term. This can manifest in multiple ways, including regulatory fines, loss of an environmental permit or social licence to operate, or reduced demand for products due to reputational damage or shifting societal preferences.”
Lamb said Allan Gray focuses its research and engagement efforts on ESG issues that are most material to each company, rather than applying a cookie-cutter approach.
“Every company research report we write includes an ESG section and, when material, we try to quantify ESG risks or opportunities in our fundamental valuations. We may also limit the size of our holding in a company, or choose not to invest in it, if the ESG risks are significant.
“We further integrate ESG into our engagement with company boards and management teams and by making carefully considered proxy voting recommendations to our clients. Our portfolio managers are ultimately accountable for managing the ESG risks in our clients’ portfolios, but we also report to our board of directors biannually.”
Lamb said it was easy for Allan Gray – or any asset manager – to explain how it incorporates ESG factors into its analysis and process; it is harder to apply this consistently over time.
“We would caution against investors taking undue notice of attention-grabbing headlines, which tend to oversimplify what is a multi-layered issue.”
Allan Gray pays “particularly close attention to the governance pillar”, because “as shareholders on behalf of our clients, we are not involved in the day-to-day running of companies and therefore rely on executive management and boards to act responsibly”, Lamb said.
“We assess management’s alignment with long-term shareholders by evaluating how they are incentivised through executive remuneration schemes. We also consider the board’s expertise and independence to be able to provide effective oversight. Finally, studies show that stronger governance is generally associated with stronger company environmental and social performance.”
Lamb said the intersection of the environmental and social pillars should be appropriately weighed up.
“As Raine noted, so far, environmental considerations have been in the driving seat; however, reducing the E has an impact on the S, and the Covid-19 pandemic has further accentuated deep inequalities in many countries, with potentially severe consequences, as the July riots and looting in South Africa showed. Overlooking the social aspect of ESG is as much of a global risk as failure to act on environmental issues.”