Finding the balance

By Rob Johnson & Iain Power

I start every morning of lockdown with a cup of tea, but my enjoyment of it varies. There are a number of factors which can lead to a sub-optimal tea-drinking experience.

I will focus on the most important one, which is definitely the temperature of the tea. There is a fine balance between too hot to drink comfortably and a lukewarm, herb-infused morning milk. For me, the most influential factor to missing the perfect temperature however, is children!

To achieve an optimally balanced portfolio of assets, Truffle, our fund manager partner for the Nedgroup Investments Balanced and Managed Funds, have to consider an impossibly large number of factors that could influence positions in the funds. Many are quantifiable, but some may be completely unexpected, like a global pandemic and global economic collapse. How is it possible to position a portfolio to weather such an event?

It is important to note that Truffle did not sagaciously predict that COVID-19 would introduce an unprecedented supply and demand shock to the global economy. They had positioned the funds defensively with a relatively low equity exposure. They felt markets were expensive at the start of the year and reduced equity exposure accordingly in January and February by selling down physical exposure and using derivatives. The cost of purchasing equity market protection had fallen significantly in January, which enabled the purchase of put options on the S&P500 index.

The result was a muted downturn in the Funds’ price during the first quarter of 2020, losing less than 9% while the SA and global equity markets fell more than 21%. The Funds’ ASISA peer group average lost more than 13%.

Even though the effect of the pandemic and government responses have been felt globally, the impact on locally listed and focused businesses has been far greater given the already precarious economic environment in South Africa. Hence, the Balanced and Managed portfolios benefitted from overweight to defensive offshore exposed businesses. The consistent earnings stream from tobacco and British American Tobacco’s low valuation resulted in an overweight position that contributed positively in the first quarter of 2020.  Comparably, Naspers’ link to a resilient, online Chinese consumer and investments in a suite of diversified businesses, that are yet to monetise profit streams, also offered protection.

The diversification of the portfolio in bonds and overseas assets, combined with this specific focus of the SA equity element to achieve a protective balance, has served investors well relative to broad market declines.

Given that the US stock market could have been considered expensive on most metrics before the 24% fall from its peak, the S&P500 is not yet offering value. This is coupled with an impending global recession and high corporate debt levels, which are under immense pressure and will most likely continue to weigh on global markets. Truffle are now deliberating news on economic data, potential vaccines and infection rates, just some of the factors that will continue to drive significant volatility going forward.

This poses the next big question. How do we find the right balance of holdings in order to position the portfolio for the impending environment?

As the second quarter begins, the funds remain defensively positioned. Particularly considering the 20% rebound in equity markets from the low of 23 March to 8 April, the funds maintain low local and global equity exposure. Truffle will be looking to increase equity exposure with a meaningful sell-off, subject to finding compelling investment opportunities, such as Netease, which come with exposure to gaming that should be resilient in the current environment.

The property sector remains unattractive. The lockdown has placed significantly more pressure on property companies, which is being acutely felt in the retail sub-sector. Rents will prove difficult to collect and valuation downgrades will result in dangerously higher loan to values for many property stocks.

However, Growthpoint, which sold off aggressively, has provided cheap entry into one of the higher quality property companies.

Floating rate fixed income returns remain attractive despite a gradually lower repricing over the next 3 months due to the Reserve Bank cutting interest rates by 1%. The floating rate corporate credit market was yielding a return of around 9% to 9.5% and even if spreads widen by 80 -150bps, a return in excess of inflation of around 5% on quality assets still looks possible.

Within locally listed equities, it is prudent to remain cautious on domestically focused companies and maintain a preference to offshore earnings.

Domestically focused companies do not purport to offer significant upside given SA’s low growth environment and lack of necessary structural reforms. A global recession will increase the pressure on many domestically focused companies and hamper the ability of the state to repair the fiscus. Valuations have improved, given the significant sell-offs in certain sectors and shares, despite the uncertain outlook.  As a result, there may be opportunities to increase exposure to sectors that should be better shielded from the economic fallout, such as hospitals. Many other domestic sectors are temporarily shut down or may suffer from depressed consumer demand when the lockdown period is over.

Banking sector earnings is another area that should be more defensive; they are on balance well-managed businesses and the sector offers high liquidity. There are concerns around higher credit losses and exposure to property finance, but the SA banking sector balance sheets are robust and a temporary weaker period is more than discounted in their significantly lower prices.

The outlook for the mining sector will be challenging over the short term due to the expected demand contraction arising from the impending recession. The direction of precious metals is an intriguing question of balance. The case for a positive view on the platinum group metals (PGMs) has existed since the second half of 2018, due to growing deficits in palladium and rhodium on the back of both a lack of investment in supply and tighter auto emission standards driving growth in demand. However, the risk of deficits turning to surpluses in an environment with greatly reduced motor car demand is a key consideration, alongside a significant rise in the share prices of PGM miners. Additionally, gold should be supported by low interest rates and global growth in debt as a result of fiscal stimulus.    

Looking forward to the next stage of this unprecedented blend of influencing factors and given the high levels of volatility and more attractive valuations, it can be viewed as an opportunity to increase equity exposure. However, it remains prudent to specifically seek higher quality, globally focused stocks, with strong balance sheets which should be better positioned to survive the current crisis. The recovery in the fortunes of these companies is likely to be much faster than many of the domestically focused businesses, which are likely to see far bigger earnings declines.

Every day and with each early morning cup of tea, a new set of factors present themselves for contemplation. It is very important to absorb the information provided and carefully interpret the impact it may have on your assumptions for the performance of any investment you hold. Accepting that it is impossible to predict the next wave of disturbing data, the crucial thing to concentrate on is finding the right balance of holdings to give you the highest chance of achieving your stated objectives.