Download a copy of our latest newsletter here: REZCO Asset Management Quarterly Newsletter – 20150331
We continue to believe that a conservative investment stance will provide the best balance between risk and reward for our clients. The Rezco Value Trend Fund and Rezco Prudential Fund ended the quarter with equity levels of 49.3% and 53.5% respectively. This is low relative to the 75% that may be invested in equities.
In the current market, we believe investors need to give significant attention to both parts of the ‘Preserving Capital – Creating Wealth’ equation. Opportunities do exist to achieve moderate returns, albeit at lower levels than during the past five years, but investors should practise heightened risk control.
Fund performance continued to be robust and ahead of benchmark for the period to March 2015. The Rezco Value Trend Fund outperformed the JSE All Share Index for the year, as it has consistently done over 3 year, 5 year and 7 year timeframes. The Rezco Prudential Fund also outperformed the JSE All Share Index for the year. Our intention at this late stage of the bull market is not to try and hit the ball out of the park but to conservatively chip away at achieving low double digit to high single digit returns. The funds had a high cash level during the past year, but due to the strong showing of the equities and property shares selected, excellent outperformance was generated. The local equity portion of the balanced funds achieved a total return of 16.2% compared to the JSE All Share Index at 12.5%.
This, along with a robust return of 22.3% for the foreign portion of the fund, enabled the funds to outperform the JSE All Share Index, whilst having a large portion of the portfolio in low risk cash to provide insurance against negative market developments.
SOUTH AFRICAN EQUITY FUND
The newly launched Rezco Equity Fund, on its first birthday, obtained a return of 4.2% better than the JSE All Share Index. The objective and pricing of this fund is to provide Active Management at a Passive Fee . The fund handsomely achieved this objective.
The current market environment is unique. Part of what we see is extremely familiar, yet there is a whole dimension that is completely new.
What is familiar during the later stages of a Bull market?
South African equity valuations are stretched yet move higher as each quarter passes.
Most portfolio managers agree that the South African equity market is overvalued yet valuations are continually moving higher. In many cases, this is in contradiction to weak fundamentals. We like to invest with a large margin of safety but this is hard to find at the moment. Expensive markets are where accidents happen, not cheap ones. International shares, though moderately expensive, are offering far better value than South African ones.
At this stage of the market, valuation methods move away from absolute value toward relative valuations.
Any asset price can always be incorrectly justified as being ‘totally reasonable’ in relation to some other asset. A good example of this is asserting that because some Mexican clothing retailers are valued at more than 30 times earnings, South African retailers must be worth the same. This logic feels right but is deeply flawed, as Mexico and South Africa are very different on a host of issues that go into the valuation of a company. Secondly, the proposition may be completely false if Mexican shares are themselves over-priced.
Over-paying for an asset in the belief that there is someone out there who will pay more is not, in our opinion, a good way to create wealth. In the art world, this strategy can sometimes work spectacularly. However, equities are not collectors’ items but instead pieces of a real business, which gives you ownership of a portion of the earnings.
Our investment approach is about trying to value the future earnings stream that we are buying. The excesses of the market in this regard can be observed as the values of many well-known internet companies spiral ever higher, with total disregard to earnings power.
The table below details company value and earnings. It is immediately apparent that many of these companies do not have earnings; in fact some do not even have sales. We are cognisant of the fact that the next Google could be among these, but there is just no reliable way to forecast this. I personally did not think that the Dotcom bubble would re-occur within 15 years, but this is exactly what we are seeing with these valuations.
According to Benjamin Graham, ‘the market in the short term is a voting machine but in the long term the market is a weighing machine’. We believe this to be true and that reality always wins out in the medium to long term. Companies eventually need earnings to justify any valuation.
Unsophisticated investors start clamouring for more risk in their portfolios, instead of less.
In talks around the country with seasoned advisors, I am continually hearing about some of their clients who, at the bottom of the market in 2009, demanded to be totally out of equities but now, after six years of rising share markets, are demanding more equities in their portfolios. The current market has started to ignore risk and is focused mostly on the upside. Excessive optimism has proven time and again to be an opportunity to sell not to buy.
WHERE THE MARKETS ARE IN UNCHARTED TERRITORY
Much of what we see is very common for the later stages of a bull market but there are areas where we are in unchartered territory. This mostly has to do with the Quantitative Easing (QE) splurge by central bankers around the world, who have printed about $10 trillion of new money to date. At the start of this process it was called ‘Unconventional Monetary Policy’ but as things have progressed, printing money has started to become a standard and much-loved tool by central bankers around the world. It is extremely hard to fathom how this will all unwind ‒ and unwind it must.
The world has been operating on a close to zero risk-free interest rate for over six years now. Since the risk-free rate is the starting point for many financial valuations, this is indeed a massive distortion. Just how massive this is can be seen from the graph of the Bank of England base interest rate.
Due to the outsized distortion of worldwide QE, the rates are significantly lower than at any time during the last 300 years. The graph adequately highlights how unusual near-zero interest rates are. Unfortunately, very low interest rates have been ‘hard coded’ into investor assumptions. Zooming the time frame down to the last 50 years and looking at USA rates this time illustrates how unusual zero percent short-term rates actually are.
Optimists believe central bankers have it all under control and that the process will unwind rather benignly. Pessimists would argue that printing money, lending it to yourself and then using it to pay for goods and services is a classic example of instant gratification but with possible significant long-term consequences. We are positioned between these two views but with a heightened level of caution should it all unwind badly.
The range of possible outcomes for investment markets is therefore very wide. It is certainly possible that the massive liquidity in the world’s financial markets will push the price of any financial asset significantly higher. Conversely, this massive liquidity may result in unforeseen consequences that would entail the central bankers having to mop up the liquidity and rapidly increase rates, which would be very bad for investment markets. In short: the equity markets could halve or double from here.
Bonds allow us no safe haven because if interest rates rise, losses could be significant for this asset class. This is amplified by South Africa being an emerging market, with our bonds correlating positively with our equities. So when our equities are weak, our bonds are also very weak.
INVESTMENT STANCE GOING FORWARD
The luxury of leaving the market entirely to wait for better valuations is not sensible as the market may go a lot higher. Conversely, significant unquantifiable risks currently exist in the investment markets, vastly increasing the possibility of significant capital loss.
The solution to managing this contradiction is to stay invested at moderate levels but to be extremely alert to possible risks that may require reducing equity exposure rapidly. Selective stock picking will be critical going forward.
We have been doing significant work in the construction of our Unit Trusts to make sure that the investment portfolios are robust and able to manage the volatility and range of scenarios that we face.
We advocate a flexible approach with high regards to risk control as having the highest chances of success over the next three years.