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Wednesday, July 1, 2009
Keep you dogs

One of the most telling signals that an opportunity exists within any market is when investor interest turns from outright optimism to utter disgust and then to complete apathy, notes Adrian Clayton of Alphen Asset Management. He was writing in a recent Alphen Angle electronic newsletter (visit: www.alphenam.co.za).

“I can point to many such examples in the past 15 years since South Africa was reintroduced into the global economy. The most noteworthy examples are the shunning by global investors of emerging markets, resource companies and South African assets in the late 1990s. In all instances, these subsequently became some of the best places in which to have your money invested,” he says. “Conversely, the darling investment destinations of the last decade, namely, IT companies, financials and developed markets, became the dogs of the new millennium.”
This is how markets work. The investment herd has an uncanny ability to continue to back yesterday's winner and forego yesterday's loser and to extrapolate immediate historical trends. “Clearly, though, the evidence points to this herd-like behaviour producing sub-par returns and the clever money focuses on purchasing assets that are unwanted and cheap and waits for these to become the next market favourites.”
With this theory of betting against the trend, it is interesting to note that amongst the asset classes that are accessible to South African investors, offshore assets, and most notably offshore equities, have proven the worst place to have had your money in the past decade. In fact, an investment by a South African investor, over the past ten years in the Morgan Stanley Capital Index (the MSCI), an index representing all the largest markets in the world, would have returned 0%.   Whilst zero is alarmingly poor over a ten year period, it is worth pointing out that this is in rand terms and the weakening rand has actually assisted performance. A dollar investor who purchased the same index would have lost 21% over the ten years. Looking at the S&P 500 Index over the same ten year period to the middle of 1999 in dollar terms, the fall has been 36%. 
So, with offshore having proved to be a dog of an investment is it time to bring all your money back to South Africa?
The following five reasons are exactly why you should not be doing so:
Mean reversion. Markets have an uncanny manner of delivering a relatively consistent return over the very long-term but experience periods of gross under or out-performance during certain cycles. Subsequent to extremely good or poor periods, in order to 'revert' back to long-term 'normal' or average returns, the market can generate extreme returns - either good or bad in the opposite direction. In the case of the performance of major indices abroad, it is worth noting that since 1954, the return on the S&P has averaged 6.2% per annum. From 1991 to 2000, however, the return on the S&P was 17%, a great deal higher than the long-term average. It could be argued that a process of mean reversion subsequently occurred and for the following ten years the annualised return in America was -4%. The market was in effect taking back its previous abnormally high returns. This does not imply that the US and other major global markets should continue to deliver negative returns in the foreseeable future, although many investors are now of the view that offshore markets will. In fact, it is easy to argue that to a large extent much of the excesses have now been removed and returns could prove more normal in the future.
The strong rand. “We constantly inform our clients that removing capital from South African shores based purely on rand weakness is not a sound investment approach,” observes Clayton. “This does not mean that astute investors should not take account of currency movements, particularly rand strength to position capital abroad.” Since 1981 the local currency has weakened on average by 8.7% per annum against the dollar, but has tended to produce bouts of stability followed by extreme instability. Sudden weakness is often followed by subsequent strength but the currency then stabilises at levels weaker than the previous average trading range. The rand will continue to weaken against currencies where our inflation rates are higher than those of the countries being compared against. “This means a weakening bias against most developed market currencies over time is most likely. We view present rand strength as an excellent opportunity to diversify capital geographically for clients taking a long-term investment view.”
The world is large. As proud South Africans we perceive our country as the centre of the universe. In truth, from an investment perspective, we are a small player. The JSE accounts for a mere 7.46% of the MSCI Emerging Market's Index and less than 1% of the MSCI World Index. The obvious question must then be why South African would consider exposing most and in some cases all of its capital to a market representing such a tiny fraction of the world's financial system?
Country and market specific risk. Investing offshore diversifies an asset base geographically. It prevents capital from being totally exposed to one country's social and political risks and it captures economic trends that exist outside one geographic region. Whilst the JSE is a superb market with many economic subsectors, it is a highly concentrated market with commodities accounting for a disproportionately large slug of our index. Many world class industries such as biotechnology, shipping, aviation, energy, information technology and pharmaceuticals are under-represented in South Africa. Many of those have good long term growth prospects and can only be accessed on offshore markets.
Most foreign markets, particularly developed markets, are no longer expensive. Emerging markets, including South Africa, are not ridiculously cheap relative to developed markets any longer. Emerging markets were relatively cheap late last year and have subsequently rerated. The P/E on emerging markets is now 13 compared to developed markets of 14. In fact, for certain industries in emerging markets, most notably information technology, utilities, insurance and consumer staples, the rating is higher than in developed markets. Thus, in these areas, emerging markets look rather expensive. With the JSE being an emerging market, it will be treated in a homogenous fashion with other emerging bourses by investors as they choose to invest or disinvest and we should expect continued volatility now that it has rerated. This calls for looking more broadly at other options.

“In conclusion, whilst South Africa certainly offers rewarding investment opportunities, never forget that the world's investment landscape is infinitely diverse, laden with prospects and these are no longer at prices fit only for kings,” says Clayton.

Copyright © Insurance Times and Investments® Vol:22.7 1st July, 2009
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