The Tour de France is arguably the ultimate race in road cycling.
It is an annual race that spans over 23 days with 21 days of grueling riding. Riders endure many ups and downs, mentally and physically. They battle weather conditions, fatigue and constantly have to focus on not falling, or getting up after a fall. There are stage winners, but only one ultimate winner.
The rider that manages his diet, his strategy and his body the best emerges as the ultimate winner at the end of the tour. This is synonymous with managing a fund.
There are many stages (years) and there are many ups (Naspers) and downs (Steinhoff/ Covid). Throughout the journey, one has to try and protect the fund from falling (hedging), and quickly get back up after a fall. Ultimately one has to manage the fund to a strategy to win over the long term.
The Nedgroup Investments Opportunity Fund just finished the 10th stage of its race. It is managed according to a strategy that aims to win over the long term. In this article we reflect on the first 10 stages, and evaluate whether the strategy worked, and its relevance at this stage of the race. We will also try and look at what the conditions are going forward and how the Fund is positioned for these conditions.
The Nedgroup Investments Opportunity Fund was set up in June 2011 with the following dual objectives:
- Performance objective: Achieving inflation +5% returns over the medium-long term
- Risk objective: Not having a negative rolling 24m return
Looking at the performance objective, it has been an ambitious goal for a medium equity (maximum 60%) portfolio and a tough objective to achieve. Returns from most asset classes were subdued as South Africa battled through one of the roughest periods in our history as corruption ravaged our economy and incapacitated many of our critical state institutions. This, combined with regulatory red tape, hampered the ability of local companies to deliver meaningful inflation-beating earnings growth. The deteriorating fiscal position kept our bond yields at high levels, providing a decent running yield while giving no capital growth.
While the Fund managed to achieve the objective on a gross basis, it has fallen marginally short of achieving the objective on a net basis, having returned 9.8% p.a. versus CPI+5% of 10.2% p.a. since inception. On a relative basis, the Fund has performed well, having out-performed the peer group average by 1.5% p.a. since inception, which places the Fund among the top decile of the peer group.
The risk objective of avoiding negative rolling 24-month returns was met in 94 out of 97 rolling measurement periods, with the only 3 periods not meeting this objective being the three months around the March 2020 Covid sell-off.
Relevance of strategy
As the Tour de France evolves, riders adapt their strategy to the changing conditions and manage the race within the available opportunity set. The course for fund managers over the last 10 years has also been characterised by many changing conditions and surprises, which they have had to adapt to.
Achieving an inflation plus 5% target has been a tough ask for any multi-asset fund as evidenced by the chart below.
One has to ask whether this objective is achievable over the next ten years, or whether the strategy should be adapted. Looking at the current opportunity set in the markets, we at Abax believe this objective remains relevant. This belief is supported by:
- A positively changing domestic political and economic environment
- Attractive equity valuations at this point in the cycle
- Real returns on offer in long bonds
While there are many additional supporting reasons, we will focus on these three.
Changing political and economic environment
The last decade can be described as a lost decade under the political stewardship of Jacob Zuma. Endemic corruption hollowed out government, state owned enterprises and municipalities. Valuable resources were misallocated from an ailing economic infrastructure into the pockets of a greedy few. Our state coffers were ransacked to keep supporting the ever-growing list of beneficiaries while the ‘obstacles’ to the looting were systematically removed out of key positions. This all incapacitated our economy and the ability of our local companies to grow.
However, with the change in political leadership we have seen a definite change in direction. While it will take years to repair all the damage, we believe momentum will pick up and resources will increasingly be more productively utilised. This creates an environment where our economy can start growing again and where companies will start spending capex again which will ultimately lead to profit growth. This should be conducive to the performance of our local equity market.
Attractive equity valuations
Easy monetary conditions as well as fiscal support have been very supportive for global equity valuations, leading to new all-time highs in many cases. This has not been the case in South Africa with our market, and more specifically our domestic companies, lagging this recovery.
South African equities look cheap on many measures: when compared to developed or emerging markets; relative to its’ own history; as well as relative to normalised earnings.
- 60% of our market has price versus forward earnings that are below their 3-year average multiple (re-rating potential)
- 59% of stocks have forward earnings that are still below pre-covid earnings (little recovery priced in)
- 61% of stocks have current price to pre-covid earnings that are below their 3-year average.
- The South African market is priced at its largest discount relative to both Developed and Emerging markets in the past 20-years.
South Africa has been slow in rolling out our vaccination programme. This led to a resurgence in Covid cases resulting in a third wave of new infections that exceeded the second wave. Positively, a pick-up in vaccinations, combined with increased herd immunity, brings us ever closer to a post-pandemic environment. The South African equity market is pricing in very little of this recovery potential and offers an attractive entry point to investors. In addition to this, some of our larger international companies like Naspers and British American Tobacco also trade at what we believe to be attractive valuations.
Real returns on offer in long bonds
Inflation currently runs at around 5%. An investor can buy a 2037/2040 government bond at 10.3% and 10.4% respectively. Unless the average forward 15-year inflation exceeds the current 5%, an investor can lock in a real return of 5% for the next 15 years. This provides a nice foundation to any portfolio aiming to achieve inflation + 5% over the long-term.
Opportunity Fund current positioning and outlook
The current asset allocation of the Opportunity Fund is as follows:
While global markets look expensive, South Africa continues to offer selective value, so we retain a high local equity weighting. We also have maximum FX exposure in the Fund which should protect against a significant deterioration of the rand. We continue to have a high weighting to structured notes which offers an attractive asymmetric risk/return profile currently. We have increased the duration of the Fund to capture the benefits of the high real return on offer in long bonds.
The Opportunity Fund has finished the 10th stage of its race. During a tough market environment, we are pleased with the performance since inception. We continue to view the strategy of achieving inflation plus 5% and positive two-year rolling returns as relevant and we believe the current environment provides an opportunity to achieve this going forward.
We thank all our investors for their ongoing support and are ready for the challenges that the stages of the race that lie ahead will bring.