The core Electus philosophy and process has been in place for 10 years.
Our key focus is on bottom-up investing, where we analyse, value and invest into companies based on a normalised level of sales, margins, profits and cash flows. As an example of this process in action, in 2007 to mid- 2008 we were able to avoid investing additional client funds into the resource and construction companies. During this time there were super-cycles in place, which led to well above 'normal' level of global commodity prices and South African fixed investment spending. While the top-down environment for global commodity prices and South African fixed investment spending looked very attractive in 2007 to mid-2008, at Electus we only invest in companies when the bottom-up valuations (using metrics indicated above) are attractive.
Warren Buffett once said, “Investing is simple, but not easy”, and we would agree with this statement. While the above comments might seem simple, it does require a very sound framework of top-down macro-economic (macro) understanding to work out what is ’normal’ in terms of key macro factors. Once we have determined the normal level of key macro factors, we have a framework that enables us to analyse and value South African companies.
Adopting a sound framework
While top-down macro factors have largely determined market returns since the 2007-2008 global financial crisis, these factors are often unforecastable. With a sound framework of top-down understanding, the vast majority of our skills, time and effort are best spent analysing, valuing and investing in companies on a bottom-up basis. Our performance track record has a very strong positive bias towards share selection rather than sector allocation and this will always remain the case.
When seeking to build our framework for a top-down macro understanding, we are well-supported by several leading economists and the Bank Credit Analyst group. Within our top-down framework, the key macro factors that form part of our analysis include commodity prices, current accounts, currencies, inflation, interest rates, government bond yields, country growth rates and equity markets. This analysis must be done as unified research, as all of the macro factors are inter-related and are interdependent when gauging their normalcies.
When analysing South Africa’s top-down framework, we know that the timing and order of macro events is broadly as follows:
- Commodity prices are important as we are an exporter of many resource commodities, such as iron ore, coal, platinum and gold, and an importer of oil.
- Commodity pricing therefore has a significant impact on South Africa’s current account and on whether we have a current account deficit (normally the case in SA) or a surplus.
- As South Africans, we are not good at saving (and we do not have a reserve currency, such as the US dollar), our current account is a key aspect in determining the levels of the rand relative to our key trading partners.
- The rand has a material impact on our level of inflation, with a weak rand often occurring at the same time as weak commodity prices, leading to a higher cost of imports and increased inflation.
- Inflation is the key determinant for the Reserve Bank in setting interest rates, with the goal being to keep inflation within a 3% to 6% range. Both inflation and interest rates are key determinants of government bond yields.
- Finally, interest rates impact consumers and corporates and their ability to spend and borrow, which in turn, have an impact on household consumption and South Africa’s GDP growth rate.
Over the past five years, post the commodity super-cycle and the global financial crisis, South African growth has been strongly supported by the following:
- large increases in public sector hiring and above-inflation wage increases
- large increases in social grant recipients and spending
- strong growth in unsecured lending, with high personal indebtedness versus history
The risk to this specific framework is that the SA government no longer has any levers to pull to stimulate growth. There is no room for overspending; the rating agencies are watching us closely regarding potential downgrades, and interest rates are likely to slowly rise.
When we aggregate all our company valuations on a bottom-up basis, we believe that the SA equity market is fairly valued. We have been using this normalised methodology for determining the fair level of the SA equity market since the beginning of 2009 and it has proven to be very accurate. The big decision in the equity market is when to buy resource shares more aggressively, as they now trade at extremely low Price/Book levels and all commodity prices are trading below our normalised levels.
The counter to the above comment is that the other big decision is when to sell some of the high quality domestic consumer industrial shares. These shares have performed very strongly for the past six years, heavily supported by government employment and wage growth, social grant increases and unsecured lending growth, which, as discussed above, are all indicators that are now having to slow down dramatically.
Over the past few years, the South African equity market has been driven by a few key style analysis factors, such as high earnings momentum and high price momentum. The negative style analysis factors have been typical valuation based methodologies such as low Price/Earnings and low Price/Book multiples.
While we always operate in a ‘no excuses environment’, we believe that the above Style Analysis Chart will look materially different in the next couple of years, with much less emphasis being placed on 'momentum' investing, which has been the winning strategy since 2011. We have no doubt that our top-down macro framework is in the process of normalising, with interest rates having bottomed and beginning to rise in the developed countries from their historically extremely low levels. We believe that equity markets will start paying greater attention to valuation (not value) related criteria such as Return on Capital and Price/Earnings ratios, which is totally aligned with our bottom-up methodology of investing.
On aggregate, we believe that the SA equity market is fairly valued, but through our rigorous research process, we have been able to identify specific opportunities. This has resulted in the Nedgroup Investments Growth Fund currently having a high margin of safety, with 15% of upside relative to the SA equity market.