We’re back. I’m not convinced anyone had noticed, but the monthly market summary from the team at K2 Capital has enjoyed an extended vacation. Let’s just use the excuse of end of year mayhem and writer’s block and leave it at that. The good (possibly bad) news is that we are more excited than ever to be sharing some of our thoughts about all manner of investment and worldly topics with you in 2017. We set ourselves two very simple objectives in writing the monthly market summary.
1. We want to share our views with clients and interested parties.
Developing an investment strategy is idea driven. Our clients seek our assistance in formulating a plan that is both understandable and relevant. We believe it is important to communicate not only what we are thinking but more importantly how we think about it. In a financial world dominated by numbers, we use the market summary to engage our clients with the philosophy behind our approach to money management. If we can do this with a single example once a month, we feel we have struck a good balance between ‘interesting’ and ‘overwhelming’.
2. We want to demystify some of the jargon and noise that characterises our industry.
We are fortunate to have a large, varied client base. They turn to us for assistance in growing their wealth. If they enjoyed and understood the acronyms and obfuscation of the financial industry they would probably do things without our help. We see no benefit in perpetuating the confusing language and jargon that characterises financial services. We actively attempt to communicate our ideas and thoughts in a manner that is understood by all our clients, irrespective of financial experience and knowledge. This is not an easy balance to strike so feedback is always welcome.
Whether we successfully achieve these dual objectives is, of course, a matter of personal opinion. It is not our intention to clutter email inboxes unnecessarily. You are receiving this email because you have either requested as much or you have a business association with K2 Capital. If you are not convinced, then your subscription preferences can be managed at the bottom of the page with no offence taken should you elect to unsubscribe. We are hopeful, however, that you do enjoy the read. If this is the case, then feel free to forward to friends and colleagues as you see fit.
Right, let’s kick off by having a look at the regular indicators we track every month. Please don’t forget to click the links to the local and offshore watchlists at the bottom of this newsletter which cover individual funds and shares in far greater detail. The watchlists can also be found on our website at www.k2capital.co.za
||Local listed property
|Rand / Dollar
|Rand / Euro
|Rand / Sterling
We are deep into March already, so I concede that touching on investment returns in 2016 is hopelessly dated. But bear with me as I use 2016 to sketch the backdrop for this month’s letter. 2016 was a year characterised by weak domestic equity returns, strong foreign equity markets, a strengthening rand and a swift rotation of ‘expensive’ defensive shares into ‘cheaper’ cyclical counters. In a South African context, this last theme played itself out in the rand hedge companies like Aspen, Mediclinic and Naspers significantly underperforming the commodity stocks like Anglo American, Kumba and Impala Platinum. The winners of 2015 were the losers in 2016 and vice versa. There is no need to get lost in the detail of individual share price movements. The lesson from the last couple of years is to continually remind yourself of the need to remove emotion when making prudent decisions about where to invest your money. Cast your mind back to January 2016. We were all still reeling from Nenegate. The rand was falling like a stone, a strong barometer of the mood of the country. Our bond market was being priced for junk status. An investment portfolio relying on a stable and strengthening currency, no political ’own-goals’ and a pro-South African theme was the last thing on investors’ minds. We all fell victim to the natural human instinct of using recent painful experience to influence future decisions. We would have panicked, taking as much money offshore and sold as much of our South African assets as was feasible. The risk here is the devastating impact on long term portfolio returns when decision making is driven by fear and panic instead of logic and value. Success in investing requires a combination of patience and contrarian thinking. It’s less about being different for the sake of it and more about understanding that herd mentality drives irrational pricing. And irrational pricing leads to emotional decision making. And emotional decisions result in poor portfolio outcomes. But being different isn’t easy or comfortable. But it’s often necessary, because we run the risk of glossing over important detail when we rely on headlines and 160 character tweets to form opinion. One of our roles at K2 is to act as this voice of reason on behalf of our clients and we often arrive at unusual conclusions when we do this. We don’t always get it right. We are, after all, also behavioural animals. But as time evolves we are getting better at spotting the opportunities to walk away from emotion.
Let me use a simple example to illustrate this.
The local equity market (measured by the JSE All Share Index) generated a meagre return of 2.6% last year. In addition the historic Price:Earnings ratio (PE ratio) was sitting at an all-time high of 22.8 at the end of December. This is comfortably above its long term average of 15.1. Would this combination of weak short-term returns and a record breaking PE ratio lend itself to making an investment in local equities? You wouldn’t be alone in saying ‘no’. Yet, a strong case could be made for being more optimistic about the return potential of local equities in the next several years than could be made in the last couple. Immediately the local equity bears and some of my peers will point to continuing political uncertainty, dismal GDP growth and general uncertainty as reasons to be shunning the local market and laughing my suggestion off. I would respond by highlighting that the market has the potential to exceed their return expectations in spite of their fears (most of which I don’t disagree with). How can this be? Well the first reason is a behavioural one. If your expectations are low, the odds of getting a positive surprise are that much greater. If everyone is a cautious bear, it’s often less risky to be a contrarian bull. The second reason is mathematical. Share prices will react positively when underlying earnings growth supports valuations, even if the actual earnings are weak.
Ok, it’s almost guaranteed that I have completely lost some of you. Let’s put this into plain English.
Here’s a picture of the famous PE Ratio of the local market in December 2016. I’m grateful to Investec Asset Management for allowing me to use their slides for this. You don’t need to be a technical analyst for this one. Rule of thumb – the higher the line on the chart, the more expensive shares are. You want this line to be trending down for value to be returning to the market.
So far so good? All still with me? Excellent.
Now here’s the same chart as at the end of February 2017. Notice anything happening to the line?
To arrive at a PE ratio, you put the price of the share in the numerator and the earnings of the share in the denominator and hey presto, you get the ratio. So, by way of simple example:
For a full breakdown of fund and individual share movements, kindly click on the links above to access the February 2017 Local and Offshore Watchlists.
Company X share price is R100 per share.
Company X earnings are R10 per share.
Company X PE ratio is 10 (100 divided by 10).
For the ratio to decline, which is what I am arguing is currently happening, either the share price needs to drop or the earnings of the company need to increase. In my example above, if the share price halves to R50 while the earnings stay the same at R10, the PE ratio declines to 5. So too if the earnings double from R10 to R20 and the share price remains at R100. The PE ratio will also decline to 5. In the real world, it’s usually some combination of both. But for investors, share price declines are painful. Far better that the PE decline be driven by earnings improvements for mental wellbeing. So in the absence of any share price decline, better than expected growth in earnings will lead to the PE ratio declining. And this, dear readers, is exactly what is happening right now. After a backdrop of a contracting economy, very weak currency and collapsing commodity prices, many companies have seen their earnings declining over the last few years. And while the business and political environment is in no way conducive to strong prospects, there is every likelihood that an earnings trough has been established and things will start improving. It’s called a normal business cycle and the ability to position portfolios correctly is wholly dependent on taking a view of future events.
Let me pause here, and highlight a critical point. It’s very important to dispel the linear conclusion that as the PE ratio declines and shares get ‘cheaper’, that the market automatically goes up. This is not the case. In the two months between the two charts above, the JSE has only delivered a return of 1.1%. There are many, often unrelated factors at play. But it’s a fundamental rule of thumb that at some point in time, a low PE ratio will provide a useful clue when thinking about future equity return potential. If anything, it will turn the bears into bulls and money will find its way into the market. But it just might be too late.
We are cautiously optimistic about the year ahead. We have come off a torrid 2016. We were all tested emotionally and pessimism levels were at the highest I have seen in my career. But like Joburg in early autumn, the nascent signs of a change of season bring with it all the expectations of something new and pleasant. Generally speaking, I get a sense of corporate earnings being stable, we are beginning to understand our politics a little better and almost certainly most South Africans are gaining a far greater appreciation that currency and leadership problems are not unique to us. The mood is tangibly positive. I know it may not feel like this at times, but this is my sense. And mood and human psyche are powerful forces in investment markets.
GDP growth and productivity
Stats SA released our GDP growth numbers last week. The South African economy contracted an annualized 0.3% in the three months to December 2016. It was the first contraction since the March quarter of 2016 driven by decline in mining and quarrying and manufacturing. GDP growth has averaged 2.90% from 1993 until 2016, reaching an all-time high of 7.60% in the fourth quarter of 1994 and a record low of -6.10% in the first quarter of 2009. So we have certainly had our fair share of booms and busts. We all know our GDP growth is too low to grow the economy in real terms and create the jobs we need. And even if we had supportive economic growth we suffer from small business red tape, rigid labour laws and uncompetitive productivity to compete globally. Our politicians continually talk about the number of jobs that need to be created. There is very little talk about the contribution of these jobs to our country’s productivity and efficiency. It is only by being competitive that we will grow our economy. A country with full employment of low paying, unskilled jobs remains as poor as it always was. So it was with this backdrop that I was fascinated to read that the Japanese government has introduced an unusual scheme to reduce working hours. It’s called Premium Friday and aims to force Japanese workers to leave their job several hours earlier on the last Friday of every month. It turns out that the Japanese are literally working themselves to death. They even have a word for it – ‘karoshi’, or ‘death by overwork’. The phenomenon has existed for years but the government introduced Premium Friday after the results of the investigation into the suicide of Matsuri Takahashi were released. Takahashi, a young employee at the largest employment agency in Japan, threw herself off her employers building in late 2015 after becoming depressed from overwork. She had clocked 100 hours of overtime that month alone.
It’s remarkable to think that death by overwork has come to be an accepted part of Japanese corporate culture. I mean, we all know that the Japanese are hard workers, but karoshi! And then I read an even more startling statistic. According to 2014 figures from the Japan Institute for Labor Policy, Japan has the highest percentage of workers working over 49 hours per week among the G-7 nations. However data from the Japan Productivity Centre indicates that the country also has the worst productivity among the group. So in G-7 terms, they are the hardest workers and at the same time the most unproductive. Citizens suffer from karoshi and the country doesn’t really gain! Clearly not even the Japanese understand the difference between hard work and productivity. Hopefully you won’t make that mistake.