The current disparity in markets, both locally and offshore, is creating an opportunity for bottom-up investors like ourselves to generate meaningful returns, but one needs to be discerning. Below Jacques Plaut discusses where we and our offshore partner, Orbis, are currently finding value. You can also watch the 28-minute recording of a recent Zoom webinar on the subject here.

There is currently a huge disconnect between asset prices and incomes. The ratio of US stock market capitalisation to GDP has never been this high. And it is not just shares: House prices and commodity prices are also increasing much faster than incomes, and fears of inflation are on the rise. Danger signs abound, particularly in the US market, and we believe caution is key.

What are the danger signs?

  • Valuations are expensive: It has been a good decade for stocks. If you invested US$100 10 years ago in the MSCI World Index, you would have US$300 today. However, this average hides the fact that a handful of large US stocks have done well, but the performance of the rest has been mediocre.
  • A flurry of IPOs: Another danger sign for the US market is that there is lots of money being raised in initial public offerings(IPOs),a classic sign of exuberance. Nearly US$200 Bn was raised last year, and we are already close to that number so far this year.
  • Excessive demand from retail investors: Towards the end of last year, there was so much demand from retail investors to buy stocks and options that many brokerages could not cope, and they suffered outages.

To emphasise these points, Graph 1 shows that a decade ago, the cheapest stocks were trading on about six times earnings and the most expensive stocks were trading on about 25 times earnings, as shown by the red bars. Today, the cheapest stocks are still trading on six times earnings, but the most expensive ones are trading on nearly 80 times earnings (see the grey bars). It is partly this multiple expansion which has driven the overall market higher.

Source: Capital IQ, Orbis. Each decile represents 10% of the market capitalisation of the FTSE World Index. Valuation uses Capital IQ estimates for two-year forward earnings. Series for 10 years ago calculated using 31 March 2021 market capitalisations and valuations for the current FTSE World Index constituents.

The question is, are these shares trading on 80 times earnings all overvalued and destined to go down? Not necessarily. A lot of the shares in this bucket are high-quality companies that are growing very fast, and it is notoriously difficult to value a fast-growing company. We look at companies in this bucket, but it isn’t our natural hunting ground. In our view, the biggest risk investors face is overpaying and if the expected growth doesn’t materialize, you can lose a lot of money. However, some will undoubtedly work out and do very well for investors.

What do we do in this environment?

In this environment, we continue to do what we have always done: Buy shares for less than they are worth. We try to understand how companies make money, calculate their normal earnings power and free cash flow, and value them based on their ability to pay dividends in the future. We think there is still an edge available in the market by focusing on intrinsic value. We continue to follow the same investment philosophy, which we share with Orbis, and which has proven to deliver results through different market cycles.

Finding value offshore

While the average global share is expensive, the dispersion is also very high relative to history. The Orbis portfolio looks very different from the benchmark: 68% of the Orbis Global Equity Fund is invested in sectors that make up 11% of the MSCI World Index. Orbis sees good potential for outperformance: Compared with the benchmark, their stocks are on lower price-to-earnings multiples and are growing faster.

Orbis is underweight the US and is finding more value in emerging markets than in developed markets, with stocks like NetEase, China’s second-largest gaming company after Tencent, which is trading on 20 times core earnings, but growing fast. Another example is Taiwan Semiconductor, the world’s largest semiconductor foundry. The reason there is a global chip shortage, is because it is hard to manufacture them. This is Taiwan Semiconductor’s moat, and it is very valuable for shareholders.

Meanwhile, in developed markets, Orbis is finding value in some companies that are perhaps a bit more cyclical than average, but where valuations look promising. One example is Mitsubishi, the Japanese conglomerate that does everything from mining to sushi and is trading on six times normal earnings. Another is BMW, which is trading at less than book value. People are currently only interested in electric car manufacturer Tesla. However, we doubt Tesla will have 80% market share in 2030. BMW has its own plans for electric cars. They should have a good year, as they haven’t been caught out by the global chip shortage like the other car manufacturers.

Finding value locally

Similar to the US, in South Africa a handful of shares have boosted the overall return of the FTSE/JSE All Share Index (ALSI). Over the last 10 years, for example, Naspers has delivered a return of 20% per year in dollars. Paper and packaging company Mondi has delivered 15%, Capitec Bank 17%, luxury goods company Richemont 7%. All have contributed to the overall returns.

But there is the other side of the coin: Investors in PPC, which used to be seen as a very high-quality cement company, have lost nearly all their money. Energy and chemical company Sasol, clothing retailer Truworths, telecommunications company MTN, and property investment company Hyprop have all halved in dollars over the last decade. Shares like investment holding company Remgro, retailer Shoprite, and Growthpoint Properties were all seen as blue-chip shares 10 years ago and have underperformed massively. This shows why it is so hard to identify so-called “high-quality companies”. And overpaying, even for a high-quality company, leads to poor returns.

It can be difficult to get a true sense of overall market performance because the ALSI is dominated by Naspers and Prosus. The Capped Shareholder Weighted All Share Index (Capped SWIX) caps weightings to reduce concentration risk and is more representative of what South African managers own, and therefore provides a more balanced view. Graph 2 shows the overall return since the beginning of 2020 and gives you a good idea of how various sectors have come through the COVID-19 crisis. It also shows what you needed to get right over the past 16 months. The sectors in the middle either haven’t moved a lot or are too small to have an impact on overall returns. The sectors on the edges are important and contribute to or detract from returns: If you had a big overweight position in banks, it would have hurt your performance over this period. And if you were underweight global industrials or precious metals, these too would have detracted.

Performance review

Our flagship funds have all delivered excellent absolute returns over the past year but, other than Stable, have underperformed relative to their benchmarks. The single biggest reason for the relative underperformance, is our position in British American Tobacco (BTI). BTI is a cheap share whose price has fallen, but we are still confident in the value of the business. Our intrinsic value for BTI has not gone down, presenting a buying opportunity.

Over three years, performance has been disappointing, as shown in Graph 3. Key reasons for this include:

  • Orbis’ shares have underperformed
  • Our foreign equity exposure was too low
  • We were underweight iron ore
  • A number of SA Inc shares in the portfolio have done very poorly, including Remgro, Old Mutual, KAP, and Life Healthcare

We think that most of these decisions will be proven right over the long term, but of course there is no guarantee.

The above decisions detracted from performance. Contributors to performance over the past three years include avoiding telecommunications company MTN, retailer Shoprite, and most of the property sector. Meanwhile, owning Royal Bafokeng Platinum, and the Zambezi Platinum preference shares issued by Northam Platinum, have also been good decisions.

Graph 4 shows the top 10 local and foreign equity holdings in the Equity, Balanced and Stable Funds. We think these shares are all trading at attractive prices and that you should get good returns from them going forward.

The key message: Even though the overall market has given you a reasonable return in dollars, this still represents an average which often overshadows underlying opportunities. There are in fact many shares which have delivered a poor return and may appear unattractive. In our view, this is where one can look for value. The price you pay matters.

Commentary contributed by Jacques Plaut, portfolio manager, Allan Gray

Allan Gray Proprietary Limited is an authorised financial services provider.

Copyright notice

© 2021 Allan Gray Proprietary Limited

All rights reserved. The content and information may not be reproduced or distributed without the prior written consent of Allan Gray Proprietary Limited (Allan Gray).

Information and content

The information and content of this publication/presentation are provided by Allan Gray as general information about the company and its products and services. Allan Gray does not guarantee the suitability or potential value of any information or particular investment source. The information provided is not intended to nor does it constitute financial, tax, legal, investment, or other advice. Before making any decision or taking any action regarding your finances, you should consult a qualified financial adviser. Nothing contained in this publication/presentation constitutes a solicitation, recommendation, endorsement or offer by Allan Gray; it is merely an invitation to do business.

Allan Gray has taken and will continue to take care that all information provided, in so far as this is under its control, is true and correct. However, Allan Gray shall not be responsible for and therefore disclaims any liability for any loss, liability, damage (whether direct or consequential) or expense of any nature whatsoever, which may be suffered as a result of or which may be attributable, directly or indirectly, to the use of or reliance upon any information provided.

Allan Gray Unit Trust Management (RF) Proprietary Limited (the “Management Company”) is registered as a management company under the Collective Investment Schemes Control Act 45 of 2002, in terms of which it operates unit trust portfolios under the Allan Gray Unit Trust Scheme, and is supervised by the Financial Sector Conduct Authority (FSCA). Allan Gray is an authorised financial services provider and the appointed investment manager of the Management Company and is a member of the Association for Savings & Investment South Africa (ASISA). Collective investment schemes in securities (unit trusts or funds) are generally medium to long-term investments. Except for the Allan Gray Money Market Fund, where the Investment Manager aims to maintain a constant unit price, the value of units may go down as well as up. Past performance is not necessarily a guide to future performance. The Management Company does not provide any guarantee regarding the capital or the performance of its unit trusts. Funds may be closed to new investments at any time in order for them to be managed according to their mandates. Unit trusts are traded at ruling prices and can engage in borrowing and scrip lending. A schedule of fees, charges and maximum commissions is available on request from the Management Company.

PerformancePerformance figures are for lump sum investments with income distributions reinvested. Actual investor performance may differ as a result of the investment date, the date of reinvestment and dividend withholding tax. Movements in exchange rates may also be the cause of the value of underlying international investments going up or down. Unit trust prices are calculated on a net asset value basis, which is the total market value of all assets in the Fund including any income accruals and less any permissible deductions from the Fund, divided by the number of units in issue.Unit trust prices are  available daily on www.allangray.co.za. Permissible deductions may include management fees, brokerage, Securities Transfer Tax (STT), auditor’s fees, bank charges and trustee fees. A schedule of fees, charges and maximum commissions is available on request from the Management Company.

Benchmarks

FTSE/JSE All Share Index

The FTSE/JSE All Share Index is calculated by FTSE International Limited (‘FTSE’) in conjunction with the JSE Limited (‘JSE’) in accordance with standard criteria.

The FTSE/JSE All Share Index is the proprietary information of FTSE and the JSE. All copyright subsisting in the FTSE/JSE All Share Index values and constituent lists vests in FTSE and the JSE jointly. All their rights are reserved.

FTSE Russell Indices

London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). © LSE Group 2021. FTSE Russell is a trading name of certain of the LSE Group companies. “FTSE®” “Russell®”, “FTSE Russell®”, is/are a trade mark(s) of the relevant LSE Group companies and is/are used by any other LSE Group company under license. All rights in the FTSE Russell indexes or data vest in the relevant LSE Group company which owns the index or the data. Neither LSE Group nor its licensors accept any liability for any errors or omissions in the indexes or data and no party may rely on any indexes or data contained in this communication. No further distribution of data from the LSE Group is permitted without the relevant LSE Group company’s express written consent. The LSE Group does not promote, sponsor or endorse the content of this communication.

MSCI Index

Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

Understanding the funds

Investors must make sure that they understand the nature of their choice of funds and that their investment objectives are aligned with those of the fund(s) they select. The Allan Gray Equity, Balanced, Stable and rand-denominated offshore funds may invest in foreign funds managed by Orbis Investment Management Limited, our offshore investment partner. Orbis is licensed to conduct investment management by the Bermuda Monetary Authority. A feeder fund is a unit trust that invests in another single unit trust, which charges its own fees. A fund of funds is a unit trust that invests in other unit trusts, which charge their own fees. Allan Gray does not charge any additional fees in its feeder funds or funds of funds.