The Northstar buy list
Although our asset allocation work is important, we attach greater credence to our bottom-up, fundamental valuation work which we conduct on each security (share, property, bond etc.) before making an investment. Over the years we have built valuation models on the majority of locally listed companies as well as a significant number of offshore stocks. This library of work provides us with a real-time view of what potential upside returns we think our funds offer.
So what are the numbers telling us about potential returns in South Africa from both a bottom-up and top-down perspective?
We appreciate that South Africa faces enormous challenges, many of which can fundamentally adjust the value of domestic assets. The modeling work, which we are demonstrating here, does not attempt to capture unforeseen events, it instead makes use of existing real data.
Based on our purchasing power parity (PPP) model, Figure 3, which we use internally, the rand is undervalued. A conservative value for the ZAR is R12.35 to the US$. Whilst pin-pointing an absolute number with respect to the rand’s real value is a fool’s game, we prefer to use the model as a reference for when the currency is showing extreme behavior – the present is such a time.
Figure 3. Implied PPP versus USD ZAR. Source: Northstar and Bloomberg. September 2019.
South African equities – bottom-up
The chart below tracks the discount to intrinsic value of the companies on our domestic ‘buy list.’ Currently, these shares by our calculation are on average, about 30% undervalued – unfortunately we are unable to say if or when this valuation gap will narrow. Our ‘buy list’ companies are trading as cheaply as they were in late 2018, the last time we communicated to our clients that an opportunity was emerging on the local market.
Figure 4. Upside to intrinsic value of local equity portfolio. Source: Bloomberg, Northstar. September 2019.
South African equities – top-down
Corroborating our bottom-up or fundamental valuation work on local companies is our asset allocation analysis (top-down) quantitative work on equities. In Figure 5 below, our calculation for prospective returns for the JSE Capped Swix index is 15.4% – a rational equity investor should demand a return of approximately inflation plus 7% for equities which we call a hurdle rate. With South African inflation just above 4% at present, the hurdle rate return for equities is 11%. With potential returns from the market significantly higher than that at 15.4%, domestic equities are once again a viable option for our clients.
Figure 5. South African equity expected returns. Source: Northstar. September 2019.
Fixed income assets – cash, bonds and property
We use the same approach for cash, bonds and property.
At current low levels of inflation in South Africa of 4%, the 7% yield offered by banks on deposits, is in our view, a very attractive low risk return that substantially outperforms the hurdle rate on cash, which we regard as inflation.
The hurdle rate returns for bonds (Figure 6, indicated in red) does not need to be as high as equities – bond investors take less risk than equity investors and many bonds are shorter-duration investments, implying lower required returns. Elevated yields (cheap prices) in South Africa are a function of concerns of a credit downgrade as well as the fiscus issuing a disproportionately large amount of paper into the market to fund the budget deficit and parastatal bail-outs. Our work shows that potential returns on bonds, for the most part, currently compensate investors well above the hurdle rate required.
Finally, on property, for the past few years, our analysis has been directing us away from property – potential returns remain significantly lower than what a rational investor should demand from this relatively high risk asset class.
Figure 6. Asset class expected returns. Source: Northstar. September 2019.
The Northstar Sanlam Collective Investments (SCI) Managed Fund
Our ‘house-view’ balanced fund incorporates all this thinking into one product. Asset allocation adjustments within the fund are based on both our buy list expected returns together with our asset allocation framework outlined above. It is the ideal vehicle for clients that do not want to make asset class calls themselves.
Until recently (July 2019), we have been overweight offshore assets and underweight South African risk assets, the likes of property and equities. Against this, we have been overweight bonds, which have performed superbly. During the last quarter, we have however reduced the fund’s total offshore exposure, the reasoning is two-fold, offshore equities are no longer cheap and the rand became undervalued (see above). Simultaneously, the domestic equity weighting of the fund has been increased as South African stocks have begun to offer more value.
Each of these moves is consistent with the framework shown above, an approach we have followed consistently over time and which has been value enhancing to our clients.