Finding positive asymmetry in uncertain times

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Shaun le Roux

Global markets continue to be characterised by high valuations and rising risk. A decade of ultra-accommodative monetary policy across developed economies and a nine-year, US-led equity market bull run have resulted in extended valuations and heightened levels of investor complacency.

Indeed, on some measures, the S&P 500 remains at valuation levels only surpassed during the Dotcom bubble and prior to the 1929 crash.

On the other hand, emerging markets have been volatile. A 40% decline into 2016 was followed by a 90% rise into early 2018. This has been followed by a drop of 19% from year-to-date highs amid sharply deteriorating sentiment towards assets and economies that investors perceive to be risky.

In this environment, it’s important to look in uncrowded areas for investment opportunities that present positive asymmetry, said Shaun le Roux, fund manager at PSG Asset Management.

Speaking at a quarterly roadshow in Cape Town yesterday, le Roux said that trying to identify the expectations that are embedded in the price of a security is paramount.

“When expectations discounted into the price are very low, downside is limited even if the outlook worsens. But returns should be acceptable if conditions remain the same, and excellent if they improve – thereby creating positive asymmetry,” he said.

“Conversely, when expectations for a share or asset class are high and the valuation is stretched, the investment outcome is unfavourably skewed. If expectations aren’t met, negative asymmetry means the downside can be sizeable.”

The potential for positive asymmetry is present when sentiment is poor and confidence levels are low. Equally, negative asymmetry is likely when confidence levels are high. This means that uncrowded, unloved parts of the market present the greatest prospects for mispricing.

Le Roux said that currently, less popular local shares are presenting attractive opportunities. Over the past four years, returns on the JSE (at an index level) have barely kept pace with inflation. When expressed in dollars, the local market is down 1% due to rand weakness.

“This is especially disappointing if we consider the strength of the US market and the fact that the rand has weakened substantially since 2014 (with more than 60% of the JSE Top 40 comprising rand-hedge shares).

“It would have been far better to invest in the S&P 500, which returned 11.2% in dollars and 18.5% in rands over this period,” he said.

As a result, domestic-facing South African companies, which continue to find themselves out of favour, offer the possibility of positive asymmetry (especially in the mid- and small-cap space).

At the same time, uncrowded parts of global markets offer compelling prospects. Regions such as Japan, the UK (on the back of Brexit-related fears) and emerging markets in general are among those currently least liked by global investors.

“The larger investment community has largely given up on Japanese stocks due to the country’s persistent economic challenges and demographic headwinds from an ageing population.”

The graph below shows which markets are presently very crowded, and which are least crowded.

“The taps of ultra-loose monetary policy are finally tightening, which could have a significant impact on the pricing of many assets,” said le Roux.

As such, some volatility and uncertainty has now returned to global markets, and PSG Asset Management has identified several good long-term opportunities in developed market equities.

Unsurprisingly, these have been in less popular market areas, such as Japanese financials, US speciality apparel retail, European telecommunications, agricultural chemicals and shipping.

“We have also been adding global property stocks to our portfolios, as we view the fear accompanying the sell-off in US and UK retail real estate investment trusts (REITs) as excessive.”

In conclusion, le Roux said that PSG looks for investment opportunities that satisfy its 3 M criteria; namely Moat (competitive advantage), Management and Margin of Safety (trading at below fair value). “All securities included in our funds must meet these three rigorous criteria.”