At Allan Gray, we are bottom-up investors, but we want to be on the right side of long-term trends, particularly at secular turning points. One way is to understand where we are in the sentiment cycle. In other words, are investors optimistic or pessimistic, euphoric or panicked? Duncan Artus reflects on where we are currently and how this is influencing portfolio positioning.
We have been saying for some time now that we believe the world, and therefore the investing environment, may look different over the next 10 years compared to the recent past.
Central banks have created significant credit since the 2007/08 global financial crisis (GFC), with this activity accelerating further during the pandemic. This is a major contributing factor to the levels of inflation we are currently witnessing globally. However, the expansion in central bank balance sheets that has underpinned asset prices appears to be coming to an end. This will result in a very different context that many investors have not experienced before.
The world is also increasingly dividing along geopolitical lines. This is happening in the background of mounting strategic competition between the USA and China. China is important to South African investors directly through big shares, such as Naspers, Richemont and the large, diversified miners and indirectly as a purchaser of our commodity exports, which have underpinned the South African economy. This is a risk we think carefully about when constructing our portfolios.
The third secular theme is the shortage of energy, which may result in higher energy prices persisting. While well off their peak war levels, prices could stay high for longer than investors expect due to material underinvestment in energy because of historic government policies and an increased focus on environmental, social and governance (ESG) issues. Although this can change – witness Germany restarting coal plants – the investment required in infrastructure and new resources is not something that can be easily achieved in a short space of time. It also won’t be cheap.
Lastly, as an investor in South African assets, we need to be realistic about the fundamental risks that our country, unfortunately, faces in the long term and account for that risk in the portfolio.
So, what can we do about managing the risks that may arise from a changing world?
We can use active asset allocation, weighing the benefits of local versus offshore assets, as well as risk assets such as equities versus “safer” assets such as cash and bonds. This has not been easy, especially in a world where we believed for several years that developed world bonds were extremely overvalued. One way to solve for this is to have a position in hedged equities, which have a different return and risk profile. They have been a big contributor to returns over the last year.
The other way to reduce the risk and perhaps even benefit in an inflationary, energy-short and increasingly divided world is to think about the type of shares we own.
British American Tobacco (BAT) is a top three share in our funds. Not only do we believe the tobacco industry has strong pricing power to pass on increasing costs, but BAT has no exposure to China. Sentiment towards consumer staple shares, in general, is poor. As it has underperformed the market, we have been accumulating Anheuser-Busch InBev (ABI), the world’s largest brewer. ABI is one of the most profitable and well-run global consumer staple businesses, yet it trades on a low valuation relative to its peers. It has single-digit exposure to China and will benefit as travel and leisure increase in the wake of the pandemic.
Our portfolios are positioned to benefit from an energy-short world in two ways. We own Glencore, one of the world’s largest mining companies, which has a commodity basket of metals such as copper, cobalt and nickel that will benefit from the energy transition and a thermal coal business, which is generating significant cash flow at these elevated prices. Secondly, we own energy companies involved in oil and gas and businesses that build, maintain and operate key infrastructure needed to power our economies while we transition to cleaner energy.
When thinking about exposure to local businesses that rely on the domestic economy, we prefer self-help cases, which we believe can grow value despite the moribund local economy. A good example is Pick n Pay (PIK), which has underperformed its peers for several years after being the clear market leader two decades ago. What the market often overlooks, is that PIK has two fast-growing businesses in Boxer and Pick n Pay Clothing. Taking our valuations for these two businesses and subtracting them from the current market value of PIK shows an investor is paying a low valuation for the core supermarket business. This may turn out to be correct, but we believe there is a reasonable probability of materially improving the profitability of the supermarket division over the next five years.
A different approach
In conclusion, while we don’t have a crystal ball, we believe there is a reasonable probability that the investment landscape over the coming years will look different. This means that investment strategies that worked since the GFC may not be the strategies that work going forward. We have tilted the portfolios to benefit and be protected from these secular trends.