Enormous equity returns not the end of the road

The first quarter of 2006 has seen the South African market once again setting a blistering pace. Despite the massive 195% that the JSE is up after the lows of March 2003, the market is showing no signs of abating, rising 13% in the first quarter alone.

This should not come as a huge surprise, as the current environment remains conducive to equities.
Inflation and interest rates are, we believe, in a sustainably lower environment and should remain flat this year, while the rand is stronger than expected. The consumer is therefore healthier than expected, which translates directly through to increased earnings and, by definition, a market that is cheaper than people predicted.

While there are several players who for some time now have been calling the end of the equity run, we believe that barring an abnormal event (emerging-market meltdown 1998, technology collapse, 9/11), we should be in for reasonably stable markets going forward. Certainly there are clouds on the horizon—geopolitics, oil, a dodgy dollar and bird flu, to mention a few, but in the absence of an abnormal event, these clouds shouldn’t develop to stormy conditions.

Investors are emotionally programmed to become nervous after extended periods of fun in equity markets, and deservedly so. Very few can say they didn’t lose money in both the small-cap and technology collapses between 1998 and 2001. However, these collapses occurred from enormously overpriced levels. Small company and technology funds were, at their peaks, trading at PE ratios of 60 to 100 (conservatively!). Our market, while up strongly from the ridiculously oversold levels of 2003, is by no means stretched on a forward PE of 13.

The scramble for resources in Africa by two economies (India and China), each with a billion-plus people, is pushing commodities and should continue to do so. Not in a straight line—there will be volatility. On the whole, however, we expect commodity demand over the next 10 to 15 years to be strong.

In addition, we now live in a different country, embraced by the rest of the world. Emerging-market funds have been pouring into South Africa, from R2 billion in 2003 to R29-billion in 2004 and R45-billion in 2005. You cannot compare South Africa with the “isolated Eighties”, when we were shunned by the rest of the civilised world, or the “nervous Nineties” during our transformation period, when the world gave us no more hope than it gives Iraq today. We are a different country now, and therefore the pricing in our market is not in dangerous territory.

Don’t rule out the possibility of a short-term correction, but earnings will come through, which means equities remain the place to be.

However, investors must always guard against failing in love. Since falling in love in their personal lives involves monogamy (generally!), people tend to become monogamous with their investment love affairs. Previous such examples where diversification was ignored include small caps, technology stocks (particularly Didata), offshore investment and the dollar. All these love affairs went on too long; investors weren’t diversified and tears eventually followed.

Currently, South African investors are in love with South African equities, property or the rand. We don’t have a problem with any of these; just remember the importance of diversification. Now is not a bad time to include some offshore exposure in one’s investment mix.

Quarterly commentary from portfolio managers of Investec Asset Management’s top-performing funds:

Investec Equity Fund (returned 56,57% over the 12 months to the end of March 2006*)

Gail Daniel, South African head of Equities and portfolio manager

The bull market continued in the first quarter of 2006, with the JSE all-share index delivering a 13,3% return, bringing the 12-month return to 57,4%. Equity returns have far outstripped bond returns with the all-bond index returning 12,7% over 12 months and cash lagging at 7,4%. The obvious question is: Do we see this continuing?

There are problems in the South African economy and world financial markets. The supply-side ability of the South African economy is constrained by underinvestment in fixed infrastructure as witnessed by the power outages in Cape Town. Supply-side problems typically take longer to resolve than demand-side problems.

The demand side of the South African economy remains robust with motor-vehicle and retail sales remaining buoyant as new consumers gain access to finance. This is probably a differentiator of the South African economy as it is an emerging market with a highly sophisticated and established financial sector. We remain invested in the consumer and banking sector although we have altered our stock picks in the retail space.

The current-account deficit is always a concern although it is clearly being easily funded with the rand at close to R6 a dollar at the time of writing. The Budget deficit is not a problem, but the ability of local municipalities to spend the cash allocated to them is.

Globally, demand also remains firm and broad-based. United States interest rates must be pretty close to the top now, which could see a resumption of the dollar bear market, simultaneously supporting a rerating of the US stock markets.

Commodity prices moved higher again, in a seasonally weak period. Companies are slow to bring on supply. Indeed in the recent reporting period, the big three London miners competed to see who could announce the biggest buyback, and not who could bring on supply. In the face of this it is not surprising that copper made yet another high at more than 240c a pound.

We have a 32% weighting in resource shares. Within this we are overweight gold as we are finally seeing a rising rand gold price. The companies have enormous operating leverage to a rising revenue line and earnings growth could surprise on the upside. Platinum shares delivered superb returns, benefiting from rumours of consolidation by the gold companies. While we do not see an imminent rand collapse, we do think that the currency is on the expensive side.

We have added or initiated positions in Old Mutual, Barloworld, Didata and Sappi. All have been consistent laggards. We expect mergers and acquisitions to remain a strong trend this year.

Investec Growth Fund (is ranked first in its category over 12 months to the end of March with a return of 60,48%*)

Vanessa Hofmeyr, portfolio manager

It has been a strong and very volatile start to the year. The market is up 13% for the quarter. Sectors that need to be highlighted in particular includes: technology, pharmaceuticals, electronics, construction and platinum, all up by more than 25% for the period. Valuations have increased, with the market trading on a PE ratio of 15 times and 13 times one year forward. Company results have continued to show a buoyant economic environment.

Are we concerned? Forward ratings on our growth stocks are higher, but we can still find value. Economic fundamentals continue to support our view: consumer spending is unlikely to be derailed, investment spending is likely to grow as public spending makes a bigger contribution and inflation and interest rates hold steady. Earnings growth prospects remain in high double-digit territory, well ahead of inflation.

Our portfolio has benefited from our core holdings in the stronger performing sectors. Aspen, Datatec and Impala all made an excellent contribution to performance during the past quarter. Aveng, Iliad and Ellerines also added value for the period. The performance was broad based, with good growth stories relevant in all these sectors.

We continue to believe that pharmaceuticals, technology, consumer sensitive stocks and beneficiaries of increased public sector spending are our preferred areas of exposure. We also remain positive on the banking and telecommunications sectors, based both on growth prospects and compelling valuations. So apart from the shares already mentioned, our top holdings also include Investec and MTN.

Our stock-selection growth process remains robust, highlighting new and interesting growth opportunities on a regular basis. New holdings in the portfolio for the quarter are Sappi, Didata and Nedbank, stocks that are showing strong growth recovering prospects and valuations at reasonable levels. Another recent addition is Imperial, again gaining exposure to a growth sector at a good price. We will focus on companies that create value for their shareholders, offer above-average earnings growth and are enjoying upwards earnings revisions from the investment community while paying strict attention to the price we pay for this positive momentum.

We continue to believe that South Africa has rarely been in a situation more suited for the growth style, with all the signs that the tide is finally turning in favour of growth stocks. The Investec Growth Fund provides investors with the unique opportunity to get specialist growth skills.

Investec Value Fund (returned 56,74% over the 12 months to the end of March 2006*)

John Biccard, portfolio manager

Despite a disappointing March when compared with the all-share index, the Value Fund nevertheless managed to outperform the all-share index over the quarter (+15,3% against the index’s 13,3% return).

Investors should not lose sight of the fact that the returns currently being generated (15% in just three months!) are nothing short of incredible and it would be unrealistic for performance to continue at this pace. (The fund’s 15% return over the last quarter should also be seen against the 9% return generated over the previous quarter). That said, we do not believe the market is expensive yet but rather that it is overbought short term—the average PE of the top 10 stocks in the fund remains at 12,5 times historic earnings, a level that we still believe is a little low given long bond yields of 7,2% and real GDP growth rates in South Africa of more than 4%.

During March we realigned the portfolio quite extensively by reducing exposure to select consumer stocks and adding to select resource stocks. This realignment should not be seen as a “wholesale” switch but rather as lightening holdings in select consumer stocks where the historic PE has got up to about 15 times earnings, and thus we do not believe we are being paid to continue holding them despite the quality of the asset (we lightened holdings in Truworths and African Bank).

Equally, the resource stocks purchased either represented mitigating risk via increasing the holding from zero (ie Goldfields) or buying reasonably priced assets that have recently underperformed (ie Sasol on 10 times earnings and Mittal Steel on eight times earnings).

Sasol is one large capitalisation resource stock that we currently believe offers excellent value after nine months of sharp underperformance against the market—the share is trading on just 10 times earnings and thus offers in our opinion a “free” option on higher oil prices with the company’s GTL technology also thrown in effectively for free. While the authorities’ investigation into “windfall” taxes remains a risk, we do not believe it will be implemented, and even if it is implemented, we believe it would not affect the valuation materially. Other purchases included MTN, Standard Bank, Lewis, Absa and Telkom.

Jeremy Gardiner is a director of Investec Asset Management

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