It is time to switch capital from the retail and bank sectors, where the risks are predominantly on the downside, to the resources sector, where investors are expecting the worst and where, increasingly, it does not look as if the worst is upon them.
That’s according to Chris Freund, portfolio manager at Investec Asset Management. He says: “Since the rand began the long, arduous process of recovery from the chronic weakness of 2001, most domestic fund managers have been bullish about the prospects for shares in the South African retail and bank sectors.
“We tend to lump retailers and banks together, as historically they have shown a tendency to respond similarly to changes in the rand exchange rate or to interest rate expectations. A stronger rand or lower interest rates usually mean these sectors do well.
“Unfortunately, the rand has been one of the most volatile currencies in the world, with the currency crises of 1996, 1998, 2001 and 2006 all demonstrating the vicious downside to these most uncertain macro- variables. Within the equity portion, the Investec Survey Balanced funds have had overweight positions in these two sectors for a number of years, having, on balance, successfully weathered the currency storms. So it is not a simple, flippant matter to have recently made the weighty decision to change course and significantly downweight exposure to the retail and bank sectors, switching most of the proceeds to increased investment in the broad resources sector.”
Freund says there is more to successful investing than merely taking a view on the rand or interest rates. “For example, in all investment decisions, valuation becomes an important consideration. Is the bad news already in the price? What are the prospects for earnings, or are there any company-specific reasons to be especially bullish or bearish?”
He says, in the second and third quarters of 2006, the retail and bank sectors took an incredible hit, sparked by the general emerging-market crisis and exacerbated by the far larger than expected South African current account deficit.
“Just when you thought it was safe, along came the Chinese clothing quota issue to rub salt in to the wounds. In September 2006, retail and bank shares offered outstanding value. We knew and the market knew that interest rates were still going to rise from that point, but it was more than in the price. All one needed was a little patience.”
Valuations of shares in these sectors have substantially recovered in the intervening period.
However, says Freund, there are other considerations that give cause for a degree of discomfort. “Inflation will continue to head upwards over the next quarter, driven principally by high petrol and food prices. Broad consensus, and the South African Reserve Bank’s view, appears to be that CPIX will increase to roughly 6% over the next month or two, only to fall back to around 5% before edging back up towards 5,5% by year-end.”
Too little room to manoeuvre on the inflation front is one reason to be cautious about domestic interest rate-sensitive shares.
Says Freund: “If one then considers the earnings outlook, especially for the credit retailers, there is some cause for concern. Recent trading statements and anecdotal evidence suggests that durable credit sales are rapidly slowing and that bad debts are starting to rise in inevitable lagged response to the increased interest rates to date. The quantum of debt extended over the past few years to the emerging consumer must at some stage start to put pressure on the ability to repay. We are not suggesting that earnings will fall, but merely that the rate of earnings growth will slow significantly for durable goods retailers, less so for clothing retailers and even less so for banks.”
He says it might be time to switch out of the retail sector and downweight bank holdings for a while. “In the world of resources, the conventional wisdom for some time – not just in South Africa – has been that metal prices, especially base metals, are far too high and will soon revert to lower, more normal levels.”
Jeremy Gardiner, director of Investec Asset Management, says South African investors should cele-brate the fact that the economy is growing at 5% plus, that inflation is below 6% and that there is the strongest commodity bull run for 30 years.
“In the first quarter of 2007, earnings in South Africa were up 33% and should be only slightly softer in the second quarter. We are also running a budget surplus, and foreign capital is flowing in. Confidence is at a 25-year high.”