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By Alwyn van der Merwe, 23 April 2013
Local shares can be placed into two baskets; those that have delivered a steady or predictable profit stream (shares such as BAT, SAB, Tigerbrands and Shoprite). And those that have managed to grow earnings but in a very cyclical or unpredictable fashion (examples are Astral, BHP Billiton, JD Group and Implats).
Right now, in the very uncertain macro environment, investors are prepared to pay high prices for the ‘cut diamonds’ that deliver certainty and tend to avoid the ‘rough diamonds’ because of their volatile earnings patterns. Surely this substantial value gap provides a great opportunity to sell the expensive shares and buy the cheap ones? We believe it does, but caution remains key.
During the years of high commodity prices - when China grew at 10% - investors generally favoured cyclical counters as they provided a passport to the upside of the strong growth in the region. At that time, investors tended to view the steady but lower growth of non-cyclical industrial counters as boring rather than safe.
But since the financial meltdown - or “big recession” - investors have fundamentally changed their view. Steady growth now represents safety, and cyclical earnings are deemed dangerous or risky. Since 2007 a typical basket of defensive shares has outperformed a typical basket of cyclical shares by approximately 4.5 times.
At Sanlam Private Investments we have debated this issue at length. A strategy that switches from the arguably expensive defensives into the cheaper shares would resonate well with value or even contrarian investors. The timing of this switch, however, is critical. We have witnessed that selective value managers made that switch 18 months ago as the gap in valuation was very visible even then. These managers have paid dearly as their portfolios have underperformed significantly over the period.
Our strategy is to start gradually with a “big rotation”. Earlier in the year we added Billiton to our favoured stock pool. This company has a superior earnings track record albeit a cyclical one. We suspect the “herd” is pricing this share as if the earnings are unlikely to recover. In fact, the earnings expectations are still being downgraded by analysts globally. Despite Billiton’s enviable earnings track record, the market is prepared to pay significantly higher multiples for the earnings of defensives like SA Breweries, British American Tobacco or Tigerbrands. A similar case can be made for shares like Steinhoff, Impala Platinum or Astral.
Although we have started the rotation, we are proceeding with caution. We are well aware that analysts are generally still downgrading the earnings of cyclical shares. We are also acutely aware of the risks inherent in macro-economic trends. We are mindful that the rotation is likely to dilute the quality of our clients’ portfolio. However, the recent sell-off in these cyclical shares provides wonderful opportunities to rotate not for the sake of playing to a theme but simply because the value gap between these respective shares is very compelling.
Tel: 021 469 1572 / 072 142 5159
Twitter handle: @atmospherecomms
On behalf of:
Alwyn van der Merwe
Director of investments
Sanlam Private Investments
Tel: 021 950 2273 / 082 459 5791