When patience doesn’t pay

Last quarter we wrote about active share and how our portfolios are very different from the index. The strength (both relative and absolute) that we saw in September continued through the end of the year, as our portfolios rose 13.1% in aggregate during the last quarter, bringing our total net USD return for 2019 to 23.5%, while holding roughly 15% in cash.

If in the previous quarter we were reminded of the importance of active share, then this quarter we were reminded of something equally important: Equity returns don’t come smoothly! As of end-August our year-to-date return was only 3.5%.

It’s very easy to lose patience with a stock, an investment strategy or even the whole stock market when returns don’t quickly materialize. So how do we counter this? Is it simply a matter of being patient in every instance? Turns out there’s more to it than that.

Lesson #1: Patience doesn’t pay when you invest in a bad business.

Let’s consider a tale of two stocks – Johnson & Johnson (JNJ) and Ford – two American heavyweights. Between 2002 and 2012, JNJ’s share price changed by… 0%. A decade of no real return. The same was true for Ford. Since 2012 JNJ’s share price has more than doubled, while Ford’s has languished for almost another decade. Following those 10 years of no return, how could an investor distinguish between these two companies? The answer is to break down those returns into their components: Sustainable return and revaluation. Sustainable return is a persistent source of return, while revaluation tends to cancel itself out over long periods of time.

Between 2002 and 2012, JNJ’s real sustainable return was 165%, while its valuation had dropped 60%. Ford on the other hand had delivered negative sustainable return, and its valuation had more than doubled over the same period. To an investor looking back at 10 year total returns in 2012, these two stocks would have looked the same. To an investor looking at sustainable returns and valuations, these two stocks couldn’t have been more different. JNJ is a high quality business with a proven track record of profitability and a healthy balance sheet, both of which drive strong sustainable return. Ford has always been the opposite.

Lesson #2: Patience doesn’t pay when you overpay, even for a good business.

So now we know we must invest in good businesses. But 10 years is a very long time to earn nothing from a good business like JNJ. So how can we avoid waiting 10 years to earn a positive return? Don’t overpay! In 2002, JNJ was on a 32x PE ratio. In 2012 it was 13.7x. Once you’ve determined that something is a good business, you still need to pay a good price for it to ensure good returns.

There are countless examples of high quality businesses that have delivered fantastic sustainable returns since 2000, but have only recently reached breakeven for their investors that were paying ridiculous prices during the tech bubble. It took 15 years for Microsoft investors (who paid 70x PE in 2000) to breakeven, despite the business delivering 430% real sustainable return over the same period.

Interestingly, Ford has traded on a single-digit PE for most of the last 20 years. Valuation on its own isn’t enough – you still need to buy a good business – remember lesson #1.


But what about the medium term? In 2010, JNJ traded on a 14x PE. It was cheap, it was a good business, but two years later it had delivered no return. This is when patience is required. This is when patience pays.


How can we apply these lessons today?

So let’s come back to 2020 and see how things are set up: The US stock market continues to make new highs. Over the last 10 years the S&P 500 has returned 256%. Why not simply buy the S&P 500 today and be patient?

If we adjust for the abnormally low margins of 2009/10 the S&P 500 traded at a PE of 13.5x a decade ago, vs 22x today. Roughly half of the total return of the last decade has come from revaluation from historical lows to the highest PE since the tech bubble – a non-persistent source of return. If valuations revert to anything near their long-term averages, and sustainable returns remain roughly the same for the next decade, this implies low-single-digit real returns from the S&P 500. Furthermore, these returns aren’t likely to come smoothly! Don’t expect the last decade to repeat itself. Remember lesson #2.

We’re far more comfortable holding a globally diversified portfolio of high quality businesses trading at historically low valuations, with 95% active share relative to the global benchmark index.

SA Foie Gras

AfrAsia’s latest South Africa Wealth Report found that wealthy South Africans have 83% of their assets invested locally. According to the report, their asset class breakdown between South Africa and the rest of the world is:

Let’s exclude properties, businesses and alternatives, which tend to be illiquid and might correlate with where you live or work. Let’s focus on the 44% made up of local and foreign stocks and fixed income – the liquid, more readily investible assets where investors have greater flexibility. The splits within this category are consistent with traditional asset allocations in terms of both asset allocation and global allocation:

The split between stocks and fixed income might be justifiable. The split between local fixed income and foreign fixed income might also make sense to the extent that local cash is needed to meet short-term liquidity requirements.

Too much invested in local stocks

What doesn’t make any sense is investing twice as much in local stocks as in foreign stocks, when:

  • More than half of your wealth is already tied up in illiquid local assets;
  • You have enough local cash to meet your short-term liquidity needs;
  • The local stock market is <1% of the world.

The purpose of investing in the stock market is to grow wealth and match long-term liabilities like retirement or leaving an inheritance. Surely investors in this position should be aiming to diversify their risk, which is very concentrated in South Africa, and to take advantage of the widest opportunity set possible. This means investing as much of your stock portfolio as possible in the global markets.

This doesn’t necessarily mean excluding the local market (though you probably already have exposure through your retirement annuity/pension). It means that local stocks should have to justify their place in your overall portfolio on more than the fact that they are listed where you live. They should compete on merit with every other stock in the world.


So why do so many South African investors and their advisors still seem to favour local, despite the obvious risks associated with such concentration?

“No one-size-fits-all”

I think it’s time to retire this line. We know that every investor has unique circumstances, and of course everybody doesn’t have the average allocation in the AfrAsia report. But when the averages are so skewed towards local, we can’t keep pretending that this is the perfect end-product of every individual’s unique financial plan. We also can’t keep using this line to avoid debating this important issue.

Isn’t the JSE Internationally Diversified?

“More than half of the JSE’s revenues come from outside of South Africa.” – another line often used to justify local market bias. But those revenues come from a handful of stocks – Naspers alone is more than 20% of the local market, with the top 4 companies making up half the index.

You cannot build a diversified global portfolio with a handful of stocks. There’s simply no benefit to limiting your options like this.

Ask yourself the following question: If these stocks weren’t listed in South Africa, how much of your global portfolio would you invest in them?

Where are your liabilities?

Ideally you want your assets structured in such a way that they match your liabilities. If you’re living in South Africa, it stands to reason that most of your liabilities will be local.

As far as your short-term liabilities are concerned, it makes sense to have sufficient local fixed income exposure to meet these liabilities. The primary goal here is low volatility in Rand terms.

Once you start talking about building wealth and matching your long-term liabilities, you should be less concerned by volatility and you’re probably investing in the stock market.

You might think that adding currency volatility can interfere with your long-term asset-liability matching, or with your dividend flows, but different sources of volatility are often offsetting rather than additive. Stocks are already volatile. Dividends are also volatile in times of crisis. Adding currency volatility doesn’t make them more so, especially since the Rand tends to weaken during times of crisis.

In 2008 the JSE Top 40 index lost 26%. The MSCI World index lost 21% in ZAR. The following year JSE Top 40 dividends fell by 37%, while MSCI World dividends fell by 24% in ZAR terms. Currency volatility in the stock market is a bit of a red herring. If anything, it reduces overall portfolio and dividend stream volatility.

A globally diversified portfolio of your best investment ideas chosen from the widest possible opportunity set is far more likely to meet your long-term goals than a locally concentrated portfolio. The risks are also lower.

Strong Rand keeping you up at night?

Every debate about local vs offshore seems to devolve into a discussion about whether South Africa or offshore will do better. Apparently South Africans worry that South Africa might do well – that Rand strength might somehow make us poorer. They are worried about the possibility that 99% of the world might underperform 1% of the world, despite the fact that they already have 83% invested here. This is insane.

First, this argument ignores the fact that there are many more cheap assets outside of South Africa than inside. Simple Bayesian inference.

Second, it’s not about which will do better, it’s about risk management and where your exposure is. When you are 83% invested in one small country where you happen to live, return expectations become secondary to risk management.

If Turkey, an economy twice the size of South Africa’s, was your best investment idea in the world, would you invest two-thirds of your stock portfolio there, on top of your property and your business?

We need to stop mis-framing this issue as a return issue when it is in fact a risk issue. We can’t keep dangling far-from-certain return potential as a carrot to force-feed local investors something they already have too much of. As advisors and asset managers, is our job to sell SA, or to represent our clients’ best interests?

If you’re anything like the average SA investor, you are already hopelessly overinvested in South Africa. If South Africa recovers and the Rand strengthens, you’ll benefit more than 99% of the rest of the world. Your business, your properties, your local cash will all be worth more in real terms. This is a good thing. You will survive a strong Rand.

Be more concerned about what might happen if, heaven forbid, South Africa and the Rand don’t do so well.

Don’t let the Rand dictate your portfolio

For many South African investors, the Rand exchange rate is the single most important variable they consider when deciding whether to invest money offshore. It crowds out every other consideration. We think this is a mistake.
If you’re thinking about investing globally, but you’re worried about timing the Rand, ask yourself the following questions:

1) How much of your wealth is focused in South Africa?

This is probably the most important consideration: If you’re overexposed and something goes seriously wrong here, your wealth could be permanently impaired.

This is an emotive topic for many investors and advisors who have strong views about what will happen one way or the other, ranging from doomsayers and fearmongers to the fervent “we’ve always recovered in the past” crowd.

We fall into neither camp, preferring a more probabilistic approach to risk management. Risk events have two elements: 1) Probability of occurring, and 2) magnitude of loss. A failed state is generally a low probability event, but the magnitude of loss is very high. Low probability, high magnitude risks are risks worth managing. This is the reason young, healthy people buy life cover. We think about country risk the same way. Global diversification is a form of country insurance.

Depending on where the Rand is trading, country insurance may be free, cheap or expensive. Free insurance is a no-brainer. Whether or not you decide to pay for country insurance should depend on two factors: 1) Price, and 2) how much insurance do you already have?

So how much of your wealth is focused in South Africa?

If, like many South African investors, you have a local business, a house, a pension and/or retirement annuity, chances are high that most of your wealth is focused in South Africa. If most of your liquid, discretionary assets are also invested locally, paying a fair premium for some country insurance might not be such a bad idea.

If, on the other hand, you are a global investor with very limited exposure to South Africa, your mindset is totally different. You have become the insurer, and for you it may make sense to be moving in the other direction, collecting premiums in exchange for bearing country risk as part of your globally diversified portfolio. This is a good position to be in.

Discussions about how cheap South Africa and the Rand are should be framed within the context of your global asset allocation and the size of the currency premium, if any. The higher your country risk exposure, the more it makes sense to pay a reasonable premium to manage it. The lower your exposure, the more you can afford to be opportunistic.

2) Is the Rand cheap or expensive?

In December 2001, the USDZAR reached a high of 12.45, 80% above the “fair” value based on inflation differentials and long-term trends. The premium for country insurance at this point was extreme. The perceived risks did not play out, and within 3 years the exchange rate had halved. The short-term pain was compounded by the simultaneous popping of the tech bubble.

Long-term investors who bought the S&P 500 in December 2001, and held on until March 2019, would be up 321% in ZAR, or 8.7% p.a. – not great, but not as bad as one might expect for the worst timed investment of the last 20 years. Also bear in mind that things might have played out differently. We only see what did happen in hindsight making it seem like the only possibility, but the reality is that the future is uncertain.

More recently the 2016 USDZAR high of 16.87 was about 40% above our estimation of fair, still very high, but nowhere near the extremes of 2001. We estimate today’s premium at roughly 15%. For a long-term investor, this premium could easily be a lesser consideration when weighed against other factors.

The “always recovered” commentators often use 2001 as a warning against rushing for the exits when the Rand is cheap. But cheap and expensive aren’t black and white. The current exchange rate premium is much closer to fair than it is to 2001 levels.

Your context may be one of 100% exposure to South Africa, in which case you may be happy to pay the current premium to get some global exposure. A global investor’s context may be one of only 1% exposure to South Africa, in which case the premium may warrant further investment in the country.

Within the context of your exposure to South Africa, is this a reasonable premium or not?

3) Cheap relative to what?

So, the Rand is fairly cheap. But relative to what? The US Dollar? Ironically, we tease Americans about their perceived lack of awareness when it comes to the diversity of “Africa”, but many of us make the same mistake when investing “Offshore”. There is a whole world out there that isn’t pegged to the US Dollar. There’s also more to global equity markets than the S&P 500.

By our estimation Sterling, Yen, Euros, Canadian Dollars and the Swedish Krona are also cheap relative to the US Dollar. You aren’t paying much of a currency premium to invest in these places.

The relative valuations of other currencies should also be factored into your decision to invest globally.

4) Are Rand-based assets cheap or expensive? What about other countries?

One of the major benefits of a global portfolio is having access to a very broad opportunity set. This allows you to make better investments and achieve a greater degree of diversification. You might find very cheap assets in a country where the currency isn’t as cheap. Think of Hong Kong, where the currency is pegged to USD. One of our portfolio holdings is a Singaporean company, listed in Hong Kong, which does business globally. It reports and trades in HKD, but how relevant is HKD really in this equation? Should the strong HKD put us off investing here? No.

The same applies to many companies listed on major exchanges around the globe, as well as our own local exchange. Some advisors say that investors should invest locally because a) the Rand is cheap and Rand-based assets are cheap, and b) because some of our prominent local listings like BAT, Naspers and Richemont have nothing to do with the local economy. These two points are contradictory. The fact that these companies are priced in Rands on our local exchange means nothing if they earn almost nothing in Rands. These companies stand to benefit no more from a domestic recovery than Altria, Tencent and LVMH.

There are also companies listed in the US that are cheap despite the strength of the USD.

The valuation of an asset’s trading and/or reporting currency is less important than where the company does business. It is also less important than the overall valuation of the asset, where currency effects are but one factor.

In the global investment opportunity set where South Africa represents less than 1%, it is highly unlikely that our local assets are the only cheap assets in the world. Shunning the rest of the world’s investment opportunities because “the Rand is weak” makes no sense.

Investors should Ignore Annual Predictions

After reaching new all-time highs in September, the S&P 500 lost nearly 13.5% in the fourth quarter of 2018, while MSCI World ex-USA declined by 11.4%. Equity markets have recovered somewhat from their December lows – the S&P 500 came within a hair’s breadth of official bear market territory (-20%) on 24 December, before rallying 5% in the following trading session, the largest one-day gain since March 2009.

2018 was one of the rare years in which none of the major asset classes generated returns for investors. This rarity has many investors asking “So where to from here? Have we bottomed?” The real answers to these questions are unknowable. Market movements like these are inevitable, but unpredictable.

Despite this inherent unpredictability, this time of year is always marked by an influx of predictions and forecasts for where the market is headed next, which sectors are likely to do best, which stock picks will do well in 2019, and so on. Ignore them. 85% of the major investment banks expected the S&P 500 to end 2018 higher, with the lowest price target still 5.7% higher than the final outcome.

Allowing short-term forecasts to influence your long-term financial planning is a sure way to destroy wealth. Short-term predictions – despite their popularity – don’t work. Ignore the noise and use the new year as an opportunity to reassess your financial plan and make sure you’re well positioned for the long-term.

To assist with your planning, ask yourself the following three questions:

1. Does your asset allocation adequately match your future liability profile?

  • Do you have enough liquidity to meet short-term/contingent liabilities?
  • Do you have enough equity/growth assets to counter the creeping effects of inflation and to build wealth sustainably over the long-term?

2. Is your overall investment portfolio being managed transparently and cost-effectively, or are there too many layers between you and your money?

3. Are you sufficiently diversified, particularly in terms of a global portfolio?

  • How much of your wealth is concentrated in South Africa? Are you comfortable with this?
  • Outside of South Africa, are you overexposed to any other country?

A globally diversified portfolio of consistently profitable businesses, with strong financial positions is likely to deliver good sustainable returns over time, through the inevitable highs and lows.

In our view, the best approach will always be to invest in a global portfolio of good businesses at good prices, ignore the noise and the unpredictable swings of the market, and allow the effect of compounding to do its work as the years roll on.

Global Diversification: Are you doing it right?

Most investors would agree that diversification is a good thing, but how many of us really understand what it means? All too often, South African investors think about global diversification as fleeing risk.

Diversification is about managing risk. It is not about avoiding or eliminating risk, which cannot be done without sacrificing investment goals. It also isn’t about trading one risk for another presumably lesser risk, nor should it be about taking risk indiscriminately for the sake of diversification. It is about making good investments but spreading them across different risks.

With this in mind, we address two misconceptions that many South Africans have about global diversification:

1. Moving your assets from South Africa to the UK is not global diversification

South Africa is an emerging market country with significant political and currency risks. The local stock market represents less than 1% of the global opportunity set. By now, most of us know this. This doesn’t make South Africa a bad place to invest, but it does make it a risky place to invest everything, which is what many local investors do.

For those South Africans who have decided to invest offshore, there often seems to be a significant bias towards the UK – possibly because the UK is familiar: Shared history, language overlap, similar time zones, etc. The idea is that the UK, a more developed market, has lower political and currency risk. Global diversification done.

There are two problems with this thinking. First, the UK only represents about 4% of the global opportunity set. Second, as Brexit has made it abundantly clear, the UK also has political and currency risks. The UK can still be a great place to invest, just not too much.

Have a look at two recent Business Insider headlines:

The mega rich are bailing out of Britain in the thousands, and many are moving to Australia

These incredible graphs show that the pound is starting to look like the rand

These articles demonstrate how any country, not just emerging markets, is subject to political and currency risk. Developed market risk may be lower than emerging market risk, but it is still there, and it needs to be managed.

A South Africa/UK portfolio might be better than South Africa-only, but this strategy remains vastly inferior when compared to true global diversification. The SA/UK portfolio still only represents 5% of the world, and 50% or more of your money will still be subject to the political and currency risks of just one country. Even worse, as recent events in both South Africa and the UK have demonstrated, the probability of simultaneous turmoil in any two countries remains uncomfortably high.

The answer also isn’t to move everything from the UK and concentrate it somewhere else, like Australia. This doesn’t solve the problem, it just moves it. Outside of the United States, no single country represents more than 10% of the global opportunity set, and even the Americans would do well to consider the rest of the world.

Global diversification means avoiding overconcentration to any country and taking advantage of the widest opportunity set possible: South Africa, UK, USA, Switzerland, Canada, Australia, Hong Kong, Japan, Europe, and so on.

2. The argument that “other places have their own risks” is not a valid case against diversification.

When making the case for global diversification, we’ve at times been countered that other countries have their own problems, and “fleeing” South Africa is just “swapping one devil for another”. This argument misses the point of diversification.

First, global diversification isn’t about fleeing one country for another, and in doing so exchanging one concentrated risk for another. This doesn’t manage risk, it just transfers it somewhere else.

Second, global diversification as a strategy doesn’t rely on finding places without risk. As the first point of this article suggests, no such place exists. Instead, it relies on spreading exposure between risks that are less than perfectly correlated.

To the extent that we can find two investments with similar merit that have different risks, it is better to hold both than just the one. Our risk of loss is lower because the probability of both risks playing out is lower than the probability of any single risk playing out. To the extent that we can find many good investments with different risks, it is better to hold many than just two.

Global diversification remains the best way to find many good investments with different risks.

This does not mean that indiscriminate diversification is a good strategy. Making inferior investments for the sake of diversification is a big mistake that will result in poor returns. Fortunately, having a wider opportunity set makes it easier to achieve diversification without sacrificing investment quality or returns.


In a nutshell, diversification is about exposing yourself to a wider opportunity set in order to find many good investment opportunities with uncorrelated risks. If you want to manage your risk properly, invest globally.

Why wealthy South Africans are investing in Global Equity

A recent report found that South African High Net Worth Individuals (HNWIs) substantially increased the share of their assets allocated to equities from 23% in 2007 to 28% in 2017, with the majority of this growth in equity exposure having been through increased foreign equity allocations.

Although local political uncertainty likely played a role in the shift to offshore equity, lower costs and improved access to equity markets also contributed significantly. This is particularly apparent on the global front where exchange controls have been relaxed allowing investors to take as much as R11m per person per year offshore.

Overexposed to South Africa

Having been restricted from investing offshore in the past, many South African HNWIs have the vast majority of their wealth concentrated in South Africa. They live here, work here, and own businesses here – often in addition to holding local property portfolios and even local equity portfolios.

Given that South Africa represents less than 1% of the global opportunity set, it makes sense to look at the other 99%, which includes some of the best run businesses in the world.

Earning Potential, Practicality, Diversification

The report shows that while exposure to foreign cash, bonds and property has also grown, the vast majority of money being taken offshore by South African HNWIs has been allocated to foreign equity markets. This preference comes down to a matter of earning potential and practicality, for the most part. Foreign cash earns close to nothing in interest and the yields on foreign bonds aren’t much better. While offshore property may be a fair consideration, it is far simpler to invest in and manage a foreign equity portfolio than a foreign property portfolio.

It is also easier to achieve diversification through global equities. This is because one can invest in stocks across multiple countries, industries and currencies for the price of one property.

Other major advantages to global equities include liquidity and easy access to funds. Investors can access all, or a part of your investment within days, and at very low cost. Properties generally take months to sell, at higher cost, and one can’t simply access a small part of their value at any time.

Risk Perceptions

When talking about perceived risk that is often associated with equities, much of this sensitivity has to do with the fact that equity prices are visible on a daily basis, making the volatility plain to see. You can’t see how the price of a property or a private business reacts to events as they unfold, creating the impression that these assets are somehow less risky.

But we would argue that a portfolio of high-quality, multibillion-dollar businesses spread across various countries, industries and currencies is fundamentally less risky than any individual property or private business – despite the short-term volatility.

Low-Cost, Simple Process

Another common misconception is that investing offshore is an expensive and complicated process. Opening and managing a direct global equity portfolio can be as easy and cost-effective as opening and managing a local portfolio, when done properly. With the right platform investors can log into their accounts and see their portfolios in real-time, draw statements, and request withdrawals.

Trading costs are generally much lower than for local accounts – well under 0.1% on a good platform. For those who haven’t already moved funds, taking money offshore is very easy – individuals can take up to R11m a year without much hassle.

Wider Opportunity Set, Strong Investment Process

When looking for a global portfolio manager, dealing with a specialist who can cover a very wide opportunity set is very important. Some of the best investments can be made in lesser known companies that are nevertheless very well-managed multibillion dollar businesses. Many investment managers are unable to cover the opportunity set widely enough and have significant biases towards the largest companies with household names listed in major markets like the UK, US and Switzerland, for example.

This barely scratches the surface of what is available to global investors and familiarity is a poor substitute for sound investment process. A good investment process should cover much more than just the big names.

JSE Rand-Hedges are a Poor Substitute for a Global Portfolio

With local news agendas often dominated by the rand’s dismal performance, GDP woes and an economy slipping into a technical recession – South African investors are increasingly seeking shelter via offshore exposure. But with easy access to foreign markets, investors need to seriously consider the implications of counting on locally listed rand-hedge stocks as a substitute for a truly global portfolio.

Pure vs poor rand-hedges

While a number of local stocks are referred to as “rand hedges” – and are said to benefit from a weaker rand – the majority of these are not pure rand hedges and, as such, do not offer the same protection against rand weakness and local political issues as a global portfolio would.

All too often, South African investors see ‘rand hedge’ and, because they are overexposed to South Africa and are so concerned with managing the associated risk, they overlook the causal drivers of return for these investments. The causal drivers of a stock’s return are business quality and price paid. Investing at the expense of these, for the sake of rand-hedgedness, is likely to lead to inferior long-term returns – all-the-while maintaining significant exposure to South Africa, depending on how pure the rand hedge is.

A pure rand-hedge stock as a company with very limited exposure to South Africa by revenues or operations. There aren’t many pure rand hedges listed on the JSE, though there are a number of less pure rand hedges with varying degrees of protection against rand weakness. The most significant JSE-listed rand hedges are Naspers, Richemont, BAT, AB InBev, BHP Billiton and Glencore.

With this in mind, investors should only include JSE rand-hedge stocks in their portfolios if they are high-quality businesses trading at attractive prices – the same considerations that would apply to any other investment.


A limited opportunity set

However, given the very limited opportunity set for rand-hedge stocks listed on the JSE, putting together a diversified portfolio of high-quality businesses trading at attractive prices is near impossible. In total, there are roughly 100 reasonably liquid stocks listed on the JSE, of which maybe 40 could be considered rand-hedged, at a stretch.

If we consider that roughly 30% of all companies are high-quality businesses, this leaves more or less 12 high-quality JSE-listed pseudo rand hedges – of which potentially five are attractively priced. Limiting your opportunity set means you forgo at least one of quality, price, or diversification, which has a direct impact on your expected returns and risk profile.

Unrestricted access to funds

Another significant drawback of trying to emulate foreign exposure through these stocks, is that investors won’t have direct access to their funds from abroad. South African investment accounts are not directly accessible from anywhere else in the world because of exchange controls, which is a major risk factor. All investors should aim to build wealth that would be accessible from any country, including South Africa, and for this, you need a truly global portfolio.

Going global

Furthermore, the opportunity set is far wider on a global level, with more than 7 000 reasonably liquid stocks. A good process applied to this opportunity set is likely to be vastly superior in terms of quality, price and diversification when compared to a portfolio selected from a smaller subset, such as JSE-listed rand hedges.

The larger opportunity set also affords us the luxury to walk away from anything that we’re not entirely comfortable with, at almost no opportunity cost. This can be a big problem for investors limited to smaller opportunity sets, where there is a greater tendency to ignore red flags for lack of alternatives. In today’s volatile economic environment, it makes no sense for a South African investor to limit their options to anything less than global.

The Only Game in Town

Last month we came across a chart on Twitter, posted by Michael Antonelli of Baird, which caught a fair amount of attention:


The chart shows how the US has dominated stock market returns in 2018. As of 30 September the S&P 500 has returned 10.6% year-to-date (YTD) in USD while the MSCI AC World ex-USA has returned negative 3.1% over the same period. If you’ve invested outside of the USA, you’ve probably underperformed this year.

In fact, this has been the story of the last decade. You’d have to go back to 2009 to find the last time the rest of the world meaningfully beat the US stock market:


Since 2011 the S&P 500 has returned 173% while the rest of the world has delivered only 36%, leading many investors to the conclusion that the US is the only game in town. This conclusion, however, is deeply flawed.


It wasn’t always this way

Bloomberg has data for the MSCI AC World ex-USA index going back to 1999. The following chart shows the cumulative performance comparison between the S&P 500 (white line) and the rest of the world (orange) since then:


What is clear is that the US hasn’t always been so dominant. Between 1999 and 2009, 11 years which started with the dotcom bubble and ended with the financial crisis, the S&P 500 returned only 10% in total, while the rest of the world returned 71%. If investors stretch their memory back to 2011, they’ll remember that at the time emerging markets (China in particular) were all the rage and the US was regarded as stagnant. The relative returns of these markets have been the opposite of what prevailing sentiment at the time would have predicted. This alone should act as a clear warning for any investor who thinks the US is the only game in town today.


What drives return?

To understand why we shouldn’t necessarily expect the continued outperformance of the US, despite current sentiment and a decade of experience to the contrary, we need to understand what drives return:

Mathematically, Return = Yield + Growth + Revaluation = Sustainable Return + Revaluation.1

In the short-term, return is dominated by revaluation, because revaluation is driven by volatile investor sentiment. As the years roll by, however, sustainable return (the underlying fundamental performance of the business) begins to compound and has a greater impact on return. In the ultra-long-term, return is driven almost entirely by sustainable return, while annualized revaluation tends towards zero.

Our investment horizon is typically 7 years – a time period long enough to allow superior sustainable return to compound, but still short enough for revaluation to have a meaningful impact. Our investment philosophy is to benefit from businesses with superior sustainable return, while also harvesting positive revaluation along the way, for which an investment horizon of 5 to 10 years is required.


Where has the return come from?

With an understanding of what drives return, we can now assess where the outperformance of the US stock market has come from, and make a judgement about whether this is sustainable going forward.

Since mid-2011, the real USD sustainable return of the S&P 500 has been 4.3% p.a.2 For the MSCI World ex-USA, real sustainable return measured in USD was only 0.1% p.a. At first glance this seems to confirm that American businesses have had superior sustainable return, and should thus be expected to outperform over the long-term. But there is another very important factor that we need to consider before making any conclusions.

In order to compare apples with apples, when we compare businesses in different countries, we need to measure their inflation-adjusted (i.e. real) sustainable returns in their own reporting currencies. It would be incorrect to include currency volatility in sustainable return – like revaluation, currency volatility is not a persistent source of return over the long term. Because the MSCI World ex-USA index consists of businesses from different countries with different reporting currencies, MSCI aggregates everything in USD. So we need to strip out the impact of the dollar from our sustainable return analysis and consider it separately.

As a proxy for this we use the dollar index, a measure of the dollar’s value relative to a basket of major currencies around the world. Relative to its long-term trend the dollar index has moved from its 7th percentile deviation in mid-2011 to its 85th percentile, strengthening by 3.5% p.a. This implies that the real reporting currency sustainable return of the rest of the world has actually been roughly 3.6% p.a., which compares reasonably to the 4.3% p.a. of the S&P 500.

What about revaluation? The valuations of the S&P 500 index have moved from their 19th percentile in 2011 to their 99th percentile today – a whopping 7.9% p.a., dwarfing the 3.3% p.a. revaluation from the rest of the world, which has moved from 26th percentile valuations to 77th.

In summary, since mid-2011:

S&P 500 Real Return = 4.3% Sustainable Return + 7.9% Revaluation = 12.2% p.a.;

Rest of World Real Return = 3.6% Sustainable Return + 3.3% Revaluation – 3.5% Currency Volatility = 3.4% p.a.


What this means is that 92% of the outperformance of the S&P 500 since mid-2011 has come about through excess revaluation and dollar strength, neither of which are persistent sources of outperformance over the long-term.

While the US stock market was primed for strong performance in 2011 because of the weak dollar (7th percentile) and low valuations (19th percentile), today the S&P 500 is at the 99th percentile of historic valuations, and the dollar index is around the 85th percentile of deviations from its long-term trend. Investors should seriously question whether the US is going to continue to dominate global stock market returns from this position over the next 10 years. While the US may have been the only game in town for the last decade, anyone chasing these returns now is very late to the party.


Where to invest?

Reading this, you might think we’re making the case for shifting investments out of the US into the rest of the world, but we are actually working towards a different conclusion.

Although the S&P 500 looks expensive as a whole, the MSCI World ex-USA isn’t that cheap either. While we believe there is an above average probability that the rest of the world will outperform the US over the next decade or so, valuations are still at their 77th percentile, and the sustainable return is nothing to get excited about. So where to invest?

Our approach to global investment has never been about targeting broad exposure to different markets, but rather about taking advantage of the enormous global opportunity set to find investments with superior sustainable returns trading at attractive valuations, wherever those may be.

Because the US stock market is such a broad opportunity set in itself, many of our best ideas are American companies. We also have a large portion (more than half) of our portfolios invested in other countries. This is not directly by design – we don’t target geographic exposures. It is the result of a sound process focused on the mathematical causality of return, applied to a broad opportunity set.

Without making any dollar index adjustments for our international exposure, the real sustainable return of our current holdings has been 13.3% p.a. over the last decade, 9.1% p.a. over the last 3 years and 9.3% over the last 12 months, which compares favourably to any broad benchmark index. In terms of valuations, our current holdings are trading at their 25th percentile in aggregate, and at their 1st percentile relative to the S&P 500. This is by design. We deliberately invest in high sustainable return businesses at low prices and harvest the revaluation gains on holdings that have become expensive.

Another important causal driver of future returns for any business is financial strength – a company’s ability to meet its obligations. While this doesn’t tell us much about base-case expected return, it does tell us about the downside risk to sustainable return should a company be forced to raise significant capital. In this regard, the total debt of the S&P 500 index (excluding financials) is 25% of its total market value on 99th percentile valuations. For our portfolios the comparative number is 13% on 25th percentile valuations. This, again, is by design as we deliberately avoid over-indebted businesses.



Short-term performance differences between our portfolios, the S&P 500 or the MSCI World index are of little concern to us, as long as they come from non-persistent sources of return like revaluation and currency volatility. That the S&P 500 and the dollar have gone from expensive to more expensive year-to-date, and have dominated global returns as a result, is a terrible reason to invest everything there.

As long as our holdings deliver high sustainable return, are financially sound, and we acquire them at good prices, we know we’re on the right track. Over time superior sustainable return, stronger balance sheets and the successful harvesting of revaluation from cheap to expensive can only deliver good results. These are the causal drivers of long-term investment returns.

Finally, it is important to always invest globally in order to take advantage of the widest possible opportunity set. A good process applied to a wider opportunity set should always be expected to deliver better sustainable return, better quality and better valuations, with wider diversification than the same process applied to a narrower opportunity set. As our analysis demonstrates, there is simply no reason to limit yourself to the US or any other country, even if recent returns suggest that one of these may be the only game in town.



 1 A more detailed explanation of what drives return can be found here.

 2 For stock indices with cyclical earnings, we generally measure sustainable return and revaluation in terms of revenues. If we were to measure in terms of earnings our sustainable returns would be a little higher for both indices (7.2% p.a. for US and 5.8% for RoW), and our revaluation a little lower (5% p.a. for US and 1.1% for RoW). 84% of US outperformance would still be driven by differences in revaluation/currency volatility, so we would still reach the same conclusions.

What do Investing and Insurance have in Common?

We came across an interesting product recently launched by a South African company – the world’s first equity fraud insurance. This insurance covers investors against losses suffered as a result of fraud or management impropriety. The idea is that investors pay a small percentage of their portfolio value as a regular premium, and are then covered against losses suffered within that portfolio which stem from fraud/accounting related issues. Sounds good, right? Wrong.

To understand why equity insurance is a bad idea, one first needs to understand why traditional insurance adds value. Take life insurance as an example: An individual has only one life, which if lost could have serious financial consequences for his/her dependents. The timing of the loss of life is usually unpredictable. The only way an individual can manage this risk is through life insurance.

Why does traditional insurance work?

A life insurance company essentially builds a portfolio of 1 000s of insured lives, something that no individual can do. While the risks are unpredictable on an individual basis, the aggregated risks are far more predictable. The insurance company can thus set an accurate premium across its portfolio of risks, which allows it to pay claims as they arise, cover its costs and earn a profit. Homeowners insurance, hospital plans and car insurance all work on the same principle.

Insurance companies are in the business of selling diversification for a profit. This only makes sense when a) the risk being insured is significant, and b) the risk cannot be freely diversified on an individual basis.

How is equity fraud insurance different?

This is why equity insurance doesn’t work. Regardless of the terms and conditions of the specific cover, the reality is that an individual can achieve diversification for free. The premiums paid to an insurer will exceed insured losses for a diversified portfolio over time, so it makes no sense to buy insurance against an already diversified portfolio.

This raises some important questions: Why insurance against fraud specifically? Surely there are other risks that investors could insure against. Why is this world-first being launched in South Africa, and why now? The answer is, of course, Steinhoff. To a lesser extent Resilient and Capitec have also played their part. This is the opportune time to launch a product like this, following a flurry of typically rare events that are still fresh in everyone’s mind. Clever timing, but ultimately a flawed product.

Global diversification beats equity insurance

For an equity portfolio, diversification is actually much better than fraud insurance. First, it’s free. Second, it covers much more than just the risk associated with fraud. With a broad enough opportunity set it can cover political risk, currency risk, balance sheet risk, event risk, etc.

For South African investors, political and currency risk are far more relevant concerns than fraud. The best insurance against these risks is to invest globally. This has the added benefit of a much wider opportunity set, allowing investors to be far more selective in terms of the quality of assets they invest in and the price they pay, without sacrificing diversification.

Risk and reward

Finally, the point of investment isn’t to eliminate risk, because without risk there is no reward. The point is to bear good risks in exchange for a return. In this sense, investing is exactly like insurance:

  • Insurers write policies subject to certain underwriting criteria. Investors make investments subject to certain quality/valuation criteria;
  • Insurers accept that despite their underwriting, there will be claims. Investors know that despite their process, they cannot eliminate risks associated with individual holdings;
  • Insurers manage individual risks by aggregating them. Investors manage individual risks through diversification;
  • Insurers earn a profit because they charge more in premiums than they pay to claimants. Investors earn a return because their successful investments outweigh their losses.

The keys to success in both of these models are a good underwriting/selection process and adequate diversification. Where they differ is that insurance relies more heavily on diversification, while selection process is far more important in investing.

Urban Outfitters: Patience Rewarded

We closed 3 successful investments in the last quarter: Robert Half International (+60% in 2 years), Kakaku.com (+84% in under a year) and Urban Outfitters (+82% in 2 and a half years). While Robert Half and Kakaku rewarded us from the outset, it was Urban Outfitters that gave most of our clients their first real taste of what it means to be a long-term investor, despite being a fairly short-lived investment.

We are long-term investors. This means that we make an investment with the understanding and the expectation that it may take 5 to 10 years for our thesis to play out. At Bellwood Capital, our clients have not yet been invested for 5 years, so their investments are still in the early stages. Those stocks that have been sold have either exceeded our expectations very quickly, or in some cases have seen their investment thesis change. The temptation to judge any individual investment a success or a failure after year 1 or year 2 is immense (people are naturally inclined towards short-termism), but it would be a mistake to do so. Urban Outfitters demonstrates this well.

We started investing in US apparel retailers late in 2015 – notably The Gap and Urban Outfitters. Their stock prices had fallen following a period of weakness in US retail. The common sentiment was that Amazon was killing the bricks-and-mortar retail industry. These were not popular stocks.

Our investment process, however, is not based on sentiment, stories or popularity, but rather on the presence of certain preconditions that have a direct causal link to long-term returns: Good sustainable return, consistent profitability matched by cash flows, strong balance sheets, all combined with attractive valuations. We concluded that these companies met our preconditions, and were priced for good returns on the back of the negative sentiment.

Unfortunately that sentiment was about to become much worse. Within a couple of months, Urban had fallen nearly 30%. The consensus was that US retailers were doomed. Many sentiment- or story-driven investors would have agreed that these were failed investments, and sold their shares amidst the onslaught of negative press and falling share prices. Psychologically, holding a stock in the face of what seems like a mountain of disconfirming “evidence” is extremely difficult.

This is where having a strong process and an understanding of the drivers of return is critical. Return = Sustainable Return + Revaluation. Sustainable Return is the fundamental performance of the underlying business – its quality. Revaluation is driven by investor sentiment, which is often irrational, unpredictable and volatile. In the short-term, return is driven almost entirely by revaluation, which is why short-term returns are so unpredictable.

If a stock drops by 30% in two months, it is unlikely that the sustainable return of the underlying business was -30%. As time passes though, sentiment tends to ebb and flow, cancelling itself out, while sustainable return compounds and contributes more and more to total return. Over very long periods of time, annualized revaluation tends towards zero, while total return tends towards sustainable return. When a stock returns 1 000% over a decade or two, it is most likely that the vast majority of this would come from sustainable return.

The best long-term returns come from buying high sustainable return businesses at low valuations (implying negative sentiment), holding them for the long-term and selling them if they become too overvalued. While sentiment is completely unpredictable in the short-term, the probability is that if we give our investments enough time (5 to 10 years) they are likely to experience the full range of sentiments and resulting valuations. This provides us with the opportunity to buy some very good businesses cheaply, benefit from their sustainable return and sell them expensively should the opportunity arise at the other end of the sentiment scale.

The key to executing this strategy successfully is to overcome the emotional hurdle that arises in those cases when irrational sentiment moves further in the wrong direction. This means differentiating between sentiment and sustainable return. The ability to do so is one of the best edges any investor can have. Having a strong process and an understanding of the drivers of return is the critical difference between success or failure in this regard.

Having lost 30% off the bat on Urban Outfitters, we retested our investment case against our process (which involved much internal debate and consternation) and concluded that the fundamentals of the business had not changed. The business had no debt, remained profitable, was returning large amounts of capital to shareholders (a form of sustainable return) and was likely to grow revenues in time. Further, the valuation was more attractive than before. Instead of selling we invested more at the lower prices.

Before the end of 2016, Urban had nearly doubled (sentiment had improved!) and we were far less concerned about our investment, perhaps even feeling the job was done. The stock was trading around fair value, we trimmed a few overweight positions, but we were happy to keep holding the majority of our shares. Up to this point, most investors would agree that losing 30% off the bat wasn’t too bad given that the stock doubled quite quickly after that.

By June 2017 the stock had fallen more than 50% again, and was now 20% lower than in December 2015. Sentiment towards retailers was rock bottom, not only in the press, but in our office too. In aggregate we were down nearly 40% on Urban Outfitters after 18 months. At this point, any normal person would feel that Urban was a failure. We weren’t immune to the pervasive negativity either, but we stuck to our process, retested our thesis and bought more shares in Urban at these prices. This wasn’t a comforting decision per se, but it would have been impossible without a strong process.

Over the next 12 months, Urban rallied 187% from its low. Now overvalued and priced for weak returns, we decided to sell the stock for an aggregate profit of 82% in 2 and a half years (27% p.a.). Urban Outfitters has been a successful investment for us, but it wasn’t a smooth ride and it required a lot of patience and intestinal fortitude.

Now consider the bigger picture: This was still only a 2 and a half year investment. We are making investments with a 5 to 10 year horizon. Sentiment and revaluation have provided us with unusual opportunities to buy Urban cheaply and sell expensively in a short space of time. Sustainable return was a lesser contributor to total return (contributing roughly a quarter) – though this would have become more meaningful in time.

While some of our investments will run their course quite quickly, like Robert Half, Kakaku and even Urban, many of them will take longer. Fortunately they won’t all be as challenging as Urban. Some of our best investments will deliver excellent returns over several years without becoming expensive (NetEase and TSM are good examples of this) but they too will have their ups and downs along the way. What is important is that in each case we are making investments that meet the preconditions set out in our investment process, and that we give them enough time.

To reap the rewards of long-term investment we need a strong, unemotional investment process and, at times, patience. This is what it means to be a long-term investor.