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.