Time to diversify offshore

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Added on 26 January 2011 @ 10:17 AM

A strong chance that the rand will depreciate, the logic of diversification, and attractive relative valuations offshore are all significant factors that make 2011 a good time for investors to increase their international equity exposure, according to Peter Brooke, head of Macro Strategy Investments (MSI) boutique at Old Mutual Investment Group SA (OMIGSA). In fact, he believes international equity will be the best performing asset class in real terms over the next five years.

Explains Brooke: "If your risk tolerance allows, and you're holding less than the 30% maximum offshore exposure now permitted, there are some compelling reasons to consider adding international equities to your portfolio this year. First there are the obvious benefits of diversification - such as reduced risk and providing exposure to fast-growing companies and industries not available in SA. Detailed historic analysis done by MSI shows that an optimal portfolio for SA investors would hold more than 35% in international assets to capture these benefits. At the same time, SA equity volatility is 30% higher than that of international equity, making the former more risky than the latter."

The timing of the government's December exchange control easing could not have been better, he added. Those invested in active asset allocation funds have likely already had their offshore exposure increased by their fund managers. "For instance, we at MSI have already taken advantage of the strong rand over the new year period to increase offshore equity in the funds we manage."

Looking at valuations, Brooke notes that following 2010's exceptional performance by SA equities (the FTSE/JSE SWIX gained 20.9% in rand terms and 34.5% in US dollar terms to be the best-performing major market in the world), the local equity market's previously relatively attractive valuation has now been eroded. "The current price/earnings ratio of 17.2 times is high historically, and SA companies will need strong earnings growth this year to produce good investor returns. South African equities no longer trade at a discount and therefore no longer justify an overweight position. We are forecasting a real return of 6.0% per year over the next five years from SA equities, and 6.5% per year from international equities."

Turning to the rand, he points out that the local currency was the third-strongest major currency in the world in 2010, making the real value of the rand now expensive by historic measures. "Although the big global investment themes do remain supportive of the rand this year, they are weakening. The global emerging markets (GEM) theme, strong demand for commodities, relatively high SA interest rates and the quest for yield are favourable for our currency, but gradual rate hikes elsewhere, a possible slowdown in emerging markets growth (particularly China) and an upside surprise in US growth could all mean bad news for the rand."

Japanese and African markets offer opportunities

So with the rand, relative equity valuations and the benefits of diversification all increasing the appeal of offshore equity investments, which does Brooke think offer some of the best opportunities? He suggests Japan and Africa.

"These markets sit at the two extremes of the development spectrum, but both offer their own attractions. Japan offers a contrarian trading opportunity - the Japanese equity market has experienced massive underperformance for years, and is currently trading at the same levels in real terms seen 30 years ago. Its shares are un-loved and under-owned, which is shown by the market's price:sales ratio of 0.6 times. However, I believe the headwinds it's been experiencing have now turned to tailwinds with a better global growth environment and the potential of yen intervention. Given its cheap valuations, now could be a good time to buy.

"On the other hand, Africa represents a longer-term opportunity for higher returns, albeit with higher risk. The continent is truly the last investment frontier, with good growth prospects but underdeveloped equity markets. With its large resource base, it offers a leveraged play to the emerging consumer - particularly through soft commodities like food."

SA equity still likely to outperform other local asset classes

Turning to the options for investors in the local market, Brooke says he continues to favour local equity over property, bonds and cash, although stresses that all asset classes are likely to return far less in the next five years than in the previous decade. This means investors need to save more in order to retire with adequate finances.

He expects SA equities to post a real return of 6.0% per year through 2016, seeing a "grind higher" in 2011 given the market's relatively strong 2010 performance. This will be driven by earnings growth, particularly from resources. The return is downgraded from his forecast of 6.5% last year.

On listed property, he has downgraded his real return forecast to 5.5% per year over the next five years, from 6.0% previously. With no further interest rate cuts likely, the potential for capital gains is limited, following another year of being the best-performing asset class.

Brooke expects bonds to return 2.5% (real) per year, beating cash yields due to their higher interest rate rather than through capital gains. Cash will also provide a lower real return of o¬nly 1.5% (real) per year over the next five years, with rates seen remaining near their current 35-year lows, while inflation accelerates from low levels.

Fairbairn Capital | Old Mutual

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