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SPECIAL REPORT: Investing wisely in a tough economy

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Wealth creation is not only about investing for the highest possible growth; it includes designing a plan that will take you on a comfortable, risk-appropriate investment journey and help you to achieve your lifestyle goals. By Monique Verduyn

American stock investor Peter Lynch said it best: “Know what you own, and know why you own it.” Widely known for his role at Fidelity Investments, where he managed the Magellan Fund between 1977 and 1990 averaging a 29% return – making it the best 20-year return of any mutual fund over the period – his approach to investing and wealth management was built on doing the homework before making a decision, and then re-evaluating the portfolio regularly, because what’s working for you today, may not work for you in the future.

Simple advice, certainly, but in the cold, hard world of investing, determining what to do with your money for the best returns remains the million dollar question.

“There’s no blanket answer to this question, and no answer that will apply to everyone,” says Leigh Köhler, head of Glacier Research, at Glacier by Sanlam. “When looking at returns, you also need to look at risk profile. More upside returns typically equal more risk. Also, there is more than one way to realise ‘highest returns’ – this could come from a handful of stocks, or even a single stock. That’s why it’s important that investors seek advice from a qualified financial adviser and invest according to their individual risk profile and time horizon.”

EQUITIES OFFER THE BEST CAPITAL GROWTH

Equities remain the long-term driver for optimal capital growth in any portfolio. Statistics have consistently proven that, which is why any growth portfolio should favour equities as the dominant asset class.

Having said that, realise that at the best of times equity investing remains challenging in that it also represents high-risk investing.

Taking a long-term view is important. Andrew Newell, head of business development at Cannon Asset Managers, says that equities will give the best results over the long term. “Equities have the ability to grow their income over time, which leads to growth in capital values. Equities have performed well recently, so investors would be well advised to temper their future expectations.”

Yet not all equities currently offer good investment opportunities, so stock selection is vital. Stocks that have robust fundamental characteristics such as earnings supported by cash flow, stable balance sheets, and strong management track records are the most sought out.

“Critically, however,” adds Newell, “these companies only make for good investment prospects if they are attractively priced. Examples of stocks which we favour at present include OneLogix and Pan African Resources. Both companies have the right characteristics and, despite being smaller and less glamorous than many of their peers, they are well priced, setting investors up for a good chance of outperformance over time.”

He also favours Microsoft and Intel. “Both are ubiquitous in the IT industry and stand to benefit from growing demand for consumer electronics,” Newell says. “Considered somewhat unglamorous now – and therefore cheap – especially compared to a company like Apple, they are set to see ongoing penetration into emerging markets where, despite the rapid adoption of smartphones and tablets, laptop and desktop demand remains robust.”

You need to be prepared to stomach volatility, however, which includes seeing the capital value of your investment potentially dropping below its initial value, particularly in the earlier stages, before substantial profits have accumulated. “Not many people can really bear this,” says Francois le Roux, financial planner: private wealth management, at Old Mutual. “I have seen people professing to be high-risk investors, only to change their tune when markets start going south. Understand that investing in equities is like aging a good bottle of red – you need to postpone your consumption and enjoyment thereof. Ultimately you will be rewarded with something of superior quality and value, provided you are prepared to stay in the market for five years or longer for optimal reward.”

Most analysts favour offshore equities above South African equities, because of the price-earnings ratio of our equity market, compared to those of offshore equities. Also bear in mind that the South African market is but a drop in the ocean compared to the rest of the world, so it remains important to spread your eggs across more baskets, Le Roux adds.

“We have become accustomed to exceptional equity returns over recent years and even more so in 2014. The long-term annualised real return from South Africa equities has historically been 7,4% per annum. But over the last five years it’s been 15,5% per annum. The current price-earnings (PE) ratio for South African shares is at about 18 (end June 2014), whereas the long-term average is at about 12 to 13. This means that our market is relatively expensive and it is becoming more challenging to find outstanding buying opportunities. The likelihood of negative returns is higher when you buy equities in an expensive market.”

Le Roux notes that speculation is rife about an imminent correction of some kind in the local market, although there’s no conclusive evidence. “The last week of September, however, was a tough one. Continued bad news had finally started to have an effect and the ALSI was down by 3,50% compared to the MSCI Developed Market Index which declined by 1,77%. ”

He maintains he would still enter the market under these conditions, albeit with caution. “Now is certainly not the time to rush into the equity market with all your investable capital. If the equity market continues to decline, you might want to consider investing a portion thereof. Think about phasing into the market over a period of six to twelve months and spreading the risk appropriately.”

CAPITAL GROWTH VS INCOME

Because it is better to have investments in your portfolio that do a bit of both, you should avoid choosing investments aimed at delivering only capital growth over those that also provide an income.

Jason Garner, area manager: private wealth management at Old Mutual, says investing in equities that aim to grow your capital when share prices move higher may give you a better return over the long term than income-producing investments. “However, an investment in equities is likely to be volatile, with the market rising and falling over the period for which you are invested. Depending on when you disinvest, this could result in your suffering a capital loss. Imagine you had R1 million in October 2003 and disinvested in 2008 – you could have lost 40% of your capital value.”

Over longer periods, investments that are intended to deliver capital growth typically do show gains, but it can be a rough ride. Investments in cash, which deliver returns by earning interest income, will give you a smoother ride but a lower long-term return. South African bonds are delivering poor returns and will most likely continue to do so, given tumbling commodity prices and an emerging-market selloff sparked by the Federal Reserve.

“Nonetheless, taking the risk of investing in a more volatile investment definitely gives you a better return,” Garner says.

THE OPTIMUM PORTFOLIO FOR HIGHER-INCOME EARNERS

For people at the upper end of the salary scale, tax efficiency becomes more of a concern and can be found at both product and portfolio level.

If you are a higher-income earner looking for an investment that will result in you paying less tax while still following a growth investment strategy, and where maximum liquidity is not essential, then an endowment may be a suitable investment option.

“Endowments are taxed at a flat rate of 30% in the case of individuals and trusts, making them suitable for investors with a marginal tax rate greater than 30%,” says Köhler. “Interest income declared within the endowment would therefore be taxed at 30%, as against the maximum marginal rate of 40% for individuals. This also translates into a lower capital gains tax rate of 10%, compared to a maximum rate of 13,33% for individuals. If an endowment is housed within a trust with natural persons as beneficiaries, capital gains will be taxed at an effective rate of 10%, as opposed to the effective capital gains tax rate for trusts which is 26,64%.”

Nominating a beneficiary on the endowment can lead to potential savings on executor’s fees of up to 3,99% of fund value. Where a beneficiary has been nominated, payment of the death benefit does not depend on the winding up of the estate and beneficiaries will receive the proceeds relatively quickly. Investors can also choose tax-efficient funds, which don’t generate interest and dividends.

The components of an optimum investment portfolio are really a function of your investment objectives and not solely the size of the investment. Peter Hewitt, the Financial Planning Institute’s Financial Planner of the Year winner, says the most effective long-term strategy is to have a multi-asset approach that not only diversifies across asset classes, but also across asset managers and geographies.

“To maximise tax incentives and discretionary investments, the investment portfolio needs to include allocations to compulsory investments. This also maximises planning flexibility. The most appropriate investment vehicles – in terms of hedge structures, retirement annuity structures, endowment structures, guaranteed structures and the like – would be dependent on each person’s specific financial circumstances. This must be compiled taking account of income tax, capital gains tax and estate duties as different structures have very significant benefits, and risks. The ultimate returns on an investment portfolio will be meaningfully impacted by the manner in which the portfolio is structured.”

AVOIDING THE PITFALLS IN THE CURRENT ECONOMY

Current wisdom has it that investors would do well to manage their expectations, as most market commentators and industry analysts are not expecting the same level of returns going forward as has been experienced over the past few years.

“It’s a mistake to look at recent winners and extrapolate their performance,” says Newell. “This will not necessarily be repeated. Rather, look at the underlying factors as well as the value on offer. You may be tempted to rush money offshore following the recent slump in the rand, but it would be wrong to take this as a sign that the rand only weakens. It’s preferable to invest offshore in a considered and measured way for the right reasons – portfolio diversification. We’ve observed that, over time, the level of the rand has far less bearing on an investment result than selecting the correct assets.”

Newell also notes that leaving money in cash for fear of losing it in the market is more dangerous than investing it, especially in today’s low interest rate environment. “Investors have been known to confuse low volatility with safety. The reality is that almost the only guarantee that cash will afford you is that the value of your asset will be going backwards after accounting for inflation.”

To ensure superior long-term returns and to guard against permanent capital losses, you need to invest at an attractive valuation. It’s also critical to ensure that you have an investment structure designed to accommodate your risk appetite,” Hewitt cautions. “It is important to understand that components of your investment portfolio are going to be exposed to high volatility. This is the age-old risk versus return trade-off. One of the key pitfalls to avoid currently is ‘get rich quick’ schemes which promise non-market-related returns form unregulated product providers. Remember, if it looks too good to be true, it is.”

Le Roux offers this advice: “Do not try to time the market. It’s more important to plan spending time in the market than trying to time it.”

PROPERTY CONTINUES TO OFFER STABILITY AND GROWTH

Property provides the benefit of a high income yield together with prospects of income growth.

Property is a hybrid asset class which has both equity- and bond-like characteristics. “Unlike bonds, the income received can increase over time and unlike most equities, the majority of the income is contractual so it is more defensive and certain,” says Evan Robins, listed property manager at Old Mutual Investment Group’s MacroSolutions. “Given the diversified benefits offered by listed property as an asset class, it is an important component of a long-term growth portfolio.

Listed property provides liquidity, diversification, and access to some of the best assets in the country as well as to management infrastructure and scale. Investing in listed property is very different from investing directly in property and a direct property portfolio is unlikely to offer the benefits offered by listed property portfolios.

“In most cases direct property will consist of lower quality and less defensive assets putting the investor more at risk in an economic slowdown such as the one we’re currently experiencing,” adds Robins. “We therefore believe that investing in listed property offers more opportunities for long-term growth for investors in the current economy.”

Property is not necessarily a “must-have” as a stand-alone asset class, but brings great benefits of diversification and a worthwhile income stream, particularly in times of low interest rates such as we are experiencing at present, according to Andrew Newell, head of business development at Cannon Asset Managers. “Although property can be subject to capital fluctuations, it is backed by a tangible asset and holds the benefit of a growing income stream.”

He says the best ways to invest in property is through an established and credible unit trust or via listed property like real estate investment trusts (REITs). An advantage of such investments is that the properties are managed by professionals leaving investors free to focus on other issues.

“Unit trusts and REITs enable investors to acquire property that would otherwise be unaffordable for the individual,” Newell adds. “Depending on the units being purchased, the minimum investment could fall between R500 per month, or R5 000 as a lump sum investment. For this, the investor can access a diversified portfolio with exposure to a variety of properties. The spread could include retail, industrial, commercial, leisure or other properties as well as exposure in different geographic regions. This spreads the risk for investors substantially and allows them to participate in different types of property and their various economic drivers.”

Property investments are also highly liquid. An investor can sell his or her stock and realise the funds within a week of making the decision to sell. The same cannot be said for physical property, which can take a substantial period to liquidate and comes with inherent risk, such as deal failure or fraud.

AFRICA’S LOOKING GOOD

A recent report shows a dramatic improvement in investor perception about the attractiveness of the continent.

Africa’s share of global foreign direct investment projects has reached the highest level in a decade, according to Executing Growth, Ernst and Young’s 2014 Africa Attractiveness Survey.

The overall survey results show that Africa has moved from third last position in 2011 to become the second-most attractive investment destination in the world, behind North America. Sixty per cent of survey respondents said that there had been an improvement in Africa’s investment attractiveness over the past year, up four percentage points from last year’s survey.

However, there remains a stubborn perception gap between those already operating on the continent and those who are not yet present. For the first time, this year’s survey shows that companies with a presence on the continent perceive Africa to be the most attractive investment destination in the world. In stark contrast, those with no business presence in Africa still view the continent as the world’s least attractive investment destination.

Seventy-three per cent of those who are already established in the region believe Africa’s attractiveness has improved over the past year versus 39% who are not established. What does that mean for people wanting to invest?

Where to invest and why

It makes sense to invest in a local fund manager investing in Africa, rather than an international manager investing in Africa. “The local fund manager will likely have a deeper understanding of the culture and doing business in the relevant country,” says Leigh Köhler, head of Glacier Research, at Glacier by Sanlam. “Index-like exposure, within a diversified portfolio, would enable an investor to achieve exposure to African markets.”

Cannon Asset Managers see the best opportunities lying in sub-Saharan Africa, specifically in Nigeria and Senegal in West Africa, Kenya, and several southern African countries. “We are able to compile a portfolio in these countries with a mouth-watering dividend yield approaching 5% – a most attractive option in this low-yield environment,” says Andrew Newell, head of business development at Cannon. “The returns achievable are noteworthy – it has become a bit hackneyed to label Africa as the ‘last investment frontier’, but there truly are exceptional opportunities available on the continent that cannot be ignored.” ❐

TIPS FOR MAXIMISING YOUR INVESTMENTS

  • Invest as much as you can. Always try to increase your contributions annually, in line with inflation.
  • Everyone’s circumstances are different, so make sure your plan takes your needs and goals into account.
  • Regardless of where you are on the wealth spectrum, always take account of where you are on the risk spectrum. Not everyone has the same tolerance for risk.
  • Whatever the stage in the economic cycle, investing is for the long haul and the portfolio outcome is less influenced by prevailing environmental factors and more by observing the simple investment ground rules. Stay invested. This is a long-term endeavour and the best results are found over time. Allied to this is the power of compounding: the generation of earnings and capital growth on an asset’s reinvested earnings.
  • Buy assets at the right price. Overpaying for an asset will result in poor investment returns. Look for value and attractive prices. These shares are unlikely to be the fashionable or sexy ones, the “good story” stocks. They are more likely to be the hidden gems, the unnoticed and “unloved” ones.
  • Research shows that smaller cap stocks have performed better than the bigger cap ones over time so look for quality smaller counters where there is the potential for greater upside. Large stocks will certainly have periods of outperformance, but over time the real winners come from companies that are smaller, not bigger.
  • Investors looking for more returns will need to take on more risk, while still staying within their risk profile.
  • If something sounds too good to be true, then it probably is.
  • The theory of investment management emphasises the crucial asset allocation decision. Examine your risk appetite and decide what proportion you need to invest in equities versus bonds and cash.
  • Spend time analysing the current economic conditions to determine which sectors of the economy will do well relative to others, for example, banks versus resources, industrials versus IT, food versus construction. But be there.

SHOULD YOU PAY THE BOND OR INVEST THE CAPITAL

Unlike shares, ETF’s or Unit Trusts are measured and priced, property is not

  • Property is an asset, but you only realize your profits or losses once you sell the asset
  • Depending on area and leverage, on average since 2007, property has not beaten inflation (according to states given by ABSA bank)
  • Investing R1 million in property in 2007, means you may have only received 3% or less from rental income. And the capital price hasn’t beaten inflation of 5.7% (results will obviously vary), so your R1 million is now only worth R1,500,000. If you received   R230,000 in rental income profit provided it wasn’t bonded, your R1 million would   now be worth around R1,8 million
  • Since January 2007, the JSE all share has given over 100% return, with around 10.75% compound over the period, meaning your R1 million has now doubled and would be worth around R2,050,000
  • The above figures are only looking at capital price, excluding any dividends on shares and other variables on property like monthly rates and taxes, maintenance etc
  • With a rising interest rate cycle, we could see rates going up by another 2% over a 24 months period helping clients with interest bearing investments, but not the man    in the street with debt
  • The higher the Prime rate, the better “return” you receive by paying off a bond
  • With the current Prime rate at 9.25%, and a potential 1-2% increase over the next  24 months, means you could see a return of up to 11.25% if you have the capital to pay off your bond
  • A return of 10% plus compounded over 5-10 years on the JSE would still beat this 11% return. If we start seeing rates return to the 13-15% levels then there may be  an argument for Debt consolidation versus Equity investments
  • If you required an income, could you break a corner of your gingerbread house off to   eat if money is tight?

Source: Deton Private Wealth Pty(Ltd)

Author: Monique Verduyn