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The FTSE/JSE Africa all share index has appreciated by about 26 percent over the past year. But the return is distorted by a poor performance from resources and hides the strong achievements of the industrial and financial sectors, which rose 38 percent and 42 percent respectively. Given these price movements, many investors are asking whether now is the time to start selling South African equities. As a manager of absolute return portfolios, where the preservation of capital is as important as return optimisation, Coronation Fund Managers constantly asks this question — and more so in the past few weeks. Alternative to selling equities is to utilise derivatives for downside protection. To achieve the objective of generating positive, real (above inflation) returns over time, it is vital that Coronation does not hold overvalued assets in its clients’ portfolios. Despite the strong performance from equities, many shares are still fundamentally undervalued, albeit significantly less so than a year or two ago. This view is given further support when compared with the likely returns from the alternative asset classes. Cash returns, at about 7 percent, result in an even less attractive 4.2 percent net, or after-tax, return. The R157 government bond, at a yield of 8.5 percent is, in Coronation’s view, overvalued and if purchased today carries the real possibility of capital losses. Inflation-linked bonds are yielding a real return of about 3.7 percent, and with an inflation expectation of between 5 percent and 6 percent, one can expect a return of between 8 percent and 9 percent from these bonds. Listed property stocks are more attractive than bonds, despite the historical high correlation of these two asset classes. Fundamentals in the property market, particularly retail, are very favourable, and property companies are well placed to grow their distributions by between 3 percent and 6 percent over the next few years. Preference shares are attractive for after-tax portfolio’s, yielding just over 7 percent. Shares trading on forward dividend yields above 5 percent and single-digit price:earnings multiples (based on forecasts of earnings and dividends), include Telkom, Remgro, Metropolitan, Mr Price, Peermont Global and Alexander Forbes. The tax-free dividend income stream from these investments is more attractive than cash. In addition, capital appreciation is expected over the next few years, due to a combination of free cash flow growth in the underlying businesses and a rerating to more adequately reflect their quality. Based on dividend income and expected capital appreciation, we believe that South African equities are still the most attractive asset class. An alternative to selling the underlying equities in a portfolio is to utilise derivatives for downside protection, such as buying market put options to cover part of the equity exposure. Such an approach enables a portfolio to participate in the upside in the event of continued rally, though it will be partly protected in a falling market. Coronation believes it prudent to put this protection in place given the recent strong performance of equities. The time to start selling equities has not yet arrived, but added caution is advisable. Stock selection with a strong focus on valuation has become even more important, and careful attention needs to be paid to accurately determining the fair value of equities so as to facilitate their timeous sale. By Gavin Joubert Gavin Joubert is an absolute return portfolio manager at Coronation Fund Managers.
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