Over the last year investment gurus have told us to take advantage of a relatively strong rand and lower global valuations by investing offshore. Since then the world has gone pear-shaped once again with negative real interest rates, an investment in government bonds resembling a game of roulette and our best option seems to be krugerrands stashed away in our safes.

Speaking to global fund managers you get the sense that they would like nothing better than to knock together the heads not only of short-term traders but many of their investors too.

“When a client wants to cash in because they are worried markets will fall further we have to sell companies with dividends yields of 5% against our better judgment. People pulling the money out don’t realise the value of this dividend income and are instead investing it in cash at 0.5% if they are lucky,” says one such frustrated manager, Kokkie Kooyman international fund manager at Sanlam Investment Management Global.

Coronation Global Balanced Fund manager Gavin Joubert concurs highlighting one of his top picks, Vodafone, which is currently trading at 9x its cash flow which will pay a 7.5% dividend in British Pounds next year while Tesco’s one of the UK’s largest retailers is paying investors 4.5% a year. It seems like a no brainer when you would be receiving 1% from a UK bank right now.

“You can buy one of the biggest mobile phone companies in the world with 25% of its earnings from emerging markets at these levels. It is the biggest opportunity you can find,” says Joubert.

Equity as income

The point both these managers make is around income and it is an important one. In a world where real yields on government bonds and cash are negative, investors will have to start looking for better yields and high dividend paying blue chip shares will be in demand.  In many ways it goes back to the fundamental reason for investing in shares which is earnings and dividends which in turn drive the share price over the longer-term.

“If you invest now, as long as you know the company will pay dividends every six months, then you can live through the share price volatility because the earnings are safe,” says Kooyman who adds that investors sitting in good quality US companies are receiving dividend income of around 5%. This is real tangible income, not a price variable on a stock exchange manipulated by short-term traders.

When you compare that to virtually zero percent returns from cash and bonds, it seems like a no brainer, so why the flight to US Treasuries which are producing virtually no income and have just been downgraded or gold which has no value beyond jewelry, except a sentimental one ,and generates no income?

The fear factor

There are several factors at play. Firstly the market is made up of investors and traders. Traders try to exploit short-term movements and are focused on the short-term prices of shares not long-term earnings.

Joubert points to the high frequency trading funds which are programmed to buy or sell on certain triggers; this tends to feed on itself pushing the market to extremes and creates massive volatility.

Investors on the other hand are susceptible to human emotions namely fear and greed and when faced with uncertainty flee to what they perceive as “safe” namely US treasuries and gold.

The irony is that while existing investors are cashing in their funds, new investors are relishing the opportunity to buy companies and dividend income at record lows.

Kooyman says SIM Global are on the lookout for companies that not only are paying good dividends but also have a track record of paying dividends to ensure that they continue paying.

Joubert currently has a 70% equity weighting in his managed fund as he takes a strong view on under- priced equities. Despite this high equity weighting the Coronation Balanced Fund has maintained a positive return for the year losing only 3.5% during the August bloodbath.

Joubert says nothing has fundamentally changed for the prospects of the companies he invests in. Take beer company Anheuser–Busch the brewer that produces Budweiser; it generates a significant portion of its earnings from high-growth emerging markets. “If you asked me if I would have changed my five-year earnings forecasts between the months of July and August, I wouldn’t as nothing has changed to impact that model, yet the share price fell 15%”.

Investing geographically

An interesting anomaly has been developing over the last few years in terms of geographical asset allocations. Although the US economy is in dire straits, US companies delivered earnings growth above expectations.  In this world of globalization, where a company is actually listed has very little to do with where its earning come from.

Take Coca-Cola for example, a stalwart of the New York Stock exchange, makes 50% of its earnings from outside America and is very much geared to the emerging market. Ditto other companies like Microsoft, Apple and even YUM Brands which owns KFC. Buying a US listed company does not mean you are tied to the US economy.

Michael Power, strategist at Investec Asset Management says their Global Franchise Fund simply invests in high quality global companies irrespective of where they are listed. “We chose the best companies wherever we find them, it just happens that 20% of the best companies are listed in US’” says Power.

As companies become increasingly global the idea of geographical investing is losing its relevance as the investor has to look beyond the listing to where the earnings are being generated. “We do a lot of homework and focus on regions which are conducive to good growth,” says Kooyman.

When looking at companies with geographically diverse earnings streams, Kooyman says the fund managers looks at each earnings streams separately based on the region and then calculate the earnings going forward.

In Europe there are a number of good European companies with offshore exposure like Renault which sells outside of France. It is currently inexpensive as investors have sold out European stocks. Microsoft is the cheapest it has been in 20 years with a p:e of 8X yet 40% of sales are outside America.

The problem with globalisation is that it is more difficult to manage currency risk. You may get great earnings out of a region but the currency in which the company is listed collapses, so one needs to include currency risk in the relative valuation of the share.

For example if the view is that the Euro will depreciate by 10% then any purchase of a European company will have to offer a discount of 10%. In other words companies listed in countries that have currency risk will have to trade at a lower value to make them attractive.

Buying at the right price

Many offshore investors have been extremely disillusioned with their returns over the last ten years. During that time global equities have been flat while the JSE has delivered returns of 17% per annum. Joubert argues that this is exactly the reason investors should go overseas, because finally valuations have come back down to reasonable levels.

In 2000 investors simply way over-paid for global equities. In the accompanying table Joubert demonstrates that in 2000 at the height of the tech bubble you would have paid $38 for technology company Cisco. Eleven years later that share price is still down 58%.

However the earnings per share have increased by 250%. There was nothing wrong with the company, what was wrong was the amount paid for it. share price performance is determined by how much you pay for those future earnings. At the moment Cisco is trading at a price to earnings ratio of 9.6X compared to the mind blowing 81.4x in 2000.

Delphine Govender, portfolio manager at Allan Gray says long term investors need to understand that risk is not volatility but the permanent loss of capital.

If your investment falls in value due to short-term market volatility that is not a significant risk. The problem is if you are never able to recover your losses and that happens when you overpay for an asset, as in the case of Cisco in 2000. “Since our primary definition of risk is the probability and the extent of capital loss, we always try to invest in businesses when share prices are well below our assessment of the company’s intrinsic value and we are offered some protection should things turn out worse than we forecast – in other words, a margin of safety exists.”

She says Allan Gray believes that to invest where value is exceptional is not only the lowest risk, but also the most rewarding strategy. “In our opinion, the best predictor of returns is the price you pay for the investment relative to its intrinsic value and risk.”

Kooyman says people make the mistake of comparing current valuations to valuations over the last five or ten years. That is too short a comparison and you are comparing to a period of overpriced assets, again demonstrated by the accompanying price and earnings table. Kooyman argues that one should analyse the company price versus earnings and net asset value over the last 20 years to understand its relative valuation.

Based on these criteria good opportunities are available overseas to a greater extent than locally. It is interesting to note that for the first eight months of the year the global markets had outperformed the JSE by 5% before accounting for the rand devaluation.

An investment approach

In uncertain markets a focus on income is a sound investment strategy as income, whether from earnings or interest, is more stable and predictable. Michael Power recommends the following strategy:

• Invest in the equity and corporate debt of high quality blue chip companies who have earnings from high growth areas.
• Invest in emerging market debt (government bonds) rather than US or European bonds. There is less risk of default and the yields are higher
• For cash Power’s best bet is Singapore dollars. Although the returns are only 1% it will appreciate by 3% to 4% against the US dollar providing a total return of around 4%.
• Gold although expensive is preferable to US treasuries. Although gold does not pay an income nor do US treasuries to any significant degree and gold will act as a hedge against a weaker dollar price.

This article by Maya Fisher-French was first published in InvestSA