Uncertainty creates opportunity

The upcoming elections in May are considered to be one of the most divisive elections since the birth of our democracy 30 years ago. Will the ANC manage to maintain their majority, or will compromises and coalition deals with their opponents on either end of the political spectrum be necessary? Not a day goes by without investors asking what the various scenarios are to consider and how their investments should be structured to withstand the broad potential range of outcomes and the ensuing impacts on asset prices. While we at Abax Investments don’t believe in forecasting, part of our investment process is to consider various scenarios and risks that may arise, although, more often than not, it is the unexpected events that have the biggest impact.

A further complicating factor is that often the market reacts differently to what one might expect under various outcomes. For example, interest rates have increased globally by more and faster than any time in history, yet markets continue to hit new highs – which is arguably the opposite of what should have been expected!

From an asset allocation point of view, we ascertain what we understand to be the risk premium currently baked into asset classes and whether or not that is sufficient given all the quantifiable risks on the horizon. To give some colour, the country risk premium (CRP) is the additional return or premium required by investors to compensate for the higher risk associated with investing in South Africa over more developed markets such as the US.

The CRP that Abax Investments requires from investing in South Africa is currently in the top quartile when looking back over the past 20 years.

Source: Abax Investments

We believe it is more prudent to build robust portfolios than trying to predict the future. Thus, we focus our efforts on:

• Maintaining a high degree of diversification across asset classes, geographies, individual securities, and risk drivers

• Using diversification tools to establish ‘offsets’ in the portfolio – so if a particular outcome negatively affects a certain part of the portfolio, there will be an offsetting position that benefits/retains its value and helps negate some of the losses

• Overlaying hedging strategies on a stock and index level to protect on the downside and deliver a more asymmetric return profile (i.e., greater potential upside than downside)

• Identifying and utilising hybrid instruments such as convertible bonds and structured notes which provide an uncorrelated return profile and some level of capital protection

• Having a larger bias than usual for higher quality companies with strong balance sheets, trading at attractive valuations

Therefore, if we have a ‘left-winged’ SA election outcome resulting in an ANC and EFF/MK coalition, we expect it to be negative for the currency, as well as local bonds, financial, and industrial stocks. We expect the impacts of this in the portfolio to be offset by our exposure to SA rand-hedge stocks (e.g., Naspers/Prosus, BTI, Richemont, Bidcorp, Mondi, and non-SA miners like Billiton, Glencore and South32).  In this scenario, our SA equity derivative hedges should help offset some losses, alongside our foreign equity and bond holdings which we expect to be uncorrelated to SA assets.

A more ‘centre-ist’ election outcome on the other hand (for example, one that results in an ANC and DA coalition) should bode well for the currency, as well as local bonds, financials and industrials. It is likely to have little effect on foreign holdings other than via some potential rand strength.

Agility is key to managing uncertainty  

Source: Abax Investments.

The Nedgroup Investments Opportunity Fund has navigated many elections and cycles. It is through a diversified approach and active management that it continues to make the most out of uncertainty and find opportunity to deliver market beating returns, while aiming to protect capital over a two-year period.