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Watch for risk hidden in offshore returns
The significant weakening of the rand against major currencies over the past two years has been a big driver of returns for South African investors invested offshore, and may even have masked poor investment allocation. Now that the rand is close to fair value, the performance of the underlying offshore assets will be far more important for future returns.
Further, with international markets now looking expensive, offshore exposure should be carefully managed. according to RECM Senior Analyst Linda Eedes. She says that over the past two years having money invested in hard currencies has paid off for local investors, and it hasn’t really mattered how the money was invested. “Moving assets into other currencies was a no-brainer two to three years ago when the rand was so clearly overvalued. With the rand depreciating 35% over the last three years, it didn’t matter as much where you put your money, you would have in all likelihood seen a strong return in rand terms. Even if your investment actually lost 10% over the period in the underlying investment, you made 25% thanks to the depreciation of the currency alone.”
But with the rand now much closer to fair value, future returns will likely be more dependent on the performance of the underlying investment offshore, says Eedes. “On a long-term purchase power parity basis the rand is actually slightly undervalued right now, but not significantly so. There’s likely to be short-term volatility in the rand, but there’s no longer the strong swing factor of a currency set to weaken significantly. This means that offshore returns from this point will be much more closely linked to how the money has been invested than has recently been the case.”
According to Eedes, another challenge to prospective returns is the high current valuations of major international markets at the aggregate level. “Given strong returns from global indices, many investors may be considering a passive index-tracking fund. But this approach is backward-looking – now is precisely the time to actively select global investments that still offer value and omit those investments which are now expensive and represent risk.”
A number of indicators suggest that international markets are overvalued, says Eedes. “While price-to-earnings ratios of the major markets are sitting at the top end of their historical range, there are several other indicators also pointing to significant overvaluation. Prices are high compared to ten-year average earnings and share buybacks have decreased significantly, which often indicates that management feel their shares may be overvalued. IPOs are on the rise, which tends to show the same thing. Share price volatility has fallen to very low levels, something that also happened just before the 2008 crisis.
“We’re not calling the top of the market. We have no idea what the market will do at the aggregate level, but then neither does anyone else. Equally, we don’t know where the rand will go in the short-term,” warns Eedes. “However, with the rand now trading at fair value, it’s unlikely to be the big swing factor over the next three or four years that it was over the last two or three years. And with international markets looking pricey, investors need to think about where their money is invested offshore. Ideally, they should be in assets that can give them real capital growth over the long-term while protecting against the risk of significant capital loss.”
The best way to achieve this is through taking a bottom-up, value oriented approach, wherever in the world you invest. “We don’t pretend to know what’s going to happen next with global markets or the rand. Our approach is to follow our convictions and focus on building in a margin of safety by buying good businesses when these are trading below our assessment of what they’re worth. By doing so, we not only stack the odds of generating real returns in the favour of the investor, but also reduce the risk of significant capital loss should markets correct. “