Rand hedge shares and offshore investments are popular among South Africans concerned about the direction in which the currency has been heading. But, should investors be overly concerned about the currency when allocating assets? Brian Munro, Head of Multi Assets at Cadiz Asset Management, keeps a cool head when assessing the rand’s value and its importance in a portfolio.
If you are opting for shares, don’t neglect the details about the underlying business in which you are investing because ultimately the business value should determine the share price, is his message.
He doesn’t believe in selecting shares on the basis of the rand’s value compared to other currencies unless this value is at extremes. Betting on the rand’s value is unlikely to be rewarding because it is notoriously difficult to forecast in the short term.
However, suggests Munro, constantly re-assess your holdings from the perspective of the currency in order to understand whether the fundamentals of the companies in your portfolio are likely to deteriorate or improve as the rand’s value changes. Munro shares his current thinking on the rand’s value and how he factors the rand into asset allocation decisions. – Jackie Cameron
By Brian Munro*
With ongoing political and economic uncertainty both locally and globally, rand volatility has become the norm rather than the exception. Although the value of the rand is crucial to the local economic outlook, it can have a meaningful impact on a company’s earnings.
However, buying shares simply because of their rand exposure might not be prudent. Rather, when deciding where to invest you need to understand the underlying business, and apply a disciplined process.
Business value before rand value
Underlying business value (not currencies) should determine whether you buy a share
Any exporter, importer or tourist knows that the influence of the rand on the local economy has always been profound. The value of the rand can have a meaningful impact on corporate earnings.
However, it is important to know why you are buying a particular share. Are you buying the share simply because you are concerned about the rand and want to load your portfolio with rand hedge shares? Or is it because the underlying business offers value?
A key principle in our decision to own a share is to focus on understanding the underlying fundamentals of the business by assessing:
• the quality of the business and management’s ability to execute a well-formulated and articulated strategy,
• the company’s ability to grow profits over time and where in the profit cycle the company finds itself, and
• the value of the business and what price we are willing to pay for that asset that provides a sufficient margin of safety in case we are wrong (in other words, we assess whether the discount to the intrinsic value is high enough to compensate us for the risk of investing).
The best approach to a fluctuating rand is to maintain a long-term perspective.
There are times however, when the rand can have a disproportionately large impact on the fundamentals of a business. This is particularly true if the rand depreciates or appreciates to extreme levels that are subsequently sustained.
Predicting the absolute level of the rand is notoriously difficult and we believe it is a futile exercise. In line with our philosophy, we believe a better approach is to have a long-term perspective and act only when the rand is at extremes, in other words when it is significantly above or below its intrinsic value.
The depreciation of the rand/dollar
The exchange rate suggests that the rand is oversold.
Chart 1 shows the rand/dollar exchange rate since 1994. The trend rate of depreciation has been 4.4% per annum (p.a.) This is in line with standard economic thinking that the rand should depreciate by roughly the difference between South Africa’s inflation rate of 6% p.a. and the global inflation rate of 2% p.a. (based on the US inflation rate).
Had the rand depreciated according to this trend rate of 4.4% p.a. from 1995, it should now be at R11/$. The starting point to the analysis can significantly influence the result. However, whether fair value is R11.00/$ or R12.50/$, at the current price of R14.23/$ (as at 12 October 2016), the rand still appears to be oversold.
’Table 1 shows the composition of the local equity market categorised according to the following ‘rand types’:
• rand defensives – large multinationals where the majority of their business operations are outside South Africa
• rand cyclicals – commodity companies that have mining operations in and outside South Africa; the commodities are usually priced in dollars, but could have a large rand cost base
• rand plays – banks, local property and retailers based in South Africa where the majority of their revenue and cost base are in rands; these assets are also affected by South African bond yields
• rand neutral – domestic industrial companies where most of their revenue and cost base are in rands and that are not significantly affected by the rand
Rand: Buying opportunities opened up in 2015
At the end of last year the rand depreciated significantly to over R16/$. This was an overreaction to the increased political risk coupled with the real risk of South Africa’s sovereign credit rating being downgraded to sub- investment grade or ‘junk’ status.
This caused other local assets such as sovereign bonds, banks and a number of domestic industrial stocks to be oversold as well. As prices moved away from their intrinsic value, buying opportunities were created. Consequently, we were able to reposition the portfolios we manage by:
• increasing exposure to banks,
• increasing exposure to various domestic industrial shares,
• reducing exposure to multinationals, and
• protecting a portion of the offshore assets from a strengthening rand
There are still risks but we will assess them as they occur and respond appropriately.
The risk to this positioning is that the rand could sell off significantly if fears increase because of either domestic or global factors. Looking towards the end of the year, various risk events lie ahead, including:
• an Italian referendum in December,
• the risk of a US interest rate hike in December, and
• the possibility of South Africa’s sovereign credit rating being downgraded to junk status.
These events – and other unexpected events – could trigger a negative reaction from the rand. As each incident occurs we will assess whether the risk event is temporary or structural, in other words whether it could cause the fundamentals of the companies we’re invested in to deteriorate or improve. It is important to remember that the trend is for the rand to depreciate over the long term. It is only because the rand depreciated so quickly and to such extreme levels that we were in a position to restructure the portfolios.
An improved trade balance and the search for yield support the recent rand strength.
1. Commodity prices for our export commodities (gold and platinum) have improved in comparison to the commodity price of our major import (oil). This has improved South Africa’s trade balance.
The rand on your investment decisions: Stay objective
The rand can have a major bearing on company fundamentals and movement in asset prices, which could be either temporary or structural in nature. However, the rand is extremely volatile in the short term and notoriously difficult to forecast, so this should be avoided. When considering the impact of the rand on investment decisions, we believe that having a long-term perspective, a sound investment philosophy and disciplined process is vital.
Brian Munro is Head of Multi Assets at Cadiz Asset Management.
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