Wednesday, 18 November 2015 - 20:00

 

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Seed Weekly - Local Equity Valuations

From time to time we document the approach that we take with respect to our tactical asset allocation of local equities. This is not the only input into our process, but the methodology has proven to be sound, especially when taking a longer term view.

Essentially, the thesis is one that says the more expensive the price paid for a particular share or market, the lower the expected return from that investment. Anecdotally, most investors can appreciate the advantage of buying into a good business at a cheaper valuation, in order to maximise the investment upside.

Investment risk then is less about the daily volatility of share prices and more about the price paid relative to the underlying or intrinsic value of the business.

At the same time – and this is what we have being seeing over the last few years – what starts off at expensive levels, continues to be pushed up to even more expensive levels as investors become more and more optimistic about the future outcome and are therefore willing to pay up. It is however at exactly the time of maximum investor optimism that risk (i.e. investment risk) is at its maximum level.

Seed has developed a model where, on a monthly basis, we measure the market valuations in order to try and “predict” the future market returns. The chart below reflects rolling 5 year compounded returns superimposed on top of the model’s return expectations.

The model is a multi-factor one that also learns from history and we therefore expect it to become more accurate over time. At the market bottom in February 2009, the model predicted a return of approximately 28% pa over the next five years. History has shown that, at that time when investors were extremely nervous, this proved to be an excellent entry point. The 5 year compounded return from the ALSI from that point was actually 24% pa.

Since then, the expected return has oscillated between 10% and up to 22% in September 2011. As the market has become more and more expensive, and in fact is now at one of the most expensive levels since we started measuring, so the expected compounded return from local equities over the next 5 years has fallen to 8.5% pa.

Because all forecasting models are fallible, we do not rely 100% on the outcome. However, as can be seen from the chart above, there is a high correlation between its expected return and the subsequent five year return and given the very low total return expectations at this time, means that we remain cautious with respect to the level of allocation to local equities.

Sincerely,

Ian de Lange

Tel +27 21 914 4966
Fax +27 21 914 4912
Email info@seedinvestments.co.za

Seed is hiring: Visit the Seed Analytics LinkedIn profile to view vacancies.

www.seedinvestments.co.za

Wed, 18 Nov 2015

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