Notes from my inbox - January 2021
“Uncertainty is the only certainty there is. Knowing how to live with insecurity is the only security.” – Mathematician John Allen Paulos
Human beings abhor uncertainty. In a recent study, subjects played a computer game where they received an electric shock if they overturned a rock with a snake underneath. The researchers varied the probability of encountering the unpleasant outcome when overturning a specific rock over time, making it alternately easier or harder to predict where the snakes are. They found that stress levels peaked when the sequence was random and the player just did not know what was coming next, which they equated to irreducible uncertainty. Study participants were much more agitated when they did not know what was coming than when the level of shocks incurred was higher, but more predictable.
This outcome has a lot to do with how we are wired. The striatum, an ancient part of the brain, combines two core functions. It is responsible for taking action, as it controls movement and other aspects of cognition. It is also linked to a dopamine-rich part of the mid-brain and as a result is often referred to as the brain’s reward centre. While dopamine is proven to cause pleasurable sensations, it is also a precursor to adrenaline, which in turn exists to provide us temporarily with more clarity and energy to deal with life-or-death situations. The striatum effectively anticipates good and bad outcomes and creates most stress if the outcome is highly uncertain, when a quick response is most likely to make a difference to the likelihood of survival.
Unfortunately, this system becomes unhelpful if it is constantly triggered by stressors that are not life threatening and it can certainly impede successful investment decision-making. As portfolio manager Neville Chester points out here, the response of many investors to the Covid-19 market shock in February and March last year was to de-risk their investment portfolios and move to cash. Given the strength of the subsequent market recovery, this was not a useful reaction.
The magnitude of market movements over 2020 is illustrated by the performance of Top 20, our concentrated equity fund. By mid-March, when the scale of the pandemic became clear and a few days before the first hard lockdown was announced, the value of the fund declined by a third (measured from the start of 2020). Since then, its unit price increased by 68%, for a total return at the time of writing of 13.2% over the last 12 months. An investor who divested in late March would have missed the subsequent recovery, and given the very low (albeit more certain) cash returns, would still be nursing a loss of around 30%.
Craving certainty is a fool’s errand when you are dealing with the future, which is by definition uncertain. Academic literature defines the excess return expected from equity markets as a risk premium, basically a reward for embracing and managing uncertainty.
A NEW YEAR, NEW RISKS AND OPPORTUNITIES
At the start of 2021, there is, as always, much uncertainty to stress about. The state of the local economy is still precarious, and government as yet has no clear path to fiscal sustainability. The pandemic caused inequality to widen further, with job losses falling more severely on low-paid, often young and female, employees in industries, such as hospitality and tourism. Higher taxes on asset owners and companies will be one likely result. Supported by unprecedented levels of fiscal and monetary support, many equity markets around the world are trading at record highs. At some point the income support programmes and central bank balance sheet expansion will stop, with unclear consequences for markets. Pundits, especially in the US, are debating whether we are in bubble territory or not. Over time, inflation may make an unwelcome return. Locally, vaccine procurement and roll-out have not been handled well initially, rendering South Africa one of the worst-supplied countries in the world, which will delay the exit from pandemic-related social and economic constraints.
Yet, there are also reasons to be positive. The local economic problems are well known and reflected in asset valuations. South African government bonds pay the highest real yield available in the world’s investable bond markets. Local equity valuations are very undemanding on an already severely depressed earnings base. A small change in investor confidence can lead to significant gains from current levels. Over the longer term, investors can protect themselves against pockets of overvaluation and inflation by investing in sensibly diversified portfolios built from the bottom up, based on the individual investment cases from assets sourced from around the globe. While inequality has increased, a more conventional administration in the US means more global alignment in fighting climate change and a move away from the trade war rhetoric of the Trump era. The work-from-anywhere lessons we learnt last year widen the gap between businesses that successfully embrace technology and that do not. All these trends create an environment in which good stock-picking and portfolio construction can add significant value.
There may even be better news on the vaccine front soon. While we currently only have vaccine supply for a fraction of the population, this situation may change more quickly than generally expected. Most developed countries placed multiple advance orders for enough doses to cover two to four times their population. Some of this excess will eventually become available to the stragglers, especially as more vaccine candidates are proven to work. In addition, if the Johnson & Johnson vaccine proves to be efficacious, this may also help to accelerate domestic supply. Aspen has the contract and capacity to annually manufacture 300 million doses of this vaccine in Port Elizabeth. It is possible to imagine that some of this may become available locally later this year.
ALSO IN THIS EDITION
Marie Antelme provides a comprehensive review of the global and economic data and shares our macro outlook for 2021. Nicholas Stein provides some colour on how undemanding valuations have become in the local equity market and sets out the investment case for life insurers and, specifically, Momentum Metropolitan Holdings. Home improvement retailers were one of the beneficiaries of people spending more time at home. Danie Pretorius sets out the investment case for Home Depot and Lowe’s Companies, the US market leaders in this sector. We also include Nishan Maharaj’s regular bond market update, as well as detailed fund commentaries from our portfolio management team.
After two consecutive years where investors were rewarded for taking risk, we hope that it becomes a little easier for our clients to deal with the inevitable uncertainty that comes with long-term investing. We remain focused on the task of managing uncertainty on your behalf, by making sensible security selection and asset allocation decisions in our portfolios. As always, I invite you to contact us via firstname.lastname@example.org if any aspect of our delivery to you is unsatisfactory.