The relevance of equity in a balanced fund
The asset allocation decision within a balanced fund, largely based on the well-known and not always appreciated, concept of understanding the relationship between risk and reward and what ultimately drives returns, remains one of the most important opportunities in achieving longer-term returns.
- Asset allocation decisions are key to achieve longer-term returns in balanced funds.
- Understanding the behaviour of equity return drivers critical to evaluate relative attractiveness of the asset class.
- Consumer spending changes are influencing business models and earnings growth.
Historically, equities have been relied upon by asset allocators as a growth or return driver in balanced funds with the appreciation that higher returns are accompanied by higher risk, owing to the volatility in equity prices. The asset class has proven to be an excellent inflation hedge and an important asset to include within a fund to grow the real value of capital. Investing in the right amount of equity at the right time of the cycle, can clearly differentiate return outcomes.
The basics of equity return drivers
Equity returns are primarily driven by earnings growth and, to some extent, by the distributions made to shareholders in the form of dividends. Data shows that rating changes (market valuations) are often cyclical and over the long term, they have not consistently driven the overall market return for South African equities. As shown in the chart below, there is some deviation from this rule in the short term, when ratings changes impacted overall returns more materially.
Understanding the different equity return drivers in each cycle is critical in making an allocation to equities within a balanced fund, especially relative to other asset classes.
1. Earnings growth: changing share of consumer wallet
It is important to note, when considering both earnings growth and valuation, that there is a wide divergence between valuation levels or ratings across different markets and individual company shares within these markets. The spread between earnings growth and capital returns has grown over the years, as markets and industries have become more polarised.
The polarisation of the market is evident in changing consumer spending behaviour over the last decade. Consumers are spending more and more time and money on the internet of things, including online shopping and gaming and social media activities. They are also reverting more to online services such as banking, healthcare and transport (Uber).
Companies that were able to reinvent themselves by adopting technology to meet changing consumer demand trends have been able to reap rewards. Structural changes in the share of consumer wallet, where disruptive competitors have taken market share from some of the more traditional players, were accelerated by the COVID-19 pandemic. This pushed dislocation to extreme levels as a result of reduced consumer activity during lockdowns.
Although we expect this will recalibrate as the environment recovers, the underlying structural trend is expected to persist over the longer term.
This is evident from the technology sector’s aggregate percentage of fundamentals (sales, EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) and Free Cash Flow (FCF)) and market capitalisation in the Russell 1000 Index, which has increased significantly over the last 10 years.
This shift is also evident in a report published by Accenture Research. It showed that, of 8 300 companies, the top 10% demonstrating technology adoption, technology penetration, and organisational change, were achieving rates of revenue growth double those of the bottom 25%. These top 10% of companies are also growing revenues more than 50% faster than the middle 20%.
We believe that companies able to drive sustainable top-line growth (especially organic growth), while maintaining margins/FCF, will deliver the greatest growth in shareholder value. Earnings growth must be accompanied by value creation, an essential ingredient in achieving superior shareholder returns.
2. Contextualising valuations
Some investors argue that lower real interest rates, or the expectation of lower real interest rates in future, should justify higher share earnings ratings and valuations. As shown below, what is more relevant, is the differential between equity and real bond yields.
US Treasury yields and inflation have been steadily falling since the 1980s, with some cyclicality. However, it is important to note that the 10-year real yield has been moving in and out of negative territory for the last 15 years, with a tighter oscillation around the zero point for the last five years.
The current differential shows the relative value in holding equities. However, the expectation of a more substantial rise in future real bond yields could be negative for equity valuations. We believe that the risk of bond yields increasing in the current environment is low.
Impact of COVID-19 on equity valuations
Equity markets reacted sharply at first to the potential and planned co-ordinated COVID-19 lockdowns worldwide. This resulted in the most significant sell-off in the domestic market on record on a daily, weekly and monthly basis during March 2020.
Markets rebounded rapidly as it became clear that global policymakers would protect the capital structure of economies and would do “whatever it takes” to protect the integrity of the financial system. Investors in risky assets took comfort from this reassurance and restored valuation levels in the course of the year. Towards the end of 2020, news about viable vaccines gave the market another push higher, as investors effectively looked through the current environment of lower consumer activity and company earnings.
In this environment, the compression of credit spreads has been a good proxy for equity valuations. Credit spreads (the difference between risk-free government bonds and corporate bonds) are seen as a barometer of the risk of corporate distress. These spreads, across the issuance curve, increased significantly with concerns over the economic and financial impact of the COVID-19 lockdowns. Spreads in the lower quality spectrum of the issuance curve blew out significantly, signalling potential defaults and spill-over effects into the equity market.
This triggered widespread panic selling, which in turn fuelled the unprecedented sell-off in the equity market.
Actions by policy makers across the globe to compress these credit spreads by vouching their support for many of these debt instruments, especially those below investment grade, helped to ease investors’ fears and in time increased the risk appetite for equities.
We remain focused on investing in companies that can demonstrate a high-quality business model and have the ability to differentiate themselves from their competitors. They must, through their sustainable competitive advantage, be able to deliver above-average earnings growth consistently, while adding economic value to shareholders. The environment after the peak of the COVID-19 crisis, could again be characterised by very low global growth, similar to the period after the global financial crisis recovery in 2008.
In this environment, our strategy leans towards value-adding growth shares (especially those with previously unidentified secular growth), while taking advantage of some shorter-term opportunistic trades. We will stay committed to our investment philosophy. We remain constructive on equities as an asset class, particularly emerging markets at this stage of the cycle. The US leadership change, coupled with the expected cyclical, and importantly synchronised global, economic recovery followed by accommodative monetary policy, should support this asset class, in our view.