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The Rising Importance of Capital Appreciation

Growth is an ever-important aspect of life in general, and financial markets are no exception. Our interest, when it comes to investments, lies in growing our investment over time, thereby enabling capital appreciation.

The Rising Importance of Capital Appreciation
Vanessa Mathebula

Vanessa Mathebula

Quantitative Analyst,
STANLIB Index Investments

Growth is an ever-important aspect of life in general, and financial markets are no exception. Our interest, when it comes to investments, lies in growing our investment over time, thereby enabling capital appreciation. However, this growth should be at a reasonable rate for the investment proceeds to amount to something sustainable in the future.

 

When it comes to the inflation rate, the devil is truly in the detail. Imagine the impact on your grocery bill if cooking oil suddenly increased to account for over 10% of your grocery budget!

 

The buying power of your money is a very important aspect, especially when it comes to investments. It is, therefore, important to use an investment vehicle that will not only grow by the inflation rate through time, but also one that will hopefully beat it. Ultimately, the main goal is for your money to be able to buy more tomorrow than it can today. That is the fundamental basis of investing for capital appreciation.

 

To be in a position to reap the rewards of capital appreciation, you have to first be able to spot a good investment portfolio proposition. There are various ways to achieve this. It is our view that such a portfolio should deliver top-quartile performance at a competitive cost, by providing an investor with active exposure and no style bias.

 

To elaborate on this concept, we will focus on building and assessing an equity portfolio as if it were a stock, based on the quality, growth and value investment style dimensions. For instance, by assessing the characteristics of a stock that aligns with these three factors, we are able to form a holistic perspective of the key return drivers and therefore the investment proposition of the given stock. The same thinking applies to an equity portfolio.

 

Quality, Growth & Value

Before we dive into the core analysis, let us explore these investment styles, because they are the historical drivers of return. Typically, companies with strong quality attributes would possess low debt, low levels of leverage and strong Return on Equity (ROE). Those companies that have growth potential look likely to grow their earnings base into the future and outperform their peers and the overall market for some time. For instance, they would continue to deliver a higher-than-average increase in sales. Finally, those with a good value proposition would trade at levels lower than their actual worth (e.g., trading at a discount to Price Earnings (P/E) and Book Value).

 

Portfolio as a stock

Is there a way for investors to gain better exposure to these stock characteristics (ROE, earnings growth etc.) in a less risky and systematic (rules-based, data-driven, unemotional) manner? To achieve capital appreciation, risk should be managed. One of the best ways to do this is through stock selection, which involves investing in a basket of securities whose returns are driven by different styles. In line with the style theme, this would mean having a portfolio that has exposure to the different investment styles for various stocks. Constructing a portfolio based on a systematic approach would further reduce risk. This means choosing the various constituents of the portfolio based on evidence that these factors are, in fact, the key return drivers of the given stocks.

 

With the above in mind, how would we put this into practice? Let us consider a portfolio of 10 different stocks in an example of using an equal weighting scheme. The individual metrics are shown, as well as how these combine at a portfolio level.

To understand the benefits of portfolio construction, let’s analyse a few examples from the table above. If you were to invest all your money in BHP Group, you would have superior metrics across the board. But as you would be “putting all your eggs in one basket”, this would be a very risky move and should be actively discouraged. If something suddenly went wrong with the company, you would lose all your money. On the other hand, by putting all your money in MTN Group, you would have inferior metrics across the board. However, by combining these stocks, you can build a diversified portfolio profile that ticks all the important boxes and reduces risk. If you could find a stock meeting all these characteristics, it would no doubt be on the BUY list!

 

By amending the weights, we can obtain a set of portfolio characteristics that are superior and potentially better than the benchmark (a standard against which the performance of a given investment vehicle, such as a stock or a portfolio, is measured), as illustrated in figure 2 below.

Finally, to gauge the quality of our constructed portfolio, we need to evaluate the metrics against a chosen benchmark. An appropriate benchmark would be an investment vehicle/index that has similar securities to the fund/investment vehicle in question.  One practical example of this is the analysis of the STANLIB Enhanced Multi Style fund (the fund) – an actively-managed optimal fund based on a style-neutral systematic approach – against its benchmark, the FTSE/JSE Capped Swix All Share Index (the benchmark).

 

The table below shows some examples of the portfolio’s characteristics against the benchmark across a few fundamental metrics. Note that each of the main styles of Quality, Value and Growth consists of a number of fundamental metrics, which form part of the scoring methodology.

From figure 3, we see that we end up with a fund that is better than the benchmark on all three style dimensions, which highlights the fund’s potential ability to deliver outperformance compared with the benchmark. This fund has other significant benefits which contribute to overall capital appreciation. For example, because the fund is based on a systematic approach, its costs are lower than other comparable funds in the market. The fund has proven to have low alpha correlation with other active funds in the market, which highlights its ability to be used not only as an investment management tool, but as a risk management tool. Finally, it is an active fund that gives you exposure to various investment styles with relatively high active share selection.

 

For the cost-conscious investor who does not want to be left in the cold when the inflation chills blow through, an enhanced multi style fund may offer the solution.  The solid systematic philosophy, coupled with decent long-term performance, provides a good source of potential capital appreciation, potentially shielding investors from the inevitable erosion of inflation over the long term.

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