One of the greatest enemies of successful investing is emotion. In making an investment decision, being too optimistic in good times or too nervous in tough times, often leads to the wrong call. Trying to time investment entry and exit points precisely is a futile pursuit, with investors normally taking the decision too late. For instance, those who sold out of equities after the 2008 market crash would have done so after bearing the brunt of the sell-off, only to sit on the side lines waiting for the dust to settle. When the market turned in March 2009, news was at its bleakest and sentiment at its most pessimistic, but equities nearly doubled over the following two years. Unfortunately for them, most investors re-entered the market after the initial rally, thereby missing out on some of the largest gains.
A key factor in investing success is the ability to stick to a long-term strategy. Investors should establish their own risk profile, based on their long-term objectives and time frame to retirement. Then, when selecting investments, they need to keep this risk profile in mind and avoid focusing on near-term market sentiment. The longer their investment time frame, the more risk investors can bear and the more equities their portfolios should have.
Equity volatility is actually an investor's friend, as most of the return enjoyed is determined by the price that is paid: the lower the price, the greater the long-term returns that can be generated. Volatility means prices fall (representing buying opportunities) and rise (reflecting selling occasions). No matter how good a stock's future might look, if you pay too much for it, you've made a bad investment.
The chart below (Chart 1) clearly demonstrates this point. It shows the monthly cyclically adjusted price: earnings (CAPE) ratio of the South African equity market measured on the horizontal axis and the subsequent annual return for the next three years on the vertical axis. The evidence is compelling: when markets are on low CAPE's, investors enjoy handsome subsequent returns and vice versa.
The emotions inserted on the graph are characteristic of the mood of investors at these stages. In short, when investors are the most pessimistic is exactly the time at which to invest and, critically, when markets are their most euphoric it is not the time to be allocating more money to equities. The blue dot represents where the JSE is at present and it indicates attractiveness, not despite, but because of, the poor environment in which Europe finds itself.
Chart 1: Monthly cyclically adjusted price-earnings ratio, subsequent three-year return (annual) and investor emotions at that point
In trying to time the market, investors risk investing emotionally and thus make bad decisions. In trying circumstances, it is easy to disregard a strategic view and make decisions based on prevailing emotions, a sure route to failure. Investors need to remain faithful to their long-term strategy and to be patient.
Right now, it would be easy to get caught up in the negative emotion in world markets, particularly in Europe with the fears of a Euro breakup and potentially defaulting governments. We believe the problems in the developed world are entrenched, ranging from unsustainably high levels of debt to aging populations and poor government policies.
Chart 2 below shows the levels of debt in the world's largest economies. The alarming figures reported in the media are shown in black. Of far greater concern, however, should be the green, which represent those debts or liabilities that are not shown on a country's balance sheet, but they are still obligations of the respective governments. This includes various social and welfare commitments including retirement benefits, health protection and unemployment subsidies. While these liabilities are noble, they are simply unaffordable. The sad result is that governments are likely to default on their debt in some shape or form in the future, whether it is through inflation, outright default or "taking a haircut" as per Greece. Naturally, this is contributing to increased market uncertainty and greater volatility.
Chart 2: Explicit and implicit advanced economy debt
The PIIGS countries – Portugal, Italy, Ireland, Greece and Spain – exhibit evidence of financial stress. Greece has been the headline grabber and appears to be on the brink of government default again with a rising likelihood of Greece exiting the Euro monetary system. This may happen in either an orderly or disorderly fashion; however, it is safe to say that either outcome would create stress and anxiety in capital markets. Greece's economy specifically would be massively disrupted for some time.
However, the world's news is not all bad. Emerging countries are experiencing positive GDP growth and have young, dynamic and growing populations. Their savings and investment rates are on the rise, healthcare and education levels are improving and their economies are increasingly open. Table 1 below highlights how rapidly emerging markets are growing and, even more pleasing, how quickly African economies are growing.
Table 1: Fastest rates of economic growth in the world
We expect these emerging market economies to continue to be the drivers of global growth over the coming decade. A notable example of this is Nigeria, which generates 5.9GW of electricity for a population of 150 million people. South Africa, by comparison, generates 40GW of electricity for 50 million people. The difference in power generation per capita represents an investment opportunity and we are seeing an increasing amount of South African businesses that are capitalising on the strong growth emanating from the rest of Africa.
Investors globally have recognised the current difficulties as well as the structural problems the developed economies face, and this has resulted in significant volatility in equity, bond, currency and commodity markets. As South Africans, we have been through our fair share of global and local extreme market moving events, ranging from the Wall Street collapse of 1987, the change to a democratic South Africa in the early 1990's, the Asian crisis in 1997, the dot-com bubble of 2000 and more recently the global financial crisis. In addition to this, the Rand has been one of the most volatile currencies in the world through this colourful history.
However, it is precisely at a juncture of high market volatility and uncertainty that opportunities present themselves, rather than during the good times. History is a wonderful teacher and, whilst unnerving, it is at moments such as these that exceptional investment opportunities arise. Investors will profit from these opportunities most effectively by focusing on their long-term investment strategies and sticking with them. A sound investment philosophy and consistent application of that philosophy has, time and again, demonstrated to be the most effective way of achieving investment success. Although the mood at each of the times above was captured as being anxious and fearful, what we have learnt is that they have all provided entry points from which attractive investment returns were delivered.