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Investment under uncertainty
Financial food for thought in 2021
January 22, 2021
Are current equity market sentiment is overdone?
March 25, 2021
Market overview
Investment asset allocation is always a critical consideration for investors and is challenging to execute. It is especially so in the current environment as we are coming of the 5th global recession since the 1950s. Despite the strong market recovery which is partly a result of the earlier-than-expected announcements of COVID-19 vaccines, there still remains great uncertainty as to the future direction of the economy and, hence, of financial markets.
A base case scenario could well be that the economy continues on a steady recovery, and the financial market shows strong and stable returns. Simultaneously, a case can be made that the recovery falters and that a period of falling inflation ensues and persists, as has been the case in Japan. Alternatively, measures to stimulate the economy could result in higher inflation that continues as stagflation over an extended period. Uncertainty, for South Africans, becomes heightened around February each year when we receive the state of the nation address from the President and the budget speech from the Finance minister, which results in the emergence of millions of experts on fiscal policy. The questions that may be on investors’ minds are: Will South Africa’s economy sustain its expected recovery beyond 2021? Should investors allocate more of their assets away from SA?
Global asset allocation can add value when there are differing levels of uncertainty among national economies and their financial markets. So how do we make investments under uncertainty?
We need to understand the meaning of uncertainty before answering this question. Although investors dislike both uncertainty and risk, they are different. 2021 marks the 100th anniversary of the publication of Frank Knight’s masterpiece - Risk, Uncertainty and Profit, as well as the 85th anniversary of John Maynard Keynes’s - The General Theory of Employment, Interest, and Money. These two men were the first to focus on the concept of uncertainty as being radically different from risk. Risk is measurable, and uncertainty is not. The Ellsberg paradox best illustrates this. Given two investment decisions,
A – a 60% probability of losing money
B – an unknown probability of making money
Investors will almost always prefer the first choice (A), where there is a measurable chance of losing. Although investors are risk-averse, they avoid uncertainty even more. This behaviour often leads to an incorrect approach to dealing with uncertainty, such as assigning probabilities to events with no scientific basis. Additionally, when investors are highly uncertain, they may overreact to past returns leading to the well-known buy-high, sell-low phenomenon. For example, , selling out of equities or allocating more assets offshore when the Rand was flirting with the R20 to the US dollar level after the coronavirus-induced financial market crash in March last year. Sometimes, despite our best research efforts, we have to accept that we simply do not know. A scenario will not become more probable because we think it so.
A CASE IN POINT - THE PRECIOUS METALS INDUSTRY
It is true that after the event, even a fool is wise. Still, we think that a disciplined study of both history and the world affairs' economic aspects can deliver essential lessons. Consider, as an example, the case of the precious metals industry. Five years ago, many investors deemed this industry uninvestable. This investment decision resulted from challenges in productivity, declining grades, and rising costs as mines became deeper. Also, a hostile labour force, double-digit inflation on utilities, and government policies deemed unfriendly to investors added to the unattractive investment proposition. Free cash profits were significantly negative for precious metals producers such as Impala Platinum. Some investors even went as far as to call for management teams to dismantle their operations and salvage some value for shareholders by selling the scrap metal. This may have been said as a joke, but we can never be sure because the circumstances at that stage were dire! High-uncertainty stocks suffer more significant adverse return shocks during bad market states. Investors avoid these stocks during panic states resulting in depressed valuations for these stocks - such was the case for precious metal stocks. Five years later, and the picture could not be starker. Precious metal companies report record profits, free cash flows, and some share prices have increased by a multiple of seven times over the last five years! Precious metals such as platinum, rhodium and palladium are key inputs into the production of catalytic converters. Catalytic converters change harmful substances in a car's exhaust into less toxic substances. The drive for a cleaner environment has created an enormous demand for precious metals, particularly Rhodium and Palladium. The resultant supply-demand market imbalance has led to some of these precious metal prices increasing by a multiple of over three times over the last five years. As panic eases, volatility falls, the market rebounds, and investors buy back high-uncertainty stocks that were previously dumped during the panic states. Consequently, the values of high-uncertainty stocks rise sharply - this is true today for precious metal companies.
LESSONS TO BE LEARNT
What lessons can we learn from investors' behavior toward the precious metals industry about investment under uncertainty? Well, when faced with uncertainty, investors should always consider that there is still a possibility of a silver lining. Like the precious metal industry five years ago, South Africa finds itself in a difficult position. The uneven distribution of vaccines across the world could still make the mutating virus challenging to contain. The government's weak fiscal position and elevated debt levels could constrain long-term economic growth. The scarring from the recession may be long-lasting, leading to unemployment levels that remain stubbornly high. But as the IMF pointed out in their recent world economic outlook, there is potentially some upside risk. Further favorable news on vaccine manufacture, distribution, and effectiveness of therapies could increase expectations of a faster end to the pandemic, boosting confidence among businesses and households. This would generate stronger consumption, investment, and employment recoveries, with firms hiring and expanding capacity in anticipation of rising demand. Additionally, more fiscal policy support with favourable spillover effects for trading partners, would further lift global activity. In a nutshell, South Africa, despite its dire state, may yet prove to be a fruitful investment destination. The precious metals industry still faces the same structural challenges from five years ago - low productivity, deeper mines, etc but the sector has become investable notwithstanding these challenges. South Africa, despite all its challenges, may similarly prove to be a success. The world of probabilities only exists on paper, and no judgment or scenario that we or anyone else creates will influence the final result.
Now back to the question, lets rephrase it, - should investors allocate more of their funds to South African assets? We believe strongly that investment decisions with high uncertainty (for example, currency) should not dominate a portfolio’s risk. Successful investment management is as much about discipline as it is skill. By all means, be negative or positive, South Africa, but don't put your mortgage on it!
Ndina Rabali, Teboho Tsotetsi, and Bhekinkosi Khuzwayo
Lima Mbeu Investment Managers (Pty) Ltd is an authorised financial services provider in terms of section 8 of the Financial Advisory and Intermediary Act, 2002, FSP number 49018, Registration No 2017/399814/07. This document is for information purposes only. Past performance is not indicative of future performance. The information contained herein is derived from sources which are believed to be reliable. Any opinion expressed herein is based on the presenter’s current analysis and is subject to change. This presentation does not constitute an offer to sell or a solicitation to buy any security. Lima Mbeu has a conflict of interest policy which outlines how conflicts of interest are managed. This policy, as well as additional information about Lima Mbeu’s products, is readily available upon request or on our website: www.limambeu.co.za
For more information, contact Ndina Rabali: Email: ndina.rabali@limambeu.co.za
Tel: 010 023 0113; Address: Fredman Towers, 13 Fredman Drive, Sandton, 2196
