Markets are about as polarised as they’ve ever been, with extreme divergences existing between developed and emerging markets; small cap shares versus large cap; and growth shares versus value. And these extremes should be viewed in conjunction with the most notable extreme in modern-day markets: interest rates.
The 10-year US government bond is at the lowest it has been in 220 years. And if you view the US government bond as a proxy for interest rates, what we are currently seeing are the lowest interest rates in 220 years.
While the history of the South African repo rate doesn’t stretch back 220 years, it is currently the lowest it has been in 55 years at 3.5%.
So globally, interest rates are at all-time lows. The trend started after the GFC of 2008 and has been exacerbated by governments’ response to the Covid-19 crisis.
If you put this another way, cash is now more expensive than ever, and is certainly no longer the safe-haven investors considered it to be three years ago.
One thing has largely been missing from the markets since the GFC but has now returned in force: wild speculative behaviour amongst investors.
According to Jeremy Grantham, founder of US asset manager, GMO, the single most dependable feature of the late stages of the great bubbles of history is crazy investor behaviour.
Grantham believes the extremes US investors are currently seeing in terms of extreme overvaluation, explosive price increases, frenzied issuance and hysterically speculative investor behaviour points clearly to one thing: that we are in one of the great bubbles of financial history.
‘For the majority of investors today, this could very well be the most important event of your investing lives,’ Grantham wrote in a letter to investors in January this year.
When we think about speculation in the markets, and the way it is portrayed in the media, there are two names that come to mind first: Tesla and Bitcoin. Tesla is now at over 200 x earnings. In fact, Tesla is worth more than almost all the other car manufacturers in the world put together. Bitcoin, too, has continued its meteoric rise, with few investors understanding much about it other than that. The recent GameStop debacle is another example of unprecedented actions on the part of individual investors.
What is driving this speculative behaviour? There are a couple of different potential answers, but it seems that retail investors have turned their attention to the stock market. The current round of fervour is unlikely to end well.
If we are in a bubble, what do we do now?
According to Grantham, the answer is not to run to the hills and sit in cash. As we’ve already stated, cash is more expensive than ever. Instead, Grantham says investors should be looking to invest in the overlap between value and emerging markets.
This advice brings us to an interesting destination: SA mid-caps.
JSE mid-caps are very much the underdog of our stock market, but believe it or not, they outperformed the heavyweight global growth index by a factor of four between 2002 and 2016. However, the subsequent four years were brutal, with mid-caps halving on a relative basis. Much of that decline came in 2020. This underperformance has been driven primarily by a relative de-rating of smaller cap shares.
Mispricing is where we find opportunities and we believe this sector of the market is fertile ground for it because:
- Globally, there has been a protracted bias towards growth over value shares. In most cases, South African small and mid-cap shares are regarded as value shares, given the lack of economic growth.
- Emerging markets have been out of favour and South Africa has not been spared.
- South African small and mid-cap shares are perceived to be entirely reliant on the local economy. However, many of these companies are more diversified and resilient than perceived and often earn a significant amount of their profits in hard currency.
- There is very little broker research coverage of the small and mid-cap universe.
Putting it bluntly: South African Inc shares are the most unloved part of an unloved geographical market within an unloved investing style. Therein lies significant opportunity for investors who are prepared to be patient.
By Mikhail Motala, fund manager at PSG Asset Management