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Picture: REUTERS
Picture: REUTERS

South African investors are usually tuned into local political and economic risks. But what about the less obvious risks?

There is a lot of talk about the need to maintain a well-diversified portfolio. Aside from simply picking different companies, industries or countries, investors need a good sense of where underlying returns are coming from and what could affect those returns. They must also ensure their investments are not all highly correlated.

Peeling away the layers of the average South African investor’s portfolio reveals that one of the biggest risks we face is exposure to China.

The herd of elephants in the room

The FTSE/JSE all-share index is highly concentrated, with the top 10 shares making up 56.5% of the index. About 20% of that volume is Naspers.

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Naspers, the Allan Gray Equity Fund’s second-largest holding, accounts for 9.4% of the local portion of the fund, significantly less than the index – which should not come as a surprise considering the fund does not aim to track the index.

Most of Naspers’s value is derived from its holding in Chinese technology company Tencent. More than 100% of Naspers’s current price is due to Tencent, which means more than 100% of Naspers’s price is exposed to China.

Tencent is a great company. However, it is trading at close to what is seen as fair value. If it fell significantly, the Naspers price would be affected despite the large negative value the market attributes to Naspers’s other businesses. Regardless of which index you track, it’s hard to escape exposure to Naspers and therefore Tencent.

Why do we worry about China?

China is a complicated place to understand. While there is evidently much opportunity, the rapid rate at which debt is growing is a concern and unsustainable. The following graph shows the steep upward trajectory. Historically, things tend to trend down after steep peaks in debt.

China has experienced a rapid credit boom since the global financial crisis, with private sector non-financial debt increasing from 120% of gross domestic product in 2008 to more than 200% today. Similar increases in debt proved unsustainable in other countries and led to some form of correction. Put more bluntly, most credit booms end in busts, a recent example being US mortgages in 2008.

Chinese statistics are sometimes unreliable, but if the country’s credit figures are even somewhat accurate, it is likely that it will experience its own version of a credit correction. This is worrying for companies and industries that are overly dependent on Chinese demand.

Broader than just Naspers

While Naspers’s overreliance on its Chinese investment is well documented, it is not the only company on the local index that is exposed. Consider the customer base of brewer Anheuser-Busch InBev (AB InBev), luxury goods manufacturer Richemont, and miner BHP Billiton, as shown in the next graph, which looks at revenue from China, emerging markets and developed markets.

Note that none of these large shares would be immune to a slump in Chinese demand. This is only direct exposure: if something went wrong in China, there would be indirect consequences for emerging-market countries too – for Brazilian iron-ore exports, for example.

To diversify against this tail risk inherent in their portfolios, South African investors need to look for companies that are trading below their intrinsic value, with minimal to no exposure to China.

One example is British American Tobacco (BAT), which has no exposure to China, as the previous graph shows. BAT is trading at an attractive price/earnings multiple relative to AB Inbev, Richemont and BHP Billiton. Allan Gray believes it provides diversification to a local portfolio at an attractive valuation.

What about diversifying using select South African defensive stocks?

ABOUT THE AUTHOR: Duncan Artus is a portfolio manager at Allan Gray
ABOUT THE AUTHOR: Duncan Artus is a portfolio manager at Allan Gray

Some people may argue that one could buy South African defensive shares rather than dual-listed shares to reduce direct exposure to China. While that is another way to create diversification – and Allan Gray does own some of these shares – BAT’s valuation is more attractive.

Investors are undervaluing BAT based on concerns about a short-term acceleration in the decline of cigarette volumes and increased regulatory risk following the announcement by the US Food and Drug Administration that it wants to reduce nicotine levels in the US to below the addiction threshold.

These are real concerns but they are reflected in BAT’s share price, and the company’s development of new-generation vapour and tobacco heating products should help create a more sustainable earnings stream in the long term.

This article was paid for by Allan Gray.

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