DUNCAN ARTUS: Active management: potential for a comeback in a new, divided inflationary world

The world is probably going to be quite different in 10 to 15 years, though no-one knows for sure what will happen. Investing is a probability business. At Allan Gray we are bottom-up investors but want to be on the right side of long-term trends and extremes, whether in valuations or economic variables. 

There are several risks faced by investors, perhaps the most topical being inflation. We have seen unprecedented money creation globally, which dwarfs the response to the global financial crisis, and we now have fiscal spending in tandem. This is likely to carry on for some time to keep the show on the road.

However, it is leading to increased inflation, particularly in the developed world, along with higher commodity prices measured in nominal US dollars. This will be worsened by environmental, social & governance (ESG) policies, raising the cost of capital for resources and capital-intensive industries. 

Risks arising 

SA will be temporarily buffered by high commodity prices, but as each year passes the risks are increasing as our unemployment rate is not sustainable. We are used to inflation in SA: we have inflation because we are expecting it. But the world could also face stagflation (slow growth in combination with inflation) and financial repression (where governments try to keep interest rates low through yield curve control and legislation that forces you to buy government bonds, or by making it a regulatory requirement for financial companies). 

The continued money creation enables an increasing size in the government relative to the economy, and this has an adverse effect on productivity. In times when money is printed people lose faith and there is growing inequality: those who own assets get relatively wealthier. The greater inequality from money creation results in redistributive policies, and policy that favours labour. If we read history we can see that periods of inflation lead to social instability and further reinforce the trends. 

Where does ESG come into it? 

When people think about ESG there has been a strong focus on the environmental aspect. But social and governance issues are starting to get more attention — as we have seen through events in China and the US with Nike and H&M, among other Western brands, raising issues about labour practices and human rights concerns in China and subsequently facing criticism and boycotts of their products in that country. On the governance side it’s not just boards of companies; the focus is also on politics, which may result in a more polarised world. You are either supportive of the West (US) or East (China).

Why is this important for equity investors? SA has a significant direct exposure to China. Our five biggest shares — Naspers, Prosus, Richemont, BHP and Anglo American — are exposed to China through being in the country, or through the commodities sold. SA is indirectly exposed to China through the commodities we sell, which allows us to run a trade surplus. What happens in China therefore has a direct effect on the stocks in our portfolios, as recent events have illustrated. 

What can we do about all of this? 

An important point to make is that we should not assume what has worked since the global financial crisis will continue to work in future. If we look at the history of markets we see themes that last for a number of years, until they don’t. For example, the “Nifty Fifty” (a group of high-quality franchises with strong balance sheets and ever-increasing valuations that became the darlings of many investors until the US entered a bear market in the early 70s), the commodities boom, Japan, emerging markets, US technology shares, financials and now what we call “disrupters”.

So, what should an investor do? We can tilt our portfolio positioning to consider the risks discussed above. However, when a risk is well known to the market it is expensive to hedge. We are looking out for cheap and not obvious inflation hedges. When it comes to current asset allocation, we prefer: 

• Little or no exposure to developed market sovereign bonds and compressed spreads in the high-yield market; 
• To be underweight technology stocks; 
• Exposure to producers of metals used in the energy transition, such as Glencore; 
• Exposure to precious metals and precious metal suppliers, a good potential hedge against inflation; 
• To use our bottom-up process to find ideas that don’t rely on the big things discussed above, the opportunity presented through omnichannel retailers such as Country Road, or low value retailers, that can capture some of the beneficiaries of additional government spending, such as Pepkor; 
• To look beyond the “big five” towards other opportunities such as British American Tobacco, which has zero exposure to China, or AB InBev, which has great potential; and 
• To look beyond the best ESG companies that everyone is buying to the companies that are improving their ESG the most.

We believe independent thinking is going to be increasingly important, with detailed, bottom-up research key to identifying good quality opportunities. In a world that could look quite different to the recent past, active management has the potential for a comeback. One cannot be running a benchmark-cognisant portfolio and look the same as everyone else and hope to do well. 

• Artus is chief investment officer at Allan Gray. He presented on this topic at the recent Allan Gray investment summit.