VANESSA MATHEBULA: Inflation-beating capital appreciation the true test of investment portfolios

Growth is an ever-important aspect of life, and financial markets are no exception. Our interest regarding investments lies in growing them over time, thereby enabling capital appreciation. However, this growth should be at a reasonable rate for the investment proceeds to amount to something sustainable in future.

When it comes to the inflation rate, the devil is truly in the detail. Imagine the effect on your grocery bill if cooking oil suddenly increased to account for more than 10% of your grocery budget.

The buying power of your money is an important aspect, especially regarding investments. It is therefore important to use an investment vehicle that will not only grow by the inflation rate through time, but one that will beat it. Ultimately, the goal is for your money to be able to buy more in future than it can now. That is the fundamental basis of investing for capital appreciation.

To be in a position to reap the rewards of capital appreciation, you have to first be able to spot a good investment portfolio proposition. There are various ways to achieve this. Such a portfolio should deliver top-quartile performance at a competitive cost by providing an investor with active exposure and no style bias.

We focus on building and assessing an equity portfolio as if it were a stock, based on the quality, growth and value investment-style dimensions. By assessing the characteristics of a stock that align with these three factors, we are able to form a holistic perspective of the key return drivers and therefore the investment proposition of the given stock. The same thinking applies to an equity portfolio.

These investment styles are the historical drivers of return. Typically, companies with strong quality attributes would possess low debt, low levels of leverage and strong return on equity (ROE). Companies that have growth potential look likely to grow their earnings base into the future and outperform their peers and the overall market for some time.

They would continue to deliver a higher-than-average increase in sales. Those with a good value proposition would trade at levels lower than their actual worth (trading at a discount to price-earnings and book value).

Different styles

Is there a way for investors to gain better exposure to these stock characteristics (ROE, earnings growth and so on) in a less risky and systematic (rules-based, data-driven, unemotional) manner? To achieve capital appreciation, risk should be managed. One of the best ways to do this is through stock selection, which involves investing in a basket of securities whose returns are driven by different styles.

In line with the style theme, this would mean having a portfolio that has exposure to the different investment styles for various stocks. Constructing a portfolio based on a systematic approach would further reduce risk. This means choosing the various constituents of the portfolio based on evidence that these factors are, in fact, the key return drivers of the given stocks.

How would we put this into practice? Let us consider a portfolio of 10 stocks in an example of using an equal weighting scheme. The individual metrics are shown, as well as how these combine at a portfolio level.

To understand the benefits of portfolio construction, let’s analyse a few examples from the table. If you were to invest all your money in BHP Group, you would have superior metrics across the board. But as you would be putting all your eggs in one basket, this would be a risky move and should be discouraged. If something suddenly went wrong with the company, you would lose all your money.

By putting all your money in MTN Group, you would have inferior metrics across the board. However, by combining these stocks, you can build a diversified portfolio profile that ticks all the important boxes and reduces risk. If you could find a stock meeting all these characteristics it would no doubt be on the buy list.

Appropriate benchmark

By amending the weights, we can obtain a set of portfolio characteristics that are superior and potentially better than the benchmark (a standard against which the performance of a given investment vehicle, such as a stock or a portfolio, is measured), as illustrated in the second table.

To gauge the quality of our constructed portfolio, we need to evaluate the metrics against a chosen benchmark. An appropriate benchmark would be an investment vehicle or index that has similar securities to the fund or investment vehicle in question. One practical example of this is an analysis of the Stanlib Enhanced Multi-Style fund, an actively managed optimal fund based on a style-neutral systematic approach, against its benchmark, the FTSE/JSE Capped Swix all share index.

The third table shows some examples of the portfolio’s characteristics against the benchmark across a few fundamental metrics. Note that each of the main styles of quality, value and growth consists of a number of fundamental metrics, which form part of the scoring methodology. We can see that we end up with a fund that is better than the benchmark on all three style dimensions, which highlights the fund’s potential ability to deliver outperformance compared with the benchmark.

This fund has other significant benefits that contribute to overall capital appreciation. For example, because it is based on a systematic approach, its costs are lower than other comparable funds in the market. The fund has proven to have low alpha correlation with other active funds in the market, which highlights its ability to be used not only as an investment management tool but as a risk management tool.

It is also an active fund that provides exposure to various investment styles with relatively high active share selection.

For the cost-conscious investor who does not want to be left in the cold when the inflation chills blow through, an enhanced multistyle fund may offer the solution. The solid systematic philosophy coupled with decent long-term performance provides a good source of potential capital appreciation, potentially shielding investors from the inevitable erosion of inflation over the long term.

• Mathebula is quantitative analyst at Stanlib Index Investments.