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Investment trends: Time to rebalance portfolios

by Bryan Hirsch

Given the 55% rise in the resource-heavy JSE ALSI 40 index since the market bottom on 21 September 2001, it is time to take some profits and rebalance portfolios and adjust asset allocations.

One effect of the extraordinary run in resources shares relative to other asset classes is that most portfolios are now overweight in equities, and resources stocks in particular.

To illustrate the point, take a R1 million portfolio invested a year ago with a 10% weighting in property, 10% in cash, 60% in equities and 20% in bonds. With no adjustments in the portfolio, the current weightings are about 8% in property, 65% in equities, 9% in cash and 17% in bonds.

The equities weighting jumped from 60% to 65% due largely to the sharp appreciation in resources shares, pushing down the weightings in other asset classes.

Is this necessarily a bad thing, given the fact that equities have delivered a handsome return to shareholders over the last year, way ahead of the other asset classes?

It’s important to remember that as much as 80% of investment returns are attributable to asset allocation. When asset allocation is out of kilter, it heightens portfolio risk and imperils performance. Hence, it is important to rebalance portfolios from time to time to ensure asset allocations remain in balance.

Returning to the above example, let’s assume that the equities portfolio a year ago was weighted 35% in resources, 15% in financial and 50% in industrials. After the strong appreciation in resources stocks over the last year, the current weightings are 45% resources, 13% financials and 42% industrials. To bring the sector allocations back to equilibrium, we must reduce our resources holdings by 15% (bringing us back to a 35% weighting) and increase financial weightings by 2% and industrials by 8%.

The concept of buying low and selling high is at the key to all successful investment. I remain optimistic about the equity markets this year, but believe now is the time to take some resources profits as a way to rebalance portfolios and asset allocations.

The recent strengthening in the rand to around R10 to the dollar was the trigger for a correction in resources stocks, most of which have delivered outstanding returns to investors over the last year.

Take Harmony and Gold Fields, for example, both of which shot up roughly three-fold from their September 2001 levels. Anglogold more than doubled over the same period, as did Anglo American, though the latter has shed nearly 20% of its value since peaking at R215 in February.

The run in resources stocks has been exceptional in light of the preceding several years of indifferent returns on the JSE. But the party cannot last forever, and strong rallies such as we have just witnessed are always followed by a correction.

There is a tendency in South Africa to believe that rising equity markets will continue indefinitely, but history suggests otherwise. Investors poured billions of rands into over-priced small cap stocks in the mid-1990s in the belief that these would continue to deliver above average returns well into the future. Then came the market crash of 1998, destroying billions of rands in equity value. Most hurt were investors in small cap shares.

Let’s not forget that just a few years ago Anglo American traded at a price-earnings (PE) multiple of five, while new technology listings with little or no track record commanded multiples of 10 or even 12 – a clear example of “irrational exuberance”, in the words of Federal Reserve governor Alan Greenspan in reference to the US equity markets.

When the technology bubble burst, there followed a wholesale swing back to value investment.

The recent run in resources stocks cannot be characterised as a bubble, but these have captured a huge proportion of new funds flowing into the JSE over the last seven months. Consequently, other sectors – notably the industrial and financial sectors – have started to look attractive relative to resources.

A strong case can therefore be made for taking some profits in resources stocks and switching into selected financial, retail and industrial shares.

Several retail shares offer good value, among them Pick ‘n Pay holding company Pikwik, which trades at a discount to Pick ‘n Pay, Shoprite (on a price-earnings ratio of 12.6 against Pikwik’s 14.7) and Nuclicks (12.5). Food companies Tiger Brands (10.8) and Tongaat (7.9) are also attractive, while Aveng has probably tested bottom and should recover from here.

Banking shares have been primary beneficiaries of the resources sell-off and this trend is likely to continue, despite higher interest rates which eat into banking margins.

There’s no harm in holding a higher percentage of your portfolio in cash as a war chest for opportunities that arise later in the year.

Certainly, this is no time to be buying gold shares. Prices have run hard and fast and markets always give up some of their gains when this happens.

Having said this, I believe that those who try to time the market generally get it wrong. Consider the following: the S&P 500 index registered a 13% compound annual return since 1971, but excluding the best 18 months the return falls to 6.8%. Excluding the best 48 months, the return drops to zero. Try as they might, investors seldom correctly call the market tops and bottoms correctly.

Rather than trying to time the market, investors are better off commencing an orderly rebalancing of their portfolios with input from a professional advisor.

Bond yields shot up from about 9.3% in December last year to 12.9% in response to the sharp depreciation in the rand. With the recent increase in interest rates, bond yields have started improving again to under12%.

Bond yields are nevertheless expected to continue their descent once inflation is contained, so there will be good opportunities for profiting from bonds during the course of the year.

In terms of asset allocation, the closer you are to retirement, the less willing you are to accept risk and the greater your income needs. Bearing in mind that equity investment is more risky than other forms of investment, the equity component of your portfolio should probably not exceed 40%. The balance should be in secure, income-generating assets.

Younger investors still accumulating wealth can afford a much higher exposure to equities, up to about 75%.

Bryan Hirsch is chief executive of Sasfin Financial Advisory Services. he can be contacted on telephone +27 11 809 7500 or by e-mail on mailto:Bhirsch@sasfin.co.za

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The Big Change is a business strategy blog and newsletter published by Arthur Goldstuck, managing director of World Wide Worx, a leading technology research organisation based in Johannesburg, South Africa.

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