Investment lessons from the Cape Town water crisis

Just over a year ago the conversation at braais around Cape Town would have turned to water shortages, the level of the city’s reservoirs and how, if something drastic was not done, Cape Town risked becoming the first major city in the world to run out of water. Today the focus has shifted from restricting consumption of this precious resource to improving how water is harvested, stored and utilised. The City of Cape Town’s efforts to keep the taps running through severe drought conditions have some peculiar similarities with the asset management industry’s efforts to deliver consistent market returns during a multi-year economic downturn.

The trick is to have different sources to survive an investment drought
Satrix chief investment officer, Kingsley Williams, told the audience at the sixth annual i3 Summit, recently hosted by Sanlam Investments and Glacier by Sanlam, that structuring successful investment portfolios could be likened to choosing the right systems to harvest and store water. “We build portfolios to meet specific requirements and achieve specific objectives; if we equate water with market returns then we can see how the analogy plays out”. The trick is to have enough different sources of water to survive extended periods of drought, or a sufficiently diverse portfolio to generate excess return through both good times and bad.

Factor investing is used to build resilient portfolios
Portfolio managers typically structure their portfolios to exploit a particular source of returns. “It is only when you face a lengthy period of poor returns that you discover how resilient and robust your portfolio is,” said Williams, who argued the case for factor investing. Factor investing is characterised by “systematically selecting securities based on attributes that are associated with higher returns”. “The beauty of factor investing is that different factors pay off through different prevailing economic and market conditions, so they can be combined to construct more resilient portfolios,” he said. You can keep the return tap running regardless of the extent or duration of the drought.

Factor investing eliminates the risks associated with ‘style drift’
The factor investing thesis is simple: First identify the return characteristics you wish to include; then combine these characteristics into an index or portfolio that provides consistent exposure to these factors which are rewarded over long periods. Williams observed that factor investing eliminates the risks associated with “style drift” – when a portfolio does not reflect its underlying philosophy – and exposure to unrewarded factors. You may, for example, believe that you have sufficiently diversified your water storage infrastructure by building enough dams, without considering that they rely on the same factor (rainwater) to maintain supply.

Put value, quality and momentum in the blend
Satrix focuses on value, quality and momentum factors to create factor index funds, which can then be blended alongside other funds to deliver excess returns. Value investing involves choosing companies that tend to underperform through unfavourable economic conditions like recession or poor commodity prices, but shoot the lights out for investors that are able to wait for economic conditions to improve. Shares such as Imperial Holdings and Super Group currently sit in the Satrix value space because they are “tied to our domestic economy – and are presently trading at discounts relative to their potential”. Quality companies typically trade at a premium to their value peers because they are better able to withstand economic downturns. “They deliver more reliable profits consistently through time. During tough economic conditions we see the value in quality companies being unlocked,” said Williams. Most of South Africa’s major retailers, including Pick n Pay, Clicks, Truworths and Spar, satisfy the quality label. Momentum is a factor that overlaps the dominant trend playing out in the market at a given time.

How do we go about combining different factors in a portfolio? “Blending single factors together is a bit like going to every single tap and choosing how much of the water it produces to include in your portfolio. You have control over how much and when each factor is added to your fund,” said Kingsley. He referred to a recent example where a client enhanced their return experience by 1.5% (and reduced costs by 21%) by simply combining two of its funds with a Satrix Quality Index Fund. “In practice, we do this to fill a gap where portfolios may be missing exposure to well-rewarded factors in our market,” he said. The optimum combination should include positive exposure to factors such as momentum, value and quality.

A multi-factor approach at stock level
The next step in the factor investing evolution is to build a portfolio from the ground up containing the desired exposure to each of the factors, something that is done at stock level. A multi-factor approach at stock level ensures that your portfolio has enhanced exposure to the factors you are targeting, while more explicitly managing the levels of risk. “Regardless of the prevailing economic climate, factor investing has the benefit of consistent exposure to the desired characteristics within your portfolio. It addresses the problem of ‘style drift’ and makes it easier to build diversified portfolios for your clients,” concluded Williams. “It is a highly cost-effective way to deliver excess returns relative to the market.”