It’s 10 years since we launched the Allan Gray Australia Equity Fund. In this extract from the latest Allan Gray Australia Quarterly Report, Chief Investment Officer Simon Mawhinney looks at our learnings from the last decade, where we can find value today and asks what can investors reasonably expect from Allan Gray over the next 10 years?
Although Allan Gray has invested elsewhere in the world for over 40 years, we have only recently passed our 10-year anniversary in Australia. Our recent strong performance has given us double cause for celebration, with the Allan Gray Australia Equity Fund up 12.5% in the 12 months to 30 June 2016 versus 0.9% for the benchmark S&P/ASX 300 Accumulation Index over the same period.
At milestones like this, it’s interesting to look back and see what can be learned from the past decade about Australia’s sharemarket performance, our Fund’s performance and finally where we see value today. This may also help to frame what investors can reasonably expect us to deliver over the next 10 years.
Let’s focus first on the Australian sharemarket. Despite returns over the 12 months to 30 June 2016 being poor by historical standards, it is not clear that the broader sharemarket offers better-than-average returns from here. Looking at the fundamental drivers of sharemarket value – earnings, dividends and book value – we concluded in our September 2015 Quarterly Report that the sharemarket was fairly priced. Little has changed since then in either these fundamental drivers or our assessment of value.
From now sharemarket returns are unlikely to be any better than long-term average returns. But what do long-term average returns look like?
Looking back as far as we can to 1900, the Australian sharemarket has delivered annual real (inflation adjusted) returns of 6.7%. In the ten years to 30 June 2016, the Australian sharemarket delivered a lower-than-average total real return of close to 2% p.a. Although this decade hasn’t been fabulous for investors, it is far from the worst single decade of returns the country has experienced (refer Graph 1).
If the next 10 years see a return to the long-term average of the past 116 years, investors can reasonably look forward to real returns in excess of 6% p.a. However, this may be a tad optimistic. Since 1900, Australia has been the second best performing sharemarket in the world. Our rich endowment of natural resources and a relatively stable government are no doubt partly responsible for our outperformance, but it is unlikely we will be able to hold our podium position forever and our sharemarket is likely to revert to the world average, or even slightly below, for a period of time. Real equity returns for the world index have been 5% p.a. over the same 116 years.
Even if Australia’s future sharemarket returns revert to levels slightly below world averages, the near 5% p.a. real return one might expect from here is still very attractive.
With this historical backdrop, the next question is: how can you reasonably expect our Funds to perform in comparison to the sharemarket?
Over the 10 years to 30 June 2016, the Allan Gray Australia Equity Fund has outperformed the broader sharemarket by 2.6% p.a. after all fees (or close to a 30% cumulative outperformance of the benchmark S&P/ASX 300 Accumulation Index).
Although this is respectable long-term performance under usual circumstances, it’s important to remember that it has come during a period in which most value investors (like us) have struggled to eke out gains. As value investors we’re fishing in a pool of cyclically-exposed companies whose valuations have been, and remain, relatively depressed. It’s in these companies where opportunity knocks loudest today and, in our opinion, the opportunity for value investors to outperform the sharemarket from now is much higher than average.
Some sectors of the Australian sharemarket look very cheap relative to others. Graph 2 shows how various sectors of the sharemarket have performed relative to each other. For simplicity we have split the sharemarket into three sectors: Financials, Resources and Industrials (which contains everything that doesn’t fit into the first two categories). When each sector’s respective price line is rising, it is outperforming the other two sectors and vice versa.
Since 2008 the Resources sector, and to a lesser extent the Industrials sector, have borne the brunt of extremely challenging cyclical headwinds. It is in these sectors where we see the greatest value and where more than 90% of the Fund’s assets are invested today.
Of course, we can’t promise that our future performance will exceed the broader sharemarket with clockwork predictability. Nor can we promise that the next 10 years won’t be free of mistakes. But we do feel that the opportunity set ahead of us is better than that which presented itself over the past 10 years.
Simon Mawhinney holds a Bachelor of Business Science (First Class Honours) with majors in Finance and Business Strategy and a Postgraduate Diploma in Accounting (University of Cape Town). Simon qualified as a Chartered Accountant in 1998 and is a CFA Charterholder.