2018 Leverage Equity RFS review

The Leveraged Equity Strategy had a disappointing year in 2018 with a return of approximately -21% compared to the Top 40 benchmark of -11.05%.

The Strategy began the year with no gearing and was down -6.77% compared to Top40 -1.94% at the end of June.

At the end of June, after a detailed research investigation, we modified the Leveraged Equity Strategy (we changed the name from RFS to Leveraged Equity RFS). This strategy is no longer driven primarily by momentum but includes risk factors targeting value, quality, stability (and momentum). Another important change to the strategy is the addition of targeted individual stock short positions.  The short positions are selected based on our risk factor methodology allowing us to create alpha on both the long and the short positions.

The impact of these changes was that we:

• Increased our foreign exposure, predominately to US technology stocks;
• Once again geared the portfolio – we had about 130% of long exposure made up of approximately 45% to offshore and 85% to local equities;
• Decreased exposure to momentum – majority of momentum was taken offshore

By the beginning of September, we had caught up to the Top 40 return which was approximately flat for the period (i.e. we outperformed the TOP 40 by approximately 5% between July-September).

We achieved this by being:

• Underweight the Communication Services Sector with a 5% exposure compared to 27% for the Top 40. The only exposure we had was Naspers, i.e. we had nothing invested in Vodacom or MTN;
• Overweight the Energy Sector in the form of Exxaro Resources which returned 28% over this period (we had a 5% holding);
• 40% exposure offshore, mainly to US tech companies, that produced a 17.43% return

In the months of September and October, we marginally outperformed the JSE although returns were negative.

The strategy returned -11.31% for the year to date (end Oct) compared to the Top 40’s -12.06%.

Positive alpha was generated as:

• We increased our short position in real estate during this period to 16%, the Top 40 Real Estate Sector was down 6.74% during the months of September and October;
• We only had a 1.49% exposure to financials compared to the Top 40, and this sector was down 5.91% over this period;
• Exxaro, where we retained our 5% exposure, was up 5% during the months of September and October

However, these positive alpha investments were negated by:

• our large positions in US technology which was down 7.66% while the rand was approximately stable

Our large position to SA Consumer Stables relative to the Top 40 (the strategy had 27% exposure to this sector compared to a 7.93% allocation for the Top 40) and this sector was down 10% during the months of September and October.

We therefore arrived at the beginning of November having recouped our losses relative to the benchmark in the first 6 months of the year. The strategy was 150% long of which 55% was offshore exposure and 95% was local equity exposure. 49% of the portfolio was short, made up of local equities only so that our net local equity position was 46%. Additionally, our local equity exposure was quite conservative being overweight Consumer Staples while being very underweight in Consumer Discretionary, Financial and Real Estate.

This was at a time when South Africa was debating on the issue of land reform and expropriation (President Trump added to the storm earlier with tweets regarding SA farm murders). Additionally, local markets were hit on news regarding the fuel price and the spectre of zero growth inflation. Although US stocks had experienced a pullback, at this point the Nasdaq was up 25% for the year in ZAR with the S&P 500 and Top 40 having returned 17.9% and -10.5% respectively.

November and December saw significant downside with a return of -11.68% compared to the Top40 return of +1.26%. This was due mainly to leveraged offshore exposure that was very technology focused. During the months of November and December the FANGS suffered heavy losses, Facebook lost 14%, Apple lost 28%, Amazon 6%, Netflix 15%, Alphabet Inc 4%. Facebook was in the news regarding the use of users’ data and the trade war was making headlines including US president Trump’s comments about issuing a tariff on Apple products produced in China. Additionally, commodity stocks, including Exxaro (down 18% in November), took a dive on trade concerns.

In summary, during November and December:

• US Technology stocks fell significantly while the Rand Strengthened. We had a significant holding in this sector for its momentum characteristics, about 54% net exposure, and this was down 12.5%
• The strategy had minimal exposure to the JSE Communication Sector, specifically we didn’t own any Naspers given our already overweight position in offshore technology. Naspers was the biggest driver of the return of the Top40 over this period, it returned 11.56%. Naspers makes up around 21% of the Top40 index thus it contributed 2.52% to the return of the Top40 index over this time. Note, the Top40 only returned 1.26% over this period so the remaining constituents were mainly a detractor from returns.

Looking forward into 2019

Our strategies continue to be conservatively positioned to SA Inc forgoing momentum and concentrating our exposure to those securities that exhibit quality, stability and value characteristics. Historically, these factors have outperformed during less bullish market cycles. Our short positions in the SA market are expected to add alpha together with those securities that exhibit momentum, quality and stability.

We continue with our momentum exposure to US markets although we have cut down on our position size and technology exposure.

Kind Regards 

The Emperor Team