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Is the JSE really too high?

A different perspective.

CAPE TOWN – With the JSE currently trading at such high levels, it is unusual to find someone who isn’t too concerned about it. It’s almost become accepted wisdom that the market is overbought and that things are unlikely to be very rosy from here on in.

But Mike Brown, the managing director of etfSA, feels that those who see nothing but gloom in the sustained rally on the local market may be losing a bit of perspective.

It’s worth starting off by looking at the numbers:

Over the first six months of this year, the FTSE/JSE All Share Index was up 12.75%. For the 12 months ended June 30 2014, it had gained 35.35%.

Those are some terrific returns, and they go back further. For the five years to the end of June, the All Share Index had risen by 21.59% per annum, which is one of the best long term periods of growth it has enjoyed for some time.

It is because this rise has been so steep and so prolonged that questions have inevitably been asked about how long it can continue. But while Brown agrees that a market correction or a temporary down cycle have to be considered as possibilities, this rally is not necessarily a clear indication that the market has to fall.

“The worldwide financial market collapse of 2008 and 2009 was the most significant fall in nearly 90 years,” he states. “The recovery from this collapse has been sharp, but this has been from a low base.”

He points out that the JSE only made a sustained move past its previous record highs in the second half of 2012. As the below chart shows, the market was effectively flat between January 2008 and July 2012.

Source: Morningstar

In other words, three and a half years of the five and a half year bull run were actually just spent getting the market back to where it started.

“So if it is to show real returns of between 5% and 7% per annum, the Top 40 and other major indices will be required to establish consistently higher record levels for some years to come,” Brown argues.

The P/E debate

Brown also questions whether the high price-to-earnings (P/E) multiples on the JSE haven’t been overstated. He says that there are only around 15 very big shares that are truly affected, but because they make up so much of the value of the JSE they tend to distort the entire picture.

He uses the below table to illustrate his point:

P/E ratios of FTSE/JSE Top 40 Shares

Top 10 Shares in FTSE/JSE Top 40

 

Bottom 10 Shares in FTSE/JSE Top 40

Counter

P/E ratio

 

Counter

P/E ratio

BHP Billiton

14.57

 

Exxaro

9.26

SABMiller

28.77

 

Assore

7.29

Richemont

21.40

 

African Rainbow Minerals

8.70

Naspers

85.87

 

Investec Ltd.

7.84

MTN

16.02

 

Discovery

21.55

Sasol

10.59

 

Mondi Ltd.

15.38

Anglo American

28.38

 

RMB Holdings

13.43

British American Tobacco

21.12

 

Kumba Iron Ore

7.01

Standard Bank

13.14

 

Mediclinic

20.62

Old Mutual

15.81

 

Life Healthcare

25.00

Average

25.57

 

Average

13.61

Source: ProfileData

“The average P/E ratio of the top five companies on the JSE by market capitalisation is 33.3x and the top ten 25.6x,” Brown points out. “But the average P/E ratio of the bottom ten companies in the top 40 is only 13.6x.

“So only a very small portion of the JSE is overvalued, using this measurement,” he says. “The JSE is a two-tier market, with global companies having a higher valuation than local stocks. This is nothing new, it is just that now there are more of these global companies listed on the JSE.”

He also argues that since it is mainly foreign investors who have pushed these big international counters to such high multiples, it is entirely possible that they will continue to support them as long as the companies maintain consistent earnings growth.

“South Africa is being increasingly described as the ‘Switzerland of emerging markets’ in reference to the small group of global quality companies listed here that have worldwide reach and earnings streams,” he says. “Is it not logical that these ten or 15 top quality companies should trade at P/E multiples significantly higher than the non-global companies on the JSE?”

Brown suggests that this two-tier market is not unique to South Africa either, but is becoming a more common emerging market phenomenon.

The equitisation of global financial markets

Finally, Brown argues that the poor performance of government bonds in recent years and the riskier nature of these instruments as interest rates rise will keep the global focus on equity markets.

“This is coupled with the ‘retirement fund crises’, arising from the likelihood that people will now live in retirement for an average of 30 years,” he says. “Only equity markets can deliver the long term real returns necessary to sustain the lifestyles of the elderly for that length of time.”

So there is an “equitisation” taking place in global financial markets, which he believes could last for some time. In this scenario, flows into the quality companies on the JSE would be enduring.

“And investors can share in such top quality equities by buying exchange traded funds (ETFs) that give direct exposure to Top 40 index or the Industrial 25 Index, which gives the most focussed access to South Africa’s “Switzerland” companies,” Brown says. “In any event, investors should consider allocating at least a portion of their portfolios to momentum-type investments, which benefit from consistent growth in the equity markets. Market capitalisation ETFs are ideal for this purpose.”

However, he adds that this need not be an all or nothing approach. Investors can get the best of both worlds by also allocating a portion of their portfolios to value-driven active managers with stock-picking credentials.

“Whilst nobody can predict the future growth of financial markets, if investors react to every bit of noise coming from the short-term traders and asset managers that have clogged up the newspapers over the past year, they run the risk of being side-lined,” Brown concludes. “This could be for many years, whilst the market continues recording record highs while waiting for a recovery before reinvesting.

“But the cost of being on the side-lines is very often greater than maintaining investment in the equity market,” he concludes. “In the long-run, the age old mantra is true, ‘get invested and stay invested’.”

For more, visit Moneyweb’s Click-a-unit trust/ETF.

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