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Cheap may also be nasty

There is value on the JSE, but it must be treated with caution.
Value traps can be avoided; if a company's cash flows go south and its debt starts to climb, that may be a warning sign. Picture: Waldo Swiegers/Bloomberg

The performance of the JSE over the last few years has caused local investors a great deal of consternation. It has been extremely difficult to find any areas of growth.

As Claire Rentzke, the chief investment officer at 27four Investment Managers, says, the performance of many sectors on the JSE reflects the weak economic environment in South Africa.

“We’ve seen strong performances from the likes of Naspers and other rand hedge stocks that earn a vast percentage of their earnings offshore,” Rentzke points out. “We’ve also seen the resource sector benefit from increasing commodity prices and being able to restructure their businesses to be more efficient. But local, domestic-facing businesses have come under significant pressure. In the healthcare and industrial sectors particularly, a lot of companies are feeling the pressure of an economy that is not growing and a consumer that is constrained.”

As the table below shows, the healthcare index is off more than 40% in the last year. Industrials are down close to 11% over the same period.

Source: 27four Investment Managers

These stagnant or falling share prices have however led to large parts of the market looking increasingly appealing on valuation metrics. Under normal circumstances, some of the low price-to-earnings (PE) multiples and high dividend yields available on the JSE would be attracting significant interest.

“There are many counters that continue to be incredibly well priced,” Rentzke points out. “They are priced for a very poor outlook that could improve.”

The value is there, but it needs help

As the following chart shows, the market’s dividend yield excluding Naspers is at its highest point in the last 15 years. The trailing PE is not obviously as attractive by historical standards, but it has shifted substantially downwards over the last two years.

Source: 27four Investment Managers

This may make this seem like an attractive entry point, but as Rentzke points out, there needs to be a catalyst for this value to unlock.

“Companies need to be able to grow their earnings,” she notes. “And growth will only come through if the economy begins to show signs of a little more strength.”

Rentzke also believes the country needs the Reserve Bank to be more willing to ease monetary policy.

“We have incredibly high real interest rates at the moment,” she points out. “Some kind of alleviation will help to take pressure off the consumer and stimulate spending.”

So while this is a market showing value, there is also a high risk of investors being caught out by value traps. Already we have seen examples of companies that might have seemed attractive investments, but had fundamental problems. One of those is Tongaat Hulett, whose shares were suspended in June.

Digging deeper

“In hindsight it’s easy to see the pitfalls in what Tongaat was offering, but there were warning signs that the company was on an unsustainable path,” says Nadir Thokan, portfolio manager at 27four. “The company’s cash flow was declining, but that wasn’t being reflected in headline earnings, which were being boosted by accounting measures.”

As the graph below shows, the company’s cash flows turned negative in 2016. At the same time, its debt started to climb.

“In this environment I think this is going to be a theme that market participants need to be on the lookout for – to not be caught in value traps,” Thokan argues. “Don’t just invest in businesses because they are cheap. Quality can’t be compromised.”

He points to two examples that he believes show where focusing on quality has benefitted local investors. The first is MultiChoice.

Despite the losses in its African operations, the group has sustained healthy margins, and this has enabled it to generate strong free cash flows. It also has a well-developed strategy for narrowing the losses from the rest of Africa and turning those positive.

Source: 27four Investment Managers

“Even though its average revenue per user is declining, MultiChoice is still managing to maintain operating margins around 15%,” Thokan points out. “This is an example of a domestic business of higher quality, and that’s why we’ve seen the share price do as well as it has – up to over R130 from its listing price of R95.”

A second example is the local banking sector. Despite both banks and retailers being dependent on the local economy, JSE-listed banks have significantly outperformed local retail stocks.

Source: 27four Investment Managers

“Banks have delivered double the performance over a period when both sets of companies have been faced with very tough local economic conditions,” says Thokan. “Banks have kept their balance sheets in pristine condition, their non-performing loans haven’t gone through the roof, and they haven’t overextended themselves in terms of capital expenditure like many retailers have.

“This shows how quality businesses can prevail over poor quality businesses and how just focusing on short term PE multiples is not necessarily the best way to be managing money,” he adds.



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Looking forward we need to look at a failing electricity supply and the ramifications of how this will affect the production of goods and services for all businesses in South Africa.

…Eskom …no business or individual can realistically escape..the blackhole of the economy

Eskom is on life support. It is no longer financially viable. It has been looted too far and the debt is too large. Even if the state wanted to solve the Eskom problem, it is technically no longer possible. Too far gone.

Moving away from Eskom, looking at electricity supply, the government will now be compelled to allow for private power producers to enter the market en masse.

As much as it will irk the power hungry (pun intended) looters from the ANC and their friends, they will no longer have centralised power generation. Not to say that they will stop looting though.

Isn’t Eskom just the best channel for looting by the ANC? I mean if you are a white (the irony) collar criminal anywhere in the world, you should be looking to get trained by the ANC.

I honestly cannot see anybody turning around the SA economy within the next 20 years. Cadre deployment, corruption, union demands, bloated staff numbers, BEE and affirmative action have devastated the economy. None of the above is going to change soon, except possibly when the IMF bailout happens. Even then, it will take years. The JSE is a dead duck, I’m afraid.

Thanks and good read Patrick,

Ex rand hedges, the JSE has delivered solid negative real returns in the last 5 years. The cost of doing business has risen significantly in a low or no growth economy.

As for banks – simply due to falling interest rates which raises the value of their loan assets on the books imo.

If inflation comes roaring back, SA stocks will go up but purely in nominal terms. May be worth punting a few cheap LT call options here.

Honestly there are 3 elements i would look at discounted investment the first is the statement of financial position this will indicate how the assets, liabilities are taken care off. The second would be statement of profit and loss or comprehensive income this also indicates how much income after deductions the company is taking care off and the statement of cash flow, the money that the company has in their bank account should anything economical happen that the company would be able to take care of itself in the short term. And lastly if you do find a discounted or value company always always have a margin of safety for your calculation may be incorrect.

At this stage of the South African meltdown, I would venture that cash is king.

Good point on asset class choice. BUT make sure that a healthy chunk of your cash is NOT invested at a South African institution. Any bank, as a business, is not immune to failure (like we’ve now seen in the dead Construction sector, commercial property sector & depressed consumer stocks sector). Yes, have your debt at an SA bank…like your bond….if the ANC grab your land & property, your outstanding loan can implode along with the bank. People may still debate that the local banks are sound? Hmmm….bear in mind their credit rating is capped to the ceiling of the country’s sovereign credit rating…at that’s as good as junk.

Take the family for short holiday abroad & open a foreign bank account while there. (Or contact Magnus’s staff at Brenthurst Wealth…they are able to open a Mauritius bank account for you).

End of comments.





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