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.
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.
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.
“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.
“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.
“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.