The past decade on the JSE has played out in two distinct halves. The period from 2009 and 2014 was extremely good for local stocks, but the five years since have been dismal.
Investors can see this distinction in the longer term performance of local equity funds. Over the past five years, the top-performing fund has delivered around 8.5% per year. Over 10 years, the top-performer has returned 14% per year.
“If you look at the numbers, this past five-year period was bad in every possible way,” says Adrian Clayton, chief investment officer at Northstar Asset Management.
This is illustrated in the following graph:
The first set of bars shows that over the past five years the top-performing stock on the JSE was up 45%, compared to the biggest gain in the previous five years of 91%. Over the past five years, the worst-performing stock has lost 71%, while over the previous five years the worst was a 39% drop.
The median JSE-listed stock returned 20% over the previous five years, but only 3% in the past five years. And while only 58% of local stocks are in positive territory over the past five years, 83% were up in the five-year period before that.
So what’s next?
“It’s normal to have market cycles,” says Clayton. “But now that we’ve had five bad years, does that just mean that we are going to have five good years?”
The biggest reason to believe that returns from here will be better is that the market as a whole looks a lot cheaper than it did five years ago. In 2014 the JSE had become expensive on a price-to-earnings (PE) basis, but that is certainly no longer the case.
Clayton acknowledges that off this base, it is possible that the market could provide an improving return in the short term. The question, however, is whether that can be sustained, since it requires companies to justify improved ratings with growing earnings.
“I’m not in the business of predicting markets holistically, but when we look at South Africa and SA Inc, we are just deeply worried that companies are going to struggle to deliver high degrees of profitability,” says Clayton.
“Until we turn GDP growth around, we are going to be facing an uphill battle.”
He points out that companies in South Africa have already been though all sorts of ‘self help’ interventions. Many have degeared to try to strengthen their balance sheets, others have sold off underperforming or marginal assets, and a fair number have made acquisitions offshore.
“There has been a lot of movement, with management teams pulling all the levers they possibly can,” says Clayton. “They are all trying to address the same issue, which is poor growth.”
It’s the economy …
It is, however, very difficult for any company of meaningful size to outgrow their domestic economy. The graph below illustrates how nominal GDP growth and the earnings growth on the JSE are closely linked.
“There is actually a 12 to 18-month lag between nominal GDP and earnings growth,” says Clayton. “In other words, GDP leads JSE company profitability.”
Given that GDP growth has stalled since the start of 2017, he believes investors should expect earnings to follow it down.
“If this relationship continues to do what it has done historically – and I don’t see why it shouldn’t – then we are going to continue to see pressures on companies, because there’s not much more they can do,” Clayton says.
In his view, this means investors need to “navigate carefully” and work out what any company’s truly sustainable earnings are.
“Companies might look cheap, but there is the risk that their earnings continue to be under pressure,” Clayton points out. “So a PE of 10 might end up being a PE of 12 because earnings vaporise.”
With a number of management teams voicing their own concerns about the operating environment and how tough it is, investors would therefore do well to be selective.
“We are being quite cautious,” Clayton says. “We don’t mind owning certain domestic companies, but we just think you have to be very careful around those with poor balance sheets or who have a lot of leverage, because they are not in control of their own futures.”