The performance of the JSE over the past 10 years has not only been disappointing – it has been unusual. As the graph below shows, the local market has underperformed the MSCI World Index for almost this entire period.
This is, however, an anomaly.
“Historically, the South African stock market has been one of the best-performing stock markets in the world over time in US dollars,” says Saul Miller, portfolio manager at Truffle Asset Management. “In equal currency terms, the JSE has been one of the best markets if you look over 50 or 100 years.”
Using history as a guide, a normalisation would mean that returns from the JSE should be much better going forward.
“That’s what you would expect if you have mean reversion,” Miller says. “But we need to assess whether we’ve had some structural changes where perhaps we can’t expect that mean reversion and we can’t expect substantially better returns despite the underperformance that we’ve seen.”
When structural changes happen, the value of history diminishes, says Miller.
That is because you can no longer draw a straight line from the past into the future. And there are reasons to believe that structural changes in the South African market may be having these kinds of lasting impacts that investors need to consider.
The first question worth asking is whether South Africa has lost its corporate governance premium.
“South African management teams have often been regarded as on par with a lot of developed market management teams,” says Miller.
“Investing in South African businesses was almost like investing in a developed market company that was exposed to emerging markets.”
Foreign investors in particular have been willing to place higher valuations on local companies for this reason.
“But given the slew of corporate malfeasance incidents that we have seen of late, that seems to be changing,” says Miller. “Obviously the biggest offender would have been Steinhoff, where there was outright fraud, but we’ve had other companies that have been disappointing, like Sasol where there has been really poor execution, and other businesses where there has been poor allocation of capital.”
The second issue is the weak-growth environment within South Africa. While the world economy has been expanding at nearly 3%, the local economy has only shown marginal growth.
The challenge this creates becomes even more apparent when one looks at the growth in South Africa’s GDP per capita against the global median.
“In South Africa, it has basically been negative for five years,” says Miller. “It’s almost starting to look not like a cyclical event, but a bit more structural. If you look at where we rank relative to other countries, we are in the bottom 15%. That’s not the company we would want to keep. This kind of environment bodes incredibly poorly for turnover growth prospects for South African companies.”
Investment in fixed assets in South Africa has also become a significant issue.
“We haven’t been investing enough in our fixed assets to even cover depreciation. We spend a lot less than other emerging markets.”
This might be seen as an opportunity. Given these low levels, an injection of investment should be able to accelerate growth quite quickly.
“The problem you have is that our debt levels are fairly high and continue to rise,” says Miller.
The government therefore lacks the money it needs to spend on fixed investment into the economy. Price increases for services such as water and electricity have also risen well ahead of inflation, putting increased pressure on company margins.
The question this raises for investors is how they should view the JSE if these structural changes are indeed taking hold. As Miller explains, it doesn’t mean that the market has become uninvestible, or that it will never again deliver returns. But it does mean that the opportunity needs to be viewed differently.
“I’m not saying South Africa is going to fall over a cliff, but what we do think is that given these numerous risks you should certainly be paying a lot less for South Africa-exposed companies than you historically paid,” he argues. “The positive thing I will say is that, given the pressure we have seen on domestic South African names, we have seen some shares come off so much that they are starting to price this in.”
Tim Acker, an equity analyst at Allan Gray, agrees.
“Valuations have come right down, and we are finding more opportunities in the South African market, even though the economic environment is very tough.”
He points out that it’s always important to gauge the level of optimism in any market.
“When the market is extremely optimistic, you want to be quite cautious,” Acker suggests. “When people are pessimistic, that’s the time you can take more risk and be a bit more aggressive.”
He points to the fact that almost none of the largest 40 stocks on the JSE have made new highs during 2019. This illustrates a level of pessimism that more astute investors should find interesting.
“Just three to four years back, quite a lot of South African companies were making new highs,” Acker notes. “Investors were actually quite optimistic and willing to price companies to higher levels. But if we go back and look at periods like 2003 and 2009, when we had similar levels of pessimism and a lot of companies were quite depressed, the subsequent returns from those points were very attractive.
“That doesn’t necessarily mean that the same is true today, but it is quite a comforting indicator,” Acker adds.
“You might say you’ll wait for the dust to clear – but in the past, if you did take that approach, once the dust has cleared some of the bargains are gone as well.”