Given how poorly many parts of the JSE have performed for some years now, a number of local asset managers have been talking about the value they are seeing in certain South African companies. At the Meet the Managers event last week Kagiso Asset Management’s chief investment officer, Gavin Wood, said he has “very seldom been so excited about the opportunities” they are finding in shares outside of the 50 largest stocks on the JSE.
Shaun le Roux, portfolio manager at PSG Asset Management, had a similar message at the Glacier Investment Summit a few days earlier.
“We think there is a fantastic opportunity in mid cap industrials in South Africa – companies that have been able to maintain profits in this incredibly tough economic environment,” he said. “Most of them are trading at less than 10 times earnings.
“These are valuation levels we last saw in the financial crisis.”
This includes companies like AECI and Reunert. The former is trading on a price-to-earnings (PE) multiple of under nine times, and a dividend yield of 5.5%, while the latter is offering a PE of just over 10 and a dividend yield of more than 7%.
It’s just for now …
As Iain Power, chief investment officer at Truffle Asset Management, explained at Meet the Managers, investors can find value by looking for “solid businesses that are going through some sort of temporary setback”.
“We are looking for shares of good companies that, for whatever reason, have fallen,” Power explained. “It could be cyclical, as in the case of platinum shares collapsing due to commodity prices coming down. Impala fell as low as R16 per share last year, but clearly the value of the business was not R16 per share.”
Impala’s share price has since recovered to more than R70 per share.
“Or it could be something company-specific,” Power added. “For instance, Viceroy releases a report on Capitec and the share price tanks 30%. Nothing has changed in the business, but people suddenly think it’s worth 30% less.”
Capitec’s share price fell from R1 080 to R800 in the month the Viceroy report came out. It is now over R1 240.
Don’t be fooled
What is vitally important in these cases, however, is that this has to be a temporary setback.
“When that setback disappears, returns and cash flows improve and the share price moves up again,” Power said.
“The problem is that it’s difficult to identify this. A lot of companies suffer setbacks that are not temporary.”
These are ‘value traps’ – companies that look cheap on a historical basis, and therefore may interest value investors, but their problems are not merely temporary. Unless you scrutinise them carefully you may miss that something fundamental has changed.
“When you get structural changes that have taken place, the future can sometimes look very different to the past,” Power said.
He pointed out that South Africa is going through structural changes in its economy, and that must impact on local businesses. Investors therefore need to be cautious.
“The cost of doing business in South Africa has structurally gone up,” said Power. “Companies are struggling to control costs, and this is having an impact on profit margins.”
Where to look
Property companies, for instance, have to deal with municipal charges becoming an increasingly high percentage of their total operating costs. As the graph below illustrates, the costs of water, electricity and municipal rates have risen much more quickly than other expenses these companies face.
“Services rates have grown much faster than underlying rentals have grown for property companies,” Power pointed out. “You can imagine what this does to profit margins.”
Another sector where the environment has changed materially is for the hospital groups. Netcare’s share price has almost halved over the past three years and is currently trading on a PE of just over 10 times, but Power thinks that what it is facing is not a temporary issue.
“The South African medical aid member base has not grown outside of the Government Employee Medical Scheme (GEMS) over the last 12 years,” he noted. “At the same tine, the buyers of healthcare services – the medical aids themselves – have grown more dominant.”
As the graph below shows, overall membership of schemes outside of GEMS has not shifted from seven million since 2006. Discovery’s market share has however grown from around 40% to over 55%, and it is putting a lot of pressure on hospital groups to keep costs down.
At the same time, hospital groups have excess capacity, which means they have little pricing power. They need to fill beds, and this means they are getting increasingly squeezed.
“We think margins will continue to be eroded,” Power argued. “There probably isn’t a mean reversion coming. This is probably not a temporary setback.”