The news for SA Inc has not been good. The announcement last week that South Africa’s economy had shrunk 3.2% in the first quarter of 2019 was a shock to markets. Although a drop was anticipated, the magnitude was a surprise.
It also seemed like more bad news for local investors who have had to contend with a weak JSE for five years now. A large reason for that has been the depressed local economy, and the GDP numbers only added to the unease about the South African environment.
“The GDP data suggests the economy is in a much more fragile state than the market anticipated,” notes Iain Power, chief investment officer at Truffle Asset Management.
For many, this was further confirmation that conditions on the JSE are unlikely to improve. For the five years to the end of May, the FTSE/JSE All Share Index (Alsi) delivered an annualised total return of just 5.4%, and if the economy continues to stumble there may seem little reason for that to pick up.
The lesson from bonds
However, the correlation between economic performance and investment returns is not always as obvious as many might think. Perhaps the best illustration of this is that despite the state of government finances and the trouble at state-owned enterprises (SOEs), South African bonds have been an exceptionally good investment over the past five years, returning about 8.4% per annum.
“The most important thing with any asset you buy is the price you pay for that asset,” says Allan Gray’s chief investment officer Andrew Lapping. “That determines the subsequent returns.”
In the case of South African bonds, they have been cheap precisely because of the risks the country is dealing with. At times, like when Nhlanhla Nene was fired as minister of finance, they got even cheaper.
Investors therefore have to consider more than just the state of the South African environment when thinking about the future of stock market returns.
“Many people I speak to here are extremely negative about South Africa,” Lapping says. “Don’t get me wrong, there is lots to be negative about, but what does that mean for asset prices?”
In his view, the market as a whole is not particularly cheap, but this is influenced by the presence of a few large multinationals – like Naspers, Richemont, AB InBev, BHP and Anglo American – that carry little exposure to the South African economy. On the one hand, these companies have supported market returns. Without them, the Alsi would be 40% lower over the last 10 years.
On the other hand, however, they can mask the state of the broader market due to their size. If one excludes them, the remaining shares on the JSE do look somewhat cheaper, precisely because investor sentiment around South Africa is so poor.
What’s in a price?
“This is where we are looking for value,” Lapping says.
“It’s definitely not the kind of opportunity we found in 2002 or 2003 when things were extremely cheap, but we are finding selective pockets of value and over time, if the economy improves, I hope we’ll find greater value.”
This is why many local asset managers have been growing more positive about the return prospects on the JSE. They are seeing that they can buy some good local companies that have held up well even in the current economy at relatively attractive prices.
Of course, this doesn’t come without risk. As Power notes, sometimes assets can stay cheap.
“Absent significant structural reform and an overhaul of many of our SOEs, there is an increasing likelihood that South Africa is becoming a value trap as we struggle to gain any growth momentum and improvement in investor and consumer confidence,” he says. “Anecdotally, many of SA’s large corporates struggling to find growth have started to cut jobs and downsize their footprint in response to the current economic conditions.”
Investing in stocks is, however, never an exact science. It is more often about getting the odds in your favour. As Anet Ahern, CEO of PSG Asset Management notes, that means taking lessons from history.
Possibilities and probabilities
She points out that there have been five times in the past when the Alsi has delivered similarly poor returns over any five-year period. These are indicated in the graph below.
The first thing investors should take from this is that we have been in similar situations before. It is not unique.
Perhaps more importantly, however, is to consider what happened subsequent to each of these episodes.
“You have to think about possibilities and probabilities,” Ahern says. “If you were invested at these points and stayed invested, what happened in the following three years? At worst you got 16.4% per annum. At best, 40.2%.”
There is no question that the environment in South Africa is extremely uncertain at the moment. However, this is also not news to anybody. The market is fully aware of the challenges, which is why many local shares are priced the way they are.
This does, however, create an opportunity for investors. If shares are cheap, the likelihood of future returns is certainly not guaranteed, but it is greater.
“One can debate to what extent and whether the market starts getting better tomorrow or next year,” says Ahern. “But we believe there are a lot of risks discounted.”