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The lop-sided nature of the JSE hides some gems

There is value to be found in smaller stocks that are not on the radar of institutional buyers.

The general consensus is that the JSE as a whole is on the wrong side of fair value, but that’s a function of the lop-sided nature of the market, where a handful of big companies dominate the index. Dig a little deeper and there is value to be found, especially among smaller stocks that are not on the radar of institutional buyers.

The JSE All Share index (ALSI) trades at a price-earnings multiple of 24, and the Industrial index at a PE of 28. Just after the 2008 financial crisis, the ALSI was at 8.5 and the industrial index at around 9.

On the face of it, the market has gone crazy. But strip out some of the supernovas, such as Naspers and SABMiller, trading at PEs of 109 and 32 respectively, and the JSE looks a little more grounded.

Andrew Dittberner, chief investment officer at Cannon Asset Managers, says market breadth is a useful tool for analysis: it shows the percentage of shares that have outperformed the market over a given time period. Over the past year only 30% of companies have managed to outperform the JSE All Share Index. This is in contrast to the long-term average of 40%. “This would indicate that the market performance over one year has been driven by fewer and fewer shares, resulting in opportunities outside of these high flyers,” says Dittberner. “Against this background, I would argue that the overall market is not as overpriced as some suggest, and that we are firmly in a stock picking market, as opposed to a sector rotating market, right now.”

Value appears to be most evident in South Africa-facing companies, which include local industrial businesses and banks. Opportunities are also evident in a number of resource counters. The market is pricing in low earnings growth in the foreseeable future, and as such one needs to be astute in figuring out whether a business has the ability to grow earnings in the current environment, therefore warranting a re-rating in the share, says Dittberner.  

Data from financial software and data supply company TimBukOne shows where the big money has been going in the last two months: Naspers, Steinhoff, Anheuser-Busch, as well as banking shares (FirstRand, Standard Bank, Investec) and mining shares (Gold Fields, Anglogold Ashanti, BHP Billiton and Anglo American Platinum).

Bank stocks are on a rebound after a disastrous start to the year. The threat of ratings downgrade, weaker economic growth and higher interest rates hit banking shares in the early part of the year, and while all of these threats remain ever present, investors are starting to see value again.

The construction sector was priced for virtual bankruptcy a few months ago, but it too is on a rebound. Dittberner sees Group Five as a stock to watch.

“The recent annual results suggest that Group Five is no longer an engineering and construction business, but rather a concessions business, given the division’s contribution to operating profit in recent times,” he says.

In an otherwise depressed industry, Group Five out-shone its peers by growing earnings 69% in the last financial year. The concessions business entails long-term contracts to operate and maintain toll roads in Europe and South Africa, which makes it more of a property company, maintaining the property and collecting rent. There have been some recent contract wins in Europe, with more in the pipeline, which bodes exceptionally well for the group. Alongside this there is a manufacturing business that is ticking over nicely.

“The beauty of the concessions business is that it commands far higher operating margins than the engineering and construction division does, yet the company is priced as if it were a pure construction company. Given the annuity nature of the income, the higher quality of earnings alongside operating margins in excess of 20%, we believe that this single division accounts for the majority of Group Five’s market capitalisation,” according to Dittberner.

The group’s balance sheet is comfortably in cash, which means it can sustain dividend payments. The engineering and construction division is looking at an improved performance this year, and the concessions business is on the up and up. Corporate action to separate the divisions could unlock material value for shareholders.

Another stock on Dittberner’s beauty list is Combined Motor Holdings (CMH), which has diversified over the years from pure dealerships into new business areas such as car rental, which is today an important part of the business. Second hand car sales are also doing well, as they tend to do in tough economic environments, when consumers trade down. CMH is also involved in financial services.

This is a well-managed company that does not register on the radar of large institutional investors due to its relatively small market cap of R1.2 billion. It has no long-term debt on the balance sheet to speak of, and managed to grow earnings by 20% over the last financial year, delivering a return on equity of 38%. It trades on a PE ratio of 6.4 with a dividend yield of 8.2%.

On a per share basis, earnings have increased at an annual compounded rate of 18% over the past 5 years. The business is exceptionally agile, with the majority of assets being very liquid, in the form of motor vehicles and R500 million in cash. CMH repurchased R250 million worth of shares in the past financial year, giving the shares an extra spring.

Which goes to show, it pays to keep your eye on the outliers that institutional buyers tend to ignore.

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Looks like CMH may be one for the Christmas stockings? Looks interesting.

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