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The sell-off and the opportunity

You don’t have to invest in poor quality companies on the JSE to find value.

For the year to the end of October, the FTSE/JSE Shareholder Weighted All Share Index (SWIX) was down 13.6%. Over the last 12 months it was 11.1% lower, including dividends. Investors would have been substantially better off in South African government bonds and cash.

Source: 27four Investment Managers

Even over three years, the SWIX has produced an annual return of just 1%. After inflation, that means performance has been negative.

This illustrates the scale of the sell-off on the local market. Given the weakness in the South African economy, political uncertainty and a negative global environment, investors have largely walked away from the JSE.

However, as 27four Investment Managers chief investment officer Claire Rentzke points out, these kind of short-term pull-backs often create long-term opportunities.

“Over the shorter term it has been a scary picture,” she says. “Markets have been volatile, and investors have been losing money, but we need to be able to look through the noise. As Warren Buffett says, it’s time to be greedy when people are fearful. Right now we are seeing a lot of fear and we think that presents an opportunity to take advantage of assets that have sold off.”

Local prospects

Portfolio manager at 27four, Nadir Thokan, points out that if you compare the JSE to global markets on a price-to-book metric, it is currently at a 20% discount. Even if return on equity only shows a marginal improvement in 2019, which would keep it below the global average, these valuations look attractive.

“You can make the argument that the local market is delivering poorer cash generation and therefore it should trade on a discount,” says Thokan. “But when you start at this discount and have improving return on equity, historically the next 12 months give you a 15% dollar return on average.”

Source: 27four Investment Managers

“The fact that we are on very depressed multiples tells you that there is not a lot of optimism priced into the market, and not a lot of confidence in terms of what companies are going to be able to deliver,” Thokan says. “But if companies marginally outperform these very poor expectations, you could see quite a lot happening because their prices are exceedingly depressed.”

Some analysts might argue that the current multiple is however fair because it is forward-looking. With the South African economy in such a weak state, prospects for local earnings are poor, on top of which many listed companies have made some ill-judged offshore acquisitions that are weighing them down.

But Thokan points out that over the last two years company earnings on the JSE have actually grown at a reasonable rate.

“Yes we are in a technical recession, but we have been in an effective recession for the last decade,” he argues. “If companies were growing their earnings in the last two years, there’s nothing that would seem to indicate that they would have a more difficult time growing their earnings going forward. Even if earnings stay steady at this rate, equity markets are significantly better valued than they were two years ago. You don’t need massive amounts of earnings growth to find value at these levels, given the extent of the sell-off we have seen.”

Source: 27four Investment Managers

What makes the local market additionally attractive in his opinion is that the price-to-earnings differential between the most expensive and least expensive stocks has narrowed significantly. It is now below the long-term average.

Source: 27four Investment Managers

“That is telling you that the low quality part of the market and the high quality part of that market are not that different in terms of how expensive they are,” says Thokan. “If you are making an equity investment today, you don’t have to invest only in poor quality companies to find value.”

British American Tobacco, which is one of the most stable earnings producers on the JSE, has fallen over 30%. Shoprite, which is recognised by international fund managers as a world class retailer, has de-rated 25% from its peak.

The uncertainty is priced in

In addition to the attractive valuations locally, Thokan believes that investors are currently placing too much emphasis on recent returns from international markets. While it is true that over the last five years global equities have outperformed the JSE, for the decade before that the JSE delivered substantially better returns.

Investors should therefore be wary of recency bias when allocating their money.

Source: 27four Investment Managers

“There is a notion in South Africa that the answer to all your problems is to take as much money as you can offshore because the economy is going down the toilet and our politicians don’t know what they are doing,” says Thokan. “The belief is that we are going to see rand weakness of 10% a year, global markets growing 15% every year, and offshore everything is going to be fine.”

However, while investors should always diversify and keep a portion of their portfolio invested overseas, they should be careful of underestimating the risks elsewhere.

“What this year has taught us is that there is as much uncertainty offshore as there is locally,” Thokan says. “Economists are revising their growth forecasts for the US lower because of things like trade wars, policy uncertainty, and congress being at loggerheads.

“Yes there is a question mark around policy certainty in South Africa, but at least that is reflected in the price,” he adds. “The danger offshore is that there is as much policy uncertainty and yet markets are trading at just below record multiples. That is a dangerous place to be parking the maximum amount of money that you can.”

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Interesting article Patrick, it is true that many investors have walked away from the market, but for every seller there is a buyer, and these buyers will in the long term benefit having bought at a discount. South Africa has a huge potential for growth, even if the political and economical environment is noisy and not currently optimized to tap the potential of all its people. This situation is slowly changing as the eyes and ears of the people open and they realize that they are being misled by political opportunists and scammers on all fronts.

Thanks for the insight Patrick,

Share prices have come down and stocks are cheaper on the JSE relative to recent years. There are some other considerations to bear in mind.

* On a longer term basis (say 30 years), are PE PB valuations still below long term averages?

* Share prices often forecast potential trouble 6 months – 1 year down the road. The 20%+ correction in stocks may be suggesting more to come. So investors may consider averaging down into stocks rather than going all in.

* If we do go into a global bear market, the best safety net (in recent history if I recall correctly) has been USD cash.

* Historically JSE dips of 25% are good buying opportunities but some 40% of the time, these turn into 35-40+% drops. Investors and advisors should bear that in mind.

With reference to your statement: “You don’t have to invest in poor quality companies on the JSE to find value”. Are you referring to small cap stocks? I might be wrong, but I get the feeling that your argument is that the “bigger” the company is the higher the quality of the company and less risky the company is. A quality company in my opinion is a company with a strong balance sheet (i.e. little to no debt with a strong cash position), consistently profitable in an un-commoditized business sector. I can’t rationalize buying a business (i.e. Shoprite) trading on a PE of 20.4, which is equivalent to a 4.9% earnings yield in an inflationary environment of 4.9%. I will rather invest in a “low quality” company (i.e. ARB Holdings) with a PE of 7.8, which is equivalent to an earnings yield of 12.8% in an inflationary environment of 4.9%. Further, ARB offers a 4.46% dividend which is close to matching SA’s 4.9% inflation rate. To add a kicker the company has cash on hand of R259 million after R106 millions of capex was spent. Thus I do not agree that because a company’s share price has fallen in excess of 20% it now offers value. Unless Shoprite grows earnings aggressively there is no value. However, it will not be the first time that markets push up the “Price” of a share. In my opinion, the market is growth obsessed. I will rather buy a company with limited to no growth prospects trading on single digit PEs, than invest in a company with growth prospects trading on a PE of 20. If share price movements translates into value, we should all be buying Steinhoff.

@Dr Dre i could not agree 110% with you with the above, personally i believe that companies that are trading above R100 i do not touch, and companies with high debt ratio (do not touch) and low Price to Free Cash Flow(do not touch). There is so much i repeat so much value in good quality small cap companies, the likes of ISA Holdings with a P/E of 9.63 and Price to Tangible Book of 2.59 with little debt & a dividend yield of 10.38%. I’ts just a matter of looking and doing some research.

I agree with you Dr Dre BUT you stand more chance to loose capital on ARB that on Shoprite. do you want to invest or gamble?

Dear Dayview.

Speculation, in my view is when you focus on price as demonstrated in your argument:”you stand more chance to loose capital on ARB than on Shoprite”. Investing is focusing on fundamentals and value. In my opinion the downside risk for Shoprite is much larger than for ARB. Further, price only matters when you sell.

Shoprite is priced for perfection. One small glitch in earnings can result in substantial capital losses. Aspen case in point.

Finally a reasonable discussion against “taking everything offshore”. Nice article.

Interesting article but I think it lacks world perspective and is written as though SA’s JSE can be compared to first world exchanges. Let’s be frank here, we are in Africa and that, as well as the rest of the “developing” whatever third world, should be our benchmark. SA is a smidgen away from IMF begging and junk status with not that much sign of real improvement – SOE’s remain out of hand, unemployment is rising, state employment is bloated and cost increasing. As per Ludwig’s comment “South Africa has a huge potential for growth”, true, as do most third world and African countries. On its own it means precisely nothing.

The article should keep perspective. “The danger offshore is that there is as much policy uncertainty” is just rubbish when you look at SA’s threats to fundamental property rights (EWC) and blatantly racist legislation unless “offshore” means South America. It is like the comment “crime is everywhere”. Yeah right.

I am not advocating ditching SA but rather to get perspective; financially we are an unstable speck in a massive world. Investment balance should follow.

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