In February 2017, PSG Wealth undertook a survey among clients and brokers, to find out their views on the value offered by the local market. Most participants – over 53% – felt that the market was expensive.
Despite this consensus, thorough research and analysis reveal that the market’s current valuation is in line with its long-term average – and even more so when heavyweight rand hedges are excluded.
The JSE’s Big 5
The valuation of the top five market cap stocks on the FTSE/JSE All Share index (Alsi) have been masking value elsewhere in the domestic market. An analysis of the Alsi shows that when these top five companies are excluded, the forward price-to-earnings (P/E) ratio of the index returns to a level similar to the average P/E ratio recorded over the past decade.
Valuations are not straightforward
The rational approach to investing tactically in equity (as with all asset classes) is to adjust the position according to a fair assessment of opportunity and risk, increasing exposure when opportunities are presented, or lighting your stake when conditions are unfavourable.
While we recognise that valuation is often ineffective as an investment tool, it is the single most important determinant of long-term returns. Stocks on the ALSI look expensive if you use the current P/E ratios to measure value. As at 24 May 2017, shares on the ALSI were trading at P/E ratios of around 19. In the last quarter of 2016, shares in the Top 40 Index were trading at P/E ratios of around 30. The last time P/E ratios were at such elevated levels was in 1994, after which share prices fell back significantly. They also approached these elevated levels in 2008 before another substantial retraction returned the market to normality.
Current P/E ratios seem expensive, because they have been inflated, largely on the back of an earnings collapse.
Local counters have also reacted to the slide in the local exchange rate. With a significant portion of the profits generated by the JSE’s biggest listings now coming from abroad, South African stock prices have been stimulated by the depreciating rand. However, when one uses the harmonic forward PE, which we believe is a more appropriate measure of current valuations, then the P/E for the ALSI is 14.12 times. This is still expensive compared to the long-term average P/E of 12.25. The analysis shows that the P/E for the ALSI is currently trading close to 2.5 standard deviations above its long-term average.
The impact of large caps on P/E averages
When the top five companies with the largest market cap are excluded from the ALSI, the forward P/E drops to 12.58. The top five companies (Richemont SA, British American Tobacco, BHP Billiton, Naspers and Anglo American) currently constitute almost 38% of the ALSI by weight. However, they only account for 9% of the number of shares in the index.
Naspers alone accounts for about 15% of the index, trading at a forward P/E of almost 30. Richemont and BHP Billiton both contribute over 14% to the index and trade at forward P/E ratios of 25.44 and 11.95, respectively.
Some of the top five companies are currently trading up to 8.62 standard deviations above their long-term averages.
Over the long term, valuations tend to revert to the mean. Using historic P/E multiples, the JSE currently seems very expensive. Some analysis reveals that the overwhelming consensus is, in fact, wrong. This is an indication that value is still available to diligent stock pickers.
Adriaan Pask is Chief Investment Officer of PSG Wealth.
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