Corospondent - January 2020
The investment case for South African equities - January 2020
Significant opportunities may underlie a bleak outlook
THE QUICK TAKE
- Fiscal consolidation and meaningful policy implementation is essential to restore investment confidence and a meaningful growth path
- Corruption, SOE failure and high debt levels have hamstrung the economy and the aftermath is likely to continue to do so
- It is in conditions such as these that remarkable opportunity can arise and some SA stocks are worth watching
THE OUTLOOK FOR domestic equity in the period ahead is an exceptionally challenging call to make, given the two vast extremes that will potentially drive market returns and how one should be positioned.
On most metrics, the FTSE/JSE All Share Index (ALSI) shows up as extremely cheap compared to its history. Like all averages, this hides a number of desperately cheap shares and some that are still looking fully valued.
Companies that have been able to deliver consistent earnings growth despite the challenging environment trade at eye-watering valuations. At the high end of the spectrum, Clicks and Capitec are estimated at forward price-to-earnings (P/E) ratios of 33 times and 22 times, respectively; whereas companies that have had a more challenging time are trading on multiples that we haven’t seen in well over a decade. This is reflected in sectors such as the clothing retailers, where Truworths, for example, is trading at eight times earnings and an equivalent 8% dividend yield; and in the large banks, where one can invest in a bank like Nedbank, which is trading at seven times earnings and a 7% dividend yield.
The reason for the very low rating of South African companies is obvious to all who live here. The economy is in a dire state and the political environment remains one where, despite all the obvious challenges and problems, change remains marginal at best and the status quo prevails. Policies to truly step up growth are spoken about and alluded to, but we remain stymied in a low-growth environment, made much worse by the failure, both financially and operationally, of Eskom.
NOT ALL THOSE WHO WANDER ARE LOST
Much like Robert Frost’s paths in the forest, we face two divergent roads ahead. Should we fail to deal meaningfully with the economic challenges we face, the country is doomed to a low-growth future and all the attendant financial and social risks that will come with it. In that case, these low single-digit P/E multiples will have proved to be appropriate, pricing for an environment where real earnings will continue to decline in perpetuity.
However, should we see signs of the country choosing to take the path ‘less travelled’, one with short-term challenges, but ultimately leading to a better state where fiscal consolidation occurs, confidence returns and economic growth picks up, there are unbelievable bargains to be had in the local equity market at the moment.
The challenge is being able to assess the probability of which route South Africa is likely to follow, how much is actually priced into company valuations and which companies can potentially grow under either scenario. As mentioned earlier, investors who are unimpressed by the trajectory of the South African economy, but want to maintain some local exposure, are prepared to pay incredibly high multiples for the perceived safety of shares that have shown consistent earnings growth the past few years; and the consensus view is that they will continue. They are priced for this growth, and then some, and should they disappoint, the gap between expectation and reality will be enormous. A stock re-rating from an expected 33 times earnings to our assessment of a normal rating for an average South African business would result in a 62% decline in its share price.
The brutal and all-encompassing nature of the derating of the local market has meant that there are companies which we believe are above-average quality businesses, trading today at ratings we think are overly pessimistic. These are companies that should be able to defend their earnings base in real terms in a low-road scenario and, if we follow a better path, could deliver real earnings growth that is not being priced for. These make excellent investments where the pay-off profile is skewed to the upside.
However, the future is unlikely to look much like the past decade in South Africa (refer to economist Marie Antelme’s article on page 7). Years of profligate spending by government and rampant corruption meant that there was a lot of money sloshing around in the economy, a situation that is not going to recur. To make matters worse, the debts incurred in the last decade need to be repaid, which means that a much tighter fiscal policy must be maintained. In plain English, this means that money will actually be taken out of the economy to service and settle the staggering debt run up by government and State-owned enterprises.
The upshot of this is that businesses that seemed to be able to grow their earnings regardless of the economic cycle in past times, may not be able to repeat that performance in the years ahead. And therein lies the challenge: identifying investments that offer both upside potential and relative downside protection.
A COLD COMING WE HAD OF IT
Why are we even bothering if the outlook is so clouded and the risks are so high? Because the opportunities for patient investors, should we recover off the low levels to which we have fallen, are significant. The last time South Africa was in a similar situation was back in 2002/2003 when the outlook for the country was equally pessimistic, and the world was still recovering from the shocks of the Dotcom bubble and the 9/11 terrorist attacks. The rand had weakened significantly, and domestic shares were trading on ratings very similar to where they are today.
What followed was a period of very strong returns for domestic shares, as the situation normalised and economic growth returned, with the ALSI delivering a total return of 29.5% per annum for the next four years. This is by no means guaranteed to be repeated, but given where valuations are currently trading, one has to take a serious look at domestic companies as potential investments for the next decade.
A PROFESSIONAL GUIDE MAKES THE JOURNEY
Our key strength and the pillar that supports our investments at Coronation is our intense focus on proprietary research. This will, once again, be absolutely crucial in determining which companies will be the future winners and losers, not in the next 12 months, but over years. All in, the above reinforces the oft-repeated view that while investing is simple in theory, it is incredibly difficult in practice.