In conversation with Clucas Gray, Perpetua Investment Managers and Morningstar Investment Management
South African equities have long been undervalued; the conversation I had recently at our annual Investment Conference with 3 portfolio managers explores these low valuations as well as more complex concerns. While a recent rally has brought optimism, questions linger about its sustainability and whether the optimism we are experiencing now is similar to the 2017 “Ramaphoria” period. However, the current macro environment seems to support the picture of a stronger domestic equity market.
We currently have a weakening dollar and the potential deployment of $6 trillion from U.S. money market accounts could benefit emerging markets, including South Africa.
Does the picture look positive for South Africa?
Andrew Vincent (ClucasGray) highlighted challenges still faced by businesses in South Africa—ranging from political instability to power issues, rail inefficiencies, and high interest rates.
Andrew cautions that while some companies may have experienced some re-rating, the true potential lies in earnings growth, which has been stagnant for years. Should the structural changes, such as lower interest rates, take effect, South African equities could unlock significant returns, transforming long-standing headwinds into tailwinds for investors.
Delphine Govender (Perpetua Investment Management) shared this sentiment, arguing that South Africa's difficult operating environment has contributed to a damaging cycle of capital outflows and underperformance. However, recent trends show signs of improvement, with South Africa starting to outperform other emerging markets, a stronger rand, and local equities still trading at a relative discount. As local and international flows begin to shift towards South Africa, the outlook could brighten, especially as global interest grows.
Given the underperformance and capital outflows, foreign investors are currently underweight in South Africa. A simple shift towards a neutral position could result in significant inflows, which would provide much-needed liquidity. Sean Neethling (Morningstar Investment Management) added that while South African equities remain undeniably cheap, they still represent a small portion of the broader emerging markets index.
As local investors begin to invest in these undervalued companies, South Africa’s market performance could improve, boosting its weighting in the index and providing a signal for global investors to increase their exposure.
Are we going to see a reversal in the trend of delistings?
We have seen a global phenomenon of corporate actions and delistings across markets, this has resulted in a shrinking in the number of publicly traded companies available and overall, a smaller shopping basket for equity asset managers.
Andrew mentioned that while global factors may play a role, the trend in South Africa is partly a natural market evolution. Companies facing cheap market valuations are often unable to use their stock as currency for acquisitions, prompting delistings. However, as valuations improve, private companies may see the opportunity to go public, and well-valued stocks could attract investor interest over the next 12 to 18 months.
Delphine attributed the rise of delistings to the lack of price discovery in the equity market and how there is a lack of price discovery, particularly in mid-cap and small-cap companies.
Furthermore, the concentration of assets in a few stocks plays a significant role here. With the top 25 shares accounting for 70% of the index, the remaining 100 or so companies must share the balance of 30%. This skewness is compounded by the fact that capital allocators themselves are also concentrated, with a few large managers dominating the market. These managers tend to focus on the top 20 shares, resulting in strong price discovery at the top end, but a lack of it for mid- and small-cap companies.
Historically, markets have seen undervalued stocks attract value investors, who buy in at low multiples, helping the company’s story gain traction. As the stock re-rates and moves through its lifecycle, growth and momentum investors get involved, driving the next phase of valuation.
But this traditional mechanism seems broken. The concentration of capital in large-cap stocks has stunted this natural progression, leaving mid and small-cap companies unable to attract the capital necessary to re-rate and grow. This dynamic highlights the need for more active engagement between investors and companies, pushing them to unlock value internally rather than waiting for market forces to correct pricing.
How will this affect portfolio construction?
When it comes to portfolio construction in the equity environment, Sean further highlighted the narrowing South African market over the last decade, with the top 40 or 50 stocks accounting for nearly 90% of the market capitalization. This has led to a stronger case for passive investment strategies. However, there remains a need for active management, particularly in smaller, under researched companies, where price discovery is crucial. Sean suggested that a blended approach—combining low-cost passive investments with selective, high-quality active management—would provide optimal exposure while capitalizing on differentiated stock picking opportunities.
In conclusion, while South Africa faces challenges, there are signs of improvement, with the country starting to outperform other emerging markets. The trend of delistings reflects a natural market evolution influenced by factors like cheap market valuations and the lack of price discovery. While we may see a reversal of this trend; an improvement in valuations may provide an incentive for private companies to go public. However, there is a pressing need for intervention through active engagement between investors and companies in order to unlock value for these companies.