Investing in a changed environment

In 2006, only four shares out of the 140 listed on the JSE lost their investors money. By the end of last year, however, the number of declining shares had grown to 16.

And Gary Quinn, co-manager of the Prudential Equity Fund, believes that the number of listed shares that will deliver negative returns this year will be even higher.

“In 2006 it was really hard to lose money on the stock exchange and investors were literally spoilt for choice. The focus was not so much on preventing losses, but rather on picking those shares that promised the highest growth.”

Quinn says half way through last year, however, the investment environment started changing and suddenly investors had to start assessing shares a lot more carefully in order to avoid potential losers.

“Currently a stock that promises earnings growth of around 15% looks attractive and we would rather settle for a certain 15% than take our chances on a probable 20%. But in 2006 the environment was such that we would have opted for a probable earnings growth of 30%, instead of settling for a definite 20%.”

Quinn says over the past year South Africa’s economic growth had slowed substantially, necessitating a number of changes to Prudential’s equity portfolios to ensure ongoing good returns in a changed environment.

He says this resulted in a swapping of holdings whereby lower quality stocks with earnings volatility were exchanged for more stable stocks.

Quinn says his fund’s current holdings now consist of large cap defensive stocks such as Pick ‘n Pay, Tiger Brands and Sasol.

“Although not stand out cheap, these stocks have the necessary earnings predictability needed during this uncertain time.”

Quinn says cyclically deep value stocks such as Foschini and Investec, which have fallen out of favour, still form part of his equity portfolio. “We know their earnings outlook is subdued for the next 12 months but the deep discount they are trading at is likely to generate the returns over the next 18 to 36 months when interest rates are likely to start falling again,” he says.

According to Quinn, small cap stocks have also lost their sparkle. “We don’t believe there is much value left in them and the current interest rate cycle does not favour small caps,” he says.

Quinn says over the past five year, the JSE All Share Index returned on average 28% a year. This return, he says, was made up of about 18% earnings growth, 2.8% dividends and the rest came from a re-rating in the JSE.

“Because earnings growth was so exceptionally strong over the past five years, we would derive maximum value for clients by including shares that promised strong earnings growth even if the share price was at risk of a re-rating.”

Now, says Gary, the focus is on picking shares that are unlikely to suffer re-ratings and that promise stable earnings growth at the same time.

“Currently there are a lot of shares on the JSE, which look exceptionally cheap, but the outlook for their earnings growth is poor.”

Quinn says at first glance the JD Group, for example, looks cheap and therefore attractive.

“But it should be remembered that furniture companies have traditionally traded at a deep discount to the JSE. In addition their business model is under threat due to the introduction of the National Credit Act and earnings are likely to decline for another year. A forward P/E of eight for this company is probably justified given the risks that it faces.”

On the other side of the spectrum there are those shares which appear immune to an economic downturn. A good example, says Quinn, is the JSE itself. This share is, however, exceptionally expensive and yet investors are prepared to pay P/E ratios of up to 20.

Quinn believes the right type of share comes at the right price and offers certain earnings growth, combined with a good outlook for dividend growth. He lists Sasol, Pick ‘n Pay and Santam as examples of such shares.

“People don’t stop shopping for food, buying fuel or insuring their property, just because the economy has slowed and interest rates are up. Therefore these stocks are likely to offer stable growth going forward.”

Quinn says this year his investment strategy is a lot more defensive than in the past.

“We are a lot more likely to pick stocks depending on the company’s business model than the sector that it is in. In line with this approach we prefer food to clothing, bulk commodities such as coal and iron ore to base metals such as gold, and short-term insurers to micro-lenders.”

Quinn says he expects 2008 to be very much like the last six months of 2007. “We expect volatile markets for most of the year. Over all, we will be happy to get away with a 15 percent return,” he says.

However, it’s not all bad news and he does feel that there are more opportunities going forward this year in terms of stocks going cheaply, than there were at the beginning of 2007.

His advice to investors is based on his approach to investing for 2008:

• First, make sure you don’t lose money. When picking shares this year, we’ll be making sure that the own stocks that are unlikely to lose money.
• We want to make sure that we get a yield on the stocks that we buy. Therefore, we will be choosing companies that will pay dividends.
• We want to invest in stocks that will provide us with a capital return. If the dividend goes up, then the price of the asset is also likely to increase.