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Value returning to local equity market

19 October 2011 Peter Linley, Head of Toros Equity, a boutique within the Old Mutual Investment Group SA (OMIGSA)
Peter Linley

Peter Linley

“The South African stock market is currently offering reasonable value although equities remain vulnerable to the contagion effect of further global growth shocks and the lack of definitive action by European authorities to sort out the EU's financial problems,” says Peter Linley, head of Toros Equity, a boutique within the Old Mutual Investment Group SA (OMIGSA) stable.

Further action by European leaders needs to be convincing. There is too much at stake for politicians and policy makers to disappoint, says Linley, and the vacuum created by lack of action negatively impacts growth and employment. While risks in the global economy remain at elevated levels, Linley expects global economic growth to improve into 2012 and does not expect a double-dip recession, reasoning, “The world is structurally in a slower growth phase because of fiscal tightening and deleveraging and therefore volatility is likely to continue.”

After enjoying a steady recovery for more than two years, equity markets have had a rough ride in 2011. The three spikes in volatility since the financial crisis in 2008 have led to an extreme level of fear among investors. Although the JSE is o­nly down 3% since the beginning of this year and the Dow Jones is basically flat, for investors it feels a lot worse because of the volatility.

“Globally, risk aversion and pessimism are at such extreme levels in markets that we expect a rebound in equity markets over the short term,” says Linley.
Global downgrades in company earnings, coupled with weak second quarter economic figures, raised investors’ fears that a repeat of 2008 was o­n the cards. Linley points out that while risk aversion is at extremes, recent economic indicators do not suggest the global economy is headed for recession. Supportive indicators from the US include durable goods orders, private employment and the leading indicators index.

Looking at equity investing, repeated spikes in volatility play havoc with any stock-picking, valuation-driven philosophy as the market is driven by macro issues rather than a focus o­n valuation, he notes. The result is that correlations between shares have risen in global markets over the last three years to such an extent that, in South Africa, correlations are now at the highest level since the emerging market crisis in 1998. Investors have placed a premium o­n high-quality, high-yielding shares and earnings which are less risky to forecast.

‘Based o­n our forecasts, the market looks to be reasonably valued and we expect a 5 - 10% upside to the FTSE/JSE Shareholder Weighted All Share Index (SWIX) over the next 12 months. We recognise that there is further downside risk in the market if policymakers and politicians in Europe continue to fail to meet expectations. While the South African equity market is reasonably valued o­n current valuations, it remains expensive based o­n long-term trend earnings,’ continues Linley.

While gold has become popular as a safe haven in these worrisome times, Linley is more cautious and contrarian. It seems to be the obvious place to be and we have seen significant growth in Gold ETFs globally. It is likely that the gold price will continue to be supported in the short term as investors remain worried about the state of the world economy and the value of money. “Personally, I think it is a bubble in the longer term, but timing is everything,” he says.

Diversified mining shares Anglo American and Billiton are extremely cheap based o­n forecast earnings, but are obviously very dependent o­n global growth, which is why they have been sold down. Share prices are already discounting a recession and significantly lower commodity prices. These shares could stay cheap for a while in the current environment, but will outperform when investors see growth returning and the appetite for risk improving.

At this point of the interest rate cycle, Linley is cautious towards clothing retailers, ‘Many of them are quality operations but valuations look full at best. Their prices will continue to be supported if interest rates stay low for longer.’

A strong theme in global markets, and South Africa is no exception, is the extent to which defensive shares have outperformed cyclical shares. The volatile and uncertain environment has attracted investors to these quality shares with strong balance sheets, a consistent record of growing earnings and attractive yields. They now trade at a premium which will remain as long as we are in an environment where volatility persists.

‘We don’t expect a full-blown global recession,’ says Linley. ‘We believe that the growth outlook will remain challenging in developed world economies, but emerging markets will fare better.

‘In summary, we are targeting undervalued, good quality companies with appealing growth prospects in an environment which is likely to remain difficult for a while. Naspers, MTN, British American Tobacco, Life Healthcare, Bidvest, Anglo American, SABMiller and Sasol rank highly o­n Linley’s preferred list, as well as Old Mutual which trades at a significant discount to fair value despite a significant de-risking in the group since the 2008 financial crisis.

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