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Don’t fear missing out on the US bull market; SA has well-priced, world-class companies

18 April 2024 Johan Barkhuysen, Head of Equity Management South Africa at Stonehage Fleming

The US stock market’s S&P 500 Index ended the first quarter on a high note after reaching an all-time highs in the first quarter of the year and adding $9 trillion of value, rallying 22% from the start of October last year.

However, investors shouldn’t give in to FOMO because South Africa has several world-class and well-priced opportunities back home.

US valuations are historically high, and many investors have mistakenly invested near the top of the bull market cycle at expensive levels, only to lose once stock price valuations return to realistic levels. History shows that when Price/Earnings ratios are elevated, future earnings have been lower. At a Forward P/E of 21 times, for instance, historically the US market has an annualized expected 10-year return of a mere 1%, according to UBS. Meanwhile, Bloomberg data shows that the S&P 500 Index was priced at 24 times earnings in early May compared with a five-year average of 19 times.

US companies will need to grow into these P/E ratios over the next few years to justify their elevated levels. Though the US economy remains robust, the outlook is less clear, with credit card delinquencies rising steeply, unemployment ticking up, and interest rate cuts in the offing, but still subject to an unpredictable timeline. The prospect of a Donald Trump 2.0 Presidency later this year means further macro-economic and geopolitical volatility could lie ahead.

Against this backdrop, it’s well worth considering some of South Africa’s quality companies, whose businesses and growth prospects have benefited from their focus on innovation. South Africa may have a small universe of shares, but we do have world-class companies. We believe three of these are Shoprite, Capitec and PSG Financial Services. These businesses have exceptional, forward-looking leadership, a strong performance track record and the potential to grow and continue delivering strong results for investors.

Shoprite has stolen the limelight – and significant market share - in the retail sector, taking advantage of homebound customers during Covid by creating Sixty60. This previously unheard-of service commits to a 60-minute delivery turnaround time for all groceries. It has since become the largest online grocery delivery business.

The retailer managed to achieve remarkable online delivery success because of its dedicated focus on technology and efficiency – and the resources it is putting behind ongoing innovation is impressive. The group has a dedicated technology team of about 500 staff members sitting in ShopriteX, which has its own campus. Another resounding success has been its XtraSaving loyalty programme, now South Africa's largest.

The company offers investors world-class operating metrics, including attractive profit margins, efficient and scalable distribution, and strong growth prospects. We believe the main contributors to its success to date have been attracting the best people and embracing and employing the best technology in the business. These investments should enable it to continue to grow its market share.

Meanwhile, Capitec, founded relatively recently in 2001, has given the big four banks, FNB, Standard Bank, Nedbank and Absa, a run for their money through their focused and innovative product offering, saving clients time and money.

The sustained success of the bank lies in its digital focus and improved efficiency with online and digital app adoption. It continues to invest heavily in digital innovation initiatives, with 20% of all external appointments comprising professionals with technology and data talents.

The bank offers investors the opportunity to invest in a financial services company with world-class profitability and a sustainable return on equity of more than 25%, as per their annual statements, with substantial, long-term growth prospects.

Another world-class financial services business is PSG Financial Services, which has claimed its competitive advantage through its distribution footprint of more than 900 advisers. The company has an attractive business model, creating an operating platform for entrepreneurial advisors to build their businesses. PSG shares in their revenues by providing them with brand, compliance, and product support, allowing the advisors to focus on their client's needs and attracting new clients.

Its innovative proposition has translated into a highly profitable and cash-generative business, with a return on equity (ROE) of 22.5%, according do our analysis. Impressively, it has generated sustainable compound annual growth in earnings of 18% over the past 10 years. With a current market share of about 5%, there is significant upside potential to increasing its market share in the financial services sector.

Relative to the US stock market, the South African investment universe is small, with limited investment opportunities. This does not mean we don’t have some exceptional businesses that offer attractive investment opportunities. Furthermore, due to the recent challenges faced in the domestic economy, including logistical constraints and energy shortages, local businesses have experienced some of the toughest operating environments in history. The upcoming South Africa elections are also contributing to uncertainty.

However, we believe that quality businesses will perform irrespective. They are coming from an extremely low base, have remained profitable and even managed to grow profits notwithstanding the challenging broader macroeconomic backdrop. Imagine what they can do if the economic environment were to become more favourable.

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