Finding value in a rising market

Once considered backward and unattractive, the local construction sector has recently become the belle of the ball on the JSEs Alternative Exchange (AltX) with no shortage of suitors.

But while the buoyant construction industry continues to hold investors fancy, mainly because of the current and expected size of the order book, Prudential Portfolio Managers (SA) believes there is a cheaper way of getting exposure to Gross Domestic Fixed Investment (GDFI) than through the four main construction stocks and new listings.

Gary Quinn, portfolio manager with Prudential Portfolio Managers (SA), says most construction companies are expensive and the risk relatively high since it is difficult to forecast how long the current boom will last.

"We like the outlook for sectors exposed to GDFI in South Africa, but prefer our exposure to come at a cheaper price. We are therefore looking at companies with sufficient exposure to, for example, the construction sector, but with diversification into other areas to minimize risk."

Also, Quinn believes that there are companies operating in the shadow of listed construction companies likely to deliver decent returns at a more palatable downside risk. An example of this would be Reunert and the Altron Group - both companies often work side by side with construction companies on the same projects.

In addition both companies are also likely to benefit from Eskoms expansion projects, making them well diversified choices. Quinn says Reunert and Altron are significantly cheaper than the construction sector.

He says a company like Mittal Steel is also set to benefit hugely from the construction boom, but is also favourably exposed to the mining industry as well as the car industry. Investors may remember that Mittal has in the past made more money selling steel to gold companies, than the gold companies made from selling gold.

He says it often makes sense to look for bargains among companies that might not be in the limelight, but that will benefit from a sector doing well.

"An example in the construction sector could be PPC, which will probably end up making better margins and better returns than the four main listed construction companies. Currently PPCs rating is on similar valuation multiples, but has a better track record and more predictable earnings."

Quinn says Prudentials value approach to investing always involves asking whether the same exposure can be achieved at a cheaper price.

"If you like oil, but the oil companies are too expensive, why not consider some of the drilling companies? Or in the case of commodities, Grinrod would be a good secondary company to consider because it provides transport services to this sector."

Quinn says when a sector experiences good fundamentals and growth it tends to bring new listings to the market. In general, however, Prudential is weary of new listings.

Quinn says the information technology (IT) sector, for example, was all the rage with investors shortly before the dot-com bubble burst in 2000.

The fact that this year has seen a record number of listings from junior construction and mining companies is enough to make Quinn nervous. He says before considering a new listing, investors should consider the following:

* If the new listing is because of management trying to exit the business, it should be avoided.

* If the business is listing to pay off debt and recapitalize one has to ask why it has ended up in this situation in a booming sector - it is far better to invest in companies that are returning cash rather than demanding cash. An interesting observation is that private equity investors have avoided the construction sector alluding to the unpredictable cash flow in this sector.

* Some companies raise money so that they can buy other businesses. However, successful companies generally grow organically rather than through acquisitions. Acquisitive companies tend to look good in the short term, but unravel as the sector slows. Enron is a very good example of this.

Quinn says it is not enough for a company to be in the right macro sector such as GDFI the price must also be right. Since Prudential is a value house, Quinns portfolio will consist of undervalued assets where the share price is likely to rise over the longer-term to reflect their true value.