Value investors see the future for what it is – uncertain. We start our analysis when there are low expectations (often no expectations) and wait for the future to unfold.
A bad outcome results in further poor (although not disastrous returns); an unexpectedly good outcome results in a bonanza. If it sounds easy, it isn’t. It requires a steely resolve and a thick skin to buy when the news is just plain bad, and everyone else is heading for the exits.
At the moment, South African equities fall squarely in this camp, weighed down by state capture, loadshedding, rising sovereign debt, failing infrastructure and heightened crime levels, not to mention concern regarding the outcome of the upcoming election on May 29. The skill to investing is not about reading what is in the news, it is about estimating what is priced in, and what the probabilities are with respect to future outcomes.
This is where it gets interesting for SA equities. A lot of bad news is currently priced in. SA equities have just gone through what market commentators are calling a ‘lost decade’: the JSE All Share Index has returned just 2% in US dollars per annum over the last 10 years – a far cry from the S&P 500’s 12% annual return. These numbers reinforce the mantra of US ‘exceptionalism’ versus SA as a failed state.
In reality however, all these numbers represent is the history of the last 10 years, i.e., South Africa’s woes relative to a US stock market fueled by unprecedented easy monetary policy. Future returns will be determined by only two things – the starting point of valuation, and the unknown events of the next decade.
With respect to the valuation of SA shares, it is clear that the market expects the next 10 years to be at least as bad as the last. SA equities currently trade at the largest valuation discount ever relative to both the MSCI Emerging Markets Index and the MSCI World Index, and this is with respect to all the valuation metrics that matter: price to earnings ratio (P/E), dividend yield, EV/ebitda and price to book.
Positioning is also at an extremely negative level, with foreign investors voting with their feet and selling R710 billion rands worth of SA equities over the last 7 years[i], leaving them underweight South African stocks when viewed against their respective benchmarks. Local investors have joined the exodus following National Treasury’s decision to allow local pension funds to invest up to 45% offshore, resulting in the average Regulation 28-compliant fund now holding just 39% in SA equities versus nearly 70% 18 years ago[ii].
The net effect is that you can buy a diversified portfolio of SA banks, retailers, and industrial stocks today on a P/E of 9 times with at least a 6% dividend yield, and this is off somewhat depressed earnings because of loadshedding and an economy that is growing at just 1%.
What is the catalyst to unlock this value? Since May last year, when the Ninety One Value Fund increased its holding in “SA Inc” stocks, we have consistently maintained that the most significant catalyst would be a reduced level of loadshedding, which in turn would result in higher GDP growth in SA, lower inflation and increased corporate earnings, amplified by reduced diesel costs and a stronger economy.
The facts on loadshedding over the last 6 months indicate that we are on this path. The next hurdle is 29 May. Markets don’t like uncertainty and the current narrative is, “Talk to me after the election.”
Unfortunately, this is not a strategy that will work. The JSE’s liquidity is especially low now and the outcome will immediately be priced in, which could result in “SA Inc” stock prices moving substantially – even 15% higher or lower – in the weeks after the election. Positions must be in place prior to May 29.
Valuation and positioning indicate that the market is not optimistic with respect to the outcome of the election, and our view is that the extreme levels of both mean that the market is 80% sure of a bad outcome. What would constitute a bad outcome for the capital markets? Simply put, it would be ANC support falling to around 40% and the party then choosing an EFF or MK alliance to secure a majority.
We consider the chances of this happening to be quite low: firstly, the ANC will need to get only 40% of the vote (50% probability in our view) and thereafter they would need to choose EFF/MK as their partner (20% probability in our view). We therefore see the probability of a bad outcome as only 10% (i.e., 50% times 20%), a stark contrast to what the market appears to be pricing in.
Clearly, these probabilities are subjective, but it is difficult to see probabilities of these two events to be high enough to match the market’s expectations. Consequently, our entire domestic equity positioning in the Ninety One Value Fund (outside of 35% offshore and 10% in gold shares) is invested in “SA Inc”.
Our favoured stocks in this space are shares trading close to their COVID lows of 4 years ago. The extent of our conviction is such that our largest holdings that fit this description (Life Healthcare, Netcare, Spar, Reunert and ABSA) make up 27% of our portfolio against an index weight of just 3%.
Investing is never as easy as reading the news. At times like these conviction and courage are needed to make the level of return that the Ninety One Value Fund has delivered over the last 25 years.
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