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The story behind the headline - “JSE hits another record high”

17 October 2012 Nic Andrew, Head of Nedgroup Investments

This has been a regular headline over the last few months and each time it has the potential to trigger the assumption that all shares have performed well. This is not often the case according to Nic Andrew, Head of Nedgroup Investments who says that atte

He points to the graph below, which shows how the market performed very strongly up to June 2008 before losing a third of its value by March 2009 and subsequently recovering strongly over the past three and a half years.

 (Click on graph to enlarge)

“Whilst the index has reached new highs, this has certainly not been true of all stocks. In fact, the dispersion of performance amongst the underlying constituent sectors has been extreme. Broadly speaking, investments in the resource and construction stocks have been woeful; financial counters solid and SA's industrial stocks spectacular,” he says.

A share’s return is a function of the following: Earnings growth + Dividends + PE (rating) effect. Bearing this in mind, Andrew says the table reveals some valuable investment insights.

“The table highlights nine stocks and their key characteristics over the period 30 June 2008 to 30 Sep 2012. All stocks either are or were constituents of the Top 40. The table and analysis below ignores the dividend component and corporate actions. However, whilst this is simplistic and not absolutely accurate, it does not alter any of the key conclusions,” he says.

 (Click on image to enlarge)

Source: I-Net

1. Companies on high ratings can be disappointing investments even if they produce high levels of earnings growth

According to Andrew, this is demonstrated by African Rainbow Minerals (ARM) and Goldfields. Despite growing earnings strongly by 144% and 212% respectively, they saw their share prices disappoint. “Goldfield’s share price was marginally up whilst ARM’s fell more than 40%. In June 2008 investors were too optimistic, extrapolated the good news of the day and simply paid too much,” he says.

2. Paying high multiples on cyclical companies at times when their earnings are cyclically high is a dangerous cocktail

Andrew says Anglo, Implats and Murray and Roberts are good examples of this.

“Their earnings were very high four years ago on the back of surging commodity prices, a general confidence in sustained global growth and World Cup euphoria. These factors pushed margins and profitability to multi-year highs. Competition, increased supply and decreased demand post the financial crisis has seen both earnings fall and a de-rating as investor sentiment has shifted from positive to negative. The combination has been brutal - with share prices dropping by between half and three quarters of their initial values,” he says.

Andrew advises that in order to avoid this type of outcome, investors should be very conscious firstly, of where one is in the cycle and secondly, that super-profits are almost never sustainable.

3. Starting with low expectations can generate acceptable returns even if future results are not good

Andrew points to the banks to demonstrate this. “Despite almost flat earnings over the period, the stock prices of Nedbank and Firstrand have doubled. Five years ago, investors were simply being too pessimistic on the outlook for financials. Although things have not turned out brilliantly, sentiment has turned from very poor to average - with the PE increasing from 6 to 12,” he says.

4. Buying companies that have low expectations and are poorly rated that then perform well is the Holy Grail.

Andrew notes that while retailers like Woolies and Shoprite have grown their earnings admirably, the real icing-on-the-cake for investors has been the re-rating effect which has seen investors reap spectacular returns. “Their shares prices are up three to five times at a time when the market as whole has only increased marginally,” he explains.

Andrew continues that investors should be very weary of getting carried away with the story of the day and extrapolating recent successes or failures indefinitely. At the same time investors should be exceptionally cognisant of the price they pay for an investment as this is often the most critical determinant of their future return.

Today the market is reflecting an almost polar opposite of the story of June 2008. “Five years headlines were full of negative comments on the retailers, over-indebtedness of the consumer, the never-ending Chinese growth story and the enormous benefits of globalisation. The wheels of fortune have truly turned.”

According to Andrew retailers and their defensive nature are now the market darlings, the banks have won back some favour and the previous glamour stocks, the resources and construction counters are the pariahs. “It is easy to understand why. The press is full of stories of striking workers, Chinese slowdown and financial catastrophe in Europe. When we reflect in five years’ time it will be interesting to note whether history has repeated itself. I suspect it will,” he concludes.

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