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The devil is in the earnings estimates

31 July 2009 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

It’s not often that you’ll hear an asset manager admit to a ‘bearish’ bias after a 30% recovery in equity prices. But Allan Gray’s “contrarian value-based investing” strategies demand careful consideration of all factors at play in the global and domestic

Since the March 2009 lows, US-listed shares have clawed back an impressive 30% to 40%. But this ‘recovery’ is off an extremely low base, and anyone who invested at the 2007 market peak is faced with capital depletion of close to 40%. South African shares mirrored their US and UK-listed peers, and despite the impressive improvement since March, the All Share Index is still 29% below its peak too.

Serious shifts in consumer behaviour

To plot the way forward under current market conditions you have to determine what triggered the recent market resurgence. “When we look at a correction of this magnitude – the US markets up 40% and South African markets up 30% from their lows – it really reflects an adjustment of imbalances,” said Govender. Shares (particularly in the US) had fallen too far on the back of an overheated property market, overheated asset markets, poor financial regulation and crazy financial instruments. But the dominant factor both before and after the collapse remains the extreme over-indebtedness of the US consumer.

At the end of Q1 2009 the total debt as a percentage of US GDP stood at 375%. It’s a measure that’s been unacceptably high for quite some time. To make matters worse the contributors to this debt surge are substantively different to those experienced during the Great Depression of the 1930s. At the time the spike in the debt ratio was due to a severe decline in GDP, while over the last decade the spike has been due to sharp increases in household debt. It comes as no surprise the post-crisis US consumer’s behaviour is changing. The shocks through the system have rekindled the desire to save, as confirmed by the national savings rate which is at 8% (from near zero) and has the 10% level in its sights. The shift from spending to thrift gained momentum after US investors watched approximately $15trn in net household wealth go up in smoke. “There’s a multiplier effect at work here,” said Govender. Every $1 reduction in the net worth of US households triggers an US3c to US4c drop in consumer expenditure. Sound insignificant? Not when you consider that “the US consumer – not the entire US economy but just the consumption portion of the economy – accounted for 16% of world GDP at December 2008,” said Govender. This compares with Japan’s 7.8%, China’s 6.8% and Germany’s 6.2%.

Apart from the obvious concerns over consumer activity, Allan Gray’s cautious view seems to contradict numerous signs of economic recovery. Govender warned investors against setting too much store in the so-called ‘green shoots’ of recovery. Although US Unemployment, US Industrial Production, US Retail Sales and US Housing Starts are showing moderate improvements you cannot lose sight of the extent of the fall, nor the lows from which the recovery begins. An improvement in the rate of decline in these statistics doesn’t mean the global economy is out of the woods. All that we can say, said Govender, is that “the rate of reduction is not as extreme as it was!”

South Africa is not insulated

South Africa is not insulated from the global recession. A great way to demonstrate our economic vulnerability is with a graph showing the correlation between New Car Sales and the All-Commodity Index. Both measures fell off a cliff as the global economy went to the wall, painting a scary picture for a country that relies on commodity exports to get by. Consumer woes are clearly illustrated by a graph of VAT Collections Growth. The number went negative in the first quarter of 2009 after hovering in the 15% to 20% region through the recent boom times. This is bad news for government as its revenue mainstays (VAT, Personal Income Tax and Corporate Income Tax) are likely to show severe drops over the next two collection periods.

The question is whether we’re paying enough attention to the warning signs from the real economy. Govender discussed some of the major concerns. The first is with capacity utilisation in the domestic manufacturing (large enterprise) sector. South African companies’ capacity utilisation has declined from recent highs of around 87% to just 79%. And the situation is exacerbated by continued soft demand and the number of capacity expansion projects that were started during boom times coming on stream. This places companies in a really tight spot – because they’ve been upping capacity into the recession – and now face added costs, declining sales and shrinking profit margins. “From about 2000, when margins bottomed at close to 8% we’ve seen a remarkable increase in the profitability of industrial companies – to around 15%,” said Govender. Profit is going to come under severe pressure as margins head back to 8%.

How should we time our entry points to the market? Many investors make decisions based on the long term price-to-earnings ratio (PE) of the South African market, currently around 11.7 times. When the PE fell to around 8 times (in February 2009) these investors ploughed back into equities. But they should have showed some restraint. “We have huge reservations about looking at PE in isolation,” she said. You have to reference the PE in “relation to levels of earnings at any point in time!” Before being suckered by the PE/value debate you have to spend some time familiarising yourself with the “normal earnings” concept. You have to validate the PE-based market investment decision by considering whether you are in a high or low earnings environment. “The fall from current earnings levels to the trend line is 32%,” cautioned Govender, adding that “earnings could fall even further.” And that probably explains why the Allan Gray Balanced Fund is holding 53% (gross) in South African equities at the moment.

Editor’s thoughts: Allan Gray advises to tread cautiously in the domestic equity space. With disappointing returns pencilled in for cash and bonds through the remainder of 2009 the asset allocation decision is going to be quite tricky. Do you agree with the slightly bearish sentiment expressed by Allan Gray as it relates to the domestic real economy? Add your comments below, or send them to gareth@fanews.co.za

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