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Three portfolio managers confirm that South African shares are too dear

10 September 2012 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

In 2008/9 the developed world plunged headlong into recession. As banks and financial institutions teetered on the brink of total collapse the US and Euro-zone financial policymakers flooded the markets with cash (through various quantitative easing initi

To find out how “lower for longer” global interest rates and “new normal” investment returns impact South African equity investors we attended the recent Investec Asset Management 2012 Global Insights Forum. The highlight of the conference was the Outlook for South African Equities panel discussion moderated by Philip Saunders, Head of Global Multi-Asset strategies and debated by portfolio managers Clyde Rossouw, Chris Freund and John Biccard.

Eight more years of “soft” developed market returns

The first step toward unpacking the current investment environment is to formulate a view of where we are in the longer-term equity market cycle, opined Saunders. He said that developed markets such as the US and Euro-zone were 12 years into a secular bear market: “Shares in these markets have moved down or sideways for an extended period of time, there has been much churning but no absolute progress”. Secular bear markets persist for up to 20 years so these conditions could remain intact for another eight. This cycle will have an impact on commodity rich economies such as South Africa because the fortunes of commodities and developed market equities are interlinked.

Saunders said that developed market equity valuations had not yet corrected sufficiently. “If you believe that we still have some way to go before the bear market in developed world equities ends, then you cannot ignore corporate margins and the unsustainability of corporate margins at current levels,” he warned. Margins are unsustainable, valuations are not what they seem, and there is a strong chance shares will revert to their long-term mean. Ironically investors could be better served in these “soft” developed markets than locally.

The seven good years have flown by

As developed world investors endured their “go nowhere” stock markets the JSE has powered ahead on the back of a super cycle in commodities, in turn underpinned by China’s double digit GDP growth between 2000 and 2007. Biccard, portfolio manager of the Investec Value Fund, reminded the audience that investors made truckloads of money from South African equities over the period. “Over the past decade South Africa has outperformed the world, in constant money terms, by seven times,” he exclaimed. It is unlikely that equities will provide similar returns over the next decade.

In the early 2000s, when South African equities took off, our market price-to-earnings (PE) ratio was around eight times versus developed market PEs of 25 times and dearer. Today the JSE trades on a PE ratio of approximately 13 times… On the face of it you may think South African equities offer value at these levels. But the outlook is skewed by the heavy weighting of resources shares in the JSE FTSE All Share index. “The retailers, banks and industrial shares that make up South Africa Inc. are actually trading on a 17 times PE right now,” said Biccard. “The overall PE is falsely reduced by the low trailing PEs of the commodity giants”. He said that South Africa’s “real” PE was probably around 17 times, making local companies expensive compared to (say) Germany, at 13 times.

South African equities are expensive due to the fantastic performances from financial and industrial shares. Retailer Mr Price is up from R17 to R130 per share (since mid-2008) while resources giant Sasol is down from R500 to just R340. “We have seen a total switch in the market from the commodities-led boom to an apparent two-speed market where retailers are cruising ahead while the commodity giants fall behind,” he said. Our retailer share prices have been underpinned by massive inflows of offshore investor capital. US investors believe that the domestic consumer market has undergone a structural change… In contrast Investec interprets the retail boom as the positive effect of the commodity super cycle plus debt. If commodity prices fall further – a very likely scenario – then retailers will come under pressure.

Preference for developed world defensives

“The dilemma that most investors have is where to go in search of safety,” said Rossouw, who heads up the Investec Asset Management Absolute Return Strategies team and manages the Investec Opportunity Fund. “Do you favour zero yielding cash because you believe in the currency – or should you back equities, where the environment is so uncertain that nobody has a clear take on where the next growth cycle will come from?”

His preference is for shares that offer a high dividend yield and sell things that people need, every day. “The world is your oyster these days and most of the stocks that meet our selection criteria are domiciled in the developed market,” he said. His funds are increasingly allocating capital to offshore markets where they are invested at an average PE of 13.3 times, dividend yield of 3.5% and free cash yield of some 17%!

South African asset managers limited by “25% offshore” rule

Chris Freund, who manages the Investec Balanced Fund, observed that local fund managers could only take 25% of their integrated portfolio offshore. Although he shares the view that offshore equities offer pockets of value he is not as bearish on local markets. “It is highly unlikely that the offshore markets will race ahead and South Africa be left behind – because there is a great deal of correlation,” he said.

The difficulty for those investing in South African equities is they only have two “shares” to consider. On the one hand we have resources shares that seem to offer value. However, the low forward PEs attributed to companies in this sector are thanks to falling commodity prices rather than expectations of higher earnings. Another problem is that the consensus on China is fairly bearish. “London multi-asset managers say China’s slowdown is going to be worse than we think – and that the second half rebound is not going to happen,” warned Freund. Add to this sluggish global economic growth and continued worries about the Euro-zone and it seems wise to sidestep commodities for now. The only exceptions are Sasol – which should fire again as oil prices strengthen – and perhaps gold shares.

Freund said that it was too late to buy financial and industrial shares which were more likely to stabilise at current levels than power ahead. A possible “buy” is FirstRand which gives some exposure to the retail sector without the ridiculous valuations of a Shoprite or Capitec. The bottom line is that offshore equities look a whole lot better than South African equities at present… And that’s why 20% of Freund’s 25% offshore allowance is invested in equities today.

Editor’s thoughts: At first glance it appears that local investors have not yet cottoned on that the JSE is trading in expensive territory. The reality is that much of the recent domestic price action – particularly among retail shares – is driven by offshore buying. Do you think shares like Mr Price and Shoprite will come unglued when US investors lose interest? Please add your comment below, or send it to


Added by Bidnis Man, 11 Sep 2012
The froth floweth over. By my amateur calculations when the JSE went from 34 000 to 19 000 in 2008 it returned to about average PE ratios - not all time low PE ratios. We are now back to 34 000. While shares can go on a random walk based on sentiment or economic conditions at the end of the day they are anchored by fundamentals - and the most important fundamental is the PE ratio. Look to invest elsewhere - possibly in active businesses as opposed to passively.
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