Test the depth before diving back into equities!

Gareth Stokes, FAnews Online Editor

When Sanlam Private Investments (SPI) briefed retail investors after the first quarter 2009, they took a “cautiously optimistic” approach on local equities. It was an appropriate view given the wild fluctuation in global economic expectation and investor

On 25 June 2009 FAnews Online attended SPI’s Q2 2009 media briefing in Rosebank, Johannesburg. Although SPI maintains their “cautiously optimistic” stance where local equities are concerned, we noticed some greens shoots of concern. Both Kriel and SPI director of investments, Alwyn van der Merwe, are concerned about the pace of the recovery which started 9 March 2009. A recent quote by ex-Merrill Lynch executive, David Rosenberg demonstrates the magnitude of the turnaround. “A few weeks ago if someone had said you could sell all your stocks at a level 40% higher most of you would have hit the bid!” he said. Today this rebound has happened, prompting Kriel to ask: “Is the run in the market sustainable, or is it a case of too much too soon?”

On growth and earnings

Shouldn’t investors be happy with a 40% reversal? Of course they should, but the speed and extent of the reversal contradicts conditions in the real economy. Much of the buying activity is driven by hope rather than economic fundamentals. “The biggest red flag is concern over company earnings,” said Kriel. A quick look at recent trading updates demonstrates the correlation between corporate earnings and GDP growth. As South Africa ploughs through its third quarter of negative GDP growth every facet of the domestic economy is contracting. Investors, already expecting earnings declines of around 15% across the board, are bracing themselves for worse numbers from corporate South Africa.

We’ve already witnessed a raft of downbeat trading updates. Petrochemicals giant Sasol warned that headline earnings per share would be between 40% and 50% lower for the year to 30 June 2009. Naspers said its earnings would be down between 15% and 25%, while banking stalwart Absa predicted a similar result. The latest in a long list of downgrades came courtesy of banking and financial services group, FirstRand Limited. They announced FY 2009 results would be 28% to 35% worse than the previous year. According to Van der Merwe, the so-called blue chips could post a 30% decline in earnings across the board. No company or sector has been spared!

“The one factor that will drive equity performance is the rating in the market,” said Van der Merwe. He warned that the outlook for growth would have to improve before investors could bank on a sustainable recovery. The current environment is simply not conducive to growing revenues, earnings and profit. According to Van der Merwe “the strong earnings growth that you’ve become accustomed to in the South African economy is simply not sustainable.”

Primitive value indicator spills the beans

A good way to get a feel for the market is to consider the market price-to-earnings (PE) ratio. At the height of the equity market boom (in the first half of 2008) the JSE All Share Index boasted a PE of 16. In March this year the overall PE slipped to just 8. But since then, the 40% rebound in listed share prices has pushed this measure back to 11. This rapid improvement puts many asset managers in a pickle. SPI noted that to commit to the market at these levels could prove an expensive mistake. On the other hand, not participating fully in the market turnaround is potentially embarrassing too.

This argument can be expanded slightly. Through the ‘drought’ of 2008 and early 2009, the defensive SAB Miller outperformed the ALSI by some margin, while resource giant, Anglo American, was decimated. Other defensive counters performed well too, and SPI was happy with its mix of defensive investments toward the middle of 2008. The question was whether a ‘wait and see’ approach would amount to protecting a lead rather than growing it. SPI had to do some soul searching to determine if their equity basket contained the best mix of companies for the prevailing economic conditions. Van der Merwe noted that it remains incredibly difficult to pick sectors, adding that SPI preferred focusing on one of two dominant themes instead.

The place to be invested was either in defensives (like Remgro, British American Tobacco, SAB Miller, Bidvest, Tiger Brands and Pioneer Foods) or the so-called cyclical businesses. Through most of last year SPI moved funds into defensive shares. Late in 2008 and early 2009 they took steps to increase exposure in companies like JD Group, Investec and Anglo American. Of course it might be too late for private investors to follow suit. SPI was accumulating Anglo American at around R150/share and Investec at well below R40/share, and these counters have already rebounded significantly from their recent lows. Investors must also consider the risks created by excessive market volatility. You could purchase Anglo American at R240/share on Monday, and be holding fistfuls of R210 shares by Friday. Green shoots or not, SPI believes a cautious approach to equity is appropriate for the remainder of this year.

Editor’s thoughts:
It’s incredibly difficult to time your entry to the equity markets. The best strategy is to drip feed your available capital over a period of time. Smaller private investors are probably best served making regular purchases of SATRIX 40 or SATRIX DIVI exchange traded funds. Have you started adding cyclical shares to your portfolio, or do you prefer the safety of defensive companies? Add your comments below, or send them to gareth@fanews.co.za