JSE multiples not sustainable

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The JSE board in Sandton in Johannesburg. Photo: Leon Nicholas.

Geoff Blount, the chief executive of Cannon Asset Managers, sifts through the trends and drivers of the JSE’s performance

Last year, the JSE had rallied 34 percent over a year and a half, and this year the market continues to hit new highs. This is severely at odds with the state of the global economy and the South African economy.

In fact, it appears that there is a disconnect between the real world and the investment world. It leads one to wonder what is going on. This disconnect should sound alarm bells for investors, and we believe it is, but perhaps not in the way you might think.

Essentially, the South African equity market is being driven up by a narrow set of stocks that were already expensive, and are getting more expensive. We can see this clearly if we look at the contributors to the all share index return for this year.

Figure 1 shows the marginal contribution of the 20 stocks that had the most impact on last year’s performance. For example, it shows that SABMiller and Richemont alone contributed almost 7 percent age points of the 26.8 percent return.

If you owned all the other shares in the market, but not these two, you would have earned a return of 20 percent. It also shows that these 20 stocks contributed 22.4 percent of last year’s total market performance, and a staggering 15.4 percentage points came from large-cap industrials (highlighted in red).

If you did not own any of these 13 industrial stocks but you owned the rest of the market, you would have earned a return of only 11.4 percent last year, which, while lower, makes much more sense given the economic backdrop.

Refer to figure 1: Top 20 stocks’ marginal contribution to the all share index’s performance in 2012.

Most of the stocks that did well last year are, no doubt, extremely high-quality firms but – and here’s the issue – they are very expensive high-quality firms.

Take a look the cyclically adjusted price earnings (Cape) ratios of some of these popular stocks, shown in table 1.

Across different time frames and in various markets around the world, history has demonstrated consistently that anything above a Cape ratio of 16 times is expensive, and we believe anything above 19 times is very expensive.

See table 1: Valuations on the JSE using Cape ratios. While most of these stocks are decidedly expensive, it’s easy to find reasons to own them.

This is not unlike the situation in 2007, when investors and the market, enthused by the pre-Soccer World Cup construction frenzy, justified the outlandish multiples of construction stocks. In fact, those multiples and these are strikingly similar; see table 2. But back in 2008, when the realisation finally sunk in that the overpriced construction stocks simply could not grow earnings ad infinitum and would disappoint investors, the shares were severely punished, slumping by 40 percent for the year. This scenario is very repeatable today, but investors are pretending otherwise.

Refer to table 2: Cape ratios for construction stocks in 2007 versus today.

Things haven’t changed much this year. Figure 2 shows the top 20 stocks’ contributions to this year’s market rise of 6.8 percent in the year up until the end of July.

By our calculations, only the stocks shown in green are trading at a discount to fair value.

See figure 2: top 20 stocks’ marginal contribution to the performance of the all share index this year. So we see that most stocks that began this year on high ratings have just become even more expensive and pushed the market further, repeating the pattern of the past few years. This can be measured by the valuation differences between the cheaper and more expensive shares in the market: the valuation dispersions.

Figure 3 shows the dispersion of valuations between stocks in South Africa. The black line represents the lowest Cape ratio of the 20 percent most expensively priced stocks on the JSE, or the most expensive fifth of the market (quintile 5).

The green line represents the highest Cape ratio of the 20 percent most attractively priced stocks on the JSE, or the cheapest fifth of the market (quintile 1).

The remainder of the market – 60 percent of shares – lies between the two lines, in terms of valuation.

Refer to figure 3: Cape valuation dispersions on the JSE

What it shows is that in absolute terms, quintile 5 looks very, very expensive, but over the past few years, these stocks have been getting increasingly expensive relative to the rest of the market.

This relative valuation gap between the two lines has risen almost 50 percent since 2008, resulting in the longest outperformance for “growth style” investing we have seen in South Africa (compared with “value style”), as the valuations of expensive stocks continue to get much more expensive relative to low Cape ratio stocks.

At this point one might expect that we advocate the avoidance of equities, but you’d be interested to know that this is not the case.

The market’s long-run average Cape ratio is 16 times, and the current rating is 15.6 times, which says that at the overall level the market is about fair value and the asset class as a whole (South African equities) can be owned.

But the implication is that, relative to fair value, the range of valuations is becoming even more stretched and investors should be alarmed at which equities they own, if indeed they own the overpriced growth shares.

This is the tyranny of averages: this aggregate is comprised of very expensive stocks, as well as stocks that are very attractively priced.

We believe that the multiples on these expensive stocks are not sustainable – they need to maintain very high levels of earnings growth to justify such valuations. With company earning disappointments will come the risk of investor sell-offs and thus investment risk.

One interesting aside to the above is that while the price action of these stocks has pushed the JSE to new highs, it has also masked some of the tremendous value opportunities available in other areas of the market at the moment.

Cannon Asset Managers is a niche investment management company that has successfully applied the philosophy and principles of value investing – an investment management approach that has consistently demonstrated a clear advantage over other philosophies. The company has a level 2 black economic empowerment rating.


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