Amid all the doom and gloom about the world economy, the South African stock market has done very well over the past month, repeatedly hitting new record levels. But the prophets of doom are waiting in the wings, warning that it is a flash in the pan, a swan song, that reality will strike.

To me, however, reality is whether or not the profits made by listed companies and the dividends they declare now and, potentially, into the future justify the price of a particular share.

Asset managers use many methods to find value, but, to me, the best rule of thumb has always been the price-to-earnings (p/e) ratio. It is the price of a share divided by the profits made by the company. Anything above 14, and I start to worry; anything below 14, and I get excited.

In simple terms, a p/e of 14 means it will take 14 years of profits at the company’s current level of profitability to cover the cost of the share. The p/e ratio is by no means a perfect measure, but it is a good rule of thumb.

Bear in mind that there can be very valid reasons you should invest in a company even though its p/e is over 14 (for example, its profits are expected to grow). Likewise, there are reasons you should not invest in a company that has a low p/e (for example, the company’s future may be gloomy).

And there is no guarantee that the current p/e will be the future p/e; nasty surprises can slash p/es. Such a surprise would be a major global recession sparked by an incident such as the sub-prime mortgage meltdown of 2008. Because people lose their jobs in recessions, companies sell less and therefore they make lower profits, which in turn may impact negatively on the p/e, based on what you pay for the share now. So use the p/e as a rule-of-thumb measure only.

After the JSE’s run in January – its best January in six years – with the consequent rise in p/es, I asked three asset managers (Absa, Investec and Old Mutual) what they thought about current values and where they believe value lies … and whether you should wait in cash before venturing into the market in anticipation that the doomsayers are correct.

Most agree that right now the JSE as a whole is probably either pretty fairly priced or close to fairly priced, but some sectors and, in particular, some shares are overpriced, whereas some sectors still offer pockets of value.

Despite the weakening of the rand, better value is seen to lie in foreign markets rather than locally, but again on a selective basis.

So let’s look at some of the p/es (see “Price-to-earnings ratios of the main local and foreign indices”, below) and what the experts have to say about them.

Peter Brooke, the head of macro strategy investments at Old Mutual Investment Group SA, says the local equity market is valued fairly and is no longer cheap.

Craig Pheiffer, the general manager of private client management and investments at Absa Investments, says from a historical perspective the indication is that the market as a whole is not expensive and is trading in cheaper territory at slightly better than fair value.

John Biccard, a portfolio manager at Investec Asset Management, says the past 10 years have been “a glory period for South African equities, and we see the next 10 years as being significantly tougher. South Africa has been one of the best-performing markets in the world for the past 10 years, and we don’t see very much value left.

“The market is at an all-time high and trading on 13 times earnings – a relatively high p/e by historic standards. We consequently believe the upside for South African equities is very low and continue to be defensively positioned, so we have high cash holdings, high gold exposure and the remainder in ‘defensive’ shares.”

All three managers agree that value lies mainly in foreign markets, although certain sectors of the local market still offer some value.

Brooke says the industrial sector is trading at a p/e of 18.2, the highest multiple of the broad sectors, and therefore potentially has the highest downside risk.

The resources sector, at a p/e of 10.6, offers the best value. The low p/e is based on concerns over global growth and, in particular, China’s growth path, he says.

The financial sector, with a p/e of 12.1, has been badly affected by the negative worldwide sentiment over banks. However, Brooke says, there has been some good performance in recent months.

Brooke warns that there are pockets of opportunity and the need for caution within sectors.

In the broader industrial sector, for example, there are opportunities in the construction sector, whereas the opposite is true for the retail stores sector, which, Pheiffer says, has had an exceptional run, and where shares are trading at very heady p/e ratio levels that offer much less value.

There are some very expensive shares, such as Massmart, which has a p/e of 40.

Retailers have out-performed because consumers have enjoyed historically low interest rates and, with higher wages, have kept on spending, with consequent good profits for retailers. But the same robust performance cannot be expected this year, Pheiffer says.

Brooke says pockets of value may still be found in the industrial sector because, unlike the financial and resources sectors, it is not homogeneous.

Some individual companies in the industrial sector, such as SABMiller, Richemont and Naspers, have high p/e multiples, but you should bear in mind that these companies have operations in countries where interest rates are far lower than those in South Africa, and the higher p/es are justified because the cost of capital is low, Brooke says.

Biccard, whose company last week picked up the Raging Bull Award for the best-performing offshore unit trust management company of 2011, says you should cast your eyes further afield.

“While macro-economic concerns across Europe, the United States and China continue to cloud the investment outlook, valuation remains the most important investment consideration in our view.

“On that basis, we are seeing far better value outside of South Africa, particularly in Europe and Japan, where some shares are 90 percent off their all-time highs.

“Although many commentators view the p/e of 14 in the US as good value, we believe this market to be less attractive than Europe and Japan, given that US corporate profit margins are at record levels.

“Should the negative global macro-economic outlook for some reason not materialise, the fundamentally cheap shares in Europe and Japan could rally meaningfully,” Biccard says.

So, it seems there are still opportunities, but you will need time to do a fair amount of research if you want to find the gaps yourself.

Price-to-earnings ratios of the main local and foreign indices at January 31, 2012

FTSE/JSE All Share: 13.4

FTSE/JSE Resources: 10.6

FTSE/JSE Industrial: 18.2

FTSE/JSE Financial: 12.1

Dow Jones: 14.0

FTSE 100: 10.3

MSCI World: 13.3

Standard & Poor’s 500: 15.1

Source: I-Net Bridge

ASSET ALLOCATION FUND IS YOUR BEST OPTION

If you want to invest but are puzzled and perplexed by what you should do with your money, the solution is to let the experts help you to tread through this confusing and worrying time.

Craig Pheiffer, the general manager of private client management and investments at Absa Investments, says in the current market and economic climate the appropriate unit trust investment for individuals is a balanced fund with an income element (preference shares, bonds, listed property and some cash) and a strong weighting towards a growth component of domestic and international equities.

However, your investment decisions must be influenced by your unique requirements, which are based on your investment time horizon, investment constraints and risk profile, Pheiffer says.

Jeremy Gardiner, of Investec Asset Management, says the big question is how long you should remain on the sidelines, because staying in cash permanently will not enable you to beat inflation – not to mention provide the returns you require to finance a comfortable retirement.

Although markets have enjoyed something of a relief rally, there are still dark clouds on the horizon – a fact that markets at this stage seem to be ignoring – so you should keep your powder dry, but don’t sit on cash forever, Gardiner says.

However, this may be the wrong time to get back into equities. “There will be better buying opportunities ahead,” Gardiner says.

Pheiffer says consumer price inflation this year is expected to exceed the top end of the three-to-six percent target range set by the South African Reserve Bank, and, with interest rates from cash well below six percent, sitting on cash will provide you with a negative real (after-inflation) return. If tax is taken into account, the effective returns will be even lower.

Peter Brooke, the head of macro strategy investments at Old Mutual Investment Group SA, says their medium-term outlook for real returns is minus one percent from global cash and one percent from local cash.

“In South Africa, our interest rates are the lowest they have been in decades, and accelerating inflation will result in negative real interest rates. We think local rates may remain unchanged for the longest period since the 1950s,” Brooke says.

It is generally risky to take bets on single-asset-class unit trust funds, especially in times of volatility, when anything can, and often does, happen. Your best solution is asset allocation funds, which invest across a spread of assets, are optimised according to prevailing conditions and manage risk through diversification, Brooke says.

The portfolio manager will seek out shares that provide opportunities for capital gains and attractive dividend yields, sell those that reach full value, and avoid those that are detrimental to the overall value of the portfolio.

This is a process that takes hours of research, plus skill and expertise, Brooke says. Investors in asset allocation funds enjoy the benefit of all the tough decisions taken by the portfolio manager, who has access to these resources.

COLLECTIVE SCHEMES’ ASSETS TOP R1 TRILLION

The local collective investment schemes (CIS) industry now accounts for almost one-quarter of all pooled investments and retirement savings, with more than R1 trillion (at current values) in assets under management.

The CIS industry is dominated by unit trust funds and exchange traded funds.

The life assurance industry and retirement fund asset managers, with R3 trillion, account for the remaining three-quarters.

By the end of last year, the CIS industry had grown its total assets under management by R69 billion to R996 billion, narrowly missing the R1-trillion mark it has now reached.

Leon Campher, the chief executive of the Association for Savings & Investment SA (Asisa), says although the industry had hoped to exceed the R1-trillion mark in assets under management last year, the growth in assets was nevertheless pleasing, considering that it was achieved during a time of extreme market volatility and economic uncertainty.

Despite the volatility, money market funds experienced heavy outflows during last year, but this was mainly due to corporate investors re-positioning their cash holdings, Campher says.

As a result of money market fund outflows, the CIS industry attracted net inflows of only R48 billion last year, the lowest in seven years. The balance of the growth in assets under management came from returns.

Domestic asset allocation funds replaced domestic fixed-interest money market funds as the industry’s biggest category in the fourth quarter of last year.

At the end of December last year, the domestic asset allocation category held assets under management of R277 billion, or 28 percent of industry assets, whereas money market funds held assets of R252 billion, or 25 percent of industry assets.

Despite the strong shift to asset allocation funds in recent years, Campher says investors still have most of their money in domestic fixed-interest funds, which include money market, bond, income and varied specialist funds.

At the end of last year, more than 50 percent of domestic assets under management were invested in fixed-interest funds.

“Investors can be forgiven for wanting to escape the relentless volatility of equity markets. Unfortunately, however, these investors are usually still stuck in fixed-interest funds when the markets start to run.

“So, while fixed-interest seemed like a good idea when the JSE All Share index delivered a paltry 2.6-percent return last year, over the longer term equities have consistently out-performed fixed interest and inflation,” he says.

Investors with an horizon of five years or less would have been better off in a money market fund. However, equity funds rewarded with double-digit returns over 10 years or more, Campher says.