By Sean Neethling
The South African economy is currently plagued by both cyclical and structural challenges that are negatively impacting market sentiment.
Business confidence is especially low, while elevated inflation, higher interest rates and a weakening currency suggest consumers are likely to come under increased pressure in the current environment.
Government policy uncertainty and South Africa’s unreliable electricity supply are specific structural concerns that investors are also grappling with.
Markets are often not a reflection of the real economy. This is especially true in South Africa, where low levels of savings have limited most of the population from investing in listed assets. While tough economic conditions and political instability present a difficult backdrop for investors, it is important to recognise that markets are inherently forward-looking.
In the long term markets tend to be relatively efficient in pricing assets. In the short term, however, asset pricing can dislocate from underlying fundamentals as the market extrapolates current economic conditions too far into the future.
Shifting expectations for JSE-listed equities
South African equities are priced for especially bad outcomes that have largely been baked into current valuations. It is especially important for investors to be mindful of this at this stage in the economic cycle. The investment thesis for domestic equities does not rely on any of the country’s cyclical or structural challenges being resolved. It simply needs expectations around the extent to which those challenges will impact listed companies to be slightly less bad than what is currently priced in.
Underlying company fundamentals show that the domestic equity market is relatively well insulated from the especially negative outlook that has been extrapolated for South Africa. There are tangible country-specific risks, but listed companies have built robust business models with well-diversified income streams that are less dependent on the country’s near-term economic prospects than they appear to be.
Rand-based entry point into global companies
Approximately 69% of revenue from Johannesburg Stock Exchange-listed companies is generated outside of South Africa.
For local investors, the JSE provides a rand-based entry point into established multi-national companies with operations diversified by region, country, industry, business segment and currency. These are not South African businesses, but rather global conglomerates that happen to be listed on the domestic stock exchange.
Naspers has accounted for a relatively outsized contribution to the total returns at the FTSE/JSE All Share Index (ALSI) level over the past 10 years, with investors largely viewing the listing as a cheaper entry point into the Chinese technology conglomerate Tencent.
Secondary listings – including Richemont, Anglo American, BHP Group, British American Tobacco and Anheuser Busch InBev – are sizeable index positions that have historically provided so-called rand hedge properties for local investors, given that the majority of their revenue and earnings are generated offshore.
These large-cap secondary listed companies have contributed significantly to the market performance over the past 12 months, where the narrative for allocating capital to SA Inc companies has been especially bleak.
Small caps sold off significantly during the pandemic and have delivered exceptional performance over the last three years. That investment thesis is slightly less compelling today. While they still trade at optically depressed multiples, on average, the margin of safety is not high enough to compensate investors for a wide range of potential outcomes in the short term.
The higher interest rate environment, combined with the increase in SA-specific risk means that discount rates and the required return on capital should be increased. These companies are relatively more leveraged to the economic growth prospects of the country than rand hedge companies, whose earnings are more diversified away from SA-specific risks.
The most recent data also shows that, on a one-year basis, large-cap companies have significantly outperformed both small and mid-caps.
A tale of two indices
To consider the performance contribution of large-cap dual-listed companies, the SA investable equity universe can be split into two opportunity sets.
1. The broader SA investment universe captured by the ALSI; and 2. The SA domiciled opportunity set excluding secondary listings as captured by the MSCI SA Index.
The FTSE/JSE version of the index is inclusive of large-cap secondary listings and is shown to largely outperform the MSCI SA universe, with companies like Richemont and Anheuser Busch InBev, in particular, delivering exceptional returns over the last year. Naspers is a constituent of both indices and actually has a higher weighting in the MSCI SA version of the index, so on a relative basis, it is not especially significant in explaining the performance differential between the two indices.
Despite the relatively weaker performance, the more domestically exposed SA MSCI opportunity set also generates a fair amount of offshore income, with around 43% of the SA- domiciled companies’ revenues being generated outside of South Africa. These companies have diversified their income streams to be less dependent on the domestic economy, which provides ongoing business operations with some resilience to local headwinds.
Rand depreciation is a double-edged sword for these businesses. On the one hand, company input costs can be expected to increase as higher inflation filters through from rand depreciation, which then negatively impacts margins and earnings. On the other hand, having a rand(1)denominated cost base and foreign currency revenue from offshore business segments provides these companies with positive translation gains when converted back into local currency.
Unfortunately, not all companies can withstand a stalling local economy. While total market risk is considered low, there are individual companies with particularly weak fundamentals that are likely to fail.
Our assessment is that this is largely idiosyncratic in nature, where companies that have taken on higher levels of financial, operating or business risk could potentially be exposed to a potential global slowdown with higher inflation and interest rates. This is a normal part of any economic or business cycle and should not be extrapolated for the market in aggregate.
While the JSE provides an attractive entry point into global businesses that provide a partial buffer against a declining economic environment, investors need to balance risk and return.
South African equity valuations are attractive, but investors should expect a narrower grouping of companies to drive performance at the broader index level. Small and mid-caps are screening as cheap, but are exposed to lower and slower growth from relatively higher exposure to SA consumers facing a rapidly rising interest rate cycle with stretched household balance sheets.
Our current expectation is that South African equities will deliver a real return of around 6% over the next 10 years. The caveat is that investors will not earn that in a straight line and the expectation is that market sentiment will continue to play an out-sized role in driving short-term prices.
Differentiating between more robust companies with sufficiently diversified income streams that provide a suitable margin of safety is exceedingly important to protect investor capital in the current economic environment.
Investors should also increase their return for risk requirements at both the individual asset and overall portfolio levels. While the market is cheap, investment risk has increased and the potential range of outcomes around those risks are wider at this point in the economic cycle.
Sean Neethling is a senior portfolio manager at Morningstar Investment Management SA.