The world is changing fast and to keep up you need local knowledge with global context.
A really well researched article always gets the readership it deserves. So I wasn’t really surprised at how much interest there was in Geoff Blount’s piece yesterday which unpacked the real reasons for the JSE ALSI strong run of the past 18 months. We invited Geoff’s colleague Andrew Newell into the CNBC Africa studio today to pick up on the subject. Newell did a fine job of digging deeper into the key issues. We also had a bit of fun in putting together a portfolio of six dangerously overvalued stocks; and six that are relatively cheap. He is confident that in three years a portfolio of the “cheapies” will outperform the other group. That part of the discussion comes at the very end of the interview. Best you go through the whole discussion, but if you’re in a hurry, the names are at the bottom of the transcript. – AH
ALEC HOGG: The JSE has surged by 34% in value over the last year and a half and the market continues to hit records this year.
However, it’s a sharp contradiction of the global and South African economic picture, so what exactly is driving the local stock exchange on its upward trajectory? Joining us now to share his views is Andrew Newell, head of Business Development at Cannon Asset Managers. And I suppose the view is also of your CEO Jeff Blunt, who did quite a lot of research into this subject. Once you unpack the underlying data it shows that the market as a whole – the index might be telling us that things are healthy, but in fact it’s been confined to a number of stocks.
ANDREW NEWELL: Ja, Alec. That’s right. The interesting thing is how narrow a set of drivers explained this new high, and to the average investor, where you see the ALSI index hitting one and then 42 and 43, makes you feel good. But it is contradictory when we read about things like ‘concerns over economic global growth, troubles in the mining industry and stressed consumer’ so that’s what prompted the research. What we have found is the market – over the 18 months that you referred to a short while ago – about 85% of that return was explained by a very narrow set of companies, about 20 of them. Of that 20, you can break it down even further and just a handful were not big industrial companies. So to turn that around into more easily understandable English; large cap industrials really are doing all the running. The obvious suspects include Naspers, Richmont and SAB Miller. Aspen has had a wonderful time as well and this small set of counters; as they improve their ratings they contribute a bigger and bigger share of market cap to the index. So in a way its self-fulfilling if they do well. The more they do well, the more it translates into a rising index.
ALEC HOGG: I guess if you could take the last year’s growth of – let’s call it 27% – as a pie, then a whole quarter of that pie would in fact only be two stocks.
ANDREW NEWELL: That’s right.
ALEC HOGG: SABMiller and Richemont. That’s quite scary because if SABMiller and Richemont were to reverse, what then?
ANDREW NEWELL: I think we often get accused of being either cynical or pessimistic, but you’re quite right. If you hold those two stocks it feels great. The prudent observation – what we think is prudent – is as you point out; that carries disproportionate risk. If you are exposed to them when they’re going up, it’s great. If you’re exposed when they start falling, not only are you naturally exposed to those counters, but the index has a whole does suffer more as a proportion relative to all the other counters. So to put a different angle on it: the way that we are viewing the market presently, is if you look a very well-understood vanilla metric, a price earnings multiple – the market is a little bit expensive. Not outrageous, but it’s on the wrong side of average.
ALEC HOGG: That’s on an overall basis…
ANDREW NEWELL: On an overall basis. The problem we find is that an average is naturally made up of something above it and something below it. The things above it are large cap industrial counters primarily – not exclusively, but largely and they are way over-valued. On the other side of the coin you’ve got counters which are very attractively priced and they bring down what the large cap industrials bring up to give you an average reading. That is about fair. So depending where within our market you find yourself, you could find decent opportunity or you could be exposed to what we think is disproportionate risk. And the problem that investors have with this, is the counters that are over-valued using conventional metrics, are all very good business; long track records and self-management teams. In many places, global exposure, so they are good investment cases.
ALEC HOGG: Well, just take on that, on your cyclically-adjusted earnings price ratio: lovely matrix to work from. Woolworths – up 78% last year on that cyclically adjusted PE of 39. Now you said earlier – just for those who don’t know these terms too well – Price Earnings Ratio is the number of years that you have to wait for last year’s profits to get your money back. In this case – with Woolworths – you’ll wait 39 years. I doubt I’ll be around in 39 years. It’s a long time. You think or you say that anything above 16 years is expensive. So this is three times what would already be expensive.
ANDREW NEWELL: That’s right.
ALEC HOGG: Sorry. Not three times – two and a half times.
ANDREW NEWELL: A lot more. And the point I’m trying to make is; these are superb businesses. I think the absence of growth or the difficulty to identify growth globally has gotten investors so enamoured with any prospect of growth that they’ve pushed those companies’ prices up so quickly.
ALEC HOGG: Mr Market at work here in a very big way.
ANDREW NEWELL: In an inefficient way.
ALEC HOGG: But maybe…let’s look at the other side of the coin. Back in 2007 – and I love the numbers that you have brought up there – the construction stocks were as much in fashion as some of these stocks are today. And yet the consequence of that has been quite significant.
ANDREW NEWELL: It has been dramatic and it’s amazing how short our memories are when we want them to be. The difficult is: when we go back to 2006/2007 when the construction sector had such a wonderful run: at the time our view was that these counters were very over-valued. The question then is: what will cause them to re-rate? And at the time we had no idea and now you can put down answers on the table as to what actually caused it. Today we look at these large industrial counters and our comment is that they are very expensive and they pose meaningful downside risk. Again the question comes back. What is going to cause these things to derail? Because any time a company becomes expensive you can make a very good reason as to why it got expensive in the first place. That’s why it’s hard to get investors to move their view away from what has worked so well. So what will cause them to mean-revert in the medium term? We’re not sure. It could be a range of things.
ALEC HOGG: But it doesn’t matter. The fact is; it’s expensive.
ANDREW NEWELL: It doesn’t matter.
ALEC HOGG: I’ll throw something at you. 1987, which was the last big crash we saw in South Africa. It was a bad one in ’97 as well and in 2007, but ’87 was worse. There was a report that was done by Sanlam who adjusted the index to make it look like it was cheap relative to 1969 which was the other huge crash before. So you can always justify when share prices are expensive – why they should be there.
ANDREW NEWELL: You can. And I suppose the lesson in that if you torture the data enough you’ll find what it is you want to find. The CAPE ratio – the cyclically adjusted price earnings that you referred to is something we use extensively at Cannon and the reason for that is: your normal price earnings ratio is ‘what did the company earn last year and how does that compare to the price today?’ In all markets – and in South Africa I think we are particularly aware of this – earnings is very cyclical. Using last year’s earnings is either very attractive or it can give you a very poor outlook. The cyclically adjusted earnings multiple uses seven years of earnings. Why seven? It really takes into account some good, bad and mediocre years and we adjust for inflation, so it gives you a far more – what we think is a sensible view…
ALEC HOGG: Take the distortion out of the market.
ANDREW NEWELL: It does. Essentially, what can this market or sector or company sustainably generate?
ALEC HOGG: You’ve made your case and I think anybody who reads your research will see it. It’s a compelling case. But let’s perhaps look at the other side of the coin. Are there stocks still in this environment that are offering good value on the cyclically adjusted PE ratios?
ANDREW NEWELL: Ja, Alec. We find a number of stocks that satisfy that criteria. The stocks we are pointing fingers at generally are larger and that’s where all the action has been. So by inference, the smaller part of the market – mid caps and small caps – we find a number of interesting opportunities. In the financial sector as a whole, which is fairly priced, smaller players like Sasfin are interesting opportunities. They’ve had a pretty decent run as well, and still look well-priced. On the industrial side; domestically we find companies or sectors who are certainly – or have been – out of favour (dare I say construction again?), which in the case of Group Five: they’ve started to put their head up. But the companies which are well-priced and are financially robust, low levels of debt, high cash, credible management teams and building order books nicely: that’s the type of thing we want to look for. And in the resources sector it’s not just about the big headline players. One of our most interesting positions at the moment is one of the smaller gold miners, Pan African. So if you look hard and carefully there’s good stuff around.
ALEC HOGG: Well, Pan African did the settlement with their unions yesterday, so that’s good news as well. Just to encapsulate …Expensive: SAB Miller, Mr Price, Naspers, Capitec, Richemont and Shoprite. Cheap or offering value: Old Mutual, Lewis, Group Five, Zeda, Sasfin and EL Bateman. It would be interesting to have a look back in three years’ time. How long would it take, do you think, for the market to rectify itself?
ANDREW NEWELL: It is hard to know, but given that this structural mis-pricing has been in place for a couple of years now, I think three years is not an unrealistic timeframe.
* Andrew Newell is the head of business development at Cannon Asset Managers. He holds a BCom degree and a Post-Graduate Diploma in Finance, Banking and Investment Management from the University of Natal.
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