Trying to time when to buy or sell shares is a fool’s errand. So most savvy investors in SA shares prefer to buy and hold. But occasionally assets become so expensive that even the “hold forever” school needs to reconsider. This could be one of those times as the combination of the US’s massive money creation and local exchange control regulations have pushed the prices of large cap SA industrial shares into the stratosphere. Cannon Asset Management’s Geoff Blount reckons if you stripped out these big cap shares and created a separate market for them, on their current ratings it would be the most expensive “market” in the world. Much to ponder. Especially for the thousands who are heavily exposed to this mini sector through index trackers like the Satrix 40 – AH
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ALEC HOGG: Tiger Brands down 5.5% on its results today, so one of the JSE’s big stocks has taken quite a hit. That won’t be too much of a surprise to Geoff Blount from Cannon Asset Management. You’ve just been doing a lot of analysis of the big stocks on the JSE and Geoff it’s quite scary. We were mentioning a little while ago that your research shows if you took the big guys into a single market, it would be the most expensive in the world.
GEOFF BLOUNT: Yes, it’s actually an interesting analysis. If you look at South Africa, our average rating in the market at the moment – we use a cyclically adjusted PE, a seven-year PE rather than a one-year PE. You therefore take seven years of earnings, average it, and inflation-adjust it rather than…
ALEC HOGG: Through the cycle?
GEOFF BLOUNT: Yes, it’s a cycle-to-cycle: it’s the DNA earnings of a share, an economy, a market, or a sector and you put over the current price. I think it’s a better way of measuring than last year’s one-year trailing PE because you have the current price over last year’s earnings, which would be up or down based on shorter term circumstances. It’s a nice valuation tool. The really interesting thing is that the South African market currently is on about a 16-CAP ratio, which means its bang on with its long-term average. People ask us ‘is this market expensive or cheap?’ We say it’s actually bang on its long-term average, which then begs the next question. What’s it going to do for the next few years? We give a very infuriating answer: ‘equity-like returns’, because the CAP ratio of 16 says you’re probably going to get your equity risk premium over the next few years – about five/six percent real over the next couple of years. The market is neither cheap nor expensive, but the average is always made up of components and that’s where the interesting story lies. What we did is we stripped out the sectors in the marketplace. We took the financial sector, the resource sector, we stripped out Large-Cap industrial shares, and then we did the rest of the industrial market. We compared that around the world to see… How does South Africa’s rating fit within the world? How does our 16 compare to other markets around the world? However, what then about the sectors within South Africa – there were some interesting results.
ALEC HOGG: The JSE is always termed as this All Share index, but in fact, its many markets within one as you’ve just explained with the way you stripped the market.
GEOFF BLOUNT: Exactly, there are different drivers and different sectors. We tend to have three principal sectors in South Africa. In the States, Europe, and developed markets it’s typically six or seven principal sectors that drive a market. If you look at where we are at the moment, our market as an overall market, is in the most expensive quarter of markets in the world.
ALEC HOGG: That’s the All Share.
GEOFF BLOUNT: The All Share index. The headline from that is ‘hang on. Maybe you should find other markets in the world that are cheaper.’ Much of the world is cheaper, so that was sort of an interesting observation. The one notable exception is the US, which is on a CAP ratio of 20, so the US is apparently in a bull market at the moment. It’s running nicely, but it’s really expensive – at least by our count.
ALEC HOGG: If you take those constituent parts of the JSE, how do they stack?
GEOFF BLOUNT: Now we take the parts of the JSE and say ‘what happens if these were markets on their own? Where do they fit?’ You’re not just buying the JSE. You’re buying components of the JSE. Interestingly enough, if you were to look at the resource sector of South Africa – if it were a market or an economy – it would be in the cheapest 25/30 percent of markets. It’s attractive and now we know why it’s attractive: it’s because there’s lots of bad news. However, that doesn’t mean there aren’t opportunities to dig and find if you’re looking at that sector. Financials are a midpoint in the world, so financials compared to around the world valuations are probably at about midpoint.
The fascinating one however, is Large-Cap Industrials. If they were their own market, they would be the most expensive market in the world, by a country mile.
The cap ratio on our industrial stock – Large-Cap, not mid and small industrial – is 30. That is stratospheric. If long run average is 16, then 30 is huge. Our observation is, if you’re looking to rush overseas because of valuations, then perhaps those are the shares you should look to liquidate because the rest of the market is actually quite cheap compared to other markets.
GUGULETHU MFUPHI: This performance of the markets within the markets: does that follow through to your index trackers (like Satrix 40)?
GEOFF BLOUNT: Satrix is a top-40 index tracker, so naturally it’s going to have a large exposure to Large-Cap stocks/large shares. It will contain some of the big financials and the big resources, but a big component of that are Large-Cap Industrial stocks. In fact, they have been growing and growing. To put it in perspective: five years ago, resource shares made up half of the South African Stock Exchange. They now make up less than 30 percent of our market. Last year industrial stocks used to make up 30 percent of our whole market. They now make up more than half our market.
ALEC HOGG: But isn’t this a logical conclusion from quantitative easing? They’re pumping money into the system, it goes into the same places, and you make the same bets.
GEOFF BLOUNT: Yes, I suppose the observation is that we are expensive. We’re not saying…no one made a career by forecasting the end of bubbles. There’s a definite bubble here.
This bubble is funded by the liquidity supernova that we’ve seen by the printing of money – QE1 to infinity.
We have a feel for what’s driving us. Momentum is the winning strategy, just going on what’s been winning recently.
ALEC HOGG: But when do you jump off the tiger? That’s the thing. We don’t know when QE is going to end. So if you jump off the tiger now, you stay away from these Large-Cap Industrials, you might be looking silly for years.
GEOFF BLOUNT: You could look silly. The point is why go and buy Large-Cap Industrial stocks in South Africa, which are as a sector, the most expensive (relative to their history), the most expensive they’ve ever been relative to their own history. They’re also the most expensive – if you want to call it a market – in the world when I can go and buy most of Europe on attractive multiples. I suppose the argument is that there are alternative investments, which, from a valuation perspective, are very attractive and offer similar growth in terms of prospects, but are in areas that are simply cheaper. We often highlight the case-in-point. Our Large-Cap Industrial stocks, for example Richemont and SAB are brilliant businesses. We want to own them, but at some stage, you have to say ‘these are too expensive’. Richemont is luxury goods into China. I can go and buy BMW on a PE of about ten. It’s on a ‘price to book’ of about one and a half. This is about a third cheaper than Richemont, yet it has the same growth. This year BMW must sell more vehicles in Asia, driven by Chinese demand, than they ever have before. They have record sales, record margins per vehicle, record market penetration, record Rolls Royce’s ever sold in any one year, yet our market is enamoured. People often say to me ‘hang on. These are foreigners buying Breweries, Richemont, and these companies.’ Actually, many of them are our local investors. It’s not the foreigners driving this up. The market here is in a big bubble.
ALEC HOGG: Exchange control isn’t hurting.
GEOFF BLOUNT: Exchange control is not hurting. Let’s put it this way.
ALEC HOGG: Geoff, these are fascinating insights. Thank you for coming and sharing them with us. That was Geoff Blount. He is the CEO of Cannon Asset Management.
