What keeps driving the JSE higher? Surprisingly simple once you analyse the underlying data

Here, at last, is a rational approach towards the JSE’s “surge” over the past year and a half. As we hear almost daily, the JSE’s All

Geoff Blount, CEO of Cannon AM, uncovers the real reasons for the JSE's "surge" - and the handful of stocks that have made it happen.
Geoff Blount, CEO of Cannon AM, uncovers the real reasons for the JSE’s “surge” – and unmasks the handful of stocks that are actually the cause.

Share Index (ALSI) is trading in record territory. And record highs are uncomfortable places for most sane investors. But how the ALSI got there and what it means cannot be swept away in simplistic statements we hear so often from so-called pundits. I’m grateful, and am sure you will be too, for this contribution in which Geoff Blount explains the reasons behind the headlines. The data highlights numerous key issues. First, that just two stocks accounted for a quarter of the “market’s” total gain last year and have done the same so far in  2013. Also, just two of the Top 20 are trading below fair value. And by drawing comparisons with construction counters during the height of their fashion, Blount gives us an idea of how far today’s overpriced favourites could fall. This is high quality analysis from the CEO of Cannon Asset Managers. It will help all those who prefer reality to narrative. And when it comes to investing, is there any other way to give yourself a chance of following Warren Buffett’s Rule Number One: Don’t Lose Money? (Rule Number Two, by the way, is never forget Rule Number One). – AH 

By Geoff Blount*

The JSE rallied 34% over the last year and a half, and the market continues to hit new highs this year. This is at severe odds with the

state of both the global and South African economy. In fact, it appears that there is a disconnect between the real world and the investment world and leads one to wonder what is going on? This disconnect should be sounding alarm bells to investors, and we believe it is, but perhaps not in the way you might think.

Essentially, the SA 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 ALSI return for 2013. Figure 1 shows the marginal contribution of the 20 stocks that most impacted on last year’s performance. For example, it shows that SABMiller and Richemont alone contributed almost 7% of the 26.8% return. If you owned all the other shares in the market, but not these two, you would have earned a return of 20%.

It also shows that these 20 stocks contributed 22.4% of last year’s total market performance, and a staggering 15.4% came from large cap industrials (highlighted in red). If you didn’t own these 13 industrial stocks, but you owned the rest of the market, you would have only earned an 11.4% return last year, which while lower, makes more sense given the economic backdrop.

The top 20 stocks' marginal contribution to the ALSI's gain 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 16x is expensive, and we believe anything above 19x is very expensive.

Company NameCAPE Ratio (x)Return (%, 2012)
Woolworths39.277.9
Mr Price44.772.5
Aspen40.670.5
Imperial18.561.0
Richemont33.256.0
Naspers38.453.8
Shoprite48.747.9
Truworths36.447.2
Bidvest17.439.2
SABMiller30.534.8
Remgro17.134.2
MTN17.623.6
Massmart29.09.4

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 realization 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% for the year. This scenario is very repeatable today, but investors are pretending otherwise.

Fullname31 Dec 201331 Dec 2014Change %
BAT plc560136320012.8309499580454
SAB Miller plc532756053913.634913186297499
Glencore plc54815388-1.6967706622879
Naspers Ltd10960115151238.239614602056498
Richemont SA10458105000.40160642570281102
BHP Billiton plc3238924868-23.2208465837166
MTN21702221412.02285503640217
Anglo American plc2290021533-5.9694323144104802
Sasol5145043101-16.227405247813401
FirstRand3589505740.902758428531598
Standard Bank Group Ltd.129421434810.863854118374199
Vodacom Group Ltd.1330012843-3.4360902255639099
Aspen Pharmacare Holdings268724060051.086632926466201
Old Mutual plc327934705.8249466300701398
Barclays Africa Group Ltd132251820037.618147448015101
Sanlam Ltd5324700031.4800901577761
Steinhoff International4513594031.619765122977999
Nedbank Group Ltd.210002490018.571428571428498
Remgro Ltd.207822539922.2163410643826
Bidvest Group Ltd.268353038813.2401714179243
Shoprite Holdings Ltd.16400168242.58536585365853
Anglo American Platinum Ltd.3939134112-13.401538422482201
RMB Holdings Ltd.4835643433.071354705273997
Mediclinic International Ltd.76001006532.434210526315702
Intu Properties plc5455604410.797433547204401
Woolworths Holdings Ltd.746577103.2819825853985201
Kumba Iron Ore Ltd.4434523990-45.901454504453703
Tiger Brands Ltd.266933680637.8863372419735
Mondi plc18119189504.5863458248247699
Discovery Ltd.84501114031.834319526627201
Growthpoint Properties Ltd.2428274913.220757825370599
BAT plc2745408648.852459016393396
Investec plc7557971728.5827709408495
Mr Price Group Ltd.163742350043.520214974960297
Netcare Ltd.2602379545.849346656418099
Capital & Counties Properties PLC5650660016.814159292035299
Impala Platinum Holdings Ltd.123007578-38.390243902439003
Reinet Investments SCA2019252625.111441307578001
MMI Holdings Ltd.2530300018.577075098814198
Life Healthcare Group Holdings Ltd.418642762.15002388915432
Brait SE5244787050.076277650648301
AngloGold Ashanti Ltd.1229210170-17.263260657338101
Gold Fields Ltd.3289523159.045302523563301
Coronation Fund Managers Ltd.79961151644.022011005502698
Redefine Properties Ltd.97410709.8562628336755598
Exxaro Resources Ltd.1464610350-29.332240884883198
Capitec Bank Holdings Ltd.208273400063.249627886877597
Imperial Holdings Ltd.2026118500-8.6915749469423993
Liberty Holdings Ltd.12160122690.89638157894736803
Telkom SA SOC Ltd.28007000150
Pioneer Food Group Ltd.91801430055.7734204793028
Truworths International Ltd.767677280.67743616466909795
New Europe Property Investments plc81001140040.740740740740698
Massmart Holdings Ltd.13000142809.8461538461538396
Distell Group Ltd.1480013595-8.1418918918918894
Nampak Ltd.410043626.3902439024390203
Tsogo Sun Holdings Ltd.266029009.0225563909774404
Resilient Property Income Fund Ltd.5550839951.3333333333333
Foschini Group Ltd.95751332439.154046997389003
Spar Group131541613622.669910293446801
PSG Group Ltd.85701277549.0665110851808
AVI Ltd.5738781036.110142906936197
Santam Ltd.186282150015.417650848185501
African Rainbow Minerals Ltd.1890011900-37.037037037037003
Pick n Pay Stores Ltd.520052621.1923076923076901
Hyprop Investments Ltd.7650975027.450980392156801
Tongaat Hulett Ltd.113701729252.084432717678098
Barloworld Ltd.1211307.4380165289256199
Assore Ltd.3406114965-56.064120254836901
Sappi Ltd.3275422028.854961832061001
Sibanye Gold Ltd.1230225583.3333333333333
Clicks Group Ltd.6279810029.001433349259401
Rockcastle Global Real Estate Company Ltd.1400242072.857142857142804
Lonmin plc53283162-40.653153153153099
AECI Ltd.12500133827.056
Grindrod Ltd.28032240-20.085622547270699
RCL Foods Ltd.1750194010.857142857142801
Attacq Ltd.1780220023.595505617977501
Hosken Consolidated Investments Ltd.134711490010.607972682057699
PPC Ltd.31402750-12.420382165605
Northam Platinum Ltd.42003670-12.619047619047601
Fortress Income Fund Ltd.1470162510.5442176870748
EOH Holdings Ltd.80501085734.869565217391298
Sun International Ltd.95301289035.257082896117502
Oceana Group Ltd.82001048627.878048780487799
Trencor Ltd.690070402.0289855072463698
Redefine International P.L.C.1024985-3.80859375
Omnia Holdings Ltd.2019518100-10.3738549145828
ArcelorMittal South Africa Ltd.37302641-29.195710455764001
Datatec Ltd.517955707.5497200231704902
KAP Industrial Holdings Ltd.34549042.028985507246297
Reunert Ltd.68506070-11.3868613138686
Famous Brands Ltd.95761153620.467836257309902
Illovo Sugar Ltd.27852450-12.028725314183101
Zeder Investments Ltd.43075575.581395348837205
Super Group Ltd.2615342030.783938814531499
Italtile Ltd.756100032.275132275132201
JSE Ltd89731210034.8489914187005

And things haven’t changed much in 2013. Figure 2 shows the top 20 stocks’ contributions to this year’s market rise of 6.8% year-to-date to end-July 2013. By our calculations, only the stocks shown in green are trading at a discount to fair value.

Top 20 stocks' marginal contribution to ALSI performance in 2013

 

So we see that most stocks which began 2013 on high ratings have just become even more expensive, and pushed the market further, repeating the pattern of the last 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% 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% most attractively priced stocks on the JSE or the cheapest fifth of the market (Quintile 1). The remainder of the market – 60% of shares – lies between the two lines, in terms of valuation.

 

Figure 3: CAPE Valuation Dispersions on the JSE

What it shows is that in absolute terms, Quintile 5 is looking very very expensive, but over the last 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 nearly 50% since 2008, resulting in the longest outperformance for “growth style” investing we have seen in SA (compared to “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 16X, and the current rating is 15.6X, which says at the overall level, the market is about fair value and the asset class (South African equities) as a whole 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 earnings disappointments will come the risk of investor selloffs and thus investment risk.

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

* Geoff Blount is the CEO of Cannon Asset Managers, 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.