Financials offer good value compared to resources

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Investors have been surprised by the FTSE/JSE All Share Index’s strong rally of 24,9% since the market’s low on 23 January 2008. What is even more surprising is the large difference in the improvement of the major sub-indices. Resources companies have rallied by an incredible 44,8% on the back of only a few shares, followed by industrial companies with 18,6% and financial companies with only 9,4%.

As a result of the sharp rise in commodity prices on global markets and the woes of foreign banks (owing to the credit crunch), investors are sorely tempted to switch investments in resources companies to financial companies. However, investors should bear in mind that the return on an investment in a company is determined by the change in the price-earnings ratio (PER) of the share and the growth in company earnings.

The PER of a share is simply an indication of the valuation level of the share. A PER of 10 means investors are willing to pay R10 for R1 of company earnings. However, if the PER increases to 15 without a change in company earnings, it means that investors are now willing to pay R15 for R1 of company earnings. This represents a 50% increase in the price.

If the company earnings increase from R1 to R1.25 without any change in the PER, it means that investors will now pay R12.50 for R1.25 of company earnings – an increase of 25% in the price.

In real life, company earnings and PERs seldom change separately. If the two examples above occurred simultaneously (PER changes from 10 to 15 and company earnings change from R1 to R1,25), the price of R10 would change to R18,75, which would represent an increase of 87,5%.

The outlook for resources companies is closely linked to the level of global economic activity. The stronger such growth, the stronger the growth in company earnings and the higher the market rating or PER. The opposite is naturally also true.

The FTSE/JSE Resources Index is currently trading at a PER of 23,1 compared with a long-term average of 15,0. This reflects the expectation that resources company earnings will continue to show strong growth for the foreseeable future.

However, the FTSE/JSE Resources Index’s growth in company earnings recently declined sharply from more than 60% per annum in 2007 to the current level of only 2,6% per annum (Poor results from the platinum and gold stocks attributed greatly to the significantly lower growth.) If company earnings do not start rising soon, the PER of resources companies could also start falling sharply, which could mean losses for investors.

A recent survey among investment houses indicated that they expect the earnings of resources companies to grow by 35% over the next 12 months. Should their expectations be correct and the PER remained unchanged at 23,1%, investors could expect a return of 35% on their investment over the next year. However, should the PER decline to, say, one standard deviation above the average PER (i.e. a level of 18,1), investors could expect a return of only 6,1%. Should the PER decline to the average of 15,0, investors would experience a 12,3% loss.

The outlook for financial companies is linked more closely to the level of South Africa economic growth. Since 8 June 2006 the South African Reserve Bank has hiked interest rates nine times from a level of 7% to the current 11,5% owing to rising inflation, and there are clear indications that the local economy is cooling off.

The FTSE/JSE Financial Index’s growth in company earnings has already fallen from nearly 30% per annum in 2007 to the current 14,4% per annum. In contrast with the PER of the FTSE/JSE Resources Index, the PER of the FTSE/JSE Financial Index declined sharply to the current level of 9,1. This is much lower than the Index’s average PER of 13,2.

Analysts believe that the growth in the earnings of financial companies will drop to 10% per annum over the next year. Should the PER remain at 9,1, investors could expect a return of 10% on their investment over the next year. However, should the PER rise to one standard deviation less than the average (9,6), investors could expect a return of 16,1. Should the PER rise to the average of 13,2, investors could see a 60,3% return on their investment.

The accompanying graphs show an easy way of determining the expected return on the FTSE/JSE Resources Index and the FTSE/JSE Financial Index for different combinations of company earnings growth and PERs.

Investors must remember that companies in the sector are not all of the same quality and that a decline or increase in company earnings will not be the same for all the companies. There will undoubtedly be companies whose earnings will decline, whereas others will show a sharp increase in earnings. The same applies to the changes in price-earnings ratios.

Analysts’ predictions are not always correct. Good results are usually followed by a better outlook, and poor results by a weaker outlook. Perhaps we are just a little closer to the peak in inflation and the end of rising interest rates. In my opinion the current low share prices of certain local financial companies afford investors an excellent opportunity to get their feet in the water and start increasing their exposure to these companies.

Please click on the thumbnail below to determine the expected return on the FTSE/JSE Resources Index.

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Please click on the thumbnail below to determine the expected return on the FTSE/JSE Financial Index.

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