How risky are industrial and financial stock valuations?

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By Nic Andrew

Nic Andrew of Nedgroup Investments writes that certain industrial and financial stocks appear to be trading at attractive historic valuations (for example certain retailers and banks). On the other hand, these companies have operated in a very favourable environment for the last five years and have been experiencing historically high levels of profitability (margins and return on equity).

At Nedgroup Investments we are able to share the views of different fund managers, on the same topic, with our investors. This is because our fund manager partners are not bound to the house views of specific investment houses. We asked three of our fund managers to comment on the following:

How much of a risk is it that valuations could return to normal without the price increasing, but the earnings and profitability normalising?

Omri Thomas, speaking on behalf of the Nedgroup Investments Rainmaker and Entrepreneur Funds, said: “The macro environment over the last five years has indeed been extremely favourable to local consumer and financial stocks. A declining inflation environment, and consequently lower interest rates, combined with strong consumer spending, high GDP growth, rising asset prices, an emerging consumer and a strengthening rand has led to the perfect cocktail for local companies leading to record ROE’s and margins. Most of the abovementioned macro factors have, however, recently turned for the worse. Inflation continues to surprise on the upside, interest rates have already increased by 4,5%, with another 2% expected, and consumer sentiment has significantly deteriorated. This seriously affects the consumer’s spending, while bad debts should also show a material increase. It is, therefore, highly likely that we could see declining earnings in both the retail and banking space. Valuations could remain depressed despite looking attractive on a historic basis.”

William Fraser, speaking on behalf of the Nedgroup Investments Value and Stable Funds, responded: “Declining interest rates, growing disposable income, reduced input costs and a growing consumer base has been very beneficial for the rating and earnings growth of interest rate sensitive stocks from 2002 till mid 2006. That momentum has reversed, and the impact of rising inflation, higher debt levels and rising debt servicing cost – combined with an increase in the cost of non-discretionary items like food and petrol – has resulted in a significant decline in the prices of companies exposed to this part of the market. The decline in ratings has been warranted to some extent, but a closer look at individual companies have identified companies where the share prices have declined to such an extent that it appears as though the “market” is expecting earnings to collapse. Times will be tougher, and earnings growth will slow or contract in some cases, but on a longer-term view the prospects for good gains are increasing into the next down cycle in interest rates.”

Daniel Malan, speaking on behalf of the Nedgroup Investments Managed Fund, stated that this was an exceptionally high probability scenario, and one of the main reasons why their balanced funds were still relatively low on equity at around 52%. In fact, bar a few business cycles in South Africa reaching very low levels, the typical domestic industrial and financial business was still experiencing pretty good operating business conditions compared to history.

“This is not only a South African phenomenon, we observe this in companies, sectors and geographies all over the world. The only situations where we have committed more significant fund capital to individual industrial and financial stocks have been in segments of the economy where we assess business cycle conditions to be at low levels compared to history,” he said.

Source: Equinox, June 27, 2008.


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