South African stocks: Resources offering value again

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The South African stock market is again offering pockets of value after coming off the boil since South Africa’s perfect investment storm in 2010 of low inflation, a strong rand, higher inflation rates than in developed markets, the extremely successful 2010 FIFA Soccer World Cup and, on top of it all, an invitation to join the BRIC countries. So says Dr Prieur du Plessis, chairman of Plexus Asset Management and author of the Investment Postcards from Cape Town blog.

“The risk aversion on the back of an increased number of black swans in the global pond intensified after Japan’s terrible twin disaster in March saw resource-related stocks substantially underperforming the overall South African market and especially developed markets across the globe. The FTSE/JSE Resources Index retreated by close to 11.0% from its February high compared to the FTSE/JSE All Share Index’s drop of 4.4%. On a like-for-like basis the resources stocks are down by more than 8% in terms of US dollars compared to the MSCI World Index’s 1.8% and the FTSE/JSE All Share Index’s 1.6%,” says Du Plessis.

Du Plessis reckons that the Glencore listing and its size played a major role in the severe underperformance of mining conglomerates such as dual-listed Anglo American and BHP Billiton as fund managers rebalanced their exposures. “That is where I see major opportunities in the South African stock market. Some stocks such as Anglo American are currently trading at earnings multiples last seen during the 2008/2009 liquidity crisis.”

While it is perhaps early days, with the rest of the global economy still reeling from the ripple effect of Japan’s twin disaster, Du Plessis is of the opinion that most of the negative impact of the disaster is discounted in especially the prices of industrial metals and platinum. “Manufacturers in China found themselves overstocked going into a seasonal lull in economic activity and that perhaps contributed to the sell-off of certain commodities. While I am being upbeat about industrial metals and platinum, I am more neutral about gold bullion. I think the fear factor has been nearly fully factored into the price of gold and it would take major disasters to keep a strong upward momentum going.”

Regarding the overall South African stock market, Du Plessis is of the opinion that the market is fairly valued. “From a fundamental point of view I prefer Prof Robert Shiller’s Cyclically Adjusted Price Earnings ratio or CAPE in short. It is an enhanced way of calculating the PE ratio that takes into account the average inflation-adjusted earnings over the past 10 years and thereby smoothing the earnings fluctuations from year to year. CAPE is calculated by dividing the real stock index by the average real earnings over the past 10 years,” he explains.

The historical CAPE of the FTSE/JSE All Share Index over the past 18 years was 17.0. “It is frightening to see how expensive the South African equity market was from 2006 to 2008, only to revert to its historical average of approximately 17. The CAPE is currently 18.05 or 6.2% above the historical average, rendering the South African stock market only slightly expensive (as illustrated in accompanying Graph A),” says Du Plessis. He is quick to add that the problem with CAPE is that no one knows when the market will revert to its historical average. “If you base your investment decisions solely on CAPE, you may be out of the market for a very long time, as happened from 2005 to 2008, and miss significant upside,” he says.

According to Du Plessis the current PE ratio of the FTSE/JSE All Share Index of 14.5 is 12.6% higher than the historical average of 13.3 since 1982 and only 3.2% higher than the average of 15.5 since the dual currency system was abolished in 1995 (see accompanying Graph B).

“Indications are that South African equity prices as measured by the FTSE/JSE All Share Index are discounting the earnings base to grow by 15% to 20% over the next 12 months,” says du Plessis. “I view the anticipation as realistic as earnings will continue to be driven by commodity prices and some weakness of the local currency despite consumer spending being under continued pressure. My conclusion is that South African stocks are fairly valued with pockets of value in commodity-related stocks, especially since the sell-off of certain commodities in February as the Resources PE multiple fell to a discount of 6% to the market (illustrated in accompanying Graph C). The risks to equity investments remain high, though, especially while black swans abound.”

Graph A

Graph B

Sources: I-Net Bridge; Plexus Asset Management.

Graph C

Sources: I-Net Bridge; Plexus Asset Management.

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