Where to now for investors?

Terrence Craig
Chief Investment Officer

B Bus Sc (Hons), CA (SA), CFA

South African Equity markets to deliver abysmal returns for investors in the first half of 2018 with the two primary SA Equity benchmarks, the All Share Index (ALSI) and the Shareholder Weighted Index (SWIX) posting negative Total returns (including dividends) of -1.7% and –4.8%, respectively. The worst performing major sector over this six month period was Listed Property with a punishing negative total return of -21.4%, largely as a result of the collapse in the prices of the Resilient (sic) group of property companies. For the six months ending June 2018, the total return of these property companies were as follow (all negative): Fortress B (-62.2%); Resilient (-56.3%); Greenbay (-46.5%) and NEPI Rockcastle (-41.0%). The extent of the losses and the short period of time within which they crystalised is a stark reminder that fortunes can change dramatically. The Listed Property sector is another example of a former “market darling” of SA Equities that has now rolled over in terms of price – a timely reminder for investors that the good times do not last forever especially when valuations are stretched and accounting policies become too “aggressive” in the pursuit of earnings growth.

These low returns for SA Equities have extended for the last three years now - as is highlighted in the table of SA Asset Class returns below. For the 3 year period ending 30 June 2018, the SA Equity benchmark of ALSI (+6.7%) failed to beat Cash (+7.3%) or Bonds (+7.8% per ALBI). An investor would have been better off with “money in the bank” (i.e. cash) than being invested in the SA Equity market. We doubt these returns were not projected by many three years ago! The low SA Equity return environment (i.e. below Cash) is a point we highlighted as a concern for investors in our Element 2Q2017 Newsletter - a year ago.

Further points to note from the above 3 year Total return chart are as follows:

  • Resources have outperformed both Industrials and Financials for the last 3 years
  • Large size bias: ALSI Top 40 has outperformed both Mid and Small caps
  • SA Listed Property is barely positive over the last 3 years (+0.9%). It is worth noting that for the 3 years ending 31 December 2017 the Listed Property sector returned 11.7% p.a. Thus, the 3 year returns for the Property sector have been decimated by the last six months’ material underperformance.

“Ramaphoria” fades into Reality

South African investors and the country in general celebrated the election of Cyril Ramaphosa as president of the ANC in December 2017 and then as the President of SA in February 2018 after Zuma had been recalled. The Rand strengthened, a downgrade by Moody’s was avoided and SA-focused shares rallied – particularly Banks and Retailers.

“Reality Bites” as we learnt, the hard way, is not just a movie starring Johnny and Winona! There are no surprises as Eskom battles with its debt burden, SAA requests another bail-out with zero attempt to improve its productivity issues which are the cause of its problems, SA unemployment remains extremely high (particularly youth unemployment of 17-24 year olds at >50%), land expropriation without compensation (“EWC”) becomes ANC policy and the petrol price hits all-time highs (amongst many other pressing SA issues) - all examples pointing to the fading of “Ramaphoria” in SA given the long-term and structural nature of our economic and social problems. With a national election a year away in 2019, the political rhetoric will be amplified with yet more (empty) promises from politicians in return for (hoped for) votes.

Corporate takeovers continue to confirm Element’s Investment Philosophy

At Element we are focused on buying shares, based on our research, that are trading at discounts to our estimates of long-term intrinsic value. This intrinsic value includes an adjustment for relevant and material Environmental, Social and Governance (“ESG”) factors that may impact the companies concerned. In addition, these shares should offer an appropriate “margin of safety” before we invest – i.e. a large enough discount to our estimate of fair value – to allow for forecast risk and changing market and company dynamics in future.

One can view our investment philosophy as researching for companies that are trading at a share price below what a rational business person (or entity) would be prepared to pay for the company in an arm’s length transaction. A rational business person (or entity) that is prepared to pay more than Element paid to take over a company is as good a confirmation as any that our investment philosophy and process is working.

The most recent example of a Top 10 equity holding in Element’s portfolios that was, and still is, subject to a takeover bid, is that of Murray & Roberts (“MUR”). Although the takeover bid is still in process at the time of writing and a possible merger with construction peer company, Aveng, is also being considered, Element made the investment decision to exit its MUR positions entirely during the second quarter of 2018.

The original takeover offer price for MUR by the German company Aton, was 1500c which was subsequently raised to 1700c per share. The MUR share price was 959c at close on 23 March 2018 immediately prior to the takeover bid being announced. The return range realised by Element by selling our MUR position between 1500c-1700c per share was +56% to +77% from immediately before the initial takeover offer was made. It is worth noting that MUR’s listed construction competitors’, Group Five and Aveng, have seen their share prices collapse since the MUR bid was announced in late March 2018 and a further competitor, Basil Read, has gone into Business Rescue. Refer to the table below for the four Construction company price moves since the bid for MUR was announced. The “independent” valuation of MUR was stated at the time of the Aton bid at a fair value range of 2000-2200c. However, if this valuation range was to be adjusted by the relative decline of a -80% minimum price move that the other three construction companies reflected in 2Q2018, then a reasonable reflection of an adjusted MUR value range (given the peer group decline of c-80%) would be 400c-440c. Those shareholders holding out for a higher offer than 1700c for MUR, at the time of writing, may be lucky, but our opinion at Element was to take the “bird in the hand” and cash in our profits on our MUR holdings.

Warning signs remain at “Act with Caution” for investors

While global Equity valuations remain at stretched levels by historical measures, we caution investors that great returns seldom come from elevated entry points. In addition, global interest rates have started to rise – implying that high debt levels (country, company and individual) will need to be rolled over or renegotiated at higher interest rates (i.e. at higher costs).

Debt never disappears – it is ignored, conveniently, when interest rates are low. However, as the chart below of US companies’ maturing debt profile highlights – 70% of US company debt (US$4 trillion) is repayable, or will need to be renegotiated, in the next 5 years – at a higher cost than before. This will put pressure on company earnings and cash flow.

In addition, the chart below highlights the extent to which the global tech heavyweights (the leaders of the current long-term bull market) are dominating global indices. The top 8 global tech companies (5 US and 3 Chinese) had a combined valuation (as per market cap) of US$5.0 trillion at the end of May 2018 – more than the market cap of the entire Eurozone companies and materially more than the entire market cap of the Japanese equity market. Concentration risk indeed!

Element’s 3 year returns are back in the Top Quartile of our peer group

It is pleasing to note that Element’s 3 year returns to end June 2018 for all our SA Equity Unit Trusts are back in the top quartile of performance of our peer group.

In the midst of the current low return environment, we continue to research for undervalued shares and other assets for our clients and will buy these with an appropriate margin of safety when the opportunity arises. Expensive global valuations, a handful of large caps driving indices and nosebleed valuations highlight to us that the “movie is playing out the same as before”.

Investors should heed the warning signs and invest appropriately.