Month: May 2014

Property yields: Expected total returns from property or shares matters much more than initial yield

Growth can more than make up for lower initial yields – something apparently not well understood in property circles

Reference will often be made to some acquisition or other being earnings “accretive”. Clearly an acquisition would hardly be made if it did not promise at least to add to earnings per share (EPS) and thus to the value of each share in issue. It may be thought, naively, that the simplest way for a listed company to accrete EPS would be to issue shares trading at a particular superior price/earnings (PE) multiple in exchange for another company trading at a lower PE ratio.

If it were so easy to add wealth by issuing relatively highly rated shares to buy lower rated shares, no recorded differences in PE multiples could survive such an obvious arbitrage. All earnings would then command the same price which obviously has not turned out to be the case.

The reason for the observed differences in PE multiples or earnings yields (the inverse of the PE ratio), or for matter dividend yields, is that an asset, particularly the bundle of assets and liabilities that make up a company, has a life of more than one year. A company may have an indeterminately long life given that company assets may be replaced or added to. Assets with economic lives of more than one year will be valued on their earnings and dividend growth prospects as well as their initial or first year yields.

The more growth in earnings expected over the life of an asset, the more investors will be prepared to pay for the asset. The faster the expected growth in benefits for shareholders, the higher the price paid per share and the lower the first year yield.

High initial yielding assets will be expected to have short lives and / or limited earnings, when compared to lower yielding assets or companies. If the market has correctly priced two assets in a similar sector of the economy and facing similar risks to their earnings potential, their expected returns will be the same, even though the initial earnings or dividend yields may be very different. Buying the company with a low PE ratio that is expected to grow its profits slowly, while selling a part of what is expected to be a fast growing company with a higher PE will not necessarily add value to the shareholders diluting their share of profits. What is gained in the form of the relatively low price paid for the asset will likely be lost in the form of the slower growth in earnings from the cheap asset – cheap for that reason.

Unless the assets bought can be transformed by better management or the value of the combined asset pool enhanced by economies of larger scale – the fabled synergies that may or may not justify an acquisition – two plus two cannot be worth more than four. Adding low PE assets to high PE assets must reduce the combined PE in line with a weighted average of the established assets and the newly acquired assets with different growth prospects.

There is a well known equation in the financial literature used to make this point, the so calledGordon growth model (see explanation at the end of this piece). This equation simplifies the standard Present Value (discounted cash flow) valuation model applied to any stream of expected operating profits that is discounted back to its present value by applying an appropriate risk adjusted discount rate to the flow of expected profits.

Parsing property returns

The model provides yet another example of the no free lunch principle in life. High yields imply short economic lives and vice versa – though one might think otherwise when listening to the managers of SA listed property companies and their shareholders who appear concerned, above all, to avoid yield dilution when acquiring assets. They appear fearful of buying assets that currently yield less than the current yield on their listed portfolio regardless of what may be differently better growth prospects.

Such observations are however made against a backdrop of extraordinarily good returns from listed SA property. Since May 2004 listed property has returned an average 20.7% a year, while the JSE All Share Index provided an annual average return, calculated monthly, of 18.14%. The All Government Bond Index, the ALBI, has generated an average total return, capital gains/losses plus dividend or interest income, of 8.86% a year over the same period.

 

Property returns were on average less risky than shares, with a standard deviation (SD) of returns of 15.85% a year compared to a SD of share returns of 18.14%. Lower bond market returns were significantly less variable over this extended period than shares or property, with a SD of 5.16. The money market would have yielded about 7.34% a year over the same period, with still less variablity.

The chart below shows how the initial dividend yields have come down since 2008 in company with lower long term interest rates and declining growth in dividends paid. It may also be noticed that recently, while bond yields have moved higher, the initial dividend yield has moved in the other direction, meaning a recent rerating of the Property Index and improved recent returns from property compared to bonds.

The initial JSE Property Index dividend yield averaged 7.54% since 2004 compared to an average 2.75% for the JSE. The growth in JSE dividends has averaged 16.22% a year (despite the global financial crisis) compared to the steady average growth of 7.67% a year in dividends paid by the listed property companies.

 

Faster growth in dividends from all JSE equities has clearly compensated investors for initially lower dividend yields, when compared to property investors who started with much higher initial yields but were subject to slower growth in dividends received. The result has been similarly excellent total returns.

When we add the initial dividend yield to the growth in dividends realized, we get what may be regarded as an internal rate of return (IRR). The IRR for the JSE over the period 2004-2014 was an average 18.98% a year, while the IRR for SA Listed Property was 15.22%. However these realised returns from holding property rather than shares were significantly less variable in the light of the collapse in JSE ALSI dividends in 2009. The SD for the IRR of the property sector was 5.34 compared to 19.29 for listed shares. Clearly the income streams from property, if not as much their valuations (and total returns) have proved more consistent than JSE equities in general and such predictability of dividend streams must have helped to enhance their appeal.

Within the property sector itself, we tested the proposition that the highest yielding property companies can be expected to generate the highest returns. The method used was to rank all the components of the Index by their initial yield every month and to calculate and compare returns over the next 12 months. No such consistently positive relationship between initial yield and subsequent returns from the individual property companies was found. In fact, initial company yields have had no statistical power to explain differences in the returns realised by the different listed companies.

This result was consistent with the theory that what should matter for investors in property, is the combination of initial yield plus growth in dividends. Initial yield alone or apparent concerns about yield dilution should not be a focus of attention. What matters is the combination of initial yield and subsequent growth.

 

The Gordon growth model

The Gordon growth model makes the simplifying assumption that the expected growth in operating profits, earnings and dividends is a constant, permanent one. Thus the price(present value) to dividend ratio can be expressed as P/D= 1/(r-g) where r is the required risk adjusted return or cost of capital equivalent to the discount rate and g the permanent growth rate. The equation can be converted to an equivalent PE by assuming a constant ratio of earnings to dividends.

This equation can then be reformulated to infer the permanent dividend or earnings growth rate implicit in current share prices and dividend yields. That is the cost of capital r, is the sum of the interest rate available from a low risk long dated government bond , say of 8% p.a plus an appropriate risk premium. That is, an equity risk premium of an average 4 or 5 per cent per annum, to be added to the bond yield to give the required return. That is r is equal to say 8 (government bond yield) +5 (risk Premium) =13% p.a. Depending on the above or below average risks, the company faces this average risk premium can be added to or subtracted from.

The initial certain first year dividend yield (for example 3% a year) can then be subtracted from the 13% required long run return in our example to give the implied (permanent) growth in dividends necessary if the required return is to be realised over time. In this example g, the annual growth in dividends would have to be at a 10% annual rate to justify an initial yield of 3%. Clearly, the higher the initial yield the lower the expected growth rate in g required to satisfy r, the risk adjusted required returns. Vice- versa – low initial yields will be associated with higher expected growth rates in dividends or earnings.

 

Equities: Crossing the 50 000 barrier for the JSE

Democracy has been very good for SA shareholders

The JSE crossed a milestone yesterday, with the All Share Index closing above 50 000 for the first time. It first closed above 5000 in April 1994, just before SA became a fully-fledged democracy. Over the same period, dividends per Index Share have grown from R117.89 in April 1994 to R1373.25 today, and that is at an average rate of 13.68% a year. Earnings per share have increased at a compound 13.18% a year rate, implying something of a modest and surely deserved rerating for the Index over the years.

 

The move from 5 000 to 50 000 is equivalent to an average annual compound return of 14.41%. Inflation averaged 6.32% a year over the period. Real JSE returns therefore have averaged over 8% over the period, a more than adequate reward for the risks shareholders have had to bear. The best month for the JSE since 1994, compared to a year before, was in April 2006, when the annual return was a positive 54%, while the worst decline in annual returns was realised in February 2009, when the ALSI Index had lost 43%.

That the Index has been able to increase about 10 times since then is no accident – it is the result of excellent performances by the managers of the companies that make up the JSE, not only in the form of higher levels of earnings and dividends delivered to shareholders, but also in much improved returns on the capital provided by share and debt holders.

The progress of South African companies in increasing their efficiency and value is depicted graphically in the chart below. Until 1994, the year that SA became a full democracy, the average South African company was earning a real return on the cash invested by companies- the return in the form of real cash out compared to real cash in (cash flow return on operating assets, or CFROI) at or below 6%, which is the global average for non-financial firms. Thus South African companies were generally destroying shareholder value before 1994, especially when considering how much higher the real cost of capital would have been in those highly uncertain times. But since 1994, the median CFROI has sloped upwards and remained well above 6%.

Today’s median listed South African company is reporting a very healthy CFROI of 10%. And as can also be seen in the figure, the performance of the top and bottom quintiles of SA companies has also sloped upwards, indicating more value creation for the best firms and less value destruction for the worst. At present, some 20% of South African companies are generating economic returns on capital above 15%, which is world-class profitability.

(It is worth noting that if a company generates a 10% inflation-adjusted return on capital, it generates enough cash to grow its assets at 10% in real terms.)

How does SA compare to other countries?

We show in the chart below the inflation-adjusted economic returns on capital of listed non-financial companies in a number of different countries during the past decade (Matthews, Bryant and David Holland, “Global Industry CFROI Performance Handbook, Credit Suisse HOLT”, February 2013). In what may come as a surprise to many, the figure reveals that South African companies have been generating the highest median economic returns in the world, better than Australia’s and those of the US and the UK. This is an accomplishment to take pride in, one that demonstrates that listed South African companies are well managed and competitive.

Most important to recognize and appreciate is that SA’s democracy gave SA companies the opportunity to engage globally in the years after 1994, in ways that politics made impossible before. JSE listed companies have been able to realise the economies of scale and specialisation that access to global markets in good services and capital makes possible. SA shareholders have every reason to be grateful for SA democracy, which helped produce such unexpectedly good returns on capital.

Avoiding the mind games

The MPC voted to keep interest rates on hold. Without a recovery in growth rates, interest rates will stay on hold – absent the dangerous mind games of January 2014 that led to an ill-timed rise in the repo rate.

The Monetary Policy Committee (MPC) of the Reserve Bank yesterday indicated that its outlook for SA inflation over the next few years has improved marginally. To quote the statement:

“The Bank’s forecast of headline inflation changed marginally since the previous meeting. Inflation is expected to average 6,2 per cent in 2014, compared with 6,3 per cent previously, with the peak of 6,5 per cent (previously 6,6 per cent) expected in the fourth quarter. The forecast average inflation for 2015 remained unchanged at 5,8 per cent. The forecast horizon has been extended and inflation is expected to average 5,5 per cent in 2016, and 5,4 per cent in the final quarter of that year. Inflation is still expected to remain outside the target band from the second quarter of 2014 until the second quarter of 2015.”

It also reported that inflation expectations are unchanged:

“The Reuters survey of inflation expectations of economic analysts conducted in May is more or less unchanged since the previous survey. Inflation is expected to average 6,3 per cent in the second quarter, and 6,2 per cent in the final two quarters of this year, before returning to within the target at an average of 5,8 per cent in the first quarter of 2015. Annual inflation is expected to average 6,2 per cent in 2014, and 5,6 per cent and 5,4 per cent in the subsequent two years respectively, somewhat lower than the Bank’s forecast.”

The growth outlook for the economy, according to the MPC by strong contrast has “deteriorated markedly” :

“The domestic economic growth outlook has deteriorated markedly, with the reversal of a number of the tentative positive signs observed at the beginning of the year. The Bank’s forecast for economic growth for 2014 has been revised down from 2,6 per cent at the previous meeting to 2,1 per cent, implying a further widening of the negative output gap. The forecast for 2015 remains unchanged at 3,1 per cent, and growth in 2016 is expected to average 3,4 per cent. However, the risks to these forecasts are increasingly to the downside against the renewed possibility of electricity load-shedding, among other factors.”

With this backdrop one might have thought that the decision not to raise short term interest rates would have been a formality. But not so for two members of the MPC – compared to the three at the meeting before – who actually voted for a further increase in rates. What can be on their minds?

It can’t be a belief that higher interest rates can do much to slow down inflation. The Investec Securities simulation for the Reserve Bank model of inflation and growth indicates that an increase of 25bps in the repo rate will only reduce its expected inflation by roughly 8bps and this would take seven quarters to take full effect. In other words, not much help on the inflation front at considerable further risk to the state of the economy – and moreover in the knowledge that an unpredictable exchange rate (that the model treats as an independent influence, about which assumptions rather than predictions are made when running the model).

The hard pressed SA economy had some good luck in the form of a stronger rand and a bumper maize harvest, which will help to hold down inflation in the months ahead. One gains an impression that had the rains not come when they did, the case for raising rates might have had more support.

That monetary policy is hostage to such obvious supply side shocks as drought and global risk aversion is not a comfortable thought. The reality is that inflation n SA has very little to do with the demand side of the economy (as the Reserve Bank acknowledges fully) and everything to do with factors over which interest rates have little influence: exchange rates and the harvest as well as the pace of administered price increases, which is the province of the regulators and the tax collectors.

At least this time round, at the media briefing and Q&A, the Governor was asked some leading questions about supply side effects and the influence of interest rates. She was even asked if the hike in rates in January (with hindsight surely a mistake) did any harm to the economy. There was little mea culpa in the response and a resort in the response to the non-testable theory that had the Bank not raised rates then second round effects – higher inflationary expectations – would have taken inflation higher. In fact there is no evidence that inflation expectations lead inflation rather than the other way round. And, as the MPC indicated, inflation expectations remain unchanged and the great constant in the economic environment.

This Q&A unfortunately indicates the danger in monetary policy: that members of the MPC come to believe that in order to preserve their inflation fighting credentials, and because the markets may expect them to raise interest rates, then that is what they have to do. This is regardless of the predicted outcomes for inflation and, more importantly, for growth.

The trouble with such monetary policy reactions is that they can never be tested or refuted. The economic caravan always moves on even as the dogs bark. Who can say with certainy what might have happened if the Bank had acted differently? Such mind games do not serve the SA economy well. Interest rates in SA should have been lower, not higher, given the state of the economy over the past 12 months The time for a cyclical upswing in interest rates is when the economy can justify it – not before. And there is clearly no justification for higher interest rates given the growth outlook.

Hard Number Index: Modest momentum

The economy in April maintained a very modest forward momentum – but the outlook is deteriorating, not improving.

Early data releases for vehicle sales and notes in circulation indicate that the economy in April 2014 maintained the modest forward momentum of the previous month. Our updated Hard Number Index (HNI), as we show below, is largely unchanged from the month before and reveals a similar outlook for still slower, but positive, growth rates in the months ahead.

The Index is based upon 2010 values. Index values above 100 indicate forward momentum. As we show, according to the HNI, the economy began a period of positive growth in 2004 that has continued since, but for a brief move backwards after the Global Financial Crisis broke in 2008 when the rand weakened and interest rates rose.

In the figure below we compare the HNI to the Reserve Bank’s coinciding business cycle indicator, also with a 2010 base, that has only been updated to January 2014 (with a value of 118). The Reserve Bank’s Indicator was still pointing higher in January 2014 while the HNI had turned lower in Q3 2013. The HNI has generally been a good timely leading indicator for the broader business cycle.

The performance of unit vehicle sales and the note issue is shown below. The outcomes are better than the raw numbers on a seasonally adjusted basis. But for Easter coming later this year than in 2013, such seasonal adjustments, as well as the raw numbers, need to be treated with caution.

If current trends persist, vehicle sales are heading lower, from a smoothed rate of 52 000 units per month, to about 50 000 units, equivalent to an annual rate of 600 000 units by April 2015. The local industry sold 647 217 units in 2013. Trends in the note issue suggest that the cash cycle may bottom out in Q4 2014. If this turns out to be the case, this modest recovery would be very welcome.

Hopefully for the state of the economy, the recent strength in the rand and a significantly lower maize price will have reduced the Reserve Bank’s forecast inflation rate as well as reduced the danger to the economy of higher short term interest rates that would undermine the prospects of any cyclical recovery.

The Reserve Bank fortunately (in a close call) did not raise interest rates in March when the rand was much weaker and long term interest rates significantly higher. It is therefore difficult to see how the Monetary Policy Committee could argue this week for anything but maintaining interest rates at their current levels for a while longer.

Value on the JSE – A contrarian case for SA economy plays

22 April 2014

Based on valuation metrics and given that the impact of higher interest rates is already factored into the valuations of the SA Industrials and Interest rate sensitive counters, the downside for these SA economy-dependent stocks appears more limited than other key JSE sectors.

These are not the best of times for the SA economy, but not the worst of times for the JSE

The outlook for the SA economy is unsatisfactory. The rate of growth is slowing down and the Reserve Bank seems intent on raising interest rates that will slow growth further. This outlook does not portend well for those businesses that serve the SA economy. Investors on the JSE however can take comfort from the fact that the SA share market has become more dependent on the performance of the global economy. If we break down the earnings of the JSE All Share Index, over 60% is generated from revenues outside SA, while 70% of the daily movements on the JSE can be attributed to these global influences.

Should investors prefer global to local plays?

The issue for investors on the JSE therefore is how to allocate their exposure between the listed global and SA plays. Clearly, the worse the SA economy is expected to perform, the stronger the case for preferring the global over the SA plays.

The SA bond and money markets can be confidently presumed to have factored in at least a further 100bp increase in the key SA Reserve Bank repo rate over the next 12 months, with the expectation of more to come over the following 12 months. The stock market will also have taken this into account.

These forecasts currently weigh upon the valuations accorded the SA economy plays, especially those companies for whom the direction of interest rates has proved influential in the past, which can be identified as interest rate sensitive, such as banks, credit retailers and property companies. Yet we can also be confident that the forecasts and assumptions that have influenced the market place will be altered over time with the news flow and that the market will move accordingly.

What if interest rates turn out to be lower than currently forecast?

Should interest rates in SA increase by significantly less than currently expected, it would likely mean unexpectedly high and superior risk adjusted returns from investing in the SA economy plays on the JSE. The opposite impact would be registered should SA interest rates turn out to be even higher than currently expected. We regard the danger of upside interest rate surprises as significantly less than downside surprises for reasons to be explained.

The exchange value of the rand will determine the outcomes for inflation and interest rates

The path to lower than expected interest rates in SA would have to be opened up by a stronger rand. The path to higher than expected rates would have to follow a still weaker rand. A consistently stronger rand improves the outlook for inflation and would avoid any need to raise interest rates and vice versa. Chris Holdsworth1 has successfully replicated the inflation model of the Reserve Bank for Investec Securities and suggests that a rand weaker than R10.70 to the US dollar would lead to higher interest rates, designed to bring inflation back within the headline inflation target range of 3% to 6%. This target band for inflation is currently under threat following the rand weakness of the past 12 months – hence the expectation of higher short term rates. A rand consistently stronger than this R10.70 would keep short rates on hold.

The Holdsworth replication of the Reserve Bank econometric model gives a good sense of some of the dilemmas faced by the Monetary Policy Committee (MPC) of the Bank. The most important of these is that inflation has risen, and may rise further, even though the economy is operating at well below its potential, for want of domestic spending.

Raising interest rates would depress demand further, with little impact on the inflation rate itself. Holdsworth calculates, using the Reserve Bank econometric model, that a 50bp increase in the key short term interest rates typically leads to only a 16bp reduction in the inflation rate, seven quarters out. Therefore, should the rand breach R11.30 against the US dollar, the Reserve Bank would have to raise rates by 100bp or more to hope to get inflation below 6% by the end of 2015.

The possible influence of the SA output gap on the market outcomes

Such an increase in rates would have a highly predictable impact on spending and the so called output gap as estimated by the model. The output gap is the difference between the potential growth of the economy, estimated at 3-3.5% per annum by the Reserve Bank, and actual growth, which is currently well below this. This gap, as shown in the chart below, is currently very wide and will increase further with higher interest rates. Note too that the current GDP output gap is now at historically high levels, indicating that the economy is operating below its growth potential, for want of sufficient spending by households in particular.

1Chris Holdsworth, Quantitative Strategy, Investec Securities Proprietary Limited, Second Quarter 2014, April 2014.

 

 

A still weaker level of demand and the still fewer jobs associated with higher interest rates would be an unacceptable price for the economy to pay and the Reserve Bank might be persuaded that higher interest rates are not appropriate given the trade offs in the form of slower growth. Furthermore, as we show in our next chart, there is evidence that higher short term interest rates may be associated with a weaker rand, so the outlook for inflation, despite the lower levels of domestic spending, could deteriorate rather than improve with higher rates. Yet the market still expects the Reserve Bank to think and act otherwise. Our view is that should the output gap threaten to widen further, the Reserve Bank might think again about raising interest rates even if its inflation forecasts have not declined.

Questioning the structure of the Reserve Bank econometric model

One of our issues with the structure of the Reserve Bank econometric model is the assumption, incorporated in the multi equation model, that higher inflation leads to increases in wage inflation and in disposable incomes, adding impetus to household spending and helping to close the output gap.

This presumed relationship – more inflation and so temporarily faster and perhaps unsustainable growth – however relies on a demand side explanation of inflation. In other words, high rates of inflation reveal a state of excess demand in the economy that needs to be restrained. This, as we have indicated, is very far from an explanation of current inflation in SA.

The model also assumes that inflation expectations can be self-fulfilling and lead to higher prices even though demand pressures may be weak. There is no evidence of this. Inflation in SA leads inflation expectations, which remain very stable at about 6%. There is no statistically significant feedback loop from inflation expected to inflation.

Higher consumer prices can alternatively be attributed to reduced, or more expensive, supplies of goods and services, the result of the weaker rand as well as for electricity and other administratively set prices. Such supply side driven increases reduce rather than add to real disposable incomes and spending power, especially when formal employment is in decline or growing very slowly. A weak rand is bad news for the purchasing power of SA households. It becomes even worse news for them when accompanied by higher interest rates. Furthermore, households account for over 60% of all spending and the incentive private firms have to add to their plant and equipment – which accounts for another 15% of GDP – is derived from the spending actions of households. A return to SA GDP growth rates of a mere 3.5% pa will have to be accompanied by an increase in household consumption growth rates.

A combination of a stable rand with stable interest rates is essential for this important purpose. A lift in exports, labour relations permitting, could help stimulate more GDP growth, but would have to be followed up by a recovery in household spending growth rates.

The further dilemma for the monetary authorities is that, even if the output gap were to widen further, it is quite possible that the inflation outlook could worsen rather than improve. It would worsen if the rand were to weaken further and the so-called pass through effect of the weaker rand pick up strength. There is no predictable relationship between SA interest rate moves and the value of the rand, as Holdsworth has again confirmed (see the chart below).

The Reserve Bank – will it undergo an economic reality check?

Changes in short term interest rates may therefore help hit or miss inflation targets even as changes in interest rates have the opposite impact on the growth in domestic spending and output. This leaves the Reserve Bank with uncomfortable trade offs between inflation and growth, which may encourage the MPC to take little or no action on interest rates, as has been its inclination recently.

The MPC may recognise the inadvisability of raising interest rates in current circumstances, having seen how the rand weakened further as interest rates rose in January and strengthened after the March meeting of the MPC when the rates were left on hold.

Global forces will drive the rand and the SA markets

The inflation rate outcomes for SA will be determined mostly by the direction taken by the rand, independent of SA interest rate settings. The global forces that influence the exchange value of the rand are the state of emerging market bond and equity markets. This pattern is highly consistent. These developments in emerging bond, equity and currency markets, in turn reflect the appetite for risk by global investors and the outlook for the global and emerging market economies. The better the outlook for emerging market economies, the more upside for commodity prices, emerging market equities and their currencies.

These helpful trends for emerging markets and currencies, led by lower long term interest rates in the US were a notable feature of the markets in March 2014, when the MSCI Emerging Market Index gained nearly 3% in the month. In January 2014, the Index lost nearly 7% of its value, before adding over 3% in February followed by another strong month in March 2014.

As we show below, these trends were especially helpful to the SA economy plays on the JSE in March 2014. In Q1 2014, we calculate that our grouping of SA Industrials and, to a degree, overlapping SA Interest Rate Plays in March, provided returns of over 9%, the Global Consumer Plays generated negative returns of about 1% and the Commodity Price Plays returned 1.5%. Were the rand to surprise on the upside again, a similar pattern of outperformance by SA economy plays is likely.

The forces that could drive emerging markets higher

Over the next six months, investors in emerging markets, including the JSE, should hope for minimal pressure from US and other developed market interest rates, especially from long bond yields. They should hope that Fed governor Janet Yellen and ECB president Mario Draghi continue to emphasise deflation rather than inflation until the prospect of stronger global growth is fully confirmed. This dovish approach seems a likely one and its realisation will be to the advantage of emerging market economies and the companies dependent on them. Over the longer term, faster growth in developed economies will bring higher interest rates, as demand for global capital improves and when faster growth in emerging markets can compensate for the higher costs of finance that should follow.

Breaking up the JSE by dependence on global or domestic economic forces

The large listed companies that dominate the JSE can be broken down by the degrees of dependence on global or domestic economic forces as indicated in the figure above. There are the Commodity Price Plays, made up of resource companies that depend on the US dollar prices of metals and minerals. This category of JSE-listed companies best excludes the gold mining companies that dance to the sometimes very different rhythms of the gold price. The Commodity Price Plays include the large diversified mining companies Anglo American (AGL), BHP Billiton (BIL) and Sasol (SOL), as well as the platinum, iron ore and coal mining companies.

Then there are the SA Interest Rate Plays: the banks, the credit retailers, property companies etc whose valuations are dependent on the direction of SA interest rates. They include the major banks like Standard Bank (SBK) and insurers like Sanlam (SLM).

A further category of SA economy plays are the less interest rate-exposed SA Industrials, including the cash retailers.

The other important category of Industrial companies listed on the JSE are those clear plays on the global economy. These include Naspers (NPN), Aspen (APN), Richemont (CFR), SABMiller (SAB), British American Tobacco (BTI) and MTN, whose fortunes and valuation depend mostly on the profitability of their activities outside SA. We describe them them as Global Consumer Plays or as industrial hedges since they are hedged against the SA economy and the rand.

About 60% of the JSE All Share Index weighted by SA shareholders (the SWIX) is accounted for by a mere 10 companies, of whom only three companies may be described as heavily exposed to the SA economy: Standard Bank and Sanlam, both interest rate sensitive companies; and Sasol, a resource company, which generates much of its revenues and costs in SA but whose revenue is closely linked to the global US dollar price of oil.

2In this breakdown of the JSE we have combine the individual stocks into their various categories as follows:

Interest Rate Plays:
ABL, ASA, DSY, FSR, GRT, INL, INP, NED, RMH, SBK, SLM, BVT, IPL, MMI, MSM, PIK, SHP, TFG, TRU, WHL,

Commodity Plays:
AGL, AMS, ARI, BIL, IMP, LON, SOL, ACL, KIO

Industrial Hedges / Global Consumer Plays:
BTI, APN, SAB, NPN, SHF, CFR

S A Industrials:
BVT, IPL, SHP, TBS, VOD, BAW, LHC, AVI, SPP NPK

The case for SA economy plays – at current prices

The key question we now address is whether or not the JSE, taken as a whole, can be thought to offer the prospect of good returns for investors, at current valuations. The further issue is the valuation currently attached to the SA economy plays. Can they be considered demandingly valued at current valuations that incorporate the expectation that SA interest rates will rise over the next 24 months? Clearly there is upside for this class of shares should interest rates not rise as expected.

Yet a consideration of the downside risks to this class of shares needs consideration, as well as upside risks. Risks to the JSE All Share and SWIX Indexes, positive or negative, will impact to a lesser or greater degree on any subset of the market, including the SA economy plays.

Holdsworth shows that the JSE All Share Index is currently priced within the norms established since 1995. Cyclically adjusted or normalised earnings suggest an even less demanding rating for the market than do reported earnings. This is because the earnings from the Resource companies listed on the JSE are currently in only partial recovery mode from a deep, cyclical decline in normal earnings.

It would seem accurate to conclude that, by the standards of the recent past, the JSE was not demandingly valued at March 2014 month end, relative to trailing earnings (provided earnings from the Resource companies do in fact return to their cyclically adjusted norms). Clearly, such valuations also depend on the current state of emerging markets generally.

In our valuation models, we allow for an emerging market influence on the US dollar value of the JSE All Share Index and Financial & Industrial Index, in addition to factoring in the level of JSE earnings in US dollars and the interest rate spread between SA and the US. These valuation models, which have provided a good long run explanation of market value, suggest that the All Share Index is between 10 and 20% above the valuation predicted by the model.

Using a similar approach to valuing the S&P 500 indicates, by contrast, a high degree of undervaluation, 20% or so. This suggests that the better value for shareholders is for now still to be found in developed rather than emerging equity markets.

These currently stretched valuations of the JSE have been encouraged by the above long term average growth (of 10% pa) in Financial and Industrial rand earnings in recent years. This recent strong and predictable growth has been augmented by the exceptionally good earnings growth reported by the Global Consumer Plays. The SA Plays have also performed very well on the earnings front, especially in recent years.

Looking at Price/earnings ratios

In the figure below, we show the very different ratings enjoyed by these sub-sectors of the JSE. Global Consumer Plays now enjoy a much improved and exalted price/earnings rating compared to the other sectors.

While Naspers accounts for the largest share, 12.5% of the Top 40 companies included in the SWIX, its share of the Global Consumer Play sub-category is as high as 29%. Almost all of the value of Naspers can be attributed to its large shareholding in Tencent, a Hong Kong listed internet company. Without Naspers, which has recently traded at 65 times reported earnings, the Global Consumer Plays, taken together at SWIX weightings, would enjoy a still demanding 19 times earnings rating compared to the more demanding 24 times multiple when Naspers is included.

While the earnings performance of the SA Industrials has compared well with those of the Global Consumer Plays, these SA economy-dependent companies realise a significantly lower rating in the market. The Global Consumer Plays must be considered as growth companies while the group made up of SA Industrials and SA Interest Rate Plays can be considered as value stocks with much less demanding valuations.

Holdsworth has estimated that the trend earnings growth is 14% pa for the Commodity Price Plays, 9% p.a for the SA Interest rate plays, 15% pa for the Global Consumer Plays, 11% pa for the SA Industrials. The volatility of these earnings growth trends has been lowest for the SA Industrials at 17%, compared to 19% for the Global Consumer Plays, 23% for the SA Interest rate plays, 61% for the Commodity Price Plays and an extraordinarily high 158% for the Gold Mining Companies. Part of the case for the SA Industrials is thus their lower risk character. If these growth trends in earnings are sustained, current valuations of the SA economy plays cannot be regarded as demanding.

It may be argued therefore that, based on valuation metrics and given that the impact of higher interest rates is already factored into the valuations of the SA Industrials and Interest rate sensitive counters, the downside for these SA economy-dependent stocks is more limited than that of the Resource stocks or the Global Consumer Plays.

The upside is that the rand will be stronger than expected and interest rates lower than expected. All these sectors of the JSE will benefit from stronger global growth and strength in emerging market equities and commodity markets that would accompany any renewed appetite for bearing risks in emerging markets. But the SA economy plays as a group stand to benefit most from a strong rand and all that will follow a stronger rand, especially lower interest rates.

The SA balance of payments – a conundrum inside a mystery

The SA economy is vulnerable to large swings in foreign portfolio flows into and out of our debt and equity markets. It should be appreciated that the funds are attracted in part because they can be withdrawn at short notice, in what have proven to be liquid and, to a degree, resilient markets.

Furthermore the SA economy, given a lack of domestic savings (the result of a bias towards consumption spending to which government policies of redistribution and transformation contribute) cannot hope to sustain even modest growth without significant inflows of foreign savings, at the rate of 5% of GDP.

The difference between low savings, at about 14% of GDP, and higher rates of capital expenditure, running at about 19% of GDP is equal to the deficit on the current account of the balance of payments. South Africans, to maintain their standard of living, must hope that, on balance, capital continues to flow towards South Africa – for which we have to give up an increasing net flow of interest and dividend payments abroad. As a result of capital attracted over the years these payments now account for over half of the current account deficit.

These shocks may have little to do with South African events and much more to do with global events, for example global financial crises or decisions of the US Fed that impact on markets and yields in a global capital market, of which SA and other emerging markets are an integrated component of. Another factor may be the exchange controls that still apply to domestic portfolios. That the share of these portfolios held offshore may not exceed specified limits – 25 or 30 per cent – may mean that relatively favourable offshore market moves (perhaps the result of rand weakness) may require the partial repatriation of SA portfolios held abroad.

It needs to be appreciated that for every foreign seller or buyer of a listed security (unlike a new issue), there will be an equal and opposite domestic investor, attracted (or repelled), by lower (higher) prices and higher (lower) yields led by these foreign flows. These variable prices and yields act as one of the absorbers of the shocks that result in more or less foreign capital flowing in or out of the rand.

The other important shock absorber is the variability of the exchange value of the rand. A weaker rand may well lead to thoughts of a rand recovery, encouraging capital inflows while a stronger rand may well lead to the opposite.

We show, in the figures below, the link between these foreign net bond and equity market portfolio flows over a rolling 30 day period and the 30 day percentage move in the rand/US dollar since 2005. Rand weakness is represented by a positive number. The correlation between these two series is a negative (-0.40) over the period 2013-2014. Since early 2013, the worst 30 day period saw net outflows R1.382bn and the most favourable, net inflows of R759m. The best 30 day period for the rand saw it gain 12.5% and the worst was a depreciation of 5.6%.

Clearly these capital flows play a statistically significant impact on the value of the rand, though as clearly there are other forces acting on the currency market over any 30 day period. Foreign capital flowed out heavily towards the end of 2013 and then again in January 2014, enough to cause significant rand weakness. These flows have sinced turned positive and helped the rand to recover.

Ideally, capital flows to and from SA would be more predictable and the rand less volatile, to the benefit of SA based business enterprises. It would also make inflation and the direction of short and long term interest rates much more predictable, further reducing the risk of running an SA-based business. But there seems little chance of this, given the continued dependence of the economy on foreign capital and the shocks, both positive and negative, domestic and foreign, that will continue to affect flows of capital and the terms on which capital is made available.

The Reserve Bank has published its latest Financial Stability Report (FSR) (March 2014). Among its understandable concerns is this dependence of the SA economy on flows of portfolio capital into and out of the equity and bond markets.

The FSR shows how these flows in and out of the rand and shows how these flows were closely linked to much larger flows out of emerging markets generally:

The report states that “non-resident investors in South Africa were net sellers of R69 billion worth of domestic bonds and equities between October 2013 and March 2014. Over this period, a large part of of equity sales was concentrated in the mining and media sectors. Since the beginning of 2014, equity outflows from the banking sector have accounted for the largest proportion of equity outflows…………

The report goes on to state rather “…It would appear, however, that not all sale proceeds from the sell-off were transferred abroad”

This statement that indicates that not all the flow into and out of the rand from abroad can be accounted for by the statisticians and the banks that supply the record of foreign trade and financial transactions. The balance of payments accounts, that should sum to zero theoretically, are in reality balanced by what is often a very large item, known as Unrecorded Transactions. This line item was particularly large in Q4 2013, of R30.6bn, compared to recorded capital flows of R5.3bn. We show some of the the key balance of payments statistics below and the importance of unrecorded transactions in the scheme of things.

The reality is that the the SA balance of payments is somewhat mysterious; and so conclusions about the role of capital flows in the economy must be treated with some caution. The capital flows themselves may be under- or overestimated, as may exports or imports or even interest and dividend payments.

What however is fully known and recorded is what happens to the rand and security prices. Presumably the exchange rate and security prices act to equalise the supply and demand for the rand and securities denominated in rands on a continuous basis.

The important conclusion to draw is to let the markets act as the shock absorber, and for the monetary policy authorities to set their interest rates with the state of the domestic economy in mind. Monetary policy should aim at minimising the gap between actual and potential output. Interest rate stability and predictability is within the remit of monetary policy and should be an aim of policy. The influence of unpredictable exchange rates, led by unpredictable capital flows, on the rand and on inflation, are best ignored.