Some SA financial history
You would have to go back to 1969 to find the JSE Industrial Index as demandingly valued as it is today. The Industrial sector of the JSE is now valued at nearly 24 times reported earnings. The market is clearly demanding or expecting the earnings of JSE listed industrial companies to continue to grow strongly and consistently – as they have succeeded in doing in recent years.
For those with long memories or knowledge of SA financial history, that episode of very demanding valuation in the mid 1960s did not turn out well for shareholders who entered the market in 1965. As we show below, it took until 1995 for the JSE Industrial Index, adjusted for inflation, to regain its 1965 levels. Thereafter, as we also show below, real share prices on average fell back again and only decisively exceeded the average 1965 real valuations in 2005. Since then we have seen spectacular real increases. Between 2005 and 2013 the JSE Industrial the Index has increased by nearly six times in real value to reach its current record levels.
This time has been different – The explosion of share prices and earnings after 2005
These improvements in share market valuations since 2005 have been supported by almost equally strong advances in reported earnings, adjusted for inflation. While share prices have increased by six times in real terms since 2005, real index earnings have increased by nearly five times over the same period, with only one temporary set back associated with the global financial crisis. This very impressive growth, if sustained, would be well worth paying up for in higher share prices. In other words, it is economic fundamentals, not irrational exuberance, that can explain the market in JSE listed Industrials.
It should be noted that after a period of strong growth in real earnings between 1960 and 1980, real industrial earnings in 2004 were no higher than they had been in the mid 1970s. The surge in earnings and earnings growth, as with share prices, began in 2005 and has been sustained since then. It represented a sea change in the circumstances of SA industrial companies. What is to be observed is a remarkable transformation of the real profitability of JSE-listed industrial companies.
Since January 2011 the growth in real industrial earnings has averaged 12.9% a year, while real dividends have grown significantly faster – by nearly 30% a year on average. These, it will be appreciated, are very impressive recent real growth rates. As may also be seen below, while both growth rates have slowed down, a time series forecast predicts that the growth in real dividends will pick up momentum while the growth in real earnings will remain positive in real terms in 2014. But all of this will have to be proved and investors will be watching the earnings and dividend news particularly closely.
Industrial earnings dissected – global and SA economy plays
Among the large industrial companies listed on the JSE it is the group of the Industrial Hedges that have made the running on the JSE. These are companies that depend on the global economy rather than the SA economy. We have created an Index of these companies weighted by their SA share holdings. The Index is made up of British American Tobacco, Aspen, SABMiller, Naspers, Steinhoff, Richemont, MTN, Netcare and Medicilinic. This group of companies generated a total return of close to 50% over the 12 months to the end of October 2013, compared to 23% for the All Share Index and a 42% return for the Industrial Index (the latter includes the Industrial Hedges as well as the SA economy-dependent large industrial companies).
Unsurprisingly, the Industrial Hedges have also outperformed on the earnings growth front. Yet it should be noticed that in recent months the SA Industrials have increased their reported earnings, in money of the day rands, at about the same rate as the global group.
The state of the global economy will prove decisive for corporate performance
It will take good support from the global and SA economies to realise the growth in earnings required to justify current market valuations. The global economy plays will benefit directly from US growth. With faster US growth will come higher long term interest rates though. For now this makes US rates a bigger threat to emerging market economies, their currencies and their stock markets than to the US economy and US equities – as we observe from market reactions to higher and lower US long term rates. Rand weakness adds to the case for the global plays relative to the SA Industrials. Rand strength improves the case for industrials dependent on the SA economy.
In due course faster US growth should feed through to emerging market economies and the companies dependent on them – including the SA Industrials. In the long run good news about the US economy means good news for the global economy; but not necessarily immediately. For now the ideal scenario for emerging markets would be modest increases in long term US rates – as the US economy consistently gains momentum and drags global growth along with it. The more delayed and slower the tapering of the extra cash injected into the US economy, the better for emerging market equities, including the JSE.