Caught between a rock and a hard place


I remember vividly in March 2002 speaking at an investment conference in Durban and informing the audience (mostly farmers from the area) that South African companies were deeply undervalued, the rand was one of the cheapest currencies anywhere and developed markets were overvalued.

I remember vividly in March 2002 speaking at an investment conference in Durban and informing the audience (mostly farmers from the area) that South African companies were deeply undervalued, the rand was one of the cheapest currencies anywhere and developed markets were overvalued.

My arguments in 2002 were pragmatic and straightforward. The objective was to understand how expensive or cheap both markets (SA vs USA) were by looking at average price to earnings (P/E) multiples and then deduce prospective returns for investors. We must stress that there are many valuation techniques to determine whether stocks are fairly priced and P/E is not the Holy Grail but does provide insights into relative value. The results were as follows:

  • The S&P average (P/E) was over 40 times at the time, this meant that at the rate at which companies in the US were growing their profits, it would have taken an investor 40 years to make back the money invested in that market.
  • In addition, many US companies were on elevated profit levels, adding a risk that these would falter.
  • By contrast, the majority of high-quality SA companies in 2002 could have been purchased on depressed yet rising levels of profitability and on P/E’s below 10. This meant that in a ‘worst-case’ outcome, an investor’s pay-back period was only 10 years.
  • If these obvious asymmetrical potential returns were not reason enough to invest in SA rather than the US, then the currency should have been the slam dunk. In March 2002, the ZAR reached a level of R12.50 to the US dollar, but based on purchasing power parity (PPP), should not have exceeded R7 against the US$. Please see Figure 4, the PPP graph, towards the end of this article.
  • Adding further credence to the argument that SA was a rational investment pick, our economy was growing at a healthy pace of 3.7% a year, well ahead of both Brazil and Canada both similar commodity-based economies.

Fast forward to 2019, and current P/E multiples generate a distinct sense of déjà vu. However, there is a significant difference between the two periods. In this article we analyse the 2019 numbers, we assess what unfolded after 2002 and whether the same might happen again in 2020.

2019 versus 2002, a quantitative analysis

Our approach to 2019 has been essentially the same as 2002, the only difference being that we now apply a slightly more sophisticated approach using the Shiller P/E ratio, also known as the Cyclically Adjusted P/E Ratio (CAPE). This ratio is based on share price divided by average real, or inflation adjusted, earnings, over the past 10 years; as opposed to recent earnings.

Figure 1. JSE FTSE All Share Index. Cyclically adjusted P/E. Source: Robert Shiller (Yale), iNet & Northstar

Figure 1, shows that the JSE is trading slightly higher than its average.  By contrast, the S&P is close to double its long-term average (Figure 2).

Figure 2. S&P 500 Cyclically adjusted P/E. Source: Robert Shiller (Yale), iNet & Northstar.

What prospective returns should investors expect based on historical Shiller valuations?

S&P 500: Figure 3 shows the Shiller P/E and prospective, 10 year annualised returns (the second vertical axis) for the S&P. The latter has been inverted to show the relationship, which is distinctly negative when the Shiller P/E is high.

In summary, when the Shiller P/E was 28 times or more, real returns have historically averaged -0.5%, with the probability of a 1% real return being less than 30%.

Figure 3. S&P 500 CAPE & Following 10 year annualised returns. Source: Robert Shiller (Yale), iNet & Northstar.

The JSE: Based on the current 18 times multiple, the JSE has historically delivered 8% real returns with an 88% chance of returns being better than 1% real.

What about the value of the rand?

An added complexity for South Africans is that the level or cross rate at which offshore investments are made is key particularly with the rand being so volatile. Significant rand strength or weakness skews the results of rand returns versus hard currency returns. Most South Africans are focused on rand returns as they service rand-based liabilities and expenses. To negate this, it is best to measure offshore investments in hard currency only.

As we write this article in mid-December 2019, the rand is trading at R14.66 to the US dollar. Our PPP analysis, shown in Figure 4, reveals value closer to 12.50, this being 15% higher than current, coincidentally and ironically close to the level the currency was trading at in 2002.

Figure 4. Implied value of the ZAR vs USD using Purchasing Power Parity. Source: Bloomberg and Northstar 2019.

Conclusions based on the above quantitative analysis

Just as in 2002, this analysis paints a clear picture that investing by numbers should result in a deselection of US markets for the next decade and the green light for owning South African companies. Adding to this, the rand is underpriced, providing a second layer of risk when betting against SA.

What happened between 2002 and 2012, and will history repeat itself?

Let’s return to the decade after our 2002 meeting with the KZN farmers. In mid-March 2012, the rand was R7.51 against the US dollar, having appreciated 40% since mid-March 2002. The JSE All Share Total Return Index gained 400% from March 2002 to March 2012. Comparatively, the S&P returned 65% and NASDAQ 121%, in US dollar terms. Investors failing to grasp the unique opportunity in SA incurred a decade of significant negative currency effects, whilst simultaneously being exposed to equities which grossly underperformed a rampant JSE.

Will 2019 to 2029 be a replica, or is it different this time? I mentioned in the opening paragraph that predicting a great performance from SA in 2002 did not require genius level insights. Two factors made it straightforward:

  1. The numbers were firmly stacked in our favour.
  2. The real economy was robust, systems of government were operating smoothly, companies were investing, consumers were spending and hope was high!

In respect of point 2, readers are well aware of the current state of our nation and how this has largely degraded. The implications are set-out clearly in Figure 5 below, which we have used before. It shows how company earnings/company profitability mirrors nominal GDP growth (economic growth). In the absence of reasonable GDP growth, company profits fail and ultimately statistical work begins to lose credibility.

Figure 5. Relationship of SA’s nominal GDP growth and probability of JSE listed companies. Source: Bloomberg and Northstar 2019.

Caught between a rock and a hard place

The numbers indicate that South African assets are preferable versus offshore assets. But it is clear that traditional valuation frameworks are being rendered increasingly irrelevant by the tectonic economic shifts in South Africa and current dire state of affairs. In contrast, the analysis of the US markets is more credible, and returns should moderate relative to the past decade.  This presents a conundrum in terms of positioning investment portfolios, a case of being caught between a rock and a hard place.

SA stocks have binary outcomes with high tail risk, but offer the potential for exceptional returns should the SA Government improve the investing landscape. Conversely, US stocks are expensive with significantly lower potential returns, but offer fewer unforeseen hazards that could result in permanent capital loss for investors.

Essentially our view is that it is difficult to argue against finding a balance and we are convinced that a portfolio of both domestic and offshore assets makes more sense than ever for our Northstar clients.