As tighter monetary conditions continue to have a significant impact on global equity prices and valuations, it has become common occurrence to read investment articles discussing how cheap SA equities are and the opportunity they present to investors. While this argument tends to receive a fair amount of support, particularly from local bottom-up investment managers, it is often met with a high level of skepticism by various capital allocators across the industry. They struggle to reconcile this asset class’s potential, in light of South Africa’s grim medium-term outlook. In this article we try to make sense of these polarised views, provide some historical context and present an outlook for SA equities.
The positive relationship between stock performance, corporate earnings growth and nominal GDP growth over the long term is well documented. Over the short term, however, this relationship tends to breakdown as earnings growth is driven by business cycle conditions rather than longer term economic cycles. The local market is further complicated by the fact that a large component of it, is not materially impacted by local growth dynamics but rather by global developments and currency effects. Based on our calculations, more than 60% of the local equity index is exposed to global return drivers hence the significant underperformance over the past decade of SA-sensitive sectors against ZAR hedges and resources.
Chart 5: Local equity returns vs SA Nominal GDP growth
Source: Bloomberg; Iress; Northstar Asset Management (as at 30 June 2022)
When we consider the 3-year return an investor would have generated by holding SA equities over time and compare it to 3-year average nominal SA GDP growth (chart 5), two important points become apparent. Firstly, in the short term, there is a fairly low correlation between local equity returns and nominal GDP growth. Secondly, even over the long term, it appears that SA equity returns are loosely explained by local growth conditions. An analysis using other SA macro variables such as PMI tends to reveal similar outcomes. This is ascribable to market structure as aluded to above.
Valuation metrics have proved more reliable indicators than GDP growth
While GDP growth and other local macro conditions have not been particularly good explanatory variables of stock performance, they have occupied an increasing proportion of investors’ worries. Ultimately, we view stock returns to be valuation-driven and over the short to medium term, mispricing occurs and creates opportunities. Importantly, valuation metrics have proved to be more reliable than macro indicators in forecasting returns. In this regard, we find a good fit between the local market’s real earnings yield and the JSE All Share Index’s subsequent 3-year returns, particularly for the period following the Global Financial Crisis (“GFC”).
Chart 6: Local equity returns vs Real Earnings Yield
Source: Bloomberg; Iress; Northstar Asset Management (as at 30 September 2022)
While we acknowledge that certain areas of the markets are exhibiting “value trap-like” characteristics, due to a lack of self-help levers and medium term growth tail-winds, we find that the broader market opportunity-set, is extremely compelling. From a valuation perspective, local equities are now trading in real terms at levels last seen during extreme past events such as Nene-gate and the GFC.
Outlook – Various drivers shape returns not just SA growth
We are not advocating that buying cheap stocks without accounting for growth is the best investment strategy, we are merely highlighting that local market returns are shaped by a myriad of drivers and ultimately, by valuations. From a risk-adjusted return perspective we see good opportunities in both SA and non-SA sensitive areas of the market. Among SA focused companies we like resilient businesses which have demonstrated an ability to navigate downturns. This includes South African banks, various retailers (particularly those exposed to the value segment) and quality industrials. The opportunity among SA-listed ZAR hedges is also attractive and we are becoming constructive on resources which have significantly corrected over the past year.