The market taketh away and the market giveth back

In this thought piece, we provide three bits of evidence that returns from the JSE in the years ahead should improve relative the past 5 year period.

Our attached client letter addresses just how savage the market has been this year. What it does not detail is that returns have been dismal for the past five years on the JSE (just over 5% annualised nominal returns). Figure 3 shows the 5 year rolling annualised real return (returns above inflation) from the JSE over time. The following being important points:

1. Since 1965, the market’s average annualised outperformance of inflation over a 5 year rolling period is 3.5%.
2. For the past 5 year period, the real annualised return has been -2.4%.
3. This level of 5 year negative real returns occurs less than 20% of the time.

Figure 3. 5 years Rolling Real Returns. Source: Company Financial Statements. Northstar Asset Management. iNet, Morningstar and Bloomberg.

Using this inflation framework, our first piece of compelling evidence for improving prospective returns is as follows:

1. Historically, the prospective (forward looking) 5 year annualized real return that follows a -2.4% annualised real return period, is 16.7%. So future returns tend to be very good after bouts of poor returns.
2. Less than 20% of the time does a negative real return period follow a previous negative real return period. In other words, if returns have been below inflation over a 5 year period, it seldom repeats itself for the next 5 years.

Another approach to assessing prospective returns is to address the rating of the market, its simplest form being its, current and prospect P/E against its own history. Please see Figure 4. In this case, the following applies:

1. The long-term average P/E of the JSE is 12.7 times.
2. Over this past 5 year cycle, the peak JSE P/E was 23.5 times – 31 July 2017.
3. The current P/E of the market is 16.8 times but if we adjust for different company year-ends, the actual P/E on the market is 13.7 times including Naspers and Quilter and 12.1 times excluding these stocks. This is closer to the long-term average.

Figure 4. Historical Market PE. Source: Northstar Asset Management. iNet, Morningstar and Bloomberg.

Using this P/E framework together with other factors, we can say the following:

1. The JSE is no longer expensive – in fact, it is closer to fair value.
2. Earnings/profits are expected to be robust for the following twelve months.
3. Cash flows from companies are rising.
4. Debt levels are relatively low.

We view the current rating on the market as increasingly conducive to improving returns.

Our final piece of evidence which we regard as the most credible in terms of forecasting outcomes for our clients is our own Northstar Buy List. Considering we analyse and value each company ourselves, we can compare our value to the market’s share price. The larger this difference, the greater the potential returns for our clients. If we take our entire buy list of stocks, we can calculate the potential upside on our entire portfolio. Currently, potential returns exceed 20% – this is higher than we have seen in the past two years.

In conclusion, we expect returns to improve on the JSE in forthcoming years. Poor real returns over the past 5 years and statistical evidence that this is usually not repeated, the current lower P/E on the JSE with improving financial metrics around earnings, cash flow and debt levels as well as higher prospective returns from our Northstar Buy List, all point us to happier times ahead.