Careful stock selection is key as SA equities beckon

• The local market offers value amid negativity that is largely already priced into share prices

SA investors may be reluctant to invest in local equities due to discouraging headlines, but we see value in the local equity market and hold the view that the negativity is largely already priced into shares.

Further to this, many JSElisted companies not only have global sources of revenue to diversify SA-specific risk but are also trading at attractive valuations.

On a 12-month forward price-earnings (PE) basis, the SA market is at one of its cheapest levels in a long time. The possibility of any positive news in future is not being reflected in valuations. It is in such environments that the greatest opportunities exist for investors to derive excellent returns.

From a stock selection perspective one can build a resilient portfolio by considering factors that make a company more resistant to downturns, such as balance sheet strength, which often allows companies to make the best decisions for the long term when peers are under stress, and reduces the risk of the company’s equity value being wiped out by debt holders. The strength of its pricing power in its sector is also an excellent indicator, allowing companies to maintain margins in higher inflationary periods.

The overriding factor in stock selection, however, remains valuations. There could, for example, be an exceptional company with stable, high margins and a strong balance sheet, but if you’re paying a lot for it there is still a greater probability of losing money than of making attractive returns.

We’ve looked at sectors and companies that have demonstrated these attributes over the past few years. The SA banking sector is one such example. With steep interest rate increases totalling

450 basis points since 2021, it makes sense to proceed with caution here, since borrowers are now under pressure.

IMPAIRMENTS

But a caveat to this is that leading up to the period of rate hikes, most SA banks were exceptionally conservative when lending, keeping loan growth low. Banks have also managed their balance sheets cautiously by, for example, taking high provisions during the Covid-19 pandemic.

Further strengthening their position was the implementation of International Financial Reporting Standard Nine in 2019, which ensured that banks shored up their balance sheets.

There is the risk of increased impairments coming through on bank balance sheets, but we believe their capital is exceptionally well managed, and the market is aware that the consumer is under pressure. Despite SA banks’ earnings continuing to grow because of the “higher for longer” interest rate environment, the market has already priced in the fact that impairments are likely to rise. This presents a compelling opportunity for investors due to the balance sheet strength in the banking sector, which is trading at very compelling valuations.

Another interesting example of the importance of a strong balance sheet is Bidcorp. As a global business, its revenue is derived from many different parts of the world; it is not solely dependent on revenue generated in SA.

The left part of the accompanying graph shows that Bidcorp entered Covid-19 with low levels of debt on its balance sheet. When Covid-19 hit, the food services industry came under huge pressure, with restaurants and hotels closing. Many smaller players in this industry were forced to close much capacity, lacking cash or access to sustain it.

EXPAND MARGIN

Because of Bidcorp’s positioning, the group was able to expand capacity during this tough time and still had enough access to cash to fund the large working capital outflows that were required when markets started reopening. The company thus gained market share.

In theory, Bidcorp shouldn’t have had pricing power because it is a company that delivers food items that mostly are not specialised and the barriers to entry to the sector are not high.

This business model thrives off economies of scale. But because of the capacity gap that opened during Covid-19, Bidcorp was able to raise its prices to the extent of food inflation. Its revenue thus far exceeded expectations and it has been able to expand its margin, as the right part of the graph illustrates.

In constructing portfolios, we carefully consider the risks and evaluate opportunities based on valuations and robust research and analysis. In our view, continued headwinds in SA and the accompanying pessimism have created an opportunity for investors to acquire strong companies at attractive valuations.

These considerations have delivered alpha and driven longterm performance in our M&G Equity Fund and M&G Dividend Maximiser Fund.

BECAUSE OF BIDCORP’S POSITIONING, IT WAS ABLE TO EXPAND CAPACITY DURING THIS TOUGH TIME