Beware the win­ning shares

When things have been look­ing up, we tend to throw cau­tion to the wind and can of­ten come off quite badly by bas­ing fu­ture out­comes on cur­rent wind­falls. Al­though there have been some ‘win­ners’ in our stock mar­ket, it would be wise to ap­proach with cau­tio

Finweek English Edition - - NEWS - By Schalk Louw ed­i­to­rial@fin­week.co.za Schalk Louw is a port­fo­lio man­ager at PSG Wealth. *fin­week is a pub­li­ca­tion of Me­dia24, a sub­sidiary of Naspers.

amas­sive flood trapped a scor­pion in a tree, fear­ing for his life as the wa­ter level con­tin­ued to rise. Un­for­tu­nately he couldn’t swim, so in a panic he started call­ing for help. Mo­ments later, a duck swam to­wards him and asked how he could help. “No, scor­pion,” said the duck to the scor­pion once the trapped crea­ture had ex­plained his prob­lem, “I can’t let you ride on my back to safety. I know you too well. You will sting me.” But the scor­pion promised the duck that he wouldn’t do him any harm and the duck let the scor­pion climb on his back so he could be taken to safety. Just be­fore they reached dry land, the scor­pion broke his prom­ise and stung the duck. As the bird started to sink, he turned and asked the scor­pion, “But why did you sting me? If I die, so will you!” Right be­fore dis­ap­pear­ing be­low the wa­ter, the scor­pion an­swered: “I’m sorry, but it’s just my na­ture!”

The monthly pub­lished fig­ures on shares and unit trusts can eas­ily place an in­vestor in the scor­pion’s shoes. It is in our na­ture to want to choose last year’s ‘win­ners’ in com­pil­ing our fu­ture in­vest­ment port­fo­lio.

Up un­til the end of Oc­to­ber, our lo­cal stock mar­ket was up by 11.3% for 2015, and by a whop­ping 58% (17% per year) in the last three years. Within the JSE/FTSE All Share In­dex, shares such as Naspers*, Stein­hoff and SABMiller seem ir­re­sistible, with re­turns of 260%, 191% and 129% re­spec­tively over the past three years (un­til the end of Oc­to­ber). As in­vestors, it is sim­ply in our na­ture to be con­vinced that now is the time to buy.

The prob­lem, how­ever, is just as the prices of goods are pushed higher the closer we move to­wards Christ­mas, our stock mar­ket cur­rently isn’t priced cheaply at all. On the con­trary, the FTSE/JSE All Share In­dex’s his­tor­i­cal price/earn­ings ra­tio (P/E) is at its high­est in 20 years and the pos­si­bil­ity of a cor­rec­tion now seems more likely than ever be­fore.

Many in­vestors may say that they have heard this from sev­eral ex­perts since early last year, but it also has to be said that we were able to sus­tain th­ese high P/Es in 2014 and 2015 with­out be­ing stung by the prover­bial scor­pion. In 2014, com­pany earn­ings (prof­its) on the FTSE/JSE All Share In­dex in­creased by 15% to 20% year-on-year, which could jus­tify th­ese high P/E lev­els. Our cur­rent year-on-year growth, how­ever, is nowhere near those lev­els any­more. In fact, earn­ings are now 8% lower than they were a year ago, and in my opin­ion, this definitely doesn’t jus­tify our cur­rent 20-year P/E level high. My find­ings may be based on his­tor­i­cal fig­ures, but with ris­ing in­ter­est rates in South Africa – and a huge pos­si­bil­ity of an in­ter­est rate hike in the USA this com­ing De­cem­ber – growth may be sup­pressed. I rec­om­mend that in­vestors ex­er­cise ex­treme cau­tion when it comes to trust­ing the ‘scor­pion’ at this point.

By us­ing an earn­ings-per-share model (as ex­plained in my ar­ti­cle pub­lished in the 3-9 April edi­tion) and strictly ap­ply­ing its meth­ods to our cur­rent sit­u­a­tion, it would seem that our mar­ket would be fairly priced at around 40 300 points. This means that if we do ex­pe­ri­ence a cor­rec­tion, we may see a de­cline of up to 27%. It may be in our na­ture to not want to miss out on the ‘win­ners’ in the stock mar­ket, but I urge in­vestors to be care­ful of its ex­tremely ‘poi­sonous sting’.

It would seem that our mar­ket would be fairly priced at around 40 300 points … if we do ex­pe­ri­ence a cor­rec­tion, we may see a de­cline of up to 27%.

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