When the going gets tough, it’s an opportune time to invest

The best investment returns are born in times of fear and uncertainty. There is a prevailing negative narrative about the endless and seemingly unsolvable problems facing SA.

Business confidence is close to 40-year lows and recent financial results commentary from JSE-listed companies reveals just how tough the economic environment is.

Businesses exposed to South African GDP (SA Inc) are experiencing some of their most testing times.

Looking at the FTSE/JSE Mid Cap Index, it is trading at historic lows last seen in 2002 based on its price-to-book ratio.

This index serves as a good proxy for SA Inc companies, particularly as many of the constituents of the FTSE/JSE top 40 Index are global businesses, with only a small proportion of their earnings coming from SA.

Valuations closely follow business confidence, as both are proxies for investor sentiment.

Depressed valuations signal that the market has very low expectations for future earnings growth.

It is therefore not despite, but because of the tough economic environment that domestic mid-cap shares present attractive opportunities.

Many of the fears about SA’s economic woes appear to be priced in to these shares.

So even if economic headwinds persist for longer than expected, shareholders can still expect to make decent returns.

If, however, a “normal” cycle unfolds and some of the headwinds abate, the resultant earnings recovery could be dramatic. In this scenario, shareholder returns could be highly attractive.

While it is very difficult to predict if or how an economic recovery may take shape, and market participants should by no means underestimate the challenges the SA economy faces, we believe there are a few encouraging factors to consider:

In various South African industries (such as infrastructure and energy), there is pent-up demand from the so-called “lost decade” – the economic stagnation experienced over the past 10 years;

Growth follows investment. Investment into emerging markets generally is at cyclical lows;

Within emerging markets, SA has taken a bigger knock than many of our peers;

Generally, South African corporate balance sheets are strong;

Key institutions such as the National Treasury and the SA Reserve Bank have been thoroughly tested over the past 12 months and have proved their mettle;

Despite a recession and an inquiry into state capture, there has been a peaceful and democratic change in the leadership of the ruling party.

PSG’s funds feature several SA Inc opportunities, including a cluster of midcap shares, such as Hudaco Industries, AECI, Reunert and Raubex.

Most of our SA Inc holdings trade at free cash flow yields of 10% or above – very attractive entry points relative to both history and other opportunities globally.

As free cash flow is a measure of the cash available to distribute to shareholders or expand the business, these companies could effectively return well over 15% a year, even if we assume that they only grow by inflation in the absence of any GDP growth.

Our funds’ SA Inc positions are therefore not based on an expected recovery in the SA economy.

It must, however, be noted that current levels of free cash flow were generated in a recession, and any growth in the economy would provide considerable upside to prospective returns.

While these companies may therefore be undergoing the “worst of times” as businesses, their investors could, in time, be enjoying the best of times.