WHAT’S THE TIME?
Some of the sayings trotted out by commentators need careful examination
Equities carry a risk premium over cash, so make the necessary adjustment and then make the comparison
Lately our interest has been piqued by market commentators’ divergent opinions.
For instance: “It is darkest before dawn”; “Small caps are on sale”; “It’s time to ditch SA equity”; “The market is cheap by historical standards” — to name but four. As readers probably know by now, IM has a bias toward small caps — for several reasons. Mainly they are under-researched and have broad appeal among readers (particularly the DIY investor).
One point of housekeeping: the small-cap index contains those shares ranked from 101 to 160 in terms of market capitalisation. Reminiscences of a Stock
Operato r by Edwin Lefèvre is a classic. It is the thinly disguised story of Jesse Livermore, one of the greatest traders the markets have seen. It contains one paragraph that resonates with IM and distinguishes the professional from the amateur. It is worth reading until deeply etched in your mind — especially since DIY investors should strive to be consummate professional traders.
Lefèvre notes: “The professional concerns himself with doing the right thing rather than with making money, knowing that the profit takes care of itself if the other things are attended to. A trader gets to play the game as the professional billiard player does — that is, he looks far ahead instead of considering the particular shot before him.”
Supplement this quote with Addison Cammack’s memorable “Don’t sell stocks when the sap is running up the trees” and small-cap enthusiasts have the makings of a framework with which to tackle investing.
Now starts the fun part … applying this to the task at hand. Unless you are day-trading, the longer the timeframe on a chart, the more instructive it is. Trends become apparent.
Figure 1: From a purely technical perspective, there have been two periods where the “sap has been running up the tree”. These were 2001 to 2007 and 2009 to 2014. The ensuing few years were marked by a rounding top formation that was confirmed by a break lower in 2018. From a technical perspective, this chart has little to commend it.
But let us broaden our horizons and incorporate some data to establish whether investors are facing headwinds or tailwinds. The most obvious starting point is the economy. Figure 2 shows the annual growth in SA’s GDP from 1995 to 2019. Ignore the noise and two trends are apparent — the underlying trend from the late 1990s to 2008 was one of growth, and the converse occurred from 2009 to 2019. The first period was marked by SA’s most pro-business president in Thabo Mbeki, and coincided with the super-commodity cycle as China industrialised, and the infrastructural work ahead of the 2010 Soccer World Cup.
Look at Figure 1 in conjunction with Figure 2 and it is no surprise that the small-cap index had its best period of absolute returns over the period as it coincided with an expanding economy. As an investor it is wise to double down when you are satisfied the technical picture is being corroborated by the broader fundamental one. In sailing terms, when you have the wind at your back.
Moving on, Figure 3 is really concerning — especially when viewed with Figure 2. Post2008, debt has climbed substantially while GDP growth has been falling. This is the exact opposite of the previous decade, with debt to GDP now close to 70%. The reason is known to all: the catastrophic failure of our state-owned enterprises (SOEs).
Figure 3 opens a Pandora’s box. The investment community and financial advisers in general fixate on benchmarks and generally eschew cash as an asset class. People invest to make money, so it makes sense then to compare your benchmark against cash.
Private sector returns will be after-tax and the money market rate will be pre-tax. To ensure you are comparing apples with apples, make the tax adjustment to the money market first. Second, equities carry a risk premium over cash, so make the necessary adjustment and then make the comparison. If you are not being adequately compensated to hold a riskier asset (such as equities), especially in a stagnating economy facing structural headwinds, then be comfortable holding cash (at least your asset base is growing).
Figure 4: Armed with some knowledge, let’s start to address some of the headlines. “It is darkest before dawn” —
factually that is a sound statement. The question an investor should ask is: what is the time? If it is midnight, dawn is hours away and there is no reason you need to swing at any of the pitches the market is throwing at you. However, if it is 4am and the birds are starting to stir, you might want to start looking a little more carefully.
“Small caps are on sale” — when you see earnings multiples of five, six and seven times and price-to-book values of one, investors believe the market is cheap and there are bargains to be had. Several things struck IM after updating investment models recently — the deterioration in working capital and cash flows, rising debt levels, margin compression, impairment of debtors to comply with new International Financial Reporting Standards accounting standards and gloomy outlook statements from CEOs.
Take a step back and ask what the catalyst will be to lift earnings. A couple of years of earnings falling by 10%-20%, and earnings multiples of seven times quickly become double digits.
“Is it time to ditch SA equity?” — this is hard to answer.
The JSE all share is at about the same level as in mid-2015, and there have been four years of trading in a 5,000-point range above and below 55,000. It could be argued that the price action on the JSE is mindful of the enormity of the quandary facing investors. IM believes the key question investors need to ask is: are SA’s problems cyclical or structural? If you believe they are structural, the next question becomes all the more pertinent: does the ruling party have the political will to address them?
A structural problem is one that is permanent or long-lived, whereas a cyclical one will see the economy revert to previous growth levels in a few years. Many people believe state capture has been the root cause of SA’s problems, and when that is dealt with there will be an increase in economic activity. That view would tend to side with the problems being cyclical rather than structural.
Those in the structural camp see problems that include high unemployment and a highly regulated labour market. Then there is policy uncertainty: be it National Health Insurance; expropriation without compensation; poor-quality education; Eskom and other SOEs; rising debts; decreasing tax receipts and a shrinking tax base; a growing shortage of skills; high crime levels; dysfunctional municipalities; transformation versus meritocracy; lawlessness and violence in certain sectors of the economy; a lack of trust between the state and the private sector; and a large, largely unproductive civil service.
“The market is cheap by historical standards” — investment houses love to trot this one out from time to time. In reality, comparing one period and the next is meaningless, unless the periods being compared are identical in every respect (interest rates, growth rates, level of currency or anything else that affects earnings and valuations).
Peter Clucas, the late doyen of the stockbroking and fund management industry, used to bring out a list of shares towards year-end for inclusion in the Christmas stocking. Grandpa would get the staid dividend payer and the children racier small caps. Unfortunately, IM has taken a step back rather than a specific recommendation, and a framework has been laid out to help you decide whether now is an appropriate time to invest in the small-cap arena, where most counters’ fortunes are tied to that of the country. ●