WHAT’S THE TIME?

Some of the say­ings trot­ted out by com­men­ta­tors need care­ful ex­am­i­na­tion

Financial Mail - Investors Monthly - - Contents -

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. ●

Pic­ture: 123RF — ARTURALIEV

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