SA Inc still offers value
Political misrule has seen headwinds grow in the past year, writes Janice Roberts. Yet analysts say corporate SA’s resilience and China’s economic recovery present some tailwinds. The impact of load-shedding, however, may be underestimated
The challenges facing the country have mounted since last year’s Ranking the Analysts report, with the fallout from South Africa’s stance on Russia’s invasion of Ukraine and US accusations that South Africa is supplying arms to the invaders but the latest in a long list of structural headwinds that have put its attractiveness as an investment destination into question. Yet corporate South Africa is resilient and still offers attractive returns.
Any loss of trade with the US or other Western nations that make up the huge majority of South Africa’s export partners, as a result of the US’s accusations earlier this month that South Africa was supplying arms to Russia, will add to the economic destruction being caused by the power blackouts, logistical port and rail constraints, unacceptable levels of crime and corruption, and the country’s greylisting by the Financial Action Task Force.
In short, all these stem from varying degrees of political misgovernance.
South Africa’s GDP declined 1.3% in the fourth quarter of 2022 against market expectations of a contraction of 0.4%,
Stockpicking is becoming more important than a broad market or sector approach
signifying that the country could be heading for a recession. The IMF has drastically slashed its projections for South Africa’s growth this year from 1.2% to 0.1%.
Yet Marc Ter Mors, head of equity research at this year’s winning firm SBG Securities, says despite the electricity crisis and other constraints, SBG’s house view is that South Africa still presents an attractive investment opportunity.
“Even if South Africa’s economic growth is limited to Standard Bank’s forecast of 0.9% growth this year, South African companies tend to be able to eke out quite decent earnings growth. If we look at our own earnings forecasts, we expect this year’s earnings for the South African market [excluding resources] to improve by between 10% and 15%, which is quite high. The average consensus for emerging markets is for flat to slightly lower earnings and therefore South Africa can be seen within emerging markets as a relatively more defensive market.
This speaks to the quality of companies that are listed, but also, in effect, to less competitive conditions in some of the sectors and therefore a better ability to pass on inflation.”
Ter Mors believes that concerns about global inflation and higher interest rates are expected to fade as the US Federal Reserve nears the peak of its rate hiking cycle. This follows the Fed’s May meeting at which it raised its benchmark overnight interest rate by a quarter of a percentage point to the 5%-5.25% range, at the same time signalling a potential end to rate hikes.
“Investors are beginning to focus more on economic growth and the earnings growth of companies rather than on inflation. Markets are now pricing in gradual cuts by the Fed before the end of 2023,
Marc Ter Mors, head of equity research at SBG Securities
but we at Standard Bank are a bit more cautious and believe that rates could remain level for a bit longer than what the consensus is pricing in.
“We expect another 25 basis point hike from the South African Reserve Bank at its May meeting and then in our base case, 25 basis point incremental cuts to 7% next year, assuming that the Fed has finished hiking rates.”
He points out that, barring Argentina and Turkey, inflation is actually lower in emerging markets than developed markets and in South Africa it hasn’t reached the elevated levels seen in the US and the eurozone.
Matthew Rattray, CEO of this year’s runner-up firm RMB Morgan Stanley, says there has been a significant shift in investment dynamics across markets within the past 12 months.
“A year ago, we were concerned about the lack of growth from China and worried that the resilience from the US would start to fade at some stage. Now, we worry about the extent of the slowdown in the US and question the strength of the Chinese recovery.”
He says growth in developed markets has slowed and, coupled with considerable earnings risk, this means that Morgan Stanley strategists are forecasting downside in several of the main developed market equity indices. There are, however, grounds for more optimism on investment returns in emerging markets.
“There is little evidence that emerging economies have ever successfully decoupled from developed markets, but this time may be different given the size of the Chinese economy [$17.7-trillion, making it the second-largest economy by GDP in the world] and the low base that China is now coming from,” says Rattray.
Combined with cheap relative valuations for emerging markets, he says, there is less downside risk in earnings expectations and the probability of a weaker US dollar and emerging market equity returns are potentially positive, despite the developed market outlook.
Ter Mors says the demand for emerging market investments isn’t particularly strong. Usually, capital flows into emerging markets when risk appetite is robust, US rates are low and growth prospects strong.
“This is not happening right now and though sentiment on China is improving, after some extensive Covid-related lockdowns, this is balanced by a recession risk in the US and weak growth in the eurozone. South Africa can therefore be seen as a more defensive emerging market, where valuation multiples have not been this low since the global financial crisis, so quite a lot of the bad news has already been factored in.”
Unfortunately, South Africa’s relevance in some market indices has weakened. “Ten years ago, South Africa’s weight in the MSCI emerging markets index was 9%-10%, but now it’s barely 4%, mainly because of the rise of the Asian economies, so as an investment destination the country has become less relevant over time,” Ter Mors says.
There were substantial foreign inflows into South Africa in both equities and bonds last year. “Foreign direct investment, which had deteriorated partly due to the pandemic, also picked up quite materially in 2022 to an estimated $13bn and was mainly related to investments in renewables and more private sector power supply.” This year, there have been only small inflows into the equities market.
He says the list of risks that investors feel they should be rewarded for has grown because of the country’s challenges, which now include greylisting, “so certainly the cost of capital in the past 10 years has increased”.
Next year’s national elections are also on that list of risks. “A lot depends on the extent of the loss of majority for the ANC,” Ter Mors says.
“If the ANC receives slightly above or below 50% of the votes, this would have little impact on policies, but if there is a substantial loss of support for the ANC, that would create the opportunity for a large coalition partner and therefore the risk of shifts in policy. Depending on the coalition partner in question, this policy shift could present concerns for the investor community.”
Even though South Africa remains investable, Ter Mors cautions that stockpicking is becoming more important than a broad market or sector approach.
“One needs to be selective about which sectors and which stocks can be considered defensive in terms of earnings sustainability. As a research team, we prefer to have defensive retailer exposure such as drug and food retailers. The banking sector also looks attractive.”
Rattray says South African equities face a conundrum: “The large weight of dual-listed stocks means the all share index has a high correlation with global equities but significant direct [Naspers, Prosus and Richemont] and indirect [via exports] exposure to China look set to soften the blow of the potential global slowdown.
“Moreover, the nearly 9%
weight of the gold sector in the capped Swix benchmark adds another significant layer of diversification to SA equity portfolios. Of course, there is a large swathe of JSE equity listings that have to contend with the domestic earnings environment and this is being severely challenged by the electricity crisis.”
Load-shedding is no doubt the biggest concern across the market at the moment, says Rattray, as the strain of stage 6 and above ratchets up production costs and triggers significant amounts of downtime.
“Private sector investments to offset the electricity deficit are well under way, but look unlikely to make a meaningful difference until later on in 2024 given the speed at which new generating capacity can realistically be rolled out.
“However, reluctance to allow wheeling through the grid may prevent the success of private sector rollouts in other emerging markets from being fully replicated in South Africa. In the meantime, loadshedding risks sending the economy into recession with negative ramifications for the fiscal position and the current account.”
Kela Securities CEO Lesedi Kelatwang says the risk posed by Eskom to consumers is underrated. “We worry that the market is yet to adequately grasp the true extent of Eskom’s impact on the South African economy and advise investors to take extra caution when looking at JSE stocks with substantial exposure to consumers, particularly consumer credit.”
Noting how far off consensus was with forecasting South Africa’s GDP growth over the fourth quarter of 2022 as Eskom woes deepened, he says that analysts did not fully appreciate the risk posed by Eskom to the economy.
“Given Eskom’s coverage of both the formal and hard-toquantify informal sector, we believe the latter was key to the increase in forecasting risk as the impact of load-shedding increased.
“For businesses servicing lower LSM segments, this is very worrying. Findings from a survey conducted by Nedbank and anecdotal evidence from businesses such as Norcros Plc not only confirm our view that the lower and largely informal segment of the market has been severely affected, but they also suggest this is having a significant knock-on effect on our JSE-listed businesses.”
He adds that while demand from the lower income segments looks set to decline in a way that will surprise the market, demand from middle- to high-income segments could also fall off sharply, or at the very least, at a notably higherthan-expected rate.
“With South African consumer/credit-facing stocks primed to disappoint, more specifically banks, food and clothing retailers, we also see residential property, motor vehicles and insurance sectors coming under notable pressure,” Kelatwang says.
“Like banks, insurance will not only feel the pain from existing customers, but the growth in new business will also struggle because of the downturn in new property and vehicle sales. Of the sectors where we see limited downside risk, we prefer telecom and South African miners.”
Kelatwang says that as the rand price of gold for some miners is up about 33% year on year and with some of them reporting negligible creep in operating costs despite Eskom issues, the operating leverage could see earnings for some gold miners achieve high double-digit growth over the near term.
“This sector has, however, rallied 50%-60% year-to-date already while earnings are yet to catch up. Investors would have to be constructive in finding opportunities here.”
With hopes pinned on a Chinese recovery, he sees buying opportunities in some PGM and diversified miners.
“The lifting of lockdown measures saw the local consumer sector grow 10.6% year on year but industrial production, which drives demand for South African commodities, grew only 3.9% despite exports rising 14.8%. As this suggests that the modest growth in industrial production was largely due to domestic demand, we believe this too will catch up as business confidence picks up. Therefore, we still expect PGMs and diversified miners to benefit over the near term.”
Rattray says South Africa’s difficult macro and micro backdrop is being reflected in hefty downgrades to the South Africa Inc earnings outlook and has been a catalyst to push local pension funds to allocate more assets under management abroad.
“On our calculations, the
We worry the market is yet to adequately grasp the true extent of Eskom’s impact on the economy
Lesedi Kelatwang, the CEO of Kela
offshore allocation of the average South Africa domiciled pension fund is now close to 40%, up from 30% at the end of the first quarter of 2022. This points to continued selling pressure in the short term, until the average offshore allocation hits the 45% limit [as specified in the change to regulation 28 of the Pension Funds Act that came through in February 2022].”
He says the combination of negative revisions to GDP and earnings plus the reallocation of funds abroad is weighing heavily on South African asset prices, particularly in dollar terms as the rand ratchets lower.
“The upshot is that price-toasset multiples for domestic earners are starting to screen as deep value relative to their own history and compared with cross-border peers. However, there are still significant concerns about growth or the lack thereof in the current domestic environment.”
Rattray believes next year’s general election means there is a lot at stake for the ANC.
“In our base case we expect the South African electricity crisis to slowly improve over the next one to two years as more private sector investment in renewable power comes online. In addition, the drag from regulation 28 transitions should find a new equilibrium around the 45% offshore limit, stemming the tide of outflows.
Both these factors set the scene for better returns in the medium to long term, particularly if the election timetable turns out to be a catalyst for more reform.”
Ter Mors says Standard Bank is continuing to grow its franchise among South African and global investors with the number of analyst road shows increasing in both European and US markets.
“This may be an indication of continued interest in the future for inflows into South African markets, but we are still waiting for structural reforms to become embedded in the economy, particularly relating to the electricity situation, but even water scarcity and quality, as well as logistics infrastructure.”
He says there has been strong uptake of Standard Bank’s expanded ESG product as well as its corporate commissioned research offering, in which many small and midcap stocks not covered by the broker community due to commercial and regulatory changes pay for research to be covered and generate consensus earnings forecasts.
“The value proposition is that the broker will continue to cover a company and therefore the investment case is better understood by the investment community — and that over time will be positive for liquidity in the share and possibly valuation outcomes.”
Historically in South Africa, says Ter Mors, small and midcaps outperform over the longer term.
“So, it would be amiss if investors don’t get exposure to some of the attractive investment cases because of the lack of sellside coverage and insight.”