How to pick stocks in a lacklustre market
Bear markets and recessionary times in fact offer great buy opportunities for investors. But it is important to pick stocks that will withstand the bad times. Trader Petri Redelinghuys explains his methodology to find local winners.
it is no secret that the South African economy is in trouble. After a brief bout of Ramaphoria, markets once again realised that we had had ten years of Zuma – and now four years of sideways market action with no real return.
This could no longer be ignored as SA has decaying economic conditions and wilting confidence, both domestically and from the international investment community.
SA has a monumental task before it and the changes needed within governmental structures and in the broader socio-economic landscape will take a lot of effort and a lot of time to affect. It may feel like time passes quickly, but the reality is that things change slowly.
Optimism is not ill-founded. But we must stay cognisant of the current state of our economy and how the current economic backdrop can either perpetuate current market themes or perhaps ignite new ones.
THEME 1: Times of uncertainty
The theme dominating the SA investment landscape at present is probably that of uncertainty. No doubt something that many are tired of hearing about by now, as financial media has made countless references to uncertainty being the driver behind the poor market performance locally.
But to contextualise: Investors base their decisions to either invest directly into an economy or via financial markets on a set of long-term objectives unique to them. They have an almost infinite number of investment options from which they can choose and therefore endeavour to choose the investment that they believe will best balance their appetite for risk with their expectation for return.
Going through five finance ministers in six years does not exactly communicate a message of stability and low risk.
When things like the leadership of arguably one of the most important ministries in a country can change so abruptly, it becomes difficult to forecast what conditions are going to be five or ten years from now. Therefore, investors are reliant on the recent past as a frame of reference. Thus far that frame of reference indicates that the leadership structures in our government are unstable and unpredictable. Even though we now have a very strong and credible finance minister in the form of Tito Mboweni, given the recent track record we cannot at all be certain that he is going to still be around in a few years from now.
Add to that the rhetoric around land expropriation without compensation; failing state-owned enterprises in constant need of taxpayer-funded bail-outs; growing discontent towards government from the public; our ailing economy; excessively high unemployment; and all the various external fears and shocks caused by the pull-back in international markets… Ladies and gentlemen, we have a recipe for uncertainty about the future. Put more simply, we have a lot of risk and no way of knowing whether that risk will reward investors in accordance with their expectations for returns.
This theme has had a major influence on our economy over the last two years. This is best reflected in the decline in foreign direct investment in SA since 2016.
THEME 2: Recession time
The next major theme is that of decelerating GDP growth. SA’s GDP growth forecast has been cut from 1.5% for 2018 to 0.7%, with the economy shrinking a seasonally adjusted annualised 0.7% in the second quarter, following a 2.6% contraction in the first quarter. According to economist Mike Schüssler, and the BankservAfrica Economic Transaction Index (BETI) September report, GDP could well have picked up somewhat in August – maybe even enough to have put an end to the technical recession.
But he warns that the uptick in the BETI was mainly due to backdated “salary increases for civil servants in July and August, and the late salary adjustments of Eskom employees and some municipal workers. We may still see delayed backdated payments occur
in September, which will add to economic transaction improvements.”
He warns that “one or even two months of data are hardly ever an indication of a change in trend. The delayed salary increases have certainly played a positive role but, once these are out of the system, the underlying downward trend may continue.”
The BETI measures economic transactions among bank accounts in SA and is a very reliable indicator for the level of economic activity with a very high correlation to GDP.
Schüssler’s report might therefore indicate a short-term reprieve from the contracting GDP, but the message is clear: Don’t hold your breath.
THEME 3: Government debt
Over the last decade, SA’s budget deficit has averaged 4.3% of GDP and came in at 4.6% of GDP last year. This year it is forecast to be 4% (revised from 3.6%) and is expected to rise to 4.2% in 2019/20, after which it should stabilise at 4% in the years that follow.
This budget shortfall needs to be funded somehow, which means that government needs to borrow money from capital markets. Over the last decade, government debtto-GDP has nearly doubled to 53.1% of GDP last year, with the expectation that it will stabilise at 59.6% by 2023/24.
Therefore, debt payments are becoming a larger portion of government spending (it’s the thirdfastest growing expense the SA government has).
Further, the rising yields of 10-year government bonds is a sign that investors are becoming less confident in SA’s ability to repay its long-term debt obligations and are thus selling their bonds. It follows that if this trend continues, the cost of finance could increase to an unaffordable level over the same period that the government debt-to-GDP ratio is expected to reach nearly 60%.
Our new finance minister has warned that if government debt-to-GDP exceeds 60%, SA would potentially have to approach the International Monetary Fund (IMF) in search of funding the country. The IMF is likely to impose all sorts of austerity measures as a condition to extending finance, which would pretty much guarantee lower levels of government spending. That would probably cost our economy many government jobs, as well as even lower levels of overall service delivery.
Thankfully, Ramaphosa is being very proactive about bringing reforms to government and attracting direct investment into our economy. Also, our new finance minister seems to be committed to not increasing government’s spending limit. This could help SA fight back against the forces of a slowing economy and an ever-increasing budget deficit.
THEME 4: Investor confidence
The confidence that ratings agencies have in SA’s ability to turn the ship around has had a major influence on our economy and contributes to the theme of uncertainty. Both Standard & Poor’s and Fitch ratings agencies have downgraded SA government debt to sub-investment grade, or junk status.
For now, Moody’s Investors Service has been SA’s saving grace as they still rate our government debt one notch above junk. This means that our government bonds are still included in major global bond indices and are therefore still being held in major global bond funds.
Although Moody’s has expressed that it considered the medium-term budget policy statement, delivered by Mboweni in October, as credit negative, it has not made any adjustments to SA’s credit rating and is probably unlikely to do so until after the general election next year.
Politicians tend to beat all sorts of drums to get elected into office, but once there, their – and humour me here – “promise to delivery ratio” is rather low. Therefore, we are unlikely to have a clear plan on how land expropriation without compensation will be implemented, for example, until after the election. On that basis, it is equally unlikely that we will see rating agencies make any changes to their outlook on the economy until “the pudding is served”.
THEME 5: A bear phase in developed markets
Tightening monetary policy in developed economies like the US and EU is not only removing liquidity from global markets and driving the flow of investment away from emerging markets into developed markets, but is also probably the main antagonist behind the global market correction. The impact a larger-scale global correction could have on already underperforming emerging market economies should
Even though we now have a very strong and credible finance minister in the form of Tito Mboweni, given the recent track record we cannot at all be certain that he is going to still be around in a few years from now.
not be underestimated.
It would not be surprising to see developed markets enter a bear market, or even a recession, over the next 6 to 18 months. If that does in fact happen, the likelihood that our economy and market follows a further downward trend is extremely high.
The investment thesis
Each of us must sit down and consider whether these themes are more likely to persist or dissipate over the medium term. If you are of the view that they will dissipate, then you’d probably look to buy the shares you want now as they are currently available at a discount. If, however, you believe that these themes will persist, then you have two choices: Invest in non-cyclical defensive stocks, or invest in long-term value stocks.
As a general warning: Even though there is value to be found on the JSE now, share prices could come down more if these themes persist. The likelihood of buying at the bottom is rather low and you might need to exercise patience before you can reap your reward.
Non-cyclical, defensive stocks
Non-cyclical stocks, or defense stocks, are stocks that are in economic sectors that are generally not affected by the cyclical nature of markets. In other words, these companies are in sectors that are generally not too affected by changes in consumers’ disposable income. The primary sectors considered to be defensive are: consumer staples such as food retailers and producers; “sin stocks” such as alcohol and tobacco companies; healthcare and pharmaceutical companies; utilities such as electricity and telecommunication providers; and then, of course, “safe haven” commodities such as gold, copper, timber and maize.
When looking for shares in defensive sectors, we must be prudent to only buy those that have a solid investment case. It is a bit of a process to find these stocks, but luckily technology has made it somewhat easier.
You could start by making use of the stock screener available for free on www.investing.com to scan for stocks that are in the consumer/non-cyclical sector, or any of the other traditionally defensive sectors.
Once you have a list of shares, you are then able to filter them further so that you can isolate those shares that match whatever fundamental or technical criteria you might specify. From there, you are able to study each of the stocks on the list and decide whether to invest or not.
A good start is to scan for companies that have a positive dividend growth rate, a price-to-earnings ratio (P/E) of less than 16, and a total debt-to-equity ratio of less than 51%. From there, further filtering for liquidity, and doing some research on the companies themselves, could help to compile a list of potentially investable stocks.
I HAVE COMPILED A LIST OF COMPANIES FOUND IN THIS MANNER:
1. Astral Foods
P/E: 5.57 Dividend yield: 9.45% Dividend growth rate: 33.84% Debt-to-equity: 1.03%
Astral Foods is a major chicken and agricultural feeds producer. During the last financial year, it sold more than 230 000 tonnes of chicken and over 703 000 tonnes of maize. Fifty-nine percent of that maize was sold internally to the company’s chicken producing division. Thus, it is vertically integrated and capable of sustaining its chicken production from its own agricultural feed production.
Chicken also happens to be the primary source of meat protein for most South Africans and is also by far the cheapest. A strong recommendation has been made to zero-rate VAT on chicken and if that were to happen, it would no doubt have a tremendously positive impact for chicken producers.
The share price has been under a lot of pressure in recent times, although the latest trading statement indicates that full-year headline earnings per share (HEPS) will reflect an increase of between 90% and 100%.
Astral is not only a defensive stock, but a value stock as well.
2. Tiger Brands
P/E: 13.23 Dividend yield: 4.2% Dividend growth rate: 4.7% Debt-to-equity: 7.8%
Tiger Brands operates in the consumer staples space, with brands such as Oros, Koo, Tastic, Albany, King Korn, Purity, Enterprise, Jelly Tots, All Gold, Beacon, Black Cat and more.
The share price was recently hit hard, as the company was responsible for an outbreak of listeriosis. It appears that the fallout from that outbreak has now been contained as Tiger Brands reopened the factory in Germiston that was responsible, after rigorous assessments by the department of health.
P/E: 9.3 Dividend yield: 6.5% Dividend growth rate: 18.2% Debt-to-equity: 34.9%
Telkom has pulled off a remarkable turnaround over the last five years. It has restructured itself by acquiring BCX (an ICT services company), availed its infrastructure via Open Serve and outsourced maintenance and management of its assets through a wholly-owned entity called Gyro.
The next step forTelkom would be to start unlocking value from its new data products and growing its mobile market share. Over the last five years, the company has proven itself able to adapt and improve on a consistent basis.
P/E: 13.5 Dividend yield: 6.6% Dividend growth rate: 1.7% Debt-to-equity: 50.1%
Vodacom has operations throughout Southern Africa, with its largest market being SA itself. During the 2018 financial year, it added 7m new customers and grew its revenue by 6.3% to R86.4bn. Sixty-three percent of Vodacom’s revenue is earned in SA, while the remaining 36% is earned from other countries in the Southern African region.
Like other wireless telecommunications companies, revenue from traditional voice calling is decreasing, while revenue earned from data services (including fibre internet, etc.) is increasing.
An exciting add-on to Vodacom is M-Pesa, which last year helped 11.7m customers (an increase of 30.4%) process transactions worth R1.3tr, resulting in over R1.9bn worth of revenue for Vodacom.
Vodacom only just barely makes the cut from a value perspective, although it does look like a well-positioned defensive share.
As investors, we must remember that bear markets and recessions are huge opportunities for us to buy into great companies at great prices and attain great returns over the long term.
When searching for shares that can be classed as value stocks, you can use the same fundamental and/or technical criteria you used to filter out the better stocks in the non-cyclical/defensive sectors. Expanding on those criteria could also be done if required. This time, though, the search is done across the whole market and not just the non-cyclical/ defensive sectors.
1. Standard Bank
P/E: 10 Dividend yield: 5.7% Dividend growth rate: 15% Debt-to-equity: 14.1%
Banks in general have been under a huge amount of pressure recently, and if the themes above continue to play out, banks will likely remain under pressure for some time to come. Although, at present, banking stocks come with a clear warning label, some of them are starting to show some value.
The Standard Bank preference share, however, offers an opportunity to get into a much lower risk version of the share with similar fundamental values. The difference is that you are guaranteed a 6.5c/ share dividend, twice a year. With the preference share trading below R1 a share, this represents more than 13% dividend yield (15.29% D/Y at R0.85 per share). If investing for dividends is your goal, this is great value.
2. SA Corporate Real Estate
P/E: 9.19 Dividend yield: 11.3% Dividend growth rate: 8.1% Debt-to-equity: 45.7%
Of the property stocks that make the list, SA Corporate Real Estate offers the highest dividend yield at 11.34%, making it very attractive.
Between 2012 and 2017, the company successfully affected a turnaround strategy and converted itself into a corporate real estate investment trust. It has also successfully diversified its property portfolio, as it now owns properties in the industrial, retail, commercial, residential and storage sectors in SA and boasted a vacancy rate of only 4.5% during the previous financial year.
Finding your own winners
The stocks discussed above are only a handful of shares that match a very narrow set of criteria. There are many more companies out there that are offering different forms of value for investors who have a long-term investment horizon.
Investors will need to do some work to look for them, which will take effort and time, but if the themes discussed above persist, the work done to find the longterm value or defensive stocks should pay off in a few years. It is not easy to predict what is going to happen, but searching for value has never been to anyone’s detriment. Things are volatile and fragile out there. Taking the time to find quality shares might not pay off immediately, but over time, holding quality will stand you in good stead.
As investors, we must remember that bear markets and recessions are huge opportunities for us to buy into great companies at great prices and attain great returns over the long term. The trick is to find companies that are likely to still be around in 20 or 50 years from now, and that are trading at prices that are attractive enough to buy, even in the bad times.
Tito Mboweni Finance minister
Mike Schüssler Economist