ZSE is overvalued, but it will keep climbing
THE stock market has yielded hefty re- turns for investors over the first two months of the year. The ZSE mainstream index rose by 58% in nominal terms and about 53% in real terms.
The gains in United States dollars are upwards of 50% for the average market but for individual stocks 40 counters are trading at either double or tripple digit growth rate on the same scale.
In fact, 12 counters have year to date returns of above 100%. Looked at both from a historical perspective and forward looking, short term outlook, these numbers are very scary. The numbers are scary not because of the growth rates per se, but the share valuations that come with the growth. The valuations for the broader market and at least 90% of the stock market by counters, clearly shows overvaluations.
What is more worrying is the margin of variance between the current price and the implied intrinsic value of the counters ascertained through conventional valuations.
A further stress test of the current valuations for both the broader ZSE and the individual counters also shows similar results of overvaluation when looked at from a historical and long-term perspective. The stock market rallied strongly in 2020 amassing about 640% in annual returns. This was its strongest performance since 2009 in real terms.
In US dollar terms, the stock market returned about 100%, which was astronomical and the highest for all sub Saharan Africa markets. Twenty-three counters had gains of between 1000% and 12000% in 2020 in nominal terms, which would deduce to circa between 100% and 1000% in USD terms at a blended interbank and parallel market exchange rate of 1:100.
The gains in 2020 were largely driven by value preservation. Investors wary of hyperinflation dumped ZWL into stocks. The local currency was losing value at astronomical rate given an exchange rate depreciation of 78% in 2020.
At the beginning of the year the local currency was trading 1:18 to the USD on the formal market and 1:22 on the parallel market but by the end of the year the unit’s valuation had depreciated to 1:82 on the formal market and 1:110 on the parallel market, deducing to average depreciation of about 80%.
In turbulent times and times of high uncertainty, investors typically tend to invest more in less risky assets such as gold and stocks. Bond yields normally tumble as economies attempt to curb an economic decline through quantitative easing as is the case in Europe and US at the moment.
For Zimbabwe, high inflation discourages investments in money market instruments and deposits with banks as the balances are eroded quicker than they generate a return.
Zimbabwe’s inflation climaxed at about 830% in August 2020 and these levels were last seen during the world breaking record hyperinflation period of 2008. Interest rates for 2020 averaged about 50% p.a which was not commensurate to generate a positive return for money market investments and at least preserve value for bank deposits.
The question thus becomes of how far up the market had to go other than the direction it had to take. The question on how far up the market had to go in 2020 and again in 2021 can only be answered through ascertaining the intrinsic value of counters. The intrinsic value in turn can be deduced from a fundamental analysis of individual company looking at company specific and macro fundamentals.
The simplest form of equity valuations is use of multiples. These are basic ratio relating to profitability as a measure of a company’s intrinsic value. The most common ratio is the Price to Earnings ratio, which shows how many times investors are willing to pay for a dollar generated as earnings.
A ratio of 1:10 or 10x (times) in a company A shows that investors are paying 10x for a dollar of earnings in generated in company A. These individual ratios are collated together with the rest of the sector to come up with a sector average. If the sector average is 15x, it means on average investors are willing to pay 15x for a company which falls in that respective sector.
Thus if company A above falls in sector A and is trading at 10x it means investors in that sector are not paying high enough in share price to compensate for the earnings generated in that respective company A. It is such companies that have lower than sector average which typically exhibit upside. The opposite is also true for counters trading at Price Earnings Ratios above their peer average.
A look at ZSE shows that at least 93% of the listed counters are trading at PE ratios that are above their long-term averages for their respective sectors. Looked at from a more sophisticated angle, companies have to generate profits at a far much higher rate compared to present growth levels to justify valuations.
For the average ZSE, the PE ratio is now at above 50% which compares adversely to a long-term average of 10% for the bourse. A study by Equity Axis shows that six of the top 10 counters by market capitalisation have disproportionately higher
Price Earnings Ratios. These findings were arrived at after factoring regional exchanges and the companies that respectively listed on these bourses, to determine sector averages.
As a stress test of the findings, Equity Axis referred to historical prices of respective counters. Current valuations are also way above historical averages in stable years.
The study used 2014 as the base year given that inflation was still very low, the economy dollarized to a larger extend and government Treasury Bills issuance was still very negligible. Most companies are trading at least 2 times their 2014 levels and yet profitability of these companies has grossly reduced over the last two years.
Assuming aggregate demand would have remained stable over the last two years and that the economy was on positive economic growth trajectory, at best, the ZSE would be trading at 2014 price levels. The variances arising from both multiples valuations and a historical equivalence reflect that the current valuations are higher than they would typically be.
The assumption here is that most of the savvy investors are aware of this but there could be other factors influencing the rally.
So far, in the narrative above we have largely referred to company specific fundamentals as an influencer of performance, thus omitting the impact of macro fundamentals.
The economy has largely been shaky and currency stability is still very fragile and these are worrying signs. Inflation is coming off by pockets of growth are noticeable.
While these are symptoms of a fragile economy, the observations have a bearing on investor sentiment and valuations. There is overweight in terms of sentiment that the Zimbabwean-dollar will not sustainably stabilize against the USD, in the very short run. This view is despite an overwhelming sentiment that economy will at least grow in 2021.
These combined sentiments have the net effect of driving up share prices, sometimes even above their intrinsic value. All this is abated by a porous financial system abating “forex burning” through the interbank and indiscipline in money supply.
Gwenzi is a financial analyst and MD of Equity Axis, a financial media firm offering business intelligence, economic and equity research. — respect@equityaxis.net.