The opportunity cost of doing nothing

The jury on whether the prevailing stock market valuations are sustainable or not is still out. In-fact, it is a recurring theme which experts in the field skirt and laymen often misinterpret. Whichever way one looks at it, it is apparent that these debates are stemming from a very volatile macro environment which often distorts value, leads to losses, rent seeking and misinterpretation of values by users. What is also generally true is that the prevailing ZSE valuations are abated not by underlying fundamentals but largely speculative movements emanating from hyperinflation and exchange rate volatility.

The question is, given this disconnect between the underlying fundamentals and stocks valuations, what should one do? Should one be a mere spectator, confined to the sidelines and let the volatility ease? The world over, stock markets generate value for investors or speculators through both volatility and asset appreciation. In more advanced markets, investors make money when the market goes in either direction through taking short or long positions.

Even in less advanced markets, a more diversified and hedged portfolio can take advantage of swings in either direction. A choice to stand on the sidelines does yield incremental value for someone even as it does not insulate one’s funds from the downside losses. In a market where inflation and exchange rate are worsening by the day, inaction comes with a negative opportunity cost.

We will get more practical with the above assertions. The stock market, the ZSE, rose by 311% in 2021 in Zimdollar terms and in constant US dollar value, the overall ZSE All Share Index was up 103% in real terms. This was the best performance of any subSaharan stock market including big names such as the JSE and the NSE. This movement shows that hypothetically, an investor who invested US$10 000 at the beginning of the year, closed the year with a return of 100%, which means they had made double what they invested in real terms. This was not a first, in 2020, the ZSE rose by almost 250% in real terms, which means gains were more than double in constant currency. These value surges coincided with a currency reform which kicked in early in 2019 and the resultant conversion of valuation into Zimdollar, grossly lagging exchange rate derived values, pegged on historical comparatives.

With a falling currency and expectations of higher inflation, the stock market, conventionally a safer haven given the underlying value represented by the listed businesses and their asset bases, began to rerate upwards.

The disconnect between the magnitude of gains and the underlying value is largely a result of distorted financials, replete with revaluations and similar non-monetary gains and losses, the premium derived from high uncertainties associated with the economy in general and the exchange rate and inflation in particular also double up on market valuations.

These premiums are synonymous with country risk discounts, which weighed on stock valuations during dollarisations. These premiums are a part of valuations which cannot be factored mechanically through fundamentals.

At the end, given these set of challenges you find a market very volatile and very much delinked to fundamental valuations and yet in its own right following a path informed by some macro developments and probable economic outcomes. Such is the case of equities in Zimbabwe.

Narrow valuations will consider conventional asset value or better, multiples valuations. Even in conventional valuations, analysts prefer less of net asset value models since these attend less to the earning power of the underlying business. In most instances a company’s market value is way higher than its asset value and this is because investors are more focused not on the asset base but rather the business’ potential to grow earnings in the future. So at the moment, a business such as Delta Corporation shows a net asset value which is three times lower compared to the market value of the counter on the ZSE. This would appear ridiculous, but one needs to stretch their mind a bit further and look at the relative asset value against the company’s earnings. Some businesses sweat less and yet derive higher incomes. This can be done through increasing the sale of high margin products.

For others this may be as a result of efficiencies and higher capacity utilisation. For Delta, which is the biggest counter on the ZSE the variance between the net asset value and the market cap is explained by the earning potential of the business, which has almost doubled following the increased shareholding in Afdis, acquisition of Natbrew Zambia and UNB South Africa. These businesses are undergoing recovery and restructuring and will most likely drive the company’s performance in the mid term to new highs.

Again, the company’s liabilities are wrongly weighed by exchange losses and creditor or shareholder dividends held by the State. These have an impact of dragging the company’s equity position lower.

While this seems as an isolated pick from the 50 active stocks on the ZSE, the truth is that although most businesses are operating below full capacity dampened by weak demand and inherent supply side challenges such as cost of capital and derelict equipment, there is clear upside and opportunities for growth. Most companies on the ZSE are recording sales volumes below historical highs and this means there is opportunity to grow.

It is this upside which investors are factoring when valuing stocks. A lot is therefore at stake for one to remain warped in the valuation narrative. It is a fact that the ZSE is moving, and while unbridled rallies are a huge risk, the ever-shifting exchange rate, on its own, is sufficient to move markets and in process provide opportunities for higher return.

We have witnessed a trend over the last two years, where the stock market and the exchange rate move against each other. At one point, the stock market lags the movement in the exchange rate and once a rally is triggered, the losses are overturned and a net positive return emerges. At the end of it, the year end overall gains having come up significantly positive over between 2020 and 2021, reflects that behaviourally, the market is likely to sustainably outpace the exchange rate.

We are of the view that the status quo in terms of economic outturn is likely to remain the same thus driving the stock market further up. We believe a fundamental driven correction is possible only if the economy stabilises. It is a long way through the tunnel till that is realised. In the interim we encourage risk aversion and bargain hunting in top tier stocks, with strong operating models.

It will also position investors in a better stead to apply technical analysis in their trading so as to ascertain entry and exit points. It is also more beneficial to apply shorter investment cycles and less rigidity in portfolio restructuring.