Investing for value

With SA still in a post-recession phase, the investment landscape has changed considerably.

As the country’s previous recession was 17 years earlier, for many of the investment professionals practicing today, this is virgin territory.

A Reinhart and Rogoff paper (January 2009) showed that the aftermath of a financial crisis and consequent recession sees the following average peak-to-trough market moves:

• 1. Real house prices decline an average of 35% over six years
• 2. The unemployment rate rises an average of 7% over four to five years
• 3. Output falls by 9% on average over roughly two years before recovering
• 4. The real value of government debt tends to explode, rising on average by 86% and is predominantly attributed to the collapse in tax revenues combined with over ambitious countercyclical fiscal policies aimed at mitigating the downturn.

In South Africa, the consumer accounts for 64% of domestic expenditure. After five years of boom, retails sales slumped in 2008, turning negative in real terms in the middle of the year.

The SA Reserve Bank has cut interest rates aggressively to stimulate consumer demand but household savings are now as low as they have been for 40 years. The already overly-indebted South African consumer is unwilling to take on more debt while regulation such as the National Credit Act exacerbates this situation.

Inflation pressures are on the up side and we do not envisage consumer price increases being tamed in the medium term. Unit labour costs are rising at 8,7% a year (services account for 44% of the CPI basket), the rand petrol price continues to drift upwards and we have massive electricity price hikes scheduled for the next three years which will have a domino effect on much of the CPI basket.

We believe that the South African investment market is generally expensive at present.

Listed property
On a yield of 7,8%, listed property looks vulnerable. In the past there have been periods when listed property has suffered extensive setbacks over a relatively short period. For example, in 1998, the market lost 35% in five months and again in 2007 it fell by 34% in eight months.

Marriott research shows that half of the total return from listed property comes from the starting yield. In the past this asset class has delivered exceptional total returns but at current yields of 7,8%, we believe this is too low.

Expected total returns from this base are modest, while there is a far higher risk of capital loss particularly considering the low anticipated earnings growth.

Bonds
Local government bonds represent another asset class with yields that concern us. South African bonds have experienced an eleven-and-a-half year bull market, however this trend seems unsustainable as a result of ballooning fiscal deficits and risks to the inflation outlook. At 8,8%, the yield is currently well below the long-term average of just under 13%.

Equities
In the case of South African equities, approximately 25% of the total return is derived from the starting dividend yield. With a long term average yield of 4%, local equities are currently looking expensive on a dividend yield of 2,2%.

Compounding this is the issue of dividend growth.

Dividend growth has a profound impact on total return and is likely to be subdued in light of current economic conditions. The government’s 2010 budget review supports this, noting that corporate earnings are likely to decline by 4% in real terms over the next 12 months. Under this circumstance, stock-picking is critical.

From 2003 to 2008, we saw staggering growth on the JSE Securities Exchange, which is unlikely to be repeated in the near term:
All Share: +337%
Resources: +412%
Small Caps: +554%
Property: +358%

With these asset classes all currently overpriced, where should investors place their assets?

Preference shares
Certain preference shares, which are priced relative to interest rates, are yielding about 8% at present, a higher return than cash.

With the income from these instruments being classified as dividends, it is tax free. In late 2008, in the wake of the global financial crisis, the preference share yield rose well above that of cash, currently 1,5% higher. On an after-tax basis, the spread is even greater, although the actual impact would depend on the individual’s tax rate. The real opportunity lies in capital gain should this gap narrow.

Inflation-linked bonds
As an alternative to investing in equities, we view inflation-linked bonds as a sensible option in the current environment because both the income and the capital are inflation hedged. With a yield of 3,3% and an expected capital growth of 6%, together with a re-rating potential given our inflation outlook, these instruments are offering good value to investors.

With uncertain total return expectations from property, fixed-interest bonds, and equities, combined with very low cash yields low cash yields, we consider suitable alternatives to be quality preference shares, corporate debt and inflation-linked bonds.

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