Mirror Image

Current valuations suggest an environment that is under significantly greater stress than what the actual real economy suggests. SA corporates remain cash rich, consumers are financially better off than they have been for many years and SA banks are over provisioned with loan loss experience that suggests a normal credit environment that is far from experiencing any undue distress. This disconnect between sentiment driven stock valuations and the reality we are seeing on the ground provides a very attractive opportunity for significant upside in SA equities.

Equity Pricing is Suggesting Distress

Local market equity valuations remain depressed. Currently 2-year forward PEs are trading, on average, around 11.5x with most companies trading at significant discounts to their 5-year averages.

THE ECONOMIC ENVIRONMENT

GDP – Settling into Above Pre-Covid Run Rate

Coming off the back of a bumper recovery, South Africa’s GDP growth is expected to decelerate from 5.2% in 2021 to somewhere between 1.7% and 2.2% in 2022. This follows on from a -7% decline in 2020. What is being missed is the fact that 1.7% to 2.2% reflects a pick-up in growth from the trend seen in the three years prior to the pandemic. Further, longer term GDP forecasts for 2023 and 2024 remain within a tight range suggesting the above pre-Covid trend growth rate has some legs.

Inflation – Remains Under Control

Government Debt – Not Great but Getting Better

The SA Consumer – Stronger than you Think

Households are exiting the pandemic in a much better position than they entered it and consumers are in the best place that they have been for a long time. Disposable income is up in the high single digits and debt levels and the ability to service debts are at levels we haven’t seen in a decade.

Over the past few years, average private pensions have increased, recently hitting record highs. At the same time, house prices continue to appreciate further driving individuals net wealth higher. Take-home pay is higher than that seen pre-pandemic and the increase over time is on average higher than inflation. The average SA consumer is far better off than where they had been pre-pandemic, yet the perception in the market is the opposite.

Retail sales have proven to be resilient; they continue to recover from the 2020 lockdowns and the July 2021 civil unrest with current figures remaining slightly below pre-pandemic levels (Christmas trading period data not released at time of writing). Tax collection (VAT) figures show a stronger performance, indicating a 9% increase for 2021 on pre-pandemic 2019 levels.

SA Banks – No Signs of Cracks in the Credit Environment

Going into the pandemic the SA banks significantly increased their credit provisions ahead of what they thought would be a big ramp up in credit defaults. As we exit the pandemic nothing of the sort materialised. In fact, credit loss ratios are all trending within normal cyclic ranges. This provides us with another data point that shows the local economic environment is stable and better than perceptions will have you believe.

SA Corporates – Hold the Key to Secular Growth

Manufacturing production began to show signs of recovery in 2021. However, comparing to pre-pandemic levels we can see manufacturing has limped along for several years now.

Savings rates amongst corporates remain high as they choose to sit on cash over committing capital to new projects and/or expansions to increase production. This hesitancy is nothing new, for some time and many reasons including the Government’s inability to make doing business in SA easy, corporates have decided to take a cautious approach limiting growth as a result. While our view is not based on this, if Government is somehow able to succeed in unlocking confidence in the SA Corporates, spurring them on to reignite investment and growth, it could be a game changer for SA markets.

Equity – Too Cheap

Equity market valuations remain depressed, trading on undemanding PE’s and at large discounts to historic levels. We are trading under conditions where pricing is suggesting distress or strain. However, when looking at earnings growth forecasts, we can see EPS growth is forecast to remain at attractive levels around 18%, despite being down from the 41% experienced in 2021.

Despite this forecast for solid 2022 growth, the market is only being valued at a Price to Earnings valuation of 11.5x which is too cheap, in our opinion.

The Retail Sector – Attractive Across the Board

Retailers began to recover in 2021 but share prices remain below pre-pandemic levels with valuations on a 2 year forward basis remaining attractive. Earnings growth remains resilient with earnings estimates increasing steadily across the board. The pandemic saw retailers take a step back, shore up their balance sheets, reduce credit extension and provide for worse conditions than what resulted. They now sit ready to unwind provisions, extend credit and do so in a much stronger balance sheet position. The SA consumer is healthy and will be supportive of earnings growth and, in our opinion, the retail sector presents a very attractive investment opportunity.

The Financial Sector – Banking Exposure is Key

Simply put, banking valuations are too cheap. Similar to other sectors in the market, pricing presents a perception of an environment that is far worse than reality. Fundamentally SA Banks are strong:

• Credit loss ratios remain low as the consumer proved healthier than anticipated
• lending is beginning to recover both as consumer demand returns and banks’ willingness to lend increase
• Return on equity is higher than cost of capital
• Large provisions taken throughout the pandemic proved far greater than required and will be released automatically benefiting earnings

Private sector credit extension is beginning to show signs of life with other loans and advances (e.g., overdrafts) and commercial credit extension increasing for the first time in a long time. While not significant at this stage, it does indicate the return in demand for credit from private and commercial players and the willingness of the credit facilities to extend credit once again.

Valuations remain low, with Price to Book ratios trading at levels far lower than historic levels. When comparing to P/B levels pre-pandemic it can be seen how the market is pricing banks lower post pandemic despite the banks being fundamentally stronger.

In our opinion, return on equity (ROE) levels currently priced into the bank valuations are too conservative and are not reflective of potential returns over the medium-term. With the potential for provisions to be released and credit extension picking up the ROE stands to benefit. As a result, our forecasts anticipate capital upside from current levels.

The Industrial Sector – Opportunities Abound

The industrial sector presents a mixed bag of opportunities. Naspers and Prosus showed significant weakness on the back of Chinese regulation concerns while AB InBev and British American Tobacco felt weakness in line with value stocks in general.

Naspers/Prosus continue to trade at a discount of around 25% to the underlying Tencent holding (which in itself is undervalued). We expect to see a reversal in Tencent’s fortunes with the return of investor confidence for the Chinese tech sector and NPN/PRX stands to benefit as a result. Given last year’s price performance NPN/PRX are attractive buys at current levels.

Looking at consumer-based stocks, AB InBev has used the last few years to reduce debt levels and now stands ready to participate in the ‘return to normal’ while BATS has been heavily impacted by regulatory concerns but remains highly cash generative providing a strong dividend yield. Both stand to benefit from the global shift from growth to value and remain undemanding at current valuations.

The Commodity Sector – More of the Same

By far the best performing sector in 2021 but is it too late to enter the sector? Given the potential for renewed stimulus in China we may see another strong year for the commodity names. The past year showed strong operating performance allowing the miners to reduce debt levels and become leaner for the coming years. Further, the current focus on the ‘green economy’ is leading towards supply being constrained as ESG pressures curtail funding and the appetite for big ‘dirty’ projects. This is driving Commodity prices higher and providing a lucrative environment for the miners. Free cash flows are very high and since debt is paid off with few capital projects in the pipeline, high dividend yields are the norm.

Currently EPS estimates use more conservative commodity pricing when compared to spot pricing. As a result, earnings could surprise on the upside given this underestimation currently being priced in by the market.

The Listed Property Sector – New Year, Same Story

Listed property lifted off its lows in 2021 but still remains at depressed levels as we start 2022. The sector presents the same story to investors but has come a long way since its lows in 2020.

Price to Net Asset Values (NAV) remain at signficant discounts, around 40% on average. This is warranted when the underlying NAV is perceived to be wrong, in other words the company is valuing its assets at a higher price when compared to what the asset would actually sell for in the market. However, this is not the case in the market at present. Market transactions are indicating appropriate NAV valuations. In other words, the property companies are selling assets at or near the value at which the company held the asset on their balance sheet. This indicates a disconnect between the fundamentals and market pricing which should close over time.

As an investment case, listed property looks even more attractive now given that dividends have resumed and are attractive and debt levels have been reduced with further debt reduction remaining a core focus of management teams.
In our opinion, the management teams of the listed property names have done a great job in a tough environment. We continue to feel this sector is undervalued and stands to benefit.

Conclusion

SA Economic conditions are stronger than what is currently being reflected in SA equity valuations. We are of the opinion that SA Corporates are better placed than prior to the pandemic and will deliver stronger earnings than what sentiment suggests. This disconnect between sentiment driven stock valuations and the reality we are seeing on the ground provides a very attractive opportunity for significant upside in SA equities.

All outlooks come with risk, both to the upside and downside. Downside risks include more virulent Covid variants followed by lockdowns worldwide, the potential for escalating tensions between world powers such as the US, China and Russia and local power supply concerns over an above supply constraints expected from Eskom. Risks to the upside include a steady and predicatable interest rate hiking cycle by the US Fed which will do wonders to support equity demand worldwide, a ‘return to normal’ faster than anticipated and high profile arrests following the Zondo commission.

Mirror Image

Current valuations suggest an environment that is under significantly greater stress than what the actual real economy suggests. SA corporates remain cash rich, consumers are financially better off than they have been for many years and SA banks are over provisioned with loan loss experience that suggests a normal credit environment that is far from experiencing any undue distress. This disconnect between sentiment driven stock valuations and the reality we are seeing on the ground provides a very attractive opportunity for significant upside in SA equities.

Equity Pricing is Suggesting Distress

Local market equity valuations remain depressed. Currently 2-year forward PEs are trading, on average, around 11.5x with most companies trading at significant discounts to their 5-year averages.

THE ECONOMIC ENVIRONMENT

GDP – Settling into Above Pre-Covid Run Rate

Coming off the back of a bumper recovery, South Africa’s GDP growth is expected to decelerate from 5.2% in 2021 to somewhere between 1.7% and 2.2% in 2022. This follows on from a -7% decline in 2020. What is being missed is the fact that 1.7% to 2.2% reflects a pick-up in growth from the trend seen in the three years prior to the pandemic. Further, longer term GDP forecasts for 2023 and 2024 remain within a tight range suggesting the above pre-Covid trend growth rate has some legs.

Inflation – Remains Under Control

Government Debt – Not Great but Getting Better

The SA Consumer – Stronger than you Think

Households are exiting the pandemic in a much better position than they entered it and consumers are in the best place that they have been for a long time. Disposable income is up in the high single digits and debt levels and the ability to service debts are at levels we haven’t seen in a decade.

Over the past few years, average private pensions have increased, recently hitting record highs. At the same time, house prices continue to appreciate further driving individuals net wealth higher. Take-home pay is higher than that seen pre-pandemic and the increase over time is on average higher than inflation. The average SA consumer is far better off than where they had been pre-pandemic, yet the perception in the market is the opposite.

Retail sales have proven to be resilient; they continue to recover from the 2020 lockdowns and the July 2021 civil unrest with current figures remaining slightly below pre-pandemic levels (Christmas trading period data not released at time of writing). Tax collection (VAT) figures show a stronger performance, indicating a 9% increase for 2021 on pre-pandemic 2019 levels.

SA Banks – No Signs of Cracks in the Credit Environment

Going into the pandemic the SA banks significantly increased their credit provisions ahead of what they thought would be a big ramp up in credit defaults. As we exit the pandemic nothing of the sort materialised. In fact, credit loss ratios are all trending within normal cyclic ranges. This provides us with another data point that shows the local economic environment is stable and better than perceptions will have you believe.

SA Corporates – Hold the Key to Secular Growth

Manufacturing production began to show signs of recovery in 2021. However, comparing to pre-pandemic levels we can see manufacturing has limped along for several years now.

Savings rates amongst corporates remain high as they choose to sit on cash over committing capital to new projects and/or expansions to increase production. This hesitancy is nothing new, for some time and many reasons including the Government’s inability to make doing business in SA easy, corporates have decided to take a cautious approach limiting growth as a result. While our view is not based on this, if Government is somehow able to succeed in unlocking confidence in the SA Corporates, spurring them on to reignite investment and growth, it could be a game changer for SA markets.

Equity – Too Cheap

Equity market valuations remain depressed, trading on undemanding PE’s and at large discounts to historic levels. We are trading under conditions where pricing is suggesting distress or strain. However, when looking at earnings growth forecasts, we can see EPS growth is forecast to remain at attractive levels around 18%, despite being down from the 41% experienced in 2021.

Despite this forecast for solid 2022 growth, the market is only being valued at a Price to Earnings valuation of 11.5x which is too cheap, in our opinion.

The Retail Sector – Attractive Across the Board

Retailers began to recover in 2021 but share prices remain below pre-pandemic levels with valuations on a 2 year forward basis remaining attractive. Earnings growth remains resilient with earnings estimates increasing steadily across the board. The pandemic saw retailers take a step back, shore up their balance sheets, reduce credit extension and provide for worse conditions than what resulted. They now sit ready to unwind provisions, extend credit and do so in a much stronger balance sheet position. The SA consumer is healthy and will be supportive of earnings growth and, in our opinion, the retail sector presents a very attractive investment opportunity.

The Financial Sector – Banking Exposure is Key

Simply put, banking valuations are too cheap. Similar to other sectors in the market, pricing presents a perception of an environment that is far worse than reality. Fundamentally SA Banks are strong:

• Credit loss ratios remain low as the consumer proved healthier than anticipated
• lending is beginning to recover both as consumer demand returns and banks’ willingness to lend increase
• Return on equity is higher than cost of capital
• Large provisions taken throughout the pandemic proved far greater than required and will be released automatically benefiting earnings

Private sector credit extension is beginning to show signs of life with other loans and advances (e.g., overdrafts) and commercial credit extension increasing for the first time in a long time. While not significant at this stage, it does indicate the return in demand for credit from private and commercial players and the willingness of the credit facilities to extend credit once again.

Valuations remain low, with Price to Book ratios trading at levels far lower than historic levels. When comparing to P/B levels pre-pandemic it can be seen how the market is pricing banks lower post pandemic despite the banks being fundamentally stronger.

In our opinion, return on equity (ROE) levels currently priced into the bank valuations are too conservative and are not reflective of potential returns over the medium-term. With the potential for provisions to be released and credit extension picking up the ROE stands to benefit. As a result, our forecasts anticipate capital upside from current levels.

The Industrial Sector – Opportunities Abound

The industrial sector presents a mixed bag of opportunities. Naspers and Prosus showed significant weakness on the back of Chinese regulation concerns while AB InBev and British American Tobacco felt weakness in line with value stocks in general.

Naspers/Prosus continue to trade at a discount of around 25% to the underlying Tencent holding (which in itself is undervalued). We expect to see a reversal in Tencent’s fortunes with the return of investor confidence for the Chinese tech sector and NPN/PRX stands to benefit as a result. Given last year’s price performance NPN/PRX are attractive buys at current levels.

Looking at consumer-based stocks, AB InBev has used the last few years to reduce debt levels and now stands ready to participate in the ‘return to normal’ while BATS has been heavily impacted by regulatory concerns but remains highly cash generative providing a strong dividend yield. Both stand to benefit from the global shift from growth to value and remain undemanding at current valuations.

The Commodity Sector – More of the Same

By far the best performing sector in 2021 but is it too late to enter the sector? Given the potential for renewed stimulus in China we may see another strong year for the commodity names. The past year showed strong operating performance allowing the miners to reduce debt levels and become leaner for the coming years. Further, the current focus on the ‘green economy’ is leading towards supply being constrained as ESG pressures curtail funding and the appetite for big ‘dirty’ projects. This is driving Commodity prices higher and providing a lucrative environment for the miners. Free cash flows are very high and since debt is paid off with few capital projects in the pipeline, high dividend yields are the norm.

Currently EPS estimates use more conservative commodity pricing when compared to spot pricing. As a result, earnings could surprise on the upside given this underestimation currently being priced in by the market.

The Listed Property Sector – New Year, Same Story

Listed property lifted off its lows in 2021 but still remains at depressed levels as we start 2022. The sector presents the same story to investors but has come a long way since its lows in 2020.

Price to Net Asset Values (NAV) remain at signficant discounts, around 40% on average. This is warranted when the underlying NAV is perceived to be wrong, in other words the company is valuing its assets at a higher price when compared to what the asset would actually sell for in the market. However, this is not the case in the market at present. Market transactions are indicating appropriate NAV valuations. In other words, the property companies are selling assets at or near the value at which the company held the asset on their balance sheet. This indicates a disconnect between the fundamentals and market pricing which should close over time.

As an investment case, listed property looks even more attractive now given that dividends have resumed and are attractive and debt levels have been reduced with further debt reduction remaining a core focus of management teams.
In our opinion, the management teams of the listed property names have done a great job in a tough environment. We continue to feel this sector is undervalued and stands to benefit.

Conclusion

SA Economic conditions are stronger than what is currently being reflected in SA equity valuations. We are of the opinion that SA Corporates are better placed than prior to the pandemic and will deliver stronger earnings than what sentiment suggests. This disconnect between sentiment driven stock valuations and the reality we are seeing on the ground provides a very attractive opportunity for significant upside in SA equities.

All outlooks come with risk, both to the upside and downside. Downside risks include more virulent Covid variants followed by lockdowns worldwide, the potential for escalating tensions between world powers such as the US, China and Russia and local power supply concerns over an above supply constraints expected from Eskom. Risks to the upside include a steady and predicatable interest rate hiking cycle by the US Fed which will do wonders to support equity demand worldwide, a ‘return to normal’ faster than anticipated and high profile arrests following the Zondo commission.