Fund managers Shaun Le Roux and Justin Floor of PSG Asset Management
July saw horrific scenes as parts of South Africa were engulfed by riots and looting. In times like these, it is important to discount one’s personal emotions when making investment decisions. While our country faces many challenges, sensible investing at this time could yield very favourable results.
The current valuation gap between the expensive and cheap parts of global markets has reached levels last seen in the dotcom era. We believe that this presents an excellent opportunity to allocate capital to attractively valued stocks, where the market is not appreciating the quality of these businesses and their growth prospects.
In South Africa, many good businesses are cheap
Just like in 2003, the South African market is blessed with quality businesses trading at deeply discounted valuations, as the global economy emerges from a deep recession.
Domestic investors have fled underperforming local equities in favour of income funds and high-flying global investments, while foreign investors have materially reduced exposure to SA equities over a number of years. The latter was partly as a result of our lower weighting within emerging market indices but also due to poor sentiment towards ‘higher-risk’ emerging markets.
Against this backdrop, we think it highly likely that certain South African companies will grow profits substantially over the next few years. If domestic stocks rerate at the same time that they grow profits – which they usually do – total returns could be remarkable, even before considering the very attractive 2021 dividend yields on offer.
Local retail investors remain sceptical of the opportunity
However, while many local institutional investors recognise the potential superior long-term returns available in the domestic market, retail investors remain unconvinced.
The reality is that, subsequent to enduring poor returns from local assets for several years, retail investors capitulated and sold near the lows during the 2020 market crisis. Unfortunately, if history is anything to go by, they will only regain confidence in the local market after prices have risen substantially.
We pursue broader exposure to the SA Inc. opportunity set
The tried and tested approach used by institutional managers to gain exposure to the so-called ‘SA Inc.’ trade is to buy banks and retailers – sectors that are fairly liquid and heavily geared to the economy, consumers and interest rates.
As a medium-sized manager, PSG Asset Management has access to a far wider range of ‘SA inc.’ opportunities, as opposed to large managers who have to focus their attention on a limited number of highly liquid opportunities. Looking at this broader universe, which includes mid-caps and ideas outside the subset of popular stocks, we have identified some compelling investment opportunities.
Our highest conviction domestic holdings have the following in common:
- Scale with strong competitive positioning and pricing power
- Competent, aligned management teams
- Improving prospects
- Strong balance sheets
- Costs that are well controlled and in many cases were substantially reduced in 2020
- High cash conversion rates
- Attractive future dividend yields
- Many have sizeable businesses outside of South Africa
- The upside to our estimate of intrinsic value is substantial
Low starting valuations and a strong revenue cycle are a good combination for shareholder returns
As the South African and global economy recovers, prospects for some South African sectors are particularly promising. Our export markets (metals and agriculture) are enjoying strong pricing and tourism and hospitality should enjoy a bounce back in demand when travel resumes. There are also encouraging signs that large ticket local infrastructure projects are starting to be awarded, after several years of hiatus. To this end our clients have a healthy exposure to infrastructure through the likes of Raubex, WBHO, Afrimat, AECI and Grindrod, and also are sizeable shareholders of gaming and hospitality businesses via Sun International, HCI, Tsogo Gaming and Tsogo Hotels.
AECI, is another example of the quality on sale. This business has generated above-market returns on capital for most of the past two decades. We expect all their businesses to perform strongly in the years ahead as the economy recovers and local infrastructure projects commence.
Yet, AECI trades at a very attractive 7 times what we consider to be normalised profits, and should then offer a 7% plus dividend yield on current share prices. The last time AECI was this cheap (in the early 2000s) and on the verge of strong multi-year profit growth, shareholders enjoyed 15 years of 21% compounded annual returns (between 2000 and 2014).
These are but a few examples of the opportunities available in the South African market at the moment. Importantly, domestic stocks could deliver strong returns at a time when expensive global stocks falter. It however remains to be seen whether South African retail investors miss out on this opportunity.