There’s more value in this market than we’ve seen in years

For the seven months to the end of July the FTSE/JSE All Share Index was up 10.6%. This was encouraging after a long period of very weak performance, but this recovery was hardly broad-based.

“Pretty much the entire return came from Naspers, with a little bit from Richemont, Bidcorp and Shoprite,” explains Delpine Govender, chief investment officer at Perpetua. “So the reality is that we have had this highly concentrated source of return.”

To illustrate this further, the FTSE/JSE Mid Cap Index was down 3.0% over the same period, and 5.9% lower over the previous 12 months. The number of stocks that are down this year is far higher than the number that have been up.

This is not a uniquely South African phenomenon either. The FAANG stocks – Facebook, Amazon, Apple, Netflix and Google (Alphabet) – have been the primary source of returns in the S&P 500 as well.

Across the world, a very small group of high growth stocks is leading markets higher and lifting price-to-earnings (P/E) multiples. The JSE is trading on a P/E of around 20 times, while the S&P 500 is offering a P/E of over 24 times.

While, overall, this makes them look quite richly priced, value investors are seeing something different.

“Because the pendulum has swung so far in favour of these few counters, there are a lot of other stocks that have fallen off the radar,” says Govender. “If we went back to 2015 when we had a similar pattern with the high growth, bond proxies in favour, there were far more stocks holding the market up. But now a lot of those have corrected.”

What this means is that there is a far wider opportunity set for value investors. These cheaper stocks are not concentrated in a single sector, nor are they exclusively lower-quality cyclical counters.

“As things stand you don’t have to compromise that much on quality to find cheap stocks,” says Nadir Thokan, investment analyst at 27Four.

South African hospital groups are a good example. These are usually considered solid, defensive plays, but Life Healthcare, MediClinic International and Netcare are all down between 23.0% and 36.0% over the last 12 months. Life is offering a dividend yield of over 5.0% on a forward P/E of under 18.

There are a number of other stocks that were heavily in favour just 24 months ago, but have since pulled back. This includes Aspen Pharmacare, Remgro and Brait, all of which are down sharply in the past year.

Perhaps most notable amongst this group is British American Tobacco (BAT), which has slipped over 10% in just the last few months after the Food and Drug Administration (FDA) in the US announced that it wanted to reduce the nicotene in cigarettes to make them less addictive.

“BAT is now on a forward P/E of 17 times, but there is no near-term risk to earnings,” Thokan argues. “The company has very good management, the research and development spending they have directed towards cigarettes gives them quite a big moat in that business, and we think in general that BAT is trading at a discount relative to what it’s worth, especially if you compare it to other rand hedges like Richemont.”

The big four local banks are also offering interesting potential. They were sold off heavily after Nenegate and although they have recovered, none are back to their mid-2015 highs.

These banks may not have delivered outstanding earnings, but they have been far from poor. And what Thokan finds encouraging is that their credit loss ratios are going down, not up.

“This shows that they are not extending poor quality credit into an economy that is clearly suffering from chronic unemployment and structural issues with growth,” he says.

Thokan is seeing a lot of other opportunities in the mid-cap space as well, especially those businesses that are starting to generate good profits overseas.

“Ascendis is one that is increasing its offshore earnings, but in a very smart way,” Thokan says. “It’s not adding international businesses just for the sake of doing it. A lot of JSE companies have been burnt doing that.”

He also points to chemicals group AECI, which now generates around 35% of its earnings outside of South Africa, and is looking to grow that to 50%.

“These are also high-quality offshore earnings,” Thokan says. “And those offshore earnings are growing. They also have a good quality management team with a high degree of ownership, and over the long term that means that capital allocation decisions are likely to be disciplined. That’s what drives earnings growth, and that’s what ultimately drives long-term equity returns.”

The diversity of these companies illustrates just how much opportunity there is out there for value investors willing to take a longer-term view.

“The number of stocks trading below fair value is the highest we’ve seen in five years,” says Govender. “The ‘cheap’ bucket is now definitely a much more mixed bag.”

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