Thoughts on South African and international politics and culture

Wednesday, July 02, 2008

Contrarians unite!
The one thing I've loved about all the doom and gloom negativity that seems to envelop us every day in the media and around the dinner tables is how certain sage and calm people have responded with positivity and realism in the face of often hysterical pessimism. One such opinion piece doing the rounds is from analyst Mark Ingham, which I've included in full:

June 24th 2008
A calmer reflection on where we find ourselves in South Africa – MN Ingham

I shall be leaving for the United States on Wednesday evening, a follow up to my visit in December. In addition to meeting with a number of hedge funds and asset managers on the East and West coast, I shall be addressing the Harvard University Club in New York. With me on the panel will be the US Ambassador to South Africa, Eric Bost, along with three other distinguished Americans. The topic of the symposium is “The Risks and Rewards of Investing in Africa” and I shall be touching on aspects such as Eskom, infrastructure, equity opportunities, and the state of the economy and business regionally.

The title of my presentations to fund managers is “Keeping a Cool Head”. The Kiplingesque reference is deliberate – all about are indeed losing their heads when it comes to matters South African and the extreme bearishness in both the equity market and wider economy is not only a domestic phenomenon but foreigners too have been effected by the contagion. Risk aversion prevails globally and as a liquid, sophisticated “emerging market”, South Africa gets it in the teeth disproportionately. To add insult to injury South Africans are indulging in their periodic favourite pastime of national self-flagellation - if things are bad today they can only get worse tomorrow.

In reality not much has changed in the past six to nine months – consumer spending has in fact been weakening since 2007, interest rates have been rising since the 8th of June 2006 (now 500 basis points up), petrol prices began a sustained upward trend in 2006 that accelerated through 2007, as is the case with food prices. Capital expenditure has risen consistently since 2003 and in real terms is today 60% higher than five years ago and in nominal money has doubled, comprising 22% of GDP versus 15% five years ago.

We have seen shock-horror newspaper headlines about the current account deficit reaching 9% of GDP in Q1, up from 7%, but likely to subside as mining exports recover from power shortage induced downtime. In actual fact there is more to the headline number than meets the eye and there is a positive aspect.

3% of the deficit is due to net service payments, largely dividend outflows. Why should this be so? Well, by attracting capital to the country in the form of foreign direct investment and foreign purchases of financial instruments such as stocks and bonds South Africa in turn has to remit dividends and interest to overseas investors; the flip side of foreign investment is yield outflows. The same happens in rich countries such as England – Britain is the second largest investor in the world and the second largest recipient of foreign investment (after the USA) and the country earns inflows from its overseas holdings but has to remit funds overseas to foreigners that buy British companies. Foreigners now own 25% of the JSE – an all time high; something like 40% of trade on the JSE is determined by London and other global money centres.

Of the 9% deficit, 3% goes on dividend payments to investors, 3% goes on interest and travel, and 3% is a trade deficit. At least 3% is structural; nothing wrong with that. In fact if South Africa got more foreign investment that 9% would grow but we would have access to the capital domestically, dollars, pounds and euros being turned into rand. The shortfall on the trade account is now largely as a result of capital equipment imports – which goes into improving the productive base of the country – and not as commonly believed a deluge of consumer goods (in fact consumer goods imports are set to fall as the economy rebalances). Consumption as a percentage of GDP has been stable at 62% for two decades. What has changed is fixed investment (GFCF) – up 40% as a proportion of GDP since 2002 and running at 22%. The move from C/A surplus in 2002 to deficit in 2008 is due to a dramatic upsurge in GFCF (an extra R250bn per annum more than in 2002). If GFCF was curtailed to levels prevailing in 2002 the C/A deficit would be broadly eliminated. Therefore, I am sanguine as to the implications for currency (oversold but inherently volatile, carry trade foreign funds flows on interest rate differentials, excellent value in bonds) and future economic growth (driven by investment, to the extent that a recession is not even on the radar screen even though a retreat to 2-3% growth short term may feel like a recession when coming down from 5% growth).

Social problems such as unemployment and crime aside, South Africa is in reasonable shape economically. There is a budget surplus (1% of GDP), government spend is 25% of GDP (much lower than developed countries and indeed some developing countries), total foreign debt is a modest 22% of GDP, and foreign exchange reserves equal 13% of GDP – the highest ever, although a bit low compared with peers. And we have high real interest rates – not for nothing does the SA Reserve bank have a reputation as the “Bundesbank” of Africa. There is no financial delinquency as per US and banks are well anchored; the financial system is robust and the recently introduced National Credit Act strengthens already prudent credit granting criteria and provides for enhanced borrower education. Real disposable income is up 35% since 2000 and manufacturing volumes are up 33% since 2000 (automotive up 65%). CPI may be running at 11% (ex food & energy 6%) but CPI is likely to fall sharply 2009/10 as exogenous energy and food shocks exit the base. Moreover, realistic pricing of power (Eskom tariff increases) is essential as a cash flow underpin for keenly priced borrowing during a massive capital expansion programme but focuses minds on efficiency of usage; there are degrees of vulnerability but the cost of electricity is generally a small portion of operating costs (commerce, industry, mining). The real price of electricity is 40% cheaper today than in 1990 – we have been spoiled rotten for too long and it is unsustainable if South Africa is to accommodate additional investment for economic growth.

Australia, that glorified quarry most starry eyed South Africans reckon is milk and honey country, sustained a C/A deficit of A$20bn for the March quarter and it will run at over 7% of GDP for the year, largely consumer imports of which motor vehicles top the list, and net foreign debt is 57% of GDP – despite an unprecedented resources boom. When, not if, resources run out of steam there will be quite a hangover and, unlike the relief South Africa is gaining from a more competitive currency, Australia labours under the yoke of a currency that is on par with the US dollar. Manufacturing accounts for only 10% of Australia’s economy – it is almost 19% of South Africa’s gross value added. Australia’s foreign exchange reserves are $34bn – exactly the same as South Africa’s, despite having an economy 3.5x bigger at nominal exchange rates and 60% bigger at purchasing power parity. Australians can fret more safely than South Africans though – you have a 30x greater chance of being bumped off here than over there.

There is relative political stability – no fundamental shifts are expected. With a Zuma era from mid 2009, pragmatism is likely to replace the cronyism, patronage and aloofness of the final Mbeki years – a focus on burning social issues is not at odds with business imperatives.

Companies by and large are in good health, investing in working capital and equipment. Balance sheets typically have little gearing – well below levels prevailing in US. Industrial and financial stock market valuations are inexpensive and getting cheaper; recent world and local events, negative psychology, and a slowing economy have taken a toll on market prices. Investors are taking cover in globally influenced Resources as domestic focused stocks take the brunt of negativity on growth/political concerns. We have not seen valuations that presently prevail for years – you can buy a JSE listed company for less than it would cost to buy a business from a private vendor on the street corner and you have the comfort of the checks and balances and accounting that goes with it. “Value” is a watchword - forward dividend yields generally beat cash + there is EPS growth. For the majority of stocks I keep an eye on I have confidence in integrity of yield and in moderate to high growth prospects.

The market is not reacting to positive newsflow and selling at the slightest hint of negativity, any excuse to reinforce bear psychology. What is cheap today gets cheaper tomorrow – this has got nothing to do with stock specific economics, everything to do with escaping to safety at almost any cost. We have seen directors start to snap up bargains – a sure sign that they know where their best interests lie. PPC is buying back stock at fire sale prices now as handing back generous dividends gains it no credit and internal rates of return from stock purchases are in any event likely to be supernormal in time.

Below is a table of a selection of smaller to larger cap stocks – indicating projected three-year compound growth in earnings, current rolling exit P/E ratio, and twelve month forward dividend yield on exit. Estimates are by and large modest to generous, depending on where companies are in their life cycle or on their capacity to capitalise on opportunity or minimise downside. They are all first class businesses, with a mix of virtues such as good value added per staff member, clear business cycle differentiation, pricing power, technology/product & people leadership and all are on Über ludicrous discount valuations.

Hulamin is a case in point of a company that is minimally effected by domestic conditions (70% export), is ramping up production, and is in any event a dollar proxy. The company announced recently earnings would double for the six months ended June 2008. Eqstra (the Imperial spin-off) has been added and I’ll be issuing notes thereon in future – an interesting alternative to Barlows. We have seen final results out of Omnia this past week – EPS up 30% at headline level and DPS for the year up 25%. Hudaco announced earnings for H1 would be up over 55% and Basil Read is set to report earnings 55% to 75% higher for the half year. Naturally, you would expect the market to go like gangbusters on such stellar stuff – not a bit of it; they’ve all been knocked back. Standard Bank has fallen by almost 40% in price – it is on a price to book of 1.7x for crying out loud, after reporting a 23% rise in earnings for the past fiscal and budgeted to grow earnings in the mid-teens during 2008. I get CEO’s calling me with questions along the lines of “what on earth is happening to our share price, does the market expect us to bomb out”? Err, actually there isn’t much you can do about it Mr So and So, just keep your head down and buy your own stock if you must but the momentum is indiscriminately Hades-bound and you’re going with it.

It is all too easy to confuse share price performance with the economics of a business – this has rarely been the case in the short run. Stocks are routinely over and under priced. When great news fails to stir interest and the good gets dragged down with not-so-good and downright ugly you know you are in the grip of the bear. But Warren Buffet has never been truly lucky over many decades – he kept a cool head, understood company fundamentals, and developed a keen sense of the foibles of human psychology and exploited them fully – buying when others sold and holding firm in troughs because he’d done his homework and refused to be swayed by emotion. What we are seeing today are prices that will make you comatose with pecuniary anguish in a year or two or three if you never took advantage of them.

I always end of presentations with a pithy adage: “experience is not what happens to you - it is what you do with what happens to you”. It is a good reminder to not join the lemmings and become a doomed conformist; now is prime time to be contrarian.

Now that's a call worth following...