SA Inc under the microscope - Angles & Perspectives Q3 2024

SA Inc under the microscope

The months following the South African general election on 29 May 2024 have seen the formation of a Government of National Unity (GNU). Sentiment towards South Africa since the elections has turned more positive, as evidenced by the move in asset prices and the rand. It is tempting to attribute the entirety of these moves to the increased probability of economic growth stemming from the formation of the GNU, but the reality is more nuanced. The reasons for the moves in asset prices are multi-faceted.

The rally in South African markets to date has been led by local investors rather than foreign investors. Foreign flows remain subdued, and South Africa remains one of the most underweight markets within emerging markets (EMs), which in turn, are small in global market weightings given the outperformance of the US stock market. While there has been a small increase in foreign inflows since the election, net foreign flows over the past 12 months to 30 September 2024, as reported by the JSE, total outflows of R124 billion. This is a far cry from the days of ‘Ramaphoria’ in early 2018, when we saw over R30 billion of net inflows.

Local investors have also been avoiding the SA stock market
There was significant fear around election outcomes heading into the elections. There was discernible risk-off positioning by local investors through the first quarter of 2024 and in the run-up to the elections. In effect, this was a continuation of a confluence of factors which led to many local investors being underweight in South African assets over the past number of years (not just heading into the elections):

• Amendments to Regulation 28 of the Pension Funds Act increasing offshore limits from 30% to 45%.
• The load shedding crisis and associated fear of a grid collapse of 2023.
• Transnet’s much-publicised woes that have contributed to the ports and railways struggling to operate.
• Continued lacklustre economic growth.

Reversing the underweight position has led to a scramble for South African assets
To understand why we refer to a scramble, let’s look at the composition of the South African stock market, illustrated by the JSE Capped SWIX Index as at 30 June 2024 as shown below.

As can be seen from the chart above, only roughly 50% of the South African stock market can be classified as ‘SA Inc’, with the other 50% roughly equally split between JSE rand hedges (Naspers, Prosus, Richemont, British American Tobacco) and the resources sector. Of the 50% considered to be SA Inc, we find many peer portfolios concentrated in three sectors: banks, retailers and consumer staples (drug and grocery stores and food producers). The primary reason for this is the size and associated liquidity of companies in these sectors compared to the rest.

To illustrate the point, we note that the 15 largest companies in these three sectors have a combined market capitalisation of R2.2 trillion. If we take the fifty largest SA Inc companies outside these sectors (also excluding real estate), we find that the aggregate market capitalisation of those 50 stocks is only R1.5 trillion.

Selectivity remains key
There are attractive investment opportunities residing across the SA Inc landscape but discretion is required, as not all investments are created the same. Valuations, growth prospects and capital return potential (dividends and share buybacks) differ considerably.

Comparing the index to the PSG SA Equity Fund, which only invests in shares listed on the JSE, we have SA Inc exposure of 69%. However, more importantly, we have differentiated positioning within SA Inc. In the banks sector, as an example, the fund has exposure to Absa and Standard Bank, choosing to avoid the more expensive counters such as Capitec and FirstRand.

Within the retail sector, the fund has preferred to own TFG Ltd over market darlings such as Shoprite and Clicks. When the fund started purchasing TFG in 2023 we noted that it traded at its widest ever discount on a price-to-earnings ratio basis to Shoprite and Clicks. Our SA Inc exposure outside banks, retailers and consumer staples amounts to 47% of the portfolio vs 20% of the index.

We positioned into SA Inc shares well ahead of the current scramble
We built our position in SA Inc well before the advent of the GNU, when prices reflected heightened fear in South Africa. A case study of this is our positioning in the construction sector, particularly as shareholders of Wilson Bayly Holmes-Ovcon Limited (WBHO) and Raubex Group Ltd (Raubex). Post the boom of the 2010 World Cup, the South African construction industry faced more than a decade of tough times.

The words of the chairman of WBHO in his 2018 letter to shareholders encapsulate just how tough those times were: “Having spent more than 45 years in construction, it is alarming to see our local industry in such a poor state. A vibrant and substantial industry is vital to support economic growth, employment and cost-effective infrastructure delivery for government. Boosting gross fixed capital formation is critical to raising the economy’s potential growth rate. Policy uncertainty, poor governance within state-owned entities and endemic corruption (now well publicised) have strangled public infrastructure spending while at the same time, low economic growth has stifled private investment in the country. This has resulted in five quarters of consecutive decline for the industry according to Statistics South Africa and has left a number of large and medium-sized construction companies in a precarious financial position.” Mike Wiley, 2018

PSG Asset Management began building stakes in the construction sector not despite the poor state of the industry, but rather because of it – for two primary reasons:

• Shares in the sector were trading at multi-year low valuations.
• We noted favourable supply side conditions with a number of high-profile competitors unfortunately going out of business.

We couldn’t pinpoint exactly when a change in fortunes for construction demand would come. However, we had conviction that there needed to be an enhanced focus on infrastructure build given the low percentage of gross fixed capital formations relative to GDP when compared to both South Africa’s historic levels and to emerging market peers, and we recognised that with the demise of large competitors, the surviving companies stood in good stead to benefit from any pick-up in demand.

Post the elections, we’ve seen the Minister of Public Works and Infrastructure place an infrastructure build at the heart of an economic recovery plan. This intention to ‘turn South Africa into a construction site’ was echoed by President Ramaphosa at the opening of Parliament.

Excitement around the infrastructure build coming to fruition has driven up the share prices of WBHO and Raubex, both up between 55% and 60% since the elections in May. Despite the rally we still see significant scope for earnings growth from these companies as the infrastructure build comes to fruition.

There is still scope for upside from SA Inc shares
We do not believe that the revaluation we have seen to date has negated the case for holding SA Inc shares. Firstly, we believe that tailwinds from an improved economic backdrop (admittedly off a very low base) will continue to provide an earnings underpin to these shares. Secondly, given the very low valuations these shares were trading on until recently, they still offer value compared to other areas of the global market. Lastly, as was pointed out in the opening section of this article, foreigners are still cautious on SA equities. If investors regain confidence in local equities and return to our markets, it could provide a powerful boost to performance.

However, to benefit from strong performance from SA shares, investors have to ensure that they are obtaining true SA Inc exposure. We believe many of the best opportunities reside in overlooked (and less popular) parts of the market. As always, partnering with a manager with a proven track record of selecting future winners will be key.