A tough economy does not necessarily equal poor investment returns

A tough economy does not necessarily equal poor investment returns

We find that many investors conflate the issue of the prevailing economic environment with that of stock market returns. As with many things, however, the reality is often more complex. The broader economic context undoubtedly deserves consideration, but it should, in our view, only be one part of the stock selection process. We believe the opportunity for stock pickers such as PSG Asset Management lies precisely in understanding when the economy becomes a prohibitive factor to investment, and when there are aspects which the market might be overlooking due to its reliance on the popular narrative. And, while these issues may seem less important during times of buoyant economic growth as the tide ‘lifts all boats’, we believe that they become very salient in a growth-constrained environment like the current one locally.

Below, we unpack some of the often-overlooked factors that we believe can have a material impact on future returns – and which stock pickers, with their intense scrutiny of company specific factors, are well-positioned to exploit. We believe this effect is further amplified where stock picking is coupled with a focus on an appropriate entry price into the investment, as is the case with PSG Asset Management’s 3M investment process.

The economy is not one homogenous entity
While a focus on headline factors may create the impression that the economy is one homogenous entity, this is not the case. It is possible to see pockets of growth within a depressed economic environment. A recent local example is the boom we have seen in the travel and tourism sector post the Covid-19 pandemic, as pent-up demand was released. This has translated into exceptional revenue growth from companies that operate in these sectors, even as the South African economy has broadly languished.

Pockets of growth exist: examples from tourism and leisure

Source: Bloomberg. *WBHO refers to SA revenue only.

A tough economic climate undoubtedly presents a challenge to management – and this is precisely what gives stock pickers the edge. Tough economic conditions often lead to the demise of poorly managed companies, creating supply/demand imbalances as the competition falls away. A pertinent example from the local economy is the construction industry. In 2011, there were eight large, listed construction companies sharing the revenue ‘pie’. While the size of the pie has shrunk, it is now divided between only two listed companies – WBHO and Raubex.

Construction industry capacity has fallen by 60% over the last decade

Sources: Company reports and PSG Asset Management.

Superior strategies win market share
Investors should never forget that a company’s share price is influenced by a whole host of factors including its strategy, target market and management acumen – all of which are at least partially under management’s control, even if the broader environment is not. Pertinent samples here include the market share swings we have seen playing out in the food retail environment as Shoprite has become the clear market leader compared with Pick n Pay, Woolworths and Spar.

Management can create value via corporate action
Certain companies are laden with opportunities to unlock value via corporate action irrespective of the prevailing economic environment. A recent example which has benefited our clients is the action taken at Remgro, which is the quintessential investment holding company and a conglomerate with exposure to many sectors of the local economy. Faced with a share price that reflected a wide discount to the value of its underlying net asset value, Remgro created value, especially from 2020 to late 2023, by inter alia unbundling some of its banking and Grindrod holdings, selling and merging assets and buying back shares. Buying back shares can be a smart capital allocation move that leads to increased earnings per share growth even in a tough environment. In fact, the tough environment often creates depressed share prices and hence the opportunity to do buybacks.

Follow the cash flow
Many locally listed companies derive a substantial portion of their revenue from other countries and therefore in currencies other than rand. Thus, while their share prices may suffer from the association with the SA Inc. label, earnings may prove highly robust, despite the tough local economic climate as revenue from sources external to SA are not impacted by the local economic malaise. Examples here include Supergroup, AECI, Discovery, and Standard Bank. Taking a closer look at Supergroup we note that it trades on a PE ratio of six times despite approximately 60% of its market capitalisation comprising its investment in the Australian-listed SG Fleet.

Avoid the value traps
As Warren Buffett says, “Only when the tide goes out do you discover who's been swimming naked.” In a challenging environment, avoiding value traps can be as important as selecting the overlooked gems. 2023 saw the high-profile troubles at Transaction Capital. Active stock pickers can add value by avoiding exposure to failures and value-traps.

Looking beyond a constrained local environment, we see scope for stock pickers globally
Add to this the current unwinding of imbalances we are seeing in global markets, and we believe stock pickers are likely to enjoy a boon in all areas. Concentration levels in globally significant indices like the S&P in particular have soared to new levels over the past few years, delivering a period of ‘easy returns’ for index trackers and those who unquestioningly hopped aboard the ‘big tech’ bandwagon. However, we believe that these imbalances are in the process of reversing. For more about our thinking on this, watch this video.

In the process, the environment may soon become more challenging for passive investors and others who rely on the recent past to inform their investment decision making (momentum investors), while it is likely to benefit fundamental stock pickers. Thus, looking at both the local and global environment, we believe that stock pickers are well poised to add value to client portfolios going forward.

Mikhail Motala is a Fund Manager at PSG Asset Management.