Iain Power, Chief Investment Manager at Truffle Asset Management who manage the Nedgroup Balanced and Managed Funds, provides an over of the SA environment with a focus on the retail sector, which has been at the epicentre of the crisis.
The SA economic backdrop
Data from the last ten years show the dislocation of the SA economy relative to the rest of the world. From a GDP per capita growth perspective, South Africa has, by and large, returned per capita growth in line with the median country. Since 2010 and the Zuma era, there has been a dislocation and widening gap to the extent that, on a per capita basis, South Africans have been getting poorer. While we more than doubled our debt to GDP over the period, we have nothing to show for it. This context is important as it is the underlying environment in which retailers and SA focused businesses have to operate.
SA is losing its competitive position
South Africa’s electricity prices up until around 2009 were below CPI. We enjoyed a stable and powerful network that delivered a reliable service at a competitive price. This encouraged companies where electricity formed a big part of their cost base to invest in SA, e.g. BHP Billiton. From 2007/8 onwards, underinvestment and lack of maintenance resulted in Eskom tariffs increasing by 446% compared to inflation at 98% to where we are today. SA corporates have become less competitive as a consequence.
SA apparel retail sector valuations look cheap
Relative to the history, current multiples in the apparel retail sector look cheap versus the long-term median over the last 10 years. You are paying a discount for a unit of apparel retail industry. Previously you paid a 13x multiple whereas today you’ll pay about 10x on a 2-year forward PE ratio. Over that same 10 year period, however, the returns on invested capital in the apparel retail industry have halved. There are various reasons for this, including South Africa’s lower growth backdrop and margins, which have come under pressure. In an attempt to escape, many businesses went offshore in search of better markets and bought assets overseas, which have been disastrous for shareholders, e.g. Truworths’ purchase of Office where they effectively wrote off 30% of their market cap and the purchase of David Jones by Woolworths, neither of which turned out well.
SA’s own handcuffs created a tough environment for growth
Due to a lack of structural reform, the extraordinary rents that taxpayers have paid to fund bankrupt or non-going SOEs, we’ve slowly seen investor and consumer confidence decline. A low growth environment results in less money circulating in the economy, which ultimately manifests in lower sales. With margins coming under increasing pressure, businesses ultimately have to start looking at their cost base.
Over the last 10 years, the operating costs in a business as a percentage of its sales has risen. The underlying costs in the business have been rising at a faster rate than that of sales, putting pressure on margins and ultimately resulting in less profits for shareholders. It’s therefore no surprise that we saw a lot of price destruction in the retail sector even prior to Covid because of what we’ve been seeing in the SA economy.
Superficially, the current valuations of many of these businesses are much cheaper than they were, but is there a mean reversion opportunity to the extent that profits can mean revert and profits can rise with a commensurate rise in PE’s? Earnings recovery will be a function of structural reform in the economy.
The food retail sector has been a lot more defensive, but is also under a lot of pressure. The earnings growth estimates for the next three years are, on average, slightly higher than inflation and the 3-year forward looking ROE’s have come down. When you’re looking for bargains, you want to buy into these businesses at attractive prices. The current forward multiples versus the 5-year averages for some of the major food retailers don’t look compelling with the exception of Woolworths. Food retail does not look cheap optically compared to the apparel retailers which do. We think that economic certainty and policy reform is needed before investor and consumer sentiment returns and this value opportunity can be unlocked.
SA investable universe is dominated by offshore earners
Twenty years ago, SA focused businesses were almost 70% of the SWIX All Share. Today, they account for just under 40%. Many of the bigger businesses, which have continued to grow and are either listed in SA or generate their earnings by exporting, are enjoying the benefits of a robust global growth environment. While there might be opportunities in SA Inc, we need economic conditions to improve and the state to take the lead in terms of reform. If this doesn’t happen, these opportunities might turn out to be the value traps that they’ve been for the last few years.
Volatility will remain high, but this will create opportunities for managers who are nimble and able to allocate capital quickly to shares that are sold down below their intrinsic value.