Thursday, 10 January 2013

Investec Securities: Reflections on a very good year

Equity markets: Reflections on a very good year

2012 proved to be a very good year for investors on the JSE, while it was an exceptionally good year for investors in industrial shares. The All Share Index delivered a total return (capital gains plus dividends) of about 26% while industrials on average delivered over 40%. However the resources sector was a distinct underperformer. The difference in these returns from industrials and resources was of the order of 33% per annum.

Clearly, investing in the right sectors (as well as the right stocks) is very important. As we show in the chart below, such differences in performances are not unusual. The JSE Industrial Index realised 40% more than the Resources Index in 2004 and 2009; while resources rather than industrials were the right stocks to hold in mid 2006 and 2008. Over the past 10 years industrials delivered much higher returns than resources: R100 invested in the Industrial Index (with dividends reinvested in the index) would have been worth R915 by 31 December 2012. The same R100 invested in the JSE Financial Index would have grown to R522, while the R100 invested in the Resources Index would have grown to a mere R370. Lower returns for more variable returns does not seem like a good idea.

The Industrial Index is something of a mixed bag. It includes companies that depend very little on the SA economy for their sales and profits. British American Tobacco (BTI), Richemont (CFR), Naspers (NPN) and even SABMiller (SAB), MTN and Aspen (APN) among others fall increasingly into this category of companies much more dependent on global than SA economic growth. We call these companies industrial hedges in that they are will protected agains rand weakness or strength.

The other industrial companies listed on the JSE we regard as distinctly SA economy plays. SA interest rates have an important influence on their performance. The banks, retailers and listed property companies fall distinctly into this camp. As we show below, the SA plays performed in line with the industrial hedges in 2012 despite a degree of rand weakness. They were greatly assisted by stable and low interest rates.

The superior performance of the industrial hedges and the SA plays in 2012 is explained by the economic fundamentals. The industrial companies delivered consistently strong growth in earnings and dividends while the commodity price plays – resource companies excluding the gold miners – performed very poorly by comparison, as we show below. The SA plays competed very well on the earnings front, demonstrating consistent and impressive growth in earnings, while the commodity price plays performed poorly and displayed their highly cyclical character. The industrials outperformed, doing so on their distinct merits.

One should not think that the industrial companies outperformed and the resources companies underperformed because SA fund managers were “rotating’ the assets they manage in those directions (ie more industrials / fewer resources).

If anything SA fund managers were going in the opposite direction. It is not flows of funds from SA sources that drive performance on the JSE. The investors that move the market are global investors. They are not comparing value in JSE Industrials to presumed value in Resources. Their frame of reference is to compare SA Industrials with industrial shares listed elsewhere, especially on emerging markets. By this comparison, JSE listed companies offered them value; hence the impressive share price gains. Again, overseas investors will compare JSE-listed resource companies with equivalent counters listed elsewhere. They will be concerned with the value case for JSE Resources compared to JSE Industrials. Clearly global resource companies made a very weak case to global fund managers in 2012.

The same considerations will apply in 2013. What will matter will be expected economic performance in the form of earnings and dividend growth of industrial and resource companies, not their respective price to earnings multiples. The case for investing in resource companies has to be made in the form of unexpected strength in underlying commodity prices. The case for industrials has to be made on the basis of sustained good earnings growth, accompanied by persistently low interest rates. A strong global economy, which is necessary to drive commodity prices higher, will also be good for industrial companies. This includes those SA economy plays that would benefit from a stronger rand (likely to accompany global economic strength) and lower interest rates and inflation associated with a stronger rand.

The investment jury, as always, will be out on these issues. What the market is not entitled to expect is for stock markets to perform generally as well in 2013 as they did in 2012. That would indeed be a very pleasant surprise. Brian Kantor