If you own equity in South African companies that derive most of their income from business activities within South Africa, you might need to start adjusting your thoughts about what they are really worth, despite their current market prices. According to African investment specialists RisCura, the fundamental value of such equity investments have declined by as much as 49% in dollar terms between December 2014 and March this 2016. Yet this is not being reflected in asset prices.
The many economic, social and political upheavals South Africa has endured over the past 18 months have profoundly changed our economic prospects as well as the perception of risk in the country. SA has gone from a forecast GDP of 2.3% for 2015 to one of 0.7% in March. More recently, at the July Monetary Policy Committee, the forecast was further revised downwards to 0.0%.
These conditions must have had a negative impact on asset values. Yet listed assets continue to trade at very high multiples and owners of unlisted assets in many cases still have expectations of realising assets at relatively high valuations.
Perhaps investors are a little punch-drunk from the slew of high-profile events that have caused dramatic movements in asset prices.
For example, the Nenegate scandal, caused exchange rates and equity prices to plummet; the recent heightened risk of a South African sovereign debt downgrade, caused a spike in debt yields; the fall in the prices of a number of commodities, caused a decrease in export growth, while weakened emerging market sentiment has seen capital pouring out of developing markets. Recently, the rumours of the potential arrest of the Finance Minister caused a decline in stock prices and exchange rates.
Beneath the market noise of froth and panic, how have asset values really moved in the recent past as a result of decreased income prospects and a higher risk profile? Unfortunately for the South African investor, the answer is a rather sombre one.
Asset values are a function of their perceived ability to generate future income and the perceived risks that could impact that ability. The forecasts of significant indicators, such as inflation, GDP growth and exchange rates, as well as the perception of risk, which influences the cost of debt and equity will therefore drive asset values. Changes in the expectations of any of these variables will have a corresponding effect on asset value.
To find out how asset values have changed, RisCura took an example asset, and estimated its future income stream at both December 2014 and March 2016, using the then prevailing expectations for GDP growth and inflation, and discounting this income stream by a market weighted cost of debt and equity at that moment in time.
A large contributor to the decrease in asset values that resulted is the decline in forecasted real GDP growth, as mentioned above. The effect of this change alone, leads to a decline in asset value of 10.5%.
The largest factor however affecting asset values over the period has been the increase in the cost of debt and equity, which are the result of perceived risk. The cost of debt has risen due to the potential for a South African sovereign debt downgrade by the credit rating agencies, exacerbated by the 1.25% in rate hikes made by the central bank over the period, with further rate hikes on the cards. The cost of equity has also increased with increased investor uncertainty. If changes in the cost of capital are factored into the calculation, asset values decline by a further 24.5%. The combined effects with growth forecasts, leads to a total decrease of 35%.
South Africa has been fortunate in the last 20 years to receive significant Foreign Direct Investment. These investors are additionally exposed to foreign currency risk. After adjusting for the 21.3% depreciation of the Rand against the Dollar, asset values decreased by a further 14% in dollar terms, leading to a total decline of 49%; not particularly impressive for the continent’s most developed market.
What comes as a surprise then is the mismatch between the above and the JSE listed equity market, whose current multiples would imply very high valuations based on the current level of the JSE All Share Index. The index is currently trading on a price to earnings (PE) multiple of around 21 times, significantly higher than the long-term average of 15. This may be partially explained by the JSE’s large foreign exposure; 65% of the JSE top 40 earnings are earned in foreign currencies meaning these companies are less susceptible to the South African business environment and their foreign operations act as a natural hedge against South African currency depreciation.
Despite this boost in rand earnings the JSE only returned 5% for the period under review and would have been considerably less if it were not for the rally in the index in March 2016. This return would imply a negative real return, although still not nearly as significant as the fundamental calculation indicates. Similarly, Private Equity returns over the period were also respectable, even though they did drop marginally from historical averages, again showing a mismatch to the above.
This mismatch between the movement in asset prices and the movement in their fundamental value is appropriately summed up in the quote by Warren Buffett: “Price is what you pay, value is what you get”. It remains to be seen whether asset prices will fully reflect these theoretical changes in value, or if they will continue to remain buoyant. As always the market will be the final arbiter.
Mark Winter is an Analyst at RisCura
As originally appears: https://www.africaglobalfunds.com/opinion/are-south-african-asset-prices-overvalued/