Global and domestic investors have justifiably started to question South Africa’s merit as a viable investment destination. If the financial-market mantra, “capital follows growth” holds true, then capital will continue to leave South African shores in search of better returns.
According to Bloomberg, South Africa’s foreign portfolio outflows across equities and bonds reached a staggering $9.8 billion over the 12-month period to 31 May 2024. Poor economic growth impacted by misguided government policies, extremely poor governance, and widespread corruption have led to, and currently underpin, investment apathy.
Over the last 16 years, South Africa’s gross domestic product (GDP) growth has averaged just 1% per annum. By comparison, our emerging market peers averaged 5% per annum, while globally, GDP grew more than 3% annually. This measurement period is relevant because it captures the era of coordinated corruption and graft perpetrated under the guise of “radical economic transformation”. The hollowing out of state institutions and gross misallocation of taxpayer funds have had a profoundly destructive impact on the economy. In 2008, South Africa’s GDP accounted for 0.6% of global GDP; today, its contribution stands at just 0.4%.
South Africa’s investment woes
South Africa’s anaemic growth has been dire for our stock market performance as well. In 2008, the JSE All Share Index comprised 178 constituents and was valued at 2% of the MSCI World’s market value. Today there are 132 constituents accounting for just 1.3% of the MSCI World market value. Over the same 16-year period, real earnings growth has averaged just 0.4% per annum. The MSCI World Index comprises more than 1,400 listed counters globally and has delivered real earnings growth of 4.5% annually once adjusting for currency. The JSE All Share’s key financial metrics, such as return on equity and price-to-book ratios, have also underperformed against global peers and continue to drift lower.
We also cannot ignore the sub-investment grade (junk) status that was ascribed to South African government bonds in 2020. Many foreign investors were forced to sell our bonds due to mandates that restricted their investment universe to investment-grade bonds. This raised the country’s risk premium and, therefore, the cost of capital for domestic equities. Local investors have also taken advantage of the relaxation of exchange controls and Regulation 28 foreign investment limits to increase capital flows into foreign investments. With so many more external growth opportunities, it is logical that domestic capital continues to pursue a strategy of global diversification. For foreign capital, the lack of growth and decreasing market size makes it easier to ignore.
South African valuation assumptions
So where does this leave investors who are forced to hold assets in the domestic market; is all hope lost? Citadel does not believe so. It is easy to get trapped in the negative political and economic narrative and, in the process, miss the opportunities that emerge. Part of Citadel Asset Management’s role, as an investment manager, is to be pragmatic and constantly reassess its approach to the evolving investment environment and opportunity set. A major step in this process is to recognise that, without major reform, South Africa will remain a small, open, ex-growth economy that is likely to ebb and flow in a sideways trend with the global economic cycle.
This type of assessment will result in changes to our valuation assumptions as well as the way in which we select opportunities and structure portfolios. For example, if a low/no growth economic environment persists for the foreseeable future, true domestic growth companies will become increasingly hard to find. Without growth as the dominant driver of long-term returns, domestic buy-and-hold strategies will also be more challenged. On the other hand, greater macro-driven cyclicality could elevate the relevance and attractiveness of mean reversion strategies, where we try to capture profits as the price of an asset returns to more normal levels. Investors will need to adapt to an environment where excess returns (alpha) are lumpier than before and driven more by macro trends than by company-specific growth vectors.
The macro exposures we reference above are best understood by disaggregating the earnings composition of the South African equity market. Our work shows that the three biggest exposures are:
- The rand
- The Chinese economy
- Domestic interest rates
South Africa’s investment exposures
These exposures have evolved from the investing behaviour of corporate South Africa. JSE-listed companies have been directing their capital budgets offshore for at least the last two decades but this trend has gathered momentum since 2008. These ventures have achieved varying levels of success. Some investments, such as those made by Bidvest and Naspers, have been successful, while those made by many of the retail companies have been poor. Success aside, the overall result has been a rather spectacular shift in the composition of listed equities in South Africa. Currently, more than 60% of the JSE’s market capitalisation comprises companies with offshore operations and earnings.
Two observations flow from this. Firstly, the equity market is significantly diversified away from the domestic economy, leaving investors somewhat immunised against the economic performance of South Africa. Secondly, the fluctuations in the rand exchange rate play a meaningful role in determining domestic investment returns. On the one hand, the JSE All Share’s earnings are naturally hedged against a weakening rand. On the other, rand strength tends to dampen the earnings growth, dividends and returns generated by foreign assets. The rand also happens to be one of the most volatile currencies in the world. Understanding the different regimes in which the rand ebbs and flows presents an opportunity to capitalise on its cyclicality.
The JSE All Share’s earnings stream is also broadly diversified across a multitude of industries, including mining, technology, media, banking, and property, to name a few. A deeper assessment, however, shows a very high exposure to the Chinese economy. Direct exposure through companies such as Naspers (Tencent) and mining companies comprise roughly one-third of total earnings. Indirect (look-through) earnings from industrial companies like Richemont, British American Tobacco and Bidvest, among others, take this exposure comfortably above 40%. China’s economic success has provided opportunities for entrepreneurial South African companies to achieve growth despite lacklustre domestic growth.
Looking forward, however, domestic investors will need to assess the implications of China’s property crisis, technology regulation, demographics, and geopolitical tensions with the developed world. The COVID-19 pandemic highlighted the risk associated with supply chain concentration in China. Global companies have moved rapidly to diversify their supply chain away from the world’s second-largest economy. Foreign fixed capital investment (divestment) has turned into a headwind that will likely get stronger with increasing tariffs and technology export restrictions applied by Western governments. These are all potential sources of market volatility that could challenge the investment merits of South African companies with large exposure to China. A strong macroeconomic grasp on the Chinese economy will be even more important to achieving success in the South African investment arena.
Although somewhat diminished, domestic macroeconomics still plays a role in the investment environment. It impacts the fundamentals of a cluster of stocks commonly referred to as SA Inc. This is a broad collective of listed retail, financial and domestic industrial companies that derive nearly 100% of their earnings from South Africa. Their collective earnings exposure has dwindled to just 20% of the JSE All Share Index. SA Inc.’s market value has also derated in line with the weak domestic economy, high interest rates and negative investor sentiment. In a cyclical upturn, driven by lower interest rates and a stronger rand, SA Inc. still has the potential to deliver powerful returns. While South Africa’s structural challenges impact long-term growth prospects, they do not necessarily change its cyclical attributes.
Multiple headwinds continue to batter South Africa
It is fair to say that investor sentiment towards South Africa is negative at present. This has manifested in weak asset valuation across the board. Our top-down and bottom-up valuation tools show that South African equities are trading well below fair value. As discussed above, this mostly reflects the domestic political and economic reality, but global economic headwinds have also played a fundamental role. Strong inflationary pressures have caused global and domestic interest rates to rise sharply from the lows of the pandemic. Apart from the United States, Japan and India, high interest rates have hurt profitability and valuations across the globe. Emerging markets have been hit the hardest as global investors have exited emerging markets, preferring the refuge of their developed market peers.
Foreign investment in JSE-listed equities has also dwindled to historic lows. Moreover, local equities have had to deal with the added challenge of an amendment to Regulation 28 of the Pension Funds Act that raised the foreign investment allocation limit to 45%. Outflows from pension and retail funds have amplified the pressure on domestic stock prices and valuations.
To make matters worse, profitability has been under severe pressure from high domestic interest rates and a weak economy. Traditionally, when trough price-to-book ratings occurred simultaneously with trough profitability, South African equities have presented a good buying opportunity. We are approaching such a point. A declining global and domestic interest rate cycle could be an ideal catalyst.
No change without reform
Without major economic and political reform, the South African economy is unlikely to change its long-term course. South Africa’s merit as an investment destination will continue to lose appeal to foreign investors. The weight in the MSCI World Index is small enough for active investors to take zero exposure. Many already have. The marginal rand-investment by domestic investors is also likely to head offshore but for those constrained by foreign allowance limits, cyclical opportunities will still exist. However, a rethink of strategy is needed to improve the probability of achieving success.
