Stocks and Shares

Should you buy South African stocks?

South African stocks intrigue me. That’s because the country has had the world’s best performing stock market over the ultra-long run. A reader asked me to take a closer look. My thoughts follow on what to consider.

South Africa is an unusual emerging market, in that it’s had a stock exchange in Johannesburg since November 1887. That was set up shortly after large gold deposits were discovered in the country, to help fund the mining business.

This leaves the country with a pretty big stock market. According to the World Federation of Exchanges, the total market capitalisation was US$1.3 trillion at the end of January. That compares with US$1.1 trillion in Brazil, US$2.4 trillion in India, and US$0.5 trillion in each of Mexico and Indonesia.

One of the things I read every year is the Credit Suisse Global Investment Returns Yearbook. It analyses the ultra long-term performance of a couple of dozen country stock markets.

The 2014 edition highlighted a finding that surprised me. Of the markets covered – being those with long data sets – South Africa was the best performer. That was both over the 114 years from 1900 to 2013 (inclusive), and the 50 years from 1964 to 2013 inclusive.

The following table summarises the results, all in US dollar terms, including reinvested dividends but before taxes. The “Multiplier” column refers to the full 114 year period.

Clearly, this shows how even small differences, over long periods of time, make a huge difference after compounding (profits on profits). The annual rate of return from 1900 to 2013 was only 0.9% higher in South Africa than in the US. But the end result, after 114 years, was 2.7 times as much (3,372 divided by 1,248), or 170% higher.

Why did South Africa outperform so much? I suspect a lot of it was down to low wages for labourers, both when it was a colony and during the apartheid years (1948-1991). For example, this would have allowed the labour-intensive gold and diamond mines to have lower operating costs than their foreign competitors. But it’s only a theory.

In more recent times, South African stocks have continued to perform strongly. The following chart compares total US$ returns (including dividends) for the MSCI South Africa index with the MSCI USA and MSCI Emerging Markets. This goes back to December 1992, when the MSCI South Africa index started.

It’s clear that South African stocks have performed well in the long run, and also in the past couple of years. The question is, are they a good bet today?

Here are some basic facts about South Africa:

  • 24th largest country in the world (just ahead of Colombia, approximately twice the size of Texas)
  • Population 54.8 million, growing at 1.6% a year
  • 46% below 25 years old, median age 27
  • Unemployment rate 28%, youth unemployment 50%
  • Real GDP growth: 1.3% in 2015, 0.3% in 2016, 0.7% in 2017
  • GDP per capita in 2017: US$6,279
  • Gini index (a common measure of wealth disparities): 62.5, the second highest in the world
  • Finances 2017: Budget deficit 3.2%, Current account deficit 2.9%, public debt / GDP ratio of 50%.
  • 85% of the population have electricity, 54% internet
  • Main exports: gold, diamonds, platinum
  • Imports almost all oil and the bulk of natural gas needs

In summary, the country has manageable debt for now, but current finances aren’t great. In recent years the economy has been growing more slowly, in real terms, than the population. Poverty is still rife, 27 years after the end of apartheid in 1991.

The political scene has been fairly messy recently. The last president, Jacob Zuma, was in office between May 2009 and February this year.

Zuma had to resign eventually, in the face of a no confidence vote in Parliament. A couple of weeks ago it was confirmed that he will face 18 charges of corruption, including 700 counts of fraud and money laundering.

Zuma was replaced by Cyril Ramaphosa, a wealthy businessman. His big idea is land reform. It’s expected that farmland will be expropriated from current owners, in some cases without compensation, and become state-owned.

If this happens, then the best-case scenario is for the land to be rented to productive, private farmers (although that would open up plenty of new opportunities for government corruption).

However, if the farms end up state-run, or broken up into smallholdings, then I suspect food production will collapse. That will damage the economy, and potentially lead to political unrest. Whether or not South Africa turns into another Zimbabwe…well, we’ll just have to wait and see…

Can South African stocks be attractive in this environment? A glance at the chart above suggests that prices haven’t held back.

The easiest way to buy into South African stocks is via the iShares MSCI South Africa ETF (NYSE:EZA). This is a decent sized ETF, with invested assets of US$501 million and annual fees of 0.59%.

Despite the name, EZA doesn’t invest in the MSCI South Africa index, but in a modified version of it. This is the MSCI South Africa 25/50 index.

The 25/50 index structure limits any single stock to less than 25% of market capitalisation. Also, the combined holdings that are each greater than 5% are limited to a total of 50%.

In this case, the limits make at least one significant difference. In the ordinary MSCI South Africa index, one single company, Naspers, constitutes 31%. In the “25/50” index that weighting is reduced to 20%.

That’s still a lot. So if you’re interested in South African stocks then you need to know a little about Naspers.

Naspers is an internet and media group that claims operations in 120 countries. Revenue is growing at a modest 2-3% a year, and it has negative operating cash flow. However, the stock still trades with a P/E of 28 and price-to-sales (P/S) ratio of 15.6. How can that be?

The reason is that Naspers was an early investor, back in 2001, in Chinese internet giant Tencent. It still owns 31.2% of Tencent today.

Tencent operates across a lot of internet businesses in mainland China. Those include online and mobile gaming, instant messaging, online advertising, cloud storage services, payment services and online music.

Currently, Tencent has a market capitalisation of US$502 billion, and a P/E ratio of 43. That means, at the current market price, Naspers’ stake in Tencent is worth US$156 billion.

Which is interesting. Not least since Naspers’ own market capitalisation is only US$107 billion. Either investors in Naspers think the Tencent stake is massively overpriced (which is possible at that P/E), or there’s some serious hidden value embedded in Naspers stock.

As it stands, all Naspers’ other businesses and investments are currently valued at less than zero at its current stock price. I haven’t yet done a deep dive on the company, but, given this, I’ll certainly take a closer look. It’s the sort of thing that should pique any investor’s interest.

As for the rest of the EZA ETF, the biggest sector weighting (32%) is to financials, which are mainly banks. Next is consumer discretionary (27%, of which 20% is Naspers), followed by Materials (11%), being mining and such like. The rest is split across a diverse bunch of sectors.

Stripping out Naspers, I estimate that the rest of the index has a P/E ratio of 15.4, price-to-book ratio (P/B) of 1.85 and dividend yield of 3.9%. Crunching a few numbers, and assuming a constant return on equity and unchanged P/E, this points to total annual returns for investors of 8-9% a year.

But that’s in South African rand, the local currency, since most of the underlying company profits will be in rand (e.g. banks, consumer stocks, etc.). To assess whether to invest in a place like South Africa, we need to take the currency into account.

Over the past 10 years, the rand lost 41% against the US dollar. That works out as losing 5.1% a year with compounding.

Consumer price inflation was 3.8% in the past year, although that’s down from 6.1% a year ago. In fact, the rand has strengthened 22% against the US dollar since November 2016. But my suspicion is that the longer term trend will continue to see the rand lose value against the US dollar (see the next chart).

In any case, the prospect of 8-9% profit a year from South African stocks isn’t great in the first place, for a country with so many structural issues and political risks. Since there’s a good chance of losing a few percent a year on the currency too, over time, this makes me think South African stocks are unattractive at current prices.

Effectively, if you buy EZA, about a fifth is heavily influenced by Naspers’ investment in Chinese internet company Tencent. The rest looks fairly richly priced, given the currency and other risks. So I’d stay away from this ETF.

If anything, South Africa is a stock pickers’ market. But only with a lot of careful analysis to find genuine bargains, given the risks and uncertainties.

Notwithstanding the excellent long-term track record of South African stocks, I can’t see a case for buying the country index at these levels.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.