Some thoughts on valuations: Seed Investments

Ian de Lange of Seed Investments writes that a year ago the FTSE/JSE All Share index had dipped down to 18 000. A year later the index is up around 28 000.

A commentary by Allan Gray notes that, “It is a great irony (but also self-evident) that most investors would have found it incredibly difficult to buy shares then, but find it much 'easier' to buy shares today when the prevailing consensus is that the worst of the credit crisis and recession is behind us and that massive global monetary and fiscal stimulus have saved the day.”

They point out that foreign investors have been net investors into JSE shares to the extent of R22,5 billion over 6 months to February. Over the same 6 month period a year back, foreigners were net sellers of R40,2 billion, when the JSE All Share in average dollar terms was some 55% cheaper.

Time and time again, taking a contrarian investment position, proves to be a winning strategy – merely because the mass market is wrong at the extremes.

They then make an almost ominous statement saying that “It seems the global “risk trade” is currently driving up the South African stock market and the value of the rand, but as we learned  in late 2008, the door is narrow should all foreigners choose to leave at the same time.”

The question then is …. with the rand relative to the dollar up 28% and the local shares up 55% in local currency, should investors reduce local exposure in favour of foreign exposure or vice versa.

Please get me out of overseas shares

Unfortunately because most investors drive their outlook based on the review, they will make a current assessment of where to invest, based largely on what has performed well in the past.

Looking back over a 10 year period, it is very evident that local has been lekker. The global market has given you close to zero over the last ten years compared to a return in excess of 300% on the local market. 

But please don’t be mistaken. Because the return from equities are mean reverting, the superior local ten year return is NOT a permanent feature of local shares relative to global shares, but largely a function of the relative starting valuations.

I looked back at a manager commentary of the valuations of the South African market and the US market in 1999. It gives a very strong clue as to the reason for the subsequent 10 year outperformance.

On the S&P 500. “By the end of 1999, the shares of the five companies which made the biggest contributions to the S&P 500 were priced at a weighted average of 70.8 times latest earnings and 22.8 times book value. The concern is that, at current prices, these shares are discounting extremely high rates of growth in revenues and earnings and, if these challenging growth rates are not met, investors face the risk of substantial loss.”

On the South African equities. “… South African equity valuations remain low relative to those in comparable markets.”

There is a low probability that the next 10 years will be a repeat of the last 10 years.