5 South African stock picks for 2018

In terms of local share price performance, 2017 was a year of extremes, says Alwyn van der Merwe, director of investments at Sanlam Private Wealth.

Within the Top 40 shares, the winners stacked up spectacular performances – Naspers, for instance, gained 87.4% from 1 December 2016.

The losers, meanwhile, performed diabolically – Netcare bringing up the rear with a share price decline of 27%, SPW said.

“Only 11 of the Top 40 shares outperformed the average of the index, which reflects how narrow the advance of the widely quoted indices was. It was a year in which investors rewarded successful operational results exponentially, but they were equally punitive when companies disappointed,” said van der Merwe.

He noted that the group’s stock picks for 2017 generally lagged the market, which he said again served as a warning against forecasting over the short term.

“Investor sentiment can often drive share prices way off their intrinsic value over the shorter term. There is still popular demand for one-year stock picks, but we offer these with the ‘health warning’ rightly associated with short-term recommendations,” van der Merwe said.

The investment analyst has picked the following five stocks which he thinks will provide value in 2018.

Tongaat-Hulett

“Tongaat is an exciting recovery story, underpinned by organic capacity growth. The company’s results have declined over the past three years due to an extended drought in its cane-growing areas, exacerbated by high maize input prices to its starch business (which usually acts as a diversifier) over the past year,” said van der Merwe.

“Over the next three years, we expect the business to benefit from operating leverage as sugar volumes recover and prices return to more normal levels. Tongaat continues to monetise its extensive land portfolio successfully, and will likely generate more than R800 million per annum of operating profit over the next two years.

“Three years of declining sugar earnings have set the share price back to 2012 levels, but recovering earnings mean the company now trades at a 9.4 times multiple on the expected earnings for the next 12 months. Over the next three years, we expect headline earnings per share (HEPS) growth of 35% per annum from the low 2017 base to R16 per share in the 2020 financial year.”

Van der Merwe believes that the stock is also cheap on a sum-of-the-parts basis, with the land business alone worth around R55 per share (versus a share price of R106). “We have a fair value of R134 per share,” he said.

EOH

The analyst noted that EOH is a market darling that has fallen from grace. The group’s 17-year history of reporting earnings growth in excess of 20% came to an end in the 2017 financial year (FY17), when growth fell to 16%.

“In light of this slowdown, multiple concerns around the business’s stability have arisen – from the retirement of founding CEO Asher Bohbot to unproven (and subsequently retracted) media allegations of impropriety in winning government business.

“But most concerning is that working capital has risen ahead of revenue recently, creating a gap between accounting profits and cash flows. This should begin to reverse in FY18.”

Van der Merwe said that the market has punished the share price far too severely for the above issues.

“We expect HEPS growth of 15% compound annual growth rate (CAGR) for the next three years – yet the share trades at a rolled forward earnings multiple of only 8.2 times, with a 3% dividend yield and a 10% free cash flow yield.

“The share price already discounts a decline in earnings, which provides investors with a wide margin of safety. We have a fair value of R115 per share based on a conservative 11.5 time forward price/earnings (P/E) multiple. When we value the share on a discounted cash flow basis, we put a value of a R120 on the share.”

Metair

Van der Merwe said that this share also featured on the company’s 2017 list, but the share price performance was disappointing.

“Our investment thesis, however, hasn’t changed. The one-off retooling of Metair’s South African manufacturing facility and struggling European operations, largely on the back of deteriorating political relations between Turkey and Russia, continued to weigh on the share price.

“Metair delivered a better-than-expected earnings result in first-half 2017, yet the share price did not respond,” said van der Merwe.

The analyst said that the company remains on a path to rebalance the business towards batteries, which are higher margin and less cyclical than auto components.

It is, however, exposed to a number of negative factors from a news perspective, including South African manufacturing exposure, a business in Turkey, and a narrative that lead acid batteries are being displaced by electric vehicles. Ultimately, cash flows generated and dividends paid out will overrule sentiment on the former concerns.

“We believe investors will change their minds on these factors over time, or when the results prove these concerns unfounded. Uncertainty regarding the impact of electric vehicles and the demand for lead acid batteries is likely to linger longer, however.

“The company trades on a seven times forward multiple, with decent growth prospects in our view. While the market has been brutal toward smaller companies over the past few years, we don’t buy the argument that big companies will continue to get bigger into perpetuity – the maths doesn’t add up,” said van der Merwe.

Invicta

As an importer and distributor of agricultural and construction equipment, and a leading distributor of engineering consumables and provider of engineering solutions, Invicta is often at the mercy of the strength of general economic activity, particularly activity within the primary sectors of mining and agriculture, said van der Merwe.

“One can therefore understand investors’ current scepticism when ‘rating’ the company. As is common practice, investors are unlikely to give a company the benefit of the doubt when operations have been under pressure for a sustained period, as has been the case with Invicta.”

The analyst said that company has a strong balance sheet, which would allow acquisitions at a time when prices are low. Despite modest earnings growth expectations, the share is currently trading on a 12-month forward earnings multiple of just over eight times.

“In our view, investors are being overly cautious, and patient investors are likely to be rewarded for the risk they take to invest in this share.”

Coronation Fund Managers

Coronation’s profitability is mainly driven by two factors – assets under management (AUM) and its fee margin, said van der Merwe. Both of these were under pressure over the past three years, but are expected to improve over the next year, he added.

“AUM are driven by the markets and the net in- or outflows from clients. The recent rise in the South African equity market after a three-year consolidation should start having a positive impact on Coronation’s earnings in the new financial year. Despite suffering large investment outflows over the past three years, the momentum seems to be turning, driven by the reopening of a few of its key institutional mandates and a recovery in its relative investment performance.

“The improved relative investment performance is also expected to lead to a recovery in investment performance fees – despite pressure on fees in the industry – over the next year, from a low base. The share is trading on a very undemanding one-year expected dividend yield of 7.1%.”

This, said van der Merwe, compares favourably to the JSE All Share Index of 3.2%. “In our view, Coronation is a cheap proxy for those who believe local shares will continue to outperform other local asset classes.”


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5 South African stock picks for 2018