Things are looking up for stocks in South Africa

South African equities are facing significant challenges, but they are severely undervalued relative to their growth potential.

Investors in South African securities are facing significant issues, such as infrastructure collapse, the highest interest rates since the Global Financial Crisis, load shedding and corruption.

Justin Floor and Dirk Jooste at PSG Asset Management said that these challenges have resulted in many local assets being derated materially over the last few years.

“The equity market is being priced at historically low valuation multiples, and in some cases, companies are acutely undervalued relative to their prospects for growth and shareholder return,” the experts said.

“Additionally, South African Government bond yields are hovering around 12%, one of the highest real rates globally.

“The rand has also been weak and has underperformed the currencies of many other emerging market countries.”

However, there are reasons to be optimistic, such as the predicted weakening of the US dollar.

Emerging markets and commodity markets are susceptible to movements in the greenback, but evidence of the last couple of years suggests that we may be in the early stages of a dollar down-cycle.

“In the past, emerging market and South African equities have not fared well during strong US dollar periods.”

“However, periods of dollar weakness can be a significant tailwind for investment returns in emerging markets, including South Africa.”

Better back home

In addition, many of South Africa’s domestic challenges are set to improve, shifting from headwinds to tailwinds.

For instance, with inflation set to average around 5% this year, the South African Reserve Bank is expected to cut interest rates by 1% to 2% this year and into 2025.

“This would result in a substantial decrease (15% to 30%) in the base cost of capital in the economy, potentially benefiting consumers’ disposable income and reducing company interest rate expenses.”

“Moreover, it could have a positive impact on security valuations such as PEs and bond yields.”

In addition, load shedding is likely to be less intense in the next few years following energy reforms, while there is also considerable new generation capacity in the pipeline from the private sector.

Massive units at Medupi and Kusile are also coming online, while private-sector resources are being deployed at Eskom’s generation fleet.

“More reforms are needed, but the current direction of travel will be evident in economic growth, as well as the earnings and cash flows of affected companies.”

Select sectors in the local economy are also set to benefit from the progress, albeit sluggish, at Transnet and its ports.

Bring back the money

Technical issues are also expected to see greater inflows into South Africa.

Over the last five years, there has been an increase in equity and bond outflows, the relaxation of prudential offshore limits (Regulation 28), and local and foreign institutional investors reducing the allocations in South African assets.

Thus, the average global emerging market portfolio is now underweight in South Africa.

“The reality is that many large South African balanced funds are close to maximum offshore capacity (45% as per Regualtion 28) and may need to start directing funds back to rand assets.”

“A further sign of a bottom in the market is the fact that private capital is buying and delisting South African companies.”

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