Insights
US bull market FOMO? SA has its own well-priced, world-class companies – Johan Barkhuysen
Beware high US valuations
The S&P 500 Index reached an all-time high in the first quarter of the year, adding $9 trillion of value and rallying 22% from the start of October 2023. However, South African investors shouldn’t give in to ‘FOMO’ due to there being several world-class, well-priced opportunities on the domestic front.
With historically high US valuations, many investors have invested near the top of the bull market cycle, only to lose once valuations return to realistic levels. History shows that when price/earnings ratios (P/E) are elevated, future earnings have been lower.
At a Forward P/E of 21 times, for instance, historically the US market has had an annualised expected 10-year return of a mere 1%, according to UBS. Meanwhile, Bloomberg data shows that the S&P 500 Index was priced at 24 times earnings in early May compared with a five-year average of 19 times.
US companies will need to grow into these P/E ratios over the next few years to justify their elevated levels. Though the US economy remains robust, the outlook is less clear, with credit card delinquencies rising steeply, unemployment ticking up, and interest rate cuts in the offing, yet subject to an unpredictable timeline. The prospect of a Donald Trump 2.0 Presidency later this year means further macro-economic and geopolitical volatility could lie ahead.
Growth opportunities in South Africa
Against this backdrop, it’s well worth considering some of South Africa’s quality companies, whose businesses and growth prospects have benefited from their focus on innovation. Though it has a small universe of shares South Africa boasts world-class companies. Shoprite, Capitec and PSG Financial Services are good examples. These businesses have exceptional, forward-looking leadership, a strong performance track record and the potential to grow and continue delivering strong results for investors.
Shoprite has stolen the limelight – and significant market share – in the retail sector, taking advantage of homebound customers during Covid by creating Sixty60. This previously unheard-of service commits to a 60-minute delivery turnaround time for all groceries and has made Sixty60 South Africa’s the largest online grocery delivery business.
The retailer owes its remarkable success because to its focus on technology and efficiency as well as impressive investment in innovation. The group has a dedicated technology team of about 500 at their ShopriteX campus. Another resounding success has been XtraSaving, now South Africa's largest loyalty programme.
The company offers investors world-class operating metrics, including attractive profit margins, efficient and scalable distribution, and strong growth prospects. We believe the main contributors to its success to date have been attracting the best people and embracing and employing the best technology in the business. These investments should enable it to continue to grow its market share.
Meanwhile, Capitec, founded relatively recently in 2001, has given the big four banks, FNB, Standard Bank, Nedbank and Absa, a run for their money through their focused and innovative product offering, saving clients time and money.
The sustained success of the bank lies in its digital focus and improved efficiency with online and digital app adoption. It continues to invest heavily in digital innovation initiatives, with 20% of all external appointments comprising professionals with expertise in technology and data.
The bank offers investors the opportunity to invest in a financial services company with world-class profitability and a sustainable return on equity of more than 25%, as per their annual statements, with substantial, long-term growth prospects.
Another world-class financial services business is PSG Financial Services, which owes its competitive advantage to a distribution footprint of more than 900 advisers. The company has an attractive business model, creating an operating platform for entrepreneurial advisers to build their businesses. PSG shares advisers’ revenues by providing brand, compliance, and product support, allowing them to focus on the needs of their existing and prospective clients.
This innovative proposition has translated into a highly profitable and cash-generative business, with a return on equity (ROE) of 22.5%, according do our analysis. Impressively, it has generated sustainable compound annual growth in earnings of 18% over the past 10 years. With a current market share of about 5%, there is significant upside potential to increasing its market share in the financial services sector.
Relative to the US stock market, the South African investment universe is small, with limited investment opportunities. This does not mean we don’t have some exceptional businesses that offer attractive investment opportunities. Furthermore, due to the recent challenges faced in the domestic economy, including logistical constraints and energy shortages, local businesses have experienced some of the toughest operating environments in history. The upcoming South Africa elections are also contributing to uncertainty.
Quality businesses will perform irrespective of these challenges. Despite coming from an extremely low base and with the inhospitable macroeconomic backdrop, they have remained profitable and even managed to grow profits. Imagine what they can do if the economic environment were to become more favourable.
Johan Barkhuysen is Stonehage Fleming Head of Equity Management South Africa.
ENDS
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