Q&A with Jessica Bates, research analyst, STANLIB Equity team
Q: Why have equity markets performed well, despite the difficult economic conditions?
South African listed equity delivered a lacklustre performance in the three years preceding the pandemic. That means the strong performance over the last 18 months has come off a relatively weak base. South African corporates held relatively strong balance sheets going into the Covid pandemic.
However, the focus of most equity analysts in early 2020 was to identify which companies would require additional funding, have to be recapitalized through rights issues, or, in the worst-case scenario, might not survive the grueling operating environment that was to come.
It was therefore remarkable to see how well most South African corporations withstood these events, delivering earnings, cash flow and balance sheet improvements that exceeded expectations. Incredibly, many have come out of the pandemic in better shape than before.
Q: How did corporates achieve this resilience?
Companies had numerous levers available to them, and pulled them, aggressively!
Employee costs on average accounted for 25% of operating costs in 2020 but were as high as 41% for Healthcare and 38% for Diversified Industrials. Companies managed to flex these costs more than they would have been able to, under normal operating conditions. Our analysis suggests that the headcount in 2021 was almost 5% below 2019 levels (excluding companies that made significant acquisitions or disposals). Retrenchments can be costly and take time to implement, hence the real benefit of staff cost initiatives came through in 2021 as growth in employee costs remained muted at 4% (on average) while sales growth accelerated to 8% (on average).
The rental reversion cycle that existed pre-Covid continued in this period, and corporations continued to take advantage of a market in which they could renew leases at lower rentals and lock in lower escalations, as well as benefit from rental relief extended by landlords. Operating performance remains relatively resilient under the circumstances, with a strong recovery in operating margins and earnings in 2021 despite the ongoing pandemic and lockdowns.
Various steps were also taken to protect cash flow. Capex was pulled back sharply, and corporations committed to spend the minimum in business capex.
Working capital was released due to canceled orders for goods, resulting in flat or reduced inventory levels. At the same time, operating cash flow remained surprisingly robust, resulting in a strong free cash flow generation.
The pre-emptive cancellation of or delay in distributing dividends meant this free cash flow could be used to reduce borrowings, strengthening balance sheets even further. It’s remarkable that, during a period where corporations would have been expected to need additional capital, they actually paid down debt and bought back shares.
These lower debt levels translated into another income statement tailwind, with lower interest costs further driving earnings delivery from below the bottom line. This should also benefit businesses in the future, given that interest rate hikes are under way.
We expected that corporations would not waste a good crisis, and this was certainly the case for impairments and write downs. Management teams took the opportunity to clean up the asset base where assets were not generating sufficient returns, resulting in an extraordinary amount of impairments and write downs in this period.
After these moves, unsurprisingly, 2021 ROEs of 19% (on average) are now above pre-pandemic levels of 11% and in line with levels last seen in 2015.
JSE-listed companies in aggregate now offer higher returns and stronger balance sheets, and should screen better going forward on our quality growth framework.
The balance sheet capacity to grow inorganically in an environment where long-term organic growth opportunities are stifled by poor macro-economic conditions could also be an additional lever for growth.
Q: Given the strong performance since the domestic equity market’s lows of March 2020, do you consider it to be expensive at current levels?
We don’t think the equity market is overbought at these levels, because:
- We are expecting reasonable earnings growth over the next 12 months
- PE (Price / Earnings) ratios are at levels last seen in 2009 after the Global Financial Crisis, and we cannot see compelling reasons for valuation multiples to trend lower from here
- Companies have improved fundamentals, as described above
While the counter-argument may be that companies should trade at discounted valuation multiples compared with history, given the outlook for growth, the market is acutely aware of the constrained growth environment and systemic risks SA faces, so this is already reflected in the valuation.
Q: What are your expectations for earnings over the next 12 months and where do you see opportunities?
We estimate that our investable universe within the JSE can deliver “low teen” percentage earnings growth over the next 12 months. Banks screen well on our quality growth framework and should deliver strong growth earnings as their “U-shape” recovery continues to play out. Wealso favor selected companies in sectors that have experienced delayed re-opening and recovery. These include companies in the Services and Leisure sectors (BidCorp) and Hospitals (Mediclinic and Netcare). We are defensively positioned within consumer segments, and favor sectors that have secular growth opportunities, such as the Pharma-Retail sector, where consolidation and corporatisation should drive decent earnings growth.