By: Cannon Asset Managers
We recently pointed out that, since January last year, the JSE has risen a superlative 38.7% to a near all-time high, despite a tottering global economy. What we didn’t say was that two-thirds of this remarkable return is explained by just three stocks – Richemont, Naspers, and SABMiller – which contributed a staggering 25.0% of the 38.7% return. This creates a real quandary for investors.
To elaborate, the local equity market has been driven up by a particularly narrow set of stocks that, in our view, were already steep and have become increasingly expensive. Figure 1 shows the marginal contribution of each of the 20 stocks that made the biggest contribution to market performance over the last 20 months. As you can see, Richemont, Naspers and SABMiller contributed the lions’ share of the total return. If you owned all the other shares in the market, but not these three, you would have earned a return of a more paltry 13.7%, which is intuitively closer to what one would expect, given prevailing economic circumstances.
This analysis also shows that, of the top 20 marginal contributors to the JSE’s performance over this period, large-cap industrial stocks contributed a surprising 33.4%. If you didn’t own these 12 large industrial stocks, but owned the rest of the market, you would have earned a return of a mere 5.3%.
So what is going on? There is no doubt that the stocks that did well over this period are extremely high quality firms but – and here’s the issue – many are very expensive, high quality firms.
In Table 1 we have shown these 20 stocks’ price-earnings (PE), price-book (PB) and cyclically-adjusted price-earnings (CAPE) valuation metrics are on average a staggering 50% overvalued relative to their long-run multiples.
While we accept that this is a “quick and dirty” analysis, we believe the point is worth making because, in our assessment, the elevated multiples represent risk, rather than opportunity. This assessment is aggravated by the fact that while most of these stocks are decidedly expensive, it’s emotionally easy to find reasons to own them. The result of this investor exuberance for large-cap industrials has pushed their valuations to all-time records (even higher than before the crash of 2008) as shown by their CAPE ratio (green line) in Figure 2. The black line shows the three-year subsequent return from any given CAPE ratio. If history is any guide, this sector looks very dangerous to investors.
Figure 2: Large-cap industrial CAPE (x) versus subsequent three-year returns (%)
But here is the interesting part. The market’s long-run average CAPE ratio is 16x, and the current rating is 15.6x, which suggests that at the aggregate level, the market is about fairly valued and the asset class of South African equities, as a whole, is in line with long-run valuations. But the implication is that, relative to fair value, the range or dispersion of valuations between attractive and expensive shares is becoming even more stretched and investors should be worried about which equities they own. From the arguments presented above, we believe that investors should be paying particular attention to the risk presented by overpriced growth shares.
Put simply, trees don’t grow to the moon. Regardless, this outcome demonstrates the tyranny of averages: this aggregate is comprised of some very expensive stocks that represent risk, as well as stocks that are very attractively priced which present a solid investment opportunity.
Cannon Asset Managers is a niche investment management company that has successfully applied the philosophy and principles of value investing, an investment management approach that has consistently demonstrated a clear advantage over other philosophies. The company has a level 2 BEE rating.