PSG: SA mid-caps are an at interesting intersection

In his latest letter to investors, veteran value investor Jeremy Grantham called the current market a ‘fully-fledged epic bubble’. His view was that a downfall was inevitable.

However, his advice was not to sell out of the stock market and sit in cash.

‘He recommended investing in the overlap between value and emerging markets,’ said Mikhail Motala (pictured), co-manager of the PSG Flexible fund. ‘And that advice leads us to an interesting destination: South African mid-caps.’

In a weak local market, mid-caps have been hammered over the past few years. The FTSE/JSE All Share Index is only up 3.1% on an annualised basis over the 36 months to the end of December. Over the same time, the FTSE/JSE Mid Cap Index has lost -3.7% per annum.

History

However, Motala believes that it is worth considering a longer-term history.

The chart below plots the relative performance of the FTSE/JSE Mid Cap Index against the MSCI World Growth Index from 2002 to 2020.

‘The underdog, our JSE mid caps, out-performed the heavyweight global growth index by a factor of four times between 2002 and 2016,’ said Motala. ‘However, the subsequent four years were brutal, with mid caps halving on a relative basis. Much of that decline came in 2020.’

The rally towards the end of last year provided a slight inflection point. The question is how sustainable that will be.

Motala said that one of the big reasons PSG has a positive view on select local mid caps is their forward dividend yields.

Dividends will return

‘In 2020, many companies temporarily suspended or deferred dividends, and there will be no yield,’ said Motala. ‘In the case of South African banks, they were guided by the Reserve Bank to cut dividends. Many other companies acted out of prudence.

‘And while some companies will declare no profits or even losses in 2020, there are many others where cash generation was robust. It was simply out of prudence that management decided not to declare dividends.

‘This became a focus for investors – that yield had evaporated,’ he added. ‘But the market is incredibly myopic. If we look out a year or two, using very conservative assumptions about a revenue recovery, we start to see an interesting story emerge – that the 2020 pause in dividends was temporary. Dividends will return and, in some cases, we believe they will match or even exceed the levels paid in 2019.’

One example is Old Mutual, for which PSG is projecting a forward dividend yield of 10%. The JSE is another, at a yield of 7%.

These yields alone offer real returns significantly above what is available in cash. And the potential for re-rating offers further upside.

Market shift

‘Even if South Africa remains unloved, the return potential from the high yield is compelling,’ said John Gilchrist, co-manager of the PSG Stable fund. ‘But the key question is what happens if the local economic outlook improves? Or what if the outlook even stays poor, but global risk appetite returns?’

He highlighted how the equity exposure in local pension funds is the lowest it has been since the 1980s due to their down-weighting of local equities. Local fund managers have also significantly lowered their exposure to the JSE.

At the same time, foreign investors have been net sellers of R500bn of local equities since July 2015. There have also been significant outflows from equity-centric South African unit trusts.

‘It’s very clear that the consensus view is to avoid South African equities,’ said Gilchrist. ‘The obvious question is what happens when a consensus view is suddenly challenged?’

He pointed out that the market reaction to the news of the Covid-19 vaccines at the end of 2020 provided a recent, and clear example.

Extreme positioning

‘In the US, we saw small caps suddenly start to outperform. We also saw, for the first time in many years, tech underperforming the overall market,’ said Gilchrist. ‘Looking at value, financial shares outperformed quite significantly.’

The South African market felt some of the change in sentiment in a real way. December was the first month of net foreign inflows into the JSE for 18 months, and the largest in three years.

‘We’re not saying this is definitely an inflection point, said Gilchrist. ‘There is still a lot of Covid-related uncertainty out there. But it does remind us how quickly sentiment can change. And, because of the extreme positioning in the market, what a dramatic effect a change in sentiment can have on asset prices.

‘We don’t believe the current market extremes are likely to persist,’ he added. ‘The fourth quarter is a taste of what can happen if there is a change in consensus view. And, long-term, we think a multi-year reversal of the trends we have grown accustomed to for the last few years is likely.’

Patrick Cairns is South Africa Editor at Citywire, which provides insight and information for professional investors globally.

This article was first published on Citywire South Africa here, and republished with permission.