Issue: December 08/February 09

Weathering the storm

De Kock

De Kock . . . a brighter side

Certain SA equities are particularly attractive. Johan de Kock, head of equity research at Metropolitan Asset Managers, explains why and suggests where to find them.

Only 18-months ago SA companies were criticised for their “lazy balance sheets”. (Remember Bain’s acquisition of Edcon and its promise to leverage?) This could now prove a blessing for local companies which historically have had low-geared balance sheets.

As the global crisis unfolds, it’s clear that emerging markets - which largely outperformed their developed peers over the past few years - are unlikely to emerge unscathed. The decoupling theory, which suggested that emerging markets were somehow immune to exogenous shocks, has proved false.

Emerging markets including SA, Russia, India and Brazil had seen explosive growth. Now they’ve taken a hiding, weathering the storm far worse than the US and western European markets. SA, Russia, India and Brazil are respectively 34%, 63% and 43% off their 12-months highs.

Emerging markets

As global investors flee “riskier” emerging markets, emerging-market currencies like the rand have imploded in a matter of weeks and risk premiums on emerging-market bonds have more than doubled in the past two months.

As one US investor has put it: “The success of emerging markets was fuelled by an outsized dependency on foreign capital and credit that is now drying up.”

Morgan Stanley estimates that flows to emerging markets could now more than halve from US$750bn to as little as $350bn next year.

It’s clear that the crisis is going to affect emerging markets. The question is: how much, relative to other emerging markets?

While the impact of numerous and coordinated market intervention by the world’s most powerful governments remains unclear, a few realities are crystallising.

Confidence in the financial system is crucial for financing growth. As a result of risk being reassessed, banks will have to reduce their amounts of leverage. This will impact on their ability to provide credit.

Boost liquidity

While coordinated heart surgery by central banks aims to boost liquidity, it’s clear that the global economy will not emulate the global economic performance of the past five years. Growth will slow, and credit will tighten.

Consequently, over the next few years there will be a higher risk premium on all asset classes. This higher risk premium will be reflected in different ways:

  • The cost of capital will increase for most companies and strong balance sheets will again command a premium rating. That’s what makes SA counters appealing;
  • Investors will soon change from complaining about “lazy balance sheets” to complaining about excessive leverage;
  • Private equity will struggle to make deals built on the leverage buy-out model because credit risk and equity risks will be priced more expensively;
  • Higher cost of capital will impact negatively on capital-intensive industries like manufacturing, steel, paper, chemical and car manufacturers.

Winners for the next couple of years will be companies which have business models built on strong cash flows and those which are less capital intensive. Defensive stocks such as consumer staples, non-discretionary items and industries like tobacco, beer, pharmaceuticals and healthcare will do well.

Retrace value

While the news coming from emerging markets isn’t good, the outlook is better. Currencies like the rand will retrace value as present dollar strength is short-term. The implosion of banks in the US will accelerate the movement of capital from western to eastern economies.

It will have severe implications for the dollar. Although the US now looks to be a safe haven, in future the present financial crisis will impact negatively on this status.