Issue: March/May 2008
Allan Gray

It all depends on the starting point

Heaton van der Linde, Joint Head of Institutional Client Services at Allan Gray, contrasts FTSE/JSE All Share Index returns over the past five years (2003-2007) with those experienced by investors during the previous five years (1998-2002). He raises the question whether investors’ future return expectations should be informed by their most recent experience or by valuations at the beginning of 2008.

Investor expectations are strongly influenced by their past experience. The most recent five years (2003-2007) have been a wonderful time to own assets in South Africa with the All Share Index (ALSI) delivering total returns on an annualised basis of 29.3% p.a.; well in excess of CPI inflation of 4.3% annually. The market’s remarkable run is depicted in Graph 1below, which compares the most recent five-year equity market returns with those of the preceding five-year period.

Therefore as we enter 2008, many investors understandably expect share prices to continue to appreciate as smoothly, as they have done over the past five years, with small hiccups here and there. But what will the next five years hold. Will they be as kind to investors or should we expect greater volatility and lower returns more akin to the five-year period from 1998 to 2002, when the ALSI returned an annualised 14.4% and inflation averaged 7% p.a.

Future market returns depend on share price valuations at the starting point. It was, in fact, investors’ recent negative experience in 2002 (when the ALSI declined 8%) that allowed for the attractive valuations at the beginning of 2003. There had been two currency-induced inflation and interest rate shocks in the preceding five years (1998 and 2001/2); the economy was growing slowly; profit margins had contracted; and company earnings growth had been poor. Consequently, at the beginning of 2003, investors were prepared to pay only 10.6x the most recent year’s (2002) profits for the ALSI.  

Hindsight is a perfect science and we now know that the South African economy grew strongly in 2003-2007, inflation and interest rates declined, most companies expanded profit margins with earnings as the ALSI, growing at an annualised rate of 17.5% for the five-year period. Consequently, at 31 December 2007, investors were now prepared to pay a multiple of 14.9x the most recent year’s (2007) profits, anticipating that companies would sell more goods at even higher profit margins (and continue to become more profitable) over the coming five years.

What does this say about starting valuations today – and how should this influence investors’ return expectations for the next five years. As we have cautioned in recent issues of of our client communication, the Allan Gray Quarterly Commentary, the profitability of most JSE-listed companies is currently very high and, in our view unlikely to be maintained. profit margins are likely to return to more normal levels through a combination of rising interest rates, commodity price declines (from record levels) and the inability of companies to pass on their growing cost pressures to an increasingly exhausted domestic consumer. Looking forward, we anticipate much tougher conditions more akin to the five-year period from 1998 to 2002 where returns were very volatile and starting valuations were high. Our current stock picks include companies whose earnings, we believe, can be sustained through tougher times and we have reduced the equity-weightings in our asset allocation portfolios. Preservation of the capital achieved through the growth of the past five years is a key focus.

Interesting observations

A few additional interesting observations can be made from the graph which sets out the annualised returns and volatility per sector over both the two five-year periods as well as the combined ten-year period.  

  • Note how similar the returns of each broad sector (Resources, Financials, Industrials) were to the ALSI return in the most recent five years compared with those in the previous period. All sectors have contributed similarly to the ALSI 29.3% p.a. return in the most recent period.
  • Whilst Allan Gray achieved satisfactory outperformance over the most recent five years, the outperformance achieved in the period 1998-2002 was far greater when volatility was significantly higher and different sectors achieved astonishingly different returns.
  • Financials returned just 1% p.a. during 1998 to 2002 whilst Resources returned 35.2% p.a.. This too is indicative of starting valuations: in 1998 resource company earnings and valuations were extremely depressed whereas the opposite can be said of financial shares, which had been the darlings of the mid-to-late 90s. Interestingly, we enter 2008 with resource company valuations arguably more stretched than financial company valuations!