By Ray Chipendo, JOHANNESBURG, October 31 (The Source) – A few days ago we released our Market Outlook report on Zimbabwe with a view for 2015. The 14 paged paper provides Emergent Research’s perspective on the future of Zimbabwean equity market. It also shares how the last five years, post dollarization, have shaped the market and outlines what we perceive to be key drivers of returns going forward.
Great investors we have followed will let you know that forecasting the direction of Markets and economies is a futile exercise, let alone for extremely uncertain environments such as Zimbabwe. So while we itched to put a growth number out there, reason prevailed and we eventually adopted Howard Marks’ approach of “simplifying the unknowable future”. The approach applies probability ranges or distributions for specific scenarios.
We constructed three scenarios for the economy and equity market namely: Holding on the ledge (35% chance of occurring) – pessimistic view of the future with economy sliding back into recession; Reasonable expectations (55%) – a prolonging of the status quo with economy growing in the region of 0-2% rate; and Growth Reloaded (15%) – happy days where the economy is pumping north of 4% growth rate.
But before I share with you the main themes in our report, something happened this week that weighed more on our optimistic scenario for the Zimbabwean economy. It is a five member UK business delegation that has been in the country for the first time in 20 years. What made the news more meaningful to me is that Turner & Townsend, my former employer, a global construction and management consulting firm, UK headquartered was part of the delegation. When I joined Turner & Townsend in 2008, the company’s Africa MD told us that in 1995 the company was making more money in Zimbabwe than any other African market including South Africa. A replay of those days excites those that still have hope for ‘beautiful Zimbabwe’.
Major market themes for 2015!!
Back to the market outlook report – below are some of the major themes identified in report:
Our report explains that if the status-quo persists or conditions worsen, we see performance of equity market becoming polarised between companies confined to the domestic market and those with export markets.
IMF’s growth forecasts for the sub-Saharan African economy stand at 5% for 2014 and 5.5% for 2015. These growth prospects are presenting strong market fundamentals for companies exporting in the region. Overall, we believe companies with firm export markets will continue on a strong growth trajectory. On the other hand companies restrained to domestic markets will be subjected to top line growth pressure reinforced by decelerating economic growth and deflation.
Valuations Reset likely for commodities and miners
In the last three years commodity and financial stocks have generally under-performed the market with the exception of a few cases such as BNC’s recent rally. Commodity price volatility and more important questions around the impact of indigenisation law have kept investors at bay. As Government tones down on the law and investors feel more comfortable we expect to see more steel and concrete going into the ground.
The RBZ’s rescue asset manager (ZAMCO) is, in our opinion, a quasi-bailout vehicle for banks. We believe banks that will survive this phase will be in better shape and carry more confidence. With more investor confidence we expect a valuations reset moment. Most domestic banks have been trading at near bottom valuations.
Companies holding more cash now
Our research suggests that companies may be building up cash balances. Three factors might explain. Problems in the banking sectors are tightening credit markets and making refinancing difficult. Therefore, it is better to hold on to cash than retire loans which may prove impossible to raise when needed. Secondly, companies may be forecasting tough times ahead – no better way to prepare than build cash. Last, slowing aggregate demand combined with low production utilisation rates (37%) may be dissuading any investment into capacity.
What will drive Growth?
Three major elements drive market returns, namely earnings growth; dividends and multiples expansion (increase in P/E ratio as a result of investors willing to pay more for future earnings). Going forward what will drive market returns? We ignore dividends which are not a major element in Zimbabwe.
The post dollarisation phase was followed by large increases in revenue among the majority of companies. Of the forty five companies that were part of our survey in 2010, 89% recorded positive revenue growth and in 2011 the ratio jumped to 91%. Corporate growth lost steam in 2013 as the number of companies boosting revenue by more than 50% plunged to zero. In 2010 the median company registered revenue growth of 69%. The following year the figure declined to 28%; 16% in 2012; 5% in 2013 and so far this year it is 0%. The trend is quite obvious, top line growth is now facing immense pressure. A slowing economy and deflation are to blame.
The staggering revenue growths of 2010 and 2011 were not translated into bottom line growth. Earnings performance have been polarised since 2010. Companies with earnings growing or shrinking in the single digit range were on average 14% of the total companies between 2010 and 2013. More than a third of the companies were growing earnings at double digit and the rest, approximately half, were shrinking at double digits. As highlighted in the major themes we believe the majority of companies will continue to face earnings pressure if not contraction. A few exporters might continue on an earnings growth trajectory.
Will multiple expansion come to the rescue?
Excluding BAT, an anomaly valuation-wise, the entire market’s P/E value is approximately 11. Going forward three factors will influence the market’s valuation namely: Perceived risk; liquidity and economic prospects. Our data has shown that the dizzy performance heights reached by the stock market post dollarisation were primarily driven by a multiples’ expansion – investors being euphoric about the future of the economy and subsequently paying more for future earnings. Dollarisation and a unity government were all driving this optimism.
However since 2013, a slur of harmful political talk and less clarity on critical policies, such as indigenisation policy which have implications on property rights and business certainty triggered a multiples compression. Going back to the UK business delegation, it takes these bits and pieces of optimism to drive interest in our local market and trigger a multiples expansion which will jolt up prices. This why government’s welcoming a UK business delegation should be lauded and encouraged. We have maintained that Zimbabwe’s economic problems are more policy and relationship based than structural. We have nations posting better growth figures than us despite battling with a myriad of challenges (militants killing innocent people; low literacy rates; really dilapidated infrastructure; and terrible environmental conditions).
In our opinion a winning strategy will need to satisfy our “stock grading” approach which focuses on GROWTH; VALUATION; and QUALITY.
Unless if you are aiming to have outright control of a company, buying stocks based on their valuations alone will be dangerous. Most undervalued stocks are likely to remain undervalued for extended periods of time. And the majority are under-valued on many metrics expect the most important one – free cash flow.
We place premium on quality stocks. Stocks that have little need for capital investment to maintain their earnings. Such an attribute will be desirable since raising capital is likely to become difficult in light of a banking sector burdened with high bad loans. Quality will also come in the form of stocks that easily translate earnings into cash. Liquidity will distinguish survivors and victims.
High Returns on invested capital (ROIC) will be important as well. Post dollarisation most of the companies loaded up debt which was at interests rates in the mid-teens yet their returns on capital were in the in single digit region. Such companies were destroying value with the debt they used to recapitalise. High ROIC is a precondition.
Throughout we have emphasised the need to tap into growth in export markets. In an environment where production utilisation is below 40%, growth is necessary to improve utilisation of plant and equipment and hence improve efficiencies. Apart from supporting earnings growth, efficient operations are important in securing markets in a competitive global economy.
For a full copy of our Market outlook report- 2015, please email your request to firstname.lastname@example.org
Ray Chipendo is Head of Research in the Johannesburg office. He can be contacted on email@example.com