RSA _Half Full or Half Empty
Transcript of RSA _Half Full or Half Empty
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SOUTH AFRICA
Half full or half empty?For CY11, we are becoming more constructive on earnings
production (and momentum) by companies (to include banks).However, we question the current valuations particularly on a 12-month price target basis. In this report we highlight our two
primary themes for CY11. The key takeaways in this report are:
2010 performance overview : The Top 40 index monthlyreturns were more volatile than the Small cap index inCY10. The Small cap index outperformed the Top 40 indexby 6.4 percentage points (pps). However, like in CY09, the
best performer was the Mid Cap index which outperformedthe Top 40 index by a colossal 11.2pps. The Banks indexwas rather one of the average performers, with a return of
11.8% which was only 0.4pp above its average 10-yearreturn. At the recovery point of the economy, one wouldhave expected a stronger performance relative to the mean.The Top 40 index, however, showed strong outperformance
against the MSCI EM index, albeit due to the strong rand.The MSCI BRIC index and our select resource-basedmarkets also under-performed the Top 40 in US$-terms, onaverage.
Half full or half empty; Our two key themes in 2011:Our two main themes are 1) earnings should grow stronglyin order to justify the current valuations. The market hassoared by 47.3% since CY08 vs. a decline of 43.1% inearnings in CY09. However, earnings have grown by 42.1%
in CY10. There are still some uncertainties, in our view,although we carry a stronger conviction that earningsexpansion will continue this year. Nevertheless, growthcould be lower on base effects. The Top 40 index profit
margin and Return on Equity (ROE) have reboundedalthough both remain below their long-term averages. 2)money-flow (from foreign and local investors) could be an
enticing reason to enter the market, but it is a feeble one.While the under-owning of the market by local investorscould support valuations in the short-term, we see somefallacy in assuming risk simply because of this reason. In
fact, CY10 equities net purchases amounted to R35.6bnonly in a year that Emerging markets (EMs) attracted a lotof interest. Valuation metrics, mainly the PER and the
dividend yield are at worse levels than their long-termaverages. Our major concern is the lack of clear catalysts tomaintain the market momentum, despite our moreconstructive stance on earnings. The discount rate for theSouth African equities is unlikely to improve given the low
probability of further reduction in the risk-free rate and thenear record low volatility.
Peter MushangweLawrence Madzwara+27 11 551 3675
January 18, 2011 Equity Strategy
MARKET VIEW
NEUTRAL
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Banking: Sector macro issues are intact although Basel 3could have a slow but painful impact; We are warming up
on the mainstream banks relative to MFIs on valuation:Regulatory risk (and Basel 3) and its impact to the local systemattracted a lot of interest in CY10. More importantly, most
commentators opined that banks will struggle again this year. Themain area of focus has been the lacklustre revenue growthexpectations. While we agree that revenue growth will continue tolag the historical average, despite an upturn in loan growth, we
are more constructive on earnings. We believe that 1) credit costsare going to continue to reduce; 2) regulatory risk overhang(related to Basel 3) is going to wane. This will allow banks to grow
their risk-weighted assets with a mindful view of the regulatoryrequirements; and 3) the system will benefit from better costmanagement and efficiency benefits than was the case in CY09and CY10. We believe the system carries optimal capital (relative
to Basel 3 requirements) and the risk of dilutive issues to increasecapital is low. The system is building up liquidity as shown by therising liquid assets/total banking assets ratio. The liquidity build-upcreates headwinds to banks margins (and yields) but lower credit
costs and efficiency benefits should neutralise the impact in CY11and CY12.
Not all banks are created equal though. While sector sentimentremains awful, the MFIs traded well in CY10, with some euphoricsector (MFI) share price rally in the 2H10 being a major highlight.
We are taking a more constructive stance on the mainstreambanks when compared to the two MFI (Capitec and ABIL). WhileMFIs continue to show strong earnings growth, we believe
valuation is stretched and provides a most disadvantageous risk-
return profile. Capitec has gone up by 122% while Abil rose by29.5% in CY10. This compares unfavourably to the average capitalgain of 4.2% for the mainstream banks. From a valuation point of
view, Capitec is trading at 2.1X the Industry average PER (againstan average of 1.6X from CY05) and Abil is trading at 1.3X. We donot doubt the MFIs superiority in earnings growth but we are
beginning to see a non-optimal risk-return profile. 1) some of themainstream banks are encroaching into the MFI space, to includePostbank and U-bank. Competition from the shadow bankingsystem, which tends to flourish as the economy picks up, has an
elevated impact to MFIs than mainstream banks 2) the thinnerbalance sheets of the MFIs mean lower ability to expand loanbooks in a meaningful way without raising more capital, which at
times could be dilutive.
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Contents page
1. 2010: A good year for Equities 3
2. Valuation Issues : Half full or half empty 13
2.1 Earnings growth has to be strong 13
2.2 Money-flow is the weakest reason to buy shares 14
2.2 Our argument against under-valuation 16
3. Banking: Macro issues intact, Basel 3 slow but painful 19
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1. 2010: A good year for equities
Santa rally closed a good year: The Top 40 index closed theyear with a local currency return of 14.6%, not a bad return in ayear characterised by volatility and pessimism, immenseheadwinds to global economic recovery as both Europe and Japan
continued to disappoint. No-one was sure how problems in Greece,Italy and Ireland were going to play out. Now no-one is sure whatwill happen to Portugal, Spain and Belgium. There were, however,only five months that produced positive returns in the year and loand behold, they were strong returns. The strong run in the 4Q10ensured a robust performance for the Top 40 index. The Small Capindex was less volatile, with only 3 months of the year posting
negative returns. The Small cap Index outperformed the Top 40 by
~6.3pps. Top 40, Small Cap vs. Mid Cap: In our 2010 outlook, (see 2010
Outlook: Major Themes dated 12 January 2010) we highlighted the
need for investors to progressively move to Mid cap and cyclicalstocks. Migration to cyclical stocks could not have been veryrewarding as defensive stocks continued to perform well in CY10,in general. However, the Mid Cap index outperformed both theSmall Cap and the Top 40 indices. The Mid cap index provided a
gain of 25.8%, which is 11.2pp and 4.9pp higher than the Top 40and the Small cap indices respectively. It is, however, important toindicate that the Mid Cap index has massively outperformed its
CY99-CY09 average return of 13.5%, by 12.2pps while the Top 40index and the Small Cap index show lower outperformance of
2.2pps and 6.3pps respectively. The Mid Cap has gained 63.8%since CY08 against 48.5% and 47.3% for the Small Cap index and
Top 40 index in that order. This outperformance relative to historyand the Top 40 and the Small Cap indices could create negativetrading sentiments this year. Nonetheless, looking at valuationmetrics, the Mid Cap continue to look the least expensive with the
highest dividend yield and a lowest PER when compared to the Top40 and the Small Cap indices.
Banks vs. Others: We expected banks to do relatively well inCY10 when compared to CY09. While this was the case, it lookslike most of the good news was priced in already. Banks sufferedanaemic top line growth, but we see reduced headline earnings
risk this year. The Banks index gained 11.8% in CY10, a minuteoutperformance of its CY99-CY09 average return of 11.4%.Valuation metrics show relative undervaluation to the Industrial 25and Top 40 indices. We believe that the macro factors in the
banking system remain intact (ample CAR, fair liquidity, waningcredit risks and improving loan growth). Risks come from the highhousehold debt level but CY10 underperformance (relative to theTop 40 and the Financial Index) could support valuations this year.
RSA vs. EM: We compare South Africa (Top 40 index) returnsagainst the MSCI EM and MSCI EMEA indices. In US$ terms, the
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Top 40 index returned 27.9% primarily due to the strong rand. TheMSCI EM and MSCI EMEA indices provided gains of 16.4% and
20.9% respectively. In local return terms, South Africa slightlylagged both the MSCI EM and MSCI EMEA indices. South Africatrades at a higher PER than the MSCI EM and the MSCI EMEA.
RSA vs. BRIC: In US$-terms, South Africa outperformed the MSCIBric index by a significant margin, close to 15pps. In the Bricfamily, Russia provided the strongest performance, with a US$capital gain of 20.7% but other members did not put as stellar
performances. However, on a 5-year compounded US$ returnbasis, South Africa equities underperformed the Bric Index by7pps. South Africa trades at a premium (higher PER ratio and a
lower dividend yield) when compared to the Bric index, which inour view could act as a disincentive to foreign portfolio inflows inthe equities space as South African is expected to lower growthwhen compared to other the Bric family.
RSA vs. resource based markets: The US$ return of 27.9%beats the 20.7% for Russia, 17% for Canada and the 6.1% forBrazil. Australia had a negative return of 23.7% for FY10. Again,the strong rand provided a strong currency return component asSouth Africa underperformed Russia in local currency terms.
Among these resource based markets, South Africa has the secondlowest dividend yield and the highest price/book value ratio.Russia has the lowest PER - maybe for a reason as it has beentrading at a discount throughout CY10.
Local investors vs. foreign investors: Equities enjoyed netforeign inflows of R35.6bn in CY10. This is less than half theR72.2bn that foreign investors pumped into the local market inCY09. This is also less than yearly average foreign inflow of
R40.2bn since CY05 including the dramatic CY08 when themarket endured a net out flow of R54.4bn! Relative to history andother EMs, South Africa was not a sweet spot for investors inCY10. However, we note that local investors still under-own themarket. In fact the lower allocation to equities (relative to history)is often underscored as the main reason for further upward
movement expectations.
Bonds vs. Equities: Bonds enjoyed strong rally in CY10 asinterest rates declined. In our view, the interest rate cycle has
troughed, and a rebound in interest rates would naturally benegative to bonds. We compare the earnings yields of the Top 40and the Small Cap indices to the 10-year government yield as weseek to establish relative valuation between these two asset
classes. Despite its theoretical shortcomings, we believe it canprovide some insights. The spread between the Top 40 earningsyield and the 10-year government bond widened mid CY09 and
has remained out of its pre CY07 range, indicating a decline in theequity risk premium. Relative to equity, fixed income valuation isproblematic as 1) inflows in bond markets having beenunsustainably strong and 2) a rebound in interest rates are likelyto make the asset class less attractive. In our view, some banks
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could continue to buy bonds to reduce their risk weighted assetsand improve liquidity (Basel 3 requirements) but we believe that
fixed income should deliver less spectacular returns in CY11. Thequandary is that our bearish call on bonds could be construed as abullish call on equities. It is not.
At risk from the European jitters? Overall we expect the EMs toface risks from the jitters in Europe. For the local economy, thedisinflationary trend has led the Reserve Bank to engage in a morefocused approach towards growth, but the household debt level is
still relatively high compared to other EMs, although the cost ofservicing debt has reduced to manageable levels of
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The General Retailers, Consumer Services, Industrial 25 and theMid Cap indices showed strong performance, outperforming their
10-year mean returns by >10pp. Construction and materialsindices showed poor performance relative to their averages andother sectors.
Fig 2: CY10 secto r returns (vs. their 10-yrs mean returns)
19992009CAGRre turn 2010Return Deviation
Generalretailers 6.5% 55.8% 49.3%
Consumerservices 11.4% 39.6% 28.1%
Industrial 25 9.9% 23.9% 14.1%
Midcap 13.5% 25.8% 12.2%
Consumergoods 14.0% 23.8% 9.8%
LifeAssurance 1.0% 9.7% 8.7%
SmallCap 14.6% 20.9% 6.3%
Financials 6.8% 12.0% 5.2%
All Share 12.7% 16.1% 3.4%Healthcare 17.0% 19.8% 2.7%
Goldmining 9.3% 11.6% 2.3%
Top40 12.3% 14.6% 2.2%
Foodproducers 16.8% 18.4% 1.5%
Banks 11.4% 11.8% 0.4%
Telecommunications 16.6% 15.6% 1.0%
Basicmaterial 16.8% 9.8% 7.0%
Resources20 18.1% 10.2% 7.9%
MiningIndex 17.9% 9.4% 8.5%
Generalmining 19.1% 10.2% 8.9%
Pharmaceuticals 35.3% 22.9% 12.3%
Platinumandpreciousmetals 19.1% 4.4% 14.7%
Industrial metals 28.4% 11.9% 16.5%
Constructionandmaterial 21.8% 0.7% 21.1%
Source: I-net, Legae Securities
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The Mid Cap index outperformed both the Top 40 and the SmallCap indices. From CY08 level, the Mid Cap index has gained
63.8% vs. 48.5% and 47.3% for the Small Cap index and Top 40index respectively. The Banks index rose by 34.1% since CY08,lagging the Top 40 by >10pps.
Fig 3: Yearly return s for a select indices si nce CY00
40%
30%
20%
10%
0%
10%
20%
30%
40%
50%
60%
2 00 0 2 00 1 2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 00 7 2 00 8 2 00 9 2 01 0
Smallcapindex
MidCap index
Top40index
Top40av.
40%
30%
20%
10%
0%
10%
20%
30%
40%
50%
60%
70%
2 00 0 2 00 1 2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 00 7 2 00 8 2 00 9 2 01 0
BankIndex
Industrialindex
Top40index
Top40av.
Source: I-net, Legae Securities
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The Mid Cap index looks slightly attractive as it trades at adiscount to other Indices PER and enjoy a higher dividend yield.
The Top 40 index PER is now above its 10-year average.Dividend yield is below its 10-year average. This indicates areducing equity risk premium.
Fig 4: PERs and dividend yields for major indices by market cap
5
10
15
20
25
30
35
Sep00
Feb
01
Jul01
Dec01
May02
Oct02
Mar03
Aug03
Jan04
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Nov04
Apr05
Sep05
Feb
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Jul06
Dec06
May07
Oct07
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Apr10
Sep10
P/Eratio,X SmallCapindexMidCap index
Top40index
1
2
3
4
5
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7
8
Sep00
Mar01
Sep01
Mar02
Sep02
Mar03
Sep03
Mar04
Sep04
Mar05
Sep05
Mar06
Sep06
Mar07
Sep07
Mar08
Sep08
Mar09
Sep09
Mar10
Sep10
Dividendyield,% SmallCapindexMidCap index
Top40index
Source: I-Net, Legae Securities
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The Banks index is cheap in relative terms (against Top 40 andthe Industrial index). Relative to history, the PER is above its 10-
year average. Dividend yield has declined but remains relativelyattractive.
Fig 5: Banks PER and dividend yields (vs. Industrial and Top 40 indices)
0
1
2
3
4
5
6
7
8
Sep
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Mar01
Sep
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Mar02
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Dividend yield,% Banksindex
Industrialindex
Top40index
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P/Eratio,X BanksindexIndustrialindex
Top40index
Source: I-Net, Legae Securities
South Africa significantly outperformed the MSCI EM and MSCIEMEA indices, in US$-terms. In local currency terms, SouthAfrica lagged these two indices in CY10. On a 5-year absolute
return, South Africa again beat the MSCI EM and the MSCI EMEA.Fig 6: South Afri ca vs. MSCI EM and MSCI EMEA
0.8
0.9
0.9
1.0
1.0
1.1
1.1
1.2
1.2
1.3
Dec09
Jan10
Feb10
Mar10
Mar10
Apr10
May10
May10
Jun10
Jul10
Jul10
Aug10
Sep10
Sep10
Oct10
Nov10
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Dec10
Localcurrencyreturns
MSCIEM
MSCIEMEA
SouthAfrica
20.9%
16.4%
27.9%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
MSCIEMEA MSCIEM SouthAfrica
US$returns
Returnsince05
ReturninFY10
Source: Bloomberg, Legae Securities
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South Africas PER is higher than the MSCI EM and the MSCIEMEA. South Africas PER is 14.6% above its 10-year average of
15.3X while the MSCI EM PER is only 3% above its 10-yearaverage of 14X.
Fig 7: South Africa P ER and Dividend yield vs. MSCI EM and MSCI EMEA
0
5
10
15
20
25
Dec00
Dec01
Dec02
Dec03
Dec04
Dec05
Dec06
Dec07
Dec08
Dec09
Dec10
Price/Earningsratio,X
MSCIEM
MSCIEMEA
SouthAfrica
1.0
2.0
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6.0
Dec00
Dec01
Dec02
Dec03
Dec04
Dec05
Dec06
Dec07
Dec08
Dec09
Dec10
Dividendyield,%
MSCIEM
MSCIEMEA
SouthAfrica
Source: Bloomberg, Legae Securities
Comparing against the MSCI Bric index, South Africa
outperformed the MSCI Bric index by a material 20.6pps (in US$-terms) in CY10. Outperformance in local currency terms is,however, only 7pps. On a 5-year basis, South Africa
underperforms the Bric markets by 7pps.
Fig 8: South Africa versus the BRIC
0.0
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SouthAfrica
BRICIndex
27.9%
7.3%
14.8%
21.8%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
SouthAfrica BRCIIndex
5yearCAGR
2010return
Source: Bloomberg, Legae Securities
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...and South Africa maintains its higher PER ratio and a lowerdividend yield when compared to the Bric markets in CY10.
Fig 9: Valuation versu s the BRIC
17.6
13.1
0
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35
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Aug09
Sep09
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P/Eratio BRICSouthAfrica
2.22.1
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1.7
1.9
2.1
2.3
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2.7
2.9
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3.3
Jul09
Aug09
Sep09
Oct09
Nov09
Dec09
Jan10
Feb
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Mar10
Apr10
May10
Jun10
Jul10
Aug10
Sep10
Oct10
Nov10
Dec10
Dividendyield,% BRICSouthAfrica
Source: Bloomberg, Legae Securities
Against the resource-based markets, South Africa is the bestperformer, beating Russ ia, Canada, Brazil and Australia in US$-
terms. The 5-year absolute return is also respectable at 66.3%although its lags Brazil.
Fig 10: South Africa versus the resource based markets
13.4%
41.0%48.2%
66.3%
191.2%
50.0%
0.0%
50.0%
100.0%
150.0%
200.0%
250.0%
Austr alia Canada Russia SouthA fr ic a B raz il
US$returnssinceCY05
23.7%
6.1%
17.0%
20.7%
27.9%
30.0%
20.0%
10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
Australia Brazil Canada Russia SouthAfrica
US$returnforFY10
Source: Bloomberg, Legae Securities
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Of our resource-based markets, Russia remains the cheapest,with a PER about half that of South Africa. However, Russia
outperforms South Africa in local currency terms in CY10.Fig 11: South Africa P ER vs. select resources based markets.
Canada
Russia
Australia
Brazil
RSA
0.75
0.85
0.95
1.05
1.15
1.25
1.35
Dec09
Jan10
Feb10
Mar10
Mar10
Apr10
May10
May10
Jun10
Jul10
Jul10
Aug10
Sep10
Sep10
Oct10
Nov10
Dec10
Dec10
Australia
Canada
Russia
Brazil
SouthAfrica
0
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40
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Jan10
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Oct10
Nov10
Dec10
Dec10
P/EratioAustralia
Canada
Russia
Brazil
SouthAfrica
Source: Bloomberg, Legae Securities
South Africas Price/ book value ratio is the highest whencompared to our select resource based markets. The dividend
yield is also low er than yields in Australia, Brazil and Canada.
Fig 12: South Africas book value and dividend yields vs. select resources based markets.
0.8
1.0
1.2
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Ja
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M
ar10
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M
ay10
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l10
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Dec10
Price/Bookvalue,X
Autralia
Canada
Russia
Brazil
SouthAfrica
0.0
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1.0
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3.0
3.5
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4.5
5.0
Ja
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Ja
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Fe
b10
M
ar10
M
ar10
Ap
r10
M
ay10
M
ay10
Ju
n10
Ju
l
10
Ju
l
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Aug10
Se
p10
Oct10
Oct10
Nov10
Dec10
Dec10
Dividendyield,%
Autralia
Canada
Russia
Brazil
SouthAfrica
Source: Bloomberg, Legae Securities
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2. Valuation issues: Half fu ll or half
empty?
Earnings growth has to be strong: In our view, earnings growthhas to be strong to justify exposure at the current level where
valuation looks full, prima facie. Needless to say, corporateearnings are more volatile than GDP growth, and sustainability ofsome momentum in the GDP growth should see corporate earnings
rising materially. We note that there was a steep decline incorporate earnings in CY09 to an extent that indexed to CY02,
corporate earnings growth lagged nominal GDP. The recoverystarted in CY10 and in our view there are indications thatmomentum will gather pace this year.
The profit margin has recovered although it is still below the 19.4%average. The ROA has also rebounded from its lows to 8.2%
although it is still below its average of 9.7%. In our view, strongerGDP growth should sustain momentum on corporate earningsgrowth. When the growth outlook is positive, companies carrymore leverage and this would magnify the ROE which is currently
below its average rate at 17.8%. However, the problems is thatmarkets tend to overshoot when corporate earnings expectationsrise or collapse, and we believe the expectations of high earningsgrowth this year are taking valuations into unattractive territories.
Improving macro conditions provides a fulcrum but we believeearnings growth has to be significantly high to justify the current
market valuation. Earnings recovery is gaining momentumthough.
Fig 13: GDP grow th vs. Top 40 earnings grow th
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
Mar
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GDPgrowth
EPSgrowth
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Apr07
Aug
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Dec
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Apr08
Aug
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Dec
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Apr10
CurrentGDP
Top40 EPS
Source: SARB, Bloomberg, Legae Securities
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Profit margins and ROA have rebounded but remain below theiraverage. As the economy picks up momentum, ROA will increase
and companies w ill be more willing to leverage their ROEs.Fig 14: Top 40 profit margin, ROA and ROE
15.50
19.39
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Mar03
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Jul06
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Profitmargin
average
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Sep
05
Feb
06
Jul06
Dec
06
May
07
Oct07
Mar08
Aug
08
Jan
09
Jun
09
Nov
09
Apr10
Sep
10
ROA
AverageROA
ROE
Source: Bloomberg, Legae Securities
Money flow is the weakest reason to assume equityexposure at this level: Our second reason, albeit the weaker onebut well discussed and mentioned by investors, is the money flowinto equities. Of course, in our view, this is a risky basis to assume
equity risk as it makes the greater fool theory the only reason to
investing. However, we believe global investors are going tocontinue to chase for yields and growth, at least for the majority ofthe 1H11. This is because we believe Europe will continue to
perform poorly relative to EMs. US could provide some dead catbounce case this year but EMs will remain key markets. Webelieve global investors are going to continue to be long EM
equities, in our opinion, except if there is strong risk aversion toEMs catalysed by debt and/or currency problems. As a result, EMsand the local market are likely to continue to enjoy portfolioinflows.
The comforting part about the local market is that foreignparticipation in CY10 was not extra-ordinary. Net equity inflowswere R35.6bn only, which is less than half the R72.2bn thatflooded the market in CY09. The net inflows in CY10 are also the
lowest amount since CY04 when one excludes the anomalousCY08. It is below the yearly inflow average of R41.1bn betweenCY05 and CY09. To an extent, one can argue that a strong EMequities sell-off would not affect local market to the same degree
as it would affect those EMs that attracted more inflows relative totheir history and other EMs. However, a cumulative R107.8bninflow in 2 years is not a small amount.
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Page 15 of 28
We also believe that the local investors currently under-own themarket. However, the gap between the Top 40 index and M2
money supply that crudely indicates the under-ownership by localinventors is closing. While money flow could support valuations inthe short-term, we wonder what would happen when the market
runs out of this support.
In CY10 local equities attracted a net foreign inflow of R35.6bnwhich is below the average net inflow since CY05...
Fig 15: Monthly and yearly inflows into local equities
17.4 29.8
5.6 0.4
32.9 51.971.7 64.2
54.4
72.235.6
800
600
400
200
0
200
400
600
800
2 00 0 2 00 1 2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 00 7 2 00 8 2 00 9 2 01 0
Yearlyforeignpurchases
Yearlyforeignsales
Net
100
80
60
40
20
0
20
40
60
80
100
Sep
00
Mar01
Sep
01
Mar02
Sep
02
Mar03
Sep
03
Mar04
Sep
04
Mar05
Sep
05
Mar06
Sep
06
Mar07
Sep
07
Mar08
Sep
08
Mar09
Sep
09
Mar10
Sep
10
Net
Monthlyforeignpurchases
MonthlyforeignSales
Source: I-Net, Legae Securities
...but local investors under-own the market although the gap isclosing out. This could provide support to sho rt-term valuations.
Fig 16: Top 40 vs. M2 money suppl y
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
Jan
00
Jun
00
Nov
00
Apr01
Sep
01
Feb
02
Jul02
Dec
02
May
03
Oct03
Mar04
Aug
04
Jan
05
Jun
05
Nov
05
Apr06
Sep
06
Feb
07
Jul07
Dec
07
May
08
Oct08
Mar09
Aug
09
Jan
10
Jun
10
Top40IndexMoneysupply,M2
Source: I-Net, SARB, Legae Securities
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Page 16 of 28
Argument against undervaluation: Below we provide ourargument against a case of undervaluation. The market is trading
above pre-crisis levels. Both the index level and the basic valuationmetrics (PER and Dividend yield) have worsened in terms of riskssince the rebound after the epic market drama of CY08. The Top
40 indexs return has already normalised. (i.e. CY10 return is14.1% versus a 10-year mean return of 12.3%). We put forwardthe question to investors; was the market fairly valued then? (i.e.pre-crisis). If not why should it be fairly valued at these levels
when profit margins and ROEs remain below their long-termaverage and could remain below for this year? The dividend yieldhas declined to below CY05-CY06 levels. This indicates a declining
equity risk premium (cost of equity) and while the economy hasshown increasing business confidence levels, this dismal level ofdividend yield (relative to history) makes it difficult to find value.We see downside risk to equity markets, to include EMs, should
debt default happen in one of Europes weak countries and if someEMs starts to raise interest rates aggressively to curb inflation.Locally we do not see much headroom for PE ratio expansion. In amarket that is continuing to go up, the temptation is to play along.
We do not say dont but be highly selective. We admit that on alonger-term basis, there could be rationale for participation but ona 12-months basis we see meaningful risks.
We also do not see reasons for improvements in the South Africanequities discount rate. The risk-free rate has supported a lower
discount rate, but further reductions in the risk-free rate areunlikely this year. More interestingly is the fact that the volatility ofthe Top 40 index, as indicated by the 30-day standard deviation at
10.5% is only 2.8pps above the 10-year low of 7.7% (in CY05).
We are unconvinced that there is room for further compression involatility, hence our negative outlook on discount rate/cost ofequity improvements.
We also note the widening spread between the 10-yeargovernment bond yield and the Top 40 earnings yield. Despite itstheoretical weaknesses, the model still provides insights. While the
Top 40 earnings yield has constantly been below the 10-yeargovernment bond yield, except for CY08 and CY09, the wideningspread shows higher valuation risks relative to history.
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Page 17 of 28
The PER is above its 10-year average despite risks to strongereconomic recovery. The word cycle often mean some mean
reversion and we expect some cont raction in the PER this year.Fig 17: Top 40 and Small Cap PER vs. their averages
5
10
15
20
25
30
35
Sep
00
Feb
01
Jul01
Dec
01
May
02
Oct02
Mar03
Aug
03
Jan
04
Jun
04
Nov
04
Apr05
Sep
05
Feb
06
Jul06
Dec
06
May
07
Oct07
Mar08
Aug
08
Jan
09
Jun
09
Nov
09
Apr10
Sep
10
SmallCapPER
Average
2
4
6
8
10
12
14
16
18
20
Sep
00
Mar01
Sep
01
Mar02
Sep
02
Mar03
Sep
03
Mar04
Sep
04
Mar05
Sep
05
Mar06
Sep
06
Mar07
Sep
07
Mar08
Sep
08
Mar09
Sep
09
Mar10
Sep
10
Top40PER
Average
Source: I-Net, Legae Securities
The dividend yields have worsened to fall below their 10-yearaverage for both the Top 40 and the Small cap indices. Lowdividend yields indicate declining equity risk premia. We are
sceptical, given the economic uncertainty, notwithstanding theimprovements.
Fig 18: Top 40 and Small Cap dividend yi elds vs. their averages
1
2
3
4
5
6
7
8
Sep00
Mar01
Sep01
Mar02
Sep02
Mar03
Sep03
Mar04
Sep04
Mar05
Sep05
Mar06
Sep06
Mar07
Sep07
Mar08
Sep08
Mar09
Sep09
Mar10
Sep10
Smallcapdiv.yield
average
1.00
2.00
3.00
4.00
5.00
6.00
Sep00
Mar01
Sep01
Mar02
Sep02
Mar03
Sep03
Mar04
Sep04
Mar05
Sep05
Mar06
Sep06
Mar07
Sep07
Mar08
Sep08
Mar09
Sep09
Mar10
Sep10
Top40dividendyield
average
Source: I-Net, Legae Securities
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Page 18 of 28
The Top 40 index 30-day standard deviation is close to its lowestlevel in 10yrs. Further contraction is unlikely, hence that chances
of improvements in the d iscount rate are minimal.Fig 19: Top 40 30-day standard deviation and South Africa defaul t spread
0
10
20
30
40
50
60
70
80
01/17/11
10/04/10
06/21/10
03/03/10
11/17/09
08/04/09
04/17/09
01/02/09
09/16/08
06/04/08
02/15/08
10/31/07
07/18/07
04/02/07
12/14/06
09/01/06
05/19/06
01/30/06
10/14/05
07/04/05
03/15/05
11/30/04
08/18/04
05/05/04
01/16/04
10/01/03
06/19/03
02/28/03
11/13/02
07/31/02
04/17/02
12/31/01
09/13/01
Top40Indexvolatility HistVol(30D)Average
0
100
200
300
400
500
600
Jan
09
Feb
09
Mar09
Apr09
May
09
Jun
09
Jul09
Aug
09
Sep
09
Oct09
Nov
09
Dec
09
Jan
10
Feb
10
Mar10
Apr10
May
10
Jun
10
Jul10
Aug
10
Sep
10
Oct10
Nov
10
Dec
10
Jan
11
SouthAfrica'sCDS
Source: I-Net, Legae Securities
The gap between the 10-year government bond yield and theTop 40 index earnings yield has also widened which indicatesheightened valuation risks.
Fig 20: Top 40 and Small Cap earnings yiel ds vs. SAGB10 yield
0
2
4
6
8
10
12
14
16
Jan
00
Jul00
Jan
01
Jul01
Jan
02
Jul02
Jan
03
Jul03
Jan
04
Jul04
Jan
05
Jul05
Jan
06
Jul06
Jan
07
Jul07
Jan
08
Jul08
Jan
09
Jul09
Jan
10
Jul10
Top40Earningsyield
SAGB10yield
0
2
4
6
8
10
12
14
16
18
Jan
00
Jul00
Jan
01
Jul01
Jan
02
Jul02
Jan
03
Jul03
Jan
04
Jul04
Jan
05
Jul05
Jan
06
Jul06
Jan
07
Jul07
Jan
08
Jul08
Jan
09
Jul09
Jan
10
Jul10
SmallCapearningsyield
SAGB10yield
Source: I-Net, Legae Securities
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3. Banking: Macro issues are intact;
Basel 3 could be slow but painful
Banking macro-issues are intact despite the widespreadconcerns: We have listened to numerous market and banks
commentators highlighting that banks will struggle this year and inthe medium term. We do not necessarily disagree with this view,but we believe that the problems of the sector have been over
played. In our view, non-performing loans is no longer a majorissue this year. Loan growth is likely to remain anaemic this year,
but momentum will remain strong due to lower interest rates andimproving capacity by borrowers (lower cost of servicing debt).The Basel 3 is probably the greatest headwind, but its effect will be
slow, albeit painful. The key issues are capital and liquidity, andwhile the former is not a major concern (and we dont see banksissuing dilutive instruments to shore up capital, but could meetthese requirements through retained earnings), liquidity can be theprimary problematic area as it affects margins in two ways 1)
competition for longer-dated deposits could result in higher costsof deposits and 2) the requirement to hold liquid assets have acompressive effect to margins. The positive feature about thesystem is that it is not and will not be in a Northern Rock fundingmodel. The high market concentration will to a large extent
reduce the impact of the deposit wars that could arise as bankstry to reduce their funding gaps and extend the maturities of theirliabilities. Overall, we believe the sectors macro factors are intact.
Nonetheless, the banking system faced unprecedenteddeleveraging in CY09, but is recovering: We recognize that thebanking system registered massive deleveraging in CY09, withnegative growth on both banking assets and deposits. This was
after the banking assets had significantly outpaced nominal GDPgrowth when indexed to CY95. However, in CY09, banking assetwent down by 6% while loans and advances were down by 0.6%.
CY10 began to witness a recovery in loans and advances growth,which is the key asset class for banks. Loans and advancesmonthly growth rate rebounded in CY10 and the value of newmortgage loans granted has also taken an uptick.
...but the high household debt is not very supportive:Household debt remains relatively high at about 78%. While this innot a dangerous level, it is important to note that this is 12pp
higher than the average of 66.2% for the decade (CY00-CY10).The steep increase in the household debt/disposable income ratiobetween CY03 and CY07 could limit the ability by households tosubstantially carry more debt. Nevertheless, we do not expect
significant medium-term deleveraging at household level as thecost of servicing debt has declined to manageable level of
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Page 20 of 28
a result of low loan demand. In our view, demand could have beenlow, but the increase in liquid assets/total assets ratio to 7.4%
from below 4% in CY08 and above the 4.7% average since CY00indicates that banks could probably be preparing for the impedingBasel 3 liquidity requirements. On a macro-level, again we do notsee headwinds to system liquidity. The LDR is inexcessive at
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Banking assets growth outpaced nominal GDP growthsignificantly since CY95. The penetration has increased
materially as indicated by the banking assets/ GDP ratio. This toan extent clouds the long-term outlook despite under-penetration on the lower-income segments.
Fig 21: Indus try penetration
0%
20%
40%
60%
80%
100%
120%
140%
160%
0
500
1000
1500
2000
2500
3000
3500
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
GDP
Bankingassts
Bankingassets/GDP
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
GDP
Bankingassets
Source: SARB, Legae Securities
CY09 saw strong deleveraging as banking assets contracted by
>5% ...
Fig 22: Banking assets grow th
500
1,000
1,500
2,000
2,500
3,000
3,500
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Bankingassets,Rbn
10%
5%
0%
5%
10%
15%
20%
25%
30%
35%
1
987
1
988
1
989
1
990
1
991
1
992
1
993
1
994
1
995
1
996
1
997
1
998
1
999
2
000
2
001
2
002
2
003
2
004
2
005
2
006
2
007
2
008
2
009
Bankingassetsgrowth
Average
Source: SARB, Legae Securities
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Page 22 of 28
...as loans and advances grow th rate turned negative...
Fig 23: Loans and advances annual grow th rates
5%
0%
5%
10%
15%
20%
25%
30%
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Loanandadvances,bn
Growth,RHS
0%
5%
10%
15%
20%
25%
30%
500
1,000
1,500
2,000
2,500
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Deposits,bn
growth,RHS
Source: SARB, Legae Securities
...but loan growth rebounded and is indicating some momentum.Expansion of the credit multiplier will be positive to banks
earnings...
Fig 24: Loans and advances monthl y growth rates
1.5%
1.0%
0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
2005/02
2005/05
2005/08
2005/11
2006/02
2006/05
2006/08
2006/11
2007/02
2007/05
2007/08
2007/11
2008/02
2008/05
2008/08
2008/11
2009/02
2009/05
2009/08
2009/11
2010/02
2010/05
2010/08
Totalloansandadvances
averagemonthlygrowth
0.0
0.5
1.0
1.5
2.0
2.5
3.0
2005/02
2005/05
2005/08
2005/11
2006/02
2006/05
2006/08
2006/11
2007/02
2007/05
2007/08
2007/11
2008/02
2008/05
2008/08
2008/11
2009/02
2009/05
2009/08
2009/11
2010/02
2010/05
2010/08
Newmortgages
Source: SARB, Legae Securities
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Page 23 of 28
...but the high household debt level creates risks. The householddebt/ disposable income ratio is ~12pp above the average since
CY00 and rose from 35% to 78% in three decades...Fig 25: Publ ic and household debt levels
78.2
32.4
0
10
20
30
40
50
60
70
80
90
1980/01
1981/02
1982/03
1983/04
1985/01
1986/02
1987/03
1988/04
1990/01
1991/02
1992/03
1993/04
1995/01
1996/02
1997/03
1998/04
2000/01
2001/02
2002/03
2003/04
2005/01
2006/02
2007/03
2008/04
2010/01
Householddebt/disposable income
TotalGvntdebt/GDP78.2
50.4
57.8
66.2
25
35
45
55
65
75
85
1980/01
1981/02
1982/03
1983/04
1985/01
1986/02
1987/03
1988/04
1990/01
1991/02
1992/03
1993/04
1995/01
1996/02
1997/03
1998/04
2000/01
2001/02
2002/03
2003/04
2005/01
2006/02
2007/03
2008/04
2010/01
Householddebt/disposable income
10yrAverage
Source: SARB, Legae Securities
...and Basel 3s liquidity requirements could prove slow butpainful. The system is building up liquidity which should hurt thesystem margins and yields.
Fig 26: System liquid assets and liquidi ty provided by the SARB
4.7%
7.5%
3.0%
3.5%
4.0%
4.5%
5.0%
5.5%
6.0%
6.5%
7.0%
7.5%
8.0%
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Liquidassets/Total bankingassets
Average
5
7
9
11
13
15
17
19
Jan
05
May
05
Sep
05
Jan
06
May
06
Sep
06
Jan
07
May
07
Sep
07
Jan
08
May
08
Sep
08
Jan
09
May
09
Sep
09
Jan
10
May
10
LiquidityprovidedbySARB,Rbn
Source: SARB, Legae Securities
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Page 24 of 28
The loan/ deposit ratio and the funding gap look fair. From amacro view point, the systems liquidity profile is not dire.
Fig 27: Loan/deposit ratio and the funding gap
70%
75%
80%
85%
90%
95%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Loan/Depositratio
50
50
100
150
200
250
300
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
fundinggap=residentsdepositless loansandadvances
Source: SARB, Legae Securities
The banks PER is above the average (since CY02) and the
discount to the MSCI EM banks has narrow ed as indicated by thespread...
Fig 28: JSE banks PER vs. MSCI EM and averages
0
2
4
6
8
10
12
14
16
18
20
Oct02
Fe
b
03
Ju
n
03
Oct03
Fe
b
04
Ju
n
04
Oct04
Fe
b
05
Ju
n
05
Oct05
Fe
b
06
Ju
n
06
Oct06
Fe
b
07
Ju
n
07
Oct07
Fe
b
08
Ju
n
08
Oct08
Fe
b
09
Ju
n
09
Oct09
Fe
b
10
Ju
n
10
Oct10
MSCIEM
JSEBanks
4
6
8
10
12
14
16
O
ct02
M
ar03
Aug
03
Jan
04
Jun
04
Nov
04
A
pr05
Sep
05
Feb
06
Jul06
Dec
06
May
07
O
ct07
M
ar08
Aug
08
Jan
09
Jun
09
Nov
09
A
pr10
Sep
10
JSEbanks
average
Source: SARB, Legae Securities
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...but the Price/ book ratio is below its average. The MSCI EMbanks Price/ Book ratio is now slightly higher than JSE Banks.
Fig29: Banks dividend yield vs. MSCI EM and averages
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Oct02
Mar03
Aug
03
Jan
04
Jun
04
Nov
04
Apr
05
Sep
05
Feb
06
Jul06
Dec
06
May
07
Oct07
Mar08
Aug
08
Jan
09
Jun
09
Nov
09
Apr
10
Sep
10
MSCIEM
JSEbanks
0
0.5
1
1.5
2
2.5
3
3.5
4
Oct02
Mar03
Aug
03
Jan
04
Jun
04
Nov
04
Apr
05
Sep
05
Feb
06
Jul06
Dec
06
May
07
Oct07
Mar08
Aug
08
Jan
09
Jun
09
Nov
09
Apr
10
Sep
10
JSEBanks
Average
Source: SARB, Legae Securities
MFIs outperformed mainstream banks significantly in CY10.Capitecs stratospheric valuation is beginning to worry usdespite our strong growth outlook on the company.
Fig 30: Mainstr eam banks vs. MFI performances
0
2
4
6
8
10
12
14
16
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Jan
05
Ma
y05
Sep05
Jan
06
Ma
y06
Sep06
Jan
07
Ma
y07
Sep07
Jan
08
Ma
y08
Sep08
Jan
09
Ma
y09
Sep09
Jan
10
Ma
y10
Sep10
Jan
11
PerformanceindexedtoCY05 NedbankInvestecFirstRandAbsaStandardBankAbilCapitec,RHS
0%
20%
40%
60%
80%
100%
120%
140%
Capite c A Bil A bsa Fir stRand Standar d Inv estec Ne dbank
2010capitalgains
Source: I-Net, Legae Securities
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Capitec and ABIL trade at a premium to their average deviationsfrom the industry PER of 1.6 and 1.2 respectively
Fig 31: Mainstr eam banks vs. MFI PER and Capitec and Abil PER relative to industry average
0
5
10
15
20
25
30
35
Feb05
Aug05
Feb06
Aug06
Feb07
Aug07
Feb08
Aug08
Feb09
Aug09
Feb10
Aug10
Price/Earnings ratioCapitec
Nedbank
Investec
FirstRand
Absa
StandardBank
Abil
1.3
2.1
0.5
1.0
1.5
2.0
2.5
Feb05
Aug05
Feb06
Aug06
Feb07
Aug07
Feb08
Aug08
Feb09
Aug09
Feb10
Aug10
Deviation fromindustryPER Capitec
Abil
Source: I-Net, Legae Securities
Key conculding points
We are neutral on local equities: Our neutral position ismotivated by our valuation concerns. While we see company
earnings gaining growth momentum this year, we do not seeimprovements in the discount rate as both the risk free rate andthe volatility are close their 10-year lows. Our view that local
investor under-own the market could support valuations in theshort term but it could also be an indicator of valuation fears fromlocal investors. Buying equities on the basis of continued/increasedforeign money flow into equities is a risky strategy; and
We are warming up on mainstream banks, but we areseeing unfavourable risk-reward profiles as MFIs sharescontinue to trade in risky territory: Probably our mostcontrarian view form consensus. Despite the well-documentedproblems we believe the sector will benefit form declining credit
costs, regulatory clarification and leaner cost structures in CY11
and CY12. While we have a positive earnings outlook on MFIs, weare discouraged by the lofty valuations. We believe investors couldbe underestimating the risks in the MFIs (competition will increase,
CPA impact will be higher, balance sheets are thinner).
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