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WHY SA IS NOT BRAZIL (FROM AN EQUITY PERSPECTIVE)

11 April 2018

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by Sean Ashton

Given the stark change in SA’s political direction since Cyril Ramaphosa’s victory at the ANC elective conference, many commentators have been drawing parallels between SA and Brazil – concluding that SA’s “Brazil moment” has arrived.

To provide context to these parallels, Dilma Rousseff – Brazil’s then corrupt president – was impeached on 31 August 2016 in a process which had begun in December 2015. This saw the Brazilian iBovespa Stock Exchange Index (Bovespa) rise by 86% since the impeachment process was initiated, and by 45% since Rousseff was impeached in August 2016:

Figure 1: Brazilian Bovespa Index – rebased to 100 at 2 December 2015 (impeachment proceedings started)

By comparison, the FTSE JSE All Share Index (ALSI) has delivered zero return since the end of the ANC elective conference (and the precursor to Jacob Zuma’s “encouraged” resignation as SA president), while the capped Shareholder Weighted Index’s (SWIX’s) performance is marginally lower. To be clear, gains were indeed achieved in the months leading up to the event, but investors may reasonably have expected a more enthusiastic response post-confirmation of these changes or may conclude that further substantial returns are yet to come.

However, our conclusion is that the Brazil comparison is flawed for a number of reasons – at least in as far as stock markets are concerned, and at a headline index level. While we expect SA economic growth to improve materially off a low base, and domestic-focussed assets to do well, we do not expect local currency stock market gains akin to what happened in Brazil. There are a number of reasons for this:

1) Brazil had valuation levels on its side – at least by one important measure

The starting point for valuation of the Brazilian Bovespa Index is probably the key reason for the extent of the subsequent gains – investors digested the potent combination of the scent of a fresh reform agenda in Brazil, and very low valuations. To be sure, this exercise is made problematic by the fact that the Bovespa had negative earnings at an index level (caused by oil companies), which skews valuation comparisons when P/E multiples are used. However, on a price to book (P/NAV) basis, Brazil was almost 50% cheaper than SA (ALSI) at the time of Rousseff’s impeachment process commencing in December 2015. Given subsequent gains by the Bovespa, this gap has now largely closed relative to SA valuation levels.

Figure 2: Brazil vs SA indices: Brazil was significantly cheaper than SA on a price to book (P/BV) basis; gap has subsequently closed…

Figure 3: … while P/E comparisons between Brazil and SA’s equity indices is clouded by losses in Brazilian oil companies – lower ROE

2) Domestic vs global exposure at index level – Bovespa is for “Brazilian”

The devil is often in the detail. On closer analysis, it becomes clear that Brazil’s Bovespa is far more representative of a “Brazilian” stock market than is the case for SA. While this may not be immediately apparent from merely eyeballing index weightings by sector, we highlight a high weighting to financials (high beta to domestic economics) relative to SA, as well as consumer staples and consumer discretionary. These sectors alone account for over 50% of the Bovespa, while most of the materials sector weighting comprises companies which are not globally priced, i.e. dual-listed heavyweights such as Anglo American, as in the case of SA. Furthermore, SA’s stock market has a large contingent of industrial dual-listed companies such as Richemont, AB InBev and British American Tobacco, whose valuations have little to nothing to do with SA’s outlook.

Figure 4: Bovespa Index make-up by sector – largely a “domestic” market

Figure 5: FTSE JSE All Share Index construct: Far more “global” than local: >60% rand hedge

An issue closely allied to the above is currency exposure. While in the Brazil experience, the Brazilian real’s appreciation would not have weighed on market performance by virtue of significant dollar exposure in the index, this is not the case for the JSE. The rand has gained 5% against the US dollar since the ANC elective conference, while more than half of the index could be regarded as “hard-currency” exposure (as shown above).

Conclusion

There are many parallels between what has happened in Brazil politically and the current political evolution in SA, but we believe these factors do not extend to equity markets due mostly to: 1) valuations and a more-depressed starting earnings base in Brazil; and 2) a far more global stock market index construct in the case of SA. As a consequence, we do not expect annualised gains of 40%- plus in the next two years from SA equity indices, as was the case in Brazil. The implications for portfolio construction are profound – investors cannot simply “index” their exposure to SA equities by buying passive product in order to benefit from a potentially brighter future in SA. Furthermore, creating concentrated exposure in portfolios to those parts of the market which will perform well in a strong rand environment, will result in limited factor diversification at a portfolio level. We believe a balanced approach is required, but our portfolios are currently tilted towards benefitting from a better economic outlook in SA over the coming years.

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