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Cape Town - The patience required for successful equity investing can be greatly enhanced through a reasonable exposure to preference shares, according to Overberg Asset Management (OAM).
Pref shares are a form of subordinated debt but rank senior to ordinary shares in the capital structure.
OAM said in its weekly overview of the economic and political landscape in South Africa that following several years of weak performance, the valuations of pref shares have become extremely compelling.
"SA’s big 4 banks have capital adequacy ratios in excess of 15%, making them amongst the best capitalised banks in the world. Moreover, with changes to Basel 3 regulations, pref shares will no longer count towards bank capital in the future. As a result, banks will be keen to redeem their pref shares, which now form an unnecessarily costly form of funding."
South Africa economic review
• The rand recovered some ground in the past week against the US dollar, pound sterling, and euro from R/$14.47 to 14.37, from R/€16.15 to 16.11, and from R/£19.26 to 19.05, although these gains are modest compared to the previous week’s -7.6%, -6.3% and -9.6% declines. The rand is likely to react positively to an improved current account deficit in the second quarter, although may be held in check by the release later in the week of SA Airways’ financial accounts. Mirroring the rand’s stability, gilt yields narrowed in the past week with the benchmark R186 2025 yield falling from 8.93% to 8.56%.
• In his address at the annual 2016 Tax Indaba Standard & Poor’s Global Ratings (S&P) managing director Konrad Reuss said that the decision for leaving SA’s long-term sovereign credit rating unchanged in June was due largely to the National Treasury’s fiscal prudence. While Treasury deputy director general Anthony Julies confirmed that the October medium-term budget policy statement would contain a package of measures aimed at addressing rating agency concerns, the question of Finance Minister Pravin Gordhan’s survival is tantamount. According to Judge Dennis Davis, head of the tax advisory committee: “We cannot overstate the disaster that will engulf our fiscal and revenue calculations if we are downgraded.”
• House prices lost further momentum in July. According to the Absa House Price Index (HPI) nominal house price growth slowed from 4.2% year-on-year in July to 3.8% in August marking the slowest growth in over three years. Among the different housing segments, small-sized houses (40-140 m sq.) showed the strongest price increase at 7.6% on the year although down from 8.2% the previous month. By contrast large-sized house prices (221-400 m sq.) only grew 1.5% down from 2.7%. In real terms, after adjusting for inflation, the year-on-year fall in overall house prices steepened from -1.5% to -1.7%, the seventh straight negative monthly reading.
• Mining production fell in July by -2.4% month-on-month while the year-on-year contraction deepened from -3.0% in June to -5.4%. The platinum group metals (PGM) sector was the biggest culprit with production declining -10.8% on the month following the -14.0% decline in June.
Wage negotiations in the platinum sector are deadlocked with the Association of Mineworkers and Construction Union (Amcu) and Anglo Platinum, Impala Platinum and Lonmin Platinum so far failing to reach a wage agreement. The negotiation impasse raises the prospect of industrial action in the PGM sector. Amcu is demanding wage increases of more than 50% for its lowest paid members.
• Manufacturing production unexpectedly fell in July by -1.5% month-on-month while the year-on-year growth slowed sharply from 4.7% in June to just 0.4% well below the 3.0% consensus forecast. Among the ten manufacturing categories, all but two showed monthly production declines. The only positive readings were in food and beverages and the notoriously volatile furniture and related sectors, with month-on-month gains of 1.3% and 3.4%.
The vehicles and parts sector suffered a -2.4% monthly decline although the outlook has brightened following the announcement by the National Association of Automobile Manufacturers (NAAMSA) that it’s wage negotiations with unions are progressing well. Unfortunately, the sharp decline in the forward-looking manufacturing purchasing managers’ index (PMI) from 52.5 in June to a sub-50 contractionary reading of 46.3 in July, the lowest since January, does not bode well for manufacturing output in the third quarter.
• GDP expanded in the second quarter (Q2) by a far stronger than expected 3.3% quarter-on-quarter annualised well above the 2.6% consensus forecast and in contrast to the -1.2% contraction in Q1.
The biggest contributors were the mining and manufacturing sectors with growth of 11.8% and 8.1% while the service sector also grew by a steady 2.0%. The finance, real estate and business services sector grew by 2.9%. Surprisingly, agricultural production declined by just -0.8% far lower than expectations of a -3.5% contraction. Disappointingly, on the expenditure side, gross fixed capital formation fell by -4.6% with private sector investment declining -3.1% due to persistently weak business confidence. While the GDP data are encouraging, the average growth rate over the first half of the year nonetheless remains modest at 1.2% and it is unlikely that GDP will maintain its Q2 trajectory in the latter half of the year.
• After falling for six consecutive quarters the RMB/BER Business Confidence Index increased in the third quarter from 32 to 42. Although an improvement the reading indicates that only 4 out of every 10 survey respondents are positive.
The BER confidence index should be viewed with caution as the survey was compiled after the local elections but prior to the recent onset of political uncertainty following the persecution of Finance Minister Pravin Gordhan. Among the business sectors, retail confidence rebounded from 26 to 43, wholesaler confidence from 47 to 56 and building confidence improved from 38 to 44. Although showing some improvement, confidence in the motor trade sector and the manufacturing sector remained weak at 37 and 30.
The week ahead
• Reserve Bank Quarterly Bulletin: Due Tuesday 13th September. The quarterly bulletin will contain a breakdown of the expenditure side of the economy, revealing household expenditure as well as private and public sector investment spending. The current account deficit will be a key highlight, expected to show a solid improvement from -5.0% of GDP in the first quarter (Q1) to -3.9% in Q2. The current account is expected to benefit from the substantial R33 billion trade surplus recorded in Q2, fueled by an 18.1% quarter-on-quarter increase in exports, while at the same time imports have decreased by -5.1%.
• Retail sales: Due Wednesday 14th September. Retail sales growth is projected to fall from 1.7% year-on-year in June to 1.5% in July according to consensus forecast, held back by declining consumer confidence amid weakening household credit extension, rising inflation and poor jobs growth.
Technical analysis
• The rand’s downward break past R/$14.20 opens a new target of 15.10 which is the support line of the appreciating trend that has been in place since January. A break of the R/$15.20 level would open-up a target of 17.00 marking the January low.
• The US dollar index is testing a major 30-year resistance line, which if broken will pave the way for further strong gains in the currency.
• Following the Brexit vote the British pound hit its weakest level against the US dollar since 1985. The £/$1.30 level provides key support, which if broken would open up a Fibonacci projected target of £/$1.20-1.24.
• The long-term JPMorgan global bond index bull trend remains intact, with the yield targeting a new low during the fifth and final wave.
• The US 10-year Treasury yield has broken below key resistance levels of 1.6% confirming that the major bull trend in US bonds is likely to continue as the deleveraging phase is still in its early stages.
• The benchmark R186 SA Gilt yield has compressed to its lowest level since “Nenegate” last year falling below key resistance at 9.0%. The yield is now testing the bottom of the current consolidation channel at 8.5%, which if broken will target a yield of 8.0%.
• The MSCI World Equity index has broken downward from a rising trend-line which has been intact since the 2008/09 global financial crisis. Given the magnitude and duration of the 2009-2015 bull market the overall correction is likely to reach a downside target for the MSCI World Equity index of 1,400.
• Since the 1950s the Dow Jones and S&P 500 have displayed 7-year up-cycles and the top of the current US equity cycle is likely to have just occurred. The next major wave down will complete the 16-17 year secular bear market that started in 2000. The secular bottom should occur between mid-2016 and mid-2017.
• The S&P 500 index has broken to new record highs but the rally is not being confirmed by momentum indicators, which suggests the market is overbought and in danger of correction. A further negative signal is that the Dow Jones Transport Index, traditionally a lead indicator for the broader market, is underperforming the broader index.
• Despite this year’s price rally Brent crude’s break below the key $30 support level in February suggests a continuation of the weakening long-term trend to a downside $25 target. Copper is regarded a reliable lead indicator for industrial commodity prices and barometer of global economic growth. Despite its recent rally the copper price broke below the key $4 500 support level in February suggesting further downside ahead.
• Gold has developed an inverse “head and shoulders” pattern, which indicates further upward momentum and a test of the $1 400 target level.
• The JSE All Share index is testing an important resistance line but if this remains unbroken the index is likely to move back below the 24-month moving average at 50 900 in turn opening a downside target of 45 000. A break above 54 200 on the JSE All Share index would project an upward move to 60 000 marking a new high for the JSE.
The bottom line
• The patience required for successful equity investing can be greatly enhanced through a reasonable exposure to preference (pref) shares. Pref shares will provide stability to an investment portfolio during times of uncertainty and protect investors from the common error of panic selling. Pref shares are a form of subordinated debt but rank senior to ordinary shares in the capital structure.
• Pref shares provide excellent diversification in an investment portfolio. The Beta of the JSE Pref Share index is just 0.08, which means that, on average, if the JSE All Share Index falls by 1% the Pref Share Index will only fall by 0.08%. Beta refers to sensitivity of a share’s price to changes in the equity market.
• Pref shares are currently paying dividend yields ranging from 8.3-11.5%, net of Dividend Withholding Tax (DWT). This is a substantial premium to the after tax return on bank deposits or money market funds, which incur the full marginal rate of income tax rather than the 15% DWT.
• Admittedly, pref shares are riskier than cash deposits due to credit risk and liquidity risk. However, the yield spread over money markets more than compensates for this added risk. Money market funds are yielding around 7.75% on average but after tax at the marginal 41% rate, the net yield drops to 4.57%, which pails compared with the 8.25-8.65% net yield offered by the prefs of the Big-4 banks.
• SA’s big 4 banks have capital adequacy ratios in excess of 15%, making them amongst the best capitalised banks in the world. Moreover, with changes to Basel 3 regulations, pref shares will no longer count towards bank capital in the future. As a result, banks will be keen to redeem their pref shares, which now form an unnecessarily costly form of funding. Redemptions by the banks are likely to provide additional uplifts to pref share prices, offering the potential for capital growth in addition to high dividend yields.
• Following several years of weak performance, the valuations of pref shares have become extremely compelling. Over the past 3, 5 and 8 years the JSE Pref Share Index, excluding reinvested dividends, has lost -8.80%, -11.06%, -13.94%, respectively. It is only over the past twelve months to end August that the capital return has been positive at +2.97%. Pref shares were badly affected in 2014 by the failure of African Bank (ABIL), in which pref shareholders lost virtually all their value. The ABIL failure led to a negative reassessment of pref shares risks, which may be unfair given the contrast between ABIL’s balance sheet and those of the other banks.
• The time is ripe for an upward re-rating of pref shares. There is likely to be a growing recognition of the merits of pref shares as a portfolio risk diversifier amid the weak general outlook for equity markets.
• Furthermore, unlike fixed income bonds, which lose value in a rising interest rate environment, pref share yields are linked to the Prime Rate and will increase as the SA Reserve Bank continues to hike interest rates.
For the full report, including a look at international markets, click here.
* Overberg Asset Management (OAM) is an Authorised Financial Services Provider No. 783. Overberg
specialises in the private management of local and global discretionary
portfolios as well as pension products.
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judgement as at the date of this Report and should not be relied upon.
There can be no assurance that future results or events will be
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