Research Insights

Equity Strategy July 2023: Strategy, Quantitative & ESG Research

Executive Summary

Investment recommendation

  • Growth as a style, defined as high estimate EPS growth, outperforms amid a continued pedestrian economic growth environment.
  • The preferred sectors remain those with superior growth qualities or with higher estimated earnings growth such as large cap industrial rand hedge, health care, life assurance and banks
  • After a dismal earnings season due to load shedding and an aggressive rate rising cycle, the forecast growth for retailers is amongst the highest of all the sectors, bearing in mind it is off a low base.
  • Market review

    • Equity markets experienced a positive June. The US and Japan led the developed markets, while in emerging markets, Brazil gained 9% and turned positive, YTD.
    • This month the recovery in the ZAR from an oversold level assisted the JSE AllShare Index to gain 6,6% in USD terms amid a 1.4% gain in ZAR. We expect the rand to remain rangebound between 18 – 19.5 against the USD.
    • The JSE AllShare Index is up 5.9%, YTD but down 4% in USD terms. Retailers and financials are outperforming while resources and basic materials continue to weigh on the Index.
    • The Top30 (T30) of the multi-factor model outperformed the JSE AllShare Index in June but the model tested negative by 2.2% if the Top30 (T30) is compared to the Bottom30 (B30).
    • Growth as a style relative to value has outperformed over the past few years but accelerated up even more aggressively over the past few months.

    Best investment ideas

    After assessing our proprietary models which include the multi-factor model, liner regression research, technical, and fundamental inputs, we arrive at stock recommendations.

    The theme developing from our proprietary models is growth. To that point, we see large cap rand hedge having the highest forecast growth which is followed by retail off a low base. Retailers have recently produced dismal results being influenced by the interest rate rising cycle and load shedding. With load shedding dissipating, let’s hope it remains so. Recent SARB comments indicate that inflation seems to be under control, probably points to the bottom in the earnings cycle for retailers. As an interest rate sensitive sector, the more cyclical retailers or ones which are more exposed to discretionary spend and higher gearing levels are the best placed to take advantage of a turnaround in the interest rate cycle. Remember South Africa raised interest rates ahead of the US at the start of the cycle. The whole retail sector looks attractively priced, forward PE’s have traded in a range between around 21.5X on the high end and around 8X on the low end, averaging around 16X in the past 15 years. The current level is 11.8X after weak results elevated the level over the last quarter. What is more important is to look ahead as the market will anticipate a recovery early.

    Sector rotation towards interest rate sensitives is at the order of the day. Within the retail sector, Woollies currently ranks the highest but the share price has already started recovering. Our preferred pic is the no.2 ranked share in the sector, Foschini Group Ltd (TFG). Roughly 30% of its earnings are now derived offshore from its UK and Australia operations, so it has some rand hedge qualities. Gearing is relatively high at a ratio of 41%, debt to total assets but free cash flow is set to improve materially over the next year, reducing risk. The lower expected interest rate will greatly affect their interest bill and the current forecast is for 17% earnings growth, while the expected PE, one year hence is an attractively 8.2X.

    From a technical perspective, the share price looks set for a strong recovery. The diagonal downtrend was broken in June, followed by a retest of the trend line close to the end of June and the share price recovered off the base, usually a very bullish pattern. We see both a cup and saucer and inverted head and shoulder formation. The share price is also starting to make higher lows. A break above 9500cps will be hugely bullish with very little resistance all the way up to around 11700cps some 21% higher. With the possibility of interest rates declining in 2024 and beyond a much higher share price is possible. We would recommend accumulating the share at current levels.

    The graph below depicts the share price of the Foschini Group Ltd, and shows the potential upside, short term.

    (Source: Bloomberg)

    In recent months, the banking shares have gradually migrated up the ranking table. Without exception, they are all ranking in the T30 of the multi-factor ranking model. The last one in the sector to join the T30 this month is Investec. Within the universe of the financial sector, Investec now ranks second after Standard Bank as the model’s banks choice but has lagged Standard Bank by 7% since the start of the year. We believe it is catchup time for the share. Estimate EPS growth for the next year stands at 9%, EDY at 7.8% and it boasts the lowest FPE of 6.2X in the sector.

    This makes for an attractive entry level. On a different approach, a regression model, which takes into account the JSE Banks Index, short-term interest rates and the company’s own estimated earnings per share, it is relatively well-priced as the model below indicates.

    The graph below depicts the share price of Investec (blue) and the derived regression model (red & green), green offering value, while red points to expensive levels.

    (Source: Sinayo)

    The graph shows the relative peformance of Investec to the JSE Banks Index, trading at the lower end of the range.

    (Source: Bloomberg)

    We view Investec as an attractive entry at current levels especially against its peer group.

    Best reduce idea

    Our best reduce idea is also derived from our quantitative sector rotation theme rather than the quality of any of the individual companies. Resource shares tend to be mid to late economic cycle performers and we are currently in a declining economic cycle. Commodity prices in general have been under pressure during the past year so conceptually, your portfolio should be structured underweight the sector.

    S32 Ltd has fallen down the order of the multi-factor ranking table to spot 71. The earnings estimates have been revised down by more than 20% in the past 3 months and earnings is set to decline from the current high base into 2024. Free cash flow is losing momentum and the share boasts one of the highest FPE’s in the sector. The graph below shows how the earnings momentum is rolling over and that the share price can potentially play catchup with the decline.

    The graph depicts the share price of S32 Ltd and the estimate earnings profile.

    (Source: Sinayo)

    Technically the share is losing upside momentum and is breaking diagonal trend support. The next level of support is around 40 00cps, 19% lower.

    The graph depicts the share price of S32 and shows it breaking upside trend.

    (Source: Bloomberg)

    We would advocate reducing exposure to the counter.

    Quants style bias – best long ideas for July 2023

    The preferred investment style currently is growth. The graph below shows how the growth style bias has continued to outperform value in the past few years and seems to have accelerated upwards over the past few months. In the absence of economic growth in the country, the market favours those companies that are able to adapt and show earnings growth in spite of the difficult economic environment. Growth is defined by estimate EPS growth over the next 12 months, while value is defined by relatively low price-to-book values, low forward PE’s and high estimated dividend-yielding companies.

    The graph below depicts the performance of high estimate eps growth relative to low estimate PE and high DY.

    (Source Sinayo)

    Model backtest results to 30 June 2023

    The Top30 (T30) equally weighted gained by 2.2% in June outperforming the JSE AllShare Index which was up only 1.4%. The multi-factor model tested negative by 2.2% in June if the T30 is compared with the Bottom30 (B30).
    The gold and PGM counters at the top of the ranking disappointed, resulting in the model testing negatively on the month. Banks, Life Assurance and Retail at the top performed in line with the ranking.
    At the bottom end of the ranking, selected life assurance and retail companies gained against the models ranking. Impala, Sappi and Quilter underperformed as expected.

    Factor backtest results to 30 June 2023

    June saw 5 of the 10 factors we include in our multi-factor model, testing positive. What we have noticed is the increase in volatility of returns of the different factors. The outperformance margin of selected factors when they outperform is large and at the same token when they underperform. This month, free cash flow yield which tested negative for the preceding 9 months recovered with an outperformance margin of 6.3%, and the T30 of the factor gained 8,7%. Earnings revisions over both the past 3 months and 4 weeks outperformed by 5.4% and 1.5% respectively. Longer-term price momentum and earnings growth also tested positive. A clear bias towards companies with higher estimate earnings growth manifested in the past 5 years, the factor tested positive in 61% of the months during this time.

    Short-term price momentum tested negative by more than 10% and the T30 of the factor was down by 0.75%. The value indicators, estimate PE (FPE) and estimate dividend yield (EDY) tested negative by 0.6% and 2% respectively. ROIC also tested negative by 2.15%.

    Earnings momentum eventually seems to be recovering slowly from an unprecedented period of underperformance the past two years. We suspect that when there is a clearer view of the interest rate cycle and economic growth, individual factor performances will normalize and stock selection based on style bias will improve.

    Multi-factor Ranking table

    After continued positive testing we have added more weight to the growth factor in the multi-factor ranking of July 2023 model this month. This comes at the expense of the value factors after accessing the backtest results. The rest of the factors remain more evenly balanced. This resulted in various shares moving both up and down the ranking.

    The median estimated EPS growth for the universe of 90 companies is 8,9% down slightly from the previous month, as earnings estimates on the universe of shares are revised down slightly on balance. The estimated PE of the 90-stock universe stands at 10.5X from 10,6 the previous month. Bear in mind that the estimate data is rolled every month and incorporates new data, resulting in the base and forecast changing for each company. So, despite the increase in the average share prices of companies together with a slight downward revision in earnings the past month, FPE marginally declined.

    The conclusion from the movement of shares up and down the ranking this month is the continued migration of resources shares down the order, while financials and retailers are gaining. Selectively real estate companies are also moving up. The interest rate sensitive theme is taking shape perhaps somewhat premature but due to liquidity constraints, it is probably prudent to react early rather than later.

    Resources are out of favour but we caution that the sector can have a substantial rally off an oversold level sometime in the second half of the year. We would use such rallies to lighten exposure.

    The following acronyms are used:

    Growth: EPS – Estimated earnings per share for the next 12 months (green)
    Value: FPE – Estimated PE ratio over the next 12 months (orange)
    DY – Estimated Dividend Yield over the next 12 months (red)
    Quality: FCF/YLD – Free Cash Flow Yield (dark blue)
    ROIC – Return on Invested Capital (light blue)
    Price Momentum: PM 3m – 3-month price momentum (purple)
    PM LT – Long-term price momentum (pink)
    Earnings Momentum: REV 3M – 3-month earnings revisions (dark yellow)
    REV 1M – 1-month earnings revisions (bright yellow)
    Fundamental Momentum: FM (earnings momentum)
    T30: The top tercile ranked shares (30 shares) of the multi-factor ranking table
    B30: The bottom tercile ranked shares (30 shares) of the multi-factor ranking model

    “This information/research prepared by Sinayo Wealth (Pty) Ltd does not take into account the specific investment objectives, financial situation or particular needs of any particular person. The research analyst primarily responsible for the content of this research report, in part or in whole, certifies that the views about the companies and their securities expressed in this report accurately reflect his/her personal views and consequently any person acting on it does so entirely at their own risk. The research analyst also certifies that no part of his/her compensation was, is, or will be, directly, or indirectly, related to specific recommendations or views expressed in this report. You are encouraged to seek advice from an independent financial adviser regarding the suitability of the investment, under a separate engagement, as you deem fit that conforms to your specific investment objectives, financial situation or particular financial needs before making a commitment to invest. The laws of the Republic of South Africa shall govern any claim relating to or arising from the contents of the information/ research provided.”

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