The JSE has a big problem
The historic pathway for JSE-listed companies to go from being undervalued or small-cap stocks to becoming blue-chip investments appears to be broken.
This is feedback from Morningstar’s Debra Slabber and Praleena Mudley, who asked asset managers about some of the underlying problems South Africa’s stock market faces.
South African equities have long been undervalued, and while a recent rally has brought optimism, questions linger about its sustainability and whether what we are experiencing now is similar to the 2017 “Ramaphoria” period.
ClucasGray’s Andrew Vincent emphasised that South African companies still face numerous challenges – ranging from political instability to power issues, rail inefficiencies, and high interest rates.
While some companies may have experienced some re-rating, the true potential lies in earnings growth, which has been stagnant for years.
He said affecting structural changes, such as lower interest rates, could unlock significant returns for South African equities, transforming long-standing headwinds into tailwinds.
Perpetua’s Delphine Govender said South Africa’s difficult operating environment has contributed to a damaging cycle of capital outflows and underperformance.
However, recent trends show signs of improvement, with South Africa starting to outperform other emerging markets, the rand strengthening, and local equities still trading at a relative discount.
As local and international flows begin to shift towards South Africa, the outlook could brighten, especially as global interest grows.
Given the underperformance and capital outflows, foreign investors are currently underweight in South Africa. A simple shift towards a neutral position could result in significant inflows, which would provide much-needed liquidity.
South African equities remain undeniably cheap and still represent a small portion of the broader emerging markets index.
As local investors begin to invest in these undervalued companies, South Africa’s market performance could improve, boosting its weighting in the index and providing a signal for global investors to increase their exposure.
Big problems
The asset managers Morningstar surveyed all shared a concern about the JSE in its current form: It is overconcentrated, and as a result, there is a lack of price discovery.
This has partly been driven by delistings but more by the poor performance of South Africa’s economy.
Its stagnant growth over the past decade has prevented new companies from emerging and smaller ones from breaking into the upper echelons of the market.
This results in a smaller shopping basket for equity asset managers, particularly for South Africa’s relatively few but large investment firms.
Companies facing cheap market valuations are often unable to use their stock as currency for acquisitions, prompting delistings.
Furthermore, the concentration of assets in a few stocks plays a significant role. With the top 25 shares accounting for 70% of the index, the remaining 100 or so companies must share the balance of 30%.
This skewness is compounded by the fact that capital allocators themselves are also concentrated, with a few large managers dominating the market.
These managers tend to focus on the top 20 shares, resulting in strong price discovery at the top end, but a lack of it for mid- and small-cap companies.
Historically, markets have seen undervalued stocks attract value investors, who buy in at low multiples, helping the company’s story gain traction.
As the stock re-rates and moves through its lifecycle, growth and momentum investors get involved, driving the next phase of valuation.
But this traditional mechanism seems broken. The concentration of capital in large-cap stocks has stunted this natural progression, leaving mid and small-cap companies unable to attract the capital necessary to re-rate and grow.
This dynamic highlights the need for more active engagement between investors and companies, pushing them to unlock value internally rather than waiting for market forces to correct pricing.
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