Since early Q3 2014 the oil price has halved from a then $90/barrel to less than $45/barrel and more recently, the price has drifted back to over $50 per barrel. Of course the world is trying to figure out what the impact will be on consumers and businesses, and what does this mean for South Africa?
Until oil’s decline, rand weakness had been pushing inflation up, raising expectations of an interest rate hike in late-2015. The low oil price windfall has softened the inflation outlook, with the latest CPI number coming in at 3.9% and, in fact, there is now a possibility, albeit fairly unlikely, that interest rates may actually be cut later this year, all else being equal.
But the implications of lower fuel prices are more widespread than just inflation and interest rates. At the consumer level, we estimate that the saving on fuel alone will equate to a consumer spending injection in the order of R40 billion rand into the economy this year. Real wages will rise, given that recent wage settlements have typically been over 6%, well above the now low inflation rate and consumer indebtedness should improve (either as debt is paid down, or as debt affordability improves).
At the macro level, businesses will benefit from future lower wage settlements, in line with lower inflation. As a large importer of oil, our current account deficit should reduce dramatically. In addition, the cost of government borrowing may come down as yields on government bonds drop and pressure on the “debt ratings” of the country will reduce. While the recent bout of rand weakness and the imminent increase in the fuel levy may detract from the extent of the fuel price improvement, they will certainly not nullify it.
Overall, lower fuel prices will impact positively on economic growth, potentially adding 1% to last year’s 1.4% GDP growth. But our electricity supply crisis creates a headwind that will certainly take some of the shine off the oil price benefit. While it may be a wild card, Eskom could shave up to 1% off growth, bringing overall level back to just over 2% for 2015, but with potential for upside surprises. And although this growth is not an impressive number, we believe that investors are underestimating the impact it will have on certain parts of the stock market.
For some time Cannon has presented the case for smaller industrial stocks, the majority of which are South African-domiciled, managed, and generally more dependent on the fortunes of the local economy. The lower oil price will create healthier consumers with more disposable income. Many local firms also have some positive leverage to the lower oil price, and are able to be more nimble in pricing, product offering and management: smaller businesses are better able to change and adjust to the environment than their large counterparts. And, most importantly, many of these mid- and small-cap industrials are attractively priced compared to the lofty ratings and expensive prices that the loved global industrials are trading at.
The smaller firms that we are interested in may not all be as widely-known as those that have become household names. However there are some excellent businesses available to investors. In many instances, the companies have been operating, and listed, for decades. They have developed strong track records in their ability to grow earnings in varying economic climates, to consistently pay dividends, to generate a high return on equity and to adapt to changing operating environments. Smaller doesn’t mean riskier, it just means smaller. That said, investors must still be diligent in their assessment of any investment opportunity, and give equal attention to the downside and the upside.
Lewis Group is a good example of such an investment opportunity. The business is a leading credit retailer of household furniture, electrical appliances and home electronics with a market capitalisation of R8.6 billion. The business model is an interdependent model whereby 70% of sales are on credit, which is extended by and insured through divisions of Lewis.
Last year’s collapse of African Bank, continuous strike action, regulatory uncertainties, high unemployment rates and soaring debt to disposable income ratios in South Africa, combined to cause a notably negative sentiment towards the industry. In a smart move, Lewis management used this opportunity to acquire selected Beares stores at a cheap price following the demise of Ellerines. This will enable the group to gain additional market share as well as diversify the current customer base which consists predominantly of lower to middle income clients.
Operating since 1934, Lewis has repeatedly demonstrated the strength of its business model. The company is well equipped as it leans on the back of its strong balance sheet. Despite the disruptive behaviour by other retailers due to the unbundling of Ellerines – with up to 70% discounting price action – Lewis managed to deliver unexpectedly good results. The share trades on a PE of 10x, has a price to book ratio of 1.3x and a dividend yield of 5.8%. Despite the difficult and unglamorous operating environment, Lewis’ share price has recently rallied by 30%. Once again, this mispricing of a solid company offers great investment opportunities to thorough investors.