“The big pitfall many investors fall into is investing in shares where the momentum is behind the share. The general investment story is good, but the investment case is often not good. The reason [why] is that good operational performance does not always last into perpetuity,” Olof Bergh, analyst at Sanlam Private Investments, told CNBC Africa.
“However, the market often prices the share as if the good investment case will last into perpetuity. Generally what we do is try and generate what we call a normalised intrinsic value for the share, which essentially normalises the profitability generated by the share. In so doing, we generate what we feel is a truer reflection of the share’s true intrinsic value, and [this] guides us in decision making.”
Bergh added that market cyclicality is however a key aspect to watch out for, as not only is it a normal part of the economic terrain but the process repeats itself often, primarily driven by the hunt for return.
“When companies are doing very well, for example, generally capital will flow towards that industry to capture those returns generated in the industry. That would alter the supply and demand dynamics within the industry, and normalise the returns, so reduce the returns because supply of the particular product or good picks up, and the so-called equilibrium comes down,” Bergh explained.
“So when industries are not enjoying returns or delivering poor returns, generally capacity will leave the industry, changing the supply dynamics, and returns will rise. They don’t just rise back to their normal level. Because people over-respond because of the nature of the economy, it overshoots on either side.”
In 2012 and 2013, the operating environment for a number of South Africa’s retail companies was particularly good, resulting in strong performance from the sector’s shares, attracting good returns on capital.
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“In that uprun in the share price, however, the shares became so expensive that the market’s expectation was for the share to remain in those super profitable stages for a long period. The economy has subsequently cooled somewhat, consumers are under pressure from the varying fronts, and the retailers [such as] the fast moving consumer goods retailers and the more discretionary retailers, are taking strain,” said Bergh.
“There’s more competition because they were generating high returns, so they all push to up their store frontage, all pushed to increase their brand offering, and at the same time it was coupled with the weakening in the consumer. At the moment, the profitability is certainly on the decline and the share prices have responded, [and] are down some 20 per cent since the highs recorded last year.”