NGLOY - EZA: Avoid The ETF And Focus On Stock Picking

2023-07-24 16:00:28 ET

Summary

• Governmental issues in South Africa have put a heavy toll on the economy, the biggest of which is load shedding.
• The long-term outlook for the economy seems mixed. In the short term, the yield curve looks good but is likely to invert.
• There are many great stocks in South Africa, but also many stocks to avoid, so stock picking works better than buying an ETF. ETFs also come with additional risk.

The South African equity market is an attractive market for stock picking due to its low valuation and inefficiencies, but there are also many issues in the macro and lack of rule of law in South Africa.

In this article, I'm going to go over issues with the South African government and economy; iShares MSCI South Africa ETF ( EZA ) overview and how to trade this market.

Governmental Issues In South Africa

South Africa has had governmental issues since the end of apartheid but for a long time, people and companies with deep pockets could avoid the issues created by the government. For example, safety was always an issue, but those with the money would hire private security. Another example is electricity or the lack thereof, but again those with money were able to set with own generation plants; this meant that companies could avoid issues created by the government by simply paying to have their own solutions to it. Because of this investors didn't have to worry about these issues as companies were shielded from it. Now though the disarray and lack of rule of law is getting to the point where even if a company has the resources or the connections it is becoming hard to maintain day-to-day operations without having to worry about these widespread issues.

The biggest of these widespread issues created by government mismanagement is the load-shedding of the power grid. For those who aren't familiar with load shedding, it is a form of rolling blackouts. The government-owned electrical company, Eskom has a shortage of electricity. This issue has been decades in the making as corruption in the ANC (the single party that controls the majority of South Africa) has made it so that little of the taxpayer capital that should've gone into infrastructure spending has. Rather than expanding energy production or raising prices Eskom chooses to cut electricity on a routine basis when they are expected to run out of power.

Below is a chart showing load-shedding hours per year:

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As can be seen, load-shedding hours are growing at a fast rate. 1949 hours in a year is over 5.5 hours a day. This issue has only grown in 2023 and is expected to grow in 2024 and beyond.

The issue here is undeniable. Energy is the backbone of the economy and without energy day to day, modern life isn't possible. This puts a big slowdown on economic activity; imagine your waking hours are 16 hours a day and of that 6 hours are completely gone due to a daily blackout. For most Westerners this is unfathomable, and it would certainly ruin productivity. And of course, businesses aren't able to run normal operations with blackouts like this.

South African Economy

These governmental issues have a direct impact on the economy.

Below are the youth unemployment and general unemployment, respectively:

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Source

As can be seen, both youth unemployment and general unemployment are very high. For perspective, during the great depression general unemployment in the U.S. was around 30% and during the GFC around 10%. The general unemployment in South Africa is already beyond both those levels; youth unemployment is even higher, and as those youth become older and still unemployed then those figures will go into the general unemployment, raising it even further.

While high unemployment is bad in and of itself, it has a domino effect on everything else.

Due to this unemployment, there are calls on the government to step in and provide support for those who are unemployed through various forms of handouts and helicopter money. This is all while tax revenues are collapsing due to higher unemployment. Because of this, there is increased deficit spending leading to a weak Rand.

This brings us to where the currency is headed. My belief is that currency risk is the biggest risk investors have to worry about in South Africa.

Here's the USD/ZAR cross:

Source

As the price of USD/ZAR goes higher the dollar is strengthening against the Rand. The Rand has been weakening against the dollar for a long time. The only time it did better was when there was a spike in commodity prices, as South Africa is a major commodity exporter.

The main reason I think the Rand has been weak is excessive deficit spending combined with an imbalance of trade.

Below is the fiscal deficit:

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The current account has also been in a deficit due to low commodity prices:

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These two reasons are why I think the Rand has been very weak. The weak Rand shows in their inflation data:

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The way I view the current situation in South Africa, there are really only two options. On one hand, the central bank can continue to raise rates which will strengthen the Rand but will bring down equities due to a higher hurdle rate and a credit crunch. Or on the other hand, equities can go higher but the currency weakens, which would hurt USD-based investors.

Where The Economy Is Headed

When I'm looking at the trajectory of the South African Economy I'm looking at a few different metrics.

The first of which is government interference in the economy or lack thereof. As I highlighted previously in this write-up, the South African government seems intrusive in the affairs of the private sector, so I want to look at where that is headed.

The biggest intrusion of the government I see is in energy infrastructure. Eskom is clearly a failure; on the bright side the government has recently announced that they will allow private utilities to provide power to more areas, and probably the most important thing is that they will allow private utility companies to sell power to Eskom, which Eskom will then sell to South African residents.

The advantage of the model of the private sector selling power to Eskom is that the private sector gets a large payday, while government bureaucrats can continue to work at Eskom. This of course isn't ideal for the people of South Africa, but the past has shown that entrepreneurs don't want to be seen as fighting the government as that comes with negative ramifications for them, so this is an end-run which allows them to profit without disrupting the current system.

There are still some major negatives in regard to government intervention.

One area that is unfavourable is South African taxes. When you ask someone what the highest tax jurisdictions in the world are they might think it's a place in Scandinavia, but they might be surprised to hear that African countries have the highest taxes in the world and South Africa is no exception. South Africa has a corporate tax rate of 27% (compared to the U.S.'s 21%) plus a 20% dividend tax even on non-tax resident individuals and even on non-resident corporations that are listed on the Johannesburg exchange.

As the economy has suffered but taxes have continued to stay high this has caused the tax burden as measured by tax revenue as a per cent of GDP to go higher:

Source

I've provided the source which also has a map of the tax burden of all the countries around the world. South Africa is around the very top with over 26%. In comparison the US is at 11%, a low tax burden European country like Switzerland is at 10%, while a higher tax burden European country like Norway is at 25%.

This high and growing tax burden puts pressure on the private sector. To lower the tax burden there are two solutions: lower taxes and or raise GDP.

South Africa is already running a large budget deficit so taxes can't be cut from here and economic growth is the only way out of the high tax burden on the private sector.

Another worrying area of government intervention is the lack of respect for private property. For years the government has been toying with the idea of taking back people's real estate with no compensation and there have even been bills introduced time and time again to do this. While none of these bills has passed into law, just the fact that this is something that the government has been considering for years would have me worried as an investor, and if the zeitgeist in South Africa versus the haves and the have nots becomes more contentious then I could easily see this becoming law.

Another metric I like to look at when analysing where the South African economy is headed is the yield curve.

Current Yield Curve:

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Below is the 10Y Yield:

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Below is the overnight rate:

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As can be seen, the overnight rate is below the 10Y, and when looking at the World Government Bonds the spread between the 2Y and 10Y is positive at 136.5 basis points.

This positively sloped yield curve is quite surprising seeing as though most developed countries including but not limited to those in North America and Europe have an inverted yield curve. I look at this as a positive short-term signal that the GDP will likely not contract over the next two years or so.

There are some key differences between analysing the South African yield curve and the U.S. yield curve to keep in mind. The first is that while a yield curve can predict contractions in GDP(recession) what we have to keep in mind is that the South African GDP can expand in Rand terms while contracting in USD terms. The U.S. doesn't face this issue as it is the world's reverse currency, but when looking at yield curves in other jurisdictions such as the eurozone or Japan we can see that the yield curve isn't as accurate in telling us where the economy is heading as is the U.S. yield curve.

The other risk to take into account is the default risk on government bonds causing yields to trade higher than they should.

For example, rates on the 10Y went up until June 2008 and in March 2020:

Source

As can be seen above during major recessionary periods like the GFC yields didn't necessarily go down because, unlike a U.S. government bond the South African bond market isn't seen as a fight to safety.

The two main reasons are default risks and currency risks.

To measure the default risk we can look at the CDS market. Since CDS aren't traded publicly it's hard to get good quotes on it. The best quote I've found is the 5-year CDS. Below is the chart of the 5-year CDS:

Source

Currently, the implied default on the CDS is 5.23%. As can be seen during March 2020 the implied default rate went up which was one of the major causes for the 10Y yield to spike then even as there was a flight to safety.

The other major reason was that the Rand tanked against hard currencies like the JPY, USD, and CHF during March 2020 so investors didn't want to take the devaluation risk.

For these reasons, while the yield curve is positive I wouldn't put too much credence into it before looking at default risk and currency risk from the perspective of a bond investor.

Also, the central bank has been continually raising rates to fight high inflation, so I wouldn't be surprised if the whole curve were to become inverted over the next year or so; the 20Y-30Y spread has already become inverted because of this.

The third metric I look at when it comes to the South African economy is commodity prices.

The biggest commodity exports are platinum, gold, iron ore, diamonds, and coal.

Because these commodities have gone up over the last three years, South Africa's exports have been going higher:

Source

The chart above shows exports in ZAR terms. Exports figures have done better due to higher commodity prices. Since I do believe in the thesis of a commodity supercycle, I expect that South African equities which are connected to the export market or are directly producing commodities will be big beneficiaries.

With all of the above said, my big-picture view is that areas of the economy and market that are connected to the domestic economy will suffer due to internal issues such as the energy crisis and stagnant economy. These issues are structural, so they are unlikely to get solved without significant changes in the government, which I find unlikely, in fact, the trend has been seemingly more government involvement in the marketplace.

On the other hand, areas of the market and economy that are connected to the commodity market and export market are likely to do better due to higher commodity prices. These companies also benefit from a weak Rand as their operating cost of denominated in Rand, but commodities are sold in dollars, so as the spread widens it directly widens commodity producers' margins.

As for my shorter-term macro view, I believe that the central bank will continue its rate-hiking cycle till inflation goes down. This is likely to cause an inverted yield curve and an eventual recession.

ETF Breakdown

The exact ETF holdings can be found on the MSCI page .

The ETF has 43 holdings at the time of writing. The holdings are weighted with larger market cap companies having a larger percentage of ownership with the largest holding being Naspers at an over 15% weighting.

The two sectors with the largest weightings are financials and telecommunications. I'm bullish on financials not just in South Africa, but word wide due to the normalization of interest rates. Telecommunications on the other hand is a sector I'm very bearish on due to the energy crisis making it impossible to run day-to-day operations.

The biggest issue, not necessarily with just this ETF but all international ETFs is that they can always be blacklisted by regulations. This happened with all Russian Investment ETFs traded in the U.S. and Russian Investment UCITS in the EU. I know some traders who were short these ETFs on the thesis that the Russian market would crash and it did, but they couldn't cover their shorts as these funds were frozen and they still have to pay short fees to this day. This is the risk of buying emerging market ETFs in one's home country. This is why I prefer to directly invest by opening a brokerage account in that country and trading on the local exchange, thereby circumventing many of these issues.

For these reasons, I would avoid using this ETF and instead trade single stocks directly listed on the Johannesburg Exchange.

How To Go About Building A Portfolio Of South African Equities

When going about building a portfolio of South African equities I would focus on removing the biggest risks first.

The biggest risk is currency risk. I would create a hedged portfolio where all capital in equities is hedged with an FX trade. For example, if I had a million dollars I wanted to put into South African equities I would take some amount of that, say 200k, and put that into an FX trade where I'm long 800k of USD against Rand. Since FX requires little margin to put on a trade this can easily be done. CFDs, spread betting, and futures can all be used as an alternative. One's home country's currency or currency of investment denomination can be used instead of USD. Then the rest of the capital, in this case 800k is all hedged and can be invested into equities.

When it comes to equities, the proverb "It's not a stock market; it's a market of stocks" really rings true here. In the South African stock market, simple things that would be glossed over in other countries become very important. For example, if there were two retail store companies that were completely the same, one all over South Africa and another just in the Western Cape, then it would make a drastic difference due to the fact that the Western Cape is controlled by the DA, not the ANC, which makes for lower levels of retail crime, lower unemployment, higher disposable income, more reliable energy sources etc. A small difference like this might not mean much in other countries, but it would in South Africa. Because of this level of variance, I believe that South Africa is the best place for a stock picker to go.

There are a few key areas of opportunity I'm looking at in South Africa. The first is companies in the energy vertical. Since Eksom has failed and the government is now buying power from the private sector there is a major opportunity for private energy providers to sell what is likely overpriced energy to Eskom. The biggest company in the integrated energy space behind the state-owned Eskom is Sasol Limite d ( SSL ). The company trades at around 4x earnings and has growth prospects due to the issues with Eskom.

Another area of opportunity is commodity producers. Since I'm bullish long-term on commodity producers, South Africa is a great place to stock-pick them. One of the many that I'm bullish on is Anglo-American ( OTCQX:AAUKF ).

Similar to how I picked out potential long positions above, the opposite can be done by finding companies that are getting negatively impacted by what is happening in South Africa that can be used as short positions. Because South Africa is a stock-picking environment, a long-short equity strategy can be used to take advantage of the wide discrepancies between different stocks.

The Bottom Line

The bottom line here is that South Africa is a stock pickers market due to the massive variance in the market.

I'd focus on building a currency-hedged, long-short portfolio focusing on buying high-quality, low-valuation stocks that will benefit from the internal issues of South Africa and those that are a play on the commodity bull market. I would avoid or potentially even short stocks that have significant risks from the internal issues created by the government.

I would also avoid international ETFs for the reasons mentioned in this write-up.

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