Why are South African stocks cheap? and what does this mean?

South African fund managers and investors are increasingly disillusioned as the gap widens between South Africa’s equity market and global counterparts. South African stocks, notably within the financial sector, are declining sharply, prompting some fund managers to view them as significantly undervalued.

However, the evaluation of South African equities warrants scrutiny. The valuation, assessed through Professor Robert Shiller’s PE10 metric of the FTSE/JSE All Share Index (ALSI), previously mirrored that of developed markets until December 2015. This pivotal moment, marked by political upheaval, led to downgrades in South Africa’s sovereign credit rating, precipitating a substantial decline in the Johannesburg Stock Exchange.

Subsequently, South African stocks have traded at a discount of over 20% to the PE10 of developed market equities, which has expanded to over 40% presently. This begs the question of whether South African stocks are exceptionally cheap.

Analysis of global financial markets suggests that countries’ credit ratings and economic conditions influence their financial market ratings. Comparing PE10 metrics against 10-year government bond yields and credit ratings reveals that South Africa’s financial market assessments align with broader trends, indicating a fair valuation.

However, certain factors, such as corporate actions and the presence of international companies in the ALSI, may skew these calculations. Notably, the impending general election holds significant implications for South Africa’s economic and political landscape, with potential outcomes varying widely.

Positive election results could lead to a market rally, akin to Mexico’s experience, while negative outcomes may exacerbate economic challenges, akin to Russia’s scenario. Expectations of continued volatility post-election persist due to uncertainties surrounding political transitions.

In light of the above it is important to note that while South African stocks and government bonds appear attractively priced, they are not without heightened risk, particularly political instability.