Tuesday, 14 February 2012 - 20:00

 

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2012 Possible Returns

While local shares produced a total return of only 2.6% in 2011, January saw enthusiasm for so called risk assets come back into favour, as the JSE All Share index gained 5.7%, taking the index to a new all time high by the end of January to a level of 33 793.

Many investors still get confused with the nominal value of the index, equating it to the value of shares in general. However this nominal index number is merely an average price for all the shares comprising that index. The price of a share is a multiple of its earnings generated by a factor, known as the PE ratio, or price to earnings ratio. When looking at the market as a whole, it is important to focus not on the nominal index number, but rather on what level of earnings this represents. Having an understanding of the starting point is important in trying to assess the future return.

If we try and anticipate the returns from the market going forward one year and two years, we really need to know only 2 inputs – simple, yes, but not easy. The first is the growth in current earnings, i.e. what the level of total company earnings will be in the future and secondly what the multiple that investors will be prepared to pay for these earnings is.

The index is then merely the product of average company earnings and the PE ratio. Forecasting company earnings is possible, albeit difficult, but even more uncertain is trying to predict what investors will be prepared to pay for those earnings (i.e. the PE ratio). What we do know about the PE ratio is that it is mean reverting and so both high and low PE’s move back to the average over varying periods of time. Over the last 50 years the PE on the JSE has had an average of 11.9 with a one standard deviation range of 8.2 to 15.6.

Looking at the specifics for 2011 helps illustrate the mechanics. At the start of 2011, investors were prepared to pay 17.3 times earnings (i.e. the market was expensive relative to its long run 11.9 times). During the year earnings grew by 34.6%, but by the end of 2011 investors were only prepared to pay 12.7 times earnings. The result in the contraction in rating was an index that declined by 0.4%, despite the exceptional earnings growth.

At the end of January 2012, earnings had climbed slightly to 2 518, while the PE rating had moved to 13.4 times. Looking ahead we can make the following forecast scenarios.

Should company earnings grow by an average of 12% in the year and the market rating remains at the same level as it is currently, investors can expect a total return of around 15%. Should earnings grow by 15% and investors become more enthusiastic again, driving the PE to 16, then a 40% total return is not impossible. On the downside should a reasonable earnings increase be offset by a de-rating of the PE to 11, then investors will sustain a loss of 8%.

The variance in one year forecast reflects the difficulty of shorter term forecasts. Because of the mean reversion in valuations, we prefer to adopt a longer term forecast such as 5 years, which has a higher predictable outcome.

Kind regards,

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Tue, 14 Feb 2012

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