On 22nd November 2016 we published a post entitled "The Most Investable Shares On The JSE Right Now", that looked at the results of one particular mechanical stock picking strategy for shares most likely to out-perform the rest of the JSE over the next 3-6 months. Eleven shares were identified.
The article was immensely popular among Sharenet readers, and I asked our two popular analysts Ian Stiglingh and Daniel Nel to cover each share in a little more detail, good or bad. This is the first part of a two-part follow-up that covers six of those shares, four of them in construction.
When private investors are considering shares for investment from a mechanical stock picking strategy, it’s useful to combine some fundamental and/or technical analysis to arrive at better decisions and timing. - Dwaine van Vuuren, PowerStocks Research.
JSE Limited [JSE]
The JSE Limited (short for Johannesburg Stock Exchange) relies on transaction volume from the market to drive revenue. Increased transaction volume also benefits other segments of the business, such as post-trade services. The main trading components include trades in equity, interest rate products and the futures associated with these. In the company’s interim results (period ended June 2016) the headline earnings per share increased by 19% compared to the same period in 2015. During this period, the company lowered transaction fees, but a pickup in trading volumes managed to offset lost revenue.
Trading volumes have continued to increase in the five months from July to November, and looks set for double-digit growth over the full year. Another big segment of the business is the market data that the JSE supplies and revenue in this segment is growing at a blistering pace. It’s important for the JSE to diversify income streams, as regulation is aimed at encouraging competition between stock exchange service providers. This may be one of the reasons the share price has come under pressure recently.
Over a one-year period, the share price has shown strength, but it has pulled back about 18% since reaching highs in July 2016. Looking at the price-to-earnings ratio, the company looks relatively inexpensive at 13.8 (3 year average: 15.9) and although a portion of market share may be lost to new entrants, there is little doubt that JSE will retain its dominant market position.
Kumba Iron Ore [KIO]
Kumba Iron Ore has been one of the biggest benefactors of rising commodity prices this year, rallying an incredible 683% from the year’s low in January (R24.15) to the year’s high in December (R189.30). The share price is largely driven by the price of iron ore, and tracked the commodity lower since 2013 when the share was trading at around R600.00. That weakness suddenly turned around at the start of the year and the share price rallied from a low base.
Over recent years, the price of iron ore could almost be predicted by looking at Chinese inflation, due to a boom in the country’s construction spending. However, from the start of 2016, the price of iron ore has left Chinese inflation behind. The macro environment has been more or less unchanged, but still the price of iron ore increases. Part of this strength is due to state-directed capacity cuts in the steel industry. We are also seeing some positive production figures from China, but overall economic conditions remain muted. The IMF expects Chinese GDP growth to slow further in 2017 and inflation to stay around current levels.
Kumba is in a better position to deal with any weakness in iron ore prices than before. The company is operating at high production capacity, and has generated enough free cash flow to wipe out its debt. Management is also looking to distribute excess cash to shareholders, which means attractive dividends could be in the pipeline.
The magnitude of the share price recovery relative to the macro environment is concerning. Markets are expecting a global economic recovery next year, and if that reignites construction in China, you can expect to see Kumba’s share price in the clouds.
A large chunk of shares revealed by the mechanical stock picking strategy were related to the construction sector. The construction sector in South Africa has been a tough environment to operate in ever since the conclusion of the 2010 FIFA World Cup.
The government has promised to increase its spending towards construction in line with the National Development Plan, but these promises are yet to be followed through, and this has left an overcrowded industry to fight for the scraps. The government is facing budgetary challenges, so expecting a big roll-out of construction spending is a bit optimistic. There are few places for construction companies to seek top-line growth in SA, and this has led to some venturing into offshore markets.
One thing to look out for is a declining interest rate cycle, which could materialize over the next 12 to 18 months. Generally, lower interest rates encourage business investment and could boost private sector construction spending.
We will now take a brief look at the four construction companies we’ve identified on our list of the most investable shares on the JSE:
Group Five [GRF]
Group Five is the cheapest in terms of price-to-earnings of the four construction companies we discuss in this article. The company has seen positive cash flow and a good increase in earnings in 2016; however, it comes off a low base in 2015. There have been cost cutting initiatives on the employee side in an effort to improve margins since top-line growth is not doing enough.
The company’s order book has steadily declined recently and is the lowest it’s been since 2012. If you want to back a construction company then you would want to consider the order book, and in Group Five’s case it is a bit of a disappointment. Currently it sits at 72% of revenue, which means revenue is likely to show little improvement next year.
Wilson Bayly Holmes-Ovcon [WBO]
WBHO enjoyed a superior performance to its peers thanks to its operations in Australia that managed to offset weakness in the South African market. Headline earnings per share and revenue advanced 23.8% and 6.3% respectively in the most recently released results.
The positives don’t end there: profit margins improved while strong cash flow generation ensured a net positive cash position. The biggest case for WBHO is its positive outlook for 2017. The company has a strong order book (80% of revenue) and the market in Australia is improving. The current price-to-earnings ratio is in line with its historical average, and with earnings expected to increase, the share price is likely to follow.
Murray & Roberts [MUR]
Murray & Roberts would’ve hoped that its offshore revenue would offset weakness in the South African construction industry. Unfortunately for the company, that offshore exposure lies in the Middle East, which has seen a slump in economic activity amidst low oil prices.
Revenue and profits disappointed relative to peers, and the order book declined over the year. If there is one positive to take from the company’s books it is the net cash positive position, which means debt is not an issue. However, that certainly is not enough to differentiate it from the competition.
The story for Raubex has similar characteristics to that of its peers. Raubex is the market leader when it comes to road works and maintenance in South Africa, and given the weakness of the local industry, it will be difficult to generate top-line growth.
The company’s order book looks more or less the same as last year in terms of size, meaning an improvement on operating margin and cost management will be a focus. All of the company’s divisions are contributing positively towards earnings, and at a relatively lower price-to-earnings multiple, we think Raubex is one of the two top picks in the sector along with WBHO.
NOW GO READ THE SECOND PART - Most Investable Shares - Follow Up #2
Quantitative Investment Analyst
Ian Stiglingh is a full time quantitative analyst, responsible for research of equities across all industries. Ian completed his degree in Mathematical Science in 2013 and his Honours degree in Financial Risk Management in 2014, both at the University of Stellenbosch. During his studies, Ian worked as an intern at Old Mutual Actuaries & Consultants as well as J.P. Morgan in Johannesburg, and is currently a CFA candidate