Is South Africa safe for investors?

South Africa is a relative newcomer to the emerging markets' party, but it's made up for lost time, with its stockmarket really kicking off last year. But is now the time to jump in?

Many emerging markets have been partying hard for a good three years now, and in 2005 South Africa finally joined them, albeit unfashionably late. While countries such as Brazil, India and Argentina have seen their stockmarkets soar over the past three years, the South African stockmarket only really kicked off last year. Since then, the surge has been remarkable: from the beginning of 2005 until February this year, the JSE All Share index rose 60%.

So where does this renewed confidence in South Africa's economy come from? For some, South Africa is still a commodity play, and certainly high commodity prices have attracted interest the FTSE/JSE Africa Mining index is up 75% since January last year.

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But there's more to South Africa than gold and platinum. Consumers have increasingly taken to South Africa's high streets, with the emerging black middle-class spending much of their disposable income. Their buying power now equals about R130bn per year, or about 22% of the country's total purchasing power, says Megan Power in the South African Sunday Times, and they're now the biggest driving force behind consumer expenditure. South Africans have been given a further boost by finance minister Trevor Manuel's recent budget. He cut tax rates slashing transfer duty rates and halving the tax on retirement funds.

Then there's the low interest-rate environment. The South African Reserve Bank, helped by a strong rand, has taken a firm grip on inflation: CPIX (consumer price inflation excluding mortgages) for January rose by a forecast 4.3% year on year, well within the central bank's 3%-6% target, and it has been on target for 29 straight months.

The credit-rating agencies seem to approve. The three major agencies (S&P's, Moody's and Fitch) raised their credit ratings to the upper rung of the lower investment scale last year.

Manuel predicts that the country's economy will expand at 5% a year for the next three years (it expanded by 4.9% in 2005, although analysts were disappointed by fourth-quarter growth of 3.3%). And a healthy macroeconomic background has also been a key factor in attracting foreign investment.

In 2004, foreign direct investment (FDI) in South Africa was just $800m. By the end of last year, it had grown to a massive $7.2bn an 803% increase points out Geoff Candy on financial website Moneyweb.com. The Barclays/Absa merger was the catalyst for other deals, including Vodafone's acquisition of Venfin.

Portfolio inflows have been strong too. In the first two months of the year, foreign investors were net buyers of shares on the JSE to the value of R20bn (£1.85bn) and now account for 50% "of the total turnover on the JSE", says Vic de Klerk in financial magazine FinWeek.

There are dangers, however. Most importantly, if foreign investors take fright, then the country's stockmarket and strong currency would be vulnerable. So what could possibly scare foreigners out of the emerging market?

The first, and perhaps the most immediate worry, is wholly external. Many commentators believe that not only emerging markets, but most financial asset prices have been inflated by institutional investors' access to easy credit. The recent announcement by the Bank of Japan that it will end quantitative easing' of monetary policy means that the principal source for that cheap borrowing the yen will not be available indefinitely. Some of that borrowed money must surely have gone into South African markets. The danger is that it might leave.

More important for the long term, there has been talk of an immediate moratorium on the purchase and sale of South African property to foreigners, because foreign ownership is said to contribute "significantly to the lack of readily available and affordable land for land reform", according to the panel who proposed the action.

This raises the spectre of land redistribution, which has hurt foreign sentiment in the past. Unfortunately, Land Commissioner Tozi Gwanya indicated that white-owned land would be expropriated from this month, which sparked fears that South Africa may follow the route taken by Zimbabwe.

Meanwhile, the "willing buyer/willing seller" principle, where both parties to a transaction are satisfied with the price for the land, has come under government review. This is because, after three years of negotiations, some 7,000 land claims are still outstanding largely because the vendors, mostly farmers, are not satisfied with the prices being offered for their land, says Donwald Pressley for newswire I-Net Bridge.

Then there's the country's ailing infrastructure. South Africa may have won its bid to host the 2010 Soccer World Cup, but the country is currently facing an infrastructure crisis, says Barry Sergeant on Moneyweb.com. For evidence, look no further than the power blackouts occurring on a daily basis in the Western Cape, caused largely by maintenance failures at the country's only nuclear power plant, Koeberg. The power outages have cost businesses in the Western Cape more than R500m (£46m) in the past month, says the South Africa Chamber of Commerce (Sacob).

Besides, says independent energy researcher Andrew Kenny, government-owned Eskom, South Africa's main supplier of electricity, should have foreseen these problems at least ten years ago. Now "South Africa does not have enough power stations and transmission lines to cope with the present load", which is a serious threat to the country's growth prospects, says Sergeant. Eskom has since announced plans to build two new gas-turbine power stations, which they hope to start using by March next year but even these will only provide electricity during peak periods.

Finally, the "golden thread running though a crumbling infrastructure" is the problem of corruption, says Sergeant. The ruling ANC and opposition parties have both referred to corruption during pre-election campaigns. The ANC has promised to stamp it out but until they do so, service delivery to the impoverished will continue to suffer. What is encouraging is that the problem is acknowledged.

Cracks in the country's infrastructure have prompted the government to spend R372bn (£34.4bn) on repairs and rejuvenation over the next three years. Ironically, the decision was announced on the very day that Trevor Manuel found himself stuck in one of the lifts in the parliamentary building.

For investors, this could be great news. A construction boom could well be on the cards, says Thabang Mokopanele in the Business Report newspaper. It may also go some way to alleviating South Africa's terrible unemployment rate. According to Bloomberg, the country has the highest unemployment rate of the 61 countries it tracks, with 26.7% of the population officially unemployed. Unofficially, the figures are much worse, with 38.8% (7.8 million people) of the potential working population without work, says Greta Steyn in FinWeek.

On the face of it, it's bewildering that the unemployment rate is so high when the economy is so strong. One reason for this is the powerhouse rand which has gained 94% against the US dollar since the end of 2001. The inevitable result has been a fall in export competitiveness, with manufacturers and mining outfits firing thousands of workers in the process, says Mokopanele in the Business Report.

Moreover, Aids is having a huge impact on the employment rate and the growing skills shortage in the country. Mines, manufacturers and transport firms have the highest labour turnover rates as a result of the epidemic, which in turn means the loss of skills and experience and additional costs in training and recruiting new personnel, says Allan Seccombe on Finance24.

A growing number of mining and financial services companies now believe their profits could be 5% lower in five years' time as a result of Aids. Workers whose family members are HIV positive often stay at home to look after the Aids-sufferer, or are simply unable to focus on work, says Seccombe. According to leading life insurance company, Metropolitan Life, Aids could account for half the national death rate in the country by 2011.

According to The Economist, a "current-account deficit sets alarm bells ringing" and with South Africa's deficit at 4.3% of GDP at some R60bn (£5.5bn), there should be cause for concern. The only industrial economies with more significant deficits are the US and Spain, both 6.5% of GDP, and Australia, at 5.9%, says Howard Preece in FinWeek. For the last two years, the growing deficit partly caused by the strong rand has been financed by foreign investment. However, should this investment stop, or worse, leave, the current-account shortfall will grow. A flight of short-term speculative capital would spell trouble for equity and bond markets and weaken the rand.

Economists generally agree that South Africa will continue to nurse a current-account deficit of between 3% and 3.5% for the next few years. This is not an immediate threat to the country, but "let's keep a close eye" on the factors influencing the current account, says Preece, and "not just dismiss the current-account shortfall as immaterial".

If hot' money were to leave the capital markets, as part of a more widespread flight from emerging markets, then the resulting weaker rand would help cap the deficit. The rand is currently trading around the R6.30/US$ level after having strengthened to R5.80 earlier this year. But forecasts for the rest of the year vary widely: ABN Amro believes the currency will revisit the R5.80 levels by the end of 2006, while NKC Independent Economist Hugo Pienaar told MoneyWeek that he thinks that it's more likely to weaken to around R6.50. Manufacturers, who make up 16% of South Africa's GDP, would be pleased with the letter.

Neither the deficit nor any of these threats to South Africa are reasons for investors to avoid investing in the country. They are warnings of potential difficulties ahead as South Africa matures from an emerging to a fully industrial economy. The nervous sentiment in the stockmarket is expected to wane and the "market as a whole will continue to grow for another two to three years", Dave Foord Chief Investment Officer of Foord Asset Management told MoneyWeek.

Also, don't be put off by a price/earnings ratio of nearly 17, which the JSE is currently trading on, says Foord although as De Klerk in FinWeek points out, historically the ratio is nearer to 13.

So which sectors of the market show the most potential? Consumers "will be the pillar of economic development" for a number of years to come, says Foord, with retail companies' earnings outlooks reflecting this for at least another two years, says Kirsty Laschinger in FinWeek.

Moreover, with the tax brackets lowered last month, consumers should find they have more money in their pockets, particularly "at the lower end" of the market, Laschinger says, where the cuts are likely to be most beneficial. And with just 17 million South Africans having retail credit accounts out of a population of some 50 million (the debt service to personal disposable-income ratio is at a low 6%), the credit cycle should have some way to go yet (see below for tips).

Then there's the budding construction boom. "Fixed-investment spending", supported by the massive infrastructure projects to be tackled by both private and public sectors, has been secured for at least another three-to-five years, Foord reckons, which should boost the construction industry.

The government plans to spend R372bn (£34.4bn) on projects such as the R20bn (£1.8bn) development of the Gautrain, a rapid rail train between Pretoria and Johannesburg, two new power stations, as well as the building and upgrading of sports facilities ahead of the Soccer World Cup. Builders such as Wilson Bayly Holmes and Murray & Roberts already have their order books full.

Retail banks are also set to benefit from a pick-up in consumer credit, says Pienaar. Low interest rates are encouraging shoppers to go into debt and banks are looking to increase their credit-card base. Only three million South Africans currently have credit cards and banks aim to raise this figure to nine million over the next three years, says Laschinger.

Bankers' confidence is also high: the Ernst & Young Financial Services Index shows banking confidence is at 100% for the fifth straight quarter. According to Anton de Souza, Financial Services Partner at Ernst & Young, banks are looking solid, with sound revenues and improving efficiency, while bad debts and provisions have fallen in the past two years.

Yet despite the increasing confidence in these sectors, the resources sector continues to attract most interest, with "walls of money" flooding from the US into South Africa's commodity markets, says UBS metals analyst John Reade. Chinese demand has pushed gold, platinum and copper prices to all-time highs, following years of underinvestment in exploration, says FinWeek.

Even rising input costs for oil and machinery (gold miner Harmony, for instance, said its costs for 2005 rose 9.4%, well above the inflation rate) are relative to increased supply, says Citigroup. Miners will continue to struggle to make up the "supply deficit" in the metals market, which in turn will result in more "windfall" returns for them, says David McKay in FinWeek.

South African platinum stocks look particularly attractive over the long-term, says Simon Marais on Moneyweb.com South Africa has 80% of the world's platinum reserves and no major platinum deposit has been found outside of southern Africa in the past 80 years (see below for tips). At the very least, commodity investments "are likely to continue growing strongly in 2006", Barclays said recently, and Merrill Lynch say that they intend to stay long on miners "on a six to 12-month view".

South Africa's President Thabo Mbeki recently urged businesses to invest in the country. Healthy economic growth, rising commodity prices and low interest rates all provide a solid base for continued JSE growth. As long as the country's economic fundamentals stay healthy, there's no reason for foreign demand to dry up.

Retail stocks are the gems of 2006

South Africa's retail boom may have kicked off last year, but the p/e multiples of retailers are still lower than those in other sectors, says Investec Asset Management's Gail Daniel in the Business Report. As a result, the sector offers growth potential and forms one of the cornerstones in Investec's domestic equity funds.

Daniel's favourite retail stocks are Truworths (TRU) and Mr Price (MPC). Truworths, she says, is one of the best-managed businesses in South Africa, while Mr Price is using its cash aggressively to grow profits. Mr Price a lower-price clothes shop also has much upside potential because it remains a cash business, which is only now starting to offer credit.

Merrill Lynch retail analyst Mohamed Mayet also likes Truworths, and makes it one of his top three picks for 2006, says FinWeek. Spar (SPP) a favourite because it's attraction to shoppers is convenience rather than price and Woolworths (WHL) a high-income food and clothes store are his other top picks for this year. He believes Woolworths has good potential for a turnaround in its clothing operations.

Evan Walker of Andisa Securities prefers retailers focused on the bottom end of the market, because they seem "more robust" than those targeting upper income earners. His top picks are Ellerine (ELH) and Shoprite (SHP).

In the construction sector, Investec analyst Thurston Goliath likes Aveng (AEG) and Murray & Roberts (MUR), which are both expected to benefit from the high number of construction contracts coming through, says Erika van der Merwe on Moneyweb.com. Group Five (GRF) and Aveng are top picks for Old Mutual Asset Managers' Feroz Basa, who says the outfits have spare capacity, which will allow them to pick and choose projects, leading to higher margins.

In the commodities sector, attention has focussed on big miners, such as Anglo American (AGL) whose share price has risen 43% over the past seven months (but fell back some 8% in the past week). Now, it's become increasingly hard to track down the mining outfits that have not been "picked off" by professionals, says FinWeek.

But they do exist and you can find them on the mid and small-cap markets. Sxr Uranium One (SXR) is one such firm: it's an exploration operation that owns the second-largest uranium deposit in the world and should start extracting the metal by 2007, says David McKay in FinWeek.

Demand for platinum has rocketed, with China especially importing the commodity for its industrial needs. Although South African platinum shares, including Implats (IMP), Lonmin (LON) and Northam (NHM) have struggled as a result of the strong rand in the past year, says Simon Marais on Moneyweb.com, as long-term investments the shares "look very favourable".