rsa _half full or half empty

8/4/2019 RSA _Half Full or Half Empty

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SOUTH AFRICA

Half full or half empty?For CY11, we are becoming more constructive on earnings

production (and momentum) by companies (to include banks).However, we question the current valuations particularly on a 12-month price target basis. In this report we highlight our two

primary themes for CY11. The key takeaways in this report are:

2010 performance overview : The Top 40 index monthlyreturns were more volatile than the Small cap index inCY10. The Small cap index outperformed the Top 40 indexby 6.4 percentage points (pps). However, like in CY09, the

best performer was the Mid Cap index which outperformedthe Top 40 index by a colossal 11.2pps. The Banks indexwas rather one of the average performers, with a return of

11.8% which was only 0.4pp above its average 10-yearreturn. At the recovery point of the economy, one wouldhave expected a stronger performance relative to the mean.The Top 40 index, however, showed strong outperformance

against the MSCI EM index, albeit due to the strong rand.The MSCI BRIC index and our select resource-basedmarkets also under-performed the Top 40 in US$-terms, onaverage.

Half full or half empty; Our two key themes in 2011:Our two main themes are 1) earnings should grow stronglyin order to justify the current valuations. The market hassoared by 47.3% since CY08 vs. a decline of 43.1% inearnings in CY09. However, earnings have grown by 42.1%

in CY10. There are still some uncertainties, in our view,although we carry a stronger conviction that earningsexpansion will continue this year. Nevertheless, growthcould be lower on base effects. The Top 40 index profit

margin and Return on Equity (ROE) have reboundedalthough both remain below their long-term averages. 2)money-flow (from foreign and local investors) could be an

enticing reason to enter the market, but it is a feeble one.While the under-owning of the market by local investorscould support valuations in the short-term, we see somefallacy in assuming risk simply because of this reason. In

fact, CY10 equities net purchases amounted to R35.6bnonly in a year that Emerging markets (EMs) attracted a lotof interest. Valuation metrics, mainly the PER and the

dividend yield are at worse levels than their long-termaverages. Our major concern is the lack of clear catalysts tomaintain the market momentum, despite our moreconstructive stance on earnings. The discount rate for theSouth African equities is unlikely to improve given the low

probability of further reduction in the risk-free rate and thenear record low volatility.

Peter MushangweLawrence Madzwara+27 11 551 3675

[email protected]

January 18, 2011 Equity Strategy

MARKET VIEW

NEUTRAL


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Banking: Sector macro issues are intact although Basel 3could have a slow but painful impact; We are warming up

on the mainstream banks relative to MFIs on valuation:Regulatory risk (and Basel 3) and its impact to the local systemattracted a lot of interest in CY10. More importantly, most

commentators opined that banks will struggle again this year. Themain area of focus has been the lacklustre revenue growthexpectations. While we agree that revenue growth will continue tolag the historical average, despite an upturn in loan growth, we

are more constructive on earnings. We believe that 1) credit costsare going to continue to reduce; 2) regulatory risk overhang(related to Basel 3) is going to wane. This will allow banks to grow

their risk-weighted assets with a mindful view of the regulatoryrequirements; and 3) the system will benefit from better costmanagement and efficiency benefits than was the case in CY09and CY10. We believe the system carries optimal capital (relative

to Basel 3 requirements) and the risk of dilutive issues to increasecapital is low. The system is building up liquidity as shown by therising liquid assets/total banking assets ratio. The liquidity build-upcreates headwinds to banks margins (and yields) but lower credit

costs and efficiency benefits should neutralise the impact in CY11and CY12.

Not all banks are created equal though. While sector sentimentremains awful, the MFIs traded well in CY10, with some euphoricsector (MFI) share price rally in the 2H10 being a major highlight.

We are taking a more constructive stance on the mainstreambanks when compared to the two MFI (Capitec and ABIL). WhileMFIs continue to show strong earnings growth, we believe

valuation is stretched and provides a most disadvantageous risk-

return profile. Capitec has gone up by 122% while Abil rose by29.5% in CY10. This compares unfavourably to the average capitalgain of 4.2% for the mainstream banks. From a valuation point of

view, Capitec is trading at 2.1X the Industry average PER (againstan average of 1.6X from CY05) and Abil is trading at 1.3X. We donot doubt the MFIs superiority in earnings growth but we are

beginning to see a non-optimal risk-return profile. 1) some of themainstream banks are encroaching into the MFI space, to includePostbank and U-bank. Competition from the shadow bankingsystem, which tends to flourish as the economy picks up, has an

elevated impact to MFIs than mainstream banks 2) the thinnerbalance sheets of the MFIs mean lower ability to expand loanbooks in a meaningful way without raising more capital, which at

times could be dilutive.


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Contents page

1. 2010: A good year for Equities 3

2. Valuation Issues : Half full or half empty 13

2.1 Earnings growth has to be strong 13

2.2 Money-flow is the weakest reason to buy shares 14

2.2 Our argument against under-valuation 16

3. Banking: Macro issues intact, Basel 3 slow but painful 19


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1. 2010: A good year for equities

Santa rally closed a good year: The Top 40 index closed theyear with a local currency return of 14.6%, not a bad return in ayear characterised by volatility and pessimism, immenseheadwinds to global economic recovery as both Europe and Japan

continued to disappoint. No-one was sure how problems in Greece,Italy and Ireland were going to play out. Now no-one is sure whatwill happen to Portugal, Spain and Belgium. There were, however,only five months that produced positive returns in the year and loand behold, they were strong returns. The strong run in the 4Q10ensured a robust performance for the Top 40 index. The Small Capindex was less volatile, with only 3 months of the year posting

negative returns. The Small cap Index outperformed the Top 40 by

~6.3pps. Top 40, Small Cap vs. Mid Cap: In our 2010 outlook, (see 2010

Outlook: Major Themes dated 12 January 2010) we highlighted the

need for investors to progressively move to Mid cap and cyclicalstocks. Migration to cyclical stocks could not have been veryrewarding as defensive stocks continued to perform well in CY10,in general. However, the Mid Cap index outperformed both theSmall Cap and the Top 40 indices. The Mid cap index provided a

gain of 25.8%, which is 11.2pp and 4.9pp higher than the Top 40and the Small cap indices respectively. It is, however, important toindicate that the Mid Cap index has massively outperformed its

CY99-CY09 average return of 13.5%, by 12.2pps while the Top 40index and the Small Cap index show lower outperformance of

2.2pps and 6.3pps respectively. The Mid Cap has gained 63.8%since CY08 against 48.5% and 47.3% for the Small Cap index and

Top 40 index in that order. This outperformance relative to historyand the Top 40 and the Small Cap indices could create negativetrading sentiments this year. Nonetheless, looking at valuationmetrics, the Mid Cap continue to look the least expensive with the

highest dividend yield and a lowest PER when compared to the Top40 and the Small Cap indices.

Banks vs. Others: We expected banks to do relatively well inCY10 when compared to CY09. While this was the case, it lookslike most of the good news was priced in already. Banks sufferedanaemic top line growth, but we see reduced headline earnings

risk this year. The Banks index gained 11.8% in CY10, a minuteoutperformance of its CY99-CY09 average return of 11.4%.Valuation metrics show relative undervaluation to the Industrial 25and Top 40 indices. We believe that the macro factors in the

banking system remain intact (ample CAR, fair liquidity, waningcredit risks and improving loan growth). Risks come from the highhousehold debt level but CY10 underperformance (relative to theTop 40 and the Financial Index) could support valuations this year.

RSA vs. EM: We compare South Africa (Top 40 index) returnsagainst the MSCI EM and MSCI EMEA indices. In US$ terms, the


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Top 40 index returned 27.9% primarily due to the strong rand. TheMSCI EM and MSCI EMEA indices provided gains of 16.4% and

20.9% respectively. In local return terms, South Africa slightlylagged both the MSCI EM and MSCI EMEA indices. South Africatrades at a higher PER than the MSCI EM and the MSCI EMEA.

RSA vs. BRIC: In US$-terms, South Africa outperformed the MSCIBric index by a significant margin, close to 15pps. In the Bricfamily, Russia provided the strongest performance, with a US$capital gain of 20.7% but other members did not put as stellar

performances. However, on a 5-year compounded US$ returnbasis, South Africa equities underperformed the Bric Index by7pps. South Africa trades at a premium (higher PER ratio and a

lower dividend yield) when compared to the Bric index, which inour view could act as a disincentive to foreign portfolio inflows inthe equities space as South African is expected to lower growthwhen compared to other the Bric family.

RSA vs. resource based markets: The US$ return of 27.9%beats the 20.7% for Russia, 17% for Canada and the 6.1% forBrazil. Australia had a negative return of 23.7% for FY10. Again,the strong rand provided a strong currency return component asSouth Africa underperformed Russia in local currency terms.

Among these resource based markets, South Africa has the secondlowest dividend yield and the highest price/book value ratio.Russia has the lowest PER - maybe for a reason as it has beentrading at a discount throughout CY10.

Local investors vs. foreign investors: Equities enjoyed netforeign inflows of R35.6bn in CY10. This is less than half theR72.2bn that foreign investors pumped into the local market inCY09. This is also less than yearly average foreign inflow of

R40.2bn since CY05 including the dramatic CY08 when themarket endured a net out flow of R54.4bn! Relative to history andother EMs, South Africa was not a sweet spot for investors inCY10. However, we note that local investors still under-own themarket. In fact the lower allocation to equities (relative to history)is often underscored as the main reason for further upward

movement expectations.

Bonds vs. Equities: Bonds enjoyed strong rally in CY10 asinterest rates declined. In our view, the interest rate cycle has

troughed, and a rebound in interest rates would naturally benegative to bonds. We compare the earnings yields of the Top 40and the Small Cap indices to the 10-year government yield as weseek to establish relative valuation between these two asset

classes. Despite its theoretical shortcomings, we believe it canprovide some insights. The spread between the Top 40 earningsyield and the 10-year government bond widened mid CY09 and

has remained out of its pre CY07 range, indicating a decline in theequity risk premium. Relative to equity, fixed income valuation isproblematic as 1) inflows in bond markets having beenunsustainably strong and 2) a rebound in interest rates are likelyto make the asset class less attractive. In our view, some banks


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could continue to buy bonds to reduce their risk weighted assetsand improve liquidity (Basel 3 requirements) but we believe that

fixed income should deliver less spectacular returns in CY11. Thequandary is that our bearish call on bonds could be construed as abullish call on equities. It is not.

At risk from the European jitters? Overall we expect the EMs toface risks from the jitters in Europe. For the local economy, thedisinflationary trend has led the Reserve Bank to engage in a morefocused approach towards growth, but the household debt level is

still relatively high compared to other EMs, although the cost ofservicing debt has reduced to manageable levels of


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Page 6 of 28

The General Retailers, Consumer Services, Industrial 25 and theMid Cap indices showed strong performance, outperforming their

10-year mean returns by >10pp. Construction and materialsindices showed poor performance relative to their averages andother sectors.

Fig 2: CY10 secto r returns (vs. their 10-yrs mean returns)

19992009CAGRre turn 2010Return Deviation

Generalretailers 6.5% 55.8% 49.3%

Consumerservices 11.4% 39.6% 28.1%

Industrial 25 9.9% 23.9% 14.1%

Midcap 13.5% 25.8% 12.2%

Consumergoods 14.0% 23.8% 9.8%

LifeAssurance 1.0% 9.7% 8.7%

SmallCap 14.6% 20.9% 6.3%

Financials 6.8% 12.0% 5.2%

All Share 12.7% 16.1% 3.4%Healthcare 17.0% 19.8% 2.7%

Goldmining 9.3% 11.6% 2.3%

Top40 12.3% 14.6% 2.2%

Foodproducers 16.8% 18.4% 1.5%

Banks 11.4% 11.8% 0.4%

Telecommunications 16.6% 15.6% 1.0%

Basicmaterial 16.8% 9.8% 7.0%

Resources20 18.1% 10.2% 7.9%

MiningIndex 17.9% 9.4% 8.5%

Generalmining 19.1% 10.2% 8.9%

Pharmaceuticals 35.3% 22.9% 12.3%

Platinumandpreciousmetals 19.1% 4.4% 14.7%

Industrial metals 28.4% 11.9% 16.5%

Constructionandmaterial 21.8% 0.7% 21.1%

Source: I-net, Legae Securities


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The Mid Cap index outperformed both the Top 40 and the SmallCap indices. From CY08 level, the Mid Cap index has gained

63.8% vs. 48.5% and 47.3% for the Small Cap index and Top 40index respectively. The Banks index rose by 34.1% since CY08,lagging the Top 40 by >10pps.

Fig 3: Yearly return s for a select indices si nce CY00

40%

30%

20%

10%

0%

10%

20%

30%

40%

50%

60%

2 00 0 2 00 1 2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 00 7 2 00 8 2 00 9 2 01 0

Smallcapindex

MidCap index

Top40index

Top40av.

40%

30%

20%

10%

0%

10%

20%

30%

40%

50%

60%

70%

2 00 0 2 00 1 2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 00 7 2 00 8 2 00 9 2 01 0

BankIndex

Industrialindex

Top40index

Top40av.

Source: I-net, Legae Securities


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The Mid Cap index looks slightly attractive as it trades at adiscount to other Indices PER and enjoy a higher dividend yield.

The Top 40 index PER is now above its 10-year average.Dividend yield is below its 10-year average. This indicates areducing equity risk premium.

Fig 4: PERs and dividend yields for major indices by market cap

5

10

15

20

25

30

35

Sep00

Feb

01

Jul01

Dec01

May02

Oct02

Mar03

Aug03

Jan04

Jun04

Nov04

Apr05

Sep05

Feb

06

Jul06

Dec06

May07

Oct07

Mar08

Aug08

Jan09

Jun09

Nov09

Apr10

Sep10

P/Eratio,X SmallCapindexMidCap index

Top40index

1

2

3

4

5

6

7

8

Sep00

Mar01

Sep01

Mar02

Sep02

Mar03

Sep03

Mar04

Sep04

Mar05

Sep05

Mar06

Sep06

Mar07

Sep07

Mar08

Sep08

Mar09

Sep09

Mar10

Sep10

Dividendyield,% SmallCapindexMidCap index

Top40index

Source: I-Net, Legae Securities


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Page 9 of 28

The Banks index is cheap in relative terms (against Top 40 andthe Industrial index). Relative to history, the PER is above its 10-

year average. Dividend yield has declined but remains relativelyattractive.

Fig 5: Banks PER and dividend yields (vs. Industrial and Top 40 indices)

0

1

2

3

4

5

6

7

8

Sep

00

Mar01

Sep

01

Mar02

Sep

02

Mar03

Sep

03

Mar04

Sep

04

Mar05

Sep

05

Mar06

Sep

06

Mar07

Sep

07

Mar08

Sep

08

Mar09

Sep

09

Mar10

Sep

10

Dividend yield,% Banksindex

Industrialindex

Top40index

0

5

10

15

20

25

Sep

00

Mar01

Sep

01

Mar02

Sep

02

Mar03

Sep

03

Mar04

Sep

04

Mar05

Sep

05

Mar06

Sep

06

Mar07

Sep

07

Mar08

Sep

08

Mar09

Sep

09

Mar10

Sep

10

P/Eratio,X BanksindexIndustrialindex

Top40index


South Africa significantly outperformed the MSCI EM and MSCIEMEA indices, in US$-terms. In local currency terms, SouthAfrica lagged these two indices in CY10. On a 5-year absolute

return, South Africa again beat the MSCI EM and the MSCI EMEA.Fig 6: South Afri ca vs. MSCI EM and MSCI EMEA

0.8

0.9

0.9

1.0

1.0

1.1

1.1

1.2

1.2

1.3

Dec09

Jan10

Feb10

Mar10

Mar10

Apr10

May10

May10

Jun10

Jul10

Jul10

Aug10

Sep10

Sep10

Oct10

Nov10

Dec10

Dec10

Localcurrencyreturns

MSCIEM

MSCIEMEA

SouthAfrica

20.9%

16.4%

27.9%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

MSCIEMEA MSCIEM SouthAfrica

US$returns

Returnsince05

ReturninFY10

Source: Bloomberg, Legae Securities


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Page 10 of 28

South Africas PER is higher than the MSCI EM and the MSCIEMEA. South Africas PER is 14.6% above its 10-year average of

15.3X while the MSCI EM PER is only 3% above its 10-yearaverage of 14X.

Fig 7: South Africa P ER and Dividend yield vs. MSCI EM and MSCI EMEA

0

5

10

15

20

25

Dec00

Dec01

Dec02

Dec03

Dec04

Dec05

Dec06

Dec07

Dec08

Dec09

Dec10

Price/Earningsratio,X

MSCIEM

MSCIEMEA

SouthAfrica

1.0

2.0

3.0

4.0

5.0

6.0

Dec00

Dec01

Dec02

Dec03

Dec04

Dec05

Dec06

Dec07

Dec08

Dec09

Dec10

Dividendyield,%

MSCIEM

MSCIEMEA

SouthAfrica


Comparing against the MSCI Bric index, South Africa

outperformed the MSCI Bric index by a material 20.6pps (in US$-terms) in CY10. Outperformance in local currency terms is,however, only 7pps. On a 5-year basis, South Africa

underperforms the Bric markets by 7pps.

Fig 8: South Africa versus the BRIC

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Dec04

Apr05

Aug

05

Dec05

Apr06

Aug

06

Dec06

Apr07

Aug

07

Dec07

Apr08

Aug

08

Dec08

Apr09

Aug

09

Dec09

Apr10

Aug

10

Dec10

SouthAfrica

BRICIndex

27.9%

7.3%

14.8%

21.8%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

SouthAfrica BRCIIndex

5yearCAGR

2010return



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Page 11 of 28

...and South Africa maintains its higher PER ratio and a lowerdividend yield when compared to the Bric markets in CY10.

Fig 9: Valuation versu s the BRIC

17.6

13.1

0

5

10

15

20

25

30

35

Jul09

Aug09

Sep09

Oct09

Nov09

Dec09

Jan10

Feb

10

Mar10

Apr10

May10

Jun10

Jul10

Aug10

Sep10

Oct10

Nov10

Dec10

P/Eratio BRICSouthAfrica

2.22.1

1.5

1.7

1.9

2.1

2.3

2.5

2.7

2.9

3.1

3.3

Jul09

Aug09

Sep09

Oct09

Nov09

Dec09

Jan10

Feb

10

Mar10

Apr10

May10

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Jul10

Aug10

Sep10

Oct10

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Dec10

Dividendyield,% BRICSouthAfrica


Against the resource-based markets, South Africa is the bestperformer, beating Russ ia, Canada, Brazil and Australia in US$-

terms. The 5-year absolute return is also respectable at 66.3%although its lags Brazil.

Fig 10: South Africa versus the resource based markets

13.4%

41.0%48.2%

66.3%

191.2%

50.0%

0.0%

50.0%

100.0%

150.0%

200.0%

250.0%

Austr alia Canada Russia SouthA fr ic a B raz il

US$returnssinceCY05

23.7%

6.1%

17.0%

20.7%

27.9%

30.0%

20.0%

10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

Australia Brazil Canada Russia SouthAfrica

US$returnforFY10



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Of our resource-based markets, Russia remains the cheapest,with a PER about half that of South Africa. However, Russia

outperforms South Africa in local currency terms in CY10.Fig 11: South Africa P ER vs. select resources based markets.

Canada

Russia

Australia

Brazil

RSA

0.75

0.85

0.95

1.05

1.15

1.25

1.35

Dec09

Jan10

Feb10

Mar10

Mar10

Apr10

May10

May10

Jun10

Jul10

Jul10

Aug10

Sep10

Sep10

Oct10

Nov10

Dec10

Dec10

Australia

Canada

Russia

Brazil

SouthAfrica

0

5

10

15

20

25

30

35

40

Jan10

Jan10

Feb10

Mar10

Mar10

Apr10

May10

May10

Jun10

Jul10

Jul10

Aug10

Sep10

Oct10

Oct10

Nov10

Dec10

Dec10

P/EratioAustralia

Canada

Russia

Brazil

SouthAfrica


South Africas Price/ book value ratio is the highest whencompared to our select resource based markets. The dividend

yield is also low er than yields in Australia, Brazil and Canada.

Fig 12: South Africas book value and dividend yields vs. select resources based markets.

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

Ja

n10

Ja

n10

Fe

b10

M

ar10

M

ar10

Apr10

M

ay10

M

ay10

Ju

n10

Ju

l10

Ju

l10

Aug10

Se

p10

Oct10

Oct10

Nov10

Dec10

Dec10

Price/Bookvalue,X

Autralia

Canada

Russia

Brazil

SouthAfrica

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Ja

n10

Ja

n10

Fe

b10

M

ar10

M

ar10

Ap

r10

M

ay10

M

ay10

Ju

n10

Ju

l

10

Ju

l

10

Aug10

Se

p10

Oct10

Oct10

Nov10

Dec10

Dec10

Dividendyield,%

Autralia

Canada

Russia

Brazil

SouthAfrica



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Page 13 of 28

2. Valuation issues: Half fu ll or half

empty?

Earnings growth has to be strong: In our view, earnings growthhas to be strong to justify exposure at the current level where

valuation looks full, prima facie. Needless to say, corporateearnings are more volatile than GDP growth, and sustainability ofsome momentum in the GDP growth should see corporate earnings

rising materially. We note that there was a steep decline incorporate earnings in CY09 to an extent that indexed to CY02,

corporate earnings growth lagged nominal GDP. The recoverystarted in CY10 and in our view there are indications thatmomentum will gather pace this year.

The profit margin has recovered although it is still below the 19.4%average. The ROA has also rebounded from its lows to 8.2%

although it is still below its average of 9.7%. In our view, strongerGDP growth should sustain momentum on corporate earningsgrowth. When the growth outlook is positive, companies carrymore leverage and this would magnify the ROE which is currently

below its average rate at 17.8%. However, the problems is thatmarkets tend to overshoot when corporate earnings expectationsrise or collapse, and we believe the expectations of high earningsgrowth this year are taking valuations into unattractive territories.

Improving macro conditions provides a fulcrum but we believeearnings growth has to be significantly high to justify the current

market valuation. Earnings recovery is gaining momentumthough.

Fig 13: GDP grow th vs. Top 40 earnings grow th

50.0%

40.0%

30.0%

20.0%

10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

Mar

03

Aug

03

Jan

04

Jun

04

Nov

04

Apr

05

Sep

05

Feb

06

Jul06

Dec

06

May

07

Oct07

Mar

08

Aug

08

Jan

09

Jun

09

Nov

09

Apr

10

Sep

10

GDPgrowth

EPSgrowth

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Dec

02

Apr03

Aug

03

Dec

03

Apr04

Aug

04

Dec

04

Apr05

Aug

05

Dec

05

Apr06

Aug

06

Dec

06

Apr07

Aug

07

Dec

07

Apr08

Aug

08

Dec

08

Apr09

Aug

09

Dec

09

Apr10

CurrentGDP

Top40 EPS

Source: SARB, Bloomberg, Legae Securities


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Page 14 of 28

Profit margins and ROA have rebounded but remain below theiraverage. As the economy picks up momentum, ROA will increase

and companies w ill be more willing to leverage their ROEs.Fig 14: Top 40 profit margin, ROA and ROE

15.50

19.39

5

10

15

20

25

30

Oct02

Mar03

Aug

03

Jan

04

Jun

04

Nov

04

Apr05

Sep

05

Feb

06

Jul06

Dec

06

May

07

Oct07

Mar08

Aug

08

Jan

09

Jun

09

Nov

09

Apr10

Sep

10

Profitmargin

average

9.7

8.2

17.8

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

Oct02

Mar03

Aug

03

Jan

04

Jun

04

Nov

04

Apr05

Sep

05

Feb

06

Jul06

Dec

06

May

07

Oct07

Mar08

Aug

08

Jan

09

Jun

09

Nov

09

Apr10

Sep

10

ROA

AverageROA

ROE


Money flow is the weakest reason to assume equityexposure at this level: Our second reason, albeit the weaker onebut well discussed and mentioned by investors, is the money flowinto equities. Of course, in our view, this is a risky basis to assume

equity risk as it makes the greater fool theory the only reason to

investing. However, we believe global investors are going tocontinue to chase for yields and growth, at least for the majority ofthe 1H11. This is because we believe Europe will continue to

perform poorly relative to EMs. US could provide some dead catbounce case this year but EMs will remain key markets. Webelieve global investors are going to continue to be long EM

equities, in our opinion, except if there is strong risk aversion toEMs catalysed by debt and/or currency problems. As a result, EMsand the local market are likely to continue to enjoy portfolioinflows.

The comforting part about the local market is that foreignparticipation in CY10 was not extra-ordinary. Net equity inflowswere R35.6bn only, which is less than half the R72.2bn thatflooded the market in CY09. The net inflows in CY10 are also the

lowest amount since CY04 when one excludes the anomalousCY08. It is below the yearly inflow average of R41.1bn betweenCY05 and CY09. To an extent, one can argue that a strong EMequities sell-off would not affect local market to the same degree

as it would affect those EMs that attracted more inflows relative totheir history and other EMs. However, a cumulative R107.8bninflow in 2 years is not a small amount.


16/28

Page 15 of 28

We also believe that the local investors currently under-own themarket. However, the gap between the Top 40 index and M2

money supply that crudely indicates the under-ownership by localinventors is closing. While money flow could support valuations inthe short-term, we wonder what would happen when the market

runs out of this support.

In CY10 local equities attracted a net foreign inflow of R35.6bnwhich is below the average net inflow since CY05...

Fig 15: Monthly and yearly inflows into local equities

17.4 29.8

5.6 0.4

32.9 51.971.7 64.2

54.4

72.235.6

800

600

400

200

0

200

400

600

800

2 00 0 2 00 1 2 00 2 2 00 3 2 00 4 2 00 5 2 00 6 2 00 7 2 00 8 2 00 9 2 01 0

Yearlyforeignpurchases

Yearlyforeignsales

Net

100

80

60

40

20

0

20

40

60

80

100

Sep

00

Mar01

Sep

01

Mar02

Sep

02

Mar03

Sep

03

Mar04

Sep

04

Mar05

Sep

05

Mar06

Sep

06

Mar07

Sep

07

Mar08

Sep

08

Mar09

Sep

09

Mar10

Sep

10

Net

Monthlyforeignpurchases

MonthlyforeignSales


...but local investors under-own the market although the gap isclosing out. This could provide support to sho rt-term valuations.

Fig 16: Top 40 vs. M2 money suppl y

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Jan

00

Jun

00

Nov

00

Apr01

Sep

01

Feb

02

Jul02

Dec

02

May

03

Oct03

Mar04

Aug

04

Jan

05

Jun

05

Nov

05

Apr06

Sep

06

Feb

07

Jul07

Dec

07

May

08

Oct08

Mar09

Aug

09

Jan

10

Jun

10

Top40IndexMoneysupply,M2

Source: I-Net, SARB, Legae Securities


17/28

Page 16 of 28

Argument against undervaluation: Below we provide ourargument against a case of undervaluation. The market is trading

above pre-crisis levels. Both the index level and the basic valuationmetrics (PER and Dividend yield) have worsened in terms of riskssince the rebound after the epic market drama of CY08. The Top

40 indexs return has already normalised. (i.e. CY10 return is14.1% versus a 10-year mean return of 12.3%). We put forwardthe question to investors; was the market fairly valued then? (i.e.pre-crisis). If not why should it be fairly valued at these levels

when profit margins and ROEs remain below their long-termaverage and could remain below for this year? The dividend yieldhas declined to below CY05-CY06 levels. This indicates a declining

equity risk premium (cost of equity) and while the economy hasshown increasing business confidence levels, this dismal level ofdividend yield (relative to history) makes it difficult to find value.We see downside risk to equity markets, to include EMs, should

debt default happen in one of Europes weak countries and if someEMs starts to raise interest rates aggressively to curb inflation.Locally we do not see much headroom for PE ratio expansion. In amarket that is continuing to go up, the temptation is to play along.

We do not say dont but be highly selective. We admit that on alonger-term basis, there could be rationale for participation but ona 12-months basis we see meaningful risks.

We also do not see reasons for improvements in the South Africanequities discount rate. The risk-free rate has supported a lower

discount rate, but further reductions in the risk-free rate areunlikely this year. More interestingly is the fact that the volatility ofthe Top 40 index, as indicated by the 30-day standard deviation at

10.5% is only 2.8pps above the 10-year low of 7.7% (in CY05).

We are unconvinced that there is room for further compression involatility, hence our negative outlook on discount rate/cost ofequity improvements.

We also note the widening spread between the 10-yeargovernment bond yield and the Top 40 earnings yield. Despite itstheoretical weaknesses, the model still provides insights. While the

Top 40 earnings yield has constantly been below the 10-yeargovernment bond yield, except for CY08 and CY09, the wideningspread shows higher valuation risks relative to history.


18/28

Page 17 of 28

The PER is above its 10-year average despite risks to strongereconomic recovery. The word cycle often mean some mean

reversion and we expect some cont raction in the PER this year.Fig 17: Top 40 and Small Cap PER vs. their averages

5

10

15

20

25

30

35

Sep

00

Feb

01

Jul01

Dec

01

May

02

Oct02

Mar03

Aug

03

Jan

04

Jun

04

Nov

04

Apr05

Sep

05

Feb

06

Jul06

Dec

06

May

07

Oct07

Mar08

Aug

08

Jan

09

Jun

09

Nov

09

Apr10

Sep

10

SmallCapPER

Average

2

4

6

8

10

12

14

16

18

20

Sep

00

Mar01

Sep

01

Mar02

Sep

02

Mar03

Sep

03

Mar04

Sep

04

Mar05

Sep

05

Mar06

Sep

06

Mar07

Sep

07

Mar08

Sep

08

Mar09

Sep

09

Mar10

Sep

10

Top40PER

Average


The dividend yields have worsened to fall below their 10-yearaverage for both the Top 40 and the Small cap indices. Lowdividend yields indicate declining equity risk premia. We are

sceptical, given the economic uncertainty, notwithstanding theimprovements.

Fig 18: Top 40 and Small Cap dividend yi elds vs. their averages

1

2

3

4

5

6

7

8

Sep00

Mar01

Sep01

Mar02

Sep02

Mar03

Sep03

Mar04

Sep04

Mar05

Sep05

Mar06

Sep06

Mar07

Sep07

Mar08

Sep08

Mar09

Sep09

Mar10

Sep10

Smallcapdiv.yield

average

1.00

2.00

3.00

4.00

5.00

6.00

Sep00

Mar01

Sep01

Mar02

Sep02

Mar03

Sep03

Mar04

Sep04

Mar05

Sep05

Mar06

Sep06

Mar07

Sep07

Mar08

Sep08

Mar09

Sep09

Mar10

Sep10

Top40dividendyield

average



19/28

Page 18 of 28

The Top 40 index 30-day standard deviation is close to its lowestlevel in 10yrs. Further contraction is unlikely, hence that chances

of improvements in the d iscount rate are minimal.Fig 19: Top 40 30-day standard deviation and South Africa defaul t spread

0

10

20

30

40

50

60

70

80

01/17/11

10/04/10

06/21/10

03/03/10

11/17/09

08/04/09

04/17/09

01/02/09

09/16/08

06/04/08

02/15/08

10/31/07

07/18/07

04/02/07

12/14/06

09/01/06

05/19/06

01/30/06

10/14/05

07/04/05

03/15/05

11/30/04

08/18/04

05/05/04

01/16/04

10/01/03

06/19/03

02/28/03

11/13/02

07/31/02

04/17/02

12/31/01

09/13/01

Top40Indexvolatility HistVol(30D)Average

0

100

200

300

400

500

600

Jan

09

Feb

09

Mar09

Apr09

May

09

Jun

09

Jul09

Aug

09

Sep

09

Oct09

Nov

09

Dec

09

Jan

10

Feb

10

Mar10

Apr10

May

10

Jun

10

Jul10

Aug

10

Sep

10

Oct10

Nov

10

Dec

10

Jan

11

SouthAfrica'sCDS


The gap between the 10-year government bond yield and theTop 40 index earnings yield has also widened which indicatesheightened valuation risks.

Fig 20: Top 40 and Small Cap earnings yiel ds vs. SAGB10 yield

0

2

4

6

8

10

12

14

16

Jan

00

Jul00

Jan

01

Jul01

Jan

02

Jul02

Jan

03

Jul03

Jan

04

Jul04

Jan

05

Jul05

Jan

06

Jul06

Jan

07

Jul07

Jan

08

Jul08

Jan

09

Jul09

Jan

10

Jul10

Top40Earningsyield

SAGB10yield

0

2

4

6

8

10

12

14

16

18

Jan

00

Jul00

Jan

01

Jul01

Jan

02

Jul02

Jan

03

Jul03

Jan

04

Jul04

Jan

05

Jul05

Jan

06

Jul06

Jan

07

Jul07

Jan

08

Jul08

Jan

09

Jul09

Jan

10

Jul10

SmallCapearningsyield

SAGB10yield



20/28

Page 19 of 28

3. Banking: Macro issues are intact;

Basel 3 could be slow but painful

Banking macro-issues are intact despite the widespreadconcerns: We have listened to numerous market and banks

commentators highlighting that banks will struggle this year and inthe medium term. We do not necessarily disagree with this view,but we believe that the problems of the sector have been over

played. In our view, non-performing loans is no longer a majorissue this year. Loan growth is likely to remain anaemic this year,

but momentum will remain strong due to lower interest rates andimproving capacity by borrowers (lower cost of servicing debt).The Basel 3 is probably the greatest headwind, but its effect will be

slow, albeit painful. The key issues are capital and liquidity, andwhile the former is not a major concern (and we dont see banksissuing dilutive instruments to shore up capital, but could meetthese requirements through retained earnings), liquidity can be theprimary problematic area as it affects margins in two ways 1)

competition for longer-dated deposits could result in higher costsof deposits and 2) the requirement to hold liquid assets have acompressive effect to margins. The positive feature about thesystem is that it is not and will not be in a Northern Rock fundingmodel. The high market concentration will to a large extent

reduce the impact of the deposit wars that could arise as bankstry to reduce their funding gaps and extend the maturities of theirliabilities. Overall, we believe the sectors macro factors are intact.

Nonetheless, the banking system faced unprecedenteddeleveraging in CY09, but is recovering: We recognize that thebanking system registered massive deleveraging in CY09, withnegative growth on both banking assets and deposits. This was

after the banking assets had significantly outpaced nominal GDPgrowth when indexed to CY95. However, in CY09, banking assetwent down by 6% while loans and advances were down by 0.6%.

CY10 began to witness a recovery in loans and advances growth,which is the key asset class for banks. Loans and advancesmonthly growth rate rebounded in CY10 and the value of newmortgage loans granted has also taken an uptick.

...but the high household debt is not very supportive:Household debt remains relatively high at about 78%. While this innot a dangerous level, it is important to note that this is 12pp

higher than the average of 66.2% for the decade (CY00-CY10).The steep increase in the household debt/disposable income ratiobetween CY03 and CY07 could limit the ability by households tosubstantially carry more debt. Nevertheless, we do not expect

significant medium-term deleveraging at household level as thecost of servicing debt has declined to manageable level of


21/28

Page 20 of 28

a result of low loan demand. In our view, demand could have beenlow, but the increase in liquid assets/total assets ratio to 7.4%

from below 4% in CY08 and above the 4.7% average since CY00indicates that banks could probably be preparing for the impedingBasel 3 liquidity requirements. On a macro-level, again we do notsee headwinds to system liquidity. The LDR is inexcessive at


22/28

Page 21 of 28

Banking assets growth outpaced nominal GDP growthsignificantly since CY95. The penetration has increased

materially as indicated by the banking assets/ GDP ratio. This toan extent clouds the long-term outlook despite under-penetration on the lower-income segments.

Fig 21: Indus try penetration

0%

20%

40%

60%

80%

100%

120%

140%

160%

0

500

1000

1500

2000

2500

3000

3500

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

GDP

Bankingassts

Bankingassets/GDP

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

GDP

Bankingassets

Source: SARB, Legae Securities

CY09 saw strong deleveraging as banking assets contracted by

>5% ...

Fig 22: Banking assets grow th

500

1,000

1,500

2,000

2,500

3,000

3,500

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Bankingassets,Rbn

10%

5%

0%

5%

10%

15%

20%

25%

30%

35%

1

987

1

988

1

989

1

990

1

991

1

992

1

993

1

994

1

995

1

996

1

997

1

998

1

999

2

000

2

001

2

002

2

003

2

004

2

005

2

006

2

007

2

008

2

009

Bankingassetsgrowth

Average



23/28

Page 22 of 28

...as loans and advances grow th rate turned negative...

Fig 23: Loans and advances annual grow th rates

5%

0%

5%

10%

15%

20%

25%

30%

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Loanandadvances,bn

Growth,RHS

0%

5%

10%

15%

20%

25%

30%

500

1,000

1,500

2,000

2,500

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Deposits,bn

growth,RHS


...but loan growth rebounded and is indicating some momentum.Expansion of the credit multiplier will be positive to banks

earnings...

Fig 24: Loans and advances monthl y growth rates

1.5%

1.0%

0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

2005/02

2005/05

2005/08

2005/11

2006/02

2006/05

2006/08

2006/11

2007/02

2007/05

2007/08

2007/11

2008/02

2008/05

2008/08

2008/11

2009/02

2009/05

2009/08

2009/11

2010/02

2010/05

2010/08

Totalloansandadvances

averagemonthlygrowth

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2005/02

2005/05

2005/08

2005/11

2006/02

2006/05

2006/08

2006/11

2007/02

2007/05

2007/08

2007/11

2008/02

2008/05

2008/08

2008/11

2009/02

2009/05

2009/08

2009/11

2010/02

2010/05

2010/08

Newmortgages



24/28

Page 23 of 28

...but the high household debt level creates risks. The householddebt/ disposable income ratio is ~12pp above the average since

CY00 and rose from 35% to 78% in three decades...Fig 25: Publ ic and household debt levels

78.2

32.4

0

10

20

30

40

50

60

70

80

90

1980/01

1981/02

1982/03

1983/04

1985/01

1986/02

1987/03

1988/04

1990/01

1991/02

1992/03

1993/04

1995/01

1996/02

1997/03

1998/04

2000/01

2001/02

2002/03

2003/04

2005/01

2006/02

2007/03

2008/04

2010/01

Householddebt/disposable income

TotalGvntdebt/GDP78.2

50.4

57.8

66.2

25

35

45

55

65

75

85

1980/01

1981/02

1982/03

1983/04

1985/01

1986/02

1987/03

1988/04

1990/01

1991/02

1992/03

1993/04

1995/01

1996/02

1997/03

1998/04

2000/01

2001/02

2002/03

2003/04

2005/01

2006/02

2007/03

2008/04

2010/01

Householddebt/disposable income

10yrAverage


...and Basel 3s liquidity requirements could prove slow butpainful. The system is building up liquidity which should hurt thesystem margins and yields.

Fig 26: System liquid assets and liquidi ty provided by the SARB

4.7%

7.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

7.5%

8.0%

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Liquidassets/Total bankingassets

Average

5

7

9

11

13

15

17

19

Jan

05

May

05

Sep

05

Jan

06

May

06

Sep

06

Jan

07

May

07

Sep

07

Jan

08

May

08

Sep

08

Jan

09

May

09

Sep

09

Jan

10

May

10

LiquidityprovidedbySARB,Rbn



25/28

Page 24 of 28

The loan/ deposit ratio and the funding gap look fair. From amacro view point, the systems liquidity profile is not dire.

Fig 27: Loan/deposit ratio and the funding gap

70%

75%

80%

85%

90%

95%

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Loan/Depositratio

50

50

100

150

200

250

300

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

fundinggap=residentsdepositless loansandadvances


The banks PER is above the average (since CY02) and the

discount to the MSCI EM banks has narrow ed as indicated by thespread...

Fig 28: JSE banks PER vs. MSCI EM and averages

0

2

4

6

8

10

12

14

16

18

20

Oct02

Fe

b

03

Ju

n

03

Oct03

Fe

b

04

Ju

n

04

Oct04

Fe

b

05

Ju

n

05

Oct05

Fe

b

06

Ju

n

06

Oct06

Fe

b

07

Ju

n

07

Oct07

Fe

b

08

Ju

n

08

Oct08

Fe

b

09

Ju

n

09

Oct09

Fe

b

10

Ju

n

10

Oct10

MSCIEM

JSEBanks

4

6

8

10

12

14

16

O

ct02

M

ar03

Aug

03

Jan

04

Jun

04

Nov

04

A

pr05

Sep

05

Feb

06

Jul06

Dec

06

May

07

O

ct07

M

ar08

Aug

08

Jan

09

Jun

09

Nov

09

A

pr10

Sep

10

JSEbanks

average



26/28

Page 25 of 28

...but the Price/ book ratio is below its average. The MSCI EMbanks Price/ Book ratio is now slightly higher than JSE Banks.

Fig29: Banks dividend yield vs. MSCI EM and averages

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Oct02

Mar03

Aug

03

Jan

04

Jun

04

Nov

04

Apr

05

Sep

05

Feb

06

Jul06

Dec

06

May

07

Oct07

Mar08

Aug

08

Jan

09

Jun

09

Nov

09

Apr

10

Sep

10

MSCIEM

JSEbanks

0

0.5

1

1.5

2

2.5

3

3.5

4

Oct02

Mar03

Aug

03

Jan

04

Jun

04

Nov

04

Apr

05

Sep

05

Feb

06

Jul06

Dec

06

May

07

Oct07

Mar08

Aug

08

Jan

09

Jun

09

Nov

09

Apr

10

Sep

10

JSEBanks

Average


MFIs outperformed mainstream banks significantly in CY10.Capitecs stratospheric valuation is beginning to worry usdespite our strong growth outlook on the company.

Fig 30: Mainstr eam banks vs. MFI performances

0

2

4

6

8

10

12

14

16

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Jan

05

Ma

y05

Sep05

Jan

06

Ma

y06

Sep06

Jan

07

Ma

y07

Sep07

Jan

08

Ma

y08

Sep08

Jan

09

Ma

y09

Sep09

Jan

10

Ma

y10

Sep10

Jan

11

PerformanceindexedtoCY05 NedbankInvestecFirstRandAbsaStandardBankAbilCapitec,RHS

0%

20%

40%

60%

80%

100%

120%

140%

Capite c A Bil A bsa Fir stRand Standar d Inv estec Ne dbank

2010capitalgains



27/28

Page 26 of 28

Capitec and ABIL trade at a premium to their average deviationsfrom the industry PER of 1.6 and 1.2 respectively

Fig 31: Mainstr eam banks vs. MFI PER and Capitec and Abil PER relative to industry average

0

5

10

15

20

25

30

35

Feb05

Aug05

Feb06

Aug06

Feb07

Aug07

Feb08

Aug08

Feb09

Aug09

Feb10

Aug10

Price/Earnings ratioCapitec

Nedbank

Investec

FirstRand

Absa

StandardBank

Abil

1.3

2.1

0.5

1.0

1.5

2.0

2.5

Feb05

Aug05

Feb06

Aug06

Feb07

Aug07

Feb08

Aug08

Feb09

Aug09

Feb10

Aug10

Deviation fromindustryPER Capitec

Abil


Key conculding points

We are neutral on local equities: Our neutral position ismotivated by our valuation concerns. While we see company

earnings gaining growth momentum this year, we do not seeimprovements in the discount rate as both the risk free rate andthe volatility are close their 10-year lows. Our view that local

investor under-own the market could support valuations in theshort term but it could also be an indicator of valuation fears fromlocal investors. Buying equities on the basis of continued/increasedforeign money flow into equities is a risky strategy; and

We are warming up on mainstream banks, but we areseeing unfavourable risk-reward profiles as MFIs sharescontinue to trade in risky territory: Probably our mostcontrarian view form consensus. Despite the well-documentedproblems we believe the sector will benefit form declining credit

costs, regulatory clarification and leaner cost structures in CY11

and CY12. While we have a positive earnings outlook on MFIs, weare discouraged by the lofty valuations. We believe investors couldbe underestimating the risks in the MFIs (competition will increase,

CPA impact will be higher, balance sheets are thinner).


28/28

Legae Securities (Pty) Ltd

Member of the JSE Securities Exchange

1st Floor, Building B, Riviera Road Office Park, 6-10 RivieraRoad, Houghton, Johannesburg, South Africa

P.O Box 10564, Johannesburg, 2000, South Africa

Tel +27 11 551 3601, Fax +27 11 551 3635

Web: www.legae.co.za, email: [email protected]

Analyst Certification and DisclaimerI/we the author (s) hereby certify that the views as expressed in this

document are an accurate of my/our personal views on the stock or sector

as covered and reported on by myself/each of us herein. I/we furthermore

certify that no part of my/our compensation was, is or will be related,

directly or indirectly, to the specific recommendations or views as expressed

in this document

This report has been issued by Legae Securities (Pty) Limited. It may not be

reproduced or further distributed or published, in whole or in part, for any

purposes. Legae Securities (Pty) Ltd has based this document on information

obtained from sources it believes to be reliable but which it has not

independently verified; Legae Securities (Pty) Limited makes no guarantee,

representation or warranty and accepts no responsibility or liability as to itsaccuracy or completeness. Expressions of opinion herein are those of the

author only and are subject to change without notice. This document is not

and should not be construed as an offer or the solicitation of an offer to

purchase or subscribe or sell any investment.

Important Disclosure

This disclosure outlines current conflicts that may unknowingly affect the

objectivity of the analyst(s) with respect to the stock(s) under analysis in

this report. The analyst(s) do not own any shares in the company under

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