Will South Africa’s struggles overshadow its potential?

  

Africa is a continent many investors bypass, but from my perspective as a long-term investor, I think that’s a mistake. South Africa has faced some struggles recently, but I think they can be overcome, and a brighter future could be ahead there for its people.

Mark Mobius

South Africa is the largest economy in Africa, and is the only country on the continent where I think the “frontier” market label doesn’t apply. Some have added an “S” to the end of the “BRIC” acronym to include South Africa in the grouping of emerging market economies of Brazil, Russia, India and China. Others include South Africa as part of a newer grouping of younger, diverse emerging markets comprised of Colombia, Indonesia, Vietnam, Egypt and Turkey (the “CIVETS”). Whichever label you use, many investors have recognised South Africa’s power and potential in the emerging markets world.

I’ve invited Johan Meyer, our SVP and managing director, South Africa, based in Cape Town, to share some of his insights on the challenges and opportunities facing South Africa today.

Johan Meyer

Throughout its history, South Africa has faced some unique and often divisive social and economic challenges. But it is also a country that has proven able to reinvent itself politically and economically. While significant social and economic problems still persist today, I believe South Africa and its people appear potentially well positioned for greater long-term prosperity.

Commodities, particularly metals and minerals, are very important to South Africa’s economy. South Africa is one of the world’s leading mining and mineral processors, with roughly three-quarters of the world’s platinum production and a significant share of others including palladium, gold, manganese and diamonds.

Strikes in South Africa’s mining industry have certainly been receiving a lot of press coverage recently, including events at one of the largest platinum mining companies in the world, which really brought to light the harsh conditions these miners endure. We have begun to see some progress being made toward achieving resolutions to the disputes, including wage increases that will hopefully end the violent protests. Still, from now on we expect investors to focus on labour relations in much more detail, especially considering the spread of the strikes to other industries and the potential impact thereof on economic activity across the country.

While the strikes haven’t had a marked impact on the equity market as a whole, we believe it will be important to achieve the right balance between corporate performance, executive compensation and wages going forward. The longer these strikes continue, the more pronounced the impact could be on corporate performance, with knock-on effects likely being felt in state income (tax revenues) and consumer spending power. It is therefore imperative that a solution is found to this issue as soon as possible.

The impact of commodity price fluctuations

Those familiar with our investment philosophy know that when we evaluate our investments, we always take a long-term view. We closely monitor the valuations and the growth prospects, and if we see any dislocation in terms of price relative to our long-term expectations, we would likely consider adding to our positions.

Generally we prefer companies that have a discernible advantage when it comes to costs because we believe these tend to be the companies that can weather tough times and can do well in good times. One area of the South African mining industry we aren’t favouring right now is gold mining, because we remain concerned about rising costs related to labour, mining equipment and utilities such as electricity and water, especially with the deep level mines in the country.

Given the economy’s dependence on commodity exports (the mining sector accounted for 8.6% of GDP in 2010), if the global economy improves, higher commodity prices could be a boost to the South African economy. While there is some concern inflation on a global scale could accelerate given the easy monetary policies and stimulative measures central banks (particularly in developed markets) have been engaging in, at the moment inflationary pressure appears to be contained in South Africa, with higher food and fuel prices up to now being largely offset by strength of the South African rand relative to the US dollar and other currencies. If recent rand weakness becomes sustained, inflation on imported goods will start to tick up.

The South African Reserve Bank recently lowered its benchmark rate to a record low of 5%, reflecting concern of the potential impact of slowing global growth on the South African economy. We believe this has the potential to translate into sustained growth in consumer spending, so we continue to like investment opportunities in the consumer sector.

By our measure, valuations of some companies in this sector appear rather pricey right now, so in some cases we are waiting for a more attractive entry point. Generally, all our investment decisions are based on relative valuation, growth prospects and risks.

Economic risks

Without a doubt, deteriorating education and the sustained high level of unemployment are the most significant issues the country faces today. The unemployment rate remained stubbornly high at above 24% in the second quarter of 2012. This leads to other challenges such as a high prevalence of crime and a higher burden on tax-paying individuals in order to fund welfare spending. Government, corporates and individuals have to start working together in a more cohesive way if they’re to stand a chance at tackling this enormous issue.

As mentioned, the corporate and individual tax rate is quite high, particularly when compared with many developing countries around the world. If these rates could be lowered or if there were greater concessions to incentivise job creation, I think it would be positive for investors. Greater labour market flexibility would also likely encourage companies to employ more people, with the resultant impact of broadening the tax base, lowering the reliance on welfare grants and greater consumer spending power.

In spite of these challenges, South Africa’s financial system is regarded as highly developed, relatively liquid and it boasts the 18th largest stock exchange in the world. Many companies listed there offer a way to tap into the African continent’s growth potential, and GDP growth in South Africa has remained positive this year. The IMF projects growth of 2.6% in 2012 and further improvement in 2013. South Africa’s corporate governance is held in high esteem by many in the global investment community. For these reasons, I think we are in a good position to seek opportunities arising from the long-term growth potential in South Africa, and across this vast, developing continent.

Mark Mobius is executive chairman of Templeton Emerging Markets Group.




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