It is said bull runs and rallies do not die of natural death, they get murdered. This bull run, running on the backdrop of a dire inflation outlook, will be put down by good news instead.
This is perhaps one of the fastest and steepest rallies we have seen. In recent weeks it has evolved — from being broad index-led to large-cap led. In May alone the all share index was up 141 percent, without a doubt outpacing inflation and the USD on the informal market.
What is driving the market? We imagine the market participants had a high conviction that inflation would run wild and lift nominal profits to justify current valuations. That theory is validated or better-still instigated by the informal exchange rate that has almost doubled in a matter of two months. That said, we have misgivings on the longevity of that thinking.
First, unlike before, consumption and aggregate demand now face overwhelming downward pressure from decline in remittances and general fall in incomes. We are wary that the rate of fall in aggregate demand will undo the inflation expectations. If such fears manifest, the carnage will be felt by companies.
Businesses will be forced to price goods and services as low as to breakeven point — just to sell enough. Second, informal exchange rate has its limitations in acting as a proxy for inflation. The relationship may hold for exporters but fail for non-tradeable goods and services. We therefore expect the CPI to lag the informal exchange rate even more.
“Tourist investors” now in the market’s driving seat
A bull market or rally has been aptly described in three stages. First, the clever guys who do fundamental research and watch the markets 24/7 start to perceive the shifting ground and asset mis-pricings on the market. So, they start buying. Second stage, most people who follow markets start to notice the now apparent opportunity and start buying too. Last, the anxious and tourist investors (because they come on the market for a week or two) take notice and feel left out and begin to take positions — belatedly off course.
We think we are now at the tail end of this episode. In our opinion, the tourists have been piling into the market, spooked by the informal exchange rate and made envious by the large gains others have made so far. To understand this, notice how the large caps are now driving the market in recent week or so. In the previous week the Top Ten index was up 41 percent to reach 964points. Medium cap index went up 26 percent and Small cap index 13 percent.
We observe that non-players with large bank balances have been making instructions to brokers — “buy whatever is available, I cannot hold cash”. And by nature, what would be available are the most liquid stocks, which are the large caps. What is interesting is, whereas the decelerating informal exchange rate would have slowed the market, the opposite has happened in the last week. The decelerating exchange rate prompted tourist investors to move their funds into equities (presumably from holding FX) where daily rises averaged 7 percent — thereby extending the rally. Yet now, the lofty valuations are now getting buyers to pause and reconsider.
Liquidity inducing an overheating of large caps
As more liquidity pours into the large caps, more and more tourists notice what they are missing and are inadvertently drawn into those same overvalued names. The result is a self-sustaining run until it is no longer.
Consider our own research into valuation of non-financial companies that reported 2019 results no earlier than September 2019. The group excludes Old Mutual and PPC whose financials are not easily traceable to Zimbabwe.
From that group we separated the top ten stocks by capitalisation and tagged them “large caps”. Our large caps sub group included seven names from ZSE’s top ten index. The rest were medium caps and small caps.
The results shown in the graph exposed the stark discrepancy in valuations. The large-caps group had a median P/E ratio of 118 relative to that of medium and small caps of 13. The price to book value ratio supported the assertion that large caps are way overvalued. Price to book ratio for the non-financial large caps came out at 14 compared to 1,77 for the medium and small caps. But our take is, despite the rally, there are still some good picks available mostly in the small to medium caps.
We caution against holding the large caps, which for the most part have attracted funds on the basis of liquidity. What we have learnt over time is that the same investors that rushed in regardless of the lofty prices will exit as fast.
In this increasingly expensive market, we still have interesting names that we view undervalued by our own assessment. Notable names that we still rate at least a “BUY” include Zimplow, starafrica, Masimba Holdings and ART. Below we provide a high-level analysis of Zimplow.
Zimplow — volumes growth drive value
Zimplow is that unflattering type of business. Sells ox-drawn ploughs, tractors, bolts and nuts and other farming, power and mining equipment. May explain why this stock seems to miss attention. The group has majority stake in Barloworld’s local unit — Barzem.
In an economy where it is normal to report 20-30 percent volumes contraction, Zimplow is on a different trajectory as Q1 March results show. Barzem sold 8 units compared to none last year same period. Parts sales improved by 24 percent from last year. Service hours were flat. Powermec, the division that produces generators sold 118 percent more generators. Aftersales business parts sales and service hours grew 86 percent and 192 percent respectively. Tractor sales at Farmec were flat but implements grew by 100 percent. After sales performance and service hours sold were 22 percent and 19 percent down respectively.
Overall, bolts sold in Q1 grew. CT, Mild steel and high tensile bolts 34 percent, 39 percent and 43 percent respectively. Mealie brand exports were 64 percent down due to Covid-19 restrictions. Overall implements volumes fell by 54 percent while spares volumes were 47 percent behind the same period last year. Excluding the property business unit, for FY2019 Farmec, Barzem and Mealie brand were the biggest contributors to revenue at 34 percent, 30 percent and 22 percent respectively. Based on Q1 results, we expect Farmec and Barzem business units to remain the strongest contributors of revenue. Overall, we expect total revenue, in real dollars, to have outgrown comparable period.
We have revised our intrinsic value estimate for Zimplow stock to 290 cents. The stock is currently trading at 192 cents as of May 3. Zimplows trades at a P/E ratio of 4.40 and the stock is trading at a net book by value of 1,38.
This article was prepared by Emergent Securities. Emergent Securities provides bespoke advisory services on retail and institutional accounts. Emergent securities is registered with Securities Exchange Commission under the name Emergent Capital Management. This article is for general information purposes only. Readers of this report shall be solely responsible for making their own independent investigation into the business, financial condition and future prospects of any companies referred to in this report.
Email: [email protected] @emerg_research; Call: +(263) 8644 289 299; www.emergent.co.zw