Navigating the impact of JSE delistings on your investment portfolio

‘We think in South Africa you have a universe that’s especially cheap at this point in time’: Sean Neethling, head of investments at Morningstar SA.

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SIMON BROWN: I’m chatting now with Sean Neethling, head of investments at Morningstar South Africa. Sean, I appreciate the early morning. Delistings have been a trend on the JSE, and delistings [out]weighing new listings have seen our own market shrink to some 300 listed stocks. It is a worrying trend and I want to dig into it. It’s also a global trend. We’ve seen a similar trend in Europe and in the UK.

SEAN NEETHLING: Good morning, Simon, and good morning to your listeners. Thank you for having me on the show. Yes, exactly right. I think delisting has been very topical, and it’s not something which is especially new. It’s been coming for a number of years.

The way that we really look at things is, if you look at the market today versus probably 20/25 years ago, we do see a very different market in terms of structure. If you look at the year 2000, that was at the height of the South African sort of mining boom. You had lots of mining companies that dominated the index and, if you look at the market today, it’s somewhat more differentiated.

But what does stand out to us is just the market levels of concentration. Again, South Africa is not unique in this regard. It’s probably one of the most topical, I suppose, issues in global markets at the moment if you look at the US. So South Africa’s certainly not unique – also  if you look at the UK and Europe with net delistings as opposed to new listings coming to the market.

SIMON BROWN: The key thing you mentioned there is it’s around that concentration. A lot of these delistings are in the smaller stocks, which for institutional investors were never a space. A R300 million stock is not investible just because of its size. But that concentration makes it harder and, I would wager, probably riskier for active managers in a more concentrated market.

SEAN NEETHLING: Yes, Simon. I think that’s exactly right. More benchmark-cognisant managers, in terms of the mandates that they’re running with their clients, would probably invest mostly in the Top 40 stocks. Those Top 40 stocks make up approximately 85% of the overall JSE. So you do find a convergence of ideas across let’s call it those Top 40 stocks.

What it does mean is that if the delisting trend continues to the extent that it has, there is a potential that it crowds out more active managers in terms of their ability to sort of add alpha and outperformance on behalf of their clients.

But if you look at the average delisting over the last five years or so, those companies have largely been small mid-cap, and probably fledgling companies with market caps that would largely preclude the larger managers allocating capital in size to them for the retail institutional mandates that they run.

SIMON BROWN: Yes. Therefore in many cases [companies] might have disappeared from a private-client portfolio, but a lot of those weren’t in the bigger ones.

The process then, I suppose, for investment managers is to understand what this market concentration is going to do and how your thinking perhaps needs to adjust – because the trend is likely to continue. It might speed up, it might slow down at points, but the investment philosophy, for want of a phrase, perhaps needs to be tweaked.

SEAN NEETHLING: I think so, Simon. If you look at the past and you lean into base rates, it’s a useful, I suppose, estimate of what you can expect in the future, particularly if you use a long enough time series of history. I think in South Africa, as I mentioned, there is a structural market change with the market looking different today versus, say, 20, 25 years ago. And then there are also structural changes that affect markets. So something like Regulation 28, which allows managers to take more capital offshore, what that does is it forces managers to potentially look outside their immediate circle of competence to opportunities in offshore markets.

So I do think if you look at let’s call it the mix of assets in South Africa today versus even two years ago, what you’ll find is you’ve probably got to take more of a forward-looking view in terms of what you can expect South African equities to deliver, given the current makeup of the market. And then at a portfolio level you’ve got to look – once you combine South African equities with global equities – what that actually means for expected returns and the risk for investors.

SIMON BROWN: I like that phrase, that ‘circle of competence’. It’s kind of almost being squeezed into areas, particularly in the offshore space, which is so significantly vaster, I suppose, in knowing what you know, and importantly knowing what you don’t know and how to fill those gaps – and what you don’t fully know.

SEAN NEETHLING: Yes, 100%, Simon. At Morningstar I don’t think we are in the camp where we think that global exposure, global equities need to be managed only by global managers; we do think we have some really good stock pickers in South Africa.

But that circle of competence particularly speaks to how teams are resourced. Again, you know what the depth of the investment and research process is. That is a potential source of outperformance and its great alpha for managers who can get it right. But we do think in South Africa you have a universe that’s especially cheap at this point in time, and that’s really where we look at delistings in terms of more active managers that potentially have a wider universe – how you combine, I suppose, market beta in terms of those very concentrated holdings with, let’s call it, those more differentiated positions that sit outside the index, and then overlay that with your ability to take capital offshore.

SIMON BROWN: I take your point. That is perhaps the opportunity for that alpha.

We’ll leave it there. Sean Neethling, head of investments at Morningstar South Africa, I always appreciate the early morning.

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Harry Byrne

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