Best of Ghost Mail: Interest rates are consuming consumers

South African consumers are in pain. We know this. It’s a headache that just keeps getting worse for people, with food inflation at astonishing levels and Eskom kicking us while we are down. 

Every time we think the Panado will kick in, the SARB raises rates again. At some point, we reach an inflection point where the meds aren’t working anymore to deal with the headache. For now, the SARB has given us a break. This doesn't necessarily mean we've seen the top of the rate cycle.

Are we there yet? Yes, it seems that way.

One of the ways to figure this out is to follow the results of retailers. They give a good indication of consumer spending habits, particularly on discretionary vs. staple items. Another handy metric is cash vs. credit sales, with the former taking strain when wallets are empty.

Even at cash stalwarts like Mr Price Group Limited (JSE:MRP), growth is mainly coming from credit sales. That’s a red flag for the entire sector.

Another good place to look is the banks. The credit loss ratio doesn’t tell you about loans that have already gone bad, but it does tell you about the bank’s expectations for the portion that will go bad. Under accounting rules, those provisions need to be recognised ahead of time based on the financial modelling done at the bank and the prior experience with credit curves and all kinds of other complicated statistical models.

During a volatile interest rate cycle when things are changing rapidly, you need to be careful when reading the banking results and any other economic indicators. The situation four months ago probably isn’t the situation anymore.

The latest bank to release an update is Absa Group Limited (JSE:ABG), with the credit loss ratio blowing out as consumers come under strain. We have also seen this issue at the other banks, particularly in retail banking (individuals) and small business credit books vs. large corporates that are still doing just fine.

The outlook at local banks has deteriorated this year, with load shedding hitting economic growth and further rate hikes expected to have a net negative impact on profit. Previous hikes were good for the banks, as net interest margin expanded. The simplest way to understand this is to think about your current account vs. your home loan. When rates go up, your home loan becomes more expensive but your current account pays the same rate – which happens to be almost nothing! The winner in that is your bank.

As a final sign that all isn’t well with consumers, the credit executive at Capitec Bank Holdings Limited (JSE:CPI) sold shares worth around R2 million. You won’t find a purer view than that on consumer health, with the timing of this sale coming soon after the Absa earnings guidance update.

The area of the market that still needs to crack is the motor industry. The ongoing exceptional performance of car dealerships surely cannot continue for much longer, with rampant inflation in new car prices and affordability deteriorating at pace because of high interest rates. The poor transport infrastructure in South Africa helps here, as does the emerging middle class, but at some point the music needs to stop.

Two things to look out for

When researching stocks in this environment and looking for winners, there are two elements that are worth looking out for.

The first is the level of debt in the business. With interest rates at these levels, the lenders are getting a big slice of the economic pie before the shareholders are. Low rates are wonderful for equity investors, as companies can use cheap debt to turbocharge returns. High rates have the opposite effect, with some companies particularly exposed after raising substantial debt when rates were lower. The likes of The Foschini Group Limited (JSE:TFG) would fall into this bucket, having followed a route of large acquisitions during the past couple of years and bringing significant debt onto the balance sheet as a result.

The other thing to look out for is pricing power. Most consumer businesses don’t have this kind of power unless they have an unusual product that targets upper income consumers.

Industrial businesses are a different story, often supplying key components and enjoying supply agreements that make allowance for price increases as input costs go up.

Even if gross margin stays the same, the absolute margin generated on the sale of a product goes up if the price goes up. For example, a 25% gross margin on a R160 product is profit of R40, but on a R200 product that jumps to R50. The percentage is the same, yet there’s R10 in extra gross profit. If overhead costs can be kept under control, this drives a significant expansion in operating margin and net profits.

Not all industrial businesses can achieve this. You need to dig into recent results to find the ones that can. The best opportunities are when valuation multiples are low relative to recent growth, with the market putting stubbornly low valuations on businesses like Bell Equipment and Argent Industrial, just to name two such examples.

In one of the most recent podcast episodes of Magic Markets, the Magic Market (together with the Finance Ghost) team talked about the “capital stack” in corporates and how they blend debt and equity into a capital structure that works for the business.

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