South African companies have made the most of the positive economic circumstances in the last few years. This is evidenced by the growth in profits of listed companies. On a trailing 12 months basis, JSE earnings growth has exceeded inflation by more than 30% for over a year now. This record growth in profits has been fueled by strong economic growth, lower interest rates, significant operational gearing and the ability of corporates to manage their businesses well. We would however suggest that profit growth is at a cyclical high and that earnings expectations should be tempered.

Investors in the local stock market have shared in this profit growth not only through their share in increased dividends, but also one of the strongest bull markets in many years. The strong local economic backdrop, together with strong commodity prices has meant that foreign investors have consistently increased their participation and ownership of local companies over the last three years. Cumulative net purchased by foreigners of local equities amounted to R33bn in 2004, R52bn in 2005 and R55bn so far this year. However, the bulk of these purchases happened in the first four months of the year, and since then foreign activity has subsided.

The current base of corporate profits has increase to such a scale that one have to caution on the likelihood of this level of profit growth continuing. Not only are there questions on the continued strength of the global economy. A combination of rising local interest rates, capacity constraints in the economy and businesses, as well as heightened investor risk aversion poses definite headwinds for investors in the local stock market.

Investor expectations embedded in current valuations are fair at best and in some instances still anticipate a better outcome than is likely. Although we expect JSE profits to still grow by up to 15% for the next year, it is likely that investors in the JSE will be disappointed by the returns generated from the market.

The areas that are most prone to over optimism are commodity companies, infrastructure stocks and listed property, where valuations suggest very high expectations of future profits. These shares are not priced for disappointments.

The real opportunity for investors over the next five years lies outside of our borders. Global Mega Cap companies have performed dismally since the beginning of the millennium, during a time when money found its way into more risky assets around the globe and investors in property, commodities and emerging markets made a killing. As we approach the upper end of the liquidity tightening cycle globally, this asset class presents attractive valuations (forward PE's of less than 14 times), rock solid balance sheets and a decent outlook for earnings growth. On a sentiment basis it has been neglected for a long time now. As liquidity conditions improve over the cycle, it is most likely that money will flow into shares of larger companies and provide investors with good returns.

ISSUED BY:

CITADEL
Private Client Wealth Care

For further information please contact:

Jan van Niekerk, Chief Investment Officer
(021) 940 7200
janvn@citadel.co.za

OR

Daleen Cornelissen
Media Liaison
(021) 940 7200
daleenv@citadel.co.za