One would think that because of the sharp declines experienced in the past year, the local equities would be cheap, but this is not the case.

One would think that because of the sharp declines experienced in the past year, the local equities would be cheap, but this is not the case.

The extensive valuation analyses done by Old Mutual Investment Group SA (Omigsa) says the local equity market has never been truly "cheap", with the current level probably representing fair value.

Steve Minnaar, head of the group's Investment Research team, says because of this investors anticipating a big general equity rally driven by fundamental valuations in the coming months are likely to be disappointed.

"Even though the FTSE/JSE All Share Index fell by 23,3percent in 2008 and another 4,2percent in the first quarter of 2009, even at its worst levels in February and November the market has not necessarily been too cheap," he says.

"This is because, based on our valuation framework using cash flow returns on investment (CFROI), share prices were so unrealistically high in mid-2007 at the peak of the bull market - pricing in corporate returns far above the long-term average - that they have now only fallen to levels where returns on investment are closer to the long-term average."

In other words, Minnaar says if you believe that companies' returns on investment will fall back to long-term average levels over the next five years (which is a very likely scenario), the equity market is fairly priced right now.

For the FTSE/JSE All Share Index to rally significantly from its current level of about 20000 points, real earnings would have to be much higher than consensus forecasts are now indicating.

This requires much better fundamental economic conditions than what is currently expected.

But for investors who still hope for bargains, there is some good news, he says.

"Whereas the market as a whole may be fairly priced, it contains many mispriced counters."

Minnaar has identified a few selective companies where the market is too bearish, and pricing in unrealistically negative prospects.

Anglo American - The current share price of R170 is pricing in that the company will not even meet its cost of capital in five years' time, while also not growing its asset base at all.

Although they did overpay for assets recently, such a bearish expectation is way off their multi-decade track record.

Sappi -The paper industry is notorious for destroying value.

In the past 20 years Sappi has not once beaten its cost of capital. The industry has too much capacity; yet no one has blinked and been first to shut production facilities.

The current market turmoil will hopefully be the needed catalyst finally to close capacity to ensure the future of the survivors, Minaar says.

He says Sappi has relatively high debt levels after its M-Real asset purchase, but they are well placed to survive.

At the other extreme, there are shares that are simply priced for too optimistic a future, especially some of the more defensive shares like Shoprite.

Says Minnaar: "Although Shoprite is a good company with excellent management and good growth prospects, its current share price of around R53 is reflecting expectations of perfection from the company across all of its operations over the next five years.

"They have to continue to deliver record margins and asset turns while strongly growing cash flows and aggressively extending their footprint (a proxy for asset growth), just to justify today's share price."

Looking ahead, Minnaar says, market conditions will remain difficult for equity investors until the global economic outlook becomes less uncertain and clear signs of recovery are apparent.