South Africa: Profits And Peril

South Africa's investment thesis is bifurcated. On one hand, this is Africa's largest economy and by far the most advanced. The country is the world's largest platinum producer and a major producer of gold and palladium.

South Africa's ascent up the global economic ladder has prompted some experts to add the country as the "S" in BRICS, joining the country with Brazil, Russian, India and China. Even if not all can agree that South Africa belongs in the BRIC house, it is a part of the CIVETS acronym.

Those superlatives do not obfuscate South Africa's challenges, which include a history of political volatility and an unemployment rate that stood at 24 percent at the end of the second quarter. In a post on Dr. Mark Mobius' blog, Franklin Templeton Senior Vice President and Managing Director Johan Meyer explores the good and the bad facing investors in South Africa.

Noting South Africa's history of political divisiveness, Meyer also highlighted the country's ability to reinvent itself, saying "While significant social and economic problems still persist today, I believe South Africa and its people appear potentially well positioned for greater long-term prosperity."

Reinvention aside, South Africa is still viewed by many outsiders as a materials/precious metals play. The $506.3 million iShares MSCI South Africa Index Fund (NYSE:EZA) devotes almost 19 percent of its weight to materials stocks, making the sector the second-largest in the ETF.

"Commodities, particularly metals and minerals, are very important to South Africa's economy," Meyer said. "South Africa is one of the world's leading mining and mineral processors, with roughly three-quarters of the world's platinum production and a significant share of others including palladium, gold, manganese and diamond."

Recent labor unrest at South African mines has plagued EZA and other ETFs with significant exposure to the country. The strikes have also punished the rand, South Africa's currency.

Perhaps investors have become jittery after learning of the oppressive conditions in which South African miners toil to bring diamonds, gold and platinum to market. Whatever the reason, EZA is off 4.4 percent in the past month. The SPDR S&P Emerging Middle East & Africa ETF (NYSE:GAF), which allocates almost 91 percent of its weight to South Africa, has lost 91 percent over the same period while the WisdomTree Dreyfus South African Rand ETF (NYSE:SZR) has given up 3.7 percent.

Strife in the mining sector epitomizes the risks inherent with investing in South Africa. As Meyer noted, the sector accounted for 8.6 percent of the country's GDP in 2010.

"...if the global economy improves, higher commodity prices could be a boost to the South African economy. While there is some concern inflation on a global scale could accelerate given the easy monetary policies and stimulative measures central banks (particularly in developed markets) have been engaging in, at the moment inflationary pressure appears to be contained in South Africa...," Meyer said in the post.

The country has Africa's most advanced banking system and, as Meyer notes, the 18th-largest stock market in the world. Unfortunately, South African banks are far from immune from the strikes. Earlier this month, Moody's Investors Service pared its rating on the foreign deposit ratings of the five largest banks in South Africa. In September, the ratings agency cut South Africa's sovereign debt rating to Baa1 from A3. Financials account for 25.4 percent of EZA's weight and 28.5 percent of GAF's weight.

The good news is that the International Monetary Fund expects South Africa's GDP to grow 2.6 percent this year and additional improvement is expected in 2013. Citing that statistic and the country's corporate governance policies, Meyer said "I think we are in a good position to seek opportunities arising from the long-term growth potential in South Africa, and across this vast, developing continent."

Those looking for more diversity when it comes to Africa ETFs should consider the Market Vectors Africa ETF (NYSE:AFK). South Africa is the ETF's largest country weight at 25.6 percent, but Nigeria and Egypt combine for 38.6 percent of the fund's weight. AFK has significantly outperformed EZA and GAF this year.

For more on South Africa and ETFs, click here.