Sharenet Blog

John Mauldin recently wrote a book called “Endgame” which is about the end of the debt supercycle and how it changes everything. I found it to be a very interesting read.

One of his first arguments why Europe and most of the West are in such a bad place is due to simple formula that defines the growth in Gross Domestic Product (GDP):

Change in GDP = Change in Population + Change in Productivity

In order to grow your economy you only have two ways to do it, there is no other clever way. You can’t borrow yourself out of the problem and you can’t let other nations work for you while you sit around doing nothing.

Change in Population
It is common knowledge that most of the nations in the West sit with an older population nearing retirement with few productive years left. Contrast this to India, China, and Africa with a massive younger population with many years still to produce products for their nation.

Below is a graph of China’s population pyramid. It is clear to see that the majority of the population is aged between 20 and 45. It is also clear to see how the one-child-policy is affecting the younger ages. This will definitely be a problem for China in years to come. A small young population has to work very hard to support a large old population. This is exactly what we currently have in the West with the “babyboom generation” now entering retirement age.

For further details refer to http://en.wikipedia.org/wiki/Population_pyramid

Change in Productivity
Well, sorry to say but there is no replacement for hard work. We need to work smarter and harder in order to increase productivity. Every decade USA employees work 1 year more than South African employees (i.e. 10% more). This is purely a result of South Africa’s more generous public holiday numbers and average annual leave when compared to the USA.

Mr Mauldin looked at an interesting study by the Kauffman Foundation. The study looked at the type of firms in the private sector that create the most jobs. (It is also a well-known fact that governments are not there to create jobs but instead should only create the healthy environment for the private sector to flourish so that it, in turn, can create jobs.)

The Kauffman Foundation focused their study on the USA from 1992 to 2005. The study shows that by far the most jobs are created by start-ups. Yes it is true that 50% of start-ups don’t make it after 5 years but they are still the best job creators. The graph below shows that start-ups created, on average, 3 million new jobs in the USA in their first year. The older the firms are the fewer jobs they create. Therefore as the Kauffman Foundation says “… we don’t count on the Intels or Microsofts to create employment: we need entrepreneurs.” I feel like changing President Clinton’s slogan from “It is about the economy dummy” to “It is about the entrepreneur dummy”.

Source: Business Dynamic Statistics, Tim Kane

For further details refer to:
http://www.kauffman.org/uploadedFiles/firm_formation_importance_of_startups.pdf

May we go into 2012 with such a drive in South Africa to work harder and smarter and support to the start-ups of the new year.

This is Seed’s last newsletter for 2011. May you have a blessed Christmas with your family and loved ones. Travel safe and keep well, we’ll see you again in 2012.

Kind regards,

Vincent Heys
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

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Looking back over an extended period of time, it is interesting to note the gains made by the local equity market on a month by month basis. We have analysed the month by month returns from the local equity market since 1970 and charted these monthly averages. The returns include dividends received – i.e. they are the total return from an investment tracking the JSE All Share index.

Firstly, given the general upward trend of the market over the long term, it is natural to find an average gain per month, with June being the lowest average at just 0.3%.

However what stands out is the average gain in each December month since 1970, which at 4.1% is far ahead of the next best month July at 2.5%.

Average monthly gains on the JSE per month from 1970:

We do know that averages can conceal a lot of variation and so looking back at the last 11 December periods, we find that only 2 out of the 11 periods produced a negative total return.

The highest gain in this time period was 11% in December 2001 – a year when the market as a whole produced a total return of 28.9%.

Gains on the JSE each December:

So the question is what is likely to happen in December 2011? Well, despite the history of generally positive performance in December, we would not want to infer too much from this.

For the year to date to the end of November the local equity market is up just over 5%, and over the last 12 months it is up 11.7%. Given that these returns are below the average annual return since 1960 of 19.4%, there is a possibility of a good end to the year.

On the other hand we have the world focusing on the European Union summit, which starts on Thursday night. The market is looking for a unified and positive outcome, but there remain many differences between the member countries as to the ideal policy and model. Watching very closely is the rating agency Standard and Poor, which has put 15 of the 17 euro countries onto credit watch negative, with a possible debt downgrade following this weekend.

The stakes are high. The market has been pushing the politicians to come up with credible solutions to the current treaty, which clearly has structural problems.

Because of the high correlations of global markets, a positive outcome over this coming weekend, together with the rating agencies holding back on any downgrades has a high probability of a rally in global equity markets to the end of the year.

Kind regards,

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Some employers now give staff the option of reducing their retirement fund contributions. I think that the main purpose of the “choice” is to help staff out with their monthly cash flow. I was recently asked by a young client who had to make such a choice what I thought of the idea. He was of the opinion that he had plenty of time and he needed the cash flow now.

My thoughts were taken back (yes many years ago) to an example we did at university which graphically illustrates the power of compound interest and thus why we should all start investing sooner rather than later.

We have 3 students A, B, and C. All 3 are 20 years old and want to retire at the age of 60.

A starts saving R100pm at the age of 20, he stops saving at the age of 30 but leaves his capital in the investment.

B starts a bit later at the age of 30 and he invests R100pm until the age of 60.

C only starts at the age of 40, but to make up he invests R500pm until the age of 60.

For those of you who are weaker at arithmetic, A has invested R12 000, B has invested R36 000, and C has invested R120 000.

If we assume investment growth of 10% pa (compounded monthly) who do you think has the most capital at the age of 60?

The chart below shows the growth of savings of the three individuals and makes for interesting reading:

The total balance of the three investors at age 60 will be:
A will have R409 745
B will have R227 932
C will have R382 848

The simple fact is that because of the incredible power of compound interest, B and C simply could not catch up. From a retirement point of view, the answer is definitely “Save Now, Live Later”. While this is a very simple illustration it shows a very powerful force at play. Naturally in the real world there will be inflation and returns aren’t smooth, but this concept holds true under most scenarios.

For those investors who haven’t started saving from a young age the message is that another day shouldn’t be wasted before you begin saving – each day is important for compounding your assets. For those investors who were disciplined enough to start early the message is that you should do everything in your power to avoid having to prematurely draw down on your savings – leave that preservation fund to grow until retirement.

Kind regards,

Barry Hugo
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

News broke on Wednesday last week that the US credit rating agency Moody’s has downgraded the outlook on South Africa’s local and foreign currency government debt from stable to negative. This announcement resulted in the rand and local bonds weakening immediately on Wednesday, highlighting once again the significant effect these credit ratings have on market sentiment.

But how do these ratings work in practice?

There are three top credit rating agencies globally: Standard & Poor’s (S&P’s), Moody’s, and Fitch IBCA. These agencies assign ratings to most major investment instruments issued by both corporations and sovereigns, including short and long term debt obligations, securities and other loans. The ratings assigned are designed to inform potential investors of the risks associated with a particular credit issue, especially the issuer’s ability to repay the debt.

Moody’s uses a multidisciplinary or “universal” approach to credit analysis, trying to effectively combine qualitative and quantitative factors in their methods. A quantitative computer model provides an objective and factual starting point, and this initial rating is then discussed further by a diverse panel of credit risk professionals. This panel considers factors unique to the particular instrument, issuer, industry, and country in order to adjust the rating.

They follow these basic principles:
• Focus on the long term, looking through the next economic cycle or longer and not adjusting ratings based on business cycles and other short-term factors.
• Global consistency, ensuring that ratings are comparable across countries and industries and ensuring that a company’s debt rating can never exceed that of the country in which it is based.
• Level and predictability of cash flow, analysing strategic factors that drive the generation of cash flows that can be used to repay interest and capital.
• Reasonable adverse scenarios are analysed to try and determine if a company will still be able to meet its debt obligations under difficult conditions.
• “Seeing through” local accounting practices, in order to determine how different accounting practices can influence true economic value. Their focus when valuing assets are on future cash flows as opposed to balance sheet values.

The table below compares the 3 main rating agencies’ different ratings:

South Africa’s government debt currently carries an A3 rating from Moody’s, signifying they are upper medium grade obligations subject to low credit risk. Moody’s didn’t downgrade the actual rating on Wednesday, but rather the outlook which might indicate a future downgrade if certain factors in our economy don’t improve.

They indicated the following reasons for adjusting the outlook:
• Rising pressure from society at large, as well as from within the ANC, to ease fiscal policy and address SA’s high levels of poverty and unemployment. Spending more in order to deal with these socio-economic challenges could force debt levels higher.
• Moody’s expects economic growth to be lower than previously expected, limiting it to about 3% to 3.5% over the medium term. This is mostly a result of an overall weaker global economy. If this lower growth rate results in further increases in unemployment, risks of political instability may be increased.
• The ongoing debate regarding nationalisation of mines or other sectors may harm the future flow of private investment into SA.

The National Treasury responded quickly to these arguments, confirming that they are committed to a sustainable fiscal policy and low inflation targets. They also stated that they are managing their debt efficiently and although their budget deficit is widening they are not borrowing more.

It is agreed that the next two years will be especially challenging for SA’s political system, and the influence on our economy will be significant. Any downgrade will increase the rate at which the government can borrow, which in turn puts more pressure on the fiscus.

Kind regards,

Cor van Deventer
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Sources: Moody’s, Fin24

A common assumption often made by the layman and sometimes by the professional investor is that good growth, be it in company earnings or in an economy, will be followed by strong returns (from the company or market as a whole, as the case may be). The logic behind this thinking is that good growth should equate to good returns, and poor growth to poor returns. What is often forgotten is that markets are forward looking, and that good growth often gets priced in before it happens.

In order to determine whether good economic growth was generally followed by good market growth I took South Africa’s annual GDP real growth and the ALSI’s annual (calendar year) real return (i.e. both measures stripping out the effects of inflation) from 1969 – 2010, over which time the South African economy has grown at an average of 2.7% per annum. I then split each year’s growth into a bucket: GDP growth of between 1% and 4% was considered to be average (2.7% + or – approximately 1.5%) with any growth in excess of this considered high and any periods below this considered low growth periods.

The chart below shows the GDP growth buckets and the following year’s return from the market. It is interesting to note that periods of low economic growth have typically been followed by strong 12 month periods of market returns and average growth was followed by the worst returns.

In the following chart it is plain to see how uncorrelated these two data sets are, just going to show that good economic growth isn’t always followed by good market growth. Importantly this is just a general observation and there are good economic periods followed by good market growth and vice versa (in 1986 for instance, GDP growth was 0% and in 1987 the market fell by 20%). Investors should therefore be wary of blindly using this type of strategy when investing.

With my interest piqued, I decided to see whether there was any correlation between current market returns and future GDP growth. The logic behind this thinking was that markets should react favourably to future GDP growth.

Using the same data set, but lagging GDP growth rather than market returns, gave the outcome below. Essentially the graph indicates that good market returns are typically followed by strong economic growth, although one can’t assume that good market returns are the cause of good economic growth.

Variations of this research have been done in many countries and economies with similar results. This isn’t a uniquely South African occurrence. Essentially what this research indicates is that investors at all times need to establish what’s in the price of any market (or share for that matter) and determine the difference between a good economy and one that will produce strong market returns, bearing in mind they often aren’t the same.

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Take care,

Mike Browne
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

If one had taken a poll across a range of investors and even professional fund managers at the end of September after the local market had fallen 3,6% and global equities were down 8,6% and 16,5% over the 3 months, it is highly unlikely that even one would have predicted a return of 9,4% for local shares in one month.

It is this high monthly and even quarterly volatility that in fact frightens off many investors. But if one understands the drivers of performance, then investors with a longer term investment horizon can take advantage of shorter term mispricing.

The question then is this – just what drives the return on an investment in a financial asset – i.e. an ownership stake in an underlying business?

There are 2 main components of return, which may be further subdivided into 3 components:
• In the first instance an ownership stake in a company gives an investor access to the dividends declared;
• Secondly an investor stands to make a capital gain – i.e. the difference between the price paid for the share and the current selling price.

While most investors understand the concept of dividends – i.e. the excess profitability paid out by a company, what is less understood is what drives the capital gains component. Well, we can break down the capital gains component into 2 elements. The first is the growth in earnings per share and the second is the change in the price paid for these earnings.

As an example: Company A, generates earnings per share of R1,50 and the price is trading at R16,50 – i.e. a multiple of 11 times the most recent earnings. Over the next 3 years, should earnings per share move up to R2,20 a share, and the market is prepared to pay the same multiple for these earnings, i.e. 11 times, then one can expect the price to trade at R24,20.

One alternative is that the earnings grow to R2,20, but the investors are now prepared to pay 13 times and not 11 times for these earnings, then the price will ratchet up even further to R28,60. It is clear from this that an ideal scenario for an investor is where a company pays out strong dividends, continues to grow its earnings and over time investors are prepared to pay a higher multiple for these earnings.

While there is a higher degree of stability in company earnings and the payment of dividends over time, what does tend to fluctuate, sometimes on an almost irrational basis, is the multiple paid for these earnings (the price earnings multiple or PE ratio). At times investors become very pessimistic about the future and are only prepared to pay less than 8 times for R1 of earnings and at other times they act with exceptional enthusiasm and are prepared to pay 20 – 25 times per R1 of earnings.

Sanlam Value fund managers segmented the JSE historical returns from 1960 into bull, bear, and range bound markets and aggregated these 3 components in each phase as follows:

From this analysis it is very clear that in various market phases earnings and dividends are positive, but it’s the price paid for these earnings that is volatile and indeed has by far the biggest impact on the total return over defined bull and bear phases.

But what is very important to remember is that while PE multiples tend to be volatile over shorter and medium periods of time, they will never keep on moving in one direction (up or down) forever. Over the extended period there is a degree of normalcy with this rating change making a far lower contribution that would typically be expected. A study by JP Morgan notes that over 40 years to the end of 2010, rating change added only 2,6% per annum out of a total of 20% per annum. Over the 10 year to end of December, PE rating change had subtracted an annual 1,4% per annum.

What this tells us is that times of high earnings multiples will be followed by times of low multiples and vice versa. This is one of the major reasons why formalising an tactical asset allocation strategy is so important – i.e. a process that will down weight exposure to equities when investors are paying too high a price and conversely increase weighting when investors are too bearish.

Kind regards,

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Dear Client

Every year, the JSE reviews their pricing and as of 1 January 2012, they will be instituting an increase. Due to these and other rising costs, Sharenet, as from 1 January 2012 will be initiating an increase of 9% across its products and services (excluding PowerStocks subscriptions which are increasing to R454 per month).

At Sharenet, we continually strive to maintain excellence in our service and to enhance our product offerings, adding more data and features where we can. 2011 was particularly exciting as we launched several free smartphone and tablet applications as well as ran a successful national seminar calendar, both of which have been warmly received. We are already developing several other exciting initiates which will be unveiled over the course of 2012.

We welcome any and all suggestions which could help us improve our service to our clients and encourage you to send these through to support@sharenet.co.za

Thank you for your continued support and business.

The Sharenet team

All of the companies on the JSE are grouped into industry sectors based on the business sector that they fall into, e.g. Standard Bank falls into Financials and MTN into Telecommunications. As much as it’s unwise to invest all your money in one share it’s also unwise to invest all your money into one sector. The average investor might believe that his portfolio is diversified if he is invested into different companies, but if he is invested into only one sector he will face similar risks as if he’s invested into one share (although slightly less amplified).

Companies in the same sector or industry are typically driven by the same economic factors and experience similar business cycles. An example of this is when we experience periods with high interest rates, banks come under pressure due to households borrowing less money, and more people default on their current loans. In the same period food retailers with low profit margins generate high turnover as a result of higher inflation that typically leads to an increase in revenue.

Below is a graph of the rolling 12 month returns of the 9 major sectors on the JSE.

It is logical (and evident from the chart above) that there are periods when certain sectors outperform the others. For an example Technology, from mid 2007 to the end of 2008, underperformed most sectors, but for the most of 2010 it outperformed the other sectors.

The graph below shows the ranking of the different sectors compared against each other. They are ranked according to their 12 month rolling return. The sectors with the highest ranking (i.e. best performance) are on top and the worst performers are at the bottom.

From this chart you can see that there are certain sectors that are more cyclical than others. Consumer Goods is an example of a sector that isn’t very cyclical, which would be expected as it is comprised of shares like SABMiller, Richemont, Tiger Brands, and Clover.

For this reason it is better to invest across all of the different sectors, although you can still manage your level of exposure to each of the different sectors. If you believe that one sector will outperform the other sectors you can increase your weighting to that specific sector to capture some of the expected excess return and vice versa.

While this article has purely focused on share portfolios, for most investors a share portfolio will only form a portion of your total investable assets. A similar principle can be used for your investments into the other asset classes and for your other investments.

If you have any questions or require any assistance with wealth or asset management please feel free to contact us on 021 9144 966 or info@seedinvestments.co.za

We can also be reached through Facebook or Twitter (@Seed_Invest).

Kind regards,

Gerbrandt Kruger
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Purchasing Power Parity (PPP) is an economic and investment concept explaining how prices of goods and services increase at the same rate (all else equal) around the world. Over the long run, differences in inflation rates should result in changes in exchange rates, with those countries experiencing high inflation seeing their currencies depreciate and vice versa.

The table below shows how this concept works in reality (using an extreme example to illustrate the theory):

In the above example we can see that at the start of the period identical rugby balls cost the same amount (in common currency) in South Africa (SA) and New Zealand (NZ). Over the period SA has a higher inflation rate and at the end of the period in order for the rugby balls to still cost the same (in common currency) the rand would need to have weakened to R9.09/NZ$.

In a world of zero frictional costs (i.e. transport, taxes, etc) if the actual exchange rate is R4.55/NZ$ (too strong) then South Africans’ would be able to exchange R 1 000 for NZ$ 220 (R 1 000 / R4.55/NZ$) and buy 2 rugby balls in NZ. They would then be able to sell these balls in SA for R 2 000 and make a riskless profit of 100% (R 1 000). Conversely if the rand had weakened to R20/NZ$ then rugby balls could be bought in SA and sold in NZ at a healthy profit. This process is known as arbitrage and will happen until either the price of rugby balls changes to neutralise the difference (change in inflation rate) or the exchange rate moves to neutralise the difference.

In this frictionless world exchange rates would always trade at fair value. In the real world there are frictional costs which therefore result in currencies spending periods where they are either over or undervalued relative to other currencies. PPP therefore doesn’t hold over the short term, but will generally provide a good estimate of fair value over the longer term.

As a currency moves further and further away from its fair value, the likelihood being able to arbitrage (make a riskless profit) goods between the two countries increases. At some point the currency will move back to fair value as the flow of goods and cash equalises the exchange rate.

In reality this plays out in the import and export sectors. Importers always want a strong currency so that imported goods cost less, while exporters prefer a weaker currency which lowers the prices of their goods in foreign currencies and therefore boosts demand.

The chart below shows how the rand has traded against the US$ over the past 26 years and compares it to the fair value exchange rate implied by PPP (i.e. the difference in inflation rates between the two countries). Notice that there are extended periods where the rand doesn’t trade at fair value, but over this long period we can see that the PPP fair value rate does provide a good anchor of where the actual exchange rate should be. The recent rand weakness has seen it move closer to fair value, but will still think that it is overvalued.

This method of valuing currencies is a blunt method and should therefore not be used to predict short term movements, but it does give an indication of which way your currency should move over the longer term.

Take care,

Mike Browne
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Coronation recently published their Corolab booklet with quite a few interesting articles that are summarized here.

1. Plan for higher inflation:
Over the last 10 years South Africa mostly experienced low inflation. However, we often feel that our personal inflation rates are a lot higher than the published rate (currently 5.3%). The reason for this is because the 5.3% is the average rate across South Africans’ basket of goods, but each individual’s basket is made up differently. E.g. Recreational equipment had a negative inflation rate of 5% for the past 12 months while electricity stands at 18% and private transport (including petrol) at 17%. Inflation of individual sectors ranges between -5% and +18%, which means your own inflation rate is as personal as your own investment strategy.

It is therefore important to look at your inflation rate and how your investment strategy should be developed to incorporate that.

2. The returns from the last decade versus the longer term history:

The graph below shows the annualised real returns of the last decade relative to long term average returns (last 111 years of data).

Clearly, local assets have done extremely well compared to the longer term averages while offshore equities in rand terms have been dismal. However, if you purely use the returns of the last decade as a proxy of what might happen in the future then you could well be disappointed.

Coronation set out their 10 year forecast of the various asset classes. Naturally these returns don’t materialize in linear format but could be lumpy. From the table below it is clear that the returns from local asset classes could be muted despite a bleaker inflation outlook. It is also evident that history might not repeat itself, with future returns most likely coming from offshore assets.

Coronation makes the point that at a 6% inflation rate you probably require nearly 6 times the level of income at the end of say 25 years to be able to buy the same basket of goods.

This makes it important to invest in growth assets that are able to grow faster than inflation over a longer period.

3. Life expectancy:

Finally, the change in life expectancy because of better healthcare technology could mean that the average person is going to live longer. The table below illustrates the life expectancy of people at certain ages. For example, a female that is currently 65 years old is expected to live a further 20 years (age 85)

Therefore, your personal inflation rate, changes in future returns and life expectancy all influence the investment strategy you need to follow.

Kind regards,

Vincent Heys
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966