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This is the Sharenet company blog where we will bring you the latest news and events on the go at Sharenet, together with tips on using our site and our products.

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    Compound Interest

    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
    021 9144 966

    Permalink2011-11-28, 17:09:00, by Mike Email , Leave a comment

    Credit Ratings: What Do They Mean?

    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
    021 9144 966

    Sources: Moody’s, Fin24

    Permalink2011-11-17, 17:18:15, by Mike Email , Leave a comment

    Economic Growth versus Market Returns

    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.

    e v m lagged

    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.

    To sign up to Seed's newsletter (which includes weekly investment reports, fund fact sheets, market overviews, and more) click here and enter your details. For regular updates on investment and economic news visit our Facebook Fan Page by clicking here and 'Liking' our page.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2011-11-14, 10:03:38, by Mike Email , Leave a comment

    Components of Return

    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
    021 9144 966

    Permalink2011-11-02, 15:31:40, by Mike Email , Leave a comment