Daily Equity Report

We looked at 10 lessons that investment strategist James Montier put out in a paper issued by US fund managers, GMO. I mentioned that I would spend a bit more time on some of the lessons that he highlighted.

His lesson number 4 was – Valuation matters.

He noted that while most everyone agrees with the assertion that “value investing tells us to buy when assets are cheap and avoid purchasing expensive assets.” He has repeatedly come across investors willing to “undergo mental contortions” to avoid the valuation reality.

He highlights the Graham and Dodd methodology of calculating the price to earnings ratio by dividing the current price over the 10 year average earnings. He cites past examples when investors rejected this methodology because it is too backward looking and does not take growth into account. This was especially the case in the IT boom period when different valuation metrics were being invented.

He also cites that during the latest crisis, investors were making arguments that this methodology was overstating earnings.

However over an extended period of time, buying when the PE is low (using a 10 year smoothed earnings) generates significantly better returns than buying when markets are expensive.

The graph above reflects the compounded real return over a subsequent 10 year period, based on different starting valuations. What is clear is that when the PE ranges between 5-13, the 10 year real return is far higher than when the PE ranges from 20-48.

We have done a similar study of the real returns on the JSE at different starting valuations – modelling this, drives our basic equity asset allocation decision.

If you have any questions on your investment returns, strategy and would like to find out how Seed can assist, please don’t hesitate to give us a call.

Kind regards

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

James Montier, a global financial strategist and expert in behavioural finance, put some points out in a White Paper published by US fund managers, GMO, titled “Was it all just a bad dream? Or Ten lessons not Learnt.”

He starts off by saying that the market declines of 2008 and early 2009 are being treated as nothing more than a bad dream…. The extreme brevity of financial memory is breathtaking.

He put together 10 of the top lessons he thinks investors seem to have failed to learn. I will list them and then over the next few days discuss a couple in more detail.

1. markets aren’t efficient

While many practitioners seem willing to reject the EMH (efficient market hypothesis), the academics refuse to jettison their treasured theory.

2. relative performance is a dangerous game

He quotes the late sir John Templeton, who said, “It is impossible to produce a superior performance unless you do something different from the majority.”

3. the time is never different

His conclusion on this point – “…investors get caught up in all the details and the noise, and forget to keep an eye on the big picture.”

4. valuation matters

While it is self evident that buying when cheap, he says that he has repeatedly come across investors willing to undergo mental contortions to avoid the valuation reality.

5. wait for the fat pitch

using a baseball analogy of waiting for the perfect moment when patience is rewarded as the ball meets the sweet spot.

6. sentiment matters

Investor returns are not only affected by valuation – sentiment plays a part.

7. leverage can’t make a bad investment good, but it can make a good investment bad.

Piling leverage onto an investment with a small return doesn’t transform it into a good idea.

8. over-quantification hides real risk

The obsession with overly complex mathematics hides real risks – which should ultimately be defines as the permanent loss of capital.

9. macros matters

Neither a top down view, nor a bottom up view has a monopoly on insight. He concludes that we should learn to integrate their dual perspectives.

10. look for sources of cheap insurance

His final lesson is that insurance is often a neglected asset when it comes to investing. It is the steady short term losses (premiums) that makes insurance seem unattractive to many investors. However this disliked feature often results in insurance being cheap.

Some good points, which I will expand upon.

Kind regards

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

Company earning for full years and interims continue to come for the period to December. The price movement post the release of the results is a good indication of what analysts have expected and what they have been factoring in. Looking at 2 of the results today, while earnings went down, the share price gained ground – clearly a case of slightly better than expected.

Today we had reports from an industrial company, a commodity related and a financial services company.

AVI
Fast moving consumer goods company, AVI, reported interims to December. Revenue was flat at R4 billion, profit down slightly, at R335m, but headline EPS from continuing operations up 9% to 112,3c.

The interim dividend was increased by 8,3% to 39c

The company has the following operations. Fashion brands portfolio, which improved operating profits by 35% to R167m.

The strong rand negatively impacted the sales of its I&J division as did some pressure on selling prices. Operating profit dropped from R125m to R59,8m.

Hot beverage brands division lifted operating profit from R129m to R167million.

On a total basis margins were up slightly from 40,3% to 40,6%.

Finance costs and debt came down.

The market liked the results and the price gained 3,76% to 2345c. Last week it traded up to R24 - a new high.

Sasol
Sasol, which converts coal and gas to fuel reported their interims to December. Turnover was down from R83 billion to R58 billion, with operating profit off from R21,5 billion to R10,5 billion.

Diluted headline EPS fell from R21,79 / share to R11,14 / share, but the interim dividend was raised by 12% to R2,80c

The lower profitability was a result of lower average crude prices of $71,42 in 2009 compared to $84,75 in 2008, as well as a 14% stronger rand to the US dollar.

The price gained 2,29% to R290,50. It fell from a high of over R500 in May 2008 to R221 in November 2008, before moving mostly sideways.

JSE

JSE reported its annual numbers to December. Revenue was up slightly to R1,1billion. Personnel expenses jumped from R238m to R318m, and other expenses from R484m to R491m. This was due to increased headcount and the acquisition of the Bond Exchange. Attributable profit fell from R374m to R367m

Diluted EPS was down slightly from 434c to 425c

The share price gained 1,1% to 6420c. It had fallen to R36 in February 2009 and has therefore rebounded in line with the strong market, especially for companies in the financial sector.

In many respects the market has been expecting firmer earnings. In some cases these have not yet come through and so there is some concerns that perhaps the JSE has rallied a bit too much – but its in line with the general risk appetite across the globe.

Kind regards

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

The construction sector has, over the course of about 5 years, experienced a full cycle. Construction companies by their very nature are quite cyclical. The reason simply is that paying someone to build roads and bridges every day isn’t as important as paying someone for drugs (medicine) on a daily basis.

The graph below that maps the share price growth of Group 5 versus the Construction sector and the ALSI since the end of 2004. They all end up fairly close to each other, but you will see how the construction sector has been much more volatile.

While demand for pharmaceutical products doesn’t change too much over the short term, demand for construction companies’ produce can and does vary quite a bit. Governments are generally a large customer of construction companies and they tend to go through phases of under development and overdevelopment. Construction can and does also get used to help growth when economies are weak (this is a case in point particularly in China at the moment). It therefore stands to reason that construction companies will be more attractive when a country is in a phase of overdevelopment and less attractive when there’s a lack of development occurring.

Remember though that the attraction, or otherwise, of a company should not overly influence your decision on whether or not to invest in the company. Price is critical in the analysis. When construction companies were experiencing booming order books at record margin they appear to be very attractive, but the price more than reflected the good news. We are now at a point where many construction shares are painting a bleak picture, and it might just be the time when they are becoming more attractive as investment propositions.

Group 5, the 5th largest construction company listed on the JSE, released interim results this morning that make for some interesting reading.

The company is mainly exposed to the construction sector (74% of profits) and has therefore been operating in a tough environment where many projects have been shelved or cancelled in the private sector, and where government hasn’t been as efficient in awarding contracts.

The tough market conditions are reflected in revenue contraction of 4% and profit growth of 12%. Profit growth in the face of declining turnover has been achieved as a result of improved margins. The dividend declared is up 9% when compared to the previous first half of the financial year.

What interests me the most about the results is that cash on the balance sheet equates to R3.24bn and the company has no debt, while its market cap on the JSE is R4.26bn. Clearly the company has a lazy balance sheet, but the market’s implying that the company (other than its cash) is worth only R1.02bn. With earnings of R 533mn for the 12 months ending 31 December 2009 the PE multiple placed on Group 5 less its cash is a lowly 1.9! The quoted PE is higher at 6.1, but these multiples are extremely low compared to the market. The company doesn’t need great earnings performance for its share price to do well as there is already a lot of bad news priced into the share.

As always the key to investment success is not the popularity of your portfolio, but rather the price you pay for each share in your portfolio.

Enjoy your weekend!

Take care,

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

The JSE closed up 0.33% at 27774 with value traded at R 11.89 billion. Advances led declines 188 to 161 with 100 shares unchanged out of 449 active. Mining closed up 0.11% at 32816, while Industrials were up 0.39% at 26471 and financials ended the day up 0.79% at 20521.

The best performing sectors of the day were Software & Computer Services Index up 3.1% at 366, Technology Index up 3.1% at 17281 and General Industrials Index up 2.6% at 62194, while the worst were FTSE/JSE RAFI ALLSHARE INDEX down 3.3% at 5647, COAL MINING down 2.2% at 24224 and FTSE/JSE All Africa ex SA 30 with S A Rand values down 1.8% at 57.

There were 23 new 12 month highs today, including Redefine which closed up 5.3% at 795, Capevin up 4.9% at 8500 and Didata up 4.8% at 1070 while there were 1 new lows of which Anglopl-n topped the list, down 0% at 19000.

Of the major stocks Anglo moved up 0.7% at 29600, Mtn was up 2.25% at 11769, Arcmittal moved up 3.07% at 9302, Billiton ended down 0.2% at 24101, Stanbank moved up 0.94% at 11194.

Some of the top gainers included Sephaku up 48.51% at 300 , Lonfin up 22.45% at 300 , some of the losing shares included Afro-c down 7.41% at 150 and Ama off 6.25% at 150

The Dow was up 0.2% at 10417.54 and the S&P 500 up 0.1% at 1120.15 a few moments ago.

Gold was down 0.5% at $ 1131.90/oz

The rand was last trading at R 7.46 to the dollar, R 11.20 to the pound and R 10.15 to the Euro.

A major driver of global risk assets has been cheap money. Central banks around the world have maintained ultra low interest rates and for the most part this is continuing with 2 major central banks making announcements on their key interest rates today.

The big question for most central banks around the world is when to start to raise rates again. Typically they cannot easily lift rates in a world that is still trying to recover from a recession, but at the same time there is a concern about the implications of overstaying a position of ultra low rates.

Today, the Bank of England kept its key rate at the ultra low 0,5%, and maintained its bond purchase program on hold for the second month – i.e. elected not to extend any further cash injections into the economy.

The UK’s growth rate came in at 0,3% for the last quarter of 2009. This supports low interest rates.

However Inflation is running at 3,5% in the UK, which is way above the 2% target.

The effects of inflation, ultra low interest rates, massive fiscal deficits and money injections into the economy have weakened the currency relative to others.

The chart reflects the dollar/pound exchange rate

The European Central Bank also met today – as was expected it left its key rate unchanged at 1%. This was the 10th consecutive month at this level.

Inflation is low at 0,9%, while GDP for the Eurozone gained just 0,1% in the last quarter of 2009.
The big risk for these economies is that inflation starts to pick up, growth goes into reverse, putting more on more pressure on the fiscal positions and long term debt structures.

But cheap money is good for real asset prices.

Kind regards

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

Some managers, like the ever bullish Ken Fisher, have outlined their bullish case for US and global market equities in this the second year after the 2008 bear.

The initial stage of the 2009 bull market was driven by an improvement in sentiment and a global wall of liquidity from various stimulus packages and central banks.

While the stimulus is still largely in place, Fishers’ view is that fundamentals should start to gain some traction as the year progresses. Some of the investment drivers that they have identified include:

• An overwhelming historical precedent for another positive year;
• Fast growing emerging market and a resurging global trade;
• Very lean corporate expense structures;
• Stock valuations that are not expensive, especially on a relative basis to interest rates;
• Monetary and fiscal policies that continue to provide tailwinds;
• Sentiment that remains sceptical.

Their work indicates that on the second 12 months after a bear market decline and a positive year, that this is also invariably positive. They looked at the S&P500 and noted that the one exception to this rule was after the 1932 bottom, when shares fell 0,4% before resuming an upward trajectory.

Fisher Investments presented the following table:

They then note 3 pillars of economic expansion:

1. Emerging market economies, which are already on a cumulative basis bigger than the US economy, should lead the world out of recession.

Source: IMF, Thomson Reuters, Consensus Economics

2. They note that business investment should continue to rebound shaprly as companies in general “play catch up after skimping on, and in fact savagely slashing capital expenditure and inventories during the last 18 months.”

Their view is that contrary to popular sentiment, firms are exceptionally healthy and in a good position to capitalise on the rebounding economy.

Balance sheets are generally strong, with high cash holdings, low debt and low borrowing costs.

These lean costs structures should give firms tremendous operating leverage. i.e. smaller gains on the revenue line translate into even bigger gains at the earnings level.

The note the consensus for S&P500 earnings growth in 2010 is 29,4%. The average earnings growth per annum since 1994 has been calculated at 6,5% with a decline of 76,6% in 2008 and 50,5% in 2001 and gains of 75,2% in 2003. Their view is that following large declines, the actual earnings gains could exceed current consensus.

Already this consensus is being upped as companies are reporting numbers ahead of expectations – see conclusion.

3. Strong emerging market growth and resurgence in business investment should bolster global trade, which fell severely in the recession.

Conclusion

With 98% of all companies in the US having now reported their 2009 earnings, the aggregate earnings number for the S&P500 in 2009 is coming in at around $56,5.

Analyst forecasts, which until now have been slightly behind the actual numbers, are forecasting earnings of up to $78 in 2010, and $94 in operating earnings in 2011, i.e. a possibly gain of some 38%, followed by 20%.

As we mentioned last week, taking a longer term view of say 5-7 years, global equity, and especially high quality companies are in absolute and relative terms at fair to good value.

Kind regards

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

Warren Buffett has been described as one of the best investors of all time. He has a fantastic long term track record as an allocator of capital. Probably more than any other single person he has used the magic of compounding to its fullest extent with the listed investment vehicle Berkshire Hathaway. But is the historical performance repeatable?

His 2009 annual report has recently been released, which annually compares the movement in the per share book value of the Berkshire shares compared to the annual percentage change in the S&P500 including dividends to ensure a like for like comparison from 1965, which is when Buffett took control of the company.

The book value has been used as the most appropriate metric to measure, because this is largely controllable by the managers of the business. The market price tends to be more volatile and the managers of a business have very little to no control over this price on a year by year basis.

The book value grew from $19 in 1965 to its current $84 487 per share, which is a compounded 20,3%.

By comparison, the annual compounded gain in the S&P500 from 1965 is 9,3% and so Berkshire’s book value has grown at a rate of some 11% ahead of the overall market as measured by the S&P500.

The cumulative effect of this difference over an extended period of 45 years is very big. In the case of the S&P500 index an investor would have received a cumulative 5430% and in the case of an investor in Berkshire a cumulative 434,057%

As an early and major investor however, Warren Buffett received an even higher return. Berkshire was a listed company where the market price traded below book value – which is exactly one of the reasons which made it favourable to Buffett. From a position where the price traded at a discount, it has now moved to a position where it generally trades at a premium. Buffett, along with other early investors who stayed the course would have received this additional benefit and he calculates that on a price to price basis, the annual compounded return has been 22%, which gives a cumulative 801,516%.

The question is asked “is the historical outperformance repeatable as the company gets bigger and bigger?”

This is the same question that one needs to ask of a fund manager where performance naturally attracts more assets.

We have aggregated and averaged Buffett’s outperformance (alpha) into 9, five year periods. It is clear that the first 25 years produced exceptional outperformance, but that this has been tempered over the last 20 - still a very credible number.

Buffett himself answers the question in his report : “The big minus is that our performance advantage has shrunk dramatically as our size has grown, an unpleasant trend that is certain to continue. To be sure, Berkshire has many outstanding businesses and a cadre of truly great managers, operating within an unusual corporate culture that lets them maximize their talents. Charlie and I believe these factors will continue to produce better-than-average results over time. But huge sums forge their own anchor and our future advantage, if any, will be a small fraction of our historical edge.” Emphasis added.

Kind regards

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

Over the weekend Berkshire Hathaway, the insurance and investment holding company run and largely owned by 79 year old Warren Buffett and his partner 86 year old Charlie Munger, released their annual report for the year to December. The local Berkshire lookalike, is industrial company Bidvest, capably run by CEO, Brian Joffe. Today Bidvest reported its half year results to December.

Bidvest’s principal business is in trading, services and distribution.

In many respects, Bidvest can be compared to Berkshire Hathaway. It has these points in common:

• They both invest in an array of different business types, although Berkshire has concentrated in insurance and Bidvest in food services businesses.

• They both look to own 100% of their subsidiaries, which gives them access to 100% of the cash flow generated by the underlying business.

• They are both essentially allocators of equity.

• They are opportunistic and acquisitive.

• They both operate using a small head office.

• Operations and administration are decentralised at the business units.

With Bidvest, the various business units are aggregated into the following main divisions: Bidfreight, Bidserv, Bidvest Asia Pacific, Bidvest Europe, Bidfood Caterplus, Bid Industrial and Commercial products, Bidpaper plus and BidAuto.

Some points made by Brian Joffe at today’s presentation.

Succession planning is important, not only for head office, but for all businesses and group. This is an ongoing work in progress.

Critical mass is important and hence the business will continue to grow and make acquisitions where necessary.

Distribution and control of this distribution is important.

Head office gives management total autonomy. The role of head office is to monitor the returns that managers are giving on assets.

Into the future Bidvest will invest into food services around the world. Also going to look more into Africa.

Revenue was down 6,5% to R56,1 billion, trading profit flat at R2,6 billion, but headline EPS up 9% to 495c.

Cash generated by operations at R3 billion – up 229%.

Net asset value per share is R49,60 up from R43,85.

Net debt to equity at 37,2% down from 56,7%. This allowed for finance charges down 31% to R385m.

Two questions he answered. What about the world cup and jobs and interest rates.

His view is that while the numbers will be lower than 0,5 million, it is not likely to be less than 250 000 foreign visitors. But Bidvest will benefit from the sheer scale even with local fans.

His view is that the government has been too slow to reduce interest rates. The important issue that they should have addressed is higher growth and more jobs and hence should have driven interest rates lower.

Bidvest relative to the JSE

Source: Sharenet, market tracker

Berkshire Hathaway

Some data from the annual Berkshire numbers. Total revenue, including insurance premiums, sales, interest and gains at $112,5 billion. Net earnings for the year at $8 billion and on a per share basis up from $3225 to $5193.

Total assets are stated at $297,1 billion and shareholders equity at $131,1 billion.

Kind regards

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

Over the years, the JSE in conjunction with the FTSE has launched many variations of indices. More and more the construction of additional indices is demand driven, especially where investment products can be created from these indices.

The FTSE website boasts that it now calculates over 120 000 end of day and real time indices covering more than 80 countries and all major asset classes.

In additional to the various sector indices that the JSE calculates, it has been calculating 2 style indices from August 2004.

These are the FTSE/JSE Value index and Growth index. The value is designed to reflect portfolios focusing on the price and value characteristics of securities, weighted towards those companies with identifiable value characteristics.

The FTSE/Growth index is designed to reflect portfolios focusing on earnings and revenue growth, weighted towards those companies with identifiable growth characteristics.

The underlying constituents of these 2 indices will mirror the FTSE/JSE All Share index, but through the use of accounting data which is reviewed twice a year, shares are ranked. Those showing high value characteristics are classified into the value index and those high growth characteristics into the growth index. Companies that sit in the middle 30% - i.e. between value and growth – will be weighted to one of the 2 indices in a predetermined way.

Some of the measures used in the calculation of these indices are as follows:

Value Measures

• Book to Price. The ratio of equity to market capitalisation. A value share wants a higher ratio.

• Sales to Price – the most recent annual sales to the company’s market capitalisation.

• Dividend Yield reflects the dividend declared per share as a percentage of the share price. Again a higher percentage is an indication of value.

• Cash Flow to Price is a company’s most recent cash flow for the year divided by the market capitalisation of the company.

The chart below reflects the JSE All Share total return measured against the value and the growth index. JSE in green, value in red and growth in yellow.

Source: Sharenet and Market Tracker

Over the last 2 year period, value has outperformed the JSE All Share and also the growth index.

There is a high degree of evidence that when it comes to investing, value metrics consistently applied will produce superior performance.

Have a great weekend

Sincerely

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