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    Volatility and Market Movements

    Yesterday we had a look at how stability breeds instability, and today we’ll look at related topic, namely how volatility in the market affects the market’s performance. It should come as no surprise after yesterday’s report that the change in the market’s volatility is inversely proportional to the change in the level of the market.

    The extent to which this relationship holds true, though, is what was surprising. The indicator that is used in South Africa to measure volatility is the SAVI, which is calculated by the JSE, while the ALSI’s return measures market movements.

    The fact that an investor’s level of comfort is inversely proportional to the level of volatility makes logical sense as humans are genetically wired to seek stability and shun change.

    Looking at the percentage change in the level of the SAVI versus the level of change in the ALSI since 1 February 2007 (the longest period that data points can be obtained for both variables) it is remarkable at how strong their inverse relationship is.

    Over this period, in fact, these two indicators have a correlation of -0.74. Since the beginning of March this year (just before the market bottomed) the correlation between the change in the level of the SAVI and the change in the level of the ALSI falls to -0.98 (i.e. an almost perfect inverse relationship).

    From the information above it is clear that a profitable investment strategy would revolve around increasing market exposure before periods of low volatility and decreasing exposure before volatility rises. Unfortunately there is no causal relationship here, and volatility isn’t a lead indicator for equity returns. One therefore has to be able to instinctively feel where the volatility is going in the future (or use some other means to gauge where volatility is going) in order to be able to profit from this strategy.

    We have now had a period of nearly 5 months where the market has returned over 30%, while the SAVI has fallen by around 40% to levels last seen in June last year. Investors should take note where volatility stands now in relation to its history when assessing market risk.

    Enjoy your weekend.

    Take care,

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

    Permalink2009-07-31, 16:32:44, by Mike Email , Leave a comment

    Stability Breeds Instability

    Hyman Minsky was a well known American economist who proposed that the financial markets as we know them are inherently unstable and furthermore that their stability breeds instability. Let’s examine this paradox further.

    Financial markets as we know them today typically thrive on certainty and punish uncertainty whether on all asset classes, a specific asset class, or a specific sector of an asset class. The last year or so has been a perfect case study of this fact.

    While the general case holds (of markets thriving on certainty), the certainty and stability that gets created ultimately undermines the system. Looking back to June last year we saw commodity prices shooting through the roof on the belief (certainty) that China would absorb any new production on its way to becoming a global super power. The theory became a self fulfilling prophecy until such time that there was a realisation that the theory may not in fact hold over the same time horizon that commodity prices were discounting. When this happened we saw a massive collapse in the prices of many commodities (oil went from nearly $150 a barrel down to $40 odd a barrel).

    This phenomenon most likely occurs because when asset prices rise investors feel more comfortable that the price will continue to rise, they therefore have no problem with assisting the price to rise further by purchasing said asset at the higher price. Slowly but surely the proportion of investors that are invested in the asset, purely as a result of its price increasing, increases. ‘Investors’ (or more accurately speculators) start paying less and less attention to valuations and research, and more and more attention to the wealth created and blue sky stories.

    When the realisation that the wealth creation may not actually perpetuate into the distant future sets in and when the blue sky stories don’t become a reality, the asset price has moved to such highs that there is an inevitable market crash (typically below true value).

    A massive destabilisation of the system.

    We find at this point that robust debate is re-engaged, and different market participants put thought behind the true value of the asset. Volatility in the asset price most likely reasserts itself as there remains no ‘consensus view’ on where the asset price should be trading.

    Slowly but surely once again market participants start to come to a consensus on where the asset should trade, and this is where we see volatility starting to decrease and the asset price starting to move north again. The cycle repeats itself unless government intervenes.

    Tomorrow we will take a look at how volatility and markets are related.

    Take care,

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

    Permalink2009-07-30, 17:03:34, by Mike Email , Leave a comment

    June Inflation

    Inflation numbers for end of June were released today. The inflation number is an important input into financial models. For all investors inflation is the minimum hurdle rate over time, given its insidious ability to erode the purchasing power of savings.

    It is a moot point as to how accurate the figure is. Clearly it’s based on a basket of finished goods such as food and household contents to services such as restaurants, housing, education transport etc.

    The basket varies from person to person and from time to time the official basket of goods and services is amended. What is important is the consistency of the measurement process.

    Following on from this what is also important is the direction of the rate of change as opposed to the absolute number itself.

    With the official headline number having more recently peaked in August 2008 at 13,7%, it has been steadily coming down. While tending to have been a bit stickier on the downside in March, April and May, the June number came in at below the consensus at 6,9% versus the consensus as 7,1%.

    Food inflation was negative 0,3% month on month, which is a positive sign because food inflation has been high for some time. The coming months should reflect lower food inflation given the dramatic decline in the price of inputs such as maize over the last 12 months.

    The official inflation rate is generally expected to fall to 6,7% year on year at next month reporting – i.e. end of July and possibly lower still. However it is still outside the Reserve Bank target rate and listening to a fixed income manager today, who recently met with a Reserve Bank official, it does not look like we are in for any further interest rate cuts.

    The electricity hike is still to come through in the numbers and then there are wage hikes which are coming in ahead of the current rate and so there are a number of negatives for inflation going forward.

    Longer term then while the world faces a possible low to deflationary environment, some local fund managers have slightly upped their long run outlook for inflation to around 5,5%.


    Source : Nedbank Economic unit

    Certain industries such as food retailers benefit more from higher food inflation and conversely less as inflation, especially for food, trends down. Some fund managers expect to see some pressure on food retailer earnings as food inflation drops back from the very high levels.

    Kind regards

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

    Permalink2009-07-29, 17:23:19, by ian Email , Leave a comment

    More on China

    Jeremy Grantham from GMO released his latest report where he discusses global markets and GMO’s current approach. As always the reading of his views, as an experienced manager and a good understanding of long term valuations, is important for all investors.

    With the US and global markets having got to very cheap levels in March where the S$P500 fell to a low of 666, it has raced up very quickly to 950. His view is that if this index moves up to 1000 to 1100, it will be time to take some risk off the table.

    He sees 880 as long term fair value for the S&P500.

    Quality US stocks are their favourite. He then goes on to mention their other favourite as emerging market equities, which have had an exceptional run, especially from the point of view of a US dollar investor because of dollar weakness in 2009.

    However within emerging markets, China is potentially expensive. Grantham says “Being pro-emerging, yet anti China is a dilemma for us; we are working to resolve it.”

    “Deciphering the strength of the Chinese economy will play also play a major role in formulating our view of any future relative strength of emerging.”

    One of his colleagues is concerned about China, with a suspicion that the economy is dangerously unbalanced and very likely to come unhinged in the next few quarters, surprising the pants off investors.”

    The graph below of the Chinese market from its lows at the end of 2008 gives an indication of the possible formation of a bubble once again.

    Yesterday saw a new listing in the form of Sichuan Expressway which listed at 3,60 yuan but closed at 10,0 yuan, having raced up on demand from investors. It was even suspended having breached levels on the upside.

    This is an area that will become increasingly important to global investors.

    Kind regards

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

    Permalink2009-07-28, 18:30:24, by ian Email , Leave a comment

    Funding the US

    The big economic shift from the West to the East is fascinating. At a presentation today I listened to the inimitable Michael Power, investment strategist from Investec Asset Management. While the steady shift appears inevitable, what must be particularly galling for the US is to have to increasingly answer to China about its current and future expected fiscal position.

    Today and tomorrow, US Treasury Secretary Tim Geithner and Secretary of State Hillary Clinton will host Vice Premier Wang Qishan in Washington at a summit called the Strategic and Economic Dialogue.

    Apparently Fed Reserve Chairman, Ben Bernanke will also brief the Chinese officials about how the US plans to keep inflation in check over the next few years. Somehow I don’t think inflation is the issue, but how the US intends reigning in government spending. US President Obama is set to address the opening ceremony.

    Just a short while back in June, Geithner was in China fielding questions then about the US fiscal deficit.

    There does appear to be an increase in co-operation between the US and China, but I think that the US has no choice but to co-operate with the growing superpower given its higher and higher reliance on the Chinese for funding. Both countries however need the ongoing co-operation of the other.

    From China’s perspective one of the biggest risks that it faces is that it is acting as banker to the US and officials are getting nervous of the possibility of being repaid in depreciated dollars. The governor of the Chinese central bank has commented that the US finds itself in a financial crisis through over consumption and a high reliance on credit.

    Over the years the surplus reserves generated through Chinese exports have been sent back to the US and used to acquire US bonds. This “cheap funding” has allowed the US to live beyond its means, but now its heading for a crunch time. The People’s Bank of China announced recently that its foreign reserves have reached $2,1 trillion. A large portion of this is held in US treasury bonds.

    The US Treasury is facing a massive deficit. i.e. it needs fresh capital to plug the very big fiscal hole. Many of the individual states, with California the biggest, also face huge funding deficits. This money cannot merely be printed by the Federal Reserve, but needs to be received from net savers - i.e. the likes of China.

    The scenario forces the West to co-operate with the East

    That’s all for now

    Kind regards

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

    Permalink2009-07-27, 17:25:14, by ian Email , Leave a comment

    Some points on a living annuity

    Most investors who have money in pension and provident funds will at some point look to allocate the bulk of these funds to a living annuity. Fund managers Coronation released an article discussing some of the pertinent issues that we agree with.

    While the tax rates on the lump sum withdrawals from pension and provident funds have been simplified, the rates are punitive for levels above for lump sums above R600 000 at 27% and above R900 000 at 36%.

    A maximum of one third of the pension fund can be commuted as a lump sum, but with the higher tax rates, many investors with provident funds will also be transferring the bulk of their funds to a living annuity.

    Coronation point out the risk of not taking enough risk in the portfolio, when allocating the bulk of a living annuity to low risk money market funds and at the same time having a fairly high income drawdown.

    While money market has provided an investor with an annual return of 9,8% per annum since 2000, an investment of R1m eight years ago with a 7% annual income, would now have a real value of only R569 800.

    Had the initial R70 000 been inflated just with inflation from 2000, this would now be the equivalent of R116 850 and would represent a 12% drawdown on the current value, which is not sustainable.

    So while a 7% income or drawdown from the annuity may appear sustainable when compared to historical and even current interest rates, the problem comes in that the annual annuity needs to be escalated annually just to compensate for inflation and this starts to have a real negative impact on the underlying portfolio. A consistently high cash component is unlikely to provide the real return required for most retirees.

    Some of the advantages of a living annuity

    The investor of the annuity has the full flexibility to create a portfolio with no section 28 restrictions. i.e. 100% of the portfolio can be allocated to local equities or even offshore for that matter.

    An income must be drawdown at a rate of between 2,5% and 17,5% per annum. This is altered on an annual basis.

    On death the balance of the annuity, unlike a compulsory annuity, will be transferred to a nominated beneficiary.

    Unlike conventional or guaranteed annuities therefore, living annuities provide the investor with flexibility, choice and ownership retention.

    The living annuity itself does not attract any taxable income on capital profits, interest or rental income etc, but rather the level of income drawdown in the investor’s hands.

    For this reason where an investor has a total portfolio composed of a portion allocated to a living annuity and a portion in discretionary assets, it is important to optimise the asset allocation. If you are in your position, discretionary investors should be skewed to growth assets and living annuity assets skewed to income generating assets.

    Have a wonderful weekend

    Kind regards

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

    Permalink2009-07-24, 17:27:22, by ian Email , Leave a comment

    US bank profitability

    From anecdotal evidence, there appears a general reluctance on the part of both local and global banks to extend new advances. This is understandable following the aftermath of the credit crunch. But how then does this line up with announcements, especially from the US, of record second quarter profits.

    US banks have mostly reported large increases in second quarter profits. These have come in ahead of profit forecasts and have definitely helped boost share prices over the last few months.

    Wells Fargo one the US’s largest mortgage lenders, which acquired Wachovia in January, reported second quarter profits yesterday up 81% to $3,17 billion.

    Bank of America, which itself acquired Merrill Lynch and Co earlier in the year, reported a 5,5% drop in profits, but still coming in at $2,42 billion.

    Citigroup profits came in at $4,28 billion, but this was due to the profit on the sale of the Smith Barney brokerage.

    JP Morgan Chase reported a rise in profits to $2,72 billion on record trading fees and stock and bond underwriting.

    Investment bank and the fifth biggest in terms of assets, Goldman Sachs, recorded record profits 2 weeks back, with net income coming in at $3,44 billion

    Credit Suisse has reported profits up 29% to 1,57 billion Swiss francs or £890m.

    How have these banks generated these profits in an environment where they are not extending credit, bad debts or non performing loans are rising and the economy is still very weak?

    A big area is the wide spreads from the virtually 0% on money market to the 4,5% on US long bonds. A report from offshore Standard Bank said the following on bank profitability, “Banks are going to try and make profits in the safest way they can and the safest way is simply to use the steepness of the yield curve that has been created by the central banks. The safest way is not to go out and extend credit to companies that might go to the wall”

    In essence then banks have been given easy and virtually free capital as short term rates have come down close to zero. Instead of lending this out in the normal course, they have typically invested slightly longer and at higher rates and banked the differential as huge profits.

    Nouriel Roubini, professor of economics at New York University’s Stern School of Business, aptly summed up the state of affairs as follows: “In brief, banks are benefiting from close to zero borrowing costs and fewer competitors; they are benefiting from a massive transfer of wealth from savers to borrowers given a dozen different government bailout and subsidy programs for the financial system; they are not properly provisioning/reserving for massive future loan losses; they are not properly marking down current losses from loans in delinquency; they are using the recent mark-to-market accounting changes by FASB to inflate the value of many assets; they are using a number of accounting tricks to minimize reported losses and maximize reported earnings”

    The lending environment to corporates and the private market will normalise, but it may take a bit longer than the record profitability US banks seems to indicate.

    Kind regards

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

    Permalink2009-07-23, 18:17:46, by ian Email , Leave a comment

    is China the next bubble?

    Following the release of the June GDP numbers from China, a report from Wells Fargo Securities questioned whether China is the next bubble? Naturally given its growing dominance and impact on the world’s economy, there is much debate as to whether China is the powerhouse than can pull the world out of the current economic slowdown.

    Year on year growth rate slowed to 6,1% in the first quarter or 2009, but this picked up again to 7,9%, mostly as foreign trade started to stabilise again after the very poor 4th quarter 2008 and first quarter 2009.

    The Chinese government responded very quickly and aggressively to the 2008 crisis, and started to actively encourage banks to lend. The government announced a stimulus plan in November 2008 of $586 billion.

    In March it was announced that public infrastructure development would take about 38% of this stimulus package. Projects lined up include railway, road, irrigation and airport construction. Other areas include reconstruction work to areas hit by the Sichuan earthquake last May, rural development, technology advancement, education and cultural etc.

    Interest rates were cut, lending restrictions, which were put in place in early 2008, were rescinded, and banks were encouraged to lend, allowing loan growth to explode over the past few months. See the chart below.


    According to the report, this growth in lending now exceeds that put in place at the beginning of the decade when the government was attempting to stimulate the economy.

    Despite the massive rise in lending, the gearing levels are coming off a very low base and because the Chinese are net savers, the loan to deposit ratio has actually trended down over the last decade.

    Unlike in the US, households have a relatively low percentage of loans relative to overall GDP. In the US loans to individuals are at 97% of GDP (with US GDP around $14 trillion). In China this ratio is at 20%.

    There is a risk that loans to businesses may prove to be uneconomic and end up as being non performing. i.e. the projects and businesses themselves prove unsustainable and therefore unable to repay the debt. This is the big concern in my mind.

    The report concluded that there are few signs of excessive leverage and that the government is very wary of creating a lending boom, which occurred in the late 1980’s. This will be an important area to watch in order to determine if China has the real ability to become the powerhouse the world requires.

    Kind regards

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

    Permalink2009-07-22, 17:22:15, by ian Email , Leave a comment

    A Look at Hedge Funds

    We often find that people that aren’t involved in the investment industry immediately think of the word “risk” when you mention hedge funds. This thought is often associated in bear markets with emotions such as fear and apprehension. On delving further into why these thoughts and emotions occur, it is apparent that the main sources of these thoughts and feelings are a lack of knowledge on how they operate and “information” provided by main stream media.

    Alfred Jones is credited with creating the first hedge fund 60 years ago in 1949 with the intention of reducing the risk of the portfolio which he achieved by buying those shares that he believed that would perform better than the market, and selling short those shares that he believed would do worse than the market (i.e. borrowing shares and selling them on, before buying them back later at the market price and returning them to their owners). By doing this he was able to remove the risk of the movement in the market.

    Two scenarios below give a simple illustration as to how a hedge fund manager is able to remove a certain level of market risk.

    In scenario 1 the manager purchases share A (which returns -20%) and sells share B short (which returns -35%) on the belief that share A will outperform share B. He is proven correct, and the hedge fund returns 15% to its clients ([-20%] – [-35%]). By hedging out market risk the manager is able to make profits in a downward trending market. Had the hedge fund manager just bought share A as a result of his research indicating that A was a superior company to the market, he would have made a negative return (-20%) even though the company outperformed the market.

    Scenario 2 depicts a fund manager getting his research incorrect. Here he buys share A (which returns 50%). Here share A underperforms share B (which was shorted and returned 60%) with the result being a return 0f -10% for the clients ([+50%] – [+60%]) despite both shares outperforming the market (return of 30%). If the manager had used the market as the short (i.e. he believed that share A would outperform the market, but not share B ) he would have returned 20% to his investors ([+50%] – [+30%]).

    This illustration is merely an extreme simplification of an equity market neutral strategy with no gearing. While it is a simplification it is able to illustrate that hedging results in a manager showing his true skills. The above chart also shows that a hedge fund, run in the above manner, isn’t affected by the level of the market, but purely on the relative performance of the securities on the long side compared to the securities on the short side.

    Many of the hedge fund blow outs experienced in the past 2 years (especially overseas) have been as a result of excessive leverage, or of managers investing into illiquid assets. Those managers that stuck to simple strategies have generally been able to weather the storm much better.

    Complicated strategies can produce exceptional returns, but they also run the risk of things going wrong, which in a geared strategy can spell the death knell for a fund. Simple strategies will generally not give as spectacular returns on the upside, but should be more robust when times become testing.

    I trust that this has given a little bit more insight into the basic mechanics of how hedge funds were originally set up to be managed.

    Take care,

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

    Disclaimer: While hedge fund managers are regulated in South Africa, hedge funds (as a product) remain unregulated. Hedge funds typically make use of strategies that result in them only being suitable for sophisticated investors.

    Permalink2009-07-21, 18:11:18, by Mike Email , Leave a comment

    US investment strategists are more upbeat

    The firmer a price rally, the greater the enthusiasm. From their recent lows in March, share prices have rallied very quickly and very strongly. The US index the S&P500 is now up over 40% from its low and many investment strategists believe that it has more to go this year.

    Some factors that have added to investor enthusiasm over the last few months:

    • Federal chairman Ben Bernanke started talking about green shoots
    • Increasingly it looked as if a major credit crisis was being averted
    • Central banks continued to reduce and hold interest rates at very low levels.
    • Company result announcements started surprising on the upside.
    • Commodity prices have moved up on dollar weakness
    • The volatility index is down, an indication that risk appetite has increased.
    • China growth at 7,9% for quarter 2 annualised and foreign reserves over $2 trillion for the first time.
    • A composite of leading economic indicator improved in June

    Goldman Sachs, itself having boosted the market with its profit announcement last week, is now looking for improving earnings across corporate US and hence a further boost to equity markets into the second half. The S&P500 index to end the year at 1060, up 13% from its current level.

    They base this on operating earnings of $52 in 2009 and $75 in 2010. These estimates were raised from April of $40 and $63.

    Their preferred valuation model is the dividend discount model, which is how they arrive at their value for the overall index at over 1000.

    On a simple one year forward PE basis, the US index is trading at 12,5 times or an earnings yield of 7,9%.

    These earnings for US companies are not only very volatile, but there are so many nuances, which can distort dramatically. i.e. pre provision earnings, pre write downs.

    Looking back over a longer term perspective – 80 years –the one year forward estimate of the index earnings, the average has been 20 time. Now it’s down to 12,5 times.

    But averages can distort. At market lows, the one year forward has at times come as low as 8 and 10 times, which on this value metric would pull the index down to between 600 and 750.

    The investment strategists from both Deutsche Bank and JP Morgan are also very bullish for the balance of the year.

    The typical bias for these large house strategists is firmer markets and in some respects it becomes a self fulfilling prognosis.

    The local JSE ended up 0,5%. Gold shares bounced up 3% on the day. The rand firmed against the weaker US dollar. It was also firm against sterling and the euro.

    Kind regards

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

    Permalink2009-07-20, 17:10:34, by ian Email , Leave a comment

    Peter Peterson

    The Blackstone Group, listed at the top of the global markets in 2007 on the New York stock Exchange, in a very successful $4 billion initial public offering, made instant billionaires out of its 2 founders. In 2008, following the footsteps of other billionaires, he established a foundation with $1 billion.

    I listened to an FT interview with Peter Peterson, who according to Wikipedia was born 5 June1926, is an American businessman, investment banker, fiscal conservative, author, and politician whose most prominent political position was as United States Secretary of Commerce from February 29, 1972, to February 1, 1973 under Richard Nixon. He is the Senior Chairman of the private equity firm, the Blackstone Group. In 2008, he was ranked 149th on the "Forbes 400 Richest Americans" with a net worth of $2.8 Billion.
    Peterson was Chairman and CEO of Lehman Brothers (1973–1977) and Lehman Brothers, Kuhn, Loeb Inc. (1977–1984).

    In 1985 he and Stephen Schwarzman co founded the Blackstone Group as a mergers and acquisitions boutique and over two decades built it into one of the largest private equity investment firms in the world.

    The name is a cryptogram derived from the two founders’ names, with Schwarz German for black and Peter or Petra in Greek meaning stone or rock.

    The listing at the peak of the market was exceptionally well timed and they trumped competitors, private equity firm KKR.

    When asked by a FT interviewer on whether he would be long or short the following assets, these were his views.

    • US dollar - short
    • Oil - short over the long term
    • Gold - long
    • Goldman Sachs - long
    • China - long
    • US Treasury Bills - short
    • Print newspapers - short
    • State of California IOU - short
    • Manhattan Real Estate - neutral because he has conflict of interest

    In his memoir, Peterson outlined why he gave away $1 billion. This except from his autobiography, The Education of an American Dreamer, quoted by Newsweek.

    “In 2007 the company I cofounded, the Blackstone Group, held a most successful public offering. I found myself, at 81, an instant billionaire. I wish I could've called my father, a Greek immigrant who had spent most of his life running a 24-hour diner in Kearney, Neb. The news might have pleased him as much as my being the first Greek cabinet officer, which he never hesitated to tell perfect strangers. In the 1930s, when I was growing up, there was all this talk about millionaires like John D. Rockefeller and Andrew Carnegie. Now I was a millionaire 1,000 times over.

    But immediately I began wondering: what do I do with $1 billion? The idea of trying to make the money grow felt empty to me. For my father, who saved or gave away so much of his modest income, the ultimate pejorative was "big spender." So buying a yacht was out of the question. I was also struggling over what to do with myself. I would be retiring from Blackstone, but my mind was still sharp and my energy was good. As my work commitments diminished, the phones gradually stopped ringing. The e-mails slowed. My schedule had too many blank spots. I was liberated. I was free. But I was joyless. I found my new life to be a kind of metaphor for my declining years—one might say a slow dying. I missed the frequent interactions with people I respected and enjoyed. I missed being needed. So I started looking at the lives of other billionaires. Almost all the ones I most admired were major philanthropists: Warren Buffett, Bill Gates, Mike Bloomberg, George Soros, Eli Broad—each with a passion to do good, each getting so much pleasure from giving their money away. I decided that's what I wanted to do. But to which worthy cause would I direct my money?

    For the first time in my memory, the majority of the American people join me in believing that, on our current course, our children will not do as well as we have. For years, I have been saying that the American government, and America itself, has to change its spending and borrowing policies: the tens of trillions of dollars in unfunded entitlements and promises, the dangerous dependence on foreign capital, our pitiful level of savings, the metastasizing health-care costs, our energy gluttony. These structural deficits are unsustainable. Herb Stein, who served alongside me in the Nixon White House as chairman of the Council of Economic Advisers, once drily observed, "If your horse dies, I suggest you dismount." And yet, we keep trying to ride this horse.

    Underlying these challenges is our broken political system. Our representatives, unlike our Founding Fathers, see politics as a career. As a result, they are focused not on the next generation, but on the next election. When the long-term problems are large and real, they anesthetize us, mislead us, divert us—anything to keep us from giving up something or having to pay for it. Too often, our political leaders are just enablers, co-conspirators in a disingenuous and greedy silence. Our children are unrepresented.

    The future is unrepresented. The moment is long overdue for us to become moral and worthy ancestors. So I decided to set up a different kind of foundation, one that would focus on America's key fiscal-sustainability challenges. The fact is, for most of these challenges, there are workable solutions. Our problem is not a lack of such options. It is a lack of will to do something about them.

    Ultimately, I decided to commit $1 billion to the Peter G. Peterson foundation—the vast majority of my net proceeds from Blackstone. Why so much? Kurt Vonnegut once told a story about seeing Joseph Heller at a wealthy hedge-fund manager's party at a beach house in the Hamptons. Casting his eye around the luxurious setting, Vonnegut said, "Joe, doesn't it bother you that this guy makes more in a day than you ever made from Catch-22?" "No, not really," Heller said. "I have something that he doesn't have: I know the meaning of enough." I have far more than enough.”

    These are some good points to consider from this 83 year old.

    Have a fantastic weekend

    Regards

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

    Permalink2009-07-17, 17:45:55, by ian Email , Leave a comment

    Company pricing power

    While reading through the fact sheet and portfolio manager comments of a global fund, in which we have recommended our clients to invest, I was struck by one of their comments on company pricing power and the importance for sustainable returns.

    A key criterion that this global fund manager assesses when distinguishing good from poor earnings structures is pricing power. They said, “Nothing enhances the value of a company like gaining pricing power and nothing damages it as much as its loss”

    What is pricing power?

    It is the effect that a change in a firm’s product price has on the quantity demanded. Companies with high pricing power can steadily move up their prices with little to no impact on demand.

    Warren Buffett describes the importance of investing in businesses that can raise their prices “rather easily without fear of significant loss of either market share or unit volume.”

    In his 1981 shareholder report when inflation was running high in the US, Buffett mentioned that “… inflation acts as a giant corporate tapeworm, which pre-emptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism.”

    He went on to say that under those conditions a business earning 8% or 10% on equity often has no leftover for expansion, debt reduction or “real” dividends. I.e. inflation itself reduces real pricing power.

    The global environment

    Through the concerted efforts of central banks, a financial meltdown may have been averted but with the destruction of trillions of dollars of wealth, many industries have and will find themselves with little to no pricing power.

    There has been a massive shift in the imbalance between supply and demand, especially in the providers of capital goods over the last 2 years. China continues to expand its production capacity creating further supply increases.

    See the chart below on US capacity utilization, which is far below the lows of the previous 4 recessions and indicates that there will continue to be a lot of strain on pricing power for certain industries.

    In this type of environment with demand down and so much production freed up, many companies will struggle to enhance their pricing and margins.

    The portfolio manager in question tries to identify companies that have better than market pricing ability and those that will continue to be able to push up pricing. Many of these are being found in the international tobacco, food and drugs companies.


    Source: Wells Fargo Economics Group

    Relatively very attractive

    They go on to mention that in relative terms, the earnings yield of these consumer staple companies as a whole, compared to the yield on the 10 year bond, reflects these equities trading at a 30 year relative low.

    In the last few reports we have also mentioned this substantial relative value between earnings yields on equities and the yield on bonds.

    It is important that your funds have a higher weighting to stable earnings with some pricing power.

    Kind regards

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

    Permalink2009-07-16, 17:01:53, by ian Email , Leave a comment

    More on the Yale Endowment

    Last week we took a look at how the Yale fund has done post the release of the results to 30 June 2008, and at the asset allocation of the endowment and how it has changed over the past 5 years. Today we’ll have a closer look at the specific asset classes that make up the endowment fund.

    Superior performance has been achieved over time through allocating capital to cheap assets and selling assets that become overpriced. By looking at asset class expected returns, covariance’s of the various asset classes (a measure of the extent to which the returns on the various asset classes move together), and other techniques the committee come up with an ideal asset allocation, the will both protect capital to a certain extent but also grow in real terms over time.

    Over the last few days Ian has been looking at the pricing of various asset classes, in attempt to find where the value lies. Yale will employ a similar process across a broad spread of asset classes.

    While the committee’s asset allocation abilities are well known they also have been able to consistently beat their respective asset class benchmarks (i.e. their stock portfolio outperforming the benchmark index). In the management of the portfolio both qualitative and quantitative methods are used in an attempt to produce enhanced returns. Some techniques used for the various asset classes include.

    Absolute Return Funds
    Aligning interests between managers and Yale through implementing performance fees, with hurdles and claw-back provisions. They also ensure that the manager invests significantly alongside Yale.

    US Equity
    The University favours managers with strong bottom up fundamental research capabilities, and prefer those managers that follow a value approach to investing. Integrity, stable corporate environments, and sound philosophies are some of the qualitative aspects that are required.

    Fixed Income
    This is an asset class that Yale isn’t very attracted to due to its low expected real return (2%pa). Owing to the highly efficient nature of the bond market, Yale manages this asset class in house.

    Foreign Equity
    Here managers with similar traits to US equity managers are selected. Yale actively manages the allocation between developed and emerging markets, and also between the various countries, sectors, and styles.

    Private Equity
    Yale has been able to grow a stable of managers that are able to exploit market inefficiencies. Key traits of these managers are that they work closely with the companies in their portfolios in order to create fundamentally more value. Of secondary importance is financial engineering to enhance returns.

    Real Assets
    High transaction costs and the illiquid nature of real assets enable astute managers the opportunity to add significant value to the portfolios that they manage. Yale has created strong long term relationships with these managers to enhance value further.

    The result of these methods can be seen in the graphic below:

    At Seed we take notice of the methods used by successful managers. These methods are adapted to suit our clients’ needs. The process constantly evolves and is refined as improved techniques become recognised.

    Take care,

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

    Permalink2009-07-15, 18:36:03, by Mike Email , Leave a comment

    Long run dividend expansion

    Yesterday we discussed the concept of assessing all assets in terms of yield. Assets can be compared to one another on the basis of their yield, but there are differences. While some assets produce the same flat yield year after year, others grow their yield over time.

    All investors understand that an investment of R100 000 in a money market investment will provide a current yield of around 8% or R8000 in interest per annum. Assuming a withdrawal of interest at the end of year one, but a continuation of the investment, then, barring a change in interest rates, second and ensuing year’s income will be the same.

    Compare this to a property or equity investment

    Instead of investing at a fixed rate, a company will typically pay out a rate, which while not guaranteed, steadily rises each year. Over the longer run it’s this growth in a company’s earnings and dividends that drives the share prices up.

    In a similar way the rentals for commercial property are upward reverting. Contractually lease escalations tend to be set at 8% - upon expiry of lease agreements there will be some reversion to the spot market, which may be up or down.

    If we look back at the growth in earnings of all companies listed on the JSE we find the following.

    Across the JSE index the dividend level of 421 has grown over the 49 year to a level of 85160. This is an average compounded rate of some 11,3%.


    Over the last 40 years dividends have compounded by 13,8% and inflation has compounded at an average 9,8% per annum. Therefore average company dividends have grown by a real 4% over the last 40 years.

    On average an investor that starts with a company paying out a dividend on a yield of say 5% and potentially growing at a real rate of 4% into future years, should therefore expect a real return of 9% (5% plus 4%). This does assume a 10 years plus investment horizon.

    We can say that the average real return for listed equities on the JSE has been in the order of 8%, and therefore current values appear to be in line with long run averages.

    If you have any questions, please don’t hesitate to contact to contact us.

    For a copy of Seed’s latest market report, please click here.

    Kind regards

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

    Permalink2009-07-14, 17:59:40, by ian Email , Leave a comment

    Comparing earnings yields

    A very useful exercise is to compare all asset classes in terms of the yield that they have or are likely to produce. By reducing all assets to their yield, comparison of one asset class to the next becomes a lot easier.

    An investment into equities is volatile over the shorter period, not so much because company earnings are volatile, but largely because investors at times pay R20 for R1 of earnings and at other times for the same R1, are only willing to pay R5.

    Risk appetite is one factor that drives investors from pessimism to exuberance.

    Another factor is competing investments. Here the core competing investment and the one that all other investments are priced off is the interest rate on shorter dated money market to longer dated bonds.

    If we correctly view a holding in a company as an investment that will produce an income stream in the form of dividends plus reinvestment to produce higher future dividends, then we must assess the earnings yield.

    Earnings Yield at the company level

    A company such as Pick n Pay for example has a current price per share of R35. Over the last 12 months to February, the company produced headline earnings per share of R2,08. Shareholders benefited from these earnings by way of a dividend, with the surplus being reinvested for future growth. In the last year shareholders received a dividend of R1,70 from total earnings.

    The earnings yield for Pick n Pay is therefore running at an historical 5,9% - i.e. R2,08 / R35. An investor paying R35 is buying on a 5,9% historical yield and because earnings should move up, a slightly higher future yield.

    The average historical earnings yield across all companies from 1960 to date has been 9,6%. But at times investors have been very exuberant and prepared to accept a yield of as low as 5,5% (1994) while at other times been very pessimistic and demanding a yield as high as 20% (1982)

    Relative valuation

    At any point in time an investor should look at the earnings yield in absolute terms and in relative terms.

    If an investment into money market or a government bond can provide an investor with a yield of say 16%, then he should have a very good reason to accept a low yield on equities of say only 3 - 5%.

    If we go back and plot the relative chart of yields on equities, versus the yield on the 10 year bond, we can see that the times when the earnings yield trades at parity to the yield on the 10 year bond, has been indicative of good value for real assets.

    JSE yield / 10 year SA government bond


    Prior to 2003, the last time this occurred was in 1983. Earnings are coming off a high base though and the market is pricing in some fallback from this higher base.

    Don't hesitate to contact us if you would like Seed to provide holistic investment and retirement planning.

    Kind regards

    Ian de Lange
    info@seedinvestments.co.za
    www.seedinvestments.co.za
    021 9144966

    Permalink2009-07-13, 17:21:52, by ian Email , Leave a comment

    Corporate bonds

    Companies raise capital by issuing either equity or debt or a combination. Unlike in South Africa, globally the primary and secondary markets in corporate debt are very well developed. We all know what happened in 2008, especially into the second half as credit markets froze but into 2009 buyers of corporate debt have done well.

    In 2008 as the credit crunch hit, all forms of debt from supposedly AAA rated to junk status debt fell sharply as investors sold and yields moved up.

    But buyers of that same debt in 2009 at the far more attractive yields have seen fantastic returns as the yields came back. Returns for high yield bonds for the 6 months have been in the order of 28,6%.

    Over the same period investors favouring the safe haven US government bonds have seen losses of 4,4%.

    A hedge fund manager that has moved from being negative to positive on debt markets is the very successful John Paulson. Nervous in 2006 and 2007 on the debt markets where yields were at levels where investors were not being compensated for the risks, he went short. i.e. he sold financial shares and subprime mortgages etc.

    After the crash corporate bonds but especially higher risk junk bonds traded at say 40c or less in the dollar, which means that the potential returns jumped enormously. Risks were and remain high – many companies will default on their debt.

    General Motors was a prime example of a how debt holders have taken a bath as the company had to restructure its obligations via the bankruptcy route.

    Debt markets are ranked from investment grade to high yield or junk debt. Most institutions such as insurance companies and pension funds etc not allowed to hold the latter, which means that they become forced sellers where a corporate debt is downrated to junk status, putting further pressure on the price.

    The chart below reflects how these spreads widened out. In June 2007 yields on AAA bonds were trading at less than 1% above that of US treasuries. Junk bonds were trading at a spread of around 3%. These widened to 2% and 14% respectively, providing investors with opportunity to buy in at far more attractive prices.


    Source: econompicdata

    This year when allocating a portion of offshore portfolios to bond exposure, where possible we have tried to avoid allocating to pure sovereign (i.e. government bond) funds preferring funds with a wider mandate to invest into corporate bonds.

    If you would like Seed Investments to provide initial and ongoing investment advice on your total investment portfolio, please don't hesitate to contact us.

    Have a fantastic weekend

    Kind regards

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

    Permalink2009-07-10, 17:52:31, by ian Email , Leave a comment

    Global listed property

    Property is an investment class that many people considered very stable, and because prices only ever went up – a fantastic investment. The property enthusiastic would say, “Can’t go wrong with bricks and mortar”. But, as with most things in live when the crowd is leaning in one direction, its time to re-evaluate.

    There are many aspects to property including developing and selling property – which can be considered more akin to a typical business. Investors will typically look at buying commercial or residential property.

    Commercial property.

    In many respects commercial property in the form of either retail, office or industrial is a fantastic investment because:

    • the asset produces a steady monthly rental income.
    • the income is contractual in nature with leases running from 3, 5, 10, 15 and sometimes 20 years.
    • Landlords are often large stable companies providing security of the rental income.
    • Rental income in future years accounts for inflation either by way of contracted escalations or upward only revisions to leases.
    • Because of the steady and contracted nature of the income, it is generally advantageous to supplement owners equity with external bank debt and in this way enhance the return on equity.

    But the reality is that even with all these excellent underlying characteristics, property prices don’t and have not only moved upwards.

    A magnificent company or a wonderful asset class like property does not necessarily make a wonderful investment – it all comes back to the value.

    Prices for global property became expensive with investors prepared to sacrifice yield in the hope of making future capital gains. Given the higher values, property companies were encouraged to take on more debt and so when the global credit crunch hit, there was a rapid and severe reversal to the point where prices are now a lot more attractive.

    The chart below gives an indication of the severity of the decline – on average around 75% from its peak.

    Global property companies have, in many cases, been forced to raise equity through rights issues, lower dividend payout ratios, sell properties, and renegotiate long term debt, etc in order to maintain adequate cash flows and debt to equity ratios.

    These steps, especially the raising of fresh capital to shore up balance sheets has and will have a dilutative effect on existing shareholders equity.

    The reversal in price has now brought the yields back to levels which perhaps reflect the risk for investing into property and should be attractive enough to attract new capital to this equity class.

    We are looking at strategically increasing the allocation to global property.

    Kind regards

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

    Permalink2009-07-09, 17:21:22, by ian Email , Leave a comment

    The Yale Endowment Fund

    I recently downloaded the latest copy of the Yale Endowment, which reports on its performance for the year ending 30 June 2008. This endowment has produced consistently good absolute returns over the last few decades, the excellent growth and stability in returns can partly be attributed to strong market returns, but more importantly to the approach that their investment committee takes in investing in a wide range of uncorrelated growth assets. Further to this, they have been able to consistently outperform the relevant asset class benchmark returns through superior manager selection.

    For the period under review, the endowment returned 4.5% in USD, growing its asset base to some $22.9bn! The endowment now forms a critical part in the operations of the university, as it contributed 37.3% of Yale’s operating budget, up from 33% in the previous year, and 18% in fiscal year 1998.

    While the return to 30 June 2008 was excellent, Yale did announce that the return for the 6 months ended 31 December 2008 was approximately -25%! The global financial crisis that has spread to a global economic downturn didn’t spare the endowment as correlations of all growth assets moved closer to 1 (i.e. they all fell in unison). This negative return should be seen in comparison to global equity markets that were down over 35% (in USD) and currency weakness compared to the US dollar (sterling down 28% and euro weakening 12%). It will be interesting to see what the full year returns are when Yale releases their 2009 report (most likely in March 2010).

    As you can see from the chart below, the endowment has been slowly decreasing its reliance on the US equity market, as the committee realises that there are many other investment classes and regions throughout the world that offer better opportunities. You will also notice that their allocation to non ‘growth assets’ i.e. fixed income and cash has been reduced over the period of review.

    Also contrast the chart below to Yale’s endowment in 1988 which had an allocation of nearly 75% in US equities, bonds, and cash!


    This multi asset approach to investing is something that gets easier as the assets available for investments grow and the income requirement decreases, as many of these strategies require large initial investments and have poor liquidity (long lock-up periods). By being able to exploit these inefficiencies the Yale Endowment has been able to provide superior performance over time.

    Where possible we look to invest our clients into multiple growth asset classes. As mentioned above investment size and time horizon can restrict the implementation of the ideal investment allocation.

    We will take a closer look at the Yale Endowment in future reports.

    Take care,

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

    Permalink2009-07-08, 17:49:47, by Mike Email , Leave a comment

    Constructing an investment plan

    In the last 18 months with global economies coming under so much pressure, there have been numerous accounts of outright investment scams, ponzi schemes, debentures in default, property investment lock ups, private equity failures, etc, all of which have caused immense pain for the many “investors” in these schemes.

    I say “investors” because in most of these cases they have not made investments, but rather been attracted to various get-rich-quick schemes.

    An investor on the other hand will less likely be swayed by glossy brochures and promises of fantastic returns with little to no risk.

    An investor is the type of person that would rather spend the time assessing his total investment plan and construct what is known as an Investment Policy Statement. In essence such a plan is nothing more than a framework for all investment decisions and need not be that complex.

    Because an investment policy statement will set out your starting capital position, potential savings, target investment values at retirement, ideal asset allocation etc, investors who have gone to this trouble will not easily find themselves in the untenable position of having allocated half or more of their available capital to some scheme with a low possibility of return of capital, let alone a return on capital.

    A typical investment plan will set out along the following lines:

    • The long term required return and risk objectives. Example based on your total investments and expected capital at retirement you may only need to generate a long term real return of say 3% per annum.

    • From the analysis work performed above, the investment guidelines or longer term strategic asset allocation can be defined. I.e. knowing that you need a real 3% per annum, means that a 100% weighting to cash won’t work. On the other hand a 100% weighting to a start-up business in the form of unlisted, illiquid debentures is far too risky for the required return.

    • The broader investment policy including acceptable and unacceptable asset classes and investment vehicles, investment benchmarks, investment strategy, funding strategy etc. This will also extend to the specific implementation plan.

    • Portfolio monitoring, reporting and ongoing evaluation. It’s important to obtain clear, concise and aggregate information, which is compared back to the agreed investment strategy on a regular basis, ideally monthly.


    Because it is difficult enough to generate long run sustainable real returns, no investor can afford to put capital at unnecessary risk. One of the simplest antidotes is to spend some hours with an investment advisor that can structure a holistic plan of action.

    In the next week I will spend some time covering some of these points in a bit more detail.

    If you are perhaps one such investor that needs to take the time to consider a total investment plan, then please don’t hesitate to contact Vincent Heys on Vincent@seedinvestments.co.za

    Kind regards

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

    Permalink2009-07-07, 17:08:04, by ian Email , Leave a comment

    Some global ETF's cause investor confusion

    Globally exchange traded funds (ETF’s) have become very popular. But as with so many financial products, these start off relatively simple, but then move to become more and more complex. While they have not reached this country, globally more and more geared and short ETF are being launched.

    Locally investors have a range of funds including the Satrix 40, Zshares Rand play, Deutsche Bank World, Japan, Euro etc, Rafi etc. But these are all long only funds, i.e. they track the upward and downward movement of a selected index or portfolio of shares.

    The first exchange traded fund was the SPDR S&P500 ETF, which tracks the total performance of the S&P500 index. Its symbol is SPY and it trades on the American Stock Exchange. In recent years there has been tremendous growth into leveraged and short ETF with this growth reflected in the total value in these products escalating from $4,7 billion in April 2007 to $30 billion in April 2009.

    What are geared and short funds?

    While we don’t have access to such funds in South Africa, internationally a company called Pro Shares has recently filed to launch leveraged funds on the S&P500. It has recently filed to launch a fund that will provide a 300% exposure, i.e. 3 times exposure to the daily returns on the S&P500 index.

    In addition to launching long geared index tracking funds, it is also looking to launch a short version that will give investors 300% short exposure to the index.

    There are already 1,5 and 2 times geared products available in ETF form.

    While supposed cheap relative to traditionally managed funds, this is not always the case. These new ProShares will have an expense ratio of 0,95% and will trade on the New York Stock Exchange.

    Unlike a long only ETF, the geared and short funds access exposure to the underlying indices by way of derivatives, tracking is not always perfect and the return that the investor receives is not always what they expect, which has caused a lot of confusion. In addition to tracking, the compounded return over a longer period of time may not always be what the investor envisaged.

    Example: An investor in a short twice geared product, where the underlying index, say the S&P500 moves down 1% in a two days, would expect to make a positive return of 2% – being trice short the index. But this may not necessarily be the case – it depends on the compounding effect.

    The example below reflects that even though the investor was short the market, he made a loss greater than the index, which is clearly not what he expected. This is where the confusion is coming into for many unsophisticated investors into these products.


    Source: indexuniverse.com

    It is only a matter of time before these products are launched locally. As with all investments it is extremely important to make sure that one understands the detail. This is where even with supposedly simple products like ETF, an investment advisor is paramount.

    Kind regards

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

    Permalink2009-07-06, 17:42:57, by ian Email , Leave a comment

    Adcock Releases Interim Results

    Yesterday saw the release of Adcock Ingram’s interim results for the 6 months ending 31 March 2009. Adcock has been around for a long time, having been founded in Krugersdorp some 116 years ago! It is now a major local player in the prescription, generic, and OTC market and provides other products and services. From humble beginnings the company has grown considerably, and is currently valued at R 7.7bn.

    Adcock was unbundled from the Tigerbrands stable last year in August, and since then the share price has performed strongly, moving up over 30% during the same time that the ALSI is down over 14%!

    In the period of review Adcock was able to increase turnover by 23% and declare a maiden dividend of 70c a share. Investors will be hopeful that another dividend will be declared at year end. A year end dividend declaration of 70c would result in the company trading at a dividend yield of 3.15%, which is lower than the market, but to be expected of a pharmaceutical company. Pharmaceuticals are typically considered growth shares and therefore trade at a premium to the market.

    Adcock has been able to grow turnover and profits (7%) over the period, but the company has also felt the pinch of the recession, as margins declined by 8% to 49%. This is still a good margin when compared to other industries. Adcock is able to retain a high margin owing to the large barriers to entry that companies in this sector enjoy, and also partially explains why it trades at a premium to the market.

    In addition to the results released yesterday, Adcock this morning announced that the DTI has approved certain capital expenditure to qualify as strategic industry project expenditure. This program has been rolled out by government to encourage capital expenditure in strategic industries in an attempt to stimulate the economy. Companies are incentivised to participate in this program by being granted tax relief. In Adcock’s case the tax relief will amount to approximately R128million over four years, but the company aims to fully utilize this allowance in three years.

    Despite being a sizeable company, Adcock is still much smaller than Aspen, which has a market cap north of R 20bn. The other listed pharmaceutical company on the JSE is Cipla, but it only accounts for approximately 5% of the pharmaceutical index. Adcock previously attempted to purchase Cipla, and made a firm offer as recently as 9 April of this year, but problems arose with Cipla’s principal supplier, and Adcock subsequently withdrew their offer. Adcock’s board believed the offer was beneficial to both parties.

    Enjoy your weekend. Good luck to the Springboks tomorrow!

    Take care,

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

    Permalink2009-07-03, 17:36:27, by Mike Email , Leave a comment

    Valuing a company

    We spent some time with a fund manager that concentrates on listed property today. With prices of listed commercial property across the globe having fallen dramatically from their peaks, it does now appear that value is reasserting itself. For many investors there remains a big question mark as to how values for listed securities are derived.

    A price of a listed company or listed property fund may be a function of supply and demand in the shorter term, but ultimately the fundamentals will rule price.

    Unlike a technical analyst who is not really concerned with the underlying value, a fundamental analyst will want to try and independently establish a value for a particular security and then compare this derived value to the traded price. In this way he can try and make an assessment of whether the traded price appears cheap or not.

    Because there are so many variables, such as interest rates, levels of debt, fluctuations of future income streams, margins etc, the true or fundamental value of an asset is not necessarily one specific price, but more than likely falls into an upper and lower range.

    At its most basic, the value of an asset today can be determined by making an assessment of future cash flows that the asset will generate and then discounting these future income streams at the required rate of return to obtain a net present value.

    Investment professionals doing the analysis will typically make use of multiple valuation metrics to try and understand the values that they are buying into. These may include:

    • Absolute value models will look at a specific company or property for example, make an assessment of future returns and discount these back to a present value. A simple, but well known model is the Gordon Growth model – see below.

    • Relative value models will look at one asset class relative to another. Example the value of local listed property versus offshore listed property.

    • Composite models. Some companies may have an aggregate of excess cash on the balance sheet, different industry trading entities as well as stakes in other listed local or offshore businesses. In these cases it will be best to first isolate the cash and value the traded price of the listed stake before separately valuing the trading operation.

    The Gordon growth model is ideal for a business that pays out steadily increasing dividends. On the assumption that such a business with pay out a steadily increasing dividend into perpetuity, an indicative value can be derived as follows:

    The model is quick and easy before delving into aspects such as gearing, management, quality of earnings, cyclicality of earnings etc

    An example may be Pick n Pay with an expected 210c in dividends and assuming a required rate of 15% and dividends growing at say 10% per annum from here on out (3% ahead of inflation of 7%). Using this formula the indicative value for the shares is R42. The price trades at 3460c.

    Kind regards

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

    Permalink2009-07-02, 17:43:57, by ian Email , Leave a comment

    Asset Class Returns – Year to Date

    When making strategic investment calls, the performance of asset classes over short periods shouldn’t have much impact on your decision making process. The more important factor on a strategic level is ensuring that you get your long term asset allocation correct. But while short term movements aren’t important for strategic purposes, they certainly can impact tactical decisions.

    The returns at the end of June do mask the extreme volatility that we have seen so far this year, and it is therefore probably better to include a graph of the four main South African asset class returns for the 6 months to 30 June 2009 as opposed to just their returns over this period. They are equities (proxy’d through the ALSI Total Return, property (SA Listed Property Total Return), bonds (ALBI Total Return), and cash (STEFI Call Deposit).

    Most striking is the extreme volatility that we have seen in the equity market. Bonds have struggled so far this year on the back of inflation not falling as quickly as expected towards the end of last year. Remember, this time last year we had the report coming out from Investec to say that inflation would be much lower than was stated if Stats SA used the methods and weightings that came into use at the beginning of this year. Bonds then enjoyed a significant rally over the second half of 2008, but have faced some headwinds this year as inflation has remained stubbornly high, and the threat of increased issuance has increased due to a drastically weakening economy.

    Property has performed in between that of equities and bonds, and this should come as no surprise. Property takes on characteristics of both bonds (high income stream) and equities (growing income stream), and is often referred to as a hybrid between the two. Cash has been the top performing asset class of the four, but with rates coming down we have already seen, and will continue to see the returns from cash becoming more muted moving into the future.

    Perhaps the biggest move in these 6 months has been the rand which has strengthened against the US dollar, euro, and sterling in this period, and its appreciation against the dollar and euro has been particularly strong. The chart below shows how the rand has appreciated by almost 20% against both the dollar and euro since the beginning of the year.

    As investment managers we need to sit down, and not focus so much on the price action that has just occurred (although we will look at it in order to perform our attribution, and may offer us better entry/exit points), but rather focus on what the current prices are telling us about asset class valuations. We’ll then look to buy those assets that are cheap, and sell those that are expensive. It may sound straight forward, but we can assure you that it’s anything but.

    Take care,

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

    Permalink2009-07-01, 17:50:15, by Mike Email , Leave a comment