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    Inflation linked bonds

    Investors in conventional bonds issued by government will receive fixed interest payments and a final redemption payment in the future, but inflation linked bonds, introduced in South Africa in 2000, pay a guaranteed real yield and an inflation linked redemption amount.

    The holder of a conventional bond takes the risk that inflation will escalate beyond the fixed return of the bond, resulting in the total return on the bond falling below inflation.

    This risk can be eliminated with an inflation linked bond paying say a 2,5% real coupon rate. This means that the investor derives annual interest payments equivalent to inflation plus 2,5%. The redemption is also inflation adjusted to take into account cumulative inflation over the life of the bond.

    While inflation adjusting may sound like a fantastic investment, there are some pitfalls that investors need to be aware of:

    • Inflation linked bonds are not as liquid as traditional or conventional bonds. This is not normally a problem for private investors.
    • The official inflation rate may not adequately compensate investors for their personal inflation rates.
    • There is a lag time in adjusting the rate for inflation of up to 4 months. This is beneficial to the investor in a declining inflation environment and vice versa.
    • Market forces may adjust the pricing of bonds so that over shorter periods of time investors don’t necessarily receive an exact inflation adjusted interest coupon.

    Let’s look at this last point in the context of the US scenario where the equivalent TIPS (Treasury Inflation Protection Securities) were introduced in 1997.

    Over this period the official average quarterly US inflation has been 0,62%. The average quarterly return for the inflation bond index was 1,66%. Therefore these inflation linked bond returns have beaten inflation by 4,5% per annum.

    But because the total return from an inflation linked bond has 3 components, there can be and are periods when the total return is negative, even while inflation marches on. The 3 components to total return are:

    • The initial real coupon, which is the coupon or interest rate set for the life of the bond.
    • The inflation component, adjusted periodically
    • Price change as the bonds trade, depending on demand and supply.

    As with most traded investment securities it’s the daily, weekly and monthly price fluctuations that are the most volatile component of total return.

    The graph below reflects quarterly inflation compared to the quarterly returns from inflation linked bonds in the US. Over the extended period investors were protected from inflation but on a quarterly basis they may even have suffered a negative loss.

    It was found that the total return from these inflation linked bonds failed to outperform inflation in 17 of the 49 quarters.

    Source : Barclays Capital and TIAA-CREF

    Even so-called low risk investments such as bonds and inflation linked bonds suffer volatility over shorter measurement periods. Investors should be careful not to buy these as low risk investments in the mistaken belief that they only move up.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-31, 16:46:41, by ian Email , Leave a comment

    Murray and Roberts

    Murray and Roberts is the dominant construction and engineering company in South Africa with a market capitalisation of R17 billion. The company has had a long history, founded in 1902 and listing on the JSE in 1948.

    It operates across 7 main divisions, including Engineering, Construction SADC, Middle East, Construction Products, Cementation, the Clough division and then Investments.

    Revenue generation increased 26% to R33,7 billion for the full year, but unlike in the past 2 years which saw higher revenue recognition in the second half, the second half of 2009 was off 8%.

    Overall the company is coming off a very high base of contracts and so while earnings from continuing operations increased 14% to R2,2 billion from R1,9 billion the big question is how will this play out in the future with a reduced order book.

    Construction accounting and how revenue and profits are recognised is a lot more difficult compared to a business like MTN or a Shoprite. Long term projects running over multiple years with payments at various stages makes the calculations that much more complicated.

    The cash flow statement therefore becomes very important to look at. Here we see that the increase in working capital of R1,3 billion and the capital expenditure (capex) of R2,4billion took a total of R3,7 billion out of the business.

    In the 2 previous years this was far lower with each of 2007 and 2008 producing a positive cash flow at the working capital line.

    However the group financial director, Roger Rees pointed out that the group was now well positioned in terms of new capital expenditure and that capex should reduce by at least R1billion in 2010 and run at around R1,4 billion for the next 2 years.

    The net cash outflow saw the company end with net cash down from R4,3 billion to R2,9 billion. This will impact future earnings because depreciation which was running at R0,5 billion in 2008 and R0,8 billion in 2009 will move up to at least R0,9 billion plus in 2010.

    The general expansionary global construction phase saw the group’s order book swell to R61 billion in September 2008 from a previous R20 billion in 2007 and R10 billion in 2006. This has now contacted back to a current R40 billion, with 46% due for completion in 2010.

    Source : Murray and Roberts

    Margins have been expanding as the order book increased. Margins for 2009 came in at 8,6% while the company earned a 38,6% return on average equity. The chart below reflects how this return on equity is cyclical and at these levels is the highest since at least the early 1960’s.

    Offshore is playing a bigger and bigger roles in earnings with 35% of revenue generated offshore but close to 40% in operating profit and because of the lower tax regimes and the assessed loss of R1 billion in the Clough business, on an after tax basis its closer to 50% being generated offshore. Rand volatility therefore becomes a bigger factor when converting offshore profits.

    Source : company reports and Allan Gray

    The share price jumped 5,8% to 5180c. It appears cheap on an historical price to earnings ratio of 7,7 times and a dividend yield of 4,2%. The big factor going forward is whether it can continue to price in these higher margins on projects and thus sustain the high return on equity.

    That’s it for today – have a wonderful sporting weekend

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-28, 17:18:07, by ian Email , Leave a comment

    Imperial results

    I attended Imperial’s management report back to the investment analyst society today in order to start gaining an understanding of the nature of business conditions. Larger groups have multiple divisions, which are each differently affected by the economic slowdown.

    The company released annual results yesterday and these were dissected by management, led by CEO Hubert Brody.

    Operationally the business operated in a difficult environment, but from a cash generation perspective, it did extraordinary well. After having fallen to a price of R40 from over R160, the price has recovered back to R80, but fell 2,7% to 7598c today.

    The R16 billion market cap company had a turnover of R52 billion, but margins down to 4,7% resulted in operating profit at R2,4 billion.

    Imperial has a number of divisions, logistics, car rental and tourism, distributorships, motor vehicle dealerships and insurance.

    After tax profits came in at R1,1 billion down from R1,4 billion, but cash flow for the business was strong with operations generating free cash flow of R2,9 billion, largely due to improved working capital management. This figure was R1,8 billion in 2008.

    Over the last 2 years the business has therefore retired debt which stood at R11 billion to the current net debt (i.e. after cash on the balance sheet) of R5,1 billion. Imperial largely being an asset based company has traditionally run at higher debt to equity levels. In June 2008 the net debt to equity ratio stood at 81%, now this ratio is at 50% with the target being 60-80%.

    In other words it’s running at below the lower band, but this is probably correct in the current environment. Even at 50% this is fairly conservatively.

    In terms of the balance sheet management, management will want to be more expansionary in lighter asset based businesses with higher returns and margins, such as logistics, tourism and selected financial services. Part of the thinking is that while this may be initially more expensive to buy, their organic expansion does not require as much capital injection and this should be enhancing for return on committed capital.

    While dealerships and distributorships contributed 56% of turnover they only contributed 31% of profit. The SA logistics businesses at 19% of sales contributed 29% of operating profit. As with most divisions the second half of the year was much weaker than the first half. This division produced R738m for the full year.

    Car rental and tourism produced R336m in operating profit with an improvement in second half.

    Distributorships and dealerships, where there has been a lot of pain due to the collapse in the new car sales market, produced profit of R770 compared to R1,2 in previous year.

    The insurance business, Regent Group improved profit from R227 to R315 with the second half up massive 209%, but this included profits on investments. Underwriting profits are however improving off a low base.

    Overall this was a good result and management is convinced that at the current level of car sales their dealerships and distributorships are at the right size having being scaled back. The balance sheet has fair gearing. They are looking for Regent to be more outwardly focused after a period of consolidation.

    The car sales business will continue to be difficult given that banks are not financing at present. But should this pick up then there is the benefit of operational gearing. I.e. a lower cost base with boosted sales has a geared impact on the bottom line.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-27, 17:29:23, by ian Email , Leave a comment

    Growthpoint Results

    We have been discussing the results of quite a few companies over the past while as results for the period ending 30 June 2009 continue to be released. This full and half year results are particularly interesting as they have been achieved under generally tough circumstances. If you recall the ALSI peaked in May last year, commodity prices the following month, and inflation soon thereafter. Since then while inflation and more recently interest rates have come down, so has both local and global economic growth rates.

    By way of background, Growthpoint is the largest company in the SA listed property index (i.e. listed property companies excluding Liberty International) and is slightly bigger than Redefine. They own a broad range of some 438 properties in the retail, industrial, and office sector.

    Some of their larger retail properties are the Brooklyn Mall (Pretoria), La Lucia Mall (Durban), Constantia Village (Cape Town), Walmer Park Shopping Centre (PE), and Beacon Bay in East London. This quality portfolio has allowed Growthpoint to revalue their portfolio upwards by 0.6% to R29.2bn, despite prices generally dropping. While growing in nominal terms their portfolio would have suffered in real terms.

    Highlights for Growthpoint over the 12 months in review include:
    • Managing to grow their distribution by 7.6% to 114.6c per linked unit.
    • Inclusion in the ALSI Top 40.
    • Good liquidity as over half the shares traded hands during the year.
    • Foreign shareholding increasing to over 6%.

    A key area of concern will be the increase in vacancy levels over the last 12 months. At 30 June 2008 vacancies were at 2.9%, and this level has moved up to 5.4% (an increase in 86%). While the 2008 level was at historically low levels, and the 2009 level isn’t too bad, the concern for all listed property companies must be where the level finally ends up. Increased vacancies have a direct impact on the level of distributions that the company is able to declare. If vacancies increase too much we could see a drop in distributions in the future.

    While vacancies are rising, Growthpoint has continued to spend on new developments, with over R1.5bn spent in the financial year. They have been developed with decent expected initial yields, but these calculations are premised on them achieving the targeted letting levels which will be under pressure.

    A major reason for local listed property companies holding up so well when compared to their offshore counterparts has been the conservative loan to value (LTV) levels that these companies have been trading at. Many offshore REITS had LTV’s upwards of 60%, which increased rapidly as property values came under pressure. Growthpoint managed to decrease their LTV over the 12 months from 34.4% to 32.2%, which is a conservative level.

    Local property companies are in much better shape than their offshore counterparts, but when putting our investment hats on we feel that offshore property offers much better value.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2009-08-26, 18:33:42, by Mike Email , Leave a comment


    In yesterday’s report I noted how over the weekend US Federal Reserve chairman, Ben Bernanke had put himself and other central bankers in a good light, essentially saving the global economy from a collapse by stepping up to the plate with bucket loads of liquidity. Today it was announced that Obama awarded him a second term, subject to Senate confirmation.

    Back home local food retailer Shoprite released very good results that were ahead of expectations, but still the share price dropped 1,8% to 5755. This places it on an historical PE of 14,7 times, so ahead of the market ratings.

    The current consensus EPS was 342c and dividends of 185c, but results came in with EPS at 390.8c and the full year dividends at 200c.

    The dividends were upped from 155c in 2008 – a 29% hike.

    Turnover for the group was up 24,5% to R47,6 billion and trading profit up 28,1% to R2,9billion.

    While gross margin decreased slightly from 19,9% to 19,3%, the trading margin increased due to good cost controls and greater efficiencies from 4,82% to 4,96%. This level is the highest ever for the company. The return on equity is running at 41,5%.

    The company produced this information which is a benchmark of its margin against the average international player. It is producing similar operating profit margins on lower GP margins.

    Source: Shoprite

    Stock at year end sits at R6 billion, up 28% due to 59 net new supermarkets and 28 furniture stores.

    Cash on hand at year end was slightly down at R2,8 billion.

    The company benefited from consumers generally trading down in the food purchases from more premium brands like Pick n Pay and Woolies to Shoprite.

    Growth ahead of the market saw the company take market share and increase this to a very high 30%

    Interestingly the group earned R1,2 billion in other operating income, up 26% from 2008. This includes finance income of R198m, net premiums received of 215m, commission received of R278m, operating lease income of R201m etc.

    Going forward management noted some concerns, including:

    • No substantial evidence that the country is moving out of recession.
    • The increasing number of unemployed now over 9 million
    • Governments poor tax take and ability to support poor
    • Lower food inflation now running at 7,4% will also impact performance

    Over a long period of time, the share price has tracked the solid performance. Naturally in a tougher economy its going to be more difficult from this very high base established, but the expansion into Africa is a benefit to this company, which sold 105m litres of Coke in the year - enough to cover more than 1000 soccer fields.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-25, 17:28:33, by ian Email , Leave a comment

    Central bankers unite

    Central Bankers met this past weekend in Jackson Hole Wyoming. The agenda assessed the monetary and fiscal policies enacted over the past year. Chief of global central bankers is Ben Bernanke, US Federal Reserve chairman. His speech was titled, “Reflections on a Year of Crisis.”

    His global colleagues were in agreement that there was unlikely to be a rush to reverse the stimulus that central banks have provided to the global financial situation.

    A year ago they met just before the collapse of Lehman Brothers. Now from reports and speeches, it seems that the central bankers are the ones patting themselves on the back for a job well down in helping avoid a total financial meltdown in 2008/9.

    His speech outlined some of the major milestones in the financial crisis since their meeting 12 months back, including:
    • The placement of Fannie Mae and Freddie Mac into conservatorship.
    • Securing $85 billion line of credit to AIG
    • Approval of conversion of Morgan Stanley and Goldman Sachs to bank holding companies.
    • Bank capital injections and the extension of deposit insurance
    • Commitment of Federal Reserve to provide liquidity as necessary
    • Bringing the federal funds rate down to a target of 0% to 0,25%
    • Having Congress approve $700 billion TARP (Troubled Asset Relief Program), to provide emergency funding to large banks.
    • Having the Fed buy up long term debt from financial institutions, so as to help unfreeze financial markets.

    He noted that the case with Lehman Brothers proved exceptionally difficult, but because of a lack of resolution from the government and because the Federal Reserve could not make an unsecured loan, they were unable to save the bank, but had to concentrate on mitigating the fallout.

    He continued saying that the financial crisis had elements of a classic panic, particularly during its most intense phases and this helped to motivate a number of Federal Reserve policy actions.

    Because of this panic scenario the Fed and other central bankers provided large amounts of short term liquidity to financial institutions. This did not solve all the problems, but helped restore confidence of investors and promote stability.

    He concluded saying, “The world has been through the most severe financial crisis since the Great Depression." But he continued, "As severe as the economic impact has been, however, the outcome could have been decidedly worse. Without these speedy and forceful actions, last October's panic would likely have continued to intensify, more major financial firms would have failed, and the entire global financial system would have been at serious risk.”

    There is a strong case to be made that the seeds for this last financial crisis were actually sown by his predecessor, Alan Greenspan, who took interest rates down to the then new low of 1%, which sparked a run in credit expansion, culminating in the crisis.

    Now in an attempt to get the world out of the mess, interest rates are again one of the main tools used and these are at even lower lows.

    Kind regards

    Ian de Lange
    021 9144966

    Permalink2009-08-24, 17:51:32, by ian Email , Leave a comment

    Due diligence on private investments

    Because the investment returns from a private equity investment are often far superior to that of a listed investment, these are many aggressively marketed in various forms. At face value the investment offers appear attractive, often with a tantalising possibility that the entity being invested into will list on a stock exchange at a time in the immediate future - as if this is a guarantee of an immediate substantial profit.

    When these offers and even seemingly mainstream offers are received, one should apply a large dose of common sense and some due diligence questions, before parting with any capital.

    Some questions that should be asked:

    • When and how will I get back my money? Remember a share in a company is sunk capital – it is not a loan with repayment terms. The typical way of receiving back cash is by selling shares to a buyer. A stock market facilitates secondary trading in shares, but does not guarantee any liquidity.

    When shares are not listed on an exchange the liquidity declines dramatically and share owners, especially minority shareholders, may never have an opportunity to sell out to a third party.

    • Who is the seller? Many times this is also not that clear and before parting with any funds, this is absolutely critical. An investor may believe that he is making an investment directly into a company, but perhaps he is transacting in the secondary market – i.e. purchasing shares from an existing seller.

    • How was the price of the shares determined and how many shares will be in issue? Many, many times I have seen prospectuses where the original founders of the business allocate millions of shares to themselves at virtually no cost, but then shares to the public at say R2 a share.

    Because a nominal R2 appears cheap, the investor incorrectly assumes that its good value. However when calculating the inferred valuation of the business, one must multiply the total number of shares in issue by the issued price.

    A case in point is a recent unsolicited offering made in unlisted company Platfields for shares at a price of R3,20 a share. This appears cheap, especially in the light of possible future prices, but when looking at the implied value of the company, with over 436m shares in issue, this comes in at a massive R1,4 billion.

    • How does this valuation compare to listed, established and liquid competitors? While there may be a good opportunity for growth with an unlisted investment, unless there is a high degree of receiving back your capital, it is advantageous to consider the risk versus reward payoff of a listed competitor company.

    I hope that these few questions may help and may even trigger of other questions that you can ask.

    Have a wonderful weekend

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-21, 17:38:31, by ian Email , Leave a comment

    Mondi Releases Interims

    Mondi released their interim financial results earlier today. Mondi operates in the paper industry that has had excess capacity for quite some time now. There has been a gradual consolidation of the industry (with rival Sappi buying out a competitor with the sole purpose of shutting it down) and as the industry consolidates, so the capacity should reduce to more normal levels. A big concern is the east, who could increase capacity in an attempt to gain market share. We know that China in particular can often pay scant regard to profitability in an attempt to get foothold into industries.

    An industry that is facing tough internal issues, that has had weak demand, and then is also exposed to a global economy that has entered a recession is bound to be hit on the bottom line.

    This hardship can be seen in some of the headline figures:
    • Group revenue down 20% to EUR 2.6bn.
    • Earnings Before Income Tax Depreciation Amortisation (EBITDA) down 32%.
    • Reported loss of EUR 1mn, down from a profit of EUR 171mn.
    • A reduction in the dividend per share to 2.5c from 7.7c (but at least still maintaining a dividend)
    • The Group’s Return On Capital Employed (ROCE) is also down in the magnitude of 33% (from 11.1% to 7.4%).

    These are some fairly dire performance numbers, but should be viewed in the context of the environment in which they have been produced. Mondi has been focussing on survival so that they are able to participate in any recovery that comes their way.

    Some of the positive highlights include:
    • Net debt not changing materially (up to EUR 1.66bn from EUR 1.65bn, but down EUR 29mn since the end of December) in an environment where competitor Sappi had to do a rights issue.
    • Cash flow from operations improving by 26% to EUR 392mn.
    • Costs savings of EUR 109mn year to date (full year target of EUR 180mn).

    These efforts are clearly a ‘belt-tightening’ exercise which Mondi believes is the best way to go in current market conditions. Quoting Group Chief Executive David Hathorn in the half yearly report

    “We believe the decisive actions taken to reduce capacity, lower the overall cost base and optimise cash flows, coupled with our high-quality, low-cost asset base leave us well positioned to benefit when market conditions improve.”

    The Ltd quoted share ended the day up 2.81%, while the Plc was up only 0.52%. This compares to the ALSI which was up 1.41% today.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2009-08-20, 17:57:46, by Mike Email , Leave a comment

    Global State of Affairs

    Economies around the world have been assisted since the end of last year by co-ordinated government assistance. Governments did everything in their power to avoid the pending deep recession becoming a depression. By and large this has been achieved, with a few large economies now technically out of recession. France, Germany, and Japan announced 2nd quarter GDP growth in the past week.

    Much of the optimism has centred on terrible data ceasing to be as bad as initially predicted, and not from strong growth data. Various stimuli packages from tax cuts, to incentives from government to keep idle workers employed, to a multitude of buy back programs have provided an impetus to global stock markets.

    This has further increased risk appetite around the world with emerging market bourses and currencies performing better than their developed market counterparts since the beginning of March. We have also seen the spread between emerging market bonds and US treasuries declining on the back of money flowing into this asset class.

    Clearly the stimuli packages have worked in that they have stimulated the various economies in which they were implemented, but as the word suggests, these packages were merely a stimulus, and not a complete solution. The stimuli can only help so much, and then the economies need to start running under their own steam. This process can be likened to trying to start a fire. You require a match (stimulus) which will get the fire (economy) started, but for you to get a meaningful flame (economic growth) you require fuel (economic activity) of sufficient quality and quantity. And just like holding a match waiting for the flame to catch, the holder (in this case government) will get burnt if they fail to withdraw the stimulus in time.

    Only time will tell if governments are able to withdraw the liquidity in time to prevent them becoming too indebted, which will put a massive burden on future generations. At the same time withdrawing the stimulus too soon could result in another recession, in what is often termed a ‘double dip’. A double dip is when a country enters recession for a period before it technically ends (i.e. the economy experiencing a quarter of positive GDP) only for it to fall back into recession as the economic recovery fails to take hold.

    Germany is possibly at risk of double dipping as many companies will be required to roll their debt at the beginning of next year (i.e. retire old debt and issue new debt), which they could find difficult with weaker balance sheets and tightening lending standards from the bankers. Drying up of credit will spell the death knoll for many companies.

    Warren Buffett recently mentioned in today’s New York Times column that the US stimulus was necessary to avoid a deeper recession but warned that the side effects of this ‘medicine’ could be worse than the initial problem if not managed effectively.

    Herein lies the conundrum that all policy makers face. Remove the match too soon and fail to get a sustainable fire going, or remove the match too late and burn your fingers.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2009-08-19, 17:18:53, by Mike Email , Leave a comment

    The Chinese stock market

    The Chinese market, both real and financial is playing an increasing role in global markets. The sharp decline in the last few weeks of the Shanghai index seemed to have an impact on risk aversion across the globe. The question now – Is the effect of government stimulus starting to fade?

    We have discussed the extent to which the government has provided stimulus to the local economy. The stockmarket benefited enormously from the end of 2008 until the beginning of August.

    The 3 stock exchanges operating in the Peoples Republic of China are the Shanghai, Shenzhen stock Exchange and the Hong Kong Stock Exchange.

    Together the Shanghai and Shenzhen stock exchanges list over 1500 companies, with a market capitalisation of around $2,6 trillion in 2008.

    The SSE Composite (also known as Shanghai Composite) Index is the most commonly used indicator to reflect SSE's market performance. The constituents for this index are all listed stocks (A shares and B shares) at the Shanghai Stock Exchange.

    Some of the largest Chinese companies as ranked using sales, profits and assets by Forbes include:

    • PetroChina
    • ICBC
    • China Telecom
    • Sinopec-China Petroleum
    • Bank of China

    The government stimulus and extended credit helped propel up share prices with the SSE index gaining some 100% from November 2008 to the beginning of August. It then promptly shed 17% to Monday’s close.

    This morning the index gained 1,4% and global markets started to move up. The JSE ended up 0,76%, Europe ended up and the US is up.

    Over the years there is likely to be a steady shift in the relative weights of economic power from west to east. China must be on the radar screen of all investors.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-18, 18:08:06, by ian Email , Leave a comment

    Unnecessary investment risk

    The Financial Advisory and Intermediary Services Act (FAIS) Act is now almost 5 years old and still the number of investment related problems persist. Many investors seem to be perplexed that the law is not eliminating these problems, but I noted at the outset of this act, that it would not be the panacea that some were hoping for.

    In some respects FAIS was eventually introduced in an attempt to try and avoid a repeat of the Masterbond type debacle that occurred in the early 1990’s.

    There is no doubt that FAIS has introduced a fairly high level of compliance, but as with most law – there is only so much it can achieve as it caters for the lowest common denominator in a very broad industry.

    Investors should look to deal with managers who consider the laws as the minimum requirement.

    The Weekend Argus reported on the failure of King Financial, which was apparently placed in liquidation. The company appears to be a hybrid between a financial advisor and itself a private equity play. A July article in Finweek warned investors about investing into its unlisted shares that it was supposedly flogging to its own investors.

    Other recent investment frauds and investment failures include

    • Fidentia
    • Corporate Money Managers
    • Tannenbaum
    • Dividend Investments.

    Let’s be clear – there is always risk when making an investment. A deposit into a bank account or a money market account carries risk. But it is important to distinguish between the various risks, and where possible reduce or mitigate against these.

    Listed and regulated investments do not automatically convey low risk when compared to unlisted or unregulated investments.

    As investment advisors and managers, we categorise and try and assess the various risks on behalf of our clients.

    • Investment risk can be defined in terms of not meeting your long term investment objective and by losing capital over the short to medium term.

    • Custodian or institutional risk is the risk that we are talking about. This risk can’t typically be quantified. While the percentage may be low, when it does occur, it has the possibility of seriously damaging a large portion of an investor’s wealth. For this reason, we pay particular attention to this risk in terms of the various custodians and counterparties used.

    • Other risk classifications include reinvestment risk, credit risk, currency risk, and liquidity risk.

    Kind regards

    Ian de Lange

    021 9144966

    Permalink2009-08-17, 18:06:09, by ian Email , Leave a comment

    Government finances under pressure

    There is no doubt that global economics continue to puzzle both the layman and professionals alike. On the one hand are many positive signs that the worst may be over. At the same time there are nagging concerns that a sustained economic recovery may be some years into the future.

    What is a lot clearer is that its not only private sector finances that are under pressure and over geared, but also government finances.

    Exactly how this is going to play out no one is sure. One just needs to look at the US fiscal deficit which is currently running at 9% of GDP and headed for 12-14%. The UK is staring similar fiscal deficits in the face.

    In their ongoing attempt to reflate slowing economies, governments have dramatically escalated their spending, but in the case of the US and UK with limited ability in terms of either reserves and ability to raise new debt.

    The US federal non defence spending has risen more than 20% over a year ago, far stronger than at any time from at least 1990. At the same time that government has felt the need to spend more, income tax receipts have contracted by 25% year on year – a reflection of the contraction in the private sector.

    Source: Wells Fargo Securities

    With limited political ability to reduce spending, raise taxes, borrow (although this will continue), to meet the escalating shortfall, governments, especially the US are being compelled to monetise their debt – i.e. put more money into circulation.

    Source: Wells Fargo Securities

    Should the trend continue, then despite official inflation rates on goods and services remains muted for the foreseeable future, asset prices may continue to escalate as the new stock of money needs to find a home.

    It’s not going to be a smooth road. Increased global money supply is going to come up against generally weak company earnings.

    This looks like a recipe for ongoing high volatility, which is why investors need to try and have a multi asset class approach.

    If you are looking for an independent investment advisor to assess your overall investment plan, don't hesitate to contact Seed Investments.

    Have a wonderful weekend

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-14, 16:27:02, by ian Email , Leave a comment

    Monetary stimulus

    The South African monetary authorities have generally lagged the rest of the world in stimulating its rapidly slowing economy, but today outgoing governor, Mboweni, cut rates by an unexpected 0,5% to 7%. This takes the decline to 5% from December and the prime rate down to 10,5%.

    One economy that has not lagged in stimulating by way of cheap lending is China.

    The Economist Intelligence unit reported that it now looks like the official GDP for 2009 will reach the government target of 8% per annum.

    The bulk of this massive uptick has “only been possible owing to a massive increase in state-mandated bank lending.”

    Rapid lending always brings with it the concern that asset prices may become inflated and that banks make unproductive loans which in time will need to be impaired (written down).

    i.e. the growth rate may be more illusionary than real.

    In the first half of the year, according to the Economist, new loans reached an incredible Rmb7,4 trillion (US$1,1 trillion), a growth of Rmb4,9 trillion on the year earlier period.

    The results from mining giant Billiton alluded to the substantial sharp injection into the Chinese economy in their annual results announcements, saying, “As with all economic stimulus policies, the degree of support will be difficult to measure and there remains uncertainty about economic growth beyond the period of each specific program. In China, the response has been a sharp increase in investment that has accelerated a range of existing infrastructure and construction projects. This has provided strong support to short-term economic growth.”

    The annual report went on to say that the commodity restocking in China now appears largely complete with substantial inventory build-up in specific commodities over the last 3 months at end user level and in strategic stockpiles.

    The Shanghai stockmarket, which has been one of the best performing in the world in 2009, has doubled from its lows in October 2008.

    Some key economic data from the Economist Intelligence Unit

    A contraction in China will impact exporters, but right now though the world, including South Africa, is basking in cheaper debt.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-13, 17:29:15, by ian Email , Leave a comment

    MPC Starts Their Meeting

    As Ian mentioned yesterday, the MPC started their two day meeting today, which will ultimately culminate in them deciding whether to increase, decrease, or make no change to the repo rate (rate at which commercial banks borrow from the Reserve Bank) and if it does change by how much it should.

    As mentioned the current consensus is for there to be no change.

    There has been much change since the last meeting at the end of June, both in terms of data that has come out, and other events. At that meeting the MPC halted their rate cuts that had seen the prime rate cut from 15.5% to 11% in less than 6 months from the end of 2008 and the statement generally had a hawkish tone to it (i.e. more of a slant to tightening monetary policy again).

    Some of the events that have occurred since are listed below:

    • Gill Marcus (ABSA Chairperson and former SARB deputy governor) has been appointed as the new Reserve Bank governor effective 9 November, i.e. Tito Mboweni has 2 meetings as head of the Bank after the conclusion of this one before Ms Marcus takes over.
    • Tito entertained the idea of increasing the committee to 9 members from the current 7 after questioning by unions about their lack of representation on the committee. Mr Mboweni did, however, mention that any new member would have to resign current posts held (as Gill Marcus will be doing) to avoid any conflicts of interest.
    • June’s inflation data came out 0.3% below consensus at 6.9% at the end of July. A good sign that inflation might fall into its target band sooner rather than later.
    • Economic data has continued to disappoint across many sectors. With excess capacity increasing appreciably. Another good sign for inflation, although negative for economic growth and job creation.
    • Workers around the country and across a wide spectrum of employment sectors have gone on strike demanding higher wage increases than their employers were offering. Many strikes have since been resolved with wages hikes in excess of 10% (above both current inflation levels and the upper band of the inflation target – 6%). A big negative for inflation falling into the Reserve Bank’s target range.

    The members will discuss the conflicting data that is coming out, and then come to a decision. As can be seen there are reasons to both increase and decrease interest rates. Many different interest groups are lobbying for a decision in their favour, for example car makers want a rate cut to help the slide in demand for vehicles.

    The markets look to the MPC for direction, so they therefore word their statements very carefully. The MPC guides the markets both with their conclusions and comments. We will therefore see from their statement tomorrow where they see rates going in the future. A dovish tone will indicate that they’re more likely to cut rates in the future again, while a hawkish tone would indicate a desire to increase rates at some stage.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2009-08-12, 16:07:28, by Mike Email , Leave a comment

    Valuations and economic data

    The combination of weaker actual earnings coming through from many companies and the rapid rise in equity prices over the last few months has seen the valuation of the JSE back to long term normal levels and above from a relatively cheap level in March.

    Over the longer term it stands to reason that the price of a company will follow company earnings. But we know that over shorter periods of time – sometimes up to even a few years at a time, valuations and company earnings can move in opposite directions, causing confusion to many investors.

    Understanding that valuations and a company’s return on equity are mean reverting, Graham Benjamin and David Dodd adjusted the well know price to equity valuation metric, by smoothing earnings over 10 years.

    The graph below is the smoothed price to earnings of the financial and industrial index. It’s evident that on this method, prices are back and indeed slightly higher than longer run averages

    Source : SIM

    The JSE

    From the trough at the beginning of March, the JSE All Share index is up 38% to its current level.

    The combination of higher prices and weaker reported earnings has escalated up the average price of shares from a PE of around 8 times to its current 13 times.

    Clearly at this level, equities are now not as cheap as they were a few months back.

    Economic data

    At the same time economic data remains weak.

    Car sales in July were weaker than generally expected, declining 27,4% year on year from an annual decline of 23,8% in June.

    Statistics SA released Manufacturing data today. The numbers were not good and there was a weakening of the rand. The annual rate of production volume for June contracted at 17%, while sales value was down 19,2%. 8 out of 10 manufacturing divisions posted negative quarterly output growth.

    These numbers are slightly better than the sharp contraction recorded in April, but still reflecting very difficult trading conditions.

    Source : Nedcor

    The Monetary Policy Committee of the Reserve Bank sits for 2 days from tomorrow to discuss the suitable level of the reference interest rates – the repo rate. The last rate cut was by 1% down to 7,5%. Now the consensus is that rates will stay at this level, but there is an outside possibility that the Reserve Bank cuts by a further 0,5%.

    So while we have weak economic data across various areas, valuations of general equities are now back to longer run levels. That is not to say that valuations can’t get more expensive in the shorter term – this is largely dependent on investor psychology.

    The weaker manufacturing data however did seem to scare foreigners – the rand fell to R8,16 / dollar.

    We believe that your total asset allocation should be monitored on a monthly basis. If you are not receiving a composite monthly report from your investment advisor detailing your exact asset allocation relative to an agreed strategy, then please don't hesitate to give us a call to discuss.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-11, 17:06:36, by ian Email , Leave a comment

    Asset class returns

    There is no doubt that the single biggest apprehension most investors have in respect of investing into shares is the volatility that goes with this exercise. When compared to the smooth linear returns generated by cash, equities can appear exceptionally risky.

    Yes the substantially volatile movement in equity can be equated to risk, where an investor becomes a forced seller and is obliged to sell at a price lower than purchase price.

    But in itself the volatile price movement is not risk. A better definition of risk for an investment is longer term underperformance against inflation.

    The graph below reflects the 3 year performance of listed property, equities, bonds and cash. Until mid 2008 both property and equities were comfortably outperforming a cash investment.

    But equity prices fell further and for the full 3 years, an investment in either local equities or bonds would have slightly underperformed cash, with far higher volatility.

    source : Investec

    Because there is no volatility in a cash investment, there is a misconception that shorter term risk free also translates into longer term risk free. I.e. cash with no volatility can and has outperformed the more volatile equities - therefore it can continue to do so over the longer period of time.

    This is not true because ultimately an equity investor will demand a higher return than cash because of the additional risk he is taking with capital. He may not achieve this over any shorter period of time, but given a long enough time horizon, he will almost certainly be rewarded with a higher return. When compounded over many years, the widening gap because substantial.

    This is why for any investor with a long time horizon, we always say that there is greater risk in not taking the shorter term risk.

    Over a longer period of time – the last 5 years – cash and bonds have given a cumulative 55%, but equities 171% and listed property 228%. This was during a period of strong out and under performance, but is more indicative of the type of additional returns a long term investor will be hoping to achieve by subjecting their capital to greater volatility.

    source : Investec

    If you would like to consult Seed Investments on your investment and retirement planning, please don’t hesitate to contact us for an initial confidential discussion.

    Have a wonderful long weekend. Go bokke

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-07, 17:04:41, by ian Email , Leave a comment

    Update from African Bank

    African Bank or Abil is a R24 billion market capitalised company. It operates in the lower to middle class market providing unsecured loans. It sources its financing from the wholesale market and recently raised a further R520 million fixed rate capital note at 6,25% above the government R203 bond and another R480 million floating rate unsecured note at 6,3% above Jibar.

    This is fairly expensive funding. Speaking to a few fixed income managers last week they were excited about having picked up some of this tranche of paper at these attractive yields above government bonds.

    Because of the nature of its business – i.e. lending to the lower to middle class and furniture sales via their Ellerine business, they have direct insight into the economic strength of the consumer.

    Today they released a third quarter trading update to June. They started by saying that there is lower economic activity, rising unemployment, and a further deterioration in consumer sentiment, with little respite from lower interest rates and lower inflation numbers.

    Because of this the company has tightened its lending criteria. However its gross advances – i.e. loans mad to customers, was upped by 5% or 31% year on year to R19,5 billion.

    However quarter advances have slowed and at the current annualised rate, advances have slowed to 4% and for the full year are likely to be similar for that of 2008.

    The chart below indicates the monthly growth in gross advances

    Source: Abil

    Given the weaker economy, the company saw a slight deterioration in business written in September to December 2008. In this environment it is concentrating on operating expenses.

    Its other business, acquired a few years back is furniture retailer, Ellerines. Here sales were down 14% to R935m for the quarter. In this business gross loan advances declined by 2% to R5,2 billion. They do believe that the tighter credit criteria and emphasis on collections has improved this debtor's book.

    The share price fell back to below R30, down 3,1%. It has historically traded at a high yield. The market may still be nervous of Abil’s ability to extract benefits from the Ellerines purchase.

    By way of contrast, Nedbank gained 2,5% to R109,61. It released interim results yesterday, which were poor, but held out some promise of the future. Diluted headline earnings per share was down 34% to 474c. The result was only a slight increase in net asset value and a very poor return on equity

    Total advances were down 1% from December, coming in at R432 billion.

    Bank shares have rallied strongly from their lows. Abil fell sharply to below R20, while Nedbank fell below R70. Some value investors have been lightening their exposure.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-06, 17:28:16, by ian Email , Leave a comment

    Some Interim Results

    Ian mentioned in yesterday’s daily equity report that portfolio managers have been moving to companies that have been able to maintain their earnings and that many companies’ earnings will be coming under pressure in the coming months. Today we’ll take a closer look at some companies that released their interim results.

    Mondi, as most investors know, is an integrated paper and packaging company with key operations in Western and Eastern Europe, Russia, and South Africa. This industry has been struggling as excess capacity is a large problem. As can be expected from a company operating in such a troubled industry, in a tough economic climate, earnings have come under pressure.

    The company reported a loss of 7.1 euro cents per share for the 6 months to June, down from a profit of 17.1 euro cents per share in the corresponding period last year. While profits have been put under pressure the company has been able to take some positives. Cash flow from operations is up 26% as costs have been cut. Some EUR109m in costs have been cut year to date, with the target of EUR180m being cut by year end. Debt has also been kept under control (in a time when competitor Sappi made a rights issue to raise capital).

    Essentially Mondi is putting all its efforts into consolidating the company to ensure that it will be able to take advantage when markets and economies turn.

    Nedbank is in an industry that has been hit hard by the global recession. Bankers have generally felt the brunt as capital has dried up and clients have started to default more heavily on their debt. As a result of the downturn, Nedbank released results with earnings down over 30%, an RoE attributable to shareholders down to 11.1% from 18.7% previously, and a profit from operations down nearly 30%. Despite the lowering of the firm’s profitability it was still able to produce basic earnings per share of R6.19 and improve its Tier 1 capital to 10% from 8.9%. Tier 1 capital is important for a bank’s ability to raise capital, and an improving level has resulted in better capital adequacy for the company.

    Old Mutual
    Old Mutual is a company that was included in many portfolios not because of its earnings resilience, but more as a result of its share price falling to such an extent that it was indicating that the company was nearly going to cease to be a going concern.

    Basic earnings per share for the company has fallen from 11.2 pence to -1.8 pence compared to the corresponding 6 months in 2008, but the embedded value has increased by 2.49% to 143.8 pence from 140.3 pence. This now places the company’s share price at a 34% discount to embedded value. Embedded value is used as a type of NAV valuation for insurance companies.

    Below is a chart of the respective share price performance for the year to date. Dividends have been excluded (Old Mutual didn’t pay out a dividend in this period.

    Old Mutual’s performance has clearly been the best over this short period, despite concerns at one stage that it would go under. This shows that there is often a disconnect between company health and share price performance. Astute managers will be able to spot this disconnect and take advantage by buying shares that have performed poorly relative to the company’s health, and sell those that have raced ahead of their fundamentals.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2009-08-05, 18:03:23, by Mike Email , Leave a comment


    In the last 6 months plus there appears to have been some move by portfolio managers towards companies that have more stable earnings. I mentioned yesterday about the real possibility that earnings will continue to be under some pressure off the very high base. Naturally those companies with more stable earnings will prove more popular in such a cycle.

    One company that saw its earnings fall sharply in the second half of 2008 and now again is Afrox. Today it announced a profit warning ahead of its results this week.

    The R6,5 billion company Afrox – African Oxygen was founded in 1927 and listed in 1963. It is a leader in gases and welding products for industrial use and is therefore closely linked with the South African economy.

    In May the company announced operational and structural changes to deliver R200m in cost savings by the end of 2009. This is to be achieved through a reduction in sub profitable filling sites, closure of certain branches and a cut back of staff numbers by 15% by the third quarter.

    2008’s net profit came in at R412m or 133,7c. This was down 11% from the December 2007 year, with the big decline experienced in the second half of 2008.

    EPS for the first half of 2008 came in at 89,8c and the second half at 43,9c.

    The very poor second half of 2008 has perpetuated into 2009 and today the company announced that EPS for the first half to June will be down some 50%-60%. I.e. coming in at around 36c - 45c.

    In May, the MD, Tjaart Kruger said "Volumes, sales, pricing, cash-flow, manpower, production costs, are all under market-reflected pressure and we don’t expect any significant reversal in the short term. Customer cutbacks in capex are evident which will undoubtedly affect expansion opportunities in tonnage and we see spare capacity for the foreseeable future."

    On a quarter on quarter basis the numbers were looking less attractive and despite the cost cutting, there does not yet appear to be a reprieve.

    Assuming that there is a 15% pickup on the 2008 second half earnings, then EPS for the full year 2009 should come in at 91c.

    • First half – estimate 40 cents
    • Second half 43,9c plus 15% = 51c

    This is potentially a drop of 32% from the 133,7c of 2008. In May the broker consensus forecast was running at 167c for the 2009 year and 204c for 2010. Unless the second half of 2009 to December reflects a massive jump up – i.e. triple that of 2008 – this is not going to be achieved.

    The weaker forecast earning therefore pushes up the forecast PE. The share currently trades on an historical PE of 14,5 times, but assuming 91c for the full year – the forward PE jumps to 21 times.

    Much of this was and has been factored into the price because it hardly moved today, closing down just 10c to 1940c.

    This is still down some 44% from its peak around R35 and in the more optimistic environment investors are trying to look through the current earnings cycle.

    It will be interesting to see how the forecast numbers are updated.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-04, 17:44:00, by ian Email , Leave a comment

    Long run earnings

    I spent last week listening to the views of a number of local fund managers. While generally upbeat about prospects given the improved valuations and upward trend, there is this nagging concern that company earnings are still coming off a high base and weaker earnings will prove to be somewhat of a headwind.

    The assumption here is that company earnings and margins are mean reverting. i.e. strong periods of growth are followed by periods of weakness and vice versa. Naturally this will vary from company to company.

    One graphic penned again and again was the US capacity utilisation. This is the actual productive capacity of US industries relative to the potential output at full production. Given the very rapid slowdown in demand, excess capacity has become available. Until demand increases again, company profits and margins face some strong headwinds, especially in the developed world.

    Source: SIM

    The graph below is that of real earnings growth of the JSE from 1960. While the longer term trend has been up, it has gone through long downward and sideways periods.

    Source : Inet and SIM

    While on a case by case basis, we know that the weaker expected earnings has been already reflected in the share prices, this may not necessarily be true across the whole market.

    History tends to prove that after a strong upwards cycle, there is a period of consolidation.

    In the short run however prices are less interested in underlying fundamentals and have been driven up by demand off a low base in March. According to a Merrill Lynch portfolio manager survey a near record 54% of global managers are overweight emerging markets, higher than at any time during the 2003 – 2007 bull market.

    Citibank indicates that some R46 billion has been invested into the JSE in 2009. This has been a huge driver of both the rand and the equity prices.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2009-08-03, 17:20:17, by ian Email , Leave a comment