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    Consumer Price Inflation vs Producer Price Inflation

    Towards the end of every month South Africa’s Consumer Price Inflation (CPI) and Producer Price Inflation (PPI) is released by Stats SA. These statistics are typically released a day apart, with CPI first and PPI following the next day.

    Most investors are au fait with CPI, as it is the more relevant of the two data points, but taking note of PPI could potentially provide investors with a bit more insight as to where prices are going in the future. PPI, as the name suggests, is the inflation rate faced by producers and is often referred to as ‘factory gate inflation’. PPI typically differs from CPI for a few reasons including there being a delay in the transfer of the costs from the producer to the consumer. PPI is also typically more volatile than CPI as a result of companies expanding and contracting their margins to smooth the changes in price.

    As with CPI, PPI is computed for many sub sectors with these added together, on a weighted basis, to get the composite PPI level. The headline number is the so called domestic output level, which gives a good indication as to how prices are changing at the factory gates in South Africa.

    Yesterday CPI came out at 4.2% for the 12 months to June 2010. This was lower than consensus of 4.5% and resulted in speculation that the MPC will cut rates at their next meeting. A further cut to rates is good for fixed income instruments (bonds) and we therefore saw a rally in the bond yield (yield going down, bond price going up) after the CPI figure was released. While CPI is heading down we saw the exact opposite on the PPI side today. PPI came in at 9.4%, which was significantly above the consensus 7.4%!

    With PPI typically being a leading indicator for CPI, this dramatic pick up indicates that we could see inflation picking up over the next few months. Taking data back to 1980, we found that CPI lags PPI by around 3 months. The chart below shows this data. Note how correlated the movements are between the two indicators.

    If history repeats itself we should see an increase in CPI over the coming months. Clearly where PPI goes from here will also be important, as a sudden cooling of PPI will in all likelihood result in CPI moderating for longer.

    The Governor of the Reserve Bank, Gill Marcus, will no doubt be keeping an eye on developments in this area, although inflation expectations (as opposed to current inflation) play a bigger role in their decision. The MPC next meets on September 8 and 9.

    Take care,

    Mike Browne,
    021 9144 966

    Permalink2010-07-29, 18:47:27, by Mike Email , Leave a comment

    More on risk

    Earlier this week, we looked at ten principles of successful investing. Point 2 on the list was understanding risk. We have discussed some thoughts on risk in the past, but it is such an important issue, that it needs to be constantly looked at from various angles.

    An investment without a degree of risk is just not an investment. In fact if there was absolutely no risk to investing, then there would also be zero possibility of generating inflation beating returns.

    The essence of risk itself is that while various risks can be defined, based on what we know from past events – i.e. they are known risks, there are other risks lurking in the shadows as it were, which may be as yet undefined.

    Former US Secretary of Defence Donald Rumsfeld, speaking about the Middle East in 2002, identified the difference as "known unknowns" and "unknown unknowns". This is a subtle distinction which carries a lot of weight when it is applied to investing.

    Naturally the risk of all “known unknowns” – i.e. known risks can and must be first identified and then if possible managed. Alternatively an investor must be fully satisfied that he is going to be potentially rewarded for these risks.

    You can never however fully quantify all investment risk, because the future inevitably has unknown unknowns. A large asteroid hitting London would have enormous economic repercussions, but there's no way to protect your portfolios against such a remote risk.

    On the other hand, the risks of known unknowns can be managed to some extent. We know about the risk of inflation and interest rates rising. We can try and price this in to the valuation or we can construct a portfolio to try and mitigate against these risks.

    We can diversify our investment portfolios across shares, bonds, global, hedge etc and across various market sectors to help minimize the risks of these known unknowns.

    The overriding investment risk is one of earning a lower than expected return. Some of the specific risks that fall into the knowable category that may contribute to this overriding risk include:

    • Market risk -
    • The risk of inflation.
    • General business risk
    • Interest rate risk
    • Credit risk
    • Political risk
    • Regulatory risk
    • Exchange rate or currency risk
    • Liquidity risk

    These may not always be easy to quantify, but this does not mean that they must not be considered for each and every investment made.

    If you have any questions, or would like to have an independent assessment of your overall investment portfolio, please don’t hesitate to give Vincent a call on 021 9144 966 or mail him on Vincent@seedinvestments.co.za

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-28, 17:27:29, by ian Email , Leave a comment

    The Chinese currency

    In times of wildly fluctuating currency exchange rates, there are many that would prefer some stability, if only to smooth the business planning and forecasting process. But just where should an exchange rate be pegged? Importers always prefer a strengthening local currency and exporters a weakening exchange rate.

    China as a major exporter to the US, has preferred to manage its currency as opposed to subject it to normal market forces of supply and demand.

    The People’s Bank of China (PBoC), which is responsible for formulating and implementing monetary policy, has maintained an effective currency peg of the Chinese currency to the US dollar.

    The Renminbi (sign: ¥; code: CNY) is the official currency of the People's Republic of China, whose principal unit is the Yuan.

    Five years ago, the 8,27 Yuan per USD peg was lifted, which saw an immediate revaluation to 8,11 Yuan to the dollar.

    US officials have been putting pressure on China – to the extent that it’s possible - to allow their currency to strengthen – but the peg was reinstated unofficially when the 2008 financial crisis hit.

    On June 19, 2010, the People’s Bank of China released a statement simultaneously in Chinese and English indicating that they would "proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility." The PBoC maintained that there would not be any large swings in the currency.

    The chart below indicates just that – the currency exchange rate is managed in a very tight band. Clearly the Chinese officials prefer a weaker currency to a stronger one – this makes their production more competitive on the world markets.

    The chart below reflects the historical exchange rate between the Chinese Yuan Renminbi (CNY) and the US dollar between 28 Jan 2010 and 26 July 2010.

    The IMF has recently completed a country report on China, which although only due for release in September, unless officials in Beijing refuse its release, is quoted by the Wall Street as stating that “the renminbi is substantially undervalued.”

    For the time being it is probably best that China maintains a steady exchange rate to the US dollar, but on the assumption that it is likely to appreciate, it should be considered.

    However one report indicated that “in the mean time, holding RMB is pretty unattractive given both “the hassle of getting money in and out of China” and the low rates offered by Chinese money market funds.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-27, 17:48:37, by ian Email , Leave a comment

    Ten investment principles

    There is not one perfect way in which to invest. Rather there are multiple ways and multiple methods of investing, depending on your budget, your personal goals, your particular circumstances and your investment plan. The key to successful investing is knowing yourself and knowing what you are trying to accomplish.

    Clearly there are multitudes of available options and indeed opportunities. If you understand the “correct principles” that relate to successful investing, you will be able to “govern,” or manage, your investment portfolio well.

    Naturally different investors will come up with varying principles, but here are 10 which we would endorse. If you build your portfolio in line with these principles, you will enhance the odds of having a successful portfolio.

    • Principle 1: Know Yourself
    • Principle 2: Understand Risk
    • Principle 3: Stay Diversified
    • Principle 4: Invest Low-Cost and Tax-Efficiently
    • Principle 5: Invest for the Long Run
    • Principle 6: Use Caution if You Are Investing in Individual Assets
    • Principle 7: Monitor Portfolio Performance Against Benchmarks
    • Principle 8: Do Not Waste Too Much Time and Energy Trying to Beat the Market
    • Principle 9: Invest Only with High-Quality, Licensed, Reputable People and Institutions
    • Principle 10: Develop a Good Investment Plan and Follow It Closely

    First things first, investing should never be an end in itself; rather, it is a means of reaching your personal and family goals. For most people the biggest goal is retirement planning. It is therefore important to know yourself well, as an investor. Each investor should have well-written and well-thought-out goals. Goals are critical to knowing yourself because they will help you understand what you are trying to accomplish with your investment program.

    As part of knowing yourself, you need to know your budget. You cannot invest without funds. A critical part of successful investing is having a well-planned budget; a percentage of your income should be automatically earmarked for savings and investment in this budget.

    Review these 10 principles above and be honest about where these may be lacking in your investment planning. Then look to see how these gaps can be plugged.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-26, 17:51:37, by ian Email , Leave a comment

    A few US companies

    Over the last few days a number of high profile US companies have reported quarter earnings. Many of these companies are reporting earnings ahead of revenue and earnings estimates, but this does not necessarily translate into immediate price gains.

    This week, Thomson Reuters reported that with 100 S&P 500 companies reporting to date, 76% have reported earnings above estimates and 65% have reported revenue above estimates,"

    A few of these include:

    Apple, with a market cap of $234 billion reported quarter earnings up 78%

    McDonalds reported a 12% rise in second quarter earnings.

    Microsoft has a market cap of $224 billion. It released quarter results reflecting a 48% increase in net income from $3 billion to $4,5 billion. Revenue was up from $13,1 billion to $16,04 billion. These numbers were ahead of expectations, but the share price has been steady to slightly down at $25,70/share

    Amazon, the online book distributor, reported quarter revenue of $6,6 billion up 41% from a year back. Profit rose 45% to $207m. At face value these look like excellent numbers, but the share price fell sharply as these numbers were behind estimates.

    Ford reported profits of $2,6 billion for the quarter, which pushes its first half profits to $4,7 billion – which is apparently its largest first half profit since 1998.

    US car sales are coming off a base of 10,4 million in 2009 – the lowest annual total since 1982. They are expected to be in the region of 11,5m to 12m in 2010.

    3M (MMM), a producer of thousands of products for various markets has a market cap of $60 billion and employs 75 000 people across 65 countries. Yesterday it reported quarter sales up 17,7% and EPS up 37,5% versus the second quarter of 2009. They noted that on a geographic basis sales growth was strongest in emerging economies up 38% versus the second quarter of 2009.

    The company has upped its performance expectations for the third consecutive quarter, now expecting organic sales volumes to grow 13 to 15 percent.

    Many high quality US companies are trading at realistic valuations. They have been cutting back on costs, are generating cash flows from across the world and in many cases have strong balance sheets.

    It’s highly unlikely that the next 10 years will be a repeat of the last 10 years for US shares, given the far more attractive starting point.

    Have a fantastic weekend

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-23, 17:34:03, by ian Email , Leave a comment

    MPC Resists a Rate Drop

    There was much interest in the latest MPC meeting as analysts and market participants debated as to whether there would be an interest rate cut or not. While the consensus forecast was for no cut, the pricing in the fixed income market didn’t completely agree with this view. Ultimately the consensus view prevailed and the Reserve Bank Governor, Gill Marcus, left rates unchanged.

    One of the arguments for a rate cut was that the economy is still not out of the woods yet. A hotly debated item over the last few months has been the level of the rand and whether it is overvalued or not. A strong currency isn’t good for exporters, but does help keep inflation down as the price of imports is kept in check. A cut in rates would reduce the interest rate differential with the developed markets, thereby reducing the profitability on the carry trade, which would ultimately (in theory) result in the rand weakening. Proponents for a weaker rand were therefore trying to put pressure on the MPC to reduce the rates once more – from an already historical low.

    Arguments to leave rates unchanged included the fact that while inflation is in the midpoint of the SARB’s target of 3% - 6% (currently at 4.6%) there some inflationary pressures that will be working into the system from Eskom’s large electricity price increase and wage settlements often coming in above the target ceiling of 6%, without a comparable increase in productivity. Cutting rates would most likely have put some pressure on the rand, and rand weakness also results in higher imported inflation, thus leaving rates unchanged would assist the inflation rate staying in the target band. Cutting rates also typically spurs economic growth, resulting in inflationary pressures.

    Ultimately leaving the Repo rate unchanged at 6.5% (with Prime remaining at 10%) resulted in the rand strengthening by around 10c against the US dollar in just over an hour. The chart below shows the movement of the rand versus the US dollar for the day.

    Notice how the rand trades in a very tight range for much of the day, but strengthens sharply on the announcement that rates will remain unchanged.

    With growth still muted and inflation comfortably in the middle of the target range, there were no calls for the MPC to increase rates. Rates will only begin to be raised once growth starts to assert itself, which typically pushes up the level of inflation. A change in the MPC’s longer term outlook will pre-empt such a move.

    The continued strong rand gives investors the ideal platform to take a portion of their investments offshore. Each investor should have their own strategic allocation to offshore investments, depending on their own circumstances. If you have any questions on the positioning of your portfolio, please don’t hesitate to contact us.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2010-07-22, 18:20:27, by Mike Email , Leave a comment

    Company year ends

    As with private companies, listed companies all vary in terms of their financial year ends. Naturally fund managers tracking valuations and updating models have details of year ends and adjust expected earnings accordingly in order to make necessary comparisons.

    Many companies have June and December as their year ends, which means that from the end of July and into August we will start to see a plethora of company result announcements.

    Most of the banks and resource companies tend to have a December year end. Of the 4 large banks it is just Firstrand that has a June year end. This links in with holding company RMB Holdings.

    Companies that have a September year end are for the most part those that are or were in the Barlow’s stable – now Barloworld. After listing in 1941, the company acquired many businesses, before beginning an unbundling process in 1994. Some of the companies, now listed, which were once part of the Barlow's conglomerate, include, Freeworld Holdings, PPC cement, Reunert, Spar, Astral, Tiger, Oceana, TigerBrands, Nampak, and Adcock Ingram.

    Some of the larger listed companies with June year ends include: Truworths, RMB Holdings, Firstrand, construction companies, Aveng, Murray and Roberts and WBHO, Shoprite, Massmart, Woolworths, Steinhof, Imperial, Discovery and BHP Billiton.

    Today Woolworths with a June year end, announced a trading update for its 52 weeks to the end of June. On a like on like basis, comparable store basis sales were up just 5,7%. On a group basis Woolworths increased sales by 10,5%.

    However they now expect headline earnings to be up between 45% and 55% year on year. This is largely because of a lower base in 2009 due to a R57m unrealised forex loss and a R75m Secondary tax charge on the December 2008 special dividend.

    They expect EPS to be at a similar level to 2009, despite 2009 including a profit of R380m on the disposal of a portion of Woolworths Financial Services.

    Their Australian operation, Country Road has been disappointing. They released a trading update on the Australian stock exchange announcing that their estimate for the full year profit is a decline of between 15% and 20%.

    Woolies share price has moved up strongly over the last 12 months from R13 to its current 2485c. It ended down 5c today, even as the overall market gained 1,77%

    Massmart, Clicks and Famous Brands made new 12 month highs today.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-21, 17:37:17, by ian Email , Leave a comment

    Some latest views from GMO

    GMO latest quarterly newsletter had, as always, an interesting perspective on global markets. The newsletter was broken up over 6 essays. They have become a widely watched firm, and that in itself can become a problem, but it’s for good reason. Their no nonsense approach to asset valuations have generally stood them in good stead.

    On Jeremy Grantham’s portfolio outlook and recommendations.

    He is concerned that governments around the world are emphasising government debt reductions over economic stimulus and after a relatively strong initial recovery, “the growth rates of most developed economies are already slowing, despite the immense previous stimulus.”

    He goes on to say that, “You don’t have to be a passionate follower of Keynes to realize that to rapidly reduce deficits at this point is at least to flirt with a severe economic decline.”

    In contrast then to the economic recovery, the stock market recovery was sensational, but now the slackening rate of economic growth is disturbing.

    Despite his concerns about the slowdown and also economist Paul Krugman, talking about his fear that we are in the early stages of a third depression, they as a firm still look to their valuation models when allocating capital. These are not 12 month forecasts, but 7 year forecasts and have proven to have been prescient in the past.

    Despite the gloom, he says that “today this forecast suggests that it is possible to build a global equity portfolio with just over the normal imputed return of around 6% plus inflation.” I.e. a real 6% return.

    So where can investors derive the possibility of this reasonable real return.

    Firstly it’s not going to come from developed market or emerging market bonds. These are just too expensive and not priced to provide real returns.

    The 2 asset classes that GMO’s models indicate value are:

    • US high quality shares, which are priced to provide a potential real 7,3% real; and
    • Emerging market shares, which are priced to provide a potential real 6,6% real.

    Both of these are trading above the long term historical US equity real return of 6,5%

    So while the economists are probably rightly concerned about global growth or the lack thereof, there are certain assets that are pricing in risks and providing investors with reasonably attractive options.

    If you would like to discuss your overall asset allocation, please don’t hesitate to contact us.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-20, 18:09:51, by ian Email , Leave a comment

    Famous Brands

    Famous Brands is a company that has amalgamated a number of well known fast food brands over the years. Their core was Steers and Debonairs, but they have added Wimpy, Mugg and Bean, House of Coffees and Blacksteer amongst others.

    In order to cater for the expected pick up in volumes over the soccer world cup period, they embarked on a program to modify their logistics distribution. They also identified potential high volume sites and provided for increased deliveries, hiring of additional fleet and supplied additional staff.

    They also seconded internal staff at some of the sites to assist franchisees with the increased traffic. The ceo, Hedderwick notes that many stores extended trading hours to well after midnight on occasions in order to take advantage of the pick up in demand.

    The result has been a massive pickup in sales over the corresponding period in 2009. Group sales at OT Tambo airport grew 64% in June, brands at the V&AWaterfront grew sales 88%, group restaurants near the Durban North beach fan park grew sales 97%, sales at Sandton City increased 48% and Melrose Arch up a massive 116%.

    Interestingly turnover at stores situated at casinos also managed to capture a large percentage of the tourist market. Famous Brands at Durban’s Sun Coast Casino grew turnover 118%, while brands in Monte Casino increased turnover 75% and Boardwalk in PE increased turnover 126%.

    June sales at Debonairs increased 25% against June 2009.

    The share price gained 2,47% to 3074c. At this price it trades on a PE of 15 times historical and a dividend yield of 3,7%

    Over the longer period this company has been an exceptional performer. Looking back 10 years ago the price was trading at 140c. It has therefore compounded at 36% per annum to its current price.

    While there would be not one investor that would not say no to such a return, as with virtually any investment, a degree of patience would have been required through some periods where there was flat or negative performance. For example peaking in May 2007 at just over R20, the price went down to R12, only again touching the previous peak of R20 in October 2009.

    One large fund manager that bought into the company was Coronation Equity. It has been a holding in the Coronation Smaller Companies fund. With only a R3 billion market cap however, it is not easy for larger funds to obtain a meaningful stake in the company.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-19, 17:35:14, by ian Email , Leave a comment

    BP Cap Oil Spill – For Now

    At 14:25 on Thursday, US time, BP was finally able to stop the flow of oil into the Gulf of Mexico that has been raging since 20 April. It is estimated that between 90 and 180 million gallons of oil have been spilled, which makes it the biggest spill in the US in history.

    This plug has been developed not to stop the flow, but rather to capture all of the oil, and for now it has succeeded in stopping the oil pouring into the sea. BP is now in the middle of conducting a very important 48 hour observation process to ensure that all the oil and gas is, indeed, being captured. The ‘plug’ capturing the oil needs to be able to withstand the Macondo well’s pressure, and BP also needs to ensure that the pressure on the ‘plug’ remains constant, as any drop in pressure would indicate that there are one or more fissures in the well, leading to leaks elsewhere.

    The current longer term plan to stop the Macondo well is to drill a relief well nearby, pump mud into the well, and seal it with cement. They have begun this process, but stopped during the plugging of the well to avoid any potential mishaps while the plugging took place. Current plans are for the relief well to intercept the Macondo well at 18,000 feet (nearly 5,500 metres) below the surface. Clearly these are extreme circumstances, and best and worst case scenarios can widely vary. Let’s hope that the best case scenario – from here – pans out.

    The costs of this spill can be crudely (pardon the pun) split into three cost centres. The first is the cost not only of stopping the oil spilling, but the opportunity cost of not being able to drill for oil for the last three months at Macondo, and the possibility that deep sea drilling projects will be curtailed in the future.

    The second leg of costs are those immediately associated with the cleanup of the spill. Footage shown on Carte Blanche last Sunday show just how devastated some regions are. These two cost centres are fairly well known, and can be estimated with a reasonable degree of certainty (once the oil has completely stopped flowing).

    The third cost centre is future liabilities arising from this oil spill. BP has set up a US$20bn fund to deal with claims arising from this spill. While this is a large amount, the size of claims and lawsuits that it will face in the future is unknown. I am sure that there are many costs – particularly environmental – that haven’t been felt now, but will be felt in the future as the impact of the oil spill seeps through the system.

    In investments we always need to compare the value of the company with the price that it is currently trading at before making a purchase. At these levels there are investors who no doubt believe that the share price offers upside potential, and will therefore be buyers. Others will be wary that the future liabilities could sink BP. Still another set of investors may believe that the share price offers value, but won’t be investing in the share from a moral standpoint.

    While there are clear merits and pitfalls to the BP investment case, it’s situations like this that indicate that price is not always the only consideration when buying a share. Environmental and other sustainable investing considerations can sometimes move to centre stage.

    Enjoy your weekend.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2010-07-16, 17:54:46, by Mike Email , Leave a comment

    NTT to buy Didata

    Dual listed Information Technology company, Didata announced today that it has agreed to a recommended cash offer to be made by Japan’s Nippon Telegraph and Telephone Corporation (NTT) for the entire issued share capital of Didata. In terms of the offer shareholders will receive 120 pence in cash for each share.

    The offer price was a premium of approximately 18% to Wednesday’s closing price, sending the share price up to a close of 1412c – a gain of 22% on the day , pushing its market cap and hence approximate sale price to R24 billion.

    Nippon Telegraph and Telephone Corporation (NTT) is one of the largest phone companies in the world, mostly serving Japan, with approximately 54 million fixed-line customers and 54.16 million wireless subscribers.

    The company was formed in 1952 by the Japanese government and despite an open market in telecommunications it remains the market leader. The Japanese government retains a 33,8% stake in the company. NTT has a range of fixed line and wireless subsidiaries in Vietnam, Sri Lanka, Hong Kong, the Philippines and Australia.

    NTT has 5 principal operating subsidiaries, including NTT Data, a 54% owned publicly traded subsidiary, which markets data communication services including systems integration and network management.

    It is ranked in the top 50 of the Fortune global 500, the largest telecom company in Asia and second largest in the world in terms of revenue at $106 billion in 2009. The company has a market capitalisation of $55 billion

    Didata was once the darling of the JSE, and a portfolio “must have”, peaking in the late 1990’s / early 2000 at R70 before crashing down to180c in 2003. Since then it has had a steady and sometimes not so steady climb back to its close of 1157 before gaining 22% today

    Over the last 5 years or so, it has been steadily improving its position and earnings, and is probably leaving at a time when investors are getting more encouraged with progress.

    Over the last few years its operating margin has been improving. For the 6 months to March, the company reported an operting profit of $107m on turnover of $2,1 billion – a 5 % margin, up from 4,5% for the previous period.

    The announcement speaks about both companies sharing a common vision for the evolution of the Information and Communications Technology (ICT) industry, with each company having complimentary offerings.

    The way that technology has been progressing over the years, there is a clear merging of traditional IT services and traditional telecommunications.

    The Didata directors will recommend that shareholders accept the offer. They have already received irrevocable undertakings from shareholders and institutions representing 51%.

    The price of NTT reflects a general sideways movement over the last 5 years.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-15, 17:29:26, by ian Email , Leave a comment

    The folly of investing into last year's winner

    Much of the marketing information from investment firms continues to press home the point of taking a long term view when it comes to investing. The research and information that we have seen over time lends credence to having a systematic approach to investing.

    While we know that there is not one absolute approach to investing, certain activities do lead to reduced performance or at worst capital destruction. One certainty is buying when assets are trading at historically expensive prices.

    Another investing method that leads to reduced performance is buying last years winner, with the belief that this outperformance will continue.

    Fairbairn Capital, a division of Old Mutual produced this interesting bit of information on the negative effect of switching a portfolio into last years equity fund winners from 2003 to end of 2009 and how this has shown to be a losing investment strategy.

    Their example is as follows

    “Assume an investor that is always fully invested in an equity fund. He reviews his portfolio once a year, at the end of the year. If his fund managed a first or second quartile performance during the year, he remains invested in that fund (this assumes that investors in general do tolerate reduced outperformance). However, if this is not the case, he switches into the fund that gave the best return over the past 12 months. Between January 2003 and December 2009, our investor would have invested in the following domestic general equity funds, making switches in 2005, 2006 and 2008:”

    2003: Allan Gray Equity
    2004: Allan Gray Equity
    2005: Old Mutual High Yield Opportunity
    2006: PSG Alphen Growth
    2007: PSG Alphen Growth
    2008: ValuGro General Equity
    2009: ValuGro General Equity

    They go on to note that “these are all very good funds, but as the graph below shows, this strategy would have delivered below average returns. In fact, it delivered bottom quartile returns during the 7-year period, at above average levels of volatility.”

    Clearly this investment approach of switching into last years winner detracted from performance over this specific period.

    In the past we have looked at selection criteria that have proved to be more robust that merely looking over a list of yesterday’s top performers. I will cover some of these criteria again in an article.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-14, 17:03:08, by ian Email , Leave a comment

    Investment manager John Neff

    Last month, I profiled a couple of top names in US investment management. One fund manager that had an outstanding career managing funds is John Neff. He was profiled in John Masters “New Money Masters” as manager of the Vanguard Windsor Fund, now run by Vanguard Mutual Funds of Chicago.

    His investment style is not atypical of a deep value manager – i.e. buying good companies with moderate growth and high dividends while out of favour, and selling once they rise to fair value.

    He reportedly had fairly consistent outperformance with his fund, the Windsor Fund for more than 30 years, routinely featured in the top 5 percent of all US mutual funds. He managed this fund from 1964 to his retirement in 1995.

    Along with many other successful fund managers, including the ultra successful, Warren Buffett, he pursued an investment style modelled on the writings and approach of contrarian investor, Benjamin Graham. He preferred to characterise his investment approach as buying "good companies, in good industries, at low price-to-earnings prices."

    The average annual total return from the Windsor Fund during Neff's 32-year tenure was 13.7%, against a return from the S&P500 index of 10.6%. According to ww.incademy.com his biggest success was investing in a large proportion of his fund in Ford in 1984, when everyone feared it might go bust and the P/E ratio had sunk to 2.5! He paid an average price of under $14. Within 3 years, the price had climbed to $50, making Windsor profits of $500m.

    His basic philosophy was to invest into shares that are cheaply priced in relation to the total return. Remember total return is the sum of earnings growth plus dividend yield. One of the formulas he used is GYP (earnings growth + dividend yield) / PE ratio.

    An investor should consistently compare this GYP ratio of his portfolio with the market:
    We have noted over time how important the dividend yield is as a contributor to the total return. If two companies offer a prospective 14% return, but Company A's consists of 14% earnings growth and no dividend, whereas Company B's consists of 7% growth plus a 7% dividend, it is better to choose Company B, because the dividend makes the outcome more

    In his book, John Neff on Investing, he detailed the following 7 selection criteria:

    1. Low P/E ratio.
    2. Fundamental earnings growth above 7%.
    3. A solid, and ideally rising, dividend.
    4. A much-better-than-average total return in relation to the P/E ratio.
    5. No exposure to cyclical downturns without a compensatory low P/E.
    6. Solid companies in growing fields.
    7. A strong fundamental case for investment.

    Source: John Neff on Investing, J Neff, 1999

    Don't chase highly recognized growth stocks. Their P/E ratios are invariably pushed up to ridiculously expensive levels. This greatly increases the risk of a sudden collapse in the share price.

    He is quoted to have said, “"I've never bought a stock unless, in my view, it was on sale."

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-13, 17:21:46, by ian Email , Leave a comment

    Having a longer term perspective

    The South African 2010 soccer world cup is over and congratulations to Spain. With 4 years before all other teams are given the opportunity again for the coveted trophy, they need to have a long term perspective. It is no different with investing.

    Bill Gates is reported to have quoted, "We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don't let yourself be lulled into inaction."

    The past 3 year performance for local equities has been dismal – essentially flat at 0,25% per annum over this period.

    With that type of return, or lack thereof, it is only natural that investors question the feasibility of investing into equities, despite the fact that longer run numbers paint an improved picture, with the 5 year compounded return at 16,25% and that over 10 years at 16,37%.

    To extend Bill Gates quote to investing, investors tend to extrapolate both superior and poor recent performance into the future. Having suffered 0% in the market when cash returned almost 10% per annum, it’s natural that investors will underestimate the “change that will occur over the next 10 years.”

    We will continue to advocate the fact that an investor’s exposure to any investment asset should be increased or decreased depending on the valuation, but another factor that hinders long run results is a myopic perspective.

    Daily market price movement and attendant increased activity tends to exaggerate investors taking a shorter term perspective. One way to gain perspective is to take a step back and view an investment portfolio on a regular, but less infrequent period than day by day or even month by month.

    The chart below is of the JSE All Share index, but on a quarter by quarter basis.

    Source : Sharenet, Market Tracker

    Despite the 37% decline in 2002/2003 and the 46% decline in 2008, the less frequent time does tend to smooth out the volatility. Investors over a 10 year period to the end of June in this index would have received 16,25% per annum, almost double that of cash.

    This hopefully provides just one view of the importance of having a definite longer term perspective to investing into an asset class that has a long term investment horizon.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-12, 17:36:43, by ian Email , Leave a comment

    Looking at relative earnings yields

    One way to compare different investments is to assess their relative yields. While most investors understand the PE, using the earnings yield is less common. But in many respects assessing yields makes more sense. So where a share is trading on a PE multiple of 15 times, the earnings yield will be 100/ PE = 6,65.

    The earnings yield is a theoretical construct. If we assume that all the earnings are paid to shareholders in the form of dividends, the yield to the investor will be the earnings yield.

    Ranking shares by their yields in this way is valuable, because it can then be compared to the prevailing interest rates at any point in time.

    The earning yield is therefore calculated by dividing the earnings by the price or index value. If we look at the earnings yield for the JSE at the end of June, we can divide the earnings of 1635 by the index of 26259 to arrive at a yield of 6,23%.

    For decades it has generally been acceptable to invest in equities, despite the fact that they traded at lower yields compared to lower risk bonds or money market, on the assumption that earnings would grow over time and therefore compensate for the initial lower starting yield.

    In the US throughout the 80’s and 90’s the price of equities relative to bonds pulled higher and higher, until it reached in peak in 2000. As we mentioned yesterday, the last 10 years have seen a major de-rating in the value of US equities.

    Now the relationship between US equity yields and bond yields reflects equities at very much improved relative valuations – see the long term chart below.

    Source: Franklin Templeton and Credit Suisse

    This does not mean that the relative values should reverse any time soon back to the norm of the 80’s and 90’s. It just means that on a like for like valuation basis, they are attractively valued.

    Have a wonderful weekend and enjoy the football final

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-09, 17:29:11, by ian Email , Leave a comment

    Value in global companies

    We listened to a global market view update from Franklin Templeton fund managers. This global manager was started by the late Sir John Templeton, who is quoted as saying, “The investor who selects stocks on the basis of long-term intrinsic value must expect certain problems. In the first place, he should expect usually to purchase stocks which are thoroughly unpopular. Only when a stock is unpopular is the price likely to be depressed greatly below intrinsic value. In the second place, the investor who selects stock on the basis of long-term intrinsic value should not expect that the stocks selected will immediately begin to show a profit”.

    A few pointers from the presentation.

    Firstly on the global economy

    Deleveraging is going to be a multi decade phenomenon because the decline of overall debt levels is still only just starting. Public debt has escalated dramatically, buying time, as private sector debt has been reducing.

    By and large the high debt levels are really a developed market scenario. The Japanese debt to GDP is 200%, Italy 127% and US at 98%.

    Deleveraging will naturally have an impact on growth and is also directing government policy.

    It is these concerns about the global economy that is continuing to put a negative dampener on equity prices. Longer term though, equities, being part ownership in business, are the best performer. But over the last 10 years, it’s been the worst period for US equities. See below.

    Valuation pointers

    A point we have made for a while is that over shorter periods there is a low correlation between economic growth and performance of specific companies.

    The biggest driver of good future performance is low starting valuations.

    The graph below reflects the 10 year compounded return from the S&P500. In 1998, investors had enjoyed an almost 20% compounded return from US equities. But prices were stretched and those investors that stayed have experienced 10 years of pain in the US market with a 10 year compounded return of negative 0,7% - i.e. the worst 10 year period going back to 1839!

    Source: Franklin Templeton,

    Its interesting to note the cyclicality of the 10 year compounded returns. At this point, despite the economy, starting valuations are attractive and especially for certain companies.

    Both in absolute terms and relative to bonds, quality companies are inexpensive and its this fact more than the direction of the global economy that will drive performance.

    Generally the investor fear of getting back into equities has resulted in flows into bonds and money market, keeping equity values at good valuations.

    Another metric that they presented was looking at the percentage of large cap shares generating free cash flow yield above the 10 year Treasury bond.

    Investors often don’t get an opportunity to invest into certain high quality companies. But due to global uncertainty, general risk aversion and the ongoing deleveraging, valuation levels have come back to attractive levels.

    The second chart is a relative value chart. It reflects the percentage of large cap shares that have a free cash flow yield above that of 10 year bond. Ten years ago, only around 15% of companies had better yields than bonds.

    Now 10 years later with bond yields down and improved valuations for these large companies, some 80% of companies are trading with free cash flow yields above bond yields.

    Source : Franklin Templeton

    As an example, Oracle and Microsoft (software) trade on a free cash flow (FCF) yield of 7,5% each, Amgen and Pfizer (pharmaceuticals) on yields of 10,1% and 12,1% respectively.

    A value manager like Franklin Templeton is not finding value in highly geared companies, cyclicals and China, companies with debt.

    They are finding value in multinationals, ones that don’t depend on significant economic growth, and with high free cash value generation. These are still being largely ignored by the market as a whole.

    They are therefore favouring:

    • Defensive better value than cyclicals
    • Developed markets better value than emerging markets. Europe in particular, but also US.
    • Consumer, healthcare, and technology companies

    If you have any questions on your local or global investment portfolio, please don’t hesitate to contact us.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-08, 17:42:27, by ian Email , Leave a comment

    Gold gold shares

    Gold in dollar terms is up 30% from a year back and 10,5% year to date. For various reasons such as costs and a firmer rand, these gains have not been reflected in the price of the gold companies themselves, which have lagged over the years.

    Over a 5 year period, gold in US dollar terms and in rand terms has moved up around 200%. Gold shares on the other hand have lagged dramatically, up just 40% on a cumulative basis.

    Gold mining, as with all mining, is a finite business. The major mines in SA are now very mature, with others still ramping up production off a low base. The 3 major senior mines in South Africa are Anglogold, Goldfields and Harmony with a combined market capitalisation of R217 billion.

    Listed juniors and emerging producers include DRD Gold, Great Basin Gold, Gold One International, Pan Africa Resources, Simmers and Witwatersrand Consolidated Gold Resources. These have a combined market capitalisation of just R10,6 billion.

    According to BJM, the expected annual gold production in thousands of ounces of gold is set to increase from 2009 actuals to 2011 as follows for these mines:

    • Anglogold 4599 to 4886
    • Goldfields 3414 to 3732
    • Great Basin 45 to 248

    This gives a clear indication of how mature Anglogold and Goldfields are, compared to the biggest SA junior, Great Basin.

    Assuming an average gold price of $1231 in 2011, certain cash costs per mine and earnings per share sensitivity to the gold price, BJM has provided possible forward price to earning ratios and forward price to cash flow ratios.

    Angogold has a current PE of negative 28,9 times. This could drop to 6 times earnings and 9 times cash flow in 2011.

    Goldfields has a PE ratio of 23 times. This is expected to drop to 9 times earnings and 6 times cash flow per share.

    Great Basin should move from a current negative 11 times PE to 7 times earnings in 2011 and 5 times cash flow.

    Because the rand price of gold is a major driver of income and hence profitability, and given the average cash cost per ounce averaging $515/oz for these 3 mines, one can easily see how a $100 move in the gold price can move earnings up or down between 25% and 40%.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-07, 17:40:14, by ian Email , Leave a comment

    Hard Currencies

    The term hard currency is one that is typically bandied about in countries that have had their economies devastated by the likes of war, famine, hyperinflation, or for other reasons. The stereotype is further perpetuated in films when criminals and mercenaries in these ravaged countries negotiate their terms, demanding payment in ‘hard currency’, typically US dollars.

    Hard currencies are currencies that investors are confident won’t suddenly lose their purchasing power. It is a term typically assigned to currencies from countries/economic blocs that are politically stable, highly industrialised, and conduct a large portion of global trade. It is, however, important to differentiate between currencies that will fluctuate relative to other currencies (as they are pegged) and those that have the potential to lose the vast majority of their purchasing power.

    There will be volatility between all currencies that don’t have a formal peg, which is completely normal. Investors must therefore be aware of the potential volatility when transacting in foreign currencies. Below is a chart displaying the rolling 12 month relative performance of various currencies versus the US dollar.

    The rand is logically the most volatile currency, as South Africa’s politics aren’t as stable as the other countries, we aren’t yet highly industrialised, and therefore don’t take part in much of the global trade.

    What is probably more surprising than the rand’s volatility is that there are a few occasions where the 12 month movement has been in excess of 20% between hard currencies, and further still longer periods where one currency has consistently lost value relative to another hard currency. The US dollar, for instance, lost approximately 45% of its value versus the euro between 2002 and 2008.

    Over this period none of the above currencies were wiped out (ala the Zimbabwe dollar) but the loss (and gain) of purchasing power between currencies over the different periods is evident. Over the long term currencies should track the relative inflation differentials between the different economies, but can deviate significantly over extended periods.

    Relative to history, the volatility exhibited by currencies was extremely low during the 1990’s and most of the 2000’s. As different economies emerge from the financial crisis at different rates, don’t be surprised to see the volatility between currencies structurally increasing again.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2010-07-06, 17:32:29, by Mike Email , Leave a comment

    introduction to capital gains tax

    This October will mark the 9th year that Capital Gains Tax is in place in South Africa. It was introduced as an additional category to income tax into the Income Tax Act with effect from 1 October 2001. Prior to that date all gains which were considered of a capital nature were exempt from tax.

    Subsequent to that date and as time progresses, it is important to take into account the income tax implications of all investment decisions because there will invariably be a tax liability.

    A CGT liability is triggered on sale of an asset. This includes the sale of a resident’s worldwide assets. Except for shares sold after being held for 3 years, there are no rules for when proceeds from a sale are subject to normal income tax or when subject to capital gains tax.

    The act does not take into account any inflation impact on the value appreciation of an asset. Instead the calculation methodology included an inclusion rate depending on the status of the taxpayer, so for individual taxpayers 25% of the capital gain is included into taxable income and then subjected together with other income to income tax.

    In this way capital gains tax is not a separate tax from income tax, but essentially forms part of a taxpayer’s taxable income.

    The first thing that must be calculated is the net capital gain. This is the aggregate of all the capital gains for the year of assessment added together, minus any assessed capital loss brought forward from the previous year of assessment. Where the taxpayer is a natural person, then this net amount is further reduced by the annual exclusion of R17 500 (R16 000 in 2009).

    For individuals, the taxable capital gain is 25% of this net amount, which is included with other normal taxable income. At the maximum marginal rate of 40% for individuals, the maximum effective rate is 10% of the capital gain (excluding the impact of the annual exclusion).

    The annual exclusion, or part thereof, of R17 500, deducted from capital gains does not roll over to the next year of assessment if not used. While taxpayers may want to look for ways to realise assets in order to make use of this exclusion, transaction type costs may mitigate against this strategy.

    There are some assets that are excluded from CGT. The main exclusion is the sale of a primary residence owned by a natural person, where the proceeds do not exceed R2m. Where a primary residence is sold and the proceeds exceed R2m, then the first R1,5m of the capital gain is excluded . Therefore where the gain is calculated at R2,2m, the amount that will be subject to CGT will be R700 000.

    This merely provides an instruction into CGT and is naturally not exhaustive.

    We will be covering various aspects of this tax in later articles.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-05, 17:30:33, by ian Email , Leave a comment

    Global update

    The last few weeks of June saw global markets come under more pressure as indications point to a global economic slowdown and a possible double dip. As money moved out of equities and into bonds, so the S&P500 index, which tracks the performance of the 500 biggest US companies, fell 12% in the second quarter of 2010. For the year to date this index is now down 7,6% in US dollar terms.

    The Dow Jones industrial average is the original index in the US, tracking the movement of 30 major US based shares such as American Express, Home Depot, Microsoft, Coca Cola, Bank of America and Johnson and Johnson etc.

    This index is down 9,97% for the quarter and 6,27% for 2010 thus far.

    The worse performer was Alcoa, (Aluminium company of America), the world’s third largest aluminium producer. It is down 37% for the year and 29% in the second half.

    Microsoft is down 21% for the second quarter of 2010, Bank of America down 19,5% and Hewlett Packard 18,5%.

    The best performer for the second quarter and the year to date of the 30 companies in the Dow Jones index was McDonalds, which lost 1,2% for the second quarter, but is up 5,5% for the 6 months of 2010.

    The Nasdaq index, which has a higher bias to technology companies, also fell 12% in the second quarter – down almost 17% from its peak near the end of April.

    The graphic below gives a clear indication of the fear in the market. In times of panic money flows out of risky assets and into “risk free” assets. We saw this in the last quarter of 2008 when equities fell and money poured into US bonds, driving yields down.

    Now again we have seen a degree of panic in global markets with the 2 major “risk free” assets doing well – i.e. gold and US Treasuries, while global shares, oil and the euro have fallen back.

    Another historical lower risk asset is the Swiss franc. It has gained 12,1% against the euro and 4,1% against the dollar.

    Source : FT

    Are major economies and major stock markets standing on the precipice of another slump?

    While global markets have already come under pressure, this is the question asked in a global Standard Bank fixed income and forex report yesterday. The report went to ask, “Are we heading back to the dark days of late 2008 and early 2009 when financial markets—and economic growth—were plunging at a rate of knots?”

    In their view while it won’t be as bad, it is still likely to get worse from here. Some of their thinking:

    “Banks are in a far more liquid position. They seized up in the credit crunch and that’s unlikely to happen again. But things will get worse from here because governments in Europe have been too draconian in budget retrenchment. Big deficit cuts, mainly through spending reductions, at a time when the economy is very fragile, does risk a 1930’s style slump—as the US Administration seems to believe (although they would not admit this in public).”

    They go on to say:

    Banks are flush with liquidity with G7 central bank assets having nearly doubled from mid 2008 to near USD 7 trillion. While most of this sits with banks, who until now are just lending back to the central banks, too scared to lend out, it is still in place.

    Most of the stimulus to global growth over the last 18 months has come from fiscal policy, putting cash in consumer and business hands, but now in many countries these fiscal incentives have ended and this is problematic.

    The problem is most acute in Europe, which seems “hell bent on not just ending the fiscal incentives, but reversing the stimulus almost before its had a chance to multiply through the economy.” leading them to think that a double dip is a fair bet for Europe.

    Like some of the favoured football teams that have had their stay in SA cut short, there is a possibility that global markets struggle through the second half of the year. Stockpicking and maintaining a balanced portfolio across all the major asset classes is going to be important.

    Have a wonderful weekend and enjoy the games today and tomorrow.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2010-07-02, 14:36:58, by ian Email , Leave a comment

    Just Past Half Year

    Yesterday marked the end of the first half of the year. While there is no logical reason to use calendar month/quarter/year ends to measure performance periods, it does give us easily identifiable and comparable markers and periods. Caution must be taken as specific start and end dates, particularly over shorter periods, can either mask or amplify returns.

    We prefer to measure asset performance over rolling periods, as this gives us a better idea of how we have performed over an entire period, not just over a discrete period.

    Be that as it may, below is a table showing the performance of various asset classes (in ZAR) over various discrete periods:

    The last quarter has been particularly tough for equities, both locally and abroad, with the local market producing its poorest quarterly return since the end of 2008. Over all of these measurement periods for local equities (read ALSI Total Return), only one period stands out as having produced a good inflation beating return, that being the 12 month performance.

    As mentioned earlier, this can be misleading if you don’t roll the number.

    The ALSI return in July 2009 was 10.1%, which means that the market needs to return 10.1% this month for the 12 month return to stay at 21.8%. If we plug in a more realistic monthly return, like 1%, then the 12 month return falls to 11.7%, and if the market has another bad month (-3% return) then the 12 month return falls to 7.3%, barely above inflation. All of a sudden a ‘good 12 months’ can turn into a ‘bad 12 months’, when it is in fact just one month on either side that has affected the overall picture.

    World equity, in rands, has been a terrible performer not only over the measurement periods shown above, but also over a decade or so. While this often has the effect of scaring investors off, it should do the opposite. Asset classes that have been depressed for a long time, typically perform better going forward. This isn’t a failsafe method, but if you consistently follow a buy low sell high approach, over time your returns should be above average.

    Investors expecting a return of 15% from equities in 2010 require a strong second half from this asset class. A total return of approximately 20% is required, growing at an average of 3% per annum. This kind of return is achievable, but these investors will more than likely end up short.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2010-07-01, 17:44:38, by Mike Email , Leave a comment