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    Lies, Damned Lies, and Statistics

    For regular investment news and opinion pieces follow Seed Investments on Facebook by ‘Liking’ our Page. Click here to view our page.

    The investment world is a complicated environment. It is filled with professionals who have dedicated many years of their lives looking at and analysing numbers. While these professionals are able to analyse these numbers to come to conclusions, explaining the reasoning to someone who isn’t as versed in number crunching can prove quite difficult.

    As such there are numerous ratios and statistics that have been developed over the years to help investors reach conclusions from reams of data (read numbers - returns). Unfortunately incorrect conclusions are sometimes inferred from these statistics, which leads to poor decision making.

    Today we’ll take a look at the difference between correlation and return profile. Often investors assume that assets with a high correlation will have a similar return profile and vice versa. While this can happen, it’s not always the case!

    Below is a chart of the performance of the ALSI and Gold (both in ZAR) over the past 10 years. It is evident that their returns are almost identical, their monthly correlation, however, is only 5%!

    You will notice that although gold and ALSI often move in different directions over the past 10 years they have both delivered excellent real returns.

    The next two charts compare the MSCI World with the MSCI Emerging Market. The first chart is one that we often see, with the MSCI Emerging Market thoroughly outperforming the MSCI World. With this type of return profile most investors would assume they have a low correlation, but this couldn’t be further from the truth! Over the past 10 years there has been a correlation of over 90% between these two indices. Having a look at the second chart of the two we can see why this case. Here we’ve put the two indices on different axes and we can see that the direction of their returns are very similar (what correlation measures), but the final result is very different.

    An important point is that correlation is not necessarily the same as return profile, and extending this further is to be wary of any conclusions drawn from methods that you don’t understand.

    While correlation is a tool that we look at in an attempt to smooth returns, we believe that it is more important to get a variety of return drivers together when constructing a portfolio. In many cases assets with different returns drivers will have a low correlation, but you won’t find us excluding assets purely because they have a high correlation.

    The investor who excluded emerging market assets from his portfolio over the last decade on the basis of them having a high correlation with developed markets wouldn’t be a happy investor!

    Take care,

    Mike Browne
    021 9144 966

    Permalink2011-06-30, 17:59:46, by Mike Email , Leave a comment

    Investing R 1 000 000

    For us at Seed, investing is all about asking the right questions first and only then making an appropriate investment. We believe that in making an investment you need to start from the top (long term strategy) and then move down to deciding on which investments (stocks, unit trusts, etc.) need to be in the portfolio.

    We don’t believe that an investment process should be onerous, but we definitely think that one should follow a structured process when deciding how to invest R 1 million.

    At Seed we implement a three step value add process.

    Step 1: We need to understand your long term strategy in order to attain the desired result for you.
    Step 2: We need to understand the current valuations of the asset classes included in your portfolio to decide on your asset allocation.
    Step 3: We need to make the relevant investments in shares, unit trusts, etc. to get to the desired position.

    Let us look at a simple example.

    Step 1:

    Therefore, if:
    • you want to target a return of CPI + 4% per annum, and
    • you are prepared to lose between 5% - 10% over a one year period, if the market drops significantly, but
    • you are prepared to invest for at least 3 years in the portfolio to ensure that the portfolio has enough time to recover from any potential short term losses,

    then you should invest into a MODERATE portfolio that will look similar to this allocation:

    Step 2:

    Now that we have an understanding of your risk profile, and therefore know more or less how to invest your R1m but we still need to do the ground work and determine whether each asset is expensive or cheap (and therefore whether to under or over weight the asset classes).

    At Seed we don’t believe in forecasting, instead, we prefer to invest into assets that offer good value and sell assets that offer no (or little) value. Based on our research we have the following views of the current valuations of the different asset classes:

    Step 3:

    We believe that only once steps 1 and 2 have been completed is it prudent to make a long lasting investment.

    Based on the above assessment, we have a large overweight investment in offshore blue chip equities but avoid developed market cash and bonds (or funds that offer similar). On the local side, most assets aren’t offering much value and we are therefore underweight.

    Our focus on local equities is companies offering high dividend yields priced at low PEs as they offer a margin of safety. We would also allocate a portion of high net worth client assets to hedge funds. Finally property offers investors a decent initial yield with prospects of growth in excess of inflation. Here the investor should focus on the yield, and be less concerned about capital fluctuations.

    To be kept up to date with current investments views and news click here and become a Fan of Seed Investment Consultants on Facebook by clicking 'Like' at the top of the page.

    Kind regards,

    Vincent Heys
    021 9144 966

    Permalink2011-06-23, 17:33:47, by Mike Email , Leave a comment

    Quality Companies vs Quality Investments

    There are many instances where investors (professional and amateur alike) have mistaken a quality company with a quality investment. Successful investors are those who are able to differentiate the two, and who don’t allow emotion to sway their investment decision making process.

    First off, let’s define the two terms:

    Quality Company

    A quality company is a company that has a quality management team. The management team should be efficient allocators of capital, thereby only allocating shareholder capital to profitable ventures. Quality companies are also typically in an industry where there are high barriers to entry, which allows them to consistently grow earnings at above market rates without many competitors joining the industry. These businesses also are generally not capital intensive, generating free cash flow which can be used for (profitable) expansion or distribution back to shareholders (in the form of dividends), as opposed to being forced to reinvest the capital to replace capital intensive equipment.

    Quality Investment

    On the other hand a quality investment is an investment that one can reasonably expect an above average return over a targeted time horizon. The return generated on an investment is in a large part determined by the price paid for the investment. Overpay and you will struggle to generate excellent long term returns. Invest at a large discount to fair value, and you will increase the odds of receiving a generous return. This is the modus operandi of value investors.

    Very often we find poor quality companies that are offering good long term returns as a result of the price relative to fair value. As an investor you need to be (relatively) sure that your fair value calculation is accurate and that you are being paid to take on the risk of purchasing a poor quality investment. Sometimes we are lucky enough that a quality company is trading at a significant discount to its fair value for some reason. This is the time to fill your boots.

    Construction Industry

    The construction industry is notoriously a poor quality industry. Margins are tight and the business is capital intensive. Over time, however, the industry has offered excellent investment entry points as a result of the shares trading at substantial discounts to fair value. While not being an obvious place to hunt as a result of poor growth prospects and the shadow of the fines they’ve had to pay for anti competitive behaviour, some of the metrics show that they are offering good value. Below are a couple charts showing the value in the sector.

    In the chart above we can see that earnings are getting close to historic lows. On these low earnings we can see below that the market is offering attractive multiples. While we don’t expect these to unwind immediately they do offer good long term starting points.

    The Seed Flexible Fund currently has a large weighting (via Cannon’s equity allocation) to the construction sector. We expect that this allocation will generate good returns over the look term.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2011-06-09, 17:55:37, by Mike Email , Leave a comment

    The correlation between implied earnings growth and actual performance

    In our monthly analysis of the valuation of the local equity market, we place little to no value in attempting to forecast data. Forecasting suffers from at least two problems. In the first instance forecasting of uncertain events has a low degree of predictability and secondly even if one were to correctly forecast certain factors such as the oil price for an oil company or the input cost of maize to a poultry producer, there is little to no correlation with investment performance.

    Fundamental company analysts tend to build models that attempt to assess the main drivers of a company's performance, be it the price of oil, or maize or margins and volume growth of a retailer etc. We do agree that analysis plays a very important part in the understanding of the business drivers and risks. When investing hard earned money into a business an investor will want to have an understanding of the main factors involved.

    However of even more importance than the primary drivers is the valuations component. The reason that forecasting has a degree of predictability on actual investor returns is that at times both analysts and investors tend to become very optimistic about future prospects. This optimism is quickly factored into prices, which in turn leads to lower than expected returns.

    Conversely when expectations about future earnings are on the lower end of the spectrum, actual future investment returns realised tend to be higher. The scenario tends to be a case of build in low expectations and wait to be surprised on the upside. We tested this theory looking back in time.

    On the assumption then that an investor is looking for say a 15% compounded nominal return over a 5 year period, we can look back in time at what the market prices were implying for company earnings growth.

    On the assumptions used, the market moves from a case of implying 5% earnings growth to 25% earnings growth.

    We then overlayed this with the actual 5 year compounded return that an investor would have received had he invested at that point in time. The chart below provides a summary.

    Chart : Implied earnings growth on JSE and actual compounded return

    Source: Seed Investments

    The results back up our hypothesis in that at the times when the market is implying high earnings, this tends to correlate with low 5 year actual returns.

    Conversely at times when the implied earnings expectations fall to below 10%, investors tend to be rewarded on the upside with superior investment performance.

    With the market flat over the last 6 months, despite earnings growth, the implied growth is slowly being lowered from higher levels.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2011-06-07, 15:42:13, by ian Email , Leave a comment

    Foreign Flows and Currencies

    When looking at the strength or weakness of the rand over the long term (10 years) we believe that it will revert to its Purchasing Power Parity (PPP) level, but over the short to medium term it will be heavily influenced by other factors that may or may not have the same drivers as the long term inflation differential of two countries (essentially the method used to calculate PPP exchange rate).

    One such factor that has a large impact on any currency is flows into (out of) a country. These can typically be split into two categories: portfolio flows and Foreign Direct Investment (FDI). Naturally flows into a country help to strengthen the currency. From Economics 101 we know that increased demand for a product (in this case a currency), with a stable supply, will lead to an increase in price (in this case currency strength).

    FDI is typically preferred to portfolio flows as it’s stickier. With FDI, the investor is generally making a long term investment, as there are large transaction costs – i.e. it would be very expensive to repatriate the investment over the short term. FDI is a good indicator that the investor has faith in the country’s economy and growth prospects. The acquisition of a controlling interest in Massmart by Walmart is an example of FDI.

    On the other hand portfolio flows (investments into security markets – i.e. share and bond purchases) are more fluid. Here the investor is looking for a good return on investment, but either doesn’t have the resources or mandate for direct investment, or doesn’t have confidence in the long term prospects of the country, and wants to have the ability to withdraw the investment on short notice. South Africa is an easy target for so called ‘hot money’ as we have highly developed and liquid capital markets (i.e. it is easy for investors to get in and out quickly) when compared to other emerging markets and have favourable trading hours when compared to most of Europe which makes it easier for them to trade in and out of our market on an intraday basis.

    Over the past seven or eight years we have seen net capital inflows into our equity market, although there have been periods of heightened volatility where capital has been rapidly withdrawn from our market. In the chart below showing monthly net purchases of local equity versus the movement of the rand we can see that there is a high correlation between money flowing into our equity market and the rand strengthening, and vice versa.

    Source: I-Net

    These types of investments are typically dependant on the risk appetite of the large global investors and shorter term news flow which is difficult or even impossible to predict. We therefore stick to our valuation based approach of looking at the rand, fully cognisant that it may not revert to fair value over the short term – as a result of the above mentioned factors – but confident that over the longer term valuation will trump sentiment.

    For regular updates on economic and investment news become a Fan of Seed Investment Consultants on Facebook by clicking here and ‘Liking’ our Fan page.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2011-06-02, 17:43:11, by Mike Email , Leave a comment