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    Exchange, Inflation, and Interest Rates

    To sign up to Seed's newsletter (which includes weekly investment reports, fund fact sheets, market overviews, and more) click here and enter your details. For regular updates on investment and economic news visit our Facebook Fan Page by clicking here and 'Liking' our page.

    Last week saw the release of the latest inflation numbers and the Monetary Policy Committee’s (MPC) pronouncement on interest rates. On Wednesday, inflation came out at 5.3% year on year (no change from the 12 months to the end of July). Thursday’s MPC pronouncement was for no change in interest rates, with the repo rate remaining at 5.5% and the prime lending rate at 9%.

    At the same time since the beginning of the month (less than 3 weeks ago) we have seen the rand lose considerable value to developed market currencies. At the end of August, US$1 would have cost just under R7, it now costs over R8 (over 15% depreciation).

    These three indicators are useful in most of our lives. Interest rates dictate our monthly repayments on home, car and other loans if we have any debt, or the rate we receive on any fixed income savings. While the inflation rate can vary widely from individual to individual, the national inflation rate gives us a sense of how fast prices of goods and services are rising. It sometimes appears that the exchange rate doesn’t have a direct impact on us unless we’re involved in the import and export business or are planning an overseas trip, but the chart below shows just interlinked all these indicators actually are.

    In a country with inflation targeting (such is the case in South Africa), changing the repo rate is the main method to guide inflation. Raising the rate increases the interest/debt burden for companies and individuals, and generally results in debt being paid down, the economy slowing, and inflation falling (and vice versa with falling rates). As a lot of inflation is imported (through global pricing for commodities, goods, and services) the level of the rand has a direct impact on the inflation rate and by extension interest rates.

    With the head of the MPC, Gill Marcus, seemingly placing more of a priority on economic growth than her predecessor Tito Mboweni did, it will be interesting to see if and when she changes interest rates should the weaker rand translate into higher inflation. The argument until now for leaving rates at 30 year lows is that the inflation in the economy is cost push inflation as opposed to demand pull inflation (i.e. inflation isn’t as a result of strong economic growth, but rather external factors that can’t be controlled by the repo rate).

    For now there hasn’t been much debate about interest rates as the inflation rate has stayed within the target range of 3% - 6%, but there will no doubt be some interesting debate if/when inflation moves out of this range. If the rand stays above R8/$ (or weaker) for an extended period this debate will most likely happen sooner than expected.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2011-09-28, 15:02:25, by Mike Email , Leave a comment

    The Benefit of Dividends

    I am convinced that our generation will suffer from information overload and successful individuals will be those that are able to focus on really important matters. There is just so much out there screaming for our attention that it makes it very difficult to be focused.

    Likewise, having too much information can influence one’s investment decisions negatively. This is compounded due to emotions of fear and greed.

    Let’s assume an investor builds a share portfolio of about 15 shares, not for tradability and liquidity, but because the companies in the portfolio have proper business models, management that is trustworthy, and steady profit generating businesses. Assume also that the investor is investing into these businesses because of their quality and sustainability over the next 10 years as opposed to being the “next best thing”. A portfolio with the above characteristics can be built relatively easily with a starting dividend yield of 4.5% pa (at current market levels). Key is not look at the share prices for the next 10 years but only at whether the businesses still have relevant business plans, trusted management, and are generating enough cash to pay out dividends.

    If this is the case then a lot more people will become investors as opposed to share traders and a lot more investors will make good steady returns over a long period.

    To build wealth takes time. There are no short cuts in making money.

    Let’s compare the cash flows of a RSA retail savings bond and the cash flows of the businesses we selected by way of our investment criteria.

    Currently there is a 5 year RSA retail bond that pays 8% p.a.

    The following assumptions are made:
    - R1m to invest
    - There is a 10 year bond with the same terms
    - Income tax is calculated at 25%
    - The average starting dividend yield of the portfolio is 4.5%
    - The dividends will grow at a modest 8% per annum (6% inflation + 2% real growth)

    The likely payoff profile from these two investments net of tax for the next 10 years will be as follows:

    From the graph it is clear that after about 4.5 years the annual dividends paid will be higher than the (net of tax) income received from the retail bond.

    It is important to realize that the nominal value of the dividends is not dependent on the market price of the share portfolio but rather on the sustainability of the discussed investment criteria.

    The above analysis has not taken into account the capital value at the end of the period. The bond’s R1m nominal will be repaid at the end of the term (losing purchasing power). The shares in the portfolio will only be sold if their prices have reached (or exceeded) fair value, based on the above assumptions fair value will be approximately R1.9m. The market value of the share portfolio could be less than R1.9m in which case the likely decision would be not to sell, but to carry on receiving the increasing dividends. Any dividends received in excess of the required income level can be reinvested to grow the capital invested.

    Based on the above analysis and with interest rates possibly falling further and tough economic times predicted it makes sense to be an investor, investing in quality businesses that pay out sustainable dividends rather than a speculator that attempts to extract short term capital gains or an investor with a short term horizon that limits their income growth by investing into nominal bonds.

    Seed has developed a process to manage share portfolios for private clients based on similar principles explained in this article. If you want to know more and are able to invest more than R1m in a share portfolio then contact us at info@seedinvestments.co.za

    To sign up to Seed's newsletter (which includes weekly investment reports, fund fact sheets, market overviews, and more) click here and enter your details. For regular updates on investment and economic news visit our Facebook Fan Page by clicking here and 'Liking' our page.

    Kind regards

    Vincent Heys
    021 9144 966

    Permalink2011-09-20, 17:47:37, by Mike Email , Leave a comment

    Discovery releases annual results

    Discovery is a company known in South Africa for its health and risk financial products. The company was founded by its ceo, Adrian Gore, now 46, in 1992. Year on year it continues to impress the market with its innovation and with its financial performance.

    In a trading statement issued on the 24 August, the company said that normalised headline earnings were expected to increase by between 25% and 35% over the previous year.

    The June 2011 results revealed an increase of 31% to 365,8 cents per share. The consensus forecast has this increasing to 431c next year, putting the current price on a forward PE (price to earnings) of 9,1 times.

    The company has calculated an embedded value – the equivalent to the net asset value – at R48,45/ share up 19% year on year. The share price is trading at R39,15 and therefore a discount. The price did trade over R40 at the end of 2011, but has largely moved sideways for 2011 in line with the overall market.

    The business has the health and life as the key profit generators, while at the same time it is expanding into new areas including Discovery Invest, Insure, Prudential joint ventures and its Vitality business.

    • Discovery Health grew operating profits by 14% to R1,35 billion and with total medical scheme membership increasing by 6% to 2,5 million lives.

    • Discovery Life has been an excellent business unit, with profits increasing by 16% to R1,6 billion

    • Discovery Invest is a relative new business unit, but has turned into profitability generating R101 million with assets under management exceeding R17,2 billion.

    PruHealth is Discovery’s joint venture business in the UK. During the year it acquired Standard Life Healthcare, the UK’s fourth largest assurer. By contributing this to the joint venture, Discovery’s stake has increased in both PruHealth and PruProtect from 50% to 75%.

    Discovery has a joint venture in China called Ping An Health. Although still very early, this company administers a total of 300 000 lives.

    The company remains on a definite growth path with the following major acquisitions and new launches:

    • At the beginning of the financial year, Discovery acquired Standard Life Healthcare.
    • Concluded a joint venture with US health insurer, Humana and launched HumanaVitality.
    • It launched the short term operation – Discovery Insure.

    The company mentioned that its Vitality is the underpin to Discovery’s performance, saying that with Vitality they can make better selection, more accurate pricing, etc., which assists with the product development. The model is being used for the new Discovery Insure, where they will apply the principles of behavioural economics to the science of driving and linking this with premiums.

    Discovery had the early backing of the RMB group. With the more recent restructuring of the Momentum group and the separation of FirstRand, the company RMI Holdings was listed on the JSE on the 7 March 2011. This company owns 25% of Discovery, 24,4% of the new MMI Holdings (merger of Momentum and Metropolitan) and 83% of Outsurance. This is a way to access 3 life businesses through one share.

    This is definitely a growth business, but remains a complex business with many moving parts. At face value it does appear to be good value. On a dividend yield basis it however trades at a premium to the market. The market did appreciate the results, taking the price up over 3% higher towards the end of the day.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2011-09-01, 16:27:09, by ian Email , Leave a comment