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    Bond Returns in an Inflation Targeted Environment

    As multi-managers we focus most of our research in two areas:
    • Selecting the best fund managers and blending them together
    • Valuing asset classes to determine expected returns and risks going forward

    This week we’ll take a closer look at valuing bonds.

    As mentioned in previous weekly reports, bonds are essentially loans made by investors to the issuers (governments, parastatals, corporates) who promise to repay the bond back at a predetermined date with a predetermined interest rate. The return of the bond is therefore fairly simple to calculate. The initial yield will in a large part determine the total return (on a nominal basis) if the bond is held to maturity. Factors that will affect the total return will be any default (failure to pay either coupon or principal) and the reinvestment risk.

    Reinvestment risk comes about when the coupons (interest payments) are paid to investors and need to be reinvested. Should prevailing yields be below the initial yield then the total return will be lower than the initial yield to maturity, but if they are higher, then investors will be able to enhance their return by reinvesting at the higher rate.

    The chart below shows the relationship between the initial 10 year spot bond yield and the subsequent 5 year annual return. As can be seen, there is a tight relationship between the two variables with the initial yield explaining over 90% of the total return.


    A large part of the Monetary Policy Committee’s (MPC) mandate is to keep inflation between 3% and 6%. While there is a ‘political’ mandate to encourage strong GDP growth (which will sometimes result in inflation staying higher for longer) there is at least the framework to bring inflation back should it move significantly above 6% for any extended period.

    The inflation rate that is priced into the market for the next 5 years can be approximated by taking the difference between the long (nominal) bond rate and the inflation linked bond rate. Since the turn of the millennium the implied inflation rate has been between 4.5% and 6% nearly two thirds of the time. This range is intuitive as it sits in the upper portion of the MPC’s target range.

    History shows that when the implied inflation rate was above 6% the average subsequent 1 year return from bonds is 18%. When the implied inflation rate is below 6% the average subsequent 1 year return from bonds is 9%. Naturally it is therefore better (in general) to invest into bonds when the inflation outlook is poor than when it is rosy. Taking a closer look at the numbers reveals an average 1 year return of only 6% when the implied inflation rate is below 5% and 25% when it’s above 7%.

    Below is a cross section of the implied inflation rate and subsequent 1 year return from bonds. Notice the trend line:


    We expect that this relationship will hold as long as inflation targeting is part of the MPC mandate. With actual inflation expected to sit between 3% and 6% (but more likely closer to 6%), periods where the market expects high inflation will generally be followed by periods where expectations moderate. Falling inflation expectations are good for bonds returns as the market prices in lower interest rates, which results in capital gains on fixed income investments.

    As with any valuation model, the actual outcome will most likely differ from the model’s expected outcome, but the model does give a good indication of the type of return that one should reasonably expect going forward. Periods with high starting yields AND high implied inflation rates are good periods to be investing into bonds, with the converse also being true.

    Kind regards,

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

    Permalink2012-03-27, 10:51:09, by Mike Email , Leave a comment

    Earnings and PE

    9 March marked the 3rd anniversary of the bottom of the 2007/2008 bear market, where the S&P500 index declined a massive 57% to 9 March 2009 from its October 2007 high. Then in just 2 years, the same index gained 100% from the lows made! Most global stock markets followed a similar pattern.

    In trying to understand valuations, let’s revisit some basics. The value of a business is the discounted value of its future earnings at an appropriate discount rate. This should be relative easy to arrive at, but we know that because we are dealing with future uncertainty, there is a range of possible outcomes, hence the ongoing price volatility.

    At the core, there are only 2 variables that affect the value of a share of a business – the income that it will generate, and the discount rate applied to that future income stream in order to arrive at a net present value. Expanding on each of these:

    • A 100% shareholder has a claim on all of the future earnings generated by that business. Therefore a part shareholder has a proportional share in those future earnings. Some of the earnings will be received by way of a dividend, while typically the bulk will be reinvested back into the business for future growth and hence higher future dividends.

    • The discount rate applied to the future stream of income is the second main factor in valuing a company. While the discount rate is affected by the prevailing interest rates, a rational investor will want to apply a higher discount rate to a more cyclical business, while one with superior management, a strong balance sheet and better quality and higher earnings growth, will justify a lower discount rate.

    Instead of quoting discount rates, use is made of the price to earnings (PE) ratio, which is more or less the inverse of the discount rate. i.e. a company with steady and growing earnings, a strong balance sheet and quality management will justify a higher PE ratio. This metric is widely used and typically easier to understand.

    The effect of the multiplication of these two factors can and does cause the price volatility that we see on a daily, weekly, and monthly basis. For example look at the reported earnings per share for all the S&P500 companies. It peaked in mid-2007 at around $85. Analysts would have been forecasting various forward levels around this, but then came the global financial crisis and earnings fell dramatically to below $10 a share by mid-2009.

    As reduced earnings were quickly factored into investor forecasts throughout 2008, so share prices tumbled, eventually ending down almost 60% off the peak. But the interesting thing is that just as quickly as company earnings fell, so they have reversed all the way back up again with the 12 months to the fourth quarter of 2011, with almost all companies having reported, reflecting earnings per share of $87. Forecasts from S&P expect these to rise to $100 for the full 2012.

    The chart below reflects S&P500 earnings from 1970 with the massive 2008 dip and subsequent recovery.

    Source: Crestmont Research

    In addition to the sometimes very volatile earnings, the multiple that investors apply to those earnings has a huge impact on valuations over various periods. I.e. an investor might suffer a loss from a company, which delivers on its expected earnings, because the rating on these earnings goes down. For example earnings may move up as expected from say 23 to 35, but the rating drops from an initial 18 to 10, resulting in a price decline from 414 to 350.

    The only certainty with any investment is the price paid. Other than this, an investor does not know the exact details of the future earnings stream or the future price that an investor will be willing to pay for those earnings, making forecasts difficult.

    A prudent investor will look at both the level of earnings and the rating of these earnings when making an investment.

    Kind regards,

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

    Permalink2012-03-20, 16:29:57, by Mike Email , Leave a comment

    Death benefits from Approved Retirement Funds vs Policies

    One of the most misunderstood areas of financial planning in South Africa is how trustees of retirement funds deal with death benefits of the funds. Most people either have their own benefits or have to deal with family members or staff who are frustrated when a claim either takes too long or the benefits aren’t paid out as stipulated in the beneficiary nomination form.

    The beneficiary nomination form for an approved retirement fund benefit does not carry the same weight as one for a life policy. When you nominate a beneficiary on a life policy or an unapproved group scheme, the insurer will pay the proceeds of the policy directly to your nominated beneficiary, whether it is your mistress, your brother or the SPCA. This is not the case with a beneficiary nomination on death benefits on an approved retirement fund.

    Death benefits on a retirement fund are paid out in accordance with the stipulations of section 37C of the Pension Funds Act. It grants the trustees a 12 month period from the death of the member to search for dependants of the deceased member. This needs to be done despite the existence of a nominated beneficiary. The trustees are granted discretionary powers in awarding the death benefits; however, the overriding consideration is equity in distributing the death benefit. The trustees cannot merely follow the beneficiary nomination that the member placed on the policy or pay the benefit to the dependants found by them, but must exercise their discretion provided to them by section 37C in doing so. The beneficiary nomination will act as a guideline to the trustees as to the wishes of the member, but in no way diminishes their responsibility in determining who should receive the death benefit.

    In a Pension Fund Adjudicator decision of S Segal v Lifestyle RA Fund, the adjudicator stated that in order for the trustees to act equitably, they should give regard to the following factors:

    • The age of the parties;
    • The relationship with the deceased;
    • The extent of dependency;
    • The financial affairs of the dependants, and
    • The future earning potential and prospects of the dependants.

    The adjudicator then goes on to provide a class of potential claimants, which includes:

    • Those whom the deceased had or would have had a legal duty to support, namely spouses, children, parents, grandparents, and unborn children;
    • Factual dependants, such as so-called common law spouses and same-sex partners;
    • Customary law spouses and those married under Islamic law, Hindu, Buddhist, Confucian, or Taoist rites;
    • Major children of the deceased whom the deceased had no legal duty to support; and
    • Beneficiaries nominated in writing after 30 June 1989.

    A nominated beneficiary, for example a brother, who is not financially dependant on the deceased, will have very little chance of receiving the benefits if the deceased had a wife and children. This is an example of where customary law and legal statue are directly in conflict with one another, because it is common practice amongst Zulus that the oldest brother / oldest son must inherit and he will then look after the remaining dependants. Unfortunately, for customary law legal statute carries more weight.

    Therefore, when you are nominating beneficiaries for your retirement fund’s approved risk benefits, take note of the parameters, which the trustees must use when allocating benefits. They are not trying to be difficult if they do not follow your wishes, they are just following the law.

    Kind regards,

    Barry Hugo
    info@seedinvestments.co.za
    www.seedinvestments.co.za
    021 9144 966

    Permalink2012-03-14, 17:47:19, by Mike Email , Leave a comment

    Basic Share Selection – Tiger Brands vs. Nampak

    When it comes to selecting shares to construct your share portfolio, several factors can be used to evaluate shares for inclusion. At Seed our Model Portfolio has a tilt towards value shares, buying shares with dividend yields higher than the market and PE ratios lower than the market average. Our process also favours shares where earnings and dividends are expected to grow in future.

    When deciding between two shares, an investor first must decide which criteria to use to provide the best indication of the return that can be achieved, and then compare the universe of shares using these criteria. There are always shares with compelling stories making headlines, but as a rational long term investor fundamental factors and ratios should be the main drivers behind your share choices. The two factors most familiar to investors are probably the Price Earnings (PE) ratio and Dividend Yield (DY).

    PE ratio

    The PE ratio is calculated as the current market value per share divided by the company’s earnings per share over the past twelve months. A further variation on this figure is the forward PE ratio, which uses forecast earnings over the next twelve months in the calculation. Using forecast earnings to calculate a PE ratio is not as reliable as using actual past earnings data, because forecasts can be inaccurate (especially at turning points). However, the forward PE has a prospective nature, which can sometimes be more useful to evaluate the share’s future performance.

    Dividend Yield

    A share’s dividend yield is calculated very simply as the annual dividend received per share divided by the share price. A healthy dividend yield is an important factor for investors that rely on dividends as an avenue of income. Although large and consistent dividend declarations are often regarded as a sign of a company’s good financial health, some companies may have very valid reasons for not declaring dividends, e.g. setting profits aside for expansion or acquisition activities. The forward DY can be calculated on a similar basis, but using an estimate of the next 12 months’ dividends to create a prospective measure of the DY.

    Tiger Brands vs. Nampak

    Nampak Ltd (NPK) and Tiger Brands Ltd (TBS) both form part of the Industrials super sector on the JSE, and although very different in operations and market capitalisations they can still be compared on a PE and DY basis.

    Nampak was listed in 1968 and has grown to be Africa’s largest and most diversified packaging company through various acquisitions. It produces packaging products for various products from metal, paper, plastics, and glass, and also collects and recycles used packaging.

    Tiger Brands was formed in 1952 with the launch of Tiger Oats, and has grown to become one of SA’s largest consumer goods companies. The company owns a wide assortment of brands including Purity, All Gold, Energade, Beacon, and Albany.

    These companies’ share data as on 05/03/2012 can be summarised as follows:



    Tiger Brands’ share price has increased by 46.1% over the last 12 months, pushing the PE up to 16.8 which is well in excess of the JSE ALSI PE of 13.3. The forward PE of 15.3 implies 9% earnings growth in the next year.

    On the other hand, Nampak’s share price has not run as hard over the past 12 months, increasing by only 8.6% but showing strong growth over the last 30 days with a 5% increase. The PE of 13.7 compares favourably to the ALSI, and the forward PE is a further 14% lower at 11.8. This is a very reasonable price to buy into a quality company. On the dividend yield side, Nampak has the upper hand with a 4.6% yield compared to Tiger Brands’ 3.0%. Both companies have a DY in excess of the ALSI (2.8%).

    Conclusion

    Tiger Brands has rewarded investors with phenomenal growth over the past 3 years, but given the high current PE and modest DY we believe that there are better buying opportunities out there. Seed has recently included Nampak into our model portfolio, at the expense of Tiger Brands, as the current valuations are very favourable and we believe that further growth in earnings can be expected as SA’s manufacturing sector grows.

    Kind regards,

    Cor van Deventer
    info@seedinvestments.co.za
    021 9144 966

    Permalink2012-03-13, 11:44:25, by Mike Email , Leave a comment