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    Does Active Management Outperform

    We at Seed Investments write weekly newsletters and also compile a monthly market overview. Please click here to sign up on our mailing list to receive the emails directly to your mailbox.

    We have recently compiled a brief overview on the Seed Absolute Return Fund, taking a look at the strategies implemented in the fund, who should invest in this fund and why. Click here to go to Seed's Articles and Research and feel free download the review and some of our fund fact sheets.

    Many research papers and countless reports have been commissioned to investigate whether active managers outperform the market, especially once costs are taken into account. The emphatic response is that managers (in general) don’t outperform the market. While this is generally true, any purely passive strategy will also underperform the market as there are always costs involved in managing any strategy.

    Most studies focus on a single period when comparing the performance of a fund or a group of funds versus the market. This approach is disingenuous as, while there are periods of both out and under performance for active managers, the period chosen is typically altered to match the desired outcome – i.e. the chart is fitted to the data! The 2 charts below show how two different conclusions can be reached on the South African market.

    Chart 1: 10 Year Performance of the ALSI vs the Average Value Equity Manager and the Average General Equity Manager

    Chart 2: 3 Year Performance of the ALSI vs the Average Value Equity Manager and the Average General Equity Manager

    Chart 1 indicates that over the past 10 years active managers (Value and General Equity) have managed to outperform the market (ALSI) after taking into account all costs involved in managing the funds. Over a shorter period (3 years in chart 2) the ALSI has been able to beat both category averages. There will naturally be a bit of survivorship in both data sets, but the evidence is there that if you do your homework and choose a good manager there is the potential to outperform the market over the long term.

    The above analysis is highly dependent on the starting point, and as such can be changed to suit the needs of the argument. At Seed we therefore look at rolling performance to get a better idea of what has been achieved over different periods. A comparison over rolling periods removes a large element of starting point bias.

    Chart 3: Rolling 12 Month Performance of the ALSI vs Rolling 12 month Alpha of the Average General Equity Manager

    Chart 3 above clearly shows that local managers do best when the market delivers low (or negative) nominal returns, as it is in this environment that stock selection skills are more important. Manager performance is cyclical, and determining the market environment going forward plays a role in the selection of the managers within the Seed Funds.

    In previous reports we have discussed how smart beta investing (investing into passive strategies that are, by design, different to the index and are able to outperform) can form part of an investor’s toolbox. We are agnostic when it comes to deciding between active and passive investment vehicles and focus purely on those investments/strategies that have the greatest chance of delivering market beating returns after all costs have been levied.

    We therefore typically construct our Funds with a combination of smart beta AND active managers. In this way we attempt to extract the best of both worlds.

    Take care,

    Mike Browne

    021 914 4966

    Permalink2012-10-30, 14:16:15, by Mike Email , Leave a comment

    Stock Market Crashes

    This month marked the 25th anniversary of one of the biggest stock market crashes ever. 20 October 1987 is known on international markets as black Monday, where in one day the US market lost over 20% and between October 14 and 19th prices fell 28.5%. Over this period, the value of all US shares lost almost $1 trillion.

    A stock market crash is an event where there is a sudden price decline across a broad section of the market, where prices are driven down sharply by negative psychological sentiment. The history of publicly quoted market prices is one which is littered both with price bubbles and with spectacular crashes.

    For many investors it is this possibility of a meltdown in prices that scares them from investing a reasonable proportion of their capital. Indeed, it is healthy to have a sceptical attitude towards quoted prices because, while fundamentals ultimately drive prices over the longer term, it is also important to understand that the emotional factors of fear and greed can drive prices far away from their true values.

    25 year ago on Monday the 19th, panic set in and everyone turned seller, resulting in the Dow Jones Industrial Average plummeting 22.6% on the day. This was the biggest single decline since 1929 and was the subject of plenty of debate including a detailed report to the US president titled the “Presidential Task Force on Market Mechanisms”.

    Prices had been driven up over 40% from the previous year to August 1987. Over a 5 year period from August 1982, the Dow had risen by a compounded 28.5% to its then peak in August 1987. Despite the spectacular October crash the Dow Jones Industrial Average ended up slightly for the year.

    The benefit of hindsight and a large degree of rationality allowed market participants to investigate some of the reasons that may have sparked the panic. Some of the reasons put forward included:

  1. On Friday 16 October, UK markets were closed due to a major storm

  2. In the week prior to the crash, an unexpectedly large US trade deficit was released, which led to the possibility of a decline in the dollar relative to other currencies

  3. The most widespread explanation was so called program trading, which is computerised trading by large institutions using buy and sell levels

  4. Another major cited factor was the increased use of derivatives. Typically futures and options are used as portfolio insurance, but the writers of these were forced to sell as prices plummeted, further exacerbating downward pressure

  5. Relatively expensive valuations. PE ratios had expanded to a level of 20, from a long term average of 15.

    The long term log chart of the Dow Jones Industrial Average below puts the crash into perspective. Devastating at the time, with the benefit of hindsight, this particular crash was relatively short-lived and had very little impact on the economy.

    Chart : Dow Jones Industrial Average

    There is never one specific cause of a market crash and indeed while some have predicted previous crashes including that in 1987, this is near impossible with any degree of regular success. The market decline in 2008 was as a result of a whole different set of circumstances.

    We believe that the single biggest factor that investors need to pay attention to is valuation. This in itself is not an absolute, as emotions of greed can, and often do, stretch valuations. Reducing exposure as valuations become stretched may initially hamper performance, but it often proves beneficial as prices fall back to more normalised levels.

    Kind regards,

    Ian de Lange

    021 914 4966

  6. Permalink2012-10-23, 12:46:01, by Mike Email , Leave a comment

    Slowing Global Growth

    Last week, the IMF (International Monetary Fund) released updated world growth forecasts in their detailed World Economic Outlook report. Expected growth for 2012 has been reduced to 3.3%, down from 3.5% in their July forecast, which in turn was down from their April forecast. This is due to low growth and uncertainty in advanced economies affecting emerging and developing economies. Their projection is for advanced economies to grow by 1.3% compared to 1.6% last year and 3% in 2010.

    These forecasts rest on some assumptions – the important ones being that European policymakers will adopt policies that will ease financial conditions in affected countries and in the US policymakers will be able to prevent a major negative impact of the looming tax increases and spending cuts – the so called fiscal cliff.

    Emerging and developing countries are expected to grow by 5.3% from 6.2% in 2011 and 7.4% in 2010. China’s growth is expected to come in at 7.8% compared to 10.4% in 2010. The report makes the note that there is a 1 in 6 chance of global growth falling below 2%.

    Everything being equal, lower economic growth forecasts are negative for markets, but we have noted before the low annual correlation between a country’s specific GDP and its market return. It is important to look at all the components of return that make up the total return. These are:

    • The dividends received;
    • Growth in earnings which can translate into higher dividends; and
    • The change in the valuation of those earnings.

    Dividends are the most stable component of total return. This is especially the case in times of slower economic growth. A growing company will be able to grow earnings and hence its dividends, being the second component of total return. Thirdly an important, but by far the least predictable, element of total return is the valuation of those earnings.

    The chart below reflects total return from the US market per decade from 1926, splitting between the dividends and capital (growth and change in valuations). The period 2000-2011 was a low growth period, not because companies did not grow their earnings, but because starting dividend yields were low and valuations were very high.

    Equity returns by decade: Dividends and Capital Appreciation

    Source: Pimco, Standard and Poor

    Historically US shares have produced around a 6.6% real return. Pimco’s view is that in a lower growth environment, this is likely to come down to around 3% - 4%, with most of this return derived from dividends. In order to boost this, active management becomes even more crucial as does looking for growth in companies that are expanding into emerging markets.

    Kind regards,

    Ian de Lange

    021 914 4966

    Permalink2012-10-17, 08:14:17, by Mike Email , Leave a comment

    Currency Fair Value

    Where the rand is trading on any given day versus a range of other currencies is a very topical subject, with almost everyone having their opinion on where it should be trading, where they think it will go, and the reasons for its more recent moves.

    Like most financial instruments, one can arrive at a fair value for a currency against either a single currency, or a basket of currencies, through a number of methods. While a fair value can be calculated it doesn’t mean that the currency will immediately move to the fair value, it can take up to 10 years (or in certain cases even longer) to revert to fair value. When using longer term valuation techniques, rather than shorter term ‘signals’, it is important to have a long term view, otherwise short term forex gyrations can result in decisions that will destroy capital.

    At Seed we make use of the Purchasing Power Parity (PPP) method to determine the fair value of the rand. This method is based on the assumption that in a perfect world, goods and services should cost the same in whatever market (country) they trade in, when taking into account the current exchange rates. Where there is a mismatch between prices, arbitrage will take place and the laws of supply and demand will ensure that the exchange rates will move to reflect the mismatch in pricing, bringing the prices between the two regions into equilibrium.

    Naturally we don’t live in a perfect world. Each country has its own competitive advantages, there are costs involved in transporting any good or service, countries have foreign reserves and other measures to manipulate the exchange rate, there are taxes and levies imposed by governments, and in more repressive regimes laws are created to restrict trade of goods and services. PPP will therefore not work 100%, but over time will give a good idea of where the currency should be trading. Over time this ‘fair value’ acts as a magnet that helps to anchor an exchange rate around the fair value.

    The chart below shows the ‘fair value’ of the rand versus the US dollar over the past 28 years. It is clear in the chart that while the rand doesn’t spend much time at fair value, the ZARUSD PPP fair value exchange rate does provide an anchor to the exchange rate at any point in time. At the end of 2001 and 2008 the model indicated that it was a good time to be reducing exposure to the USD and at the end of 2004 and 2010 it was a good time to be accumulating USD.

    By using this method to determine fair value, one would have been too early in bringing forex back at the end of 2000, but this decision would have paid off on a 4 year horizon with the rand strengthening from R7.60/USD to R5.60/USD from the end of 2000 to the end of 2004.

    The current rand weakness (from R8.30/USD at the end of September to R8.75/USD currently) has only brought the rand closer to fair value which we estimate sits between R8.85/USD and R9.00/USD. Naturally there is the risk that the currency continues to weaken through fair value, but we use this tool to assist in our decisions on when to send currency offshore and when to repatriate it.

    Take care,

    Mike Browne

    021 914 4966

    Permalink2012-10-16, 08:25:28, by Mike Email , Leave a comment

    Cashbuild - Building Value

    Cashbuild, one of the leading building material retailers in South African, has recently released its annual results for the financial year ending 30 June 2012. Cashbuild employs more than 4,000 people in 191 stores across South Africa, Namibia, Lesotho, Botswana, Swaziland, and Malawi. The company was listed on the JSE in 1986 and has a current market capitalization of just below R 4bn.

    Annual Results
    The results were excellent compared to last year, but management highlighted the fact that the June 2011 results covered only 52 trading weeks and also included the effects of last year’s BEE transaction to incentivise management members.

    Source: Cashbuild.co.za

    Net Asset Value per share increased by 25%, revenue increased by 11%, and total dividends were up 92% year on year. Operating profit increased by 67% at first glance but, excluding the 53rd trading week and BEE transaction, came to a more comparable 26%. In the same way, headline earnings per share increased by 88% for the year, but come to 26% on a comparable basis.

    Source: Cashbuild.co.za

    Cashbuild has managed to increase its gross profit margin slightly by 0.8% to 23.3%, despite a competitive environment in which many of its competitors are struggling. Operational expenses were well controlled by management, increasing by 9% largely due to the people cost component for new stores. Stock levels were in line with management’s expectations with an overall stockholding of 63 days, compared to 72 days reported in 2011.

    Competitive Advantage

    Cashbuild aims to offer quality products at the most competitive prices, and use their substantial buying power to control prices from their suppliers. The company enjoys a very strong customer base in the rural areas, amongst previously disadvantaged home improvers, and small scale building contractors. Cashbuild has managed to position their stores optimally to meet the ever growing demand in the mining provinces, a significant competitive advantage that might extend even more as the resource sector picks up. Cashbuild stores carry a focused range of products and services, which is tailored to the specific needs of each community in which that store operates.

    Expansion Prospects

    The number of Cashbuild stores has remained at 191 since last year’s results, with thirteen stores being refurbished and three relocated. Four new stores were opened, and four stores that were in close proximity to other Cashbuild stores had to be closed down. The company will be continuing its store expansion, relocation and refurbishment strategy, with management hoping to open up to five new stores in the first six months of the new financial year.

    Demand for building materials is expected to rise in the next twelve months, as housing delivery normally increases in the run-up to elections. With wage increases and social grants ever increasing, Cashbuild expects their target customer base to be able to spend more on refurbishment and expansion of their homes going forward.

    Current Valuation

    Cashbuild shares have performed exceptionally well over the past five years, with the share price increasing by 139% from R 66 to R 158. Over the last twelve months the share is up 53%, after a slight drop from its recent high of R 168.

    Source: Sharenet

    Cashbuild shares currently trade at a PE of 12.6 times and a dividend yield of 3.6%, which compares favourably with the JSE’s respective metrics of 13.9 and 3.0%, and are by no means expensive.

    Given the recent run it is up to investors to decide if the growth in share price can be continued, and whether Cashbuild’s competitive advantages will be eroded or built up over time.

    Kind regards,

    Cor van Deventer

    021 914 4966

    Additional sources:
    www.cashbuild.co.za, www.moneyweb.co.za

    Permalink2012-10-03, 15:57:34, by Mike Email , Leave a comment