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    Seed weekly - Capital Protection

    One of the many pearls of wisdom dispensed by Warren Buffett is “Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1”. Unfortunately this is easier said than done in the real world. Fund managers are acutely aware of investor aversion to losses.

    Losses on portfolios can be due to market movements in the price of the investments or when investments go under or default on their obligations. The latter is permanent capital loss, as there is no opportunity to recover the losses suffered. African Bank is an example of this. Investors may get some of their capital back, but will unlikely get a material portion of it back.

    When suffering losses, an investor requires a return higher than the loss to return to breakeven. The graph below shows the subsequent required return needed to breakeven for a particular levels of loss.

    From the above graph we can see that the breakeven return required grows exponentially as losses increase. When investors suffer a 10% loss, they only need 11% to get back where they were. At a 50% loss the investments needs to have subsequent return of 100% to breakeven.

    Fund managers have different ways in trying to minimise possible capital losses. If the fund manager is managing a multi asset class fund he/she will be able to underweight or avoid asset classes that are expensive (high in risk) and rather allocate capital to asset classes that are cheap (low in risk). An active fund manager can also try to reduce possible losses by individually picking the instruments he/she wants to include in their portfolio. They can select the companies that are undervalued and avoid ones that are expensive.

    No fund manager is exactly alike and each has a different way in classifying risk and varying levels of risk aversion. The more aggressive fund managers will tend to outperform a conservative manager at the end of strong bull market. In bull markets a conservative manager will typically start taking profits from the stocks that performed well and deploy the capital into asset classes where there are opportunities. The aggressive manager will tend to ride the run as far as possible and will experience a bigger drawdown when the markets correct. Managers that avoid deep drawdowns typically perform better over full market cycles.

    The graph below is a drawdown comparison between two funds (blue and green) and the category’s average fund (yellow). The blue line is a typical conservative manager and the green line a more aggressive manager. Both of these funds fall into the (ASISA) South African MA High Equity category.

    During the financial crisis of 2008 the blue fund manager was able to protect capital much better than the green fund. The maximum drawdown of the blue fund was 11.8% compared to the green’s 23.4% and the average manager’s 16.8%.

    This is one of the reasons one should take time to understand a fund manager’s philosophy and investment process. You might just be able to spare yourself some heartache by avoiding making an investment with an aggressive fund manager at the peak of a market cycle.

    At Seed we understand that risk needs to be taken to generate inflation beating returns, but seek to structure our solution Funds (Seed Flexible and Seed Absolute Return) in order to ensure that they don’t experience permanent capital destruction.

    Kind regards,

    Gerbrandt Kruger

    021 914 4966

    Permalink2014-09-30, 09:02:16, by Mike Email , Leave a comment

    Seed weekly - Bond Valuations

    Bonds form an important role in many multi asset (asset allocation) Funds. As a bond’s starting yield typically determines over 90% of the return that it will generate (some variability due to reinvestment risk) if held to maturity, this asset class can often be seen in somewhat of a simplistic light. This simplistic logic doesn’t take into account mark to market moves over an issue’s lifespan. As Ian mentioned a couple weeks back, bonds aren’t risk free investments and it is therefore important to scratch below the surface.

    As managers of multi asset Funds we have developed tools that assist our process of determining when to increase the Fund’s allocation to bonds and, likewise, when to reduce the exposure to these fixed income investments. We understand that the bond’s capital value can, and will, fluctuate and therefore attempt to tactically alter the allocation to bonds depending on whether value is apparent or not.

    Two of the measures that we look at (versus their history) are:
    • Are nominal SA government bonds showing value versus inflation linked bonds?
    • Are nominal SA government bonds showing value versus US government bonds?

    The South African Reserve Bank ( SARB ) is mandated to keep inflation in a 3% to 6% band, and while they also have a mandate to generate policy to stimulate economic growth, the inflation targeting forms a large part of their process. To calculate the market’s inflation expectations one simply needs to subtract the yield of a government inflation linked bond from the yield on a like for like maturity government nominal bond. At certain times the market will be overly optimistic on inflation expectations, and likewise there will be periods when inflation expectations are overstated.

    With the SARB committed to (broadly) maintaining inflation within the bands, when inflation expectations are too high we would expect that inflation will surprise on the downside (providing a fillip to nominal bonds) and conversely an overly optimistic view of inflation going forward is typically a good indicator to reduce the allocation to bonds. The chart below shows the difference in these two yields over time, overlaid with the subsequent 1 year nominal bond return. As can be seen there is quite a high correlation between the 2 lines.

    The second measure looks at local versus US bonds. Again, when SA yields are significantly higher than their US counterparts it’s typically an indicator that local bonds are showing good value and vice versa.

    On both of these measures the local market is looking close to fair value (when using history limited to this century) with the implied inflation indicator moving quite strongly from cheap territory at the beginning of the year into an area that’s closer to expensive than cheap.

    We used the implied inflation valuation tool as the major input at the beginning of the year to increase the duration in our multi asset Funds (Seed Flexible and Seed Absolute Return). It was interesting (and pleasing) to see that the manager of the bond mandate in the Seed Flexible Fund reducing duration into the end of August as the market moved into slightly expensive territory. Over time these tactical adjustments to the asset allocation have improved the returns of our Funds when compared to a static strategic asset allocation.

    Take care,

    Mike Browne

    021 914 4966

    Permalink2014-09-23, 11:07:40, by Mike Email , Leave a comment

    Seed Weekly - Steinhoff – Increasingly Global

    Steinhoff International Holdings Ltd is an internationally integrated retailer that manufactures, sources, and retails furniture and household goods across Europe, Africa, and Australasia. The group is positioned to benefit from the entire value chain by having stakes in the sourcing, manufacturing, logistics, and retail stages. The Group recently released its results for the financial year ended 30 June 2014, and overall the company performed admirably.


    Bruno Steinhoff founded the company in Germany in 1964, by sourcing furniture from Eastern Europe to sell within Western Europe. In 1991 the group converted from a pure marketing and distribution company by establishing manufacturing facilities in Germany, Hungary, Poland, and the Ukraine. Steinhoff Africa was formed in 1997, when the Steinhoff family acquired a 35% interest in Gommagomma Holdings. The three Steinhoff divisions in Germany, Europe and Africa were consolidated in 1998 and listed on the JSE as Steinhoff International Holdings Ltd.

    Numerous strategic investments and acquisitions followed over the next 16 years, including the Cornick Group, Unitrans Limited, Reylon Group, Sprung Slumber in the UK, PG Bison, KAP International Holdings, and JD Group. In 2011 Steinhoff acquired Conforama, the second largest home furnishings retailer in Europe with a network of 260 stores.

    More recently, Steinhoff has streamlined its position as a retailer by increasing its holding in JD Group from 56% to 86% and reducing its KAP holding to 45%. In addition, JDG is in the process of selling its consumer finance division, excluding insurance operations, to an international buyer. This will enable JDG to focus on growing its retail operations.

    Latest Financial Results

    The group released its final results for the year ended 30 June 2014 last week. Improved consumer confidence across Europe resulted in increased revenue in euro terms, while the rand weakened by 20% during the reporting period and further boosted the results in rand terms. African operations suffered from the continuing pressure on consumer spending and the sustained high debt-to-income levels locally.

    Revenue from continuing operations increased by 20% to R117bn, while adjusted HEPS improved by 27% to 480cps. The group was strongly cash generative, and cash generated from all operations increased by 68% to R21bn. Finally, the cash dividend has increased by 88% to 150cps.

    The graphs below illustrate the revenue generated per geographical region and segment for the year:

    It is clear that Steinhoff offers local investors truly global exposure, with 74% of revenue coming from outside Southern Africa. International retail activities account for 52% of the total revenue; while the Group’s strategic property holdings also contribute 2% to revenue. Fixed-yield internal rental streams are charged on group properties, protecting the Group’s cost base and increasing sustainability going forward.

    International retail revenue comes mainly from developed markets, with France alone contributing 43% through Conforama.

    The segmental analysis of operating profit also indicates that Steinhoff’s international operations are key to its profitability.

    The group has property investments valued at R45bn, with these properties delivering an operating profit of R 2.7bn at an average return on investment of 7.1%.

    Outlook and fundamentals

    Management believes that Steinhoff Europe will continue to win market share based on the Group’s competitive product range, efficient supply chain, and recognised local brands. The continued investment in retail stores should protect the cost base going forward, and the increasing asset base will help to secure financing at competitive rates. Local operations via KAP and JDG are clearly under pressure, and management hopes that streamlining JDG will ultimately increase the African operations’ contribution to total profit.

    A unique combination of momentum (strong price momentum over the past year) and value (low PE compared to market) characteristics ensures that the share features strongly in the share selection process for the Seed Equity Fund. As a result, Steinhoff has been a significant holding in the Seed Equity Fund since inception, and is currently held at a 9% weight.

    Kind regards,

    Cor van Deventer

    021 914 4966

    Permalink2014-09-16, 11:16:12, by Mike Email , Leave a comment

    Seed Weekly - A brief overview of South African government debt

    When any government spends more on its various departments (such as general public services, health, education, infrastructure etc.) than it receives by way of its taxes, they need to borrow the difference by way of issuing bonds in various forms.

    Because the South African government has a long history of running fiscal deficits, it has developed a sophisticated treasury operation which is responsible for the debt management for government amongst other things.

    Treasury released its 2013/14 Debt Management Report last month. If one looks at the size of the South African economy, it is approximately R3,5 trillion. The second quarter reflected the economy growing by only 0,6% quarter on quarter (annualized), after declining by the same percentage in the first quarter.

    Against this backdrop, the government’s total outstanding debt continues to climb and in the latest report it now stands on a net basis (i.e. after reducing for cash balances) at R1,4 trillion. This level of debt as a percentage of the economy’s GDP is therefore 39,8%. Government was originally budgeting 39% at March 2014.

    Because the government’s medium term estimate over the next 3 years is for expenditure to exceed tax revenues by around R430 billion, the only way that this shortfall can be met is for government to borrow more money in the debt market. But just who does it borrow these funds from?

    The chart below reflects the various types of lenders that have lent money to the South African government and the change in their ownership from 2008. Seven years ago non-residents owned just 12,8% of all issued government debt. Now they own over 37% of total issued debt.

    Holders of government bonds 2008 – March 2014

    Local pension funds owned 44% in 2008 but greater foreign participation over these last few years has diluted pension funds to the second biggest holder of debt. The increase in foreign ownership has largely been due to the search for higher yields post the global financial crisis.
    Fortunately the local government has very little foreign issued debt. Net of foreign cash holdings it is just R59 billion and just 4% of total net debt.

    Naturally as the level of debt increases, as the rand weakens and as interest rates potentially move up as lenders require a greater return for the increased risk, the interest burden on total outstanding debt escalates. Currently the government is spending around R101 billion per annum or 9,6% of government expenditure.

    As investors we need to make an assessment of the risk versus potential return of allocating capital to government bonds. Lending capital to a government may be lower risk than lending capital to a company because a government generally has greater ability to borrow and so repay its debt, but it is never risk free. Furthermore globally we have seen governments default on their debt obligations.

    On a cursory “top down” view of the risks in investing into government debt, one may want to consider the following:

    1. Increasing foreign ownership of local bonds has been positive, but it can quickly turn negative should global interest rates move up and foreign holders turn net sellers.
    2. Ongoing fiscal deficits necessitate additional government borrowing. When seen against a generally stalling economy, the total debt to GDP metrics start to make investors nervous.
    3. Love them or hate them, rating agencies still carry weight. The South African government has solicited ratings from four major credit rating agencies. Recently however S&P downgraded their rating to BBB - (one notch above speculative or non-investment grade). Fitch retained their BBB rating but changed their outlook from stable to negative. Moodys is still more optimistic and retains Baa1(negative outlook).
    These factors all point to the risk that lenders will demand higher yields as risk increases. With bonds, as the yield increases so prices decline, resulting in capital losses for investors. At Seed we remain generally more cautious of the longer term investment outlook for local bonds.

    Kind regards

    Ian de Lange

    021 914 4966

    Permalink2014-09-10, 08:37:23, by Mike Email , Leave a comment

    Seed Weekly - Investment greats – Philip Fisher

    Following my series on Warren Buffett and value investing I decided to write another series on some of the greatest minds in the investment world. These seminal figures of modern investment thinking have impacted many, and have increased the wealth of their clients for the better. Much to learn from these fine minds, I trust that you would find value from their lives and/or thoughts.

    Born in San Francisco in 1907, Philip Fisher was a pioneer in the growth stock school of investing. Fisher was the first to consider a stock's worth in terms of potential growth instead of just price trends and absolute value. Mr Fisher started his investment career in 1928, just before the Great Depression, when he dropped out of the newly created Stanford Business School to work as a securities analyst for a bank. He started Fisher & Company in 1931 and remained in the money management business for 74 years, managing the company's affairs until his retirement in 1999 at the age of 91.

    Philip Fisher followed a growth investment philosophy specialising in companies at the forefront of innovation and driven by research and development. He sought well managed, high quality growth companies that could be bought at a reasonable price, and then held for the long term. A famous example was his purchase of Motorola stock in 1955 (by then a radio manufacturer) which was held to his death in 2004. He kept a concentrated portfolio of stocks. "I don't want a lot of good investments; I want a few outstanding ones." He was not well known to the general public until he published his first book, Common Stocks and Uncommon Profits in 1958. It was the first investment book ever to make the New York Times bestseller list in its time.

    According to Mr Fisher, conservative investors sleep well. In his book he stresses his famous "fifteen points to look for in a common stock” which was his qualitative strategy for finding well managed quality companies. He divided his criteria into two categories namely characteristics of the company’s management, and those of the company itself. I just highlight them – though more detail is available online and well worth the read.

    1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
    2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
    3. How effective are the company’s research and development efforts in relation to its size?
    4. Does the company have an above-average sales organization?
    5. Does the company have a worthwhile profit margin?
    6. What is the company doing to maintain or improve profit margins?
    7. Does the company have outstanding labour and personnel relations?
    8. Does the company have outstanding executive relations?
    9. Does the company have depth to its management?
    10. How good are the company’s cost analysis and accounting controls?
    11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
    12. Does the company have a short-range or long-range outlook in regard to profits?
    13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this s anticipated growth?
    14. Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur?
    15. Does the company have a management of unquestionable integrity?

    With his approach known as “scuttlebutt”, he searched above and beyond these fifteen points for information on a company – since a company’s own information and accounting can be subjective. Known as a good networker, he made use of all contacts he could find to gather information and perspective on a company including questioning customers, industry competitors and suppliers. Asking the right questions was fundamental in this approach.

    "I sought out Phil Fisher after reading his "Common Stocks and Uncommon Profits". When I met him, I was impressed by the man and his ideas. A thorough understanding of a business, by using Phil's techniques … enables one to make intelligent investment commitments." (Warren Buffett) Mr Buffett himself later described his strategy as 15% Fisher, 85% Benjamin Graham.

    Many people say there are two must have books needed for your library to become a successful stock investor – Fisher’s Common Stocks and Uncommon Profits, which explains the qualitative side to value investing and Benjamin Graham’s The Intelligent Investor, where Graham explains the quantitative side. Perhaps not a bad idea for a Christmas shopping list?

    Keep well,

    Lourens Rabé


    021 914 4966

    Permalink2014-09-02, 14:31:01, by Mike Email , Leave a comment