The South African Index Investor

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Newsletter: January 2008

Remy and Friends

By Daniel R Wessels

According to the Chinese lunar calendar the year 2008 is the Year of the Rat (also known as Wu Zhi) with New Year officially starting on the 7th February (always starting on the second new moon after the winter solstice, i.e. the shortest day of the year). This calendar is different from the international solar calendar because it is entirely based from the astronomical observations of the movement of the sun, moon and stars. For example, a month starts with the new moon and ends after a full cycle has been completed; in total about 30 days. Furthermore, due to its scientific and mathematical nature, the calendar can be accurately calculated forwards and backwards for thousands of years; for example, numerically, this year will be 4705. Animal names are given to each year; in total 12 animals are named, thus a specific animal name occurs every 12th year.1

The reader might very well want to know how such trivial information is relevant to discussions on financial matters. I certainly do not have much faith in astrology; or that I perhaps have some kind of strange superstitious belief that a particular name or title should have a bearing on the actual outcome of a year. Yet, to some extent I find the above designation a fitting description of how some economic, political (and even judicial) issues may very well affect the behaviour of financial markets in the coming months. Let us see whether I can build some arguments to justify my choice of theme for the year 2008.

1 I do not particularly like rats, or any variant of the rodent species for that matter. Not that I am afraid of them in the classical sense, but rather that I abhor their presence in and around our neighbourhoods and workplaces. I know that they are probably an important part of nature’s food chain, but to me they are only potential carriers of contagious diseases that could cause severe illnesses in humans.

Unfortunately, they are always around and to a certain extent as long as we do not see them we do not really care about them. But sometimes as their numbers in a specific area grow without the necessary precautions (pest control) in place we become acutely aware of their presence. Obviously by then we have to consider and expect some drastic remedial action.

Some time last year I watched an excellent animation movie – Ratatouille – which tells the story of a

French rat, Remy, who had the dream of becoming a master chef in one of Paris’s most prestigious restaurants. Remy did not only have a dream, but also the talent and ambition. The only problem was that he was a rat; even in this animation movie it was unthinkable for a rat to become a chef for human beings.

Against the good advice of his family and friends Remy sneaked into the restaurant kitchen where he met and befriended a wannabe chef, Linguini, who in turn was useless in preparing meals. Linguini soon realised that Remy had a special talent as a chef and together they devised a master plan by which

Remy could direct his human friend (while hiding under Linguini’s see-through chef’s hat and pulling his hair in certain directions) to prepare wonderful meals for the guests. Linguini became an overnight success and guests were streaming to the restaurant. But eventually the plot was uncovered and the prestigious restaurant had to close due to the large-scale protests from the public that their food was prepared by a rat. Luckily, the story ends well for Remy who finds an alternative, less fancy restaurant where he could live his dream of being a chef.

Despite the numerous positive attributes of the movie, the motto of the story (for me anyway) is that rats are not welcome to mingle with human beings in their social activities, despite their seeming innocence.

Inherently they carry real risks to the wellbeing of humans. I remember some years ago, before I had a dog and cat, how rats sometimes plagued our neighbourhood, at the time still a new residential area.

These rats almost assumed the attitude and tameness of a domestic pet. [Luckily, I got rid of them with the aid of rat poison and since then my real pets have kept them at bay.]

2 Markets also experience from time to time the eruption of so-called “black swan” or unforeseen events.

They typically relate to some economic or socio-political phenomena that can seriously dent investors’ confidence and sentiments in markets which previously were considered to be relatively stable (and profitable) while we seemed to be living in a seemingly predictable (event-free) world.

At the start such an event may not seem to pose any real threat, but in time it becomes clear that the extent of “casualties” was initially severely underestimated. Suddenly a major problem is at hand with seemingly not much time to rectify the situation. Emotions run high.

What “rats” are out there that can plague financial markets this year? To be sure, they are always out there and I think they are more visible this year than they have been over the past four or five years.

Just as in the case of a real-life rat epidemic I expect many investors to jump into action, driven by emotions of fear and uncertainty rather than logical reasoning. In short, I will not be surprised if a very volatile year lies ahead of us.

The story that dominated and adversely affected financial markets across the globe over the latter half of 2007 was undoubtedly the subprime mortgage debacle together with the slump in housing prices in the US. To date we have seen massive write-downs from the major prime US and European banks

(about $75bn and counting). Unfortunately, the write-down episode does not seem to have reached its final swansong. In fact, the worst might still be ahead. Moreover, while banks’ exposures, write-downs and losses are continuously in the fray – for example, Citibank recently posted a $10bn quarterly loss – many hedge funds still have to come clean (mark their book assets to true value).

A side note: prime financial institutions like Citibank had to re-capitalise their capital base over the past few months and interestingly they found financiers from private equity funds and sovereign wealth funds funded by oil-rich Arabian countries in the Middle East and Asia. Are we seeing an accelerated shifting of the world’s economic power to Asia and the Middle East?

I commented on the subprime debacle in my August 2007 and September 2007 newsletters. Suffice it to say that since then the situation has only worsened. Again, the extent of the problem and its far- reaching consequences for global credit markets were vastly underestimated. The US economy, by far the largest economy in the world is teetering on the brink of a recession. Stock markets globally have undergone sharp retractions, despite efforts by the major central banks to calm investors’ nerves and to

3 provide liquidity in the markets. At the same time US government bonds and treasury funds rallied as investors’ appetite for risky asset classes dissipated.

With a US recession looming and subsequent rise in corporate insolvencies, another huge “engineered” credit market may soon be in a similar predicament as the subprime credit market, namely Credit

Default Swaps (CDS).

Basically, this is a market where investors (bondholders) can insure their investments against companies defaulting to meet their obligations. Investors pay an insurance premium to counterparties who supposedly will make up the losses to investors in case of a default. The real problem is that this market, estimated to be worth about $45,000 billion is unregulated and there is no guarantee that a lot of the counterparties, those that are supposed to provide the insurance, will be able to meet their commitments once a recession commences and corporate insolvencies return to a much more normalised level than we have seen over the past few years. A widely respected analyst and market commentator, Bill Gross of Pimco, who is running the largest bond fund in the world, estimated that losses from this market could easily top $250bn. A scary thought indeed.

History has time and again shown to those that are willing to see that cheap and easy credit always leads to irresponsible lending practices and major excesses at the end. When those situations unwind and credit becomes squeezed its consequences are widely felt across the economy. For example,

Germany experienced a rather long recession at the beginning of this decade, brought about by similar expansive credit practices. It took a fair amount of time to clean up the balance sheets of banks. The bottom line is that economic growth goes hand in hand with a sound and healthy banking system; when the latter is in trouble the economy stalls.

All in all, not a rosy picture for global economic growth prospects in 2008. Emerging markets, notably

China, India and Russia might keep up the growth numbers to some extent (see also my December

2007 newsletter) but psychologically a significant slowdown in the US, UK and Europe will place a restraint on investors’ moods on the major financial markets. Then to heighten investors’ uncertainty we have geopolitical tensions in Pakistan and Iran, while Iraq seems a complete mess.

Locally, we will probably not be doing much better either. High interest rates, runaway food and fuel prices do not bode very well for consumer spending in 2008. Interest rates might go up even further, while inflation is running way above the target benchmark. Certainly, one could expect insolvencies and

4 liquidations to rise in such an environment. Furthermore, the increase in housing prices, that reliable source of households’ wealth creation over the past few years, might this year even dip below the official inflation rate with declines in some areas a real possibility. The net result of all this would be less consumer spending, a slowdown in economic activity and declining corporate profits.

Moreover, since December 2007 a new element of political uncertainty and fears emerged with the election of Jacob Zuma as new president of the ANC. Yet at this stage it appears that the new leadership, strongly supported by the populist factions within the party, understands the importance of maintaining current economic policies and foreign investor confidence. Thus all the emotions and hype surrounding the ANC’s electorate’s choice may prove to be unfounded.

However, I cannot help but start to doubt somewhat my own optimistic beliefs. In my October newsletter

I portrayed an optimistic, long-term economic scenario, given a strong, political leadership adhering to democratic principles. What we have noticed thus far with the ongoing tussle between the Government

(Mbeki faction) and the Party (Zuma faction), mudslinging and use (misuse) of public or government powers to discredit one faction or the other, and questioning of the integrity of the judicial system and government officials lead me to believe we are still far removed from a mature democracy and political leadership.

Another test for our democracy will be the Zuma trial in the second half of the year. How readily Zuma’s supporters will accept whatever the court finds, especially should he be convicted on corruption charges, remains some cause for concern. Some questions remain whether democratic principles are truly understood and practised by our society at large.

The Rand prospects? By now everyone should know not to try to predict the exchange rate, especially against the dollar which in any event is under severe pressure. In fact, one could probably list ten possible negatives, including the huge current account deficit and the political uncertainty, and only one positive like high precious metal and base metal prices, and that one positive could still outweigh all the negatives. I do not make any forecasts on the exchange rate, but advise investors to diversify their investments into various currencies.

While forecasting financial market returns is mostly meaningless, it is nonetheless interesting to sketch some scenarios of what kind of returns are possible for the year ahead. First, let us review the year

2007:

5 Performance J203T J200T J210T J212T J211T J253T Top 20 Top 15 Top 25 Top 20 over ALSI Top40 Resources Financials Industrials Property 1 Month -4.4% -4.9% -6.2% -5.4% -2.3% -1.8% 3 Months -3.0% -3.4% -7.5% -1.1% 2.1% -0.5% 6 Months 3.5% 4.0% 5.0% -3.3% 6.6% 9.0% 12 Months 19.2% 19.0% 29.1% 0.5% 17.5% 26.5%

Basically, all the year’s returns happened in the first half of the year and were mostly provided by the resources and property sector, while the industrial sector gave some decent returns. The big let-down was the financial sector. All in all, a very decent return was posted for the past year backed by three great bumper years, namely 41% in 2006, 47% in 2005 and 25% in 2004. That is of course if you were invested more or less according to the index. Unfortunately, many investors in actively managed equity funds did not come close to these numbers – typically these funds were heavily exposed to financial counters which were not the place to be, especially in 2007.

If one analyses equity returns into its three return components, namely dividend yield, earnings growth and the change in price/earnings ratio, the following contributions were made towards the ALSI return of

19.2% for 2007:

Dividend yield: 3%

Earnings growth: 38%

Change in P/E multiple: -22% (from a P/E of 17.2 to 14.5 at the end of the year)

By using the same methodology as above one could estimate possible equity returns for the year ahead. Say dividends will contribute about 3% of the return. By varying the expected earnings growth and/or change in the P/E rating of the market a number of return scenarios can be calculated. Currently, earnings growth is exceptionally high (more than 30% growth) and should moderate to about 10-15% growth in the climate of higher interest rates and a tighter credit environment. The P/E of the market is currently around 14; not exceptionally high, but we have seen in 2003 the P/E rating dropping as low as

9, also at a time when interest rates were hiked by 4%, but then the prime overdraft rate was at 17.5% compared to the current 14.5%. Thus, it would be really surprising (inter alia a very pessimistic market or a number of further rate hikes) to see similar low ratings again. Nonetheless, for the purpose of our exercise I will use three possible P/E rating levels, namely 10, 12 and 14 together with two earnings growth scenarios, namely 10% and 15%.

6 The table below forecasts the possible equity returns given the realisation of the different earnings growth and P/E ratings of the market index. Clearly, compared to the previous years returns could be very moderate and could easily enter the negative return territory.

Earnings Growth = Earnings Growth =

15% 10% At year end Total Return Total Return

P/E = 14 14% 9% P/E = 12 -2% -6% P/E = 10 -18% -21%

How would other asset classes perform? Cash probably between 10-12%, bonds 7-10%, and properties probably in line with the overall equity market – low single digit returns or even negative. All in all, cash is probably not a bad option this year and should form a significant part of a multi-asset class portfolio.

Equities (and properties) still have an outside chance to outperform all the other classes, but it would be challenging for investors to stick to their equity strategy amidst the volatility in the market.

Which equity sectors should perform (hold their own) this year? In all probability industries that are known as defensive or non-cyclical and less interest rate sensitive. The infrastructure theme is an excellent story, but it is very well discounted into those stocks that should benefit from it. Some IT stock might still do very well. Resources? A lot has been said about record-high commodity prices and one should be wary for that reason, but I will not avoid those stocks altogether – they are still generating a lot of cash and will still do even if commodity prices had to drop significantly. At some point banks and retailers, which are having a torrid time of continuously selling pressures will start to offer bargain propositions for longer-term investors.

A side note: In recent weeks and months a lot was said about “cheap” banking or retail shares. While it is undoubtedly true that one’s best acquisitions are normally made during bearish market conditions, one must take care of the so-called “value trap”, i.e. buying shares that offer on face value considerable value until the dividend is unexpectedly cut or earnings growth disappoints. The danger here is to extrapolate past earnings growth well into the future, not realising we have experienced the most extraordinary profit cycle in a long time, probably not to be repeated soon.

7 A final word: The “rats” have come out of their hiding places and their population seems much greater than we envisaged not too long ago. Suddenly we are forced to dig in our heels, remain steadfast not to react emotionally and not to desert our long-term investment plan. This is the point where investing becomes extremely difficult; not to revert to the popular strategy of hiding in the trenches, and never to return again or only when most of the gains have already been made in the next cycle.

8 1 The twelve animals are, in order, the rat, ox, tiger, rabbit, dragon, snake, horse, sheep (or goat), monkey, rooster, dog, and pig. A legend explains the sequence in which the animals were assigned. Supposedly, the twelve animals fought over precedence in the cycle of years in the calendar, so the Chinese gods held a contest to determine the order. All the animals lined up on the bank of a river and were given the task of getting to the opposite shore. Their order in the calendar would be set by the order in which the animals managed to reach the other side. The cat wondered how he would get across as he was afraid of water. At the same time, the ox wondered how he would cross with his poor eyesight. The calculating rat suggested that he and the cat jump onto the ox's back and guide him across. The ox was steady and hard-working and did not notice a commotion on his back. Meanwhile, the rat sneaked up behind the unsuspecting cat and shoved him into the water. Just as the ox came ashore, the rat jumped off and finished the race first. And so the rat got the first year named after him, the ox got the second year, and the lazy pig ended up as the last year in the cycle. The cat finished too late to win any place in the calendar, and vowed to be the enemy of the rat for evermore. [Source: www.wikipedia.com]