All bad things must come to an end

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By Neels van Schaik

It will be with no small sense of relief that a lot of market participants and business people will sign off on 2008. It has been a year of extremes, not only on the business and investment front, but also with regards to global politics. However, some of these changes come with very good prospects.

2008, and more specifically the second half, has been characterized by massive policy stimulus, on a scale that not too many people have witnessed before. This stimulus, both fiscal and monetary, is likely to continue well into 2009 and it will be a global phenomenon. The death of inflation – at least in the short term – has created a feasible environment for these policies to be implemented. There will definitely be countries that will push too hard on the easing cycle with dire consequences down the road for yields and currencies, but in the short-term they are likely to be vindicated by a globe that is liquidity-starved and these policies are likely to be equity friendly in the medium term.

The years ahead will see the stronger companies become even stronger, while the weak players are likely to disappear. This does not mean that it will be only the big companies that survive. Smaller companies that understand their markets, have strong balance sheets and have management depth will find this environment ideal for growing their businesses organically as well as through acquisitions.

Share price declines of many companies have left significant scars on investment portfolios, to the extent that many market participants have become extreme pessimists regarding the asset class’ future potential. This has traditionally been a good contrarian indicator of the market’s prospective returns. During these instances of extreme pessimism, even good companies get marked down to prices not reflective of future earnings potential, and investors should rather use current conditions to acquire such businesses.

2009 will see significant declines in domestic inflation and interest rates (we’ve started already) and, as we have discussed recently, we urge investors to remember that cash has never outperformed equities during declining interest rate cycles. In this regard, history is likely to repeat itself. Clearly profits are under pressure though due to the economic slump we are witnessing, but many companies have already discounted a significant slowdown in profit growth, in some cases much worse than what is likely to unfold.

Dividend yields are at very attractive levels, especially when compared to the income that will be available from cash investments in 12 months time. In some instances dividend yields are high enough for companies to almost be subsidizing investors to own them. These are opportunities that seldom come around and should be seized upon!

We are often asked to try to foretell where the bottom in the market may be, or what the catalyst will be for equity returns to improve. In the short term investor sentiment determines equity returns and it would be pretentious of us to think that we can predict what the sentiment will be. In the long run though, equity returns are determined solely by valuations and the underlying assets and earnings potential of a company. Valuations will therefore determine where the market bottoms and we think valuations of some companies are offering compelling reasons why investors can and should start to commit surplus cash into the market.

We do not claim to have the skill to predict the performance of the equity market in the short term, but we do feel that there is a very high probability that equities will deliver superior returns relative to cash during 2009. On that basis we would encourage investors to use pullbacks in the equity market to further increase their exposure thereto at the expense of cash and bond investments.

Given the declines we have seen during 2008 and the ratings at which a lot of businesses are trading, the potential for a permanent erosion of capital has decreased significantly and equities are therefore a much lower risk investment than they were, for example, 18 months ago.

In the face of adversity there are always opportunities.

Source: Neels van Schaik, Alphen Asset Management, December 12, 2008.


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