Investment Postcards from Cape Town

By Greg Flash

Volatility is one of the most discussed issues in the investment industry at this time. Volatility of world markets, volatility of our market, volatility of the rand. The world of finance is not unique to extreme changes, just look at the political world. In four days - if the latest polls are to be believed - we could see a gigantic shift in US political history with the first African American president being elected. Here at home, SA political issues have been raised to new highs, as we may be about to witness a split in the 90 year old African National Congress, and even stranger and definitely more entertaining, the launch of the first political party headed by a female impersonator in the form of Evita’s Peoples Party http://www.epp.org.za/! Let’s not even talk about the threat to our beloved Springbok Rugby emblem and the problem with some of our “Springboks” not being able to keep their breakfast down. Definitely not a dull time to be alive!

Let us return to the financial world. With the All Share Index (ALSI) having collapsed in the last two months, I thought it important to see how the Domestic Equity Unit Trust industry has oscillated in comparison. Using data from Morningstar, volatilities for all unit trusts in the Domestic General, Growth and Value Equity sectors were compared to that of the ALSI. The first unit trusts in these sectors date back to May 1987. I decided to compare the volatilities of these and subsequent unit trusts to the ALSI. In addition, the first multi-managed equity unit trusts date back to July 1998 and hence I have calculated the volatilities of these and subsequent multi-managed funds from this date. In the graph below, average 1 year rolling volatilities for the abovementioned funds are plotted.

As can be clearly seen, the ALSI is far more volatile than the average equity unit trust and the average multi-managed funds within these sectors. Looking at the last 10¼ years since multi-managed equity funds have been in existence, the ALSI has had a volatility of 21.8%, while the average equity fund has had a volatility of 18.4% and multi-managed equity funds for the same period have had the lowest volatility of just 16.2%.

These numbers are to be expected, particularly that of the multi-managed funds having the lowest volatility which can be attributed to their diversification characteristics. This multi-managed fund volatility is also lower than the volatility of the equity unit trusts over the longer period of 17.1% and the ALSI for this same 21½ year period of 20.7%. These numbers are summarised in the table below:

The other interesting thing to note from the graph is the level of volatility presently experienced and how this compares to absolute highs and lows over the period. Even though this graph only includes data to the end of September 2008 - the volatility of October 2008 will definitely be much higher - we can see that we are not at the highest level of volatility. The highest 1year rolling volatility for the average equity fund was 38.5% for the months of Nov ‘98 to Jan ‘99. Conversely, the lowest was 5.1% in August ‘93.

Capital preservation should always be the starting point when constructing a portfolio. This could be achieved through the correct combination of funds in a portfolio, as this is likely to yield lower volatility over time, while still generating adequate returns. Managing and understanding the volatility of a portfolio is a key risk management tool. This is well referenced by well known author and investor Peter Bernstein who points out that maximizing return makes sense only in very specific circumstances.

Survival, according to Peter Bernstein is the only road to riches and you should try to maximize return only if losses would not threaten your survival and if you have a compelling future requirement for the extra return that you might achieve by taking on additional risk.

Source: Greg Flash, Alphen Asset Management, October 31, 2008.

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By Mark Seymour

From a valuation perspective, there is a strong argument to be buying the local market at these levels.

Based on historic returns the market is prone to solid gains when initiated off a low base of single digit price-to-earnings ratios and high dividend yields (see tables 1and 2 below). Economic doom and gloom is the necessary catalyst for driving markets to very cheap levels and, now that this scenario is playing itself out, the time has come to take advantage of this rare opportunity.

Click on the table below for a larger image.

Table 1. Market crashes over the last 50 years

Source: I-Net Alphen Asset Management

Table 2 below reflects market returns for periods between significant market corrections, when the market is in recovery and creating new highs. It is worth noting that the annualised return, tabled below do not include dividends reinvested and would otherwise be 2% to 5% higher.

Table 2. Market rallies over the last 50 years

Source: I-Net Alphen Asset Management

It seems superfluous to point out the obvious, but the average investor is in a state of high anxiety about their current equity exposure to the All Share Index. As of Friday the All Share Index was down nearly 45% from its highs, and the economic news remains unrelentingly bad. Given this, it is worth dissecting the state of market returns through the cycle and seeing where we currently stand.

During a sharp market correction, the price falls from a high-point (draw-down) and eventually reaches a trough (See Table 1). Next, the market recovers whereby the price rises above the low-point and eventually reaches the high-water mark (price of the previous high). Third, the market rallies above the high water-mark creating a new high.

At present we are well entrenched in the draw-down phase, however valuations are supportive of a turn-around sometime, at which point the market will enter the recovery phase.

We acknowledge that the timing of the recovery is impossible to calculate and would therefore, recommend a gradual and focussed strategy of accumulating equity exposure back to benchmark or strategic levels.

Source: Mark Seymour, Alphen Asset Management, October 27, 2008.

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By Cees Bruggemans

This Thunder Will Pass.

Nice theme the Minister of Finance used for his medium-term budget framework last week.

But which thunder did he have in mind?

A typical summer Highveld thunderstorm, starting by 4pm and all cleared by 7pm? Or the equivalent of Shaka Zulu, raging for years, laying waste to our interior, with the demographic, economic and psychological consequences still felt 200 years on?

Current events are no ordinary thunderstorm. And though Shaka wrecked much mayhem, he was only a local phenomenon. What we have now is global.

Events still keep rippling outward from the original detonation. Poor US credit decisions, subsequent exotic securitization of much toxic debt, pleasingly and reassuringly rated, and its gullible unquestioning absorption by the global financial system, created a global Chernobyl.

Apparently not only Russians know how to mess up. But this is in a category of its own, the financial equivalent of nuking the Mid-East and wishing us all a nice day.

The veil was pierced in August 2007, when a French bank developed a problem. Brother banks must have been in a high state of preparedness, knowing only to well what their own books looked like.

Anyway, the plaintive cry for central bank assistance from this weakened brother set in motion an avalanche of self-preservation. The new principle: trust no bank.

As the global comprehension of the bad loans grew, and market values plunged, further amplifying bank paper losses, banks had to increasingly recast their balance sheets even as their capital was being destroyed.

It took a year with only the odd bankruptcy, but by August this year the ninepins finally started to collapse in union. Global banks stopped lending, indeed credit collapse was next.

Even as global policymakers heroically matched systemic hits with growing lifeboats, to the point of effectively guaranteeing the global banking system in principle, the slow motion fallout was still steadily progressing.

From being a budding financial sector firestorm, the phenomenon transformed itself this October into an even bigger, fully-fletched economic one, as the real economy spillover finally came fully into view.

Credit collapse in critical areas of the global economy signaled deep and prolonged recession in the US, Europe and Japan, threatening to take other bits and pieces with it, also unceremoniously pulverizing emerging market (EM) growth prospects.

This fed the global financial panics with renewed vigour.

As equity and commodity market prices kept collapsing, a typical firestorm phenomenon, observed in WW2 in places like Dresden, Hamburg, London and Tokyo, came into being.

An inferno needs fuel, foremost combustibles and then lots of oxygen. Combustibles there were aplenty, in the forced deleveraging observable daily in New York, London and Tokyo, as overleveraged hedge funds, banks, insurers, private equity funds, pension funds, individuals, global companies and others had liquidity calls, panic redemptions and carry-trade unwinding to meet.

And thus they sold, and sold, and sold.

And what they sold most of all was the stuff still mostly out of harms way, but exotic and offshore and ultimately exposed to currency risk. With home bias resurrected with a vengeance, the money centres sold the periphery and oxygen became sucked out of all extremities.

With many EM banks and corporates Dollar and Yen funded for years, because of low interest rates and their own currency appreciation, a mad scramble was induced as the global centres sold and remitted, and EM entities tried to cover their open positions by buying Dollars.

Enormous EM sell-offs and outflows of capital resulted, shocking most EM currencies lower, increasing local inflation risk (despite oil’s demise), threatening further interest rate hiking (as in Hungary), further threatening financial and economic decline.

As the 1970s should have taught, during an intense financial shock even 1000% interest penalties overnight won’t prevent the shock event from playing out, as France and Italy then discovered.

What a puny 3% annual rate increase hopes to achieve today is anybody’s guess. Instead, with domestic collapse in progress, one should welcome the external support offered by the temporary currency depreciation.

The current global firestorm probably has more weeks to run. Global equity and commodities will likely sell off more, oil potentially ending up below $50 despite output cutbacks, before eventually reversing.

EM currencies should sell off more, also Euro and other commodity producers.

This suggests one more bailout to come. Leading central banks have Dollar swap facilities in place to assist in times of turbulence. Most emerging markets haven’t.

But culling EM looks as inadvisable as letting your banks go bust. EM is now too big to fail, either because they have sizeable reserves (China, India) or the regional cost, also geopolitically, would be far too big (Eastern Europe, South East Asia, Latin America).

The IMF is undercapitalized (only $200bn available, while $1 trillion is needed). This suggests G7 governments authorizing their central banks and/or with a stroke of a rapid pen enlarging the IMF balance sheet (politically unlikely?) to bail EM.

Source: Cees Bruggemans, FNB, October 27, 2008.

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By Kevin Lings

Unlike the 2001/2002 SA currency crisis, when the reasons behind the Rand weakness were difficult to ascertain, the cause of the current Rand currency crisis is clearly rooted in the global financial market turmoil and subsequent increase in global risk aversion. The increase in risk aversion is reflected in SA’s sovereign risk spread crashing to a massive 683bps over the equivalent US bond, which is the weakest on record (see chart attached). This compares with a low of 50bps during 2007 and a 2007 year-end level of 164bps.

The fact that SA has been systematically running a very large current account deficit (in excess of 7% of GDP), which has been mostly funded through portfolio inflows, has obviously exacerbated the weakening. During the first 22 days of October, foreigner’s have sold a net R22.6bn of SA equities, which is the largest monthly sell-off by foreigner’s every recorded in SA. In the year to date, foreigner’s have sold a net R43.7bn of SA equities. This is very substantial, and in sharp contrast to previous years. In 2007 as a whole foreigner’s bought a net R64.16bn of SA equities and a net R220bn over the period 2004 to 2007.

The dramatic acceleration of foreign equity sales (and some bond sales) has clearly weakened the Rand. In the year-to-date, the Rand has weakened by 31.7% on a trade-weighted basis and by 41.1% against the Dollar. This makes the Rand the worst performing emerging market currency this year (see chart attached).

Given the massive foreign selling of SA equities (and bonds), it is no surprise that the SA stock market has been under enormous pressure. In the year-to-date, the SA equity market has lost around 30% of its value in Rand terms and a massive 58% in Dollar terms.

This sell-off (across all assets classes and markets) is simply overdone. This is especially the case when one considers SA’s strong fiscal position (budget surplus, very low government debt, low debt servicing cost, and extremely low risk of default), and the significant improvement in our external vulnerability ratio (healthy exports, very low foreign debt, and a significant increase in our foreign exchange reserves). In addition, SA’s banking sector is also in relatively good shape considering it is mostly domestically owned, well capitalized and well managed, with relatively low levels of bad debt levels; albeit on the rise. The corporate sector also remains profitable and under-leveraged.

Source: Kevin Lings, Stanlib, October 23, 2008.

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