The cost of Comfort+ living

I was running along the beach the other day, minding my own business when I was distracted by the "for sale" signs along the road. The houses on offer where huge and mostly ugly but they did have a fantastic view of Table Bay and the mountain.

My mind was taken to the current economic uncertainties in the world and the words I read that morning in a research article that stated "Don't focus on the things you can't change. Rather focus on the things you can".

Now, I have always been fussy about where I lived, but never about what I drove. During my early years as a Financial Planner at Citadel, I noticed that most people spent a huge amount of money on their cars and I came to realise how fortunate I was to not have such a weakness, because it was pretty difficult to accommodate their passion and still get them to retire before they turned 80! 

I understand that everybody has something they splurge on, unfortunately cars and houses are two of the biggest ticket items. So, if you can be disciplined enough NOT to spend that extra couple of thousand on the top of the range product and adhere to the "focus on something you can change" principle, it will help a tremendous amount.

I call this the "Comfort +" effect.

Let's take an example. Your child finishes school and studies something for 4 years. The child is now 22 and starts working. The child earns enough to rent a small shared flat and to finance a small car. At age 30 the child saved enough money to buy a car without financial assistance and here the child is faced with the first choice. Buy a new car for R80 000 or a second hand one for R60 000? The child chooses the R60 000 option, thus saving R20 000. Time goes by and at age 35 the child faces the same choice. The child also has a choice to buy a flat for R1mil or one for R800 000. Once again the child chooses wisely and saves R20 000 on the car and R200 000 on the house.

The option of new or used car repeats itself every 5 years and at age 60 the child contemplates retirement at age 65. What was the financial impact of the wise choices made during the last 40 years? The answer is R3 000 000 if the cumulative saving of R340 000 grew at 8.5%. If we take inflation at 6%, the real saving was R580 000. This is R580 000 saved because the Comfort + effect was eliminated.

At this stage of my jog I am tired and sweating and the cool sea breeze isn't as comforting as before. I flop down onto a sofa and take a long drink from my water bottle, both of which would have been equally as nice in one of those big, ugly houses for sale on the beach, but not more so!

What I am trying to say is, spend money on what makes you happy in life, but remember that the bigger, faster, brighter, sweeter, smarter, louder product will not necessarily make your life more comfortable, but will definitely cost you more than it offers!

I feel better now.......

September was a bad month. The ride up and down the market was fun for a trader but unsettling for an investor. I do feel better than I felt at the end of August about the EU. The reason I can provide is the fact that I sense the market was waiting for someone to accept responsibility for the mess they have created. The difference between 2008 and 2011 is the fact that in 2008 a smelly skeleton was discovered as a complete surprise, where as in 2011 everybody knows about the skeleton but want somebody to actually open the cupboard and claim it!

Make no mistake, when the final medicine gets dished out, or the actual double dip recession is formally announced, the market will crack the whip with a knee-jerk 10% drop. But, I believe the bottom of this negative spiral is very close and investors are buying value on the dips.

For longer term investors, do not sell good shares, start buying good shares on dips if you have cash or trust your Unit Trust Fund Manager to do it for you.

Always remember, never use short term funds for equity investments, or hold long term money in cash!

The EU, Hurricane or Tropical Storm?

From the last week of July 2011, right after the USA debt ceiling fiasco, the JSE and Dow Jones lost 12% for the month to date. In investment terms it is called a "correction" on the markets. The exact same thing happened in the beginning of April 2010 so this is not new or alarming. We also predicted a lot of volatility in the markets after the recovery in 2009.

Something that should actually frighten you is a repeat of the 2008 crash, where the JSE dropped 46% and the Dow 54%. In financial terms that was a Hurricane, what we saw this month was only a strong wind with lots of rain.

The EU (European Union) on the other hand is turning out to be either a Tropical Storm at best, or a potential Hurricane. The USA has problems but I get this feeling that they will manage to fix the problems over time. The EU on the other hand has me spooked. The sad thing is that even though our beloved country (SA) is in a good position, we will be dragged down with the Tsunami of negative sentiment if Europe should go into a recession.

What should we do as a South African investor?

I think we should consider the following:

• After the August 2011 correction, only 6 of the top 40 shares are on the consensus selling list of Stockbrokers.
• The current Dividend Yield of the top 40 SA shares is 3.19% (note that a 4% DY is equal to a 6.15% interest rate after 35% tax).
• The Forward PE of the top 40 shares is 12 times (below the 15 year average).
• The loss incurred on an investment in 4 Balanced Unit Trust Funds was only 1.65% over the last 2 months.
• It is very apparent that investors are fearful if we look at the flight to Gold and the willingness of investor to buy US 10 year bonds at 2.2%.
• When others fear you should be bold, that is what Warren Buffett tells us.

On the negative consider this:

• If the EU does go into a recession, the market can drop another 10% in a day!
• If you are exposed to small companies or in a geared investment, you might experience a permanent loss of capital.
• Even without a recession, the world GDP growth might be very slow and equity returns much lower than in the previous decade.

Some more thoughts:

• If you are invested in shares, make sure you can wait for10 years before you have to sell.
• If you are thinking of investing in shares, make sure you can wait 10 years before you need to sell.
• If you have a lump sum to invest in shares, consider phasing in the investment over 12 months. Take note however that although we are at the same level on the JSE as we were in April 2010, phasing in or lump sum investments at the beginning of 2010 would not have made a difference.
• Always remember to diversify, especially into international companies.
• Cash must only be held for the short term (3-4 years). If you wait for the crash or for the pullback after a run, you will never invest!

Last thoughts:

• I believe that the outcome of the problems in the EU is very unclear and therefore you have to invest with caution. You have to select companies that are well established, with lots of cash and whose income streams are well diversified. They have to pay you a good DIVIDEND!
• It seems as if governments have no more solutions for the problems but somehow, they always end up finding one. The thing that hurts your investment the most is the negative sentiment created by uncertainties. Never act on sentiment, always act on fundamentals.

I have to admit that I have used the recent correction in the market to sell some of the companies in my portfolio which I believe offer less value than others based on size, valuation, prospects as well as overweight percentage of the total. I increased my cash in this way and will re-balance into a more diversified portfolio in the months to come. I will not hold onto the cash for too long!

USA is not a responsible parent!

Do you want to tell me that the politicians in the US could not have handled their problems in a more responsible manner!? Was it necessary to parade their power hungry ambitions in public, demonstrating to the whole world how stupid they are when given their 15 minutes of fame in front of the camera and the world stage?

And after receiving the reprimand from a dysfunctional rating agency (S&P) in the form of a downgrade to AA+, after the same agency was unable to see the debt crisis of 2008, Obama stands up and says that the US will always be AAA!

So now the ignorant world investor is losing his/her money due to the market reaction. US is 16% down and SA 14%. I believe that the US policy makers created this new round of panic selling.

For those who have extra cash to invest, this is a mega sale in Blue Chip companies. Look at this:

• BHP Billiton: trading at same price as in July 2007
• Anglo American: trading at same price as in April 2006
• FirstRand: trading at same price as in December 2005
• Standard Bank: trading at same price as in December 2006
• Old Mutual: Trading at same price as in July 2002

The combined average PE of these 5 companies is 9.86 with a dividend yield of 3.33%. The forward PE is 8.17.

In a newsletter written at the end of May 2011 I said that an equity investor needs to understand that volatility will play a big part in his/her investment. I also wrote that trying to time the market will end in tears and that no matter what happens with the price of a good quality company, you will receive the dividend and the company will continue making profits and eventually you will make a good return on investment.

Please, do not invest in Equities if you haven't got the guts to hold on during the bad periods, and do not invest in cash if you have a longer term time horizon!!

So, unfortunately as an SA investor all the profits for the last 20 months have been erased from your portfolio. Fortunately you will still receive your dividends because most of the companies have strong Balance Sheets and loads of Cash!

I received a question regarding Satrix

Unfortunately this question was from anonymous and I have to provide my answer in public rather than in person. Perhaps it is a good thing because the debate about Index tracking funds like Satrix vs Actively managed unit trust funds is in the spotlight again.

When the market as a whole is down, the market as a whole will bounce backup as we saw after the crash of 2008. It is more cost effective to be in an index tracking fund like Satrix in those circumstances.

Currently the JSE is close to its level prior to the 2008 crash and not very cheap so an Active Fund Manager's fund like Coronation Top 20 can perform better than the Satrix fund because even though the market as a whole re-rated upwards, some quality shares might have stayed behind. A good fund manager will be able to identify such shares and outperform the Index.

If you have decided to go for Satrix anyway, I would rather invest in the "Smart" Satrix funds like Satrix Divi and Satrix Rafi because the companies in the portfolio are not included purely on size.

Hope this helps!

Gold!

Yes, gold is over $1 600. Do I have to buy now? Well, consider this:

• Most novice investors buy an investment when it has reached its peak, and sell when it is at its bottom. This is a better way of losing money than gambling!
• Gold is not even back to the inflation adjusted level it was at the all time high in 1980. So, if you bought at the top in 1980, you are still making a loss on your investment on an inflation adjusted basis after 31 years.

For the last 51 years gold was an investment where if you bought it at the right time, you made mega bucks, but if you bought it at the wrong time, you lost mega bucks. You also do not get any interest or dividends when buying gold.

So, if you feel lucky, buy gold when you get the urge. Just remember that you might have to wait for 30years to get your money back, without any return!

If you buy a portfolio of shares on the other hand, there are also times where you have to wait for 10 years to get capital growth on an inflation adjusted basis, but at least you receive some dividends while you wait.

In most instances, you can determine the fundamental value of a company. Gold is driven more by sentiment than anything else. After everything is said, understand that gold has had a fantastic run over the last 5 years on the back of financial uncertainties in the world. If you buy now, make sure you can wait for a very long time before you have to sell again.

Lastly, if you decide to go ahead and buy gold, rather buy the ETF on the JSE called Newgold, rather than coins or gold mining company shares.

Happy gambling!

Investments, where to from here?

Go look at the South African All Share index from 1 January 2010 till 7 September 2010. What you will see is a very jagged line but ending at the same level as where it started. What does this mean? Well...., you had some symptoms of bipolar ups and downs emotionally but with no return over the period!

Now look at the same graph for the year to date. What do you see? Exactly the same!! The only difference is that the 2011 base line (value) is at about 32000 points, 15% higher than in 2010.

Why is this important? Perhaps because for the patient investor in 2010 all his/her returns were generated in the last 4 months of the year. The only question now is will it be the same in 2011?

The Bad news:
USA and Europe have sooooo much debt and other problems that there seems to be NO light at the end of the tunnel! Every time the markets receive some good news, it gets up onto one knee just to be flattened again by some bad news.

Good news:
There is a mountain of cash in the system that can be invested, and investing in cash via developed economies like the USA offer almost 0% return. The result is Billions of $ being invested in South African companies and Bonds.

Where to from here?
As always this question is very easy to answer. One of three things will happen:

1. The market will continue its sideways movement.
2. The market will move upwards like at the end of 2010.
3. The market will have a correction downwards.

Before we invest money today we have to consider 2 things:

• Is the investment world in which we now live different from the one 10 years ago and does this imply that the different asset classes in which we can invest our money are also different?
• Which one of the 3 scenarios is the most likely to happen?

On the first point I do believe that we are now living in a different economical climate from the one 10 years ago and that although this new environment will not last for the next 50 years, the next decade will experience its influence. One of the main reasons for believing this is because the American consumer has for a very long time lived beyond its means and spending rather than saving was the national pastime. This was the same for a lot of the European countries.

This spending frenzy caused companies word wide to generate huge returns and they became fat and happy. The paper wealth caused lots of other assets like house prices to follow the "golden" brick road up. So when the bubble burst in 2008 it was like waking up out of a drug induced slumber for the US consumer.

So for the next 10years we might see the US consumer saving and paying back debts rather than spending!

China and the rest of the BRIC countries now have to pick up the slack in spending. They have to first upgrade their infrastructure (giving rise to commodities shooting up, whooo hoooo! for SA!), and lift the overall well being of their consumer base before they will be able to spend the same as the deceased US consumer. I do however believe and trust in the inherent gambling dependency of human nature and coupled with the limitations of long term memory, expect the next bubble to explode within the next decade!

On the second point regarding where the SA stock market will go from here, I am unsure about scenario 1 and 2 but rather confident that scenario 3 is unlikely. The reason why I believe that the market going down some 40% from current levels (i.e. Scenario 3) is unlikely can be explained as follows:

• Drivers of stock market sentiment comes from the US and Europe. Before 2008 most big players in the investment game only considered investments in those areas and allocated only a miniscule amount of money to "developing" economies. When 2008 happened the US share market was at a point where share prices were where they were a decade earlier and dropped another 40% during the crash. This caused big solid US companies to offer very good value. The big investors however discovered that the neglected emerging markets offered great value and started investing. So, where they only invested in the mature markets prior to 2008, they now discovered the emerging markets as well. So even when the valuations in emerging markets become expensive, they can now return to the US and Europe where better value exist.
• A second reason is that the next bubble will take some time to reach the point of no return. The bad news we experience now are only "after shocks" from the 2008 crash. Like any big earthquake the original quake causes the extensive damage and for the markets the damage is in the price already.

Summary:
If you invest in shares today just because it was the best asset class over the last 100 years, you might have to wait a long time before you can smile about the returns and will have to endure a lot of volatility. If you decide to keep your money in cash, you will miss out on those companies that will perform well and with inflation around the corner, returns will be very disappointing.

I believe the middle road will be the best option. After you have determined which part of your money could be invested for the 5, 7 or even 10 years + term, go equities, SA and International. But for the money you will have to spend over the next 3-4 years, stay in cash or capital guarantee investments. For the money you allocate to the longer term, you have to trust the Fund Manager to select those companies worldwide that will be profitable, regardless of the pressure sentiment will put on the share price.

We must remember that trying to determine when the market sentiment will change can only end in tears!

Income tax versus Capital Gains tax

Beware of selling any asset within 3 years of buying it!

In South Africa SARS will deem any asset you sell after 3 years from date of purchase as a capital gain/loss and not as income. Why is this important? Because Capital Gains tax is calculated at 10% for individuals instead of the marginal income tax rate of 40%.

Lets look at an example:
Invest R1mil for 3 years and get 10% per year return. After 3 years you will have R1 331 000. If you sell that asset after 2 years and 360 days, you will have to pay income tax of R132 400. If you wait till the next week to sell, you will pay capital gains tax of R33 100.

You save R99 300 if you wait the few days!

So, before you buy any asset, make sure that you want to keep it for at least 3 years. But then you might want to re-consider the investment, and if we are talking about shares, re-balance your portfolio by taking profits on the performers and buying into the next 3 year potential winners.

So what I am saying is that if we only look at financial investments like shares or unit trusts, do not forget about the investment but do not tinker with it for the first 3 years (even SARS agrees on this).

A word of caution perhaps: The Capital Gains Tax rate in other countries can be up to 50%. It will be very easy for SARS to finance the budget shortfall by increasing the current rate of 10%!!!

So, perhaps we should all re-consider our investments and the gains on them every 3 years?!

Update on investments.

You who have equities in South Africa should not expect double digit returns over the next couple of years!

In short the following:

• Inflation is going to kick ass in a couple of years from now.
• That is bad for equities!
• USA will have less of a problem because they can't raise interest rates for a year or two.
• That is good for equities!

So, equities in Developed markets like USA should outperform SA equities over the next couple of years. (also because USA gave you 0% for the last 10 years!!!)

Bottom line
Do not sell SA equities but if you have very little International equity exposure, try to swap some SA for International. This should be done after considering the TAX effect. (Remember, any investment sold 0- 3 years after acquisition will be taxed as INCOME!). This swap should also not be tried if you are not invested on a "platform" offering a range of unit trust funds.

If you have enough international equity exposure for you longer term investments, ride out the equity volatility because Cash after tax will give you even less than equities over longer periods of time.

For longer term investments avoid Bonds, Cash and even property.

UPDATE: The Momentum Protected Index Plan I wrote about in a previous blog, now gives you a capital guarantee on the Top40 shares in South Africa with a 39% after cost participation in growth in that index over a 3 year period. If you have cash to invest for 3 years and do not want to remain in cash but are afraid of losing money on the SA equity market, this might be a good product for you.

Save tax with a Retirement Annuity!

A Retirement Annuity (RA) Fund is a personal retirement plan which enables you to save tax-effectively for your future needs. It is an ideal way to supplement your existing retirement savings if you earn non-pensionable taxable income (also called "non-retirement funding" income). Non-pensionable taxable income includes:


 All earnings of tax payers who are not members of pension or provident funds;

 Earnings of members of pension or provident funds where such earnings are defined as non-pensionable income; and

 For both such members and non-members, it also includes bonuses, share option gains, director's fees, certain allowances and also taxable income from portfolio or property investments.

Tax Incentives

 Up to 15% of non-pensionable taxable earnings can be invested in RA's and deducted from taxable income. Please see the example below to understand how this benefit helps to reduce tax and enhance wealth.

 Coupled with the tax deduction on the contributions, there is no tax payable on either the capital gains resulting from investment growth or on the income earned (such as interest, net rental income and foreign dividends) within the RA. The tax benefit within the fund comes into effect immediately, enhancing your capital at retirement. On retirement, the lump sum tax-free component has been increased with reduced average tax rates applied to the taxable portion.

 Whilst the eventual proceeds on retirement from the fund are subject to tax, this is deferred in the first instance and the allowances are relatively generous. This means that the tax rates on your receipts (be they as capital in the form of a lump-sum "cash" payment or as income in the form of annuity payments) should always be less than the current rate applicable to such contributions.

 The legislative changes to the Income Tax Act also make RA's an attractive estate duty-free investment.

Example showing indicative tax and net wealth benefits using non-pensionable taxable income of R1 000 000 per annum:

1. Without RA Rand

Non-pensionable income 1 000 000

Less: normal tax at 40% -400 000

Net after-tax income 600 000

Net wealth (after-tax income 600 000 + no investment) 600 000



2. With RA Rand

Non-pensionable income 1 000 000

Less: Contribution to RA at maximum 15% -150 000

Taxable income 850 000

Less: normal tax at 40% -340 000

Net after-tax income 510 000

Net wealth (after-tax income 510 000 + 150 000 investment) 660 000

 As shown above, the R150 000 contribution to the RA is subsidized (in the form of reduced tax) and reduces the tax payable by R60 000 from R400 000 to R340 000. In effect, this means that it only costs R90 000 (after tax) to create an investment of R150 000.



 It is important to note that 28 February 2011 is this tax-year's deadline for you to take advantage of the tax benefit on your Retirement Annuity contributions. If you are interested in contributing to an RA, be it to top-up an existing investment or to start investing into a new RA, time is of the essence in order to complete the process ahead of the tax year-end.

Momentum Protected Index Plan (PIP)

This is a brand new fund offered by Momentum Wealth and does the following:

• Gives you 100% capital protection over a 3 year term.
• Participate in the growth of the JSE Top 40 index for the 3 years.
• Trades once a month and the current cap on growth participation is 35% after costs.

Why it serves a purpose?
The JSE is close to its all time high. A lot of investors do not want to venture into shares because they believe a correction is imminent, so they carry on making the mistake of keeping their longer term money in cash. This product provides them with an alternative to cash!

What I think:

• Let's say cash gives you a taxable 7% effective every year for 3 years. That is 4.2% after 40% tax for 3 years which is 12.6% for the period.
• Let's say inflation creeps up and settles on an average of 6% pa for 3 years. Then you should earn an 18% effective return over 3 years to break even.
• Clearly you lose money in cash!
• If you invest in Momentum's PIP, and the markets do perform, you get 35% return after 3 years. If they muddle through you might only get the cash rate (12.6%) and if they crash and burn, you get 0% return but all your capital back. You get anything between 0% and 35%.

So, the worst you can do is to not earn the after tax interest return on your capital if you stayed in cash, but you can also get 35% return if the JSE Top 40 companies recover as we all expect they will.

This is just a summary and there are some technical issues as well.

Conclusion: If you have R50 000+ which you want to invest for at least 3 years, rather invest in PIP than cash.

Stock picks Jan 2011

                   current        Price       Forward      Dividend
Share          price       Earnings        PE              Yield
Peregrine     11.70         9.50          8.14             2.68%
Basil Read   12.30         4.33          4.33             3.47%
Old Mutual  13.97        16.71         8.24             2.11%

These are the shares I would buy for 'n longer term portfolio. The only one which I would buy at a lower level is Old Mutual at round R13.20. They are all lagging the market and Peregrine will publish good results for Y/E 2011. Basil Read is cheap and when construction recovers in a year or two I would like to have this one in my portfolio. Old Mutual might benefit from corporate action.

Peregrine might go down to R11.50 which is a very good level and Basil might go to R12.20. If this should happen I would buy some more.

Later
G

Investing 2011

Better than expected!

That sums up 2010. The 10 shares I chose in April 2009 and discussed in my June 2009 Blog returned 64% over the last 20 months and you can add 6% for dividends paid by them. At the beginning of 2010 I thought the JSE All Share Index would give us 9% for the year, it gave us 16% to which you can add 3% dividends. This year my crystal ball tells me that we should end the year 7.42% up at 34 503 points on the JSE. You can add another 3% for dividends so the return on an investment in the SA share market should give you 10.42% after tax. The market always over react so add a 10% to the 34 503 and the JSE ends on 37 953 points, that is a return of 18% excl dividends.


Cash will probably give you the same as 2010 which was a taxable 6.9% which is just pathetic.


So, you can clearly see that 2011 should be another good year for equities. As I mentioned in my November 2010 Blog, the companies which I think will perform well are American Multi Nationals and SA companies with a well established footprint in Africa.

"What about the Rand!"......you shout. Well, what about it? Who cares. It is overvalued and will get back to parity sometime. Don't delay making international investments just because you think the Rand will go to R6 against the US$. This is a long term game and the investment in the company you buy will always outperform the short term value of a currency!

When do I invest? I think the markets will come down about 7% before end of Feb 2011 which will give us a better buying opportunity. I have to mention that I thought the markets would come down at the end of September 2010 as well and lost some good money when I bought a Put option on the JSE Top 40 index to hedge my long term portfolio!

So, if you have cash you want to invest for the longer term (5 years plus), perhaps invest one third every month for the next 3 months.

If you do not have any investable cash but you have a job, fab! Earning an income not only provide us with pride in our abilities but also the most powerful financial tool. Just remember not to spend any money on buying a new car if you have one that does what it needs to do just because some dog tells you to!

I will cover a new product from Momentum Wealth in my next blog which gives you protection on the downside of the JSE Top 40 index but also participation in the growth over the next 3 years.

I will also use this Blog in future to share with you some stock tips (shares I believe offer value) and would appreciate the same from you.