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!