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.