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Allan Gray investment insights |
I feel like a kid at Christmas when I get my Allan Gray quarterly report - there's always so much insight they share, freely. Thank you, Allan Gray (disclaimer - I have a substantial amount invested with them).
"At year-end prices, based on bottom-up stock analysis, the reward on offer relative to the risk of loss in most JSE-listed stocks remains as unexciting as it was a year ago." (Ed: I concur, there are only a handful of stocks on the JSE I'm finding value in at the moment, and they're too illiquid for Allan Gray to gain a meaningful position in).
"Investors need to ask a lot of questions. Is the business sustainable? Is the demand for the product likely to shrink or grow? Will excess capital investment destroy returns? Are returns above or below normal? The goal should be to extract factual data to aid quantitative valuation.
"The most important variable in establishing the value of a company is the estimate of future cash flows. As it is not possible to forecast the future with any accuracy, we try instead to establish the average cash flows a business can sustain through the business cycle. We use this sustainable cash flow in normal conditions to determine the value. It is important not to think of current conditions as normal & just extrapolate these...That the market often extrapolates current conditions as normal, is what enables us to generate alpha".
"When the news is terrible it is likely you could be looking at a good investment opportunity. The reason is that investors may be extrapolating the current situation into the future. They may be right, buat at least it is in the price. And if things turn out to be even a little better, it is more than what is discounted in the share price."
"GDP growth & stock market returns are not well correlated...One of the most important reasons for the low correlation...(is that)...investment spending can have the opposite impact on equity returns & GDP growth. When a business invests in new plant & machinery, it is reflected as GDP growth, so the greater the level of investment the faster GDP grows. Unfortunately, all these companies putting capital to work & investing, brings down the return on capital. Lower returns on capital mean lower profits & poor returns for equity investors...The current negativity towards the European & the US economies, and the subsequent lack of investment, may actually lead to higher returns on capital...The takeaway is not that you must look for weak economies for investment opportunities; rather it is the fundamentals & the entry price that matter."
"With the industry investing record amounts of capital (presumably as a result of the record profits), iron ore projects already under construction are forecast to add one-third to existing supply. At the same time, question marks remain over the sustainability of Chinese consumption. While we cannot predict the future, knowing where we are in the cycle gives us reason to be cautious and we believe the risks are now to the downside."
"In contrast to iron ore, current platinum group metal prices are below those required to generate a fair return on capital...Whille we view this as unsustainable, we regard Impala Platinum & some of the juniors as more attractive than Amplats at current prices. Despite excellent cost control over the past 3 years, Amplats' unit costs remain above those of Impala. We have our doubts as to whether any further savings are achievable to change Amplats' relative position. We further have doubts about whether Amplats is investing sufficient capital to maintain & indeed grow production over the long term. In contrast, Impala is reinvesting a considerable portion of current profits in sinking new shafts, which should entrench its position as a low-cost producer over the longer term."
(Ed: There are a couple of risks which the Platinum miners are facing in the medium/long term - (1) scientific advancements are increasingly allowing platinum to be replaced by palladium in autocatalysts, and (2) over the long run the price of petroleum is increasing, and motor vehicles may be replaced by electric vehicles, which don't require autocatalysts. I too cant predict the future, but these are risks the platinum miners face, which cant be ignored. That being said, I do hold a small number of platinum shares, in the hope that short-term increases in demand will outweigh the medium-longterm influence - if prices spike sufficiently I'll sell them).
The Dividend Withholding tax is due to come into effect from 1 April 2012, replacing the Secondary Tax on Campanies. "DWT is a 10% tax levied on investors receiving dividends declared & paid by South African resident companies or foreign companies listed on the JSE. Although DWT is a tax borne by investors, it is the responsibility of the companies paying the dividends, or where relevant, certain 'withholding agents', to withhold the tax & pay it to the SA Revenue Service on behalf of the ultimate recipients."
"The new dividends tax is a final withholding tax set at 10% on dividends paid. The dividend income will still be exempt from normal tax in the beneficiary's hands because the dividends tax does not influence the normal tax rules. Ten percent will be the final tax payable on the dividend."
The theme in Allan Gray's quarterly surrounds the high levels of company profit (compared to trend and the last 10 years) as a result of high commodity prices and consumer expenditure and the risk of a reversion to mean.
Record company profits:
"Over the past 52 years, earnings for listed companies in South Africa in aggregate have grown by 3.3% above inflation". "Current reported profits are 45% above the long-term trend line (an exponential curve fitted to earnings). Earnings have only been higher than they are today 9% of the time, relative to the trend line." "Profits are 37% above the 10-year rolling average."
Allan Gray cite the main reasons as being high commodity prices and high consumer expenditure (as a result of "falling inflation rates, falling interest rates and strong domestic asset prices").
"The potential supply of certain commodities such as iron ore (30% of Anglo American and 40% of BHP Billiton profits), manganese or thermal coal is virtually unconstrained over the
long term. With the only barrier being the capital required to build mines and surrounding infrastructure, it is only a matter
of time before the supply will rise to meet the projected demand. As we highlighted in our previous issue of Quarterly
Commentary (Q2 2011), the combined capital expenditure of
four big global miners, namely BHP Billiton, Anglo American, Vale and Rio Tinto, is likely
to exceed US$50 billion next year. Adjusted for inflation, this is more than 10 times
what they spent in 2000." This is in line with RE:CM's concerns regarding iron ore prices, and Deutsche Bank's Long Term Asset Return Study which said "Commodities have become very expensive...long-term investors have to be very careful with commodities, especially Gold".
"Although it is entirely possible for global and South African profit levels to remain elevated for quite some time, the unfortunate reality is that profits usually return to historic averages. To bet on profits remaining high intoperpetuity would be to disregard the 50 years of earnings history we have on South African businesses".
We're in debt, folks:
"Net household debt to disposable income in South Africa has grown from just over 50% to almost 80% over the past decade." In South Africa, microloans are growing at a rate of 44% per year, and many listed companies are expanding their activities in the sector."
"One of the threats to current company profitability in South Africa is that consumers are heavily indebted. Part of this debt is flowing from the microlending industry. Alarmingly, microloans are growing at a rate of 44% per year. Jacques Plaut researches a few of the most well-known microlending crises, and concludes that the current high rate of growth in South Africa is a sign for investors to be cautious."
"Underlying this financial turbulence is an increasingly widespread recognition that much of Europe and the United States is burdened with excessive debt, and in particular unsustainably large sovereign debt". Deutsche Bank's Long Term Asset Return Study's main theme was how the US has moved from a secular bull market to a secular bear market, as a result of a shift from building up debt to paying off debt
"The mature developed economies also face major demographic problems...The lack of adequate pension funding has been aggravated by longevity." Deutsche Bank's Long Term Asset Return Study showed how the ratio of those accummulating assets is expected to reduce relative to those selling assets.
"It is ironic that the market accords a higher rating to sovereign issuers that can debase their currencies over those that cannot, probably because the fiscal oppression through money printing and inflation takes longer than a sudden default to exact its toll."
Allan Gray are skewing their Anglo American position towards the stub assets (excluding Anglo American Platinum & Kumba Iron Ore), maintaining their full offshore exposure in their balanced fund, their position in the Newgold ETF has been reduced in the Stable Fund, South African equity exposure has been slightly increased in the Optimal Fund (although they think that "the South African stock market is still not unequivocally cheap"), have kept the duration of the Bond Fund below the ALBI but "have taken advantage of the recent selloff to buy certain higher yield long-dated bonds", and the Money Market Fund has reduced duration to 67 days.
Buying Anglo American's stub assets (exlcuding Anglo American Platinum and Kumba Iron Ore):
"Despite a decade-long commodity bull market, Anglo American has
underperformed the ALSI over the last 10 years. It is now trading not far
away from its relative low over the last decade. The investment case for
Anglo American is mixed. For example: we are concerned that the rapid
growth in credit and the commodity-intensive building boom in China are
unsustainable, but we are also concerned about the sustainability of the
rand's strength. We believe that Anglo's base metal expansion projects in
South America will yield attractive returns through the commodity cycle, but
we are concerned that its investment in the Minas Rio iron ore mine and its
associated infrastructure in Brazil will not deliver the returns the company
expects.
A further example of the mixed investment case stems from the
conglomerate nature of Anglos. One can think of buying one share in Anglo
American for R275 (the quarter-end price) as the equivalent of investing R93
in Anglo American Platinum and R72 in Kumba Iron Ore (both separately
listed on the JSE), and R110 in the remaining (or 'stub') assets of Anglo
American. Anglo's investment in Kumba has proven to be a spectacular
success, but at its current price we believe the risk is to the downside. This
may seem surprising with Kumba trading on less than 10 times profits, but
our concern is that Kumba's current profitability (72% EBITDA margins) is
unsustainably high. Kumba currently generates higher operating profits per
employee and contractor (US$417 000 pa) than does Goldman Sachs.
While the platinum miners have all underperformed the market significantly,
we regard Impala Platinum as a more attractive long-term investment than
Anglo American Platinum at current prices. Although a large proportion of
Impala's profits is currently being spent on sinking new shafts, this should
entrench the company's advantage as a low-cost producer over the longer
term. Impala is now a top 10 holding.
On the other hand, we regard R110 as an attractive price to pay for Anglo's
remaining 'stub' assets, which include De Beers, its copper and nickel mines
in South America, its coal mines in Australia, South Africa and Colombia
and other non-core assets. We have thus skewed the Fund's position in
Anglo American towards the 'stub' assets by investing a portion of the total
position in Anglos 'stub' certificates, which are listed on the JSE and priced
daily."
Maintaining full foreign exposure: "The rand depreciated from R6.76 per dollar to R8.09 per dollar over the
quarter, but the Fund has maintained its full foreign exposure. We remain
convinced that at current market prices Orbis is presented with more
attractive investment opportunities in the global markets than are available
to us on the JSE. Furthermore, the Fund's foreign exposure provides
diversification of country, currency and sector exposures. Orbis is able to
access investment opportunities in sectors of the global economy, which are
under-represented on the JSE.
For example, the biggest sector exposure in the Orbis Global Equity Fund is
to the technology sector (27% of the Fund). In contrast, technology sector
stocks account for less than 1% of the value of the South African shares in
the Fund, and for only 0.3% of the FTSE/JSE All Share Index (ALSI). Orbis
is able to invest in global technology companies such as Cisco, Qualcomm,
Google, SAP and Samsung which are simply not available to us on the JSE.
The second biggest sector exposure in the Orbis Global Equity Fund is to
the consumer services sector (18% of the Fund). Although this sector is well
represented on the JSE, making up 9.5% of the ALSI, we find the current
valuations of most of the local stocks in this sector, especially the retailers,
unappealing. Consumer services stocks thus account for only 3% of the
value of the Fund's South African shares. We believe that similar stocks in
the developed markets (such as Safeway, CVS Caremark, Rakuten, SunDrug
and Nippon TV) are much more attractive investments at current prices.
The market is presently enamoured by the perceived long-term growth
potential for South African retailers. For example, Shoprite is now trading
on close to double the P/E multiple on which Safeway trades. There is a risk
that the markets are confusing need with economic demand backed up by
buying power."
"the net equity component of the (Optimal) Fund was slightly increased when panicked selling created patches of
opportunity. Notwithstanding this, the South African stock market is still
not unequivocally cheap, especially in relation to our estimate of sustainable
earnings for the market, which is somewhat below the current high level of
earnings. We continue to remain cautious about our expectations for the
likely performance of equities over the short term and remain ever focused
on pursuing, inter alia, the capital stability objective of this Fund."
here's a link to the Allan Gray quarterly commentary, which they published on their website on 29 July 2011. Here's the extracts which interested me:
"we do not have high expectations for returns from South African shares or for continued rand strength" Allan Gray have had lower exposure to equities for a while, largely favouring offshore assets and money market investments in South Africa.
If you believe that volatility or tracking error are good measures of risk, then I strongly encourage you to read their report, as it neatly explains why these measures are flawed. "To us, investment risk is not about how variable a share’s returns are over history, either versus its own average or that of any pre-selected benchmark. It is simply the probability of permanently losing money from an investment." (and the extent of that loss)
"Consensus views on current commodity prices seem to be anchored around recent history and do not factor in demand
and supply risks. These risks may not imply an imminent crash but do favour caution."
"Orbis Global’s allocation to Japan is 17% – more than double the benchmark weighting."
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