Friday, April 30, 2010

Equities: Proceed with Caution

High PE ratio = danger

Historically, the market has only spent 15% of its time at a PE ratio of 16 or higher. The market is currently at an un-nerving PE ratio of 17.6. Historically it has only been higher than this level 6% of its time, therefore the market is not cheap if history is anything to go by.

Historically there have been 6 (broadly speaking) periods where the market has broken through a PE ratio of 16 (see Figure 1). We can test the theory of "high PE ratios equate to poor commensurate equity returns" by tracking the performance of the equity market as the PE ratio goes through some predetermined level. Setting the PE ratio at 16 generates some interesting results with regards to equity market vs. cash returns. The subsequent 3 year returns (post a PE ratio > 16) for the All Share Index (yellow) and Cash (red) are plotted in the graph (Figure 2) below.

Briefly what does the graph above (Figure 2) say?

1. Cash has out-performed equities 4 out of the 5 times over a 3 year period.
2. The market has experienced a serious crash within 3 years, 2 out of 5 times.
3. The market has rallied at least 34%, 5 out of 5 times from the point the market PE ratio goes above 16.

In summary the All Share Index has fared poorly relative to cash over a 3 year period when the PE ratio has breached 16. Secondly it is important to recognize that the market can initially perform very well over the short-term even when the valuations look very expensive on a PE ratio basis. Figure 2 and Table 1 highlight this fact with interim returns having reached between 34% and 68.5% before market returns turn sour.

Thursday, April 29, 2010

Buffett: The Good, The Bad, The Unknown

The Good
  • In 1976, Berkshire began accumulating an equity stake in auto insurer Geico, 24 years after selling an earlier stake for $15,259. It finished buying Geico in 1996. The acquisition brought aboard Tony Nicely, who still runs Geico and whose leadership Buffett has lavishly praised, and Lou Simpson, whom Buffett has said could replace him as Berkshire's chief investment officer but for the fact that he, too, is in his 70s.

  • In 1989, Berkshire bought $600 million of preferred stock in Gillette, the razor blade maker that had been hurt by the introduction of disposable razors. In 2005, Gillette was acquired by Procter & Gamble . Berkshire at year end still held a 2.9 percent stake worth $5.04 billion, and for which it had paid just $533 million.

  • Berkshire owns 200 million Coca-Cola shares, an 8.6 percent stake it had amassed by 1994. The stake was worth $11.4 billion at year end. Berkshire paid $1.3 billion for it.
  • The Bad

  • In 1993, Berkshire bought Dexter Shoe for $433 million in stock. Eight years later, it folded the struggling company into another business.

  • In 2008, Buffett amassed a large stake in oil company ConocoPhillips , not expecting oil prices to fall by about three-fourths from their record high. Berkshire spent $7.01 billion on Conoco shares, but has been reducing its stake.
  • The Unknown

  • Buffett has entered into derivatives contracts, most of which are essentially bets on the long-term direction of stocks and junk bonds. Berkshire has four major types of contracts

  • Berkshire has equity index "put" options tied to where the Standard & Poor's 500, Britain's FTSE 100, Europe's Euro Stoxx 50 and Japan's Nikkei 225 trade between June 2018 and January 2028.

  • Berkshire has contracts tied to credit losses in higher-risk "junk" bonds, which at year end were on average expected to mature in two years.

  • Berkshire wrote credit default swaps on various companies, mostly investment-grade.

  • Berkshire entered into tax-exempt bond insurance contracts structured as derivatives.

  • In September 2008, at the height of the financial crisis, Berkshire acquired $5 billion of Goldman Sachs preferred shares that throw off a 10 percent dividend, plus warrants to buy an equivalent amount of common stock. The warrants carry a strike price of $115.

  • South Africa's Mineral Wealth the "Highest in the World"

    According to a Citigroup report:

    South Africa is the world's richest country in terms of its mineral reserves - worth $2.5 thousand billion - according to research by the American banking group Citigroup, reports Bloomberg. The Citigroup report, which was compiled by its mining analyst, Craig Sainsbury, says that Russia comes second after South Africa, and Australia third.

    Of South Africa's $2 500bn worth of reserves, $2 300bn resides in the platinum group metals.

    In dollar values Guinea, South Africa, India, the Ukraine and Kazakhstan are the countries that under-produce the most in terms of their reserves, says Sainsbury.

    Wednesday, April 28, 2010

    RE:CM on Economic Moats

    Buffett: "So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn't necessarily mean the profit will be more this year than it was last year because it won't be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that's tenuous in any way - it's just too risky. We don't know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses - or virtually all of our businesses - have pretty darned good moats. And we think the managers are widening them. Charlie?"

    Munger: "How could you say it better?"

    Buffet: "Sure. Have some peanut brittle on that one."
    From the 2000 Berkshire Hathaway annual meeting

    "We suggest the margin of safety concept may be used to advantage as the touchstone to distinguish an investment operation from a speculative one."

    Benjamin Graham

    Every once in a while a news item comes along that makes one sit up and take notice such as the shock announcement that Kumba Iron Ore has decided to rescind its agreement to sell iron ore to Mittal Steel at cost plus 3%. Another example is that Hulamin announced that BHP Billiton is not only ending the very attractive (from Hulamin's perspective) pricing agreement for aluminium, but that they will completely stop supplying Hulamin with aluminium.

    The consequences of this news are important for the future of the SA economy. Two very large and important businesses, namely Kumba Iron Ore and BHP Billiton, have decided to end long-standing contracts. These contracts have effectively subsidised the competitiveness of a portion of South Africa's exports, at the expense of the two businesses' shareholders and taxpayers. The two events highlight the difference in time horizons between the capital investment decisions of business, which is often very long-term, and government's efforts to attract investment to meet their own objectives, which is often quite short-term. This discrepancy in time horizons always carries the potential to permanently destroy significant economic value. Although we have our own views about how government should attract investment (and avoid rent seeking behaviour), these are largely irrelevant from an investment standpoint. No one knows how government will act.

    Key Thoughts:
    • There are very few businesses with true moats.
    • Moats are not absolute and vary in strength.
    • "In the long run everything is toasters." The historic return of a business is not necessarily an indication of the future as businesses seldom earn a positive economic return indefinitely. When assessing the strength of the moat, even more important than the level of excess returns is the time period over which it can be sustained.
    • Stick to what you know. Investors can reduce risk and improve returns by focusing their efforts on companies for which they can predict the future economics.
    • A competitive advantage based on less permanent arrangements requires a higher margin of safety.
    • Management plays a central role in investment outcomes.
    • Rising electricity costs are a reality and will have a major negative impact on profitability and the feasibility of new and existing capital projects in South Africa (in the case of price taker industries like many resources companies) and inflation (in the case of quality businesses that are able to pass on such effects to customers).
    • When government facilitates an advantage for business it should ensure that it is lasting. If it does not, the government's own (legitimate) objectives will suffer.
    • In the long run the SA economy will most likely be better off if government focuses on bringing down the cost of doing business while the private sector decides on where to allocate capital.

    Monday, April 26, 2010

    Tidbits from IMF Regional Economic Outlook - South Africa is in good shape

    "Dominating prospects for the middle-income countries is South Africa, which is projected to expand by some 2½ percent in 2010, rising to 3½–4 percent in 2011 and beyond, compared to an average growth of nearly 5 percent in 2004–08".

    "South Africa is by far the largest and most sophisticated market in the region. By market capitalization, its equity market is among the 20 largest in the world (including advanced economies) and foreign investors trade actively in a large and liquid local debt market. South African companies (both private and public) as well as the government have been able to borrow routinely in international capital markets. Reflecting this, South Africa relies more than its neighbors on portfolio and other more volatile forms of investment and was more exposed to the global financial cycle, accounting for two-thirds of the growth in private capital inflows to the region between 2002 and 2007 and experiencing a larger reversal than the rest of the region during the crisis".
    Facts and Figures (as percent of GDP):

    • Government Debt = 31.5 %
    • External Debt to Official Creditors = 1.8 %
    • External Current Account = -4.0 %
    • Trade Balance = 0.1 %
    • Overall Fiscal Balance = -6.1 %
    • Domestic Saving = 18.4 %
    • Total Investment = 19.3 %

    Read the IMF's Regional Economic Outlook - Sub-Saharan Africa

    Friday, April 23, 2010

    Michael J. Burry: How did nobody see this coming??

    ALAN GREENSPAN, the former chairman of the Federal Reserve, proclaimed last month that no one could have predicted the housing bubble. “Everybody missed it,” he said, “academia, the Federal Reserve, all regulators.”

    But that is not how I remember it. Back in 2005 and 2006, I argued as forcefully as I could, in letters to clients of my investment firm, Scion Capital, that the mortgage market would melt down in the second half of 2007, causing substantial damage to the economy. My prediction was based on my research into the residential mortgage market and mortgage-backed securities. After studying the regulatory filings related to those securities, I waited for the lenders to offer the most risky mortgages conceivable to the least qualified buyers. I knew that would mark the beginning of the end of the housing bubble; it would mean that prices had risen — with the expansion of easy mortgage lending — as high as they could go.

    I had begun to worry about the housing market back in 2003, when lenders first resurrected interest-only mortgages, loosening their credit standards to generate a greater volume of loans. Throughout 2004, I had watched as these mortgages were offered to more and more subprime borrowers — those with the weakest credit. The lenders generally then sold these risky loans to Wall Street to be packaged into mortgage-backed securities, thus passing along most of the risk. Increasingly, lenders concerned themselves more with the quantity of mortgages they sold than with their quality.

    Meanwhile, home buyers, convinced by recent history that real estate prices would always rise, readily signed onto whatever mortgage would get them the biggest house. The incentive for fraud was great: the F.B.I. reported that its mortgage fraud caseload increased fivefold from 2001 to 2004.

    At the same time, I also watched how ratings agencies vouched for subprime mortgage-backed securities. To me, these agencies seemed not to be paying much attention.

    By mid-2005, I had so much confidence in my analysis that I staked my reputation on it. That is, I purchased credit default swaps — a type of insurance — on billions of dollars worth of both subprime mortgage-backed securities and the bonds of many of the financial companies that would be devastated when the real estate bubble burst. As the value of the bonds fell, the value of the credit default swaps would rise. Our swaps covered many of the firms that failed or nearly failed, including the insurer American International Group and the mortgage lenders Fannie Mae and Freddie Mac.

    Read the rest of this Op-Ed piece here...

    Genetically Modified Food - The Solution to World Hunger

    The technology will have wide-ranging effects, from helping farmers draw less irrigation water to lowering insurance premiums and boosting land values in drought-prone regions.

    Key Thoughts:
    - Expected to boost yields in dry environments by at least 6%

    - Agriculture accounts for 70% of global fresh-water use, Monsanto CEO Hugh Grant says in an interview. Reducing irrigation not only contributes to more sustainable farming, it’s a “game changer” that will boost profits and help feed a rising world population

    - Monsanto also is engineering crop seeds, including cotton, wheat and sugar cane, for drought tolerance, and the company and BASF are donating drought-resistant maize technology to farmers in sub-Saharan Africa through the Nairobi- based African Agricultural Technology Foundation.

    - By expanding the maize- growing region, the technology can help grow more grain to meet government targets that call for tripling use of biofuels including ethanol, which is made from maize in the US, by 2022

    Wednesday, April 21, 2010

    Tuesday, April 20, 2010

    O.R. Tambo Airport Upgrade - a Sign of Things to Come

    From Airports Company of South Africa:

    President Jacob Zuma today officially opened the new Central Terminal Building (CTB) at O.R. Tambo International Airport. The revamp of Africa's biggest and busiest international airport under the management of Airports Company South Africa (ACSA) saw the completion of the CTB at a cost of R2,2 billion.

    "The construction of this facility placed emphasis on the creation of spaces specially designed to ensure efficient and pleasant airport experiences for all our users," says Chris Hlekane, General Manager of O.R. Tambo International Airport. In addition to the CTB, other completed facilities at O.R. Tambo International Airport include the International Pier, international departures terminal upgrade, and the second multi-storey parkade with parking for 5 200 vehicles. There is now a total of 17 500 car parking bays on-and-off the airport precinct. In addition, there are seven new aircraft parking stands, bringing the total to 105, the Gautrain Rapid Rail link and added storage fuel tanks with a capacity of 60 million litres. Since 2006 the total investment is approximately R5 billion on all projects including the CTB.

    "In less than 50 days the airport will serve as the gateway to South Africa for hundreds of thousands of 2010 FIFA World Cup fans and millions of future tourists. The upgraded facilities are the all-important first impression of not only O.R. Tambo International Airport, but also South Africa," says Hlekane. "It was therefore vital that we provide a world-class African airport with cutting-edge international transport facilitation abilities, technologies and design."

    The upgrades undertaken were specifically designed to create lightness and openness in the terminal buildings, enabling passengers to quickly navigate and move between terminals. The revamp of O.R. Tambo International Airport means that the airport can now efficiently handle 28 million passengers a year. It has been an enormous undertaking that makes flying, both locally and internationally, an efficient, seamless and memorable experience. For this enhanced travel experience domestic passengers pay ACSA only R57 per departure.

    "This is a significant and fitting end to 15 years of transformation and a lot of hard work and dedication," says ACSA Chairperson, Sindi Zilwa. "It is a tribute to the contributions of many people and an accolade to the memory of Oliver Reginald Tambo, one of the most important founding fathers of our new, democratic, South Africa. O.R. Tambo International and the other nine airports can compete proudly with the best facilities in the world, to market South Africa as a preferred destination for investment and tourism."

    In addition to O.R. Tambo International Airport being ready for the 2010 FIFA World Cup, key airports in the ACSA network are fully prepared and ready to run 24 hours a day to ensure the smooth flow of operations. Cape Town International Airport has a new Central Terminal Building, a 400-vehicle multi-storey parkade, five new aircraft parking stands and greatly improved access roads. In Durban the newly-constructed King Shaka International airport, with the capacity to handle 7,5 million passengers per year, is ready to open on 1 May 2010. Port Elizabeth, Upington, Kimberley, East London and Bloemfontein have all undergone runway upgrades and terminal refurbishing and final sign-off will take place by May 2010.

    South Africa and opening up the communications network

    South Africans will have universal access to broadband by 2019, Communications Minister Siphiwe Nyanda said in his budget speech in Parliament on Tuesday.

    "We have finalised the broadband policy whose vision is to ensure that South Africans have universal access and services to broadband by 2019," Nyanda said. "The benefits accruing from the policy will include the provision of multimedia and e-government throughout the country."

    The growth of broadband would "expand markets" and have widespread benefits for the South African economy, Nyanda said.

    "The implementation of the broadband policy will impact on the growth of the economy through expanding markets, increasing business efficiency and promoting competition."

    Nyanda said the roll-out of effective ICT services would ensure that government services were available to all South Africans, irrespective of where they were in the country.

    "South Africans will be able to see a single face of government and be able to connect with all levels of government and different departments using a single platform," he said.

    "ICT offers a possibility of e-government where government offers a seamless and integrated platform for interaction."

    ICT could contribute to the scientific interpretation of outputs in the agricultural sector, water management, including numeracy and literacy training of communities, he said.

    "We are in discussions with the department of rural development and land reform to ensure that we participate in the agrarian reform and food security programme through technology intervention in our sector.

    "This will also contribute to our involvement in growing the second economy." Nyanda said he "intended" to introduce legislation in the current parliamentary session "aimed at further strengthening the ICT policy framework".

    Mohnish Pabrai on

    Mohnish Pabrai, founder of Pabrai Funds and author of Dhandoo Investor, talks to Steve Forbes:

    Full Video

    Pabrai talks about his funds, his investment style, how he picks stocks, his "free" analyst network, and his afternoon naps...

    Jerome Booth on Emerging Markets (

    Forbes: How do you define emerging markets? You've got a unique definition of that.

    Booth: I define it by risk perception. All countries are risky and the emerging markets are the ones where it's priced in.

    And the opposite of course is a developed country where the domestic investor base doesn't even think of their own sovereign risk. So I don't think it's a surprise that Iceland is a developed country. It wasn't that people couldn't have worked out that there was a problem. A 13-year-old probably could have typed in IMF.ORG and worked it out in 2006. Likewise Greece, which today has a probably larger risk of default, sovereign default, in the next one year than any major emerging market. So it's really about risk perception. And that's the particular way I define it.

    Forbes: Now political risk. How do you define political risk and why do you find that higher in so-called developed countries than your bailiwick of emerging markets?

    Booth: Well political risk is everywhere, but I think it's on the increase in the developed world, whereas I think in the emerging world. For example, last year you had Indonesia and India, two examples of elections where the domestic the electorate returned the existing government's, prior reform governments because they understood that this was an external shock. They don't have credit crunch. And they didn't blame their politicians, but they also understand the importance of continuity. Whereas in certainly my country and a lot of the developed world I think you've got a massive increase in political risk. You've had several pieces of retroactive legislation. You've got measures really which are denying the scale of the credit crunch. Nobody should talk about the credit crunch in the past tense, you see. All the academic research on this is pretty clear. It will take many years to delever.

    And political risk is everywhere. Political risk is when there is a risk that a road project as a private equity investor, say, the government or a local government will change the terms of the deal before it's completed. And that in some sense is often as high in a developed country as it is in the emerging world, frankly.

    Friday, April 16, 2010

    Patents and R&D in Emerging Markets

    Number of international patents and R&D show how the future of innovation is taking shape.

    There is a strong link between the number of international patents that a country is granted and the amount that it spends on research and development. A 2007 snapshot shows this clearly, and also that America and Japan led the pack.

    The size of each dot represents total spending, and their colours represent the number of patents per capita, red for higher intensity and blue for lower.

    Click “play” on the bottom left to watch as the countries that spent more on R&D over the past two decades reaped the benefits by gaining progressively more patents. Then click on "Emerging markets take off" above.

    India Snaps up Coal Assets

    Indian conglomerate JSW appears to have outflanked rival bidders for control of suspended coal group SA Coal Mining Holdings (SACMH). An announcement released on Friday disclosed that JSW had struck a R85m agreement with various entities associated with the Royal Bafokeng Tribe and Strider Holdings, which are the major shareholders in SACMH.

    SACMH is in essence a fully-fledged South African Coal producer delivering coal to Eskom and the export market through Richards Bay Coal Terminal.

    Direct Link

    Jet Airways first airline to fly direct between South Africa and India.

    Growing Relations:
    Indian makes biggest export to South Africa in 2009 - The Indian Premier League (link)

    The new masters of management

    Developing countries are competing on creativity as well as cost. That will change business everywhere:

    "Just as Henry Ford and Toyota both helped change other industries, entrepreneurs in the developing world are applying the classic principles of division of labour and economies of scale to surprising areas such as heart operations and cataract surgery, reducing costs without sacrificing quality. They are using new technologies such as mobile phones to bring sophisticated services, in everything from health care to banking, to rural communities. And they are combining technological and business-model innovation to produce entirely new categories of services: Kenya leads the world in money-transfer by mobile phone, for example."

    Read The Economist's Special Report

    Thursday, April 15, 2010

    Wednesday, April 14, 2010

    Bruce Greenwald on Shorting and Current Opportunities

    Connectivity in Africa

    Text message phone apps now help African people check market prices, transfer money, learn languages and alert authorities to the need for food or other aid in the event of a disaster. And this all comes despite Africa's reputation as the "least wired" continent in the world.

    Mobile phone subscriptions in Africa are growing at a rate of about 50 percent per year in recent years, faster than that of any other continent, according to the International Telecommunication Union. A 2009 ITU report found 28 percent of people in Africa have a mobile phone subscription. By contrast, only 5 percent of people there use the Internet, the ITU says.

    EASSy, Seacom and TEAMS cables are going to provide Africa with much needed bandwidth. The possibilities from this point on are tremendous. The days of low bandwidth, smartphone and internet penetration on the continent are finally coming to a close.

    EASSy landed in Tanzani recently. It's benefits include:

    • Connectivity into and between 20 African countries

    • The most flexible contracts in the region:

      » leased capacity contracts from just 1 month up to 10 years
      » long-term rights of use (IRUs) for the 25-year lifetime of the system
      » capacity from as little as 2Mbps up to multiple 10Gbps wavelengths
    • Direct, assured connectivity into Europe

    Read more about EASSy here

    Sasol to Produce Coal-to-Liquids in China

    A feasibility study of the joint coal-to-liquids project between China's top coal producer Shenhua Group and South Africa's Sasol has been completed, the top executive of Shenhua said on Wednesday.

    Zhang Yuzhuo, president and chief executive officer of the group, told a news conference the scale of the project would be 93 000 barrels per day.

    The project was earlier estimated at equivalent to 80 000 barrels of oil output per day.

    Zhang said the project would need government approval and declined to comment on the time frame of the project.

    Shenhua's other coal-to-liquids project in Inner Mongolia has already launched trial production.

    The group, which has invested 80 billion yuan (R85.32 billion) in coal conversion, is also developing various coal-to-chemical plants in provinces in northern China.

    "If oil prices are like today -- $84 to $85 a barrel, coal conversion projects can be very feasible," Zhang said.

    Shenhua Group plans to produce over 30 million tonnes of coal-derived liquids and chemicals in the next 5 years, in addition to 800 million tonnes of coal, Zhang added.

    Coal-to-liquids projects have long been controversial due to concerns over their high water consumption. But Zhang argued such projects would not necessarily be water-guzzling monsters.

    "Water consumption is very, very low compared to the average industry water consumption in China," he said, arguing that compared to the average water consumption on every 10 000 yuan of added industrial value of 127 cubic metres, coal-to-liquids only consume less than 12 cubic metres of water.

    More about: Coals-to-Liquids and Future Coal Fuels

    Tuesday, April 13, 2010

    Dividend Investing: Mercury General Corporation (MCY)

    The Company's operating results and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $189 million and $65 million in 2009 and 2008, respectively. Cash flow from operations has been used to pay shareholder dividends and to help support growth. The dividend has grown over the last five years at a compound annual growth rate of 7.8%, and currently yields 5.29%.

    At the current stock price of $44.48, Mercury is trading on an undemanding PE ratio of 6.11 and a somewhat generous price to book value of 1.38 times. Caution however must be warranted given the extraordinarily high profits the company realized in fiscal 2009 resulting from realized gains of $341 million. This was however after a realized loss of $551 million in 2008 during the height of the financial market crisis. On normalized basis earnings were around about $3 per share (this excludes unusual items such as realized gains or losses on large parts of an insurance company's equity portfolio, as well as a subsequently adjusted tax rate). That puts the company on a historical PE of about 14.82 times.

    However the company is on a less than 6 times price to cash flow and a price to sales ratio of 0.78, which indicates investors can pick up more sales per share for a lower price. The outlook in terms of investment returns is set to prove and the underwriting margin should also normalize after relatively high claims during fiscal 2009.

    Monday, April 12, 2010

    The Investment Case for Africa

    Daniel Broby, "The Case for Investment in New Emerging Markets—Africa and the Middle East" from CFA Ireland on Vimeo.

    Buffett: Charlie is Too Pessimistic

    Warren Buffett on Charlie Munger's "Sad Parable"

    A Life Assurer's Worst Nightmare - Incorrect Assumptions

    Like the sub-prime crisis faced by banks, the risk of people living for up to 20 years after retirement seems to have crept up on an industry using historical data to calculate people's chances of an early death.

    Pension funds and insurers say the mounting burden of protracted pension payments is concentrated on a small group of providers: them.

    Global private sector liabilities for pensions are at about $25 trillion (R180 trillion), according to a January Pensions Institute report, which cited estimates that every extra year of life expectancy at age 65 adds about 3 percent to the value of some UK pension liabilities.

    Several factors - the market crash brought on by subprime lending, new solvency rules for insurers due in 2012 and the stampede of baby-boomers to retirement age - are adding urgency to providers' efforts to spread their exposure.

    If that seems like a small group, the evidence is it's the population segment most likely to grow. There are about 450 000 centenarians in the world today and experts estimate that there could be 1 million by 2030.

    Thursday, April 8, 2010

    Average Industry ROIC

    Harvard Professor Michael Porter, using data from Standard and Poor's as well as Compustat, has calculated the profitabilites of various industries over the 1992-2006 period, some of which are shown below:

    Courtesy Baral Karsan

    Adam Smith on Investor Psychology

    “The gold-bugs have been around forever. The market still has gas. Who understands gold, anyway? And how can you worry about something you can’t understand?”

    “What is it the good managers have? It’s a kind of locked-in concentration, an intuition, a feel, nothing that can be schooled. The first thing you have to know is yourself. A man who knows himself can step outside himself and watch his own reactions like an observer ...”

    “The market is a crowd ... a composite personality. In fact, a crowd of men acts like a single woman. The mind of a crowd is like a woman’s mind. Then, if you have observed her for a long time, you begin to see little tricks like little nervous movements of the hands when she is being false.”

    “If the profit numbers on income statements are treated with such reverence, it was obviously only a question of time before some smart fellows would start building companies not around the logical progression of a business but around what would beef up the numbers. ”

    “A man is really at his best, his most fulfilled, when he’s on the way to becoming what he’s going to become ... With good men, you can see the learning juices churning around every mistake .”

    “Logic, to an outsider, would say that you have a company selling at 10 and you go and do a lot of research on it and figure out the sales and the profits and you figure if they can earn one dollar it will sell for 20. So you buy it and wait, and the story gets that they earn the one dollar … but the market does not follow logic, it follows some mysterious tides of mass psychology . Thus earnings projections get marked up and down as the prices go up and down, just because Wall Streeters hate the insecurity of anarchy. If the stock is going down, the earnings must be falling apart. If it is going up, the earnings must be better than we thought. Somebody must know something we don’t know.”

    “Quarterly reports came out saying, the outlook is favourable ... But from 1930 to 1933, a real blight of the spirit took place. The prudent men, believing in the long-term growth of the American economy, saw their holdings in the bluest of American blue chips drop 80%-90%. It was the psychology of panic ... the fall in the market was very largely due to the psychology by which it went down because it went down .”

    “We all know what a millionaire is, and when the adding machine says $1m, there is a beaming figure facing it. But when the machine says 00.00 there should be no one at all because that identity has been extinguished, and the trouble is that sometimes when the adding machine tape says 00.00 there is still a man there to read it.”

    Adam Smith's "SuperMoney"

    Tuesday, April 6, 2010

    South Africa, Electricity and Recovery

    South Africa's second integrated resource plan (IRP2), a blueprint for the country's energy mix over the next 30 years, is close to being finalized.


    Eskom and BHP Billiton agree to new aluminum smelter electricity pricing.

    Monday, April 5, 2010

    Why China Insists on Controlling its Currency

    U.S.-Chinese relations have become tenser in recent months, with the United States threatening to impose tariffs unless China agrees to revalue its currency and, ideally, allow it to become convertible like the yen or euro. China now follows Japan and Germany as one of the three major economies after the United States. Unlike the other two, it controls its currency’s value, allowing it to decrease the price of its exports and giving it an advantage not only over other exporters to the United States but also over domestic American manufacturers. The same is true in other regions that receive Chinese exports, such as Europe.

    What Washington considered tolerable in a small developing economy is intolerable in one of the top five economies. The demand that Beijing raise the value of the yuan, however, poses dramatic challenges for the Chinese, as the ability to control their currency helps drive their exports. The issue is why China insists on controlling its currency, something embedded in the nature of the Chinese economy. A collision with the United States now seems inevitable. It is therefore important to understand the forces driving China, and it is time for STRATFOR to review its analysis of China.

    An Inherently Unstable Economic System

    China has had an extraordinary run since 1980. But like Japan and Southeast Asia before it, dramatic growth rates cannot maintain themselves in perpetuity. Japan and non-Chinese East Asia didn’t collapse and disappear, but the crises of the 1990s did change the way the region worked. The driving force behind both the 1990 Japanese Crisis and the 1997 East Asian Crisis was that the countries involved did not maintain free capital markets. Those states managed capital to keep costs artificially low, giving them tremendous advantages over countries where capital was rationally priced. Of course, one cannot maintain irrational capital prices in perpetuity (as the United States is learning after its financial crisis); doing so eventually catches up. And this is what is happening in China now.

    STRATFOR thus sees the Chinese economic system as inherently unstable. The primary reason why China’s growth has been so impressive is that throughout the period of economic liberalization that has led to rising incomes, the Chinese government has maintained near-total savings capture of its households and businesses. It funnels these massive deposits via state-run banks to state-linked firms at below-market rates. It’s amazing the growth rate a country can achieve and the number of citizens it can employ with a vast supply of 0 percent, relatively consequence-free loans provided from the savings of nearly a billion workers.

    It’s also amazing how unprofitable such a country can be. The Chinese system, like the Japanese system before it, works on bulk, churn, maximum employment and market share. The U.S. system of attempting to maximize return on investment through efficiency and profit stands in contrast. The American result is sufficient economic stability to be able to suffer through recessions and emerge stronger. The Chinese result is social stability that wobbles precipitously when exposed to economic hardship. The Chinese people rebel when work is not available and conditions reach extremes. It must be remembered that of China’s 1.3 billion people, more than 600 million urban citizens live on an average of about $7 a day, while 700 million rural people live on an average of $2 a day, and that is according to Beijing’s own well-scrubbed statistics.

    Moreover, the Chinese system breeds a flock of other unintended side effects.

    News in the Long-Run

    John Mauldin on The Recovery

    Last week I wrote a letter to my kids trying to explain what Greece meant to them. Reader Ken V wrote: "Great letter, John. Now you should write one for the adults who are retired and don't have the long future your kids do. If the US becomes Greece, things won't recover in time for much of the rest of my life to be more than one grim, dreary period. What is your investment advice for those with roughly a 10-year horizon, not 30-40-50 years?"

    A very good question Ken, and one that was asked more than a few times. So today I will touch on that thorny issue, as well as look at the employment numbers for what we see about the potential for an actual recovery.

    First, let me say that what I am not doing here is giving you, gentle reader, specific advice. To be able to do that I would need to have specific knowledge of your situation, assets, location, needs, health, etc. But what I will try to do is give you a general assessment of what I see for the economy over the next few years and what the investment climate might look like. I am also going to refer to a lot of previous letters I have written, for those of you who want to do further research.

    Is This a Recovery?

    First, we are in a nascent recovery from the depths of the Great Recession, but the question is "what kind of recovery?" Many suggest that we will see a typical recovery, like we have seen with every recession since World War II. As regular readers know, I don't think we've gone through a typical, garden-variety recession, and to expect a typical recovery is more faith-based than factual. We had a deleveraging recession and we are still deleveraging. The process, as shown in studies I have written about, takes years to conclude.

    When I started talking in 2002 about a Muddle Through Economy for the rest of the decade, I had a lot of people giving me a hard time by 2005-6. But as we closed out the decade, average growth of US GDP for the entire decade was less than 2% annualized, which by my definition is Muddle Through. For the US economic machine, that was pretty anemic growth. It resulted in a lost decade for stocks, except for the NASDAQ, for which it was merely a dismal decade. Traditional 60-40 (stocks to bonds) portfolios did not fare well, coming nowhere close to the projections of standard-issue money managers.

    I think we are in for yet another Muddle Through period, at least for 5-7 years and maybe for the decade, depending on a few scenarios I will come to in a minute. As my friend Prieur du Plessis outlined for us in last Monday's Outside the Box, if we measure the stock market by either earnings or dividend yields, valuations are in the top 10% historically. Average (!) returns, going out for ten years, are 2.6% real, with some historical 10-year periods being negative. Below is the range of returns, based on dividend yields. It does not look much different from the chart based on earnings. We are currently at the far right-hand bar.


    This does not suggest a happy outcome for those who espouse buy-and-hope portfolios, at least not if you have expectations or needs of 7-8% or more.

    This Time is Different

    If you are a new reader, I suggest going to the archives at and searching on the name "Rogoff," to read the letters I have written on his and Carmen Reinhart's must-read book, This Time is Different, which shows us that it is never different this time. They looked at 266 financial crises in over 60 countries across a span of 200 years.

    Debt crises have sadly similar conclusions: they always end in pain and tears. And although we have stopped, as private citizens, from accumulating debt (or in some cases, such as mortgages, have just walked away from the debt), our national government has stepped into the breach and is borrowing at mind-boggling levels.

    Below is a chart that is a wonderful illustration of an economic truth: if something can't happen then it won't happen. We cannot borrow $15 trillion in the next ten years. Not at anywhere near the low interest rates we enjoy today, and probably not even at nosebleed rates. (Note that the chart was created before the health-care reform bill. Add at least another trillion to the total. Anyone who thinks that bill was revenue neutral is kidding themselves.)


    The End Game

    Something has to change. We have two paths to choose from. We can either slowly bring the US budget deficit back into balance (or at least to a level less than the growth in nominal GDP) or we can continue on the current path and become Greece or Japan. (Again, go the archives and search for "Japanese Disease".)

    The first choice is a bad one, but the latter choice would be disastrous. If we take the first choice, which I call the Glide Path Option, a meaningful reduction would have to be on the order of $200-250 billion a year. That, along with reduced spending by state and local governments could (and probably will) amount to reducing spending by a little more than 2% of GDP.

    I have written several letters on the equation GDP = C (consumer and business consumption) + I (investments) + G (government spending) + E (net exports) (again, searchable). The Keynesians point out that when "C" is reduced in a recession, "G" should be increased to offset the effects of reduced consumption. And they are correct that a deficit will help overall GDP in the short run.

    But we are coming to the end of the Debt Supercycle. There are limits to what even the US government can borrow, and the sooner we recognize that as a nation the better off we will be in the long run.

    But if we start to reduce our deficits (the "G"), it will be a short-term drag on GDP. There is no way around it. That means that if inflation is 2% and we have a reduction in "G" of 2% of GDP, then the nominal growth in GDP will have to be 6% in order to achieve after-inflation growth of 2%. Two percent as in Muddle Through.

    But wait, John, didn't we just grow at 5.6% last quarter? Why are you being so gloomy? For several reasons. First, the growth was largely statistical. Part of it came from inventory accounting, as inventories had got as low as they could go. Note that an increase in inventories will increase GDP but possibly result in a lower future GDP as the excess inventory is depleted. And inventories are still rising, but not by as much.

    Secondly, a significant portion of the increase in GDP came from the stimulus. As noted above, an increase in "G" will be reflected in current GDP. This stimulus begins to go away in the second half of the year, and I think there is little reason to believe there will be anything other than an extension of unemployment benefits past two years, by way of "stimulus" this year.

    I rather think the last half of the year will show a slowing (though still positive) economy. Unemployment will be closer to 10% than 9% at the end of the year, as the large number of temporary census workers will no longer be employed by the government.

    Some Good News on Unemployment

    The good news is that employment rose by 162,000 jobs last month, with about 48,000 of those being census workers and another 82,000 coming from the birth/death ratio, a way of guessing how many new businesses are started. The birth/death ratio is eventually squared up when we get real statistics, but it will be several years before we know the true picture. So, while the headline is good, the reality is not quite as good. But let's take what we can. The direction is positive, and it should get better over time.

    Small businesses have at least stopped laying people off, according to my friend Bill Dunkenberg, chief economist of the National Federation of Independent Business. The improvement is due to fewer reductions in jobs, not gains in new hiring.


    There are not a lot of job openings, according to the survey that goes along with this note from The Liscio Report: "The probability of a person unemployed in February finding a job in March fell to from 20.1% to 18.7%, an all-time low for this series (which goes back to 1948).

    This reinforces a letter I wrote last November, talking about the prospects for longer-term employment rates. Even the rosy scenarios still have unemployment above 8% in four years. That assumes a total of 1.5 million new jobs can be created this year and two million every year thereafter, with no recession.


    Remember, we need about 125,000 new jobs a month to just keep up with the growth in our population. Though if you look at today's employment release, they added a whopping 398,000 people to the civilian labor force (a huge number when compared to the 162,000 new jobs - a discrepancy you didn't read about in any report.). What kept the unemployment rate from rising significantly was that they deducted 238,000 people who are no longer considered unemployed, due to the fact that they have given up looking for jobs. The U-6 unemployment rate rose to 16.0%, however. The U-6 rate includes people who have part-time work but wish they had full-time work. That part-time number rose above 9 million again this month, in a rather large monthly jump.

    You can read the whole November letter and see the other two scenarios.

    The Effects of a Tax Increase

    I have written about the effects of tax increases in several letters. Basically, tax increases have a negative impact on GDP of three times the size of the tax increase. (Again, in the archives, search for "Romer", as in Christina Romer, Obama's head of the Joint Council of Economic Advisors and co-author with her husband of the research).

    Taxes may be going up by as much as 2% of GDP in 2011, when you include state and local increases. This could be as much as a 6% drag on GDP over the next three years (probably somewhat front-loaded).

    So, let's add it up. We will likely see a reduction in government spending (from all levels) over the next few years, a really nasty set of tax increases, which will hit small businessmen the hardest, and continued high unemployment, and all of it coming in a weakening economy by the end of the year.

    I put the odds of a double-dip recession in 2011 at better than 50-50. Not a sure thing, as maybe sanity flowers and they phase in the tax increases over 3-4 years. Plus, the American economy and businesses are more resilient than we think, and it is possible we Muddle Through 2011. Not much growth, but perhaps we avoid that recession.

    Deflation in the US is the dominant force. There is little likelihood today of a worrisome increase in inflation. I have written letters about why this is the case. (Search for "elements of deflation" and "velocity"). Actually a little inflation (2-3%) might be welcome as a protection against slipping into outright deflation, if we slow down next year.

    Let's try to sum it up. We have a Muddle Through Economy this year (not much more than 2% overall growth for the year), with a slowing economy next year. Unemployment stays high. If we get our deficits under control, we lock in a slow-growth economy for 5-6 years, but after that we could get back on track. A recession puts that brighter outlook out a little farther. Unemployment would go north of 12%. I might note that the stock market drops an average of 40% during a recession.

    Or we do not get our deficits under control. We can go on borrowing for a lot longer than most of us think. But the Rogoff and Reinhart book makes clear that there is an end. You can't solve a debt crisis with more debt. Ask Greece in about 6-12 months, as the "fixes" are temporary. Things go along until there is a loss of confidence in the bond market, and then all hell breaks loose. When is that? Who knows? But it is not ten years away, and probably not five. Rates skyrocket and the currency takes a hit.

    And then we are presented with a conundrum. Would the Fed really enable the government to run huge deficits by monetizing the debt? It would be a crisis decision. If they just stand by, interest rates soar and the economy goes into recession or worse. If they print, we could see inflation and a crashing dollar, with rates soaring. As I said above, this would be a disastrous scenario. I think we avoid it, as there will be a growing backlash at the polls against government deficits. But then I am an optimist. If you think the politicians cannot muster the will to make the cuts, then bet on the disaster scenario. Think gold and hard assets and foreign assets and absolute-return funds.

    But optimist though I am, I can't rule out disaster. So, either we have a slow-growth economy for 5-6 years, or we hit the wall all at once. Think depression if it's the latter. Either way, it's a tough investment environment.

    So, how about those with a 10-year time frame, like the reader I opened with? First, lengthen your time frame. There are some amazing new medical therapies coming your way and you are likely to live longer. I would plan on it. You will need more than you think you will.

    Second, really think about your commitment to equities in general. By that I mean the usual index funds. If you have (or your manager has) some real skill in picking stocks, then that is different. But I think it is very possible we'll see another lost decade for stocks in the US. If we do have a recession next year, the world markets are likely to fall in sympathy with ours. At the bottom, it is quite possible that emerging-market stocks will finally decouple from the developed world, so for those who should be in stocks (those with a longer time horizon), think about going beyond the developed world.

    For most of you, caution is appropriate. Do not plan to make 8% a year from your portfolio, or to spend 7% of your savings. As Ed Easterling has shown, there are historical periods where people taking 5% a year from their portfolios would be left with nothing after 30 years. In fact, about 50% of those portfolios would run out of money in an average of just over 20 years. The key? Starting valuations.

    For most people already retired, a fixed-income portfolio should be your first choice. High-quality corporate bonds, high-quality state and municipal bonds (do your homework - don't trust the rating agencies!), and a "ladder" of not not more than 4 years. I know that does not yield much, but you should be protecting your principal.

    If you have enough income from a portion of your assets to live on, then think about absolute-return-type funds.

    Ken, if your time horizon really is ten years, then safety should be your number-one objective.

    Also, I know some people are managing their wealth for the next generation. That may make my note of caution not as emphatic, assuming you really do have enough to make your expected time horizon and more.

    All that being said, I am still bullish about certain businesses. As I noted a few weeks ago, I see an opportunity in bleeding-edge software consulting for media and other businesses that have to innovate or die, and I'm investing in such a startup. I am also investing in small-cap biotech stocks, with a 10-year horizon. Remember that birth/death ratio? While I do not believe it is as high as they estimate, there are businesses being started all over the country. That is what a free market does.

    If I had the stomach to deal with renters, I would be buying distressed homes at prices where I could more than make a reasonable return. For some of you, that may be a way to get income. (Commercial real estate will soon become a real potential as well, for experienced investors.)

    The US economy is not coming to an end. There will be lots of opportunities, but it will be harder than in the past. More like swimming through peanut butter. But nothing is ever easy. For the next few years, I simply think being more cautious makes sense - but choose your targets. There are funds and managers I like.

    A 10-year time frame? There is not much I can say that will make you happy. 20 years? That should be another thing. One way or another, this deficit crisis will resolve itself, and then we can get back to doing what we do best.

    Risks Facing China

    The drought, which started last summer in southwestern provinces in the upstream of the Yangtze River, has reduced the water level of the massive Three Gorges reservoir -- located mostly in Hubei province -- by six metres versus a year earlier, Xinhua said.

    Friday, April 2, 2010

    China is going Vehicle Mad

    US auto giant General Motors said Friday it sold a record 230,048 vehicles in China last month with demand strong for smaller, fuel-efficient cars.

    The result marked a 67.9 percent year-on-year increase and was the 15th straight monthly sales record for GM in China, the world's biggest and fastest growing auto market.

    Risk and Margin of Safety in Value Investing

    Risk is an important investing concept that is crucial to value investors. Most investors analyse an opportunity by determining how much they can make on a particular investment (generally of the speculative nature). Value investors have another consideration: how much can they lose on each investment?

    Risk is defined in financial theory as the volatility of share prices in relation to their historical average. A share that fluctuates 50% in a certain time period is considered a “riskier” investment. Value investors disagree with this interpretation. Share price movements often have little to no relation to underlying value, especially over the short-term. Value investors believe that risk really is the probability of permanent loss of capital.

    Consider the following example: assume Sasol trades at R300 per share. If the price subsequently declines to R200, for a 33% drop, financial theory will dictate that Sasol is now a riskier investment at R200 than it is at R300. Compare this to the movement in the price of Awethu Breweries: if the share price moves from 4 cents to 5 cents, for a 25% gain, Awethu becomes a less risky investment than Sasol. Such a conclusion is not only structurally flawed – it is downright absurd.

    Value investors therefore pay as much emphasis on what can be lost as to what can be gained. It is using this logic that the concept of Margin of Safety was first ventured by Benjamin Graham in his investing classic, The Intelligent Investor. A margin of safety demands that the thoughtful investor seek a significant margin between purchase price and intrinsic value in order to protect against incorrect analysis. Value investors have as a primary goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizeable losses over time¹.

    Such a strategy allows value investors to outperform during periods of market decline, whilst lagging during periods of exuberance. When the market increases beyond a level supported by prudent research and fundamentals, value investors find safety in cash. Through patience, diligence and thorough research, the Margin of Safety approach has provided sustainable long-term returns for almost all value investors.

    What Richemont sees in Net-a-Porter

    Swiss luxury goods maker Compagnie Financière Richemont SA on Thursday announced a deal to buy U.K.-based online luxury retailer Net-A-Porter Ltd., a transaction that signals the increasing importance high-end consumer goods companies are assigning to online sales.

    Richemont, the owner of brands such as Cartier, Montblanc and Chloe, previously held a 33% stake in closely held Net-a-Porter, but agreed to acquire a majority of the company from a group of private shareholders for up to £225 million ($341 million). Richemont said the transaction values the overall company at £350 million.

    What Net founder and chairman Natalie Massenet (mass-in-ay), 44, has done is combine on one website the thrill of shopping at a chic boutique with the pleasure of reading a fashion magazine. Net not only showcases and sells clothes but also publishes a weekly online glossy that decodes the latest trends.

    And by mixing these two addictive leisure activities -- shopping and perusing a magazine -- into one designer drug, Net is doing for $2,000 Calvin Klein dresses what Amazon did for "The Da Vinci Code" and iTunes for Coldplay.

    As a result the company is growing exponentially at a time when many purveyors of luxury goods are struggling.

    The focal points of the office are two giant flat screens that track orders as they come in, a motivational tool that reminds everyone that this is all business. The top screen shows an image of the products and the price of each order as it is placed, along with a running tally of the day's sales figures. The bottom one depicts a map of the world that rotates to show the origination point of the latest order.

    "Almaty Kazakhstan $806" moves across one monitor as the locator screen tracks over Europe and past the Caspian Sea before alighting on the business center of the former Soviet Republic. The locator map then shifts to "Hamburg, Germany," while on the adjacent screen a $350 organic cotton tee with that Peter Blake cloud print drifts by.

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