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The Emperor has no clothes and other investment myths

10 March 2011 Cannon Asset Managers

Adrian Saville, CIO of Cannon Asset Managers, lifts the skirt on investment risks that abound and explores some of the opportunities that lie beneath the surface.

Since the onset of the global financial crisis, investors seem to have surged from risk loving to risk fearing and back to risk loving. Unlike the Emperor of yore, investors should not be fooled into thinking that risk has been effectively reduced by policy actions and the return to a more normal mood amongst the participants in capital markets. Indeed, whilst there is an overwhelming sense that risks have waned in the last year, there is a lot of evidence to suggest a different view which sees some high risk events that are resident in capital and financial markets. An investor who is naked to these elements raises the risk of capital erosion, under a best-case outcome, and the permanent destruction of capital, under a worst-case scenario. By the same token, an investor who is equipped to deal with these risks has the fabric to seize the abundant opportunity that is presented in this environment.

Sovereign debt is alarmingly high, with a possibility of “hard” default

It has been the case for some time that national debt amongst some of the world’s biggest economies (as well as smaller ones) is too high. An Economics 101 rule of thumb says that the debt:GDP ratio should not surpass 60%. In many countries, the ratio far exceeds this level. In addition, if one looks at the debt:tax revenue ratio, alarm bells are ringing. While an acceptable level for this ratio is 180%, several countries have run out of road as far as their debt to revenue levels are concerned. Some of the PIIGS (Portugal, Ireland, Italy, Greece, Spain) as well as Japan, the US and Vietnam have levels well above 180%. Somewhat more concerning is that of the world’s three largest economies – the US, China and Japan – two of them – the US and Japan – display exceptionally stretched national debt:income metrics. Together these two countries are responsible for about 45% of the world’s total government debt.

As the financing of public sector spending has become increasingly stressed, some governments have turned to more exotic forms of funding. For instance, in the US the issuing of 100-year bonds has been proposed recently. When you think that of the 200-odd countries around today, only 41 have existed for over 100 years, you realise the boldness of any country that issues debt of such maturity. Moreover, in deliberating the above debt:income metrics, what we are seeing is just the tip of the iceberg. This is because most national debt is held off-balance-sheet in the form of future spending obligations on social welfare commitments. In essence, whilst already alarming, what we are looking at is only a small fraction of the total national debt problem.

Where is this likely to lead us?

There are several possible responses to the bloated public sector debt: from high economic growth and low public spending leading to good repayment; to defaulting on the debt as Argentina did in 2001. Perhaps the most frightening, but also the most likely, is what we term “the Zimbabwean option”, which involves simply inflating debt away by printing money which causes inflation, and in turn, makes the historical debt worth less and less.

As evidence of the “effectiveness” of this tool, from 1945-1973 inflation did half the work of cutting US government debt from 122% to 25% of gross domestic product. The explosion witnessed in the US money supply during 2009 will result in inflation, ultimately leading to a “soft” default. The risk to investors is that in this scenario inflation silently confiscates private sector wealth and redistributes this to government. In essence, this is what the Mugabe government did in Zimbabwe during the past decade, with hyperinflation eliminating the Zimbabwean government’s debt obligation.

While countries may not yet be reporting a rise in inflation, it appears that the problem is being under reported, according to a variety of measures, such as The Economist’s McFlation index. As further evidence of this, price pressures are building globally. Food prices, for example, are at record levels. This has dangerous implications and much bigger ramifications for global stability. As Nobel Prize-winning economist Amartya Sen observed "there is no such thing as an apolitical food problem."

Although Ben Bernanke avers that the US monetary policy, known as quantitative easing, is not to blame for food price inflation, it clearly has played a role. The majority of food price hikes are not explained by global warming. In this setting, there are clear risks to the investor, as well as evident opportunity, in particular in agri-business.

Fast-growing emerging markets are not great investment cases

A further risk to the investor comes about by confusing fast economic growth with investment attractiveness. Just because a country is showing rapid economic growth, it does not follow that its financial markets will perform well. In the same way that we should not confuse great businesses with great investments, we should not confuse a growing country with a good investment. While China led global growth last year, the Shanghai Composite Index fell 5.3%. By contrast, whilst Japan’s economy grew slowly, the Nikkei 225 Index outperformed the Chinese market by about 10 percent. Our view is that the explanation for this is simple: asset prices are high in China as they have fully priced in anticipated growth. By contrast, Japan has been left for dead, leading to the underpricing of some high quality assets.

This argument does not change the result that, with the resurgence of China and other dynamic markets the economic centre of gravity of the globe is moving steadily east and south, and this trajectory is set to continue. In this broad cluster of countries, Chindia seems unstoppable. In 2010 the US, with 307 million people, saw 12.7 million new cars purchased. In China and India, which together have a population of 2.5 billion people, there were 13.1 million new cars bought. China is now the world's largest energy consumer and as its energy intensity increases, we expect consumption to gallop ahead. One way of harnessing this exceptional opportunity is through markets that are exposed to global growth, but priced “domestically”. Three examples of this are Russia, Spain and Italy. More than two-thirds of the revenue earned by Italy and Spain’s listed companies come from the rest of the world, yet those countries markets are priced for “gloom”. Similarly, Russian companies are on extremely low price multiples. Yet, because of their high resource bias, Russia’s listed businesses will do very well in an environment of global economic growth and surging demand for commodities.

South Africa hosted a damn fine soccer World Cup

Considering the domestic economic setting, South Africa is experiencing positive economic growth across a broad base in the economy. The recovery in international commodity prices is expected to give local firms an additional boost. To boot, consumer price inflation remains relatively low and stable, resulting in a key lending rate which is at a multi-decade low. Furthermore, portfolio and direct foreign investment inflows are strong. This, in turn, has resulted in a strong and stable Rand. Whilst the mood in some parts of the economy is less-than-ebullient, the SARB leading indicator points to a continuation of steady economic growth. In the run-up to local government elections, there is a renewed focus on service delivery, which can only help to lift communities.

We see similar positive trends on a broader regional level. The Sub-Saharan region is showing some of the strongest economic growth rates on the globe, comfortably higher than developed countries. Seven of the 10 fastest-growing countries forecast for the 2011 to 2015 period are from sub-Saharan Africa. South Africa is located in a robust neighbourhood: even Zimbabwe (where price inflation has normalised) is getting into the game. Whilst conditions and risk vary widely in the region, one way of gaining attractive investment exposure to African growth is through directly investing in these markets, which generally are on low and relatively desirable valuation multiples. Another path is available by investing in South African companies in which this opportunity has not been recognized. Grindrod is one such example.

So what does this mean for an investor?

In this environment there are exceptional opportunities but also clear traps in terms of investment risk which we need to take into account. As James Montier, of GMO, notes: “Value investing is the only approach that puts risk management at the very heart of the investment process.”

But most investors seem to have strayed far from the value approach. If we look at a metric such as the holding period for shares, we see that market average has slumped from 25 years in the 1970s to some one-and-a-half years in the 2000s. People are holding shares for a shorter period than they buy a toaster or a washing machine. By comparison, at the moment Cannon Asset Managers’ holding period is about four-and-a-half years and, in recent times, this has been as high as seven years. This firmly establishes us as investors, distinct from a market that is dominated by speculators. Speculation brings with it specific risks that often work to the detriment of the participant. By contrast, investment behaviour is exactly that: investment behaviour.

Another risk for investors in this setting is that of failing to differentiate between a great business and a great investment. A perverse behavioural attribute of many market participants is that they often want to buy more of a stock as prices rise and go ever higher and, when prices fall, they want less or want out. This behaviour turns the foundation of successful investing – buy low and sell high – on its head. In this vein, over-paying for shares turns a great business into a bad investment.

A tool that is effective in managing this investment risk is the Graham and Dodd p:e ratio. A maximum ratio of 16 is advised for investment purchases. China is currently on a ratio close to 30 times, while value can be found in Russia, Spain and Italy, as mentioned earlier. Importantly, the Graham and Dodd ratio is as effective at the country level as the company level. This flags a number of much loved companies in South Africa that are priced on very demanding multiples and, whilst they may be world class businesses, they are priced for perfection which leaves the investor naked to the risk of disappointment. Such examples include Naspers, Capitec and BHP Billiton. Amongst others, compellingly-priced businesses include the under-loved building and construction firms, Aveng and Group 5, as well as Anglo American and Grindrod, to name a few.

A third concern is that of operational risk: “the danger of a loss of quality and earnings power through economic changes or deterioration in management” (Benjamin Graham, 1949). Importantly, operational risk should not be observed just from a bottom-up perspective. A top-down approach should be the point of departure, only then can bottom-up make sense. The world is not flat, nor is it borderless: events in any part of the globe have an impact elsewhere and that must be incorporated into one’s assessment. Recent events in the Middle East and North Africa give evidence for this argument.

As a fourth risk factor, there is balance sheet risk: the risk of permanent loss of capital. Whilst cases of specific company risk exist in all markets, it is notable that in the current setting, South African companies listed on the Johannesburg Stock Exchange show a high level of balance sheet strength and quality. Compared to other markets, this strength is not reflected in the prices of many companies, which offers specific opportunity. Included in this set are the building and construction firms Group 5 and Aveng which, notwithstanding the turbid and uncertain environment, have exceptionally strong, cash-rich balance sheets.

In summation, in switching back-and-forth from “risk on” to “risk off” and back again to “risk on”, in many places investors have lost sight of the principal threat to any investment decision: hidden risk. In turn, in taking decisions naked to such risks, investors render themselves vulnerable to the erosion of capital value or, in a worst case scenario, permanent capital destruction. In the first instance, recognizing these risks clothes the investor, equipping them to deal with the systemic and specific risks that are present in the current setting. By extension, our investment process, which places risk at the centre, reveals a world filled with exceptional opportunity.

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