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Transcript
30 June 2007 Balance Nature strives for balance. In the wild, lions eat the antelope until there are too few left to sustain the lion population. The lions then struggle to catch the remaining antelope until some of them starve or move away. Eventually the antelope population recovers until their numbers are in balance with the predators in their ecosystem. Listed companies could be seeking to monetise their future earnings, raise capital or have other goals made possible by a public listing. Investors might be looking for a safe haven, inflation beating returns or the latest speculation. So while one takes solace from averages and The economy and the financial market that exists within it are a man made system, which unlike trends, the market is constantly over and undershooting as it tries to find its balance. nature, never maintains a position of equilibrium MONTHLY PERCENTAGE CHANGE ALL SHARE INDEX for very long. In simple theoretical terms the equity market should appreciate at the nominal rate of aggregate earnings growth, assuming that investors have correctly estimated future earnings growth and selected the correct discount rate. We know this to be correct because over the long term, equity market returns are quite stable. However in the short to medium term the market struggles to forecast earnings growth accurately. Investors veer 30 20 10 0 -10 -20 -30 -35 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 between over and underestimating future earnings as they attempt to make sense of a never ending barrage of information and opinion. firmly on the side of the bulls, but after 277% In addition, the various market participants do not all have the same objectives. The Reserve Bank is trying to manage inflation and growth. The Finance Minister is trying to encourage economic growth, collect taxes government’s cheque book. and For the last 4 years the market has been weighted balance the growth just how balanced is the equity market? Analysing the strong market growth shows us that although earnings have risen by a robust 113% since 2003, the All Share Index PE ratio has climbed from 9 to 16. Some of the rise in the market multiple can be ascribed to the fall in interest rates from a high of 17% to a low of 10,5% in 2005. Yet interest rates have risen by 250 basis points in The building companies will also have to deal with power ahead. deadlines in order to convert revenues into profits. the last 12 months and equities have continued to From this point there does not appear to be much room for further share market skills and material shortages, as well as tight An gains as a result of improvements in valuation. important factor not to neglect when considering the outlook for equities is the global picture. The global bull market has been fed on a 18.0 18.0 17.0 17.0 16.0 16.0 15.0 15.0 14.0 14.0 13.0 13.0 12.0 12.0 11.0 11.0 10.0 10.0 This behaviour is evident in the gap between US 9.0 9.0 Government 8.5 8.5 8.5 2003 2004 PRIME OVERDRAFT RATE SA (13) 2005 2006 2007 ALL SHARE INDEX [PE] (16.41) high calorie diet of cheap money. Although interest rates have bottomed, the spreads between risky and less risky investments have remained narrow, encouraging risk seeking behaviour. Treasuries and the bonds of emerging markets. Since the crisis of 1998 the additional yield that investors earn by taking the risk of buying emerging market bonds over US The implication must be that South African investors are Treasuries has shrunk from 1000 basis points to growth, especially emerging very confident from construction related companies. about earnings commodity and 165 basis points. Such a narrow spread leaves markets vulnerable to negative developments, which could rapidly affect their bonds and equities. Strong commodity prices have been underpinned by supply shortages and strong demand from Another threat to risk seeking behaviour comes strategy on the continued expansion of a centrally so-called sub-prime sector. Lenders have been exchange rate. We firmly believe that China will be customers on increasingly laid-back criteria. One but income, so called liar loans, with an interest rate China. We are unwilling to pin our investment managed, opaque economy with a managed a major influence on the world for years to come doubt whether their conversion to a prosperous market economy will be achieved without some major hiccups along the way. There from the lower end of the US housing market, the granting mortgages to less credit worthy example would be loans granted without proof of set at a low level for the first two years. is also a massive supply side response underway These mortgages have then been packaged into so shortages in commodities are unlikely to so-called collateralised debt obligations (CDO) persist into the future. South African infrastructure is another strong with differing levels of risk and on-sold to investors. growth story. Government spending on the 2010 As the rates on these low quality loans have reset Gautrain and various private sector initiatives all, growing number of homeowners have defaulted. sector’s revenues. homebuilding industry, taking with it builders, World Cup and other infrastructure projects, provide a significant underpin to the construction growth is already In our opinion much of the reflected in the sector’s on their two year anniversaries, a This has resulted in an implosion in the US mortgage originators and ultimately the CDO’s that are backed by sub-prime mortgages secured valuations. Hermes Asset Management (Pty) Ltd upwards by houses. Page 2 One early casualty has been investment bank Bear Stearns, which had to pay $3bn, or a quarter of its capital to rescue one of its hedge funds that was active in the CDO market. As these mortgage backed instruments are not priced daily in an open exchange, there is still much more pain to come, while another 2 million mortgages will reset to higher rates in coming months, potentially escalating the level of defaults. Estimates of the ultimate losses from sub-prime lending range from $50bn to $250bn. Such huge Best Smaller Group over 1 Year at the S&P Fund Awards for 2007. 1st Floor, ICR House But what does this matter to investors in South Africa? Hermes Management Company was awarded losses on low quality investments will encourage lenders to demand higher returns on risky loans. The recent buy-out of Edgars was affected, when the yield on the debt instruments funding the deal had to be raised to ensure its success. Emerging markets might also Alphen Office Park Constantia Main Rd Constantia 7806 Hermes Asset Management (Pty Ltd) is an Authorised Financial Services Provider. FSP No. 5769. Reg no. 2004/002377/07 find investors less willing to accept a historically narrow premium over developed markets. Hermes Asset Management (Pty) Ltd does not take any responsibility for any portfolio actions that readers may take on In summary, we would caution that the current equity bull market is getting increasingly mature and that investors should be aware that returns in the near future are unlikely to match those of the spectacular last four years Collective Investment Schemes in Securities (unit trusts) are generally medium to long-term investments. The value of participatory interests (units) may go down as well as up and past performance is not necessarily a guide to the future. Unit trusts are traded at ruling prices and can engage in scrip lending Returning to the wildlife analogy, one wants to avoid being an old bull in a field stripped of sheltering vegetation, when the lions are hungry. and borrowing. Different classes of units may apply to these portfolios and are subject to different fees and charges. Unit trust prices are calculated on a net asset value basis, which is the total value of all assets in the portfolio including any income accruals and less Contact any permissible deductions (brokerage, UST, VAT, auditor’s fees, bank charges, trustee and custodian fees, and the annual management fee) from the portfolio, divided by the number of Philip Thompson units in issue. A schedule of fees, charges, and maximum Arthur Karas commissions is available on request. Hermes portfolios are valued Bill McAdam Telephone: Facsimile: daily at 3pm. Instructions must reach Hermes Management Company (Pty) Ltd before 2pm to ensure same-day value. The Hermes Equity Fund Class A has an annualised Total 021 795 6000 Expense Ratio (TER) of 1.24%. For the period from 1 January 021 795 6060 2007 to 30 June 2007 0.62% of the average Net Asset Value of the portfolio were incurred as charges, levies and fees The E-Mail: [email protected] Web: the basis of this document. Hermes Flexible Fund Class A has an annualised Total Expense www.hermes.co.za Ratio (TER) of 1.12%. For the period from 1 January 2007 to 30 June 2007, 0.56% of the average Net Asset Value of the portfolio were incurred as charges, levies and fees. A higher TER ratio does not necessarily imply a poor return, nor does a low TER imply a good return. The current TER can not be regarded as an indication of future TER’s. Hermes Asset Management (Pty) Ltd Page 3