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Friday, 14 December 2012

Basics of Reading the Economy and Shares Lesson 3



Lesson 3- Reading the Economy
Business within context of the economy

When you buy shares, you buy co-ownership of that business. How well that business performs, determines how well your share price will do. How well the business performs, is determined by good general and financial management, and the economic climate in which that management must run the business.

A good economic climate for business would include: Interest rates are relatively low, which means companies can obtain “cheap” loans to fund expansion or invest in machinery or extra stock. Because interest rates are low, consumer spending is high - meaning profits are easy to make. Inflation that is within the central bank’s plans is also good: This means the central bank would not have to curb high inflation by increasing interest rates. By raising interest rates, the average bond-paying consumer effectively has less money to spend. Therefore he is more cautious with how he spends his money. 

Producers and service providers now have to take care not to overprice their products or services so that the consumer goes elsewhere. So they limit price increases – thus curbing inflation. We will explain in this chapter how to understand these factors and what they mean to the share market.

A low oil price usually also has an effect on inflation: Rising oil prices causes high petrol and production prices, in turn causing a rise in products as production and transport costs goes up. The result is a rise in inflation. However, a drop in oil prices should be reason for lower transport costs resulting in getting products to the consumer at a lower cost. This could contribute to lowering inflation rates.
Oil prices are however out of the reserve bank’s control. Interest rates are not. The reserve bank lends money to the other banks, which then correlate their own lending rate with that if the reserve banks. These banks add a margin to make their money. However every reserve bank decision to change their lending rate, reaches the consumer through the other banks.
To be able to read the economy is a key skill for investing. The stock exchange performance is strongly linked to the country's economic climate.
There are several indicators that can help us gauge the economic climate. Lets first list them, then discuss these indicators in more details.
Indicators of economic climate:

1. Gross Domestic Product
2. Gross Domestic Expenditure
3. Balance of Payments
4. The Interest Rate & Inflation
5. Other Economic Indicators
6. Related indicators: Demography


1. Gross Domestic Product (GDP) is the sum total of the price of all services and goods produced within a specific country. It excludes the value of products and services of companies that operate outside of the boundaries of this country. It is measured over a certain period of time – of one year.

GDP is calculated by adding together a lot of numbers: this takes time and GDP figures are often released much later that the year of measurement. Other economic indicators can however be used as indicators of the economy’s health. We will look at these after our discussion about GDP.

The numbers used in calculating GDP are contained in this formula:
GDP = C + I + G + E – I
C = Consumer spending (= the purchase of comsumer goods and services by consumers)
I = Investment (= purchase of production equipment and property necessary to facilitate production)
G = Government purchases (= purchase of goods and services by government)
E = Exports (=Good and services produced locally but sold elsewhere in the world)
I = Imports (= Purchases of goods and services orignating abroad)

Analysis of this formula will show the investor changes in the above categories. These figures are published in publications such as the central- or reserve bank’s quarterly bulletin and summations might be found in financial magazines. By analyzing the line items and comparing with previous years, it’s easy to see the trend of Consumer spend, Investment, or Government spend.
Often GDP is also broken down into a sector-composition: Main sectors are:

Agriculture, Forestry, Fishing

Mining and Quarrying
Manufacturing
Electricity, gas and water
Construction
Retail, wholesale, catering, and accomodation
Transport, storage and communication
Finance, Insurance, Fixed Property and business services
Community, social and personal services
Central Government
Other Producers

Again an analysis of these lines can lead the investor to understand changes in the composition of GDP and which sectors are hinting slowdown or increase of tempo.

How does GDP affect the share market?
An increase in GDP from the previous GDP figure, means that increased economic activity took place. This means more money is going around in the economy, from which a profit can be made.

In case where growth for the economy is forecast, it is likely for the stock market to also grow in value. For example, if the GDP forecast for 2007 is 4% higher than the actual 2006 GDP figures, the economic climate would support growth of the stock market.
However, the stock market is the first to feel an economic slowdown - up to 9 to 12 months ahead of a change in economic cycle. Therefore it’s important to also keep an eye on other economic indicators discussed later on.

2. Gross Domestic Expenditure (GDE)is the sum total of the payments for local products and services within a specific country. Effectively it measures the total amount inhabitants of this country within the country have spent over a year.

How does GDE affect the share market?
What is interesting about Gross Domestic Expenditure, is that it can be divided into sub sections, based on the durability of certain items on which money was spent
For example, you can distinguish between durable goods, such as cars or radio’s, and semi-durable goods. After that non-durable goods are listed, such as food. And after that comes services – that aren’t goods at all.

These can serve as indicators to the economy: The volumes of durable goods bought are likely the first to be reduced when the economy is under pressure. For example: If the economy goes down, car sales (Cars are durable goods) will faster go down than sales of food (Non durable goods). Therefore, if car sales are going down, you should be moving your shares to companies that produce non-durable goods, such as food.

In our example a reduction in car sales can forecast a downturn in the economy. In case of a slowdown, you might want to keep shares in a food producing company. However, if a real economic downturn is about to take place, it might be better to exit the share market and convert your shares to cash in the bank.

3. The Exchange Rate and Balance of Payments
Countries export to each other and import to each other. For example, South Africa might export maize to America, and import coffee from Brazil.
When South Africa exports maize to America, it receives payment in Dollars. In other words, there is an in-flow of money into the country. When South Africa imports coffee, money flows out of the country to America. Since money is also a commodity, the value thereof goes up or down according to supply and demand. In the case where America imports more and more from South Africa, they will want to buy Rands with which to pay for their imports. Therefore the Rand price goes up in Dollar terms, since demand is higher.

The Balance of payments tells us in which directions money flowed mostly. If the balance of payments has a deficit (shortfall), it means that the value of products imported was higher than that which was exported. Therefore more money left the country, which will likely cause a smaller supply, which could make that money more pricey. A prolonged deficit could cause the currency to strenghten: for example:

Assume the exchange rate is R6.00 for $1.00. If you calculate how much dollars must be paid to buy one Rand, you divide the one dollar by the six Rands:
$1.00 divided by R6.00 = $0.16
South African imports more and more from the US, and the balance of payments shows that there is a growing deficit. In other words, every month more and more money leaves the country, and supply gets reduced. The price for buying a Rand becomes $0.20 cents instead of $0.16 cents. Working this back to Rand : Dollar exchange rate, it becomes R5.00 for $1.00.

4. The Interest Rate and inflation
Interest rates are part of government’s monetary policy to manipulate the economy. Within their ability, government aims at achieving economic conditions favorable to the country. If inflation is too high (meaning prices on consumer goods are climbing at a high rate), the central reserve bank can increase interest rates. Banks, who loan their money which they loan out to businesses and individuals, also have to raise their interest rates to pay for the higher interest levied by the reserve bank.

The consumer now pays a higher monthly amount on interest on his house and car, and has less money to spend on consumer goods. So, demand for consumer goods decrease, and the prices come down.

Different theories exist about the relationship between Interest rates and share prices.  Some theorize that as the interest rate goes up, the economy is stifled, so the share market reacts with a slowdown. The opposing theory is that a lower interest rate would cause investors who have invested in interest-bearing securities to rather move their money to the stock exchange, because of higher anticipate rewards. This again would push up share prices.

Understanding the economy. All these economic indicators are explained so that you may understand the economic context within which business takes place. In addition to watching out for these statistics, you can watch out for other economic indicators to identify trends.

5. Other economic indicators
Because GDP data is so comprehensive and takes so long to calculate, other indicators can be used to gauge the economy. These indicators are often listed in financial magazines with the share prices. Some of the most important ones are:
-          Foreign reserves
-          Motor car sales
-          Money Supply
-          Building plans approved for residential homes
-          Inolvencies
-          New companies registered
Although these indicators are by-products of actual economic factors, they do have the ability to signal trends. Changes in these indicators allude to changes in the underlying economic factors.

Let us use the example of car sales. Car sales are just a small section of the expenditure on current durable goods. However, the number of cars sold can be calculated swiftly, and the number of cars sold was also found to correlate to the total expenditure on current durable goods. Therefore it is considered as representative to the bigger durable goods expenditure picture. A slowdown in car sales could therefore signal that consumers are feeling the effects of inflation, interest rates or a combination of these and other economic pressures. 

As an investor, this could stir you to make a decision about staying in shares that are dependant on buoyant consumer spending, or rather move to shares earn you income by exporting to countries where purchases of exported minerals or capital goods are doing well while the Dollar is relatively weak.


Similar to car sales, construction data is an indicator of capacity expansion in the economy: New buildings and homes are adding room (capacity) for more consumers or producers that are important role players in the economy.
House price data alludes to the demand for credit within the economy: Most consumers finance at least a portion of their house cost. Rising prices tell a story of consumers spending more money on houses; this spending is likely funded by credit.

As shown, these indicators are really the symptoms of principle economic factors. But interpreted, they can signal changes in economic climate before the actual economic data gets released to confirm the facts. As an investor be cautious to take cognizance of this data, react where necessary, and when in doubt confirm your suspicion by looking for factually published economic data contained within the framework of the above numbered items.
A last indicator to watch out for is job data. The markets carefully watch such data to draw conclusions from it: Fewer jobs predict a slowdown in economy, and visa versa

6. Related indicators:  Demography
Population forecasts are important to the share market, although few investors take the trouble to take the real long-term view and invest according to data such as demographic data.

For example population forecasts can give you an idea of numbers of people are likely to appear in certain age groups in the not too distant future. Currently 15% of the population might be between 12 and 16 years of age, however improved healthcare to a wider population causes reasonable expectation that this could grow to 25% of the population within 5 years, whereas people within the 16-45 age are likely to have smaller salary growth due to economic slow down and higher interest rates expected within the next two years.

Such statistics, if accurate, would make the clever investor move into stocks that sell popular brand name teenage clothing and sports gear, and out of stocks that produce luxury goods for the middle-income class.



Thursday, 13 December 2012

Basics of Reading the Economy and Shares: Lesson 2


Lesson 2- A first view of Derivative Products
Derivatives are by-products of the actual shares. Let me explain with the example of Pete’s business, using warrants.
Roger notices that Ivan sold is share to Melissa for R2500. He knows that Melissa expects Pete’s business to do more and more international placements, therefore she’s expecting a higher dividend and was willing to pay more for the share that will give her that dividend.
But Roger also expects the job market in South Africa to improve, which might cause a profit reduction for Pete’s business, as more people will find jobs locally and won’t need to go overseas. 

He approaches Melissa with the following proposal:
“Melissa, I will give you the option to buy my share in Pete’s business for a price of R2200 on 1 December 2011. However, to reserve that option, I’m asking you R350 for the option. “
Melissa thinks it through: “This means I have to pay R350 for the option, to buy the share in December 2012. If I buy it then it will be at a price of R2200. That means my total costs for the share will be R2550. Not too bad – I’m sure the dividend will be big enough to cover the costs. The share should probably be worth R2800 by then – Pete is doing good business.”

So Melissa pays Roger the R350, and he gives her a note saying:


“I hereby give the holder of this note, the option to buy my share of Pete’s business, at R2200 on 1 December 2012.”

Roger’s expectation of a better job market failed to impress: Even more people were looking for jobs in the UK by October 2011. Pete’s business is doing better than expected. The dividend expectations are now much higher. People are willing to buy the shares at R3000.

Melissa however needs money for a new car, but does not want to trade her shares to fund the car – she wants the dividends that will be paid soon. She remembers the option she has to buy Roger’s share at a good price. She does some calculations, and approaches Ivy with this offer:

“Ivy, as you know, Pete’s business is doing very well, earnings are up, and dividend expectations are very promising. People are willing to buy the shares for about R3000 now. I have an option to buy shares at R2200.

This means I can get the share cheap compared to the current market value. I will transfer this option to you for a cost of R700. It’s a good deal!”
Ivy does this calculation in her head: “The share is worth R3000. I would be paying Melissa R700 for her option to buy the share at R2200. That means I can get the share at a total price of R2900 which sounds like a bargain!”

Ivy is eager, and buys the option from Melissa.


The option, or warrant, is something they now started to trade. Ivy may sell this option at an even higher price if the share price further increases. If the share price drops too far, she can choose to not exercise the option, thus loosing only the R700 she paid, and not the share itself.

Something important to note, is the increase in share price, compared to increase in the price of the option, or the warrant’s price:

The share price increased by 50% from R2000 to R3000.

The warrant price increased by 100%, from R350 to R700

This means that the warrant price climbed 2 times more than the share price. This principle is called gearing, and sometimes it is referred to as leverage:: For every 1% increase in share price, there’s a 2% increase in warrant price. This would be a 1:2 gearing.

The reverse would also be true: For every 1% drop in share prices, a 2% drop in warrant prices would occur. These ratios differ from warrant to warrant.

For now it’s important to understand the principles of leverage or gearing.
For further explanation of leverage or gearing, a last example of leverage could be a rental property purchase. Assume you find a building for sale for R250000. You have R25000 cash, which is 10% of the total purchase amount. You pay a deposit and the bank finances the remaining R225000. 

The money you contributed is in a 1:9 ratio with what the bank supplied. Your R25000 was geared 1:9 (for everyone one rand, the bank supplied 9).
The power of leverage or gearing can be seen when you sell the property. Assume the tenant paid rent equal to the monthly installments you had to pay to the bank, and also the levies.
After two years the property is worth R390000 and you sell it. You settle your bank load which is on standing on R215000 by that time. The difference is R175000. You will have to pay capital gains tax on this amount.

However, you’ve made R175000, by getting a 25% annual growth on a property that was worth R250000, for which you invested only R25000 from your pocket!
You do not have to be in stock market derivatives to make use of gearing. However, stock market derivatives can offer you the benefits of both gearing, as well as profits using put options when the markets are going down.

A word of advice: Warrants are not as liquid as shares. In other words, you might not always find a buyer for your warrant. Warrants therefore carry a greater risk, partially because they are less liquid, but also because losses will also be amplified because of the gearing effect.

Warrants are more complex than this. However a few things worth noting about warrants are:
  • They are short term trading instruments: They have an expiry date and it is best to trade these instruments only if the expiry date is more than 2 or 3 months in the future. The further that date is, the less risk that you will have to sell at a price
  • Because of the gearing effect of warrants, you can use much smaller amounts to get the same returns as you would have from buying shares valued at a higher level. For example, with R2000 you can make R300 within a few weeks, whereas to make this by owning the share, you would have had to buy R10000 worth of shares.
  • When you buy a warrant you never own the underlying asset (the share of ownership). You only own the option to buy or sell it at a certain price on a certain date in the future.
  • Warrants are highly volatile, their prices could rise or fall 10% in a week easily.
  • Warrants can tempt you to become a gambler. Do not substitute good analysis practices for taking a chance on a warrant with a price that dropped and you assume it will recover well. Do the research first.
  • Warrants are less liquid than shares. In the share market there's almost always a willing buyer to take over your shares. On the warrant market you might have a bit more difficulty selling.
Practical Section

Page through the list of share prices in your business section of the newspaper. Try to highlight the 10 or 20 "biggest" companies. How do I know which are the biggest companies?

Look at the Market Capitalisation column. Market capitalisation is the value of each individual share multiplied by the total number of shares in issue.
These companies are also the likely ones to have warrants issued. These derivative products are not issued by the companies themselves, but by companies such as banks!

Also try to see the trading volumes of these companies, you will notice they are also normally high. This is something to keep in mind: High volumes means the share is "liquid", meaning, it sells easily. If the share is highly liquid, likely so will be the derivative products.

Wednesday, 12 December 2012

Basics of Reading the Economy and Shares: Lesson 1



After reading the examples and lessons below you will understand how shares and derivative products such as warrants work. You will understand how to make money even if the markets are going down. You will understand and be able to "read" the economy. You will be able to do technical analysis and use it to predict in which direction a share price is heading. And much more!
But for now, let's explain what shares are based on a simple example:

Lesson 1 - Business Evolution
PETE'S BUSINESS EVOLVES...
Pete is 18 years old, and has just left school. He still lives with his parents, and has very little expenses of his own. He gets a great idea for a business: Realizing that many of his friends have difficulty in finding jobs, he contacts an overseas employment agency who are advertising stacks of jobs. He becomes their marketing partner in South Africa. He charges R1400 to arrange telephonic interviews, type out a professional CV, follows up on references, and puts people in contact with the overseas employment agency after thorough screening. They benefit from receiving high quality candidates, and he benefits R1400 for each candidate he screens. The candidates benefit from Pete’s reliability, good contacts, and thorough screening as it lands them more jobs more often. By word of mouth about 3 people hear of Pete’s service, and pays him to find them jobs.

However, Pete realizes that operating from his parents’ house, not having a fax machine or computer, and not having money to advertise his business, are all limiting factors to his business. His R4200 per month income is just enough to pay his small car he bought, his new cellphone, and the R500 rent his parents are now charging him.

PETE'S BUSINESS EVOLVES...
Pete needs to make a plan to grow his business. If he had a fax, he could save time traveling to a Post-Net to send faxes. He could use that time to market his services. If he had a computer, he could type the CV’s faster, instead of waiting for his father to stop working on his laptop in the evenings. Pete gets a quote on a computer and a fax for R7000. Since he does not have cash, he cannot afford it. The bank won’t loan him the money, since he’s got enough debt on his car already.

The above example is a simple, typical example of a company that would want to list on the stock exchange. Companies issue shares on the stock exchange to get more money, in order to expand, so as to be more profitable.

Pete does a similar thing than to issue shares on the stock exchange. He draws up a business plan with a market analysis and financial forecasts and a plan on how he will run and operate his business with the fax and computer. He calls a family meeting, and explains his plans. He says to them:

“This is the plan to expand this business: I will offer you the opportunity to get a portion of this business. For that portion of the business, you will have to pay R2000. All you have to do is to buy into the business. You don’t have to do any work. We will use your money to make more money, and reward you on an ongoing basis, for the investment you have made. The portion of the business you will get for R2000 is 9%. In future, you will be entitled to 9% of the dividends we pay out to our investors. If you want to get more exposure to our profit, you can buy 2 shares, at R4000.”
In essence – this is what a listing on the stock exchange is all about... let's continue to go deeper

PETE'S BUSINESS EVOLVES...

4 of Pete’s family members decides to take up the offer, because they believe Pete’s business has a lot of 
potential. Ownership of Pete’s company is now divided as Follows

Shareholder
Percentage of shares
Pete
55%
Icy
9%
Melissa
18%
Roger
9%
Ivan
9%
Melissa decided to buy two of the initial share offerings. After 6 months Pete has used his computer for advertising on the Internet, for creating a template for professional CV’s, launched an Email marketing campaign, and to print invitations to seminars on how to find work in the UK. He used his fax machine to send faxes about his service to 1000 UK employment agencies.

Pete has been able to do 20 placements per month at R1400. The results are that Pete’s income for the 6 months since selling the shares and buying the equipment, has grown from R25200 the 6 months prior, to R168000.

PETE'S BUSINESS EVOLVES...

Pete decides it’s time to reward his investors, and announces that he will pay his investors a dividend of R2000 per share in two months time. The declared dividends looks like this:
Shareholder
Percentage of shares
Divided paid out
Pete
55%
R12222
Ivy
9%
R2000
Melissa
18%
R4000
Roger
9%
R2000
Ivan
9%
R2000

Melissa is very pleased with her dividend. She sees that Pete is running the business well, and she would like to get more exposure to this wealth-generating business. She approaches Ivan, and offers him R2000 for his share. Ivan is happy with the R2000 dividend he is receiving, and does not want to sell. However, Melissa knows that the next dividend is likely to be about R3000. She offers Ivan R2500 for his share. Ivan realizes that this is even more than he paid for the share, and decides that he will gladly take the capital gain of R500. He sells his share to Melissa for R2500.

Note that Pete had nothing to do with this transaction. The only change he will have to make, is the change of banking details for Ivan’s share to Melissa - when the next dividend is paid. The above is what a transaction on the stock exchange is all about
We've looked at how Pete's business evolved from a one-man-show, to a share-issueing entity. Lets place what we've learnt into context of the Stock Exchange. Lets refresh the basics of what we've learnt.
Companies list on the Stock Exchange to be able to issue (sell) shares to the public. The capital raised by the issue and selling of shares is used to expand their business and be more profitable. People trade (do transactions) on the Stock Exchange after such a listing to get exposure to the profit the company is making for them, without them actually working for it.

Before a company can list on the Stock Exchange, it must comply to a set of strict rules, determining how much profit they must make before they can list, what percentages of shares they can retain, etc.
Some important points to remember about companies and their shares are:
- You can hold shares in a company listed on the stock market.
- Companies list to gain more capital for growing their business.
- Each share represent a portion of ownership in the company. The more shares, the larger the portion of the company you own.
- When a company makes a profit, each shareholder has a right to a share of that profit in proportion to the amount of shares they own.
- The slice of profits paid to shareholders, is called a dividend.
 


- The amount of the dividend is not fixed,
 


- The directors of the company decides which part of the earnings are retained for future expansion, and which part can be paid to shareholders
- After the initial issue of shares by a company, the buying and selling of those shares occur in total separation from the operation of the company.


The number of shares can become more in a few instances: The company might create a share split. For example: ABC’s shares were trading in the area of R30 per share during 2005. ABC decided to split each share in ten, therefore multiplying the number of shares in issue by ten as well. The shareholder that had one share worth R30, now had 10, worth R3 each, and still valued at a total of R30. However investors seem more eager to buy shares at R3 each!

Company’s can also increase shares with a “rights-offer”. In essence this gives existing shareholders to obtain more shares, usually at a price lower than the current share price. For example: Company XYZ issued a rights offer giving you the right to obtain 1 share for every 12 you owned. At the time of the offer the XYZ share was trading around R22 to R23, and the rights offer was to get shares at R17. This is one way to increase shareholder value.

Another way to increase shareholder value is to do quite the opposite of issuing more shares: A company can also buy back shares. To explain how this creates value for the shareholder, we will use a simple example again:

Assume the shareholders in Pete’s Business traded around some shares, so that their individual shareholding and value now looks like this:

Shareholder
Percentage of shares
Rand Value
Pete
50%
R5000
Ivy
10%
R1000
Melissa
20%
R2000
Roger
10%
R1000
Ivan
10%
R1000
Total
100%
R10000

Pete’s Business makes good money. Instead of paying dividends, the business – as a legal entity – buys back Roger’s 10% share for R10000. The 10% of shares then gets destroyed. That means that the remaining shares make up 100% of the shareholders’ capital. Therefore the portion of total ownership of the business increases for each shareholder:

Shareholder
Percentage of shares
Rand Value
Pete
55.55%
R5000
Ivy
11.11%
R1000
Melissa
22.22%
R2000
Total
100%
R8000

In essence, the 10% bought back, now gets apportioned to the remaining shareholders, but not in terms of issuing them with shares. The remaining shareholders still hold just as many shares in number, but the decrease in the total number of shares in issue causes them to have a proportionally larger piece of ownership of the business.

Tuesday, 11 December 2012

From Basic to Business


I’ve decided to start communicating some of my thoughts about the shares on the stock exchange to people that expressed interest in the subject. Being a Warren Buffett fan my newsletters will be based on the solid investment guidelines Buffett laid down. The newsletter is for forward-thinking individuals who plan their lives and work towards goals. Most newsletters will start or end with some tasty Buffett quote that should wake your appetite for yet more intelligent investing.

1. Newsletter one – for forward thinking individuals

PE’s and DY’s

Investors are investing for one purpose only: PROFIT.

The basic ideas of investing are to look at stocks as businesses, use the market fluctuations to your advantage, and seek a margin of safety. That’s what Ben Graham taught us and a hundred year from now they will still be the cornerstones of investing.”

- Warren Buffett - 1994

How wise. I believe PE’s and DY’s are neglected in seeking our margins of safety and spotting fluctuations. Here’s the wrap from basics to business:

PE’s and DY’s are so commonly available in papers and magazines that we tend to skip over them without putting some thought into what they ought to be telling us. PE ratios (price:earnings ratios) tell us what we’ll pay for what your business is earning (based on the latest financial results).

Basics (If you know what PE’s and DY’s are skip to the “business” heading below!)
A PE of 10 means your would pay R10 for every R1 the company earns in net profit. Not all of these earnings come your way as dividends. The directors choose to allocate earnings either back to the business or as dividends to you. Take the calculation a bit further: Say you invested R10000 in a company with a PE of 10, then your company made R1000 profits for your shares. If you calculate earnings yield (earnings/investment = R1000/R10000 = 10%) you see that the company used your R10000 to add another 10% (R1000) of profit to it.

To me it makes sense not to pay too much for what your company currently earn and will earn – I try to stick around PE’s of under 12, but will go up to 16 if future earnings potential is great. The problems with anything “future” is that it is unsure. Therefore buying shares with PE’s of 20 or 30 doesn’t make sense to me: It obviously already discounts future earnings, so what will happen if a major disaster causes future earnings to me the same as current earnings? Earthquakes and tsunami’s do happen…

Dividend yield is a return-on-investment calculation that tells us what cash you could expect back from your business. What you get is tax free – the company already paid tax on it (called secondary tax). If you invest R10000 in a company, and the dividend yield is 4%, you should get a dividend of R400. Now getting only 4% back sounds silly if you could get 7.5% in the bank…? What happens to the other 6% of the 10% profit on your investment?

Theory goes that if a company re-invests that 6% into itself, they should have better profits next year (implying your dividend yield might rise to, say 5.25% on the original investment). Assume the company added an additional production plant with the extra earnings and settled some debt.

Business
The company’s assets therefore increased (they have a new plant which is likely to grow in value). If they purchased the property as well, the property value would also increase. Settling debt means that there are less liabilities and less interest to pay. The effect this all has is that you now have ownership in a company that has more property, production capacity. Calculate the net worth of your company now by deducting liabilities from assets, and you have a considerably higher net worth – not just 6% more.

On the income statement the increased capacity delivers better output and hopefully sales. Subtract the company’s expenses (which included the reduced interest on debt) and you have an increase in cash flow – of surely not just 6% - but considerably more. Your reward is increase in asset value as well as an increase in profits. Share-hunters notice your company and price it at fair value, taking into consideration the increase in asset value and profits. And your share price rises with 30%. Well, that’s the theory.

It might sound as if I’m promulgating companies that pay very low dividends to ensure that earnings go towards re-investing and expansion of the business. I’m not. I like dividends and I like cash. For the only reason that if I get a cash dividend of 4%, I know that I have a few rands already in the bank. And there’s very little risk of loosing that 4% that sits safely in the bank earning interest.

Spot a company with low PE value, offering some dividend to keep aside as a margin of safety, and then further looking at GOOD companies trading close to or even less than their net asset value, you might have a real gem in hand. Do your research thoroughly and make sure the market hasn’t priced it cheap for a reason it might know and you are yet to discover.

Happy investing!

2. Newsletter two – Invest in what you understand

To me, investing is… sort of… say “chicken business.” Here’s why.

When I started investing I was tempted to make the quick buck. “Play warrants”, they said, so I opened a warrant trading account. “Buy Sanlam call warrants”, they said, “they annual results are out tomorrow and we think it’s going to be extremely good”.

Well, it was good. But investors already expected it. In fact, they expected better, so the share price fell a few percent, and my warrant’s all lost me quite an amount as stop losses triggered.

I took a conscious decision never again to buy into something I don’t understand, whether it’s a company or the use of an unknown financial instrument. I probably missed a few opportunities, but I sleep sound now, knowing that my finances are dependent on research, not luck.

How does an investor decide on where he puts his money amongst the hundreds of companies on the JSE? What companies are out there, that are easy to understand well in order to gauge their profit potential as an investor?

Warren Buffett “missed out” on the IT boom. He chose not to invest in things he didn’t understand. He might have missed on the miracles such as Google, but he also missed out on the .com bomb. He invests in what he understands, and he is one of the richest people in the world.

I do actually have shares in a chicken business – Astral (ARL). I believe trends are converging on chicken as primary source of protein: Rich people are eating more and more of it because it’s healthy. Poor people sharing in economic upliftment can now afford something better than just maize. Risks are things like Avian influenze, nbut they have strong control measures in place. And besides all that, I like a juicy chicken just as much as “braaivleis”.

Personally, I own only 5 shares at this moment. I understand all 5. I spent at least 8 hours of research on each of them before I actually invested in any one of them. I understand what the main drivers are for future demand of their products or services. I know how economic changes impact on them. Perhaps I share Buffett’s view he expressed when he said:

“All we want is to be in business that we understand, run by people whom we like, and priced attractively relative to their future prospects” (Buffett 1994)

I noticed today that Buffett is looking for an investment in South Africa. He makes specific mention that they’ll apply the same criteria here as anywhere else. Business is business, and South Africans have ample opportunities – even Buffett thinks so.

Happy investing!

3. Newsletter three – Go small or go home.

One of the first things academic investment managers would tell you is to diversify. Spread the risk. Diversify across sectors or companies within one sector.

Well well... How should I, having a rather full time job as well, do my homework well and keep up to date on latest news and developments in my portfolio of 50 companies? The fund manager that has nothing else to do might find time to do this. And he wants money for it.

If you want to diversify, give your cash to a fund manager who gets paid to do that for you. Or invest in Satrix 40 shares (which are a basket of underlying shares of the JSE top 40 shares). By owning Satrix shares you are in fact diversifying over all the top 40 shares.

And that, in itself, is not a bad thing to do if you are a beginner and want to learn how to trade. But, for the more advanced investor, let’s go back to our Buffett-roots. Let’s think about this - critically.

Firstly, as I mentioned, time constraints does not allow us modern working individuals to really spend days on analyzing shares. We have a Saturday or Sunday maybe. It takes me at least one full day to do initial research into a company. Information abounds, and working through everything on the internet that was recently published, takes a lot of time. If I had to analyse 400 businesses on the JSE I’d either spend 10 minutes on each, or spend a lifetime doing all of them.

But the second facet is more important – and that is the quality of your understanding of what the research tells you. I’d like to quote something here: It’s from the book “The Warren Buffett Way” by Robert G. Hagstrom. He explains Buffett’s peers and educators and makes the following mention about investor Philip Fisher:

“Fisher found a simple way to reduce his workload – he reduced the number of companies he owned. He always said he would rather own a few outstanding ones than a large number of average ones. Generally, his portfolios included fewer than ten companies, and often three to four companies represented 75% of his entire equity portfolio.”

When I came across this section in the book I felt relieved. The insurmountable amount of shares I planned to keep an eye on was suddenly reduced to a select few.

Two last comments on NOT diversifying: The more you diversify, the more you average out. Yes, you average out risk, but you also average out performance and time for quality research. If you want to out-perform the market (and you can) you have to be intelligent about it and find companies that would outperform the average. You also need more than average time to do your homework.

Secondly, if someone tells me there is less risk in a diversified portfolio than my own little portfolio of 4 to 7 shares, I’ll laugh out loud (Not really, I’ll be polite & courteously tell him or her I disagree).

I sleep more soundly with my few shares, chosen because I know them so well that I understand the risks and I can therefore manage them. I expect extraordinary performance from them over years to come. I am pretty sure that my few shares are more resistant to interest rate hikes than a group of shares. I know how they react to exchange rate changes, oil price hikes, demographic changes, etc. And with this I can deal decisively.

One comment on why I believe ownership in equities via managed funds is more dangerous than directly managing your own portfolio. Suppose the oil price suddenly drops because someone finds an alternate source of energy and is able to supply in quantities that reduce the demand for oil. Fund managers all over the world notice the trend and start selling out of companies like Sasol. Suppose you also own 200 Sasol shares, and your stop losses and alerts tell you to sell out.

Here’s my question: How quickly can you get rid of your shares in a market melt down? I’d say on a liquid share like Sasol you might be able to sell to bargain hunters within an hour or two. But the fund manager that sits with millions of shares just isn’t that lucky. He’d probably be selling the whole day long as prices slide. If there are no more buyers at the price you sold at, he has to reduce his price to attract more bargain hunters. And the next day, and the next he’ll be selling at even more reduced prices. In a downward market there just are more sellers than buyers. He’ll eventually get rid of all the shares he wanted to, but at a price far below the price you were still able to sell at.

I hope this helps you a little in forming a strategy around the number of shares you try to manage. Remember, this is for the advanced investor able to manage his risks with his understanding of all the potential impacts of economic and political change or disaster.

Happy investing!

4. Newsletter Four – Buffett’s “durably competitive advantage” revisited.

I can strongly suggest a book that’s been around now for a couple of years, and which probably meant most to me in my early days of investment. It’s called “The New Buffettology” – by Mary Buffett and David Clark.  (I can strongly advise you to try to get hold of this book.)

The cover quotes Business Week’s opinion of the book: “A probe inside the head of a financial genius.” The book explains how Buffett chose companies that had a durably competitive advantage. The advantage needs to be sustainable ensuring long term growth. And having the competitive advantage means having something competitors can’t copy.

The result of this is that these companies are able to grow profits and increase prices faster and more than competitor companies. Stay away from price-competitive companies, such as airlines: They battle each other with their own profits. Find a company that has no one to battle with except the challenges to expand their markets.

Let’s try to relate this back to our own stock exchange: What companies on the JSE has this durably competitive advantage? I’d like to name a few I think are worth a look at, and why.

Firstly, Telkom. Coming from an IT manager background, they’re my least favourite people. I can’t tell you how we battled for service. Yet I had to stay with them purely because there was no one else. They had the monopoly. And a monopoly is nothing else than a durably competitive advantage. They are operating in a licensed environment which only recently opened doors to a second network operator. In a big way Telkom still has a monopoly in various telecoms applications.

How about Sasol – a huge blue chip with the rare ability to produce liquid fuel from gas. They’re and absolute leader down the path of Gas-to-Liquid (GTL) technology and has a competitive edge over other oil & energy producing companies in this regard. Consider that oil is a limited resource and demand just keeps growing. I’ve heard stories of earth having only 40 years of oil supply left. Low supply, high demand = high prices.

I previously mentioned Astral Foods – the “chicken business” in my portfolio. If I understand the company correctly they own part of their supply chain (Food nutrition) and can therefore likely cut costs lower with inter-group discounts that competitor Rainbow chickens can?

I sometimes think a having a certain person on board can give companies a competitive edge. People like Jannie Mouton. Read up on the man. His history of unlocking value is impressive and frankly I am in PSG just because Jannie Mouton is there. The company is however well diversified and I have trust that when he leaves someday the share price won’t just tumble down.

Having a license to produce or provide something can tender company’s the competitive advantage. Kagiso media owns licenses to operate Jacaranda 94.7, OFM, Kaya FM, Heart 104.9, and iGagasi 99.5 amongst others. Primedia owns 94.7 Highveld Stereo, KFM and various other brands.

Most of these companies totally outperformed the JSE average over the last 5 years, and I believe they’ll continue to do so. Do your homework and look for other companies that have a durably competitive advantage, then wait for the right moment to get in. From the companies above, Sasol is the only company that underperformed the JSE all share average over the last 5 years. Perhaps it’s a good long term company to get into now?

Warren Buffett Quotes

Leadership Quote of the Day