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Posted: 27 July 2011 - 0 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]

 

We are spoilt for choice on the JSE, with toward 6 trillion rands worth of shares to choose from. That represents an asset class with a multi-decade past track record of compound growth of 12% per annum, with an annual dividend on top of that of around 2.5%.
 
This table sets out the make up of the larger companies on the JSE, and shows one way to group them, by considering what broad area of activity drives their fundamentals.
 
alt
 
 
And lets understand something, there are over 400 listed companies, and a greater number than that of unit trusts, not to mention CFDs SSFs and all the other “enhanced ” ways of getting exposure to the equity assets through investment products. Clearly, some of the shares do really really well at times (don’t you wish you had put 100% of your portfolio into Capitec?), as do some of the red hot investment products.
 
But does all this choice help us, or is it making our life as direct investors just too complicated.
 
So how can a small direct investor get started?
 
1.       For small amounts, the best place to start is to get onto the overall market index. It means you step onto that uneven 12% escalator to wealth, and you needn’t worry about a single share you choose going belly up. All JSE share investors, professionals and amateurs, have a 50% probability of beating the index. Half of the money beats the index, and the other half gets beaten by the index, every day, every month, and every year. And That Is Before Costs! So what is the best way for you to get onto the index? Probably an index product, even if it offers tracking of just the Top 40 companies, which add up to around 90% of the whole JSE. So think about your amount to invest, your time frame, whether you can add monthly or at other intervals to your investment, what you will do with dividends (cash out or re-invest), and then choose based on what the cost structure will be over time.
2.       Once this is in hand, grow your pot diligently until you can consider changing to a cheaper platform. You will have more buying power and better understanding of the sometimes subtle costs, and can shop around.
3.       Also feel free to look at thoughtful ways to try and get a “top half” result – you may like to try a dividend-yield-based or a fundamentals-based product. But be careful of choosing an index product that is not all-share exposed – for example the gold index is also an index, but it takes a strong view to put all your cash on an index product which follows that sector!
4.       If you reach a point where you can confidently try to beat the index by picking individual shares, you will find that you probably need about a R¼million rand to get a cost effective portfolio – with an acceptable risk spread. A smart way to start is to leave 90% of your cash in the index product you have identified, and to take the other 10% and select a share. You must have a rational argument that your choice will beat the index over say a 12 month period, and you must know why it will. If it does, and you are sure it was because of your skill and not mere luck, take another 10% across, and run two shares in your second year. Ideally the first one you will keep, since you chose so well and so you can avoid trading costs and taxes! And then repeat a few times – if after five years, your share selections have beaten your index holding five times, then you will be well placed to do your own portfolio!
5.    And when you want to design a portfolio, start off by allocating percentages to the broad sectors in the table above, and seeing what rand amount you can therefore put into each area. You will quickly see two things - one is the folly of trying to spread say R20,000 or even R100,000 across every sector - it cannot be done economically; and the other is that by being clear on which sectors you back, you can get a sharply different exposure to, and thus performance from, the overall market.
6.    So - how to start? For small amounts - buy the index in the most cost effective way for your circumstances. For larger amunts, either do the same, or when you feel you want to back yourself, start by allocating your sector amounts - and only then start to pick the shares you can buy to meet the sector weights that you want.

 

I take this approach further in the Model Portfolio Group - see  http://www.tickertalk.co.za/blog.php?user=stuart&blogentry_id=2662

 

Cheers

Stuart


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Posted: 1 July 2011 - 0 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]

 

Just an update on the TTK1 Model portfolio  Link here for more on this portfolio :-
 
See chart attached – dimensioned in rand thousands (left axis) and % (right axis).
 
The TTK1 Model Portfolio (blue line) is still well ahead of its benchmark the All share index (red line) despite the slippage in this year so far.
 
Cheers
Stuart
 
 

alt


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Posted: 5 July 2011 - 0 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Research

We are not in a boom.

 

Its the opposite - and our politicians are not helping. The pervading sense of doubt, of "price-adjusted risk" is still awkwardly high for some people who might invest here.

 

And yet there is some new inward investment - think Didata, Standard Bank, Massmart; and there is still a robust savings industry here. But what will galvanise our JSE and drive share prices - or at least the results of companies even if the prices don't move? Being a primary resource country, we need large rich customer countries to get on the front foot and drive demand for our raw minerals and also for the beneficiated versions thereof.

 

A big dampener has been the US economy - however one measures, it is still the largest on the planet - and it has been badly on the back foot.

 

This chart shows just how bad it has been in the USA:-

 

alt

 

Assuming the worst is over, and looking solely at job losses, note that :-

- it took 25 months to reach its worst level

- it is ~3X as severe (in terms of [job losses X duration] ) as any other post WW2 recession data set

- charts for all the other periods are relatively symmetrical - this one came down steeply but is recovering slowly so far

- we are now into month 41 - and at the current climb rate (say 15 months per %) it will only recover in Sept 2017! 

 

All told - not a pretty sight.

 

But before you slit those pretty wrists of yours, look also at this one, for US retail sales:-

 

alt

 

So depite the joblessness, there is some jangling of the tills again - and the US retail recovery was sharper than the employment data would suggest.

 

Which paints a better picture for our medium term prospects.

 

Cheers

Stuart

 

 

 

 

 

 


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Posted: 6 July 2011 - 0 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Research

OK - so Metorex has attracted a bid of 7.35 per share from mining giant Vale. Vale (once known as Rio Doce or Sweet River) is huge, with 112000 workers around the world, operating cash flows (2010) of $19.7bn and operations close to those of Metorex - implying the prospect of synergies, which they refer to in their narrative on their bid.

 

Metorex' current board seem to like this bid - they have recommended it, have promised Vale R75m in a break fee, and have procured a "fair and reasonable" valuation opinion from KPMG - this should help little shareholders decide what to do. The KPMG opinion is several pages long, and may be summarised as follows:-

 

"Key value drivers to the valuation included the discount rate, commodity prices, operating margins and capital expenditure. Prevailing market and industry conditions were also considered in assessing the risk profile of Metorex.

 
In undertaking the valuation exercise above, we determined a valuation range of Metorex’s shares of R6.94 to R8.27 per ordinary share with a most likely value of R7.57 per ordinary share.

 

No indication is given of the assumptions they plugged in to their models, nor of the sensitivity of the various assumptions. I wonder what they charged, and who paid them?

 

BUT NOW - enter the dragon - some new miners from China have also bid - at R8.90. Not big gorilla miners like Vale, Jinchuan is smaller - see 2010 annual report at:-

http://www.jinchuan-intl.com/pdf/Release/e2362_20110228_ar.pdf


Seems it is a soon a soon-to-be-ex cosmetics house, with a new board (mainly since Nov 2010) with HK$613m in net cash and clear ambition to get into mining & expl. Kind of reverse listing. Audited by Ernst & Young who also do Vale's audit, (but as so often the case historic numbers and a change of focus mean the future can in no way be gleaned from the published audited financials).

From directors bios:-

Chaiman and CEO Yang Zhiqiang, Engineering PhD with 28 yrs experience in resource development, mine construction, metal selection (is that refining?)
 

Non exec Quiao Fuqui ,MEng, was a GM of Gansi Jin Ao a BHP Billiton JV and a director of GobiMin (TSX listed copper & nickel co)
 

Indep Non Exec Gao Dezhu is a metals heavy - State NonFerrous, China NonFerrous, BGRIMM Magnetic Materials, Western Mining, Anhui Tongdu Copper, Ningxia Orient Tantalum, China Molybdenum, Jiangxi Copper etc etc.

So it seems some tough guys from North Western China who may be a little less afraid of congo operations than some of the Metorex chaps have been. But certainly small (543 employees) and less mining cred than the 112000 employee Vale with its $19.7bn of cashflow in 2010, and Vale also has synergy potential "the majority of Metorex assets are located near two of our Central African copper projects - Konkola North under development in Zambia and Kalumines under feasibility study in the DRC - which will enable Vale to exploit synergies." So clearly Vale can pay more if they choose to.

So, to whom should one sell, and at what price?

 

I have made a stab at a DCF for Metorex, and got R12.10 - here it is:-

 

alt

 

Yes - Metorex has had a rocky ride - see the RONA performance chart in the DCF- which has no doubt rattled KPMG and the board. But what is the right figure?

 

In terms of margin, Metorex reports a 38% mining margin for 2010, after 12% in the disastrous 2009 and 25%, 35% and 50% for the preceding 2006 7 and 8. Interesting that if 2008 and 9 are averaged one still gets over 30% - I have used a more modest 18%. And what does Vale get on its Copper operations - well it seems 21.8% for 2010 after 19.5% for 2009. So my stab doesn't seem too wild. And growth - well copper demand has been crazy - and the price reflects this - see this chart...

 

alt 

 

So, can any independent shareholder be expected to swoon based on either bid? Or on the "tell from a dark room" fair and reasonable opinion?

 

Lets see what happens next

 

Cheers

Stuart


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Posted: 7 July 2011 - 0 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Market news

Is there anything new in Quantitative Easing?

 

"ECCLES: We created it.
PATMAN: Out of what?
ECCLES: Out of the right to issue credit money.
PATMAN: And there is nothing behind it, is there, except our government's credit?
ECCLES: That is what our money system is."
-- Federal Reserve Board Governor Marriner Eccles in testimony before the House Committee on Banking and Currency in 1941, during questioning by Congressman Wright Patman about how the Fed got the money to purchase two billion dollars worth of government bonds in 1933.

 

Cheers

Stuart

 


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Posted: 11 July 2011 - 6 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Research

 

There is much attention being paid to inflation at present - with some strikes seeking pay rises far ahead of "government-issue" CPI inflation of ~4.2%, and reports suggesting that top company bosses may or may not come out on a mere 23% annual increase on their little salaries.
 
Has anyone you know ever found the state's CPI figures a plausible guide to their creep in actual annual spend?
 
Of course there is always bickering about what belongs in the CPI basket. And there are some who use the wonderful concept known as hedonics to say that "well, last year a cellphone cost R400, and this year it cost R500, so that would mean 25% BUT given the 28% increased functionality in this year's models it actually means deflation of 2.3%." 
 
So, what is annual inflation in South Africa actually? What about a clearer approach - let's look at the rate at which actual cash tax collected has crept up? After all - our trusty government runs the same country each year, and so it should allow for all the local highs and lows. And if we strip out odd high and low rise years, we should be able to find a geometric mean figure - one which can be a valid guide for labourers and MDs to debate equitable adjustment. 
 
Here is a link to six years' data from  the SA Revenue Service  , with a table therefrom clipped below for your convenience, which can be used to show the growth in what our rulers have felt is necessary to collect from us. (And they haven't built up a surplus with these rises - the opposite!). According to their own work, the figure has escalated by 68.7% in five years - meaning inflation has had a geometric mean rate of of 11.02% per annum. So the debate about what the inflation rate is can end now!
 
 
 alt
 
 
 
 
 Cheers
 
Stuart
 

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Posted: 12 July 2011 - 0 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Market news

If the NewsCorp bid for BSkyB fails, NewsCorp will have to pay a GBP38.5m (around a half percent) break fee to BSkyB.

 

Press article from Independent UK

 

Quote "The fee was part of the terms agreed when Mr Murdoch, who is also chairman of BSkyB, launched its controversial 700p-a- share bid last year for the shares it doesn't already own. The fee, equivalent to 0.5 per cent of the then value of the bid, covers regulatory and other costs."

 

Yes, the bidder will have to pay the break fee to the target if the bid falls through.

 

If the Vale bid for Metorex falls through (which it now has thanks to the higher offer from Jinchuan) Metorex has to pay a break fee of R75m to Vale, around a percent.

 

Yes, the bidder will receive the break fee from the target.

 

Curious?


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Posted: 13 July 2011 - 4 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Market news

... from Singapore:-

 

"Despite the best advice of his attorneys , a person decided to throw some cash into a forex account.   He’s a very successful equities trader and hopefully he will be able to translate that into the currency racket.  His broker recently emailed him the attached document as is now required by new CFTC rules on US based spot Forex brokers.  The numbers are against him — see below.

alt

 

Clearly I’m not the only one wary of the unregulated world of Forex. I’m actually a little suprised that the number of profitable traders are as high as they are.  I would have thought less than 10% would be profitable in the bucket-shop game."

 


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Posted: 18 July 2011 - 0 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Market news

We may or may not be entering a "SocNet Bubble" as people try to wrestle with the possible valuations for the likes of Facebook, twitter, etc etc.

 

And the debate has appeared here a bit, look at

Bubble or Squeak or/and

Tencent DCF Valuation

 

Now, it does seem fair to say that any "SocNet Bubble" will be far less severe that the tech bubble of late last century, and that is largely due to the smaller size of this event. But maybe sharp practice in the drawing up of accounts for some of these entities means this "bubble" is not as small as it ought to be!

 

NYU Professor of Finance, Aswath Damodaran, probes this matter in his June blog, where he drills hardest into Groupon's deciding to exclude "customer acquisition costs" from its expenses. Bingo, strip that out and you leap to profit much higher and much quicker!

 

Aswath homes in on accounting first principles (which are often ignored by accounting rule writers, but that is a different story), and emphasizes: Recognize that all of this reclassifying of expenses does not change your cash flow status.

 

It seems he understands the centrality of cashflow, and may not need to do the Justonelap thing or the  Financial Statements Course course. Maybe he even helped draw up the How they link animation in powerpoint which simplifies corporate accounts in a trice.

 

Cheers

Stuart

 

 Here is his blog in full:-
A few days ago, Groupon filed an S-1 statement with the Securities Exchange Commission, officially signaling its intent to do an initial public offering.
http://blogs.wsj.com/deals/2011/06/02/groupon-ipo-its-here/
I do know that there are valuation questions that will come up with the IPO but talking about them will lead me to repeat earlier points that I made about the Linkedin and Skype valuations: the value will depend upon revenue growth and potential operating margins. Instead, I want to focus on a claim that Groupon has made, that has opened up the company for some ridicule in the financial press. In 2010, Groupon generated revenues of $713 million and reported an operating loss of $420 million (see the S-1 filing link below):
http://www.sec.gov/Archives/edgar/data/1490281/000104746911005613/a2203913zs-1.htm
Pretty bad, right? But here's where it gets interesting. In the same S-1, Groupon claims that it will make money in 2011 using a different measure of operating income (which is calls Adjusted CSOI: Consolidated Segment Operating Income). I am already suspicious, because the term carries two pieces that make me nervous - the word "adjusted" and a new acronym for earning. But what is Adjusted CSOI? According to Groupon, it is the income before expensing to acquire new subscribers is taken into account and since this expense amounted to about a third of overall operating expenses in 2010, removing it does wonders to profitability. It is this claim that has raised the ire of financial journalists and of some investors and their argument is encapsulated well in this blog post on Forbes:
http://blogs.forbes.com/ericsavitz/2011/06/02/deja-vu-groupons-bubble-1-0-approach-to-accounting
Is Groupon breaking new ground in measuring profitability or is this playing with the accounting rules?

To answer this question, we need to go back to accounting first principles (which are often ignored by accounting rule writers, but that is a different story). In an ideal accounting world, the expenses incurred by a firm would be broken down into three groups:
a. Operating expenses: These are expenses incurred to generate revenues only in the current period; there are no spillover benefits into future periods. Thus, the cost of labor and material incurred in making a widget will be part of operating expenses.
b. Financial expenses: These are expenses associated with the use of borrowed money in the business. Thus, interest expenses on bank loans would be included here as should lease expenses.
c. Capital expenses: These are expenses that generate benefits over multiple years. Classic examples would be the cost of building a factory or buying long-lived equipment.
Assuming that you can classify expenses cleanly into these groups, here is how they play out in the financial statements. Operating expenses get netted out of revenues to get to operating income, financial expenses get netted out of operating income to get to taxable income and taxes get netted out of taxable income to get to net income. Capital expenses do not affect income in the year in which they are made but have two effects: the first is that they show up as assets on the balance sheet at the end of the year that they are incurred and then get amortized or depreciated over their useful life. The amortization or depreciation is also shown as an expense to get to operating income:
Revenues
- Operating Expenses
- Depreciation/Amortization of Capital Expenses
= Operating Income
- Financial (interest) expenses
= Taxable Income
- Taxes
= Net Income

So, here is the best possible spin on what Groupon is doing. The cost of acquiring new customers presumably creates benefits over many years, since once a customer is acquired, he or she continues to use Groupon for years (I told you that I was taking the best possible spin here). Using this rationale, you could conceivably argue that acquisition costs are capital expenses and should not be netted out to get to the operating income. However, here is why I am skeptical about whether this is being done to get a better measure of income (which would be noble) or for window dressing (which is not):
a. Back up the claim that customers, once acquired, stay on for a while: If you are going to capitalize acquisition costs, the onus is on you to show proof that acquired customers stay as customers (and actually buy products for many years). With strong competition from other online coupon based companies (like LivingSocial), it is entirely possible that customers once acquired, are fickle and move on... If that is the case, the acquisition cost has a very short amortizable life and begins to look more like an operating expense.
b. If you are capitalizing acquisition costs, carry it through to its logical limit: This would require amortizing previous year's acquisition costs (which would in turn require an answer to (a), since the amortization will be over the customer life with the company). In other words, you cannot just remove acquisition costs (as Groupon has done) from your income statement, but you would have to replace that cost with an amortization cost.
c. Recognize that all of this reclassifying of expenses does not change your cash flow status: The bottom line is that Groupon has negative cash flows and those negative cash flows will get more negative over time, since the company will have to keep spending the money to acquire customers (to get the growth rate it would need to justify a $20 billion value...).

Note that none of this is breaking ground. I have been making this point about R&D expenses at technology firms and advertising expenses at brand name companies for years. In fact, I have a paper on how we need to take a fresh look at companies with intangible assets:
http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/intangibles.pdf
This is also a chapter in my book,
The Dark Side of Valuation (2nd edition, Wiley)
If you want to try your hand out at capitalizing acquisition (or brand name advertising or R&D) costs, try
this spreadsheet
.

The bottom line, though, is that from a valuation perspective, reclassifying acquisition costs is a mixed blessing. For growing companies like Groupon, it can make the earnings look more positive, but it will also increase the capital invested at these companies (because the acquisition costs will be capitalized). It can alter perspectives on whether the company is actually profitable and creating value: the key profitability number in the long term is not the operating margin but the return on invested capital and Groupon has just admitted that it invests a lot more capital than people realize in what it spends to acquire customers.

The other adjustments that Groupon makes to operating income that are more dubious. It is absurd to add back stock-based compensation (it is an operating expense...)  and we are taking the company at its word, when it breaks its marketing costs down into acquisition costs and regular marketing costs. What Groupon is doing is also part of a trend that I find disturbing, where analysts adopt half-baked approaches to dealing with costs like R&D and marketing by adding them back to EBITDA, leading to a proliferation of measures like EBITDAR (Earnings before interest, taxes, depreciation and R&D) and EBITDAM (Earnings before interest, taxes, depreciation and marketing). While this approach deals with a serious accounting problem (where capital expenses are being treated as operating expenses in some companies and thus skewing not just earnings but book values), it does so at a surface level. After all, if we are going to treat R&D and customer acquisition costs as capital expenditures, we should follow up by asking the key questions: How effective are they? Are they creating or destroying value?

Postscript: I forgot to mention that I hope that the tax authorities don't buy into Groupon's argument. If they did, acquisition costs would no longer be tax deductible; only the amortization would. As is often said, be careful what you wish for. You may get it.

 

 


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Posted: 19 July 2011 - 0 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Market news

There are many ways of measuring the economy - and they all matter. The most important measure is obviously the one you use to make your investment decisions...

 

Here is an update on SA VAT collections - it ignores any posturing, it just asks how many rands did the VAT system gather in, month by month by month.

 

And its hugely important - VAT and the fuel levy act as cruelly broad vacuum cleaners, and collect cash from everyone who moves in this country even if they duck and dive to avoid tax-return type tax. You may or may not know that after the 34% (and largest) contribution to national revenue from personal taxpayers, VAT at 25% is second and contributes more than corporate tax at 22.5%! (see  Inflation post   for more on the breakdown by source)

 

Anyway - this graph shows monthly VAT receipts, and the thicker line shows the moving average. For more from this slide pack, see Model portfolio group description

 

alt


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Posted: 20 July 2011 - 0 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Market news

Gold price rise = rational fear, or irrational panic, or no other investable options.

 

And boy is the gold price running! Just to toss a stone into the bushes on this one, finance professor Aswath Damadoran from New York University ( see lots at Damadoran Online ) has some concerns about what value actually is...here are his recent notes on the topic...

 

 

"Thoughts on intrinsic value
 
I know this post will strike some of you as splitting hairs and an abstraction but it is a topic that fascinates me. A few weeks ago, I got an email asking a very simple question: How do you estimate the "intrinsic" value of gold? This, of course, raised two key questions:
 
a. What is intrinsic value?
b. Does every asset have an intrinsic value?
 
On the first question, here is my definition of intrinsic value. It is the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth and risk. The essence of intrinsic value is that you can estimate it in a vacuum for a specific asset, without any information on how the market is pricing other assets (though it does certainly help to have that information). At its core, if you stay true to principles, a discounted cash flow model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk. Even a book value approach is an intrinsic valuation approach, where you are assuming that the accountant's estimate of what fixed and current assets are worth is the true value of a business.
 
This definition then answers the second question. Only assets that are expected to generate cash flows can have intrinsic values. Thus, a bond (coupons), a stock (dividends), a business (operating cash flows) or commercial real estate (net rental income) all have intrinsic values, though computing those values can be easier for some assets than others. At the other extreme, fine art and baseball cards do not have intrinsic value, since they generate no cash flows (though they may generate a more amorphous utility for their owners) and value, in a sense, is in entirely in the eye of the beholder. Residential real estate is closer to the latter than the former and estimating the intrinsic value of your house is an exercise in futility.
 
So, how do people value assets where intrinsic value cannot be estimated? They look at what other people are paying for similar or comparable assets: i.e., they use relative valuation. Thus, an auction house sets a value for your Picasso, based on what other Picassos have sold for in the recent past, adjusted for differences (which is where the experts come in). The realtor sets the price for residential real estate, based on what other residences in the neighborhood have sold for, adjusted for differences again. In fact, let's face it: this is the way even assets that have intrinsic value are evaluated for the most part. Thus, the investment banker who takes Groupon public may go through the process of providing a discounted cash flow model to back up the valuation, but the pricing of the IPO will be determined largely by the euphoric reception that Linkedin got a few weeks ago.
 
I don't intend this to come across as snobbish, but I think we need to clarify terms. Most people who claim to be valuation specialists, experts or appraisers are really pricing specialists, experts and appraisers. In other words, what separates them in terms of skills is in how good they are in finding comparable assets and adjusting for differences across assets. In fact, I have a counter question, when I am asked the question of what the value of a business or stock is: Do you want a value for your business or a price for your business? The answers can be very different.
 
In closing, though, let me try to answer the question that triggered this post: what is the "intrinsic value" of gold? In my view, gold does not have an intrinsic value but it does have a relative value. For centuries, gold (because of its durability and relative scarcity) has been an alternative to financial assets (that are tied to paper currency). Unlike the gold standard days, where the linkage between paper currency and gold was explicit, the value of paper currency rests entirely on trust in central banks and governments. As a consequence, the price of gold has varied inversely with the degree of trust that we have in these authorities. Though not a perfect indicator, gold prices have surged when a subset of investors have lost that faith, i.e., they fear that the currency is being debased (inflation) or systematic government failures. What makes this monent in economic history disquieting is that we are getting discordant signals from the market: the low interest rates on treasuries (US, German and Japanese) suggests that investors think expected inflation will be low in the future whereas higher prices for precious metals (gold, silver) give support to the argument that investors (or at least a subset of them) believe the opposite. One of these two groups will be wrong and I would not want to be in that group, when there is a final reckoning."

 

See also his price vs. value essay at http://www.tickertalk.co.za/blog.php?user=stuart&blogentry_id=2886

 

Cheers

Stuart 


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Posted: 22 July 2011 - 5 comment(s) [ Comment ] - 0 trackback(s) [ Trackback ]
Category: Research

Don't just take buybacks at face value... they may be costing you a fortune!

 

A main role of a listed company Board is capital deployment and allocation:-
 
It must tackle operating performance, it must fund organic growth/working capital/capex, and must also take investment decisions, on acquisitions & disposals.
 
And if it succeeds and matures, then the company's financing decisions move to distributions to shareholders via:-
–Ordinary dividends
–Special dividends
–Share repurchases/buybacks
 
Generally, buybacks seem popular among commentators, as shown  
 
“buybacks make a lot of sense financially. Whittling down a company's equity base automatically increases earnings per share. “
Financial Times 17 Feb 2011
 
“Share buyback a welcome surprise”   ...  “the main highlight was the announcement of a £150m share buyback programme. At c6% of market cap, this should be 3 –5% earnings accretive.” US Broker’s research commentary on a listed company announcement
 
The trend of late has certainly been for buybacks to exceed dividends as a mechanism for capital returns (with a small hiccup in the wake of the global financial crisis):-
alt
 
The reasons buybacks are almost invariably viewed as good include
 
– the EPS boost  (A dividend reduces eps (since the money which would otherwise earn a return on capital leaves the balance sheet, and the eps divisor stays constant, whereas a buyback increases the eps (by dropping the divisor)).
 
–it provides a "floor" under the share price which "must benefit shareholders"
 
– it is a sign of management confidence
 
 
But there is scarce a  mention of price or returns
 
It certainly looks plausible – if a company in SA can borrow at 9% (taxed cost of 6.3%), it means it is “right” to do a buyback if the earnings yield exceeds 6.3% (ie PE ratio is below 15.9X). But it can in fact harm shareholders’ returns!
 
As an example Pepsico bought back shares in 2008, and reported a higher ROE of 34.83% up from the 2007 figure of 34.53%. So shareholders should have been happy, right? But a more conservative interpretation I suggest here would have the company rather keeping the bought back shares in its calculations:-
 
$m
2008                                                                       as Published       Suggested
Shareholder‘s equity                                      12,203                   12,203
Add back repurchased shares                                                       4,720
New 2008 shareholders equity                 12,203                   16,923
2007 shareholders equity                             17,325                   17,325
Average equity                                                 14,764                   17,124
Profit                                                                      5,658                     5,142
Plus: profit attributable to shares repurchased                        220
New profit figure                                                                               5,362
ROE                                                                        34.83%                 31.31%
Share count                                                        1602m                   1670m
EPS                                                                         $3.21                     $3.21
 
So as you can see the EPS result is the same, but the decline in ROE is masked by the buyback as reported! 
 
So the widely stated view that “the way in which cash is returned to the shareholders is irrelevant” (FT Lex column 8 Jan 2010) is wrong –Buying back shares when they are not cheap destroys value for remaining shareholders
 
Why then has it become so popular? Look at this table showing a static company which makes a billion rand each year, and which over a decade elects to buy back 10% of its shares each year.
 
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What has the buyback achieved? EPS growth of 11% per year, compounded, which has thus given the market the option of getting a rising shareprice out of a flat market cap performance. But what else - it has catapulted the value of the directors' option pool, which had "zero" value at issue, up to  9.3% of the company! So the buyback initiative has a different effect on the parties! In essence, the company sold shares at 100 to the options pool, then is buying them back at well over R200 - following a "sell low & buy high " strategy to transfer money from its shareholders to its option holders!
 
Still happy with buybacks?
 
Stuart
 
 
 

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After a request from Sandi Brittz , here is the slide from the Standard (SBG Secutities) OST course Share Selection Course Group showing cost impact.

 

Note - it compares cost impacts on a representative return from long term investing, and uses 12.5% as the smooth "capital only" return per year (which has been the geometric mean return for the JSE allshare index for the period illustrated). It shows a smooth continuous return - be aware that actual market action is never this smooth! It also adds a smooth and continuous dividend return of 2.5% to get the higher results which assume complete reinvestment of all dividends.

 

And as to costs - the cost impacts illustrated show the erosive effect of the assumed total annual cost structures illustrated. Your stockbroker may charge you relatively little per month or year to just have an account, but advisory or management fees can be a cost, and brokerage costs on trades made in your account will add up, and may not be easily visible to you. These will also affect your results even if you do your own thing and pay no-one else. Either way,  stockbroking is only part of the cost potential - in the case of unit trusts, pension funds, retirement annuities and other investment products, there may be many layers of costs - all of which may add up and erode your end result. Tax is also an important part of the story. 

 

See also See the Asset Industry Structure and Cost Impact   for more perspective.

 

Cheers

Stuart

 

 

 

 

alt

 


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Category: Research

Just an update on the TTK1 Model Portfolio, which is available through Description of Model Portfolio Group :-

 

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And total trading costs (note UST is now actually called STT (Securities Transfer Tax)

 

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It has been said that ¾ of drivers in the traffic rate their own driving skills as “above average”, and the same probably applies to share investors.
 
In the courses in fundamental investing (http://www.tickertalk.co.za/group.php?group_id=183  & http://www.tickertalk.co.za/group.php?group_id=184 ) I refer to the classic book by Ben Graham, which has a deceptive title:-
 
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I typically also mention that “intelligence” per se  is not the pivotal ingredient – its common sense that is curiously uncommon in how many people invest…
 
 
Here is a nice piece on the distribution of IQ scores, perhaps a partial proxy for testable intelligence, and on what that distribution may reveal.  
 
Cheers
Stuart
 
While most people do not want to admit it, the vast majority of people are in fact, average.
 
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The bell curve that applies to IQ can also be applied to anything that has a statistical average.  That large blue portion that encompasses 68% of any given population is the area of the first standard deviation on either side of the literal average.  The brown area is the second SD and the light blue area is the third SD.  The grey area is the fourth and is the realm of the extremely exceptional on both ends of the spectrum and in all categories.
 
Basically, blue is most people, brown is the noticeably above or below average, light blue is very much below or above average and grey is wow on both ends.  This applies to looks, intelligence, creativity, physical strength and a bevy of other qualities which people judge both themselves and others upon. Most people who are active on the internet have seen this distribution curve before and are familiar with it.
 
The funny part of “averages” is that when surveys are taken about self-perception of any given personal quality or attribute the average (median) result is that people rate themselves at a 7 out of 10.  That is, the MAJORITY of people rate themselves in the right hand brown second SD area while, obviously, this is not possible.
 
Not everyone can be exceptional in all areas.  There are a few cases of those who are extremely intelligent, extremely good-looking, creative, physically superior, what have you.  But for the vast majority of the population this is not the case. Pursuing excellence is always a worthy goal and it is unimaginable that anyone would discourage that.  But it should be tempered with a realistic perception of both ability and potential.  A positive attitude will increase anyone’s chances of success in any field and everyone should encourage others in reaching their goals and pursuing their dreams.
 
But there is nothing wrong with being average in certain areas.  This is perfectly normal and the perception that it is somehow subpar to actually be average in any area can have a negative impact on people.  Those who excel in one category do not necessarily have time to devote to excelling in others and should not feel inadequate because they are not superstars in 14 out of 15 categories.
 
It is perfectly ok to be normal
 
From expressiveepicurean on wordpress.com
 

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