NFB FINANCIAL UPDATE Volume55 April 2011
FROM THE CEO’s DESK
R
isk is an interesting word. Some would run a mile having simply heard the word. Others are attracted to it like a moth to a light bulb. Most often it evokes emotive and even irrational reactions from individuals and, even more so, from like-minded groups. So, what is risk and which types exist in the current global environment? Risk takes many forms and it is important to assess one's life and work environment in order to understand what these are and how they might affect you. They also come with different probabilities of occurrence and severity. Take the rather catastrophic events of late: these include the Japanese earthquake and subsequent tsunami, the inundation of Australia's eastern coast, Haiti's devastation and, before that, several other regional disasters. What is remarkable is the speed with which the world moves on; almost forgetting these devastating occurrences as they pale into relative insignificance by the next such events and the media overkill they enjoy. Another form of ever present risk in the developing world is social unrest, civil war, crime and other instances where humankind seeks to unlawfully take control of places, resources, etc. Or they simply commit acts which are indefensible and which typically have far reaching consequences, sometimes lasting decades and beyond. Africa and some other parts of the historically branded Third World have poor humanitarian and political records. Ranging from outright genocide to mere one party financial rape of entire countries. This sad history is far too common and is largely ignored where strategic value is not on offer to the developed "Big Guns". Risk, which we at NFB consider every day, are market, credit, currency and similar economic risks. The well written book[1], dealing with outlier events (which are called Black Swans) is so appropriate at present as people try to deal with events and outcomes. Expecting the unexpected has become the norm rather than the exception. Large swings are to be expected as markets sway to the effect of actual and contrived events, rumour and people talking to their books. Another material risk, often neglected in these modern times, is the opposite of some of these horrible scenarios penned above. It is longevity! This risk is one of the greatest challenges to investors and advisors alike. When one could reasonably expect to leave this world at three score and ten; planning for a short retirement made things easy for planners and investors alike. The landscape has changed remarkably and, in First World environs, with healthcare and other
developments, folk are surviving and indeed thriving into their eighties and now nineties with great regularity. Making the correct assumptions and planning financially is a different game. Where one saved for thirty or forty years and survived half or less of this period after retirement is no longer the deal. This challenge, although daunting, is acceptable for younger investors who can invest aggressively and for a long time. For older investors the challenge of lower rates of interest, relatively high tax rates, risky growth markets and high volatility presents an investment backdrop which will challenge even the coolest of characters. Solutions are needed where investors don't back a single horse and certainly not one institutional provider. Balance sheet risk makes diversification very advisable. Splitting assets across types, ranging from pure equity, protected equity, property (particularly where good income from quality leases exist), interest or dividends to provide for income needs and to take advantage of tax allowances, as well as sufficient offshore diversification, is recommended. These must also have taken taxation issues into account as often investors neglect this aspect which can be used rather effectively to optimize net returns. A material, and reasonably predictable risk, is inflation. Much has already been said about the remarkable, repeated and coordinated infusion of liquidity by central banks into distressed capital markets. The US Fed's balance sheet has swollen dramatically as they have created massive liquidity to inject confidence and cash into the global banking system. Europe, the UK and other members of the Club have acted in sync. This bailout will have consequences. Inflation is one of them. Investors can ill afford to completely disregard this ominous prediction. As a result when one retires, moves funds to "safe" investments and draws an income, the outcome is gradual, or worse, capital atrophy. Managing assets to provide risk-adjusted growth and income is optimal. Higher income, dividend or rental generating investments are the most likely to deliver a balance between income and growth. As always, the caveat is sufficiency. Without enough margin of safety, having to plan for growth above necessary income is a plight to be avoided. This might sound trite, but the recurrence of this shortfall is scary. Avoid it at all costs. Mike Estment, CFPÂŽ BA CEO, NFB Financial Services Group [1]
The Black Swan, by Nassim Nicholas Taleb
IN THIS ISSUE From The CEO’s Desk Crystal Ball? A Strong Case for Offshore Equities!
25
financial services group
CRYSTAL BALL? In order to know the outcome of the next Durban July horse race or which market will perform best over the next year, would it not be handy to have a crystal ball? I think we all understand that this type of foresight or forecasting is not possible with any semblance of accuracy. However, we do think that through the analysis of historical information we may be able to form some type of base case scenario on which to base future expectations of investment returns. Unfortunately, we cannot help with horses! Written by Stephen Katzenellenbogen, NFB Gauteng, Private Wealth Manager
THE BASE CASE
deducting CPI, STEFI and dividend yield from the total return of the
This article will breakdown and then rebuild an investment return in
JSE All Share Index. The x-factor is our complete unknown.
order to gain some insight as to what we could expect from our
If you take the above 4 factors and add them together you
investment portfolios in terms of future returns. Before we get going,
should then get the total return on the All Share Index for the
it should be noted that the content to follow will be based on equity
corresponding period. This works better for longer-term periods (i.e.
returns in South Africa. Secondly, there are some inputs that are
ten years) than it does for shorter periods.
variable and, as such, assumptions or analysis needs to take place alongside these. We would ask that you apply your own views to
ONE STEP AT A TIME
these variables and, in so doing, challenge our thinking. If you happen to own or pick up some form of theoretical
INFLATION
investment book you are likely to come across a section describing the components of an investment return. It is these components that we will look at individually and then try to decide whether historical averages are likely to remain true or, if untrue, whether we have entered a new phase of economic and investment cycles. When building an investment return from the bottom up, we use, based in part on the textbooks mentioned above, the following components: = Inflation (CPI) – an investment needs to match CPI to maintain its
purchasing power. = Risk Free Rate (STEFI Call Deposit) – this is the minimum return you
would expect from a risk free asset. In other words: for anything other than risk free cash you would demand a higher return. = Dividend Yield - it is quite easy to forget the importance of a
dividend yield, alternatively known as cash flow, but when looking
The average inflation rate, using CPI, for the last ten years has
at long term total returns from equity you will see that the
been 5.84%. This should also be placed in the context of the South
reinvestment of dividends accounts for the majority of your overall
African Reserve Bank's target range of 3% - 6%. Inflation has a vast
return.
number of interrelated components than can positively or
= X-factor – this would be very difficult, if not impossible, to predict
negatively affect the final number. We will not make an attempt at
as this is the positive or negative return enjoyed by investors after
predicting these variables, but rather give a broad synopsis. We do
think that the Reserve Bank will, on average, keep inflation within the target range. It is also likely that global authorities will continue to pursue a positive, but controlled inflation environment, thus impacting South Africa's inflation environment. RISK FREE RATE
At a glance we can see that historically both the dividend yield and risk-free rate have been positive, with inflation and the x-factor moving between positive and negative territory. The average yield of the above components can be summarized as follows: The above graph depicts the downward trend in interest rates.
Table 1
We do think that going forward we will continue to be in a lower
Risk Free Rate (STEFI Call Deposit)
interest rate, and lower inflation rate, environment. As such, the ten
Inflation (SA CPI)
5.84%
year risk free return, measured by the STEFI Call Deposit rate of
Dividend Yield (JSE All Share Index)
3.49%
8.93%, is likely to average down over time.
X-Factor (JSE Total Return minus CPI, STEFI &
-1.61%
8.93%
Dividend Yield) DIVIDEND YIELD
AVERAGE TOTAL RETURN
16.65%
What we have achieved so far is identifying, describing and quantifying the different components of total return. The next and final step is to determine how this affects us as investors. For the purposes of our discussion let us assume the following going forward: Table 2: Inflation
4.5%
This is in the middle of the target
Risk Free rate
6.5%
Common belief is for interest rates to
range remain lower than those enjoyed historically Dividend Yield
3%
Increased competition may lead to
X-Factor
0%
We have given this the benefit of the
lower profits When you buy a share you are buying a part of that particular business and, as such, will participate in the profits and losses of that
doubt against its historical track record
entity. If a business has excess profits it can either apply these within the business to fund future expansion projects or, alternatively, these
of -1.61% TOTAL
14%
profits can be distributed to shareholders in the form of a dividend. Very often a combination of these options is used and shareholders
Due to a lack of space please forgive us for making some
enjoy a dividend to reward them as loyal owners of the company.
assumptions with little explanation in 'Table 2'. Nevertheless, if we
We have discussed the importance of dividend reinvestment and
can in principal agree with these numbers we then could expect
long term returns and, as such, it is worth noting that the average
long term returns to be around 2.6% lower than those enjoyed
dividend yield of the JSE All Share Index over the last ten years has
historically. Put another way, future expected returns could be
been 3.49%.
approximately 15.5% lower than historical averages.
(We must not forget that a quality company may not always pay a dividend, with Anglo American being top of mind during
THE END GAME
2010).
Throughout this article we have focused on equity returns. A
X-FACTOR
balanced portfolio should have a blend of cash, bonds, property and equity in accordance with the appropriate risk-profile.
We mentioned above that the final and fourth component of total
Expected returns would thus need to be modified based on the
equity return is:
overall asset allocation. In some instances you may have inflation
JSE ALSI Total Return minus (inflation + risk-free rate+ dividend yield) The net result of this sum gives us an average return of -1.61% over the last 10 years.
plus (e.g. CPI + 5%) targets and can adjust your sights accordingly. An unfortunate consequence of a lower return environment is the need to save additional funds for retirement or other investment goals. Always remember to, as far have possible, have a well thought out investment plan constructed in conjunction with a
WHAT IS THE 'BOTTOM LINE'?
professional advisor to ensure prosperity and peace of mind.
Let us begin by looking at a graphical representation combining the different components of investment return.
*All graphs courtesy of NFB Asset Management
A STRONG CASE FOR OFFSHORE EQUITIES! “Ladies and gentleman of the jury I ask you to find the defendant not guilty!”. I feel like Corbin Bernsen from LA Law. Those of you who remember the eighties hit TV show will remember the smooth talking attorney who would defend the murderer of his own grandmother, and often with great success. The defendant in the dock today would be offshore equities - the perennial repeat offender for the past 10 years. Written by Travis McClure, NFB East London, Private Wealth Manager
BigStockPhoto.com
T
he last few years have been dominated by emerging markets and their growth prospects. Our own equity market has averaged 14.4% p.a. over the past 10 years while the MSCI world Index has come in at 2.9% p.a. Not a great track record. Our market has had the benefit of lower inflation and lower interest rates. We were shielded from the financial and sub-prime crisis thanks to a sound banking and exchange control system. A strong Rand, supported by the demand for our commodity rich soil and attractive real interest rates relative to the developed world, has also assisted in keeping inflation lower and therefore improving our growth prospects. The problem we face now is that Governments around the world have pumped money into the system to try and save their economies. This, along with the lowering of interest rates to near zero to stimulate growth, has lead to negative real interest rates. At some stage this is going to lead to an increase in inflation and the only way forward from there will be to raise interest rates offshore. This will close the gap between the inflation rate and interest rates therefore making our own bond market look less attractive. This may lead to foreign net outflows which in turn will weaken our own currency. A strong currency should only be as strong as its productivity and SA ranks second last on the productivity scale, one ahead of Mexico amongst its emerging market peer group. Currently, offshore equities offer better risk adjusted returns than South African equities. Dividend yields from first world large cap equities are well above their historical average. You can pick up well known brands such as
Johnson & Johnson on a 4% dividend yield, Unilever at 4.25% and AT&T on a 6% dividend yield. Most of the large caps have restructured and streamlined their business over the past few years. They are sitting with great cashflow balances and are also on a lower than average PE ratio. The “Juggernaut” that is the US economy is starting to roll again. Although not out of the woods yet they are starting to create jobs and the US consumer, who has been saving and clearing debt for the past few years, may just have the propensity to spend again. We do not deny the fact that the best prospects for growth will still come from emerging markets and their growing middle class income groups. Emerging markets, however, remain underpenetrated and this upside potential can be taken advantage of by the Global Brands who earn a good deal of their revenue from these markets; companies such as YUM Brands (KFC and Pizza Hut) and Heineken who earn as much as 50% of their earnings from emerging markets. These companies are well established and are in a good position to grow their earnings in this space. With higher oil prices and the possibility of a weakening currency we can only expect that inflation will creep up and put pressure on the South African consumer. With a local equity market that seems fairly priced and that has had a great run over the past decade, perhaps now is the time to consider some offshore exposure again. Perhaps the defendant deserves a second chance and to be put on parole by adjusting your portfolio weightings to include offshore equities.
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