moneyweb investment focus, with discovery invest (november 2009)

The new ‘normal’

Alec Hogg

6 – 12 November 2009

The new ‘normal’The new ‘normal’

How the world has been changed by the Great Recession and what we should be doing about it

- ALEC HOGG, Moneyweb, November 2009

It’s theIt’s the

new normalnew normalbecause it’s herebecause it’s here

to stayto stay

GlobalisationGlobalisation

Cause one

Person PowerPerson Power

Cause two

TechnologyTechnology

Cause three

ChinaChina

Cause four

Consequence one

We’re time poorWe’re time poor

Consequence two

“Change creates a new paradigm in which enterprising companies can benefit through innovative solutions…”

- Brian Joffe, founder, Bidvest

From the 2008 annual report:

“Bidvest has risen to the challenge of “the new normal”

Business strategyBusiness strategy

Consequence three

Investment strategyInvestment strategy

Consequence four

Disruptors run by entrepreneurs:

Steinhoff (@ 1845c – earnings yield of 13.7%)

Pallinghurst (@ 468c – the Gilbertson factor)

Discovery (@ 3050c – earnings yield of 7.4%)

Altech (@ 7700c – earnings yield of 7.8%)

PSG (@ 2150c – earnings yield of 7.8%)

Some likely winnersSome likely winners

Panning for Gold in Muddy Waters


Kerrin Howard

Head of Investment Strategy

Discovery Invest

Newest elements of global economies

Debt

• Nearly USD1 trillion in stimulus bills; USA may need to borrow USD2tn

• Debt to GDP:

› USA: 70% (#1), rising to 108% by 2014 according to IMF

› SA: 31.6% (#43)

Outlook

• GDP growth is not an obvious option for meeting those obligations

• More countries will run larger current account deficits for longer

• Growth is being driven by the funds borrowed to create it

• Is such growth sustainable?

• Governments likely to inflate the debt away Sources: Bloomberg, IMF

Gold’s value as an inflation offset

Source: Bloomberg

Traditionally, gold seen as inflation hedge.

Recently, Gold began moving with stocks.

Gold’s relevance

Warren Buffett is not convinced

‘Gold just sits there, with no yield.’

‘[Gold] gets dug out of the ground in Africa, or someplace.

Then we melt it down, dig another hole, bury it again

and pay people to stand around guarding it. It has no utility.

Anyone watching from Mars would be scratching their heads.’

Warren Buffet, ‘sage of Omaha’

Maybe Buffett has a point

Source: Bloomberg

Why should Gold prices rise or fall?

Driving forces for Gold prices

• Supply

• Demand

• Strength/weakness of the US Dollar

• Inflation

• Interest rates

Views for and against rising gold prices

Shares that may benefit, or not

Supply and demand for Gold

* Net of hedginghttp://www.invest.gold.org/sites/en/why_gold/demand_and_supply/

Mine production*60% (2,209t)

Netcentral

bank sales12% (447t)

Recycledgold (scrap)28% (1,016t)

Jewellery68% (2,436t)

Industry14% (493t)

Investment19% (670t)

Industrial12%

(19,700t)OfficialSector18%

(29,700t)

Unaccounted for 2%

Investment17%

(27,300t)

Jewellery 51%(83,600t)

Supply flows5 year average (2004 – 2008)

Demand flows5 year average (2004 – 2008)

Above-ground stocks, end 2008(total: 163,000t)

Gold: Not enough of it

Sources: The Tudor Group, Bloomberg, IMF, World Gold Council

Recycled gold = 28% of production

Annual world Gold production

Mill

ion

ounc

es

80

70

60

50

40

30

90

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Annual productionas a percentage of available supplies

6%

5%

4%

3%

2%

1%

7%

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Central Bank Gold reserves

Current (mil troy oz) 1 year ago (mil troy oz) % Change

World total 967.886 09 Jul 955.255 08 Jul 1.32%

Eurozone 347.52 09 Aug 350.92 08 Aug -0.97%

United States 261.50 08 Sep 261.50 07 Sep 0.00%

Germany 109.58 09 Aug 109.74 08 Aug -0.14%

Italy 78.83 09 Aug 78.83 08 Aug 0.00%

France 78.60 09 Aug 81.53 08 Aug -3.60%

China 33.89 09 Jan 19.29 08 Jan 75.69%

Switzerland 33.44 09 Aug 33.84 08 Aug -1.19%

Japan 24.60 09 Aug 24.60 08 Aug 0.00%

Netherlands 19.69 09 Aug 19.98 08 Aug -1.45%

India 11.50 09 Aug 11.50 08 Aug 0.00%

Venezuela 11.46 09 Aug 11.46 08 Aug 0.00%

Spain 9.05 09 Aug 9.05 08 Aug 0.00%

Philippines 5.07 09 Jul 4.28 08 Jul 18.50%

Thailand 2.70 09 Aug 2.70 08 Aug 0.00%

Australia 2.57 09 Jul 2.57 08 Jul 0.01%

Central Banks globally seen as net buyers going forwardSource: Bloomberg

More investors want to buy Gold

Sources: The Tudor Group, Bloomberg

12m-trailing Gold ETF flows as a percentage of 12-m trailing production

25%

20%

15%

10%

5%

0%

30%

35%

1/3/

2006

4/3/

2006

7/3/

2006

10/3

/200

6

1/3/

2007

4/3/

2007

7/3/

2007

10/3

/200

7

1/3/

2008

4/3/

2008

7/3/

2008

10/3

/200

8

1/3/

2009

4/3/

2009

7/3/

2009

10/3

/200

9

Gold ETF Holdings as apercentage of above ground stocks

2.5%

2.0%

1.5%

1.0%

0.5%

0%

3.0%

1/3/

2006

3/3/

2006

5/3/

2006

7/3/

2006

9/3/

2006

11/3

/200

61/

3/20

073/

3/20

075/

3/20

077/

3/20

079/

3/20

0711

/3/2

007

1/3/

2008

3/3/

2008

5/3/

2008

7/3/

2008

9/3/

2008

11/3

/200

81/

3/20

093/

3/20

095/

3/20

097/

3/20

099/

3/20

09

At the end of 2006, the World Gold Council estimated that all the gold ever mined totaled 158,000 tonnes.This can be represented by a cube with an edge length of just 20.2 meters

USD strength/weakness affects Gold

Source: Bloomberg

Relative performanceDollar value of total international reserve assets

10,000

8,000

6,000

4,000

2,000

0,000

$USbn

Apr

70

Apr

73

Apr

76

Apr

79

Apr

82

Apr

85

Apr

88

Apr

91

Apr

94

Apr

97

Apr

00

Apr

03

Apr

06

Apr

09

JP Morgan’s economic outlook

Consumer prices % year-on-year

2Q09 4Q09 2Q10 4Q10

USA -0.9 1.2 2.1 1.0

Eurozone 0.2 0.3 0.9 1.2

China -1.5 0.9 3.2 2.7

South Africa 7.7 6.3 4.5 4.1

Real GDP growth % (quarterly, over previous period)

1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10

USA -6.4 -0.7 3.5 3.5 3.0 4.0 4.0

Eurozone -9.6 -0.07 3.0 2.5 3.0 3.0 3.0

China 8.4 14.8 10.0 9.1 9.0 9.5 9.3

South Africa -6.4 -3.0 0.6 3.4 4.5 3.7 3.6

Global GDP growth: largely funded by government borrowing

Low interest rates spur Gold demand

Official interest rates forecast

12/2009 03/2010 06/2010 09/2010 12/2010

USA 0.125 0.125 0.125 0.125 0.125

Eurozone 1.0 1.0 1.0 1.0 1.0

China 5.31 5.31 5.31 5.58 5.85

South Africa 7.0 7.0 7.0 7.0 7.5

Source: JP Morgan

Gold can be seen as cheap

Source: The Tudor Group

Gold inflation-adjusted cash prices – average = $556.2Inflation-adjusted all time high was $2,422 on 21 Jan 1980

Back to Buffett: better off elsewhere?

Source: Bloomberg

Whither South African Gold stocks?

Earnings outlook

• Upward potential:

› Higher prices globally

› Higher demand

› More ways to buy Gold

› Central Bank buying: India bought USD6.7bn/200 tonnes from IMF

› Lacklustre production outlook

• Downward pressure:

› Margins under pressure due to lack of upgrade

› ZAR strength

› Higher electricity and wage costs

South African Gold shares: focus onhedging, margins, marketshare

Deutsche Bank forecasts 2008A 2009E 2010EAngloGold Ashanti Buy EPS (USD) -0.47 -0.41 3.85P/E (x) - - 11.3EV/EBITA (x) - 133.6 7.6Harmony Gold Mining Buy EPS (USD) 0.39 0.43 1.22P/E (x) 25.4 25.9 9.1EV/EBITA (x) 28.4 21.2 6.6Gold Fields HoldEPS (USD) 0.49 1.16 1.8P/E (x) 20.1 12.3 7.9EV/EBITA (x) 11.8 7.9 5

Investec Asset Management’s Sam Houlie, manager of Discovery Equity Fund,

is invested in Gold-related companies

Takeaway for South Africa

Rising Central Bank purchases create market momentum

‘Weak dollar’ policy is likely to stay in place

China = largest export destination; rise in jewelry demand?

Lessons learned from the collapse of Lehman Brothers

David Shapiro


Background

Influential investment banker, Lehman Brothers filed for bankruptcy in September 2008, a consequence of problems that were fuelled by the collapse of the US housing market

Lehman had significant exposure to investment products, designed to facilitate the sale of mortgage finance, associated with the lower end of the property market

The collapse unhinged the global economy

• Stock markets went into steep decline

• Credit markets froze

• World trade halted

• Liquid markets dried up faster than assumed.

A year later, equity markets have recovered and credit markets are beginning to show signs of life

However, it will take a long time before the global economy returns to levels seen before the recent crisis – financial markets will never be the same – new regulations will see to that!

Lesson one

Most macro-economics of the past 30 years was spectacularly useless at best and positively harmful at worst

Paul Krugman

Princeton professor, economist and Nobel Laureate

Economists misread the economy on the way up, misread it on the way down, and are confused about the way out

Most economists thought that the housing bubble in the US would pop and that the dollar would fall – they believed even if house prices fell by 20% in 2 years, the slump would knock only 0.25% off GDP and add only 0.1% to the unemployment rate

Most were sanguine about the collapse of Lehman - no one expected the financial system to break

Furthermore, they overestimated the power of monetary policy to restore prosperity, but their models failed and conventional weapons have proved insufficient

Theories worried about the prices of goods and services but neglected the prices of assets – it had too much faith in financial markets

Even so there is still disagreement about the alternatives and extent of stimulus packages

They have to adjust their theories from preserving price stability to safeguarding financial stability

Lessons from Keynes

Economic theory dictated that markets clear continually – if wages and prices are completely flexible, resources will remain fully employed and any shock will result in instantaneous adjustment

Keynes taught that when shocks to the system occur, no one knows what will happen next – in the face of the uncertainty spending is not adjusted, people refrain from spending until the mist clears sending the economy into a tailspin – the economy does not maintain its buoyancy and it becomes a leaky balloon

Keynes believed in those instances the authorities need to inflate the economy to minimise the shock – his theories were thrown out as economists reverted to old doctrines that markets were self-correcting

But it was financial deregulation that led to the credit crisis – Keynes opposed financial innovation beyond the bounds of human understanding – complexity for its own sake had no appeal to him

Where he was misunderstood is that he believed in a balanced budget and was not a tax and spend fanatic – nor was he an inflationist, believing in price stability – but he believed that unless the government took steps to stabilise the economy at full employment the benefits would be lost and the political space would be opened up for extremists

Lesson two

The US retains its power to command the global economy and create disorder

US continues to dominate global economy

The world has not lessened its dependency on the US

The US keeps its power to command the global economy and create disorder

Belief that momentum in emerging economies would fill the void left by the slowdown in developed economies was unfounded

Emerging economies currently add more to global growth than the developed countries but with the US, Europe and Japan accounting for over 60% of world economy, their prosperity and expansion is still relevant

Still – some emerging countries positioned for healthy expansion – but without a turnaround in the US the global economy will not recover

Lesson three

The dollar remains and will remain the leading reserve currency

The dollar remains and will remain the leading reserve currency

When the credit crisis crossed the Atlantic it spread fears about growth in other major economiesIntensifying turmoil sparked a rush to the safe haven of US government backed treasuriesDollar strength triggered a rapid unwinding of commodity hedgesFalling commodity prices and global slowdown increased doubts about expansion in emerging economies – carry trades unwindDebtor countries calling for alternative to dollar, but this is unlikely to materialise in short term – needs history of political and financial stability and liquid bond markets to comfort investors

Dollar’s role as a reserve currency

Dollar has been dominant as the world’s reserve currency since World War 1General view is that the world financial system can’t rely solely on the US dollarThe servicing charge of the huge overhang of dollars is undermining confidence and stoking inflation fears – still the US government can borrow 30 year money at around 4.2% and 10 year money at 3.4% suggesting that deflation is more of a problemSome dollar weakness is welcome – it reverses the inflows into the US that facilitated the over-leveraging and under-pricing of assetsIt is worth noting that a reserve currency requires liquidity that can only be produced through the existence of current account deficits

Lesson four

Risk managers at banks, investment companies, regulatory authorities proved entirely inadequate

There are many banks but very few bankers - Warren Buffett, May 2008

The self interest of lending institutions failed to protect the interest of equity and shareholdersRisk managers at banks, investment companies, regulatory authorities proved entirely inadequate Also obvious that senior management were oblivious to the dangersSophisticated, computer-driven systems designed by financial experts failed to pick up the weaknesses embedded in the pooled productsAccording to Alan Greenspan, the data fed into the risk models covered only two decades of data during which time conditions were euphoric – hence the assets were not properly pricedIn addition, the degree of exposure to subprime lending and the level of uncovered credit swap derivatives was grossly underestimated

The future of banking under scrutiny

Only 3 out 10 bosses in the US kept their jobs after the crisis – in Europe a number of heads also faced the guillotineBankers paid themselves loads of money, made large expense claims and furnished their offices lavishly – more useless than corruptibleWith banks considerably larger than even oil companies there’s little wonder that management didn’t understand the books – the extent of their exposure to toxic assets or any assessment of how much to write down these assetsIt wasn’t a case of how many times management met – banks were simply too big to be manageableBanks need to shrink and simplify their businesses and establish a culture of excellence

Lesson five

Read Benjamin Graham, read Phil Fisher, read annual reports but don’t do equations with Greek letters in them

Warren Buffett

It is easier to rob by setting up a bank than by holding up a bank clerk – Bertolt Brecht

The origins of the credit crisis are linked to the global spread of mispriced assetsQuestions have been raised over the contribution of academics in the design and evaluation of these mispriced assetsThe intellectual view – with Greenspan as cheerleader – was that complex derivative products in tandem with electronic communication systems reallocated risk over a broader global base – the models were fine, one had to examine the input and how they were used Belief that financial products should be passed by the equivalent of the FDA before being sold to unsuspecting investorsAlso growing concerns about the role of colleges and universities over-emphasizing the use and complexity of derivatives in their courses – “I haven’t shorted before, but I do have my CFA”

The smart guys come to Wall Street

According to some cynics the integrity of financial markets began disintegrating when the smart guys started working on Wall StreetTwenty to thirty years ago the top students aspired to becoming professors, judges or surgeons – the lower third of the class went to Wall StreetThey were decent people who were not greedy and wanted nothing more than to earn a modest living – they also came from well-to-do families and didn’t need to leverageThe spread of computers and the internet attracted the smart guys to Wall Street. Where, instead of doing their PhD in physics they invented complicated derivative products like CDOs, credit swap defaults and securitisationThey wanted to make a fortune first, then become professors

Lesson six

Gold failed to perform throughout the crisis and offered little protection against falling asset prices

You dig a hole in the ground to extract gold, then dig another one to store it, and then pay someone to watch it – Warren Buffett

Gold failed to perform throughout the crisis offering little protection against falling asset prices

Recent peak reached on dollar weakness

Performance correlates more closely to movements in commodity prices and oil than a pseudo currency

In 1940 one ounce of gold bought around 30 barrels of oil – it now buys around 12

In 1940 it took 40 ounces of gold to buy the average house in the US – it now takes 187 ounces – gold underperformed US housing market

The future

Temperature is normalising but the recovery in the global market will be slow and protracted

More bank write offs anticipated – $1.7 trillion increasing to $2.8 trillion

Stimulus programmes beginning to take hold in developed and emerging economies

High levels of unemployment, surplus industrial capacity and excess householder debt will prove a drag on growth

Consumption in China and India too small to fill the void

Inflation not a short-term or medium-term problem – not reflected in capital markets, banks retaining large sums of capital, demand remains restrained, unemployment and excess capacity puts pressure on wages and price levels

Banks will face tighter regulations – could be broken up

Financial markets will be tamed – includes regulating hedge funds

Remuneration packages, share options, buy-backs, valuation techniques, scrip lending and short selling will be challenged

Thank you