Newsletter 19 July 2012: Be a brave and cautious investor

In today’s newsletter we share two articles that look at investing in a brave new world – why you have to take the plunge and invest for future wealth and why you also have to be cautious when it comes to some investment opportunities like IPOs.

We wish Team SA the best of luck as they depart for London – we hope they enjoy the Olympic experience, achieve their personal goals and personal bests and have some shiny new medals to show off when they return.

Be brave not reckless

Curiosity did not kill the cat; it was reckless. Jonathan Jansen, Letters to my Children

The dilemma an investor faces today is this – cash is not giving required real returns – but the place to find real returns is risky. This was summed up by Peter Brooke, head of MacroSolutions at OMIGSA (Old Mutual Investment Group SA) on Tuesday when he noted that low returns put pressure on investors to take on more risk – “but there is genuinely a high degree of risk and less shock absorbers than before.” Brooke was speaking at the OMIGSA quarterly briefing in Johannesburg.

This makes investing for real returns today a place for the brave investor – but that is brave not reckless or foolish.

So what is a brave investor and why do we need to be brave investors?

A brave investor is:

Curious – they ask questions and look for the positive and negative sides of an investment. They are sceptical but look for reasons for success and reasons for failure,

Time conscious – they take time to analyse an investment opportunity, know that returns take time and that there is a good time to make an investment,

Realistic – they don’t believe in a message of high or guaranteed returns only – these often lead to scams that lead to poverty,

Seeking expert advice – they look for expert advice – and make sure that it is expert advice,

Open to new world opportunities – there may be more than just the traditional choice of investments available, look at alternatives other than cash, property, bonds and equity but scrutinise them carefully and make sure the asset allocation is appropriate for needs,

Risk conscious – knows what risks exist,

Price conscious – overpaying is not the best option, and

Action oriented – you cannot earn returns by staying out of the game – if you want returns you have to invest. A brave investor will accept the good opportunities but will also decline the bad ones.


The need to be brave:

Slow economic growth – latest revisions this year were downward. But it is important to note that this is still positive growth – just very slow, commented OMIGSA senior economist Johann Els on Tuesday.

A financial crisis that just drags on – Els pointed out that since the start of the financial crisis there have been 19 summits. It is likely there will be more. And as Brooke noted – the two solutions to the crisis – austerity and growth don’t seem to be working that well. Matt Brenzel, portfolio manager at Cadiz Asset Management commented: “Until leaders stand up to voters and implement best practice management of the economy, things aren’t likely to change,” in the June Equity Market Commentary.

A world of low returns – fund managers have been warning of lower returns for some time – equity and property have to some extent defied this warning – making it sometimes difficult to believe. Local listed property returns for the first six months of 2012 were 19.2% and the FTSE/SWIX delivered 9.3% return for January to June 2012. Going forward Brooke expects SA equity to return 6.5% (real) in the long term (five years), SA Property 5%, Bonds 2% and cash between zero and one (all real returns). International bonds and cash are expected to deliver negative real returns and offshore equities 6.5% (international expected returns all real, USD).

Low interest rates – interest rates are at record lows and look unlikely to change. These are – as Brooke said – a huge tax on savers. (And retirees living on interest income) (And if you are a saver you can now save more with what is saved on even lower rates).

Low inflation numbers but higher personal inflation – inflation numbers are low globally but as we have noted before these are the officially measured averages and not the investors’ personal experience. July electricity bills may not yet be in but when scrutinised they – and other household expenses – reveal a personal rate of inflation. Financial Planner of the Year in 2009, Alec Riddle, commented at the FPI Convention in June that each investor has their own unique inflaiton.

The macroeconomic situation may look slow and befuddled – your personal situation does not have to – what do you want, what do you need, what do you have and how can you get to where you need to be – are questions you can answer without getting too involved in nations mired in political wrangling, debt and unemployment.

Be wary of IPOs

One of the investment opportunities that is always guaranteed to get pulses racing amongst both retail and institutional investors is the chance to invest in an Initial Public Offering (IPO).

An IPO is the first sale of shares by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded.

According to Wilhelm Hertzog, portfolio manager at RE:CM, while the chance to “get in at the ground floor” of a “dynamic company” with “great potential” may be an extremely enticing prospect for many investors, there is ample evidence, both globally and in South Africa, that shares bought in an IPO underperform the market substantially over long time periods.

Research by Govindasamy (2010) to determine the long run (three years) performance of IPOs listed on the Johannesburg Stock Exchange JSE in South Africa between 1995 and 2006,found that IPOs underperformed the JSE by 50% and 47% on an Abnormal Return (BHAR) and Cumulative Abnormal Return (CAR) basis respectively.

“In an IPO, one typically has a situation where informed insiders are selling to the less informed public,” says Hertzog. “The incentive is for the sellers to maximise the proceeds from the sale of the shares, which means that the IPO price is unlikely to represent attractive long term value for a buyer of those shares. The investment odds are stacked heavily against the buyer.”

He says that in particular, investors should be wary of participating in IPOs in sectors where a large number of IPOs are taking place. “IPOs tend to happen in sectors where stock prices are above intrinsic value due to short term optimism towards the sector. The most recent example of that was the local construction sector around 2006/7.”

Hertzog says that currently, the listed property sector in South Africa is attracting a large number of IPOs, which should be considered a warning signal. “With the global reach for yield that is currently happening, the local listed property sector’s share prices have been driven up to generally unattractive levels. We would urge caution for anyone considering an investment in the sector, and even more so for a new listing in the sector.

“Globally, there has been a preponderance of IPOs in emerging markets, with Hong Kong being the leading market for new listings in 2011. We are steering well clear of those markets in general, and new listings in those markets in particular.”

According to Hertzog, deciding whether an IPO offers value involves the same process of valuing a business as one should engage in prior to deciding whether the shares of any other business offers value. What complicates matters is that typically there is a limited amount of financial history available for a company coming to the market in an IPO, which can make it more difficult to establish the long term economics of the business at hand. This makes it more difficult to estimate intrinsic value with any degree of accuracy.

He says there are numerous examples of IPOs that did not benefit investors, with a number of examples from the construction sector listings boom in 2006/7. “The example that has been attracting the most media attention lately is probably Sanyati, which went into liquidation recently. Globally, investors in Facebook’s IPO have had disappointing results to date, but we would consider the time since Facebook’s listing to be too short to draw any real conclusions about the benefit to investors.”

However, he says there are some IPOs that stand out as exceptions to the rule, such as Google, whose IPO at the time was probably as eagerly anticipated and as “hot” as that of Facebook recently. “In contrast to most IPO’s however, the Google IPO greatly benefitted long term investors in the share who bought at the time of its IPO. The business has delivered financial results that have met and exceeded the high expectations reflected in the share price at the time of its IPO.”

Locally, he says that an IPO where investors did exceptionally well was that of Eland Platinum. The company listed early in 2006 and was bought out by mining giant Xstrata for almost five times the IPO price less than two years later. “In hindsight, there is little doubt that Xstrata overpaid for the company, and that the phenomenal returns achieved by the IPO investors was more due to another investor coming along and offering a ridiculous price for their shares than it was due to the underlying performance of the Eland Platinum business. But that investors in the IPO benefitted greatly is undisputable.”

Hertzog says the reason why investors invest in IPOs, and experience the disappointing longer term returns that typically follow, is not as a result of a lack of regulation, disclosure or transparency. “Investors invest in IPOs because of the positive sentiment towards sectors in which IPOs typically happen, the usually rosy short term prospects for a company coming to the market, the emotional comfort and sense of satisfaction of investing in the topic of dinner conversation, and the prospect of gaining from the first day “pop” that IPO shares often experience. Unfortunately, regulation is powerless to prevent these conditions from forming, and will have to be able to protect investors against themselves if it is to have any real impact.”

The comment and opinion in this newsletter is comment and opinion only and does not in any way constitute financial advice – please seek advice from a professional financial planner for all financial and investment decisions.

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