CIO report 1st quarter 09

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CIO report 1st quarter 09 Powered By Docstoc
					From the Chief Investment Officer

David R. Green,

It’s been another dramatic quarter. The global credit crisis has now morphed into a fullblown global economic recession, with occasional reference to “economic depression”. If memory serves me correctly, the formal acknowledgement of this fact came belatedly during the quarter, with the revelation that the recession had actually commenced in the US as far back as November 2007! Readers of my last letter will remember my writing that “Catalysts like the current sub-prime crisis often strike when the tide of economic fortunes has already turned down.” and so it has transpired. In similar vein, my previous reference to the plot of The Sting, has an unfortunate postscript.

The quarter (and year) ended with the news of the biggest sting ever. A (not-so-gentle) man named Bernard Madoff, former chairman of the NASDAQ securities exchange, admitted to running a fraudulent investment scheme by dint of which he seems to have made off with the staggering total of USD50bn in clients’ money. Imagine a fairly standard pyramid scheme (remember the “Kubus milk culture”, the “Aeroplane Game” and other South African variants?), multiply the concept by several orders of magnitude, throw in the usual dash of greed and truly creative accounting and you’ve got the general picture.

I’ll return to the subject of interesting analogies, and my love of good movies, when I deal in a bit more detail with what’s going on at the moment, and our investment positioning going forward. But first, I’ll give my usual summary of performance over the recent past.


Performance summary

The calendar year 2008 saw returns of –23.23% from the All Share Index, +12.90% from the 1-3 year Bond Index, +11.71% from the money market and –16.57% from the MSCI index. Consumer price inflation ran at +12.09% over the year. Coupled with the negative local equity return, this obviously continued to make inflation-plus targets hard to beat for now. A startling result, although irrelevant to our returns, was the +56.62% from the JPM global government bond index. Granted, the –27.93% decline in the value of our currency helped,

but the fall in global bond yields as investors around the world fled to the perceived safe haven of government bonds, is a large part of the story.

It’s perhaps worth repeating here that each of the 6 PPS unit trusts has its own benchmark and associated minimum recommended investment term. We present detailed evaluation of the performance of each unit trust in our quarterly fund fact sheets . For now, it’s notable that our equity-shy approach in the 3 inflation-targeting unit trusts (the PPS Conservative, Moderate and Managed Flexible Funds of Funds) continued to be very appropriate in the context of global equity market declines. And I’m still very happy with the performances of the PPS Enhanced Cash and PPS Flexible Income Funds. The PPS Equity Fund trailed its benchmark for the full year, but has beaten it over most shorter periods even after fees, since we introduced the current line-up of managers in April 2008. 2. What is going on now?

I said I’d return to the subject of analogies and movies. The one that springs to mind is the quaint North American holiday called Groundhog Day. The groundhog is a large furry rodent also called a marmot or ground squirrel. Folklore has it that if it emerges from its hibernation burrow on 2nd February into sunshine and sees its shadow, it takes fright and dives back inside for another 6-week nap to wait out the rest of winter, which will surely follow. If, on the other hand, the groundhog doesn’t see its shadow because it is cloudy, the prognosis is for the early ending of winter and the onset of spring. Movie buffs will have seen the comedy Groundhog Day, starring Bill Murray and Andie MacDowell. In it, Bill Murray’s character is fated to repeat a particular 2nd February ad nauseam until he learns some important lessons about himself and about life.

And the relevance of this? Well … no sooner had the existence of a very severe global economic recession been generally acknowledged, than market pundits began writing about a possible equity market rebound in anticipation of the eventual return to economic health. The problem with this line of thinking is that although equity markets are indeed forwardlooking, the correlation between market fortunes and economic fortunes is weak, and the timing of the relationship extremely uncertain. In the circumstances, I find myself behaving a bit like the groundhog. If at any point in the current episode, news seems marginally positive, I take that as a sign that the complete capitulation which should precede a sustainable market upturn is still some way off, and want to hunker down for a bit more financial winter.

The other insight from the movie, is that there are certain lessons which will be repeatedly delivered by history, until they have been properly learned. Perhaps the most important of these is, : “Buy assets when they’re cheap (while avoiding what’s deservedly cheap).” In this regard, I’ve attached a chart of asset class valuations for the past several years, produced by one of the proprietary valuation models we’ve developed at PPS Investments. Each coloured line represents an asset class’s degree of expensiveness or cheapness (NB not its return) compared to its own history and compared to a low-risk cash investment.

Relative valuation chart
20% 15% Expensive territory 10% 5%
Annual rate %

0% -5% -10% -15% Attractive territory -20% -25%
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-01

SA Equity

SA Bonds

SA Prop

SA Cash

Intl Equity

Intl Bonds

Intl Cash

It’s immediately apparent that local bonds and listed property seem particularly expensive (the orange and green lines). This explains our continued reluctance to over-expose client investments to these asset classes. It’s also clear that local and international equities are in the aggregate looking enticingly cheap (the red and blue lines). Local equities in particular seem on this simple measure as cheap as they did near the start of the previous market upswing. The caveat about avoiding what’s deservedly cheap must, however, be borne in mind. A very cautious increase of equity exposures, and the careful selection of individual securities, is appropriate as the current deep economic recession runs its course.

For completeness’ sake, I’ve also included the chart of the expensiveness or cheapness of the main sectors of the JSE relative to the All Share Index (the black line). It shows clearly that financial stocks (the lighter orange line) have bounced back from a fantastically cheap

buying opportunity last year, to more neutral valuations. I’m pleased to report that several of our equity managers saw and took advantage of this opportunity. The year-end then saw resources (the red line) looking somewhat attractive after their decline, and industrials (the darker orange line) even looking marginally expensive. Importantly, these graphs show matters in the aggregate. In an asset class or sector which looks expensive, there may of course be individual securities which look quite enticing (and vice versa).

Relative valuation chart

5% Expensive territory 0% Annual rate %


-10% Attractive territory -15%


-25% Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-01


Resi 20

Indi 25

Fini 15

My favourite source of insightful quotations, the Duc Francois de la Rochefoucauld (1613 1680) is on record as saying “The greatest of all gifts is the power to estimate things at their true worth.” In the context of apparently attractive equity valuations, I take that to mean that price should not always be assumed to be an accurate reflection of value. Or as Warren Buffett puts it: “Price is what you pay. Value is what you get.” In the circumstances, our allocating assets to carefully selected and genuinely skilled combinations of managers who know the difference between price and value, will remain crucial to determining long-run investment outcomes for our clients.


Positioning for the future

I wrote in my last letter that the approach of our Investment Policy Committee (IPC) would probably be to “very cautiously increase equity weightings towards our strategic long-run target allocations.” We held a number of IPC meetings last quarter but, thanks to a very cautious re-evaluation of our strategic allocations, and proposed target allocations relative to these, made no allocation changes. In the words of Will Durant: “One of the lessons of history is that nothing is often a good thing to do and always a clever thing to say”, and our clients have benefited from our application of at least the first part of this insight.

Since quarter-end, however, the IPC has approved an increase in local and international equity weightings, with concomitant reductions in local cash and bonds. We continue to have no deliberate exposure to the local listed property market. Importantly, the transitions from current holdings to the new approved allocations are scheduled to take place slowly over the next three month-ends, to be finalised at the earliest by the March quarter-end. This is an expression of our inherently cautious approach at the moment, and is designed to allow us to continue to monitor the appropriateness of our decision in the context of unfolding market and economic developments.

I still believe that it would be myopic to expect an immediate, smooth or sustained recovery in economies or markets. We are, however, mindful of the insidious risk of “reckless

conservatism”. Holding too much in cash and too little in equities, for too long, will not see our clients meet their investment objectives. We have done a lot of analytical work to

establish the optimal long-term holdings of various asset classes required to achieve those client objectives. And given the dictum about buying assets when they’re cheap, we believe that now may be the time to start doing exactly that. The caveat about avoiding what’s deservedly cheap, is where our appointed asset managers come in. We’ve almost

concluded the current round of face-to-face quarterly asset manager performance reviews. Across the board, I am satisfied that we’ve got a superb line-up of genuinely skilled managers who will continue to help us avoid less-than-ideal securities purchases in the months ahead.

While most readers of this letter were no doubt enjoying a well-deserved break over the recent holiday period, I remained at my desk to carefully and quietly think through aspects of the current economic and market environment. Having now, together with our team of

analysts and members of the IPC, made some carefully considered decisions, I look forward to seeing how matters develop. But if at any stage our ongoing analysis suggests that action is required, we will take it. For now, though, I’ll leave you with another relevant pearl from the Duc de la Rochefoucauld: “We should manage our fortunes as we do our health - enjoy it when good, be patient when it is bad, and never apply violent remedies except in an extreme necessity”

24 January 2009

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