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									Managing Alphen Money Asset Sensibly Management

The Alphen Angle is an electronic publication of Alphen Asset Management

21 January 2009

Never underestimate the “Return on Patience” In the long run share prices are driven by a company’s ability to produce consistent growth in earnings. Quality companies are traditionally sound investments, but an investor’s return can be significantly impacted by when you buy the share. Buying a quality company will deliver superior returns relative to inflation over the long run, but the future return is heavily dependent on the price you pay for the company relative to the profits and dividends you will receive for your capital outlay.
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Pick 'n Pay profit per share

Pick 'n Pay share price

Pick 'n Pay Price-to-Earnings ratio

Graph 1 Source: I-Net Bridge

In the graph above, we have used Pick ‘n Pay (PIK) as an example. The yellow line represents the company’s profit per share. The blue line, the share price and the green line the company’s price:earnings (P:E) ratio. The graph shows this data since 1983. Pick ‘n Pay has traditionally been a company with a very strong franchise and stable and consistent growth rate in profits and free cash flow (cash available after capital investments). The company’s P:E ratio is the prevailing rating the market applies relative to the company’s profits, but it is not necessarily the only valuation metric to look at. Nonetheless, a high P:E normally indicates that a company is expensive and a low P:E indicates that the company is cheap.

Managing Money Sensibly

21 January 2009

As mentioned earlier, the rating or P:E that you pay for a company will be the most important determinant of your long term returns and wealth creation. In August 1991 Pick ‘n Pay was trading at R5 per share. The rating of the company, on a 27 price-to-earnings ratio, was expensive relative to its history, and at that point the market was extrapolating the very strong earnings growth of the preceding six years into the future. If you bought Pick ‘n Pay at the prevailing price at that time, your capital return (excluding dividends) today would have been 580% or 11.6% per annum. Subsequent to August 1991 though, the company went through a period where profit growth slowed down dramatically and essentially remained flat for two years. Investors grew skeptical of the company’s ability to sustain its profit history and in August 1992, only 12 months later, Pick ‘n Pay’s share price had fallen dramatically and was trading at R3.33 per share, on an 18 price-to-earnings ratio. If you had bought the stock in August 1992, only 12 months after the profit euphoria, your capital return to date would have been 920% (15.2% per annum). Inflation since August 1991 has averaged 7.2% per annum. Your patience would therefore have rewarded you with an additional 3.6% above inflation, per annum, over a 17 year period (see attached table).

Purchase date Aug-91 Aug-92

Inflation (pa) 7.2% 7.2%

Nominal Return (pa) 11.6% 15.2%

Real Return (pa) 4.4% 8.0%

Table 1 Source: I-Net Bridge (Note: Returns exclude dividends)

This example also illustrates that investors should employ cash into more volatile assets when the share prices of such assets are depressed and sentiment is at points of extreme pessimism. Strong franchises have the ability to survive in depressed economic conditions and often become even stronger under such circumstances, either through better allocation of and access to capital, or as a result of their ability to drive industry consolidation. Given the high profit levels in certain parts of the market, one must be careful of depicting the whole stock market as being cheap as these profitability levels are likely to be trimmed back substantially in the next few years. That said, at current attractive valuations and given the benefit of time, the marginal safety within certain quality businesses is actually relatively high. Investors are therefore unlikely to experience any permanent loss of capital at current levels, in such businesses.
ADRIAN CLAYTON MARK SEYMOUR GREG FLASH SHAUN LE ROUX PHILIPP WÖRZ NEELS VAN SCHAIK MARK CLIFF

Alphen Asset Management
is an authorised Financial services provider

If you have any queries regarding the above commentary please contact Mark Cliff on 021 799 8069 or 083 700 3600 or

PLEASE NOTE: While every effort has been made to ensure that the information contained herein is correct, Alphen Asset Management cannot be held responsible for any errors that may occur. The views of the contributors may not necessarily reflect the house view of Alphen Asset Management. Views and opinions expressed herein may change with market conditions and should not be used in isolation.

Alphen Asset Management is a subsidiary of PSG Fund Management Holdings (Pty) Limited


								
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