Corporate Finance

Lessons from Edcon

September 27th, 2016 by Brian Kantor

The Edcon story – was it a failure of capital structure or of management? Or a bit of both?

Bain and Company, a private equity fund, has thrown in the towel on its involvement with Edcon, a private company that it has owned and controlled since 2007. When it took over, it immediately converted the equity stake it had acquired from Edcon shareholders for some R25bn (with almost no long term debt on the Edcon balance sheet) into additional Edcon debt of some R24bn, with some additional finance of about R5bn provided as loans from its controlling shareholders. It has now reversed this transaction, converting the considerable outstanding debts of Edcon back into equity. Edcon is the owner and manager of Edgars, a leading clothing retailer as well of other retail brands, including CNA and Boardmans.

The 2008 balance sheet reported total Edcon assets of R38.1bn, up from R9.5bn the year before. Much of the these extra assets were created by writing up the intangible assets, including goodwill, that Bain had paid up for and raised Edcon debt against. The cash flow statement for 2008 reports “investments to expand operations: R24.4bn”. This was a euphemism – the cash was patently used to reconstruct the balance sheet, not to expand operations.

More important for the new shareholders than the description in its financial reports, it failed to persuade the SA Revenue Service (SARS) that the extra borrowing was undertaken to produce extra income. As a result, Edcon continued to have to use some of the cash it was generating from operations to pay significant amounts of tax as well as the interest it was committed to paying. In the early period, the 47 weeks to 29 March 2008, it paid cash taxes of R246m. And despite the fact that large ongoing accounting losses that were incurred as interest expenses greatly exceeded trading profits, it continued to deliver cash to SARS at the rate of over R100m per annum. More recently, according to the cash flow statement in the 13 weeks to 26 December 2015, cash taxes paid amounted to R32m.

This appears as a large mistake when Edcon was originally reconstructed. Presumably, had Bain registered a new company to buy out the Edcon assets from its shareholders and this company had then funded the purchase with debt, the interest expense would have been allowed as incurred in the production of income. And the consequent losses could have been carried forward to offset future income and to raise the current value of the company.

Much of this debt was to mature in 2014-15 (a commitment that Edcon was unable to fulfil) as was long apparent and well-reflected in the much diminished market value of its debt that traded on global markets. It will be appreciated that the Edcon financial losses have mostly been incurred by its creditors, not by Bain and Company. The statement of Edcon’s financial position in December 2015 reports a shareholders’ loan of R828m, well down from the more than R5bn recorded in 2008. Clearly Bain and its co-shareholders have walked away with nothing to show for their efforts. The company is by all accounts now worth less than was paid for it in 2008.

In the charts below we convert the 71% of Edcon euro debt it incurred into rands at current exchange rates. In January 2008 a euro cost R11.12. As may be seen, the rand value of this euro debt is now significantly higher than it was in early 2008. But the rand value of this original debt had actually fallen significantly by 2010, providing an opportunity to restructure the debt with profit that apparently was ignored.

And if the burden of this euro debt burden was dragging down the operating performance of the retail operations (denied essential working and other capital, as it has been argued by management) then there was ample opportunity surely to add more equity capital with which to compete with the competition. And the competition has been doing very well, partly at Edcon’s expense, as measured by value of the General Retail Index of the JSE.

We have rebased this index and the retailers’ dividend per share to January 2008. We have also converted these additional rand values into euros at current values. As may be seen, the share market backdrop for clothing retailers and their ilk on the JSE was encouraging, but more so in rands than in euros (until very recently) with its combination of weaker retail share prices and a weaker rand. It seems clear that had Edcon operated in line with its competition, it could have added value for its shareholders and its debt, particularly had it been converted to rand debt (which would have been manageable).


With the agreement of its creditors, who now own all of the shares in Edcon in exchange for cancelling its loans, and with new debt raised of about R6bn, Edcon can continue to operate normally, much to the relief of it managers, workers and landlords. The horrors of business rescue have thus been averted, to the presumed advantage of its creditors and its future prospects. Given that Edcon continues to realise significant trading profits, it makes every sense for it to stay in business to deliver value for its new shareholders. For the third quarter of F2016 Edcon reported a trading profit of R763m and depreciation and amortisation of R248m, making for cash flows from operations of over R1bm for the quarter (though down by 7.7% on Q3 of F2015). Net financing costs of R958m for Q3 F2016 were also reported, 10% higher than Q3 in F2015. Coincidentally the debt on the Edcon balance sheet of F2016 was of about the same rand book value of about R22bn it reported in F2007. Its euro value, as may be seen, is considerably lower.

Bain and its funders clearly failed to realise the prospective gains they envisaged when they geared up the Edcon balance sheet. The potential rewards to the owners of the much reduced equity capital were potentially very large had the company proved able to service its debts. On returning to public company status, the possibly R5bn of equity finance provided might have doubled in value had the market value of the company gained an additional R10bn of value over the 10 years.

To put it another way: had Edcon performed as well as the average general retailer did on the JSE over the period, these gains would have been realised. But the average JSE-listed clothing retailer was not encumbered by nearly as much debt, particularly the 71% of its debt denominated in euros. This appears as the major original strategic error made by Bain to which it never made the adjustment. Combining rand revenues that Edcon would generate, with hard currency debt, represents a highly risky strategy. Perhaps the SA debt market would not have been willing to subscribe the large amount of the extra debt raised. But there was surely always the opportunity to fully hedge the foreign currency risk. But this would have meant paying interest at a South African rather than a euro or dollar rate, a cost that, had it been incurred, may well have (correctly perhaps with hindsight) undermined the investment case for a highly leveraged play on the SA retail market.

The Edcon experience has unfortunately not been able to add to the case for private equity over the public equity alternative in SA, that is to say, to use public money to take a (large) listed company private. The case for private equity is not based on its superior financial structure of more debt and less equity, though clearly the leverage adds greatly to the potential returns for equity holders (assuming all turns out well for the company). Moreover, the conversion of a public company to a private one, through private equity funds, or more or less the same thing, through a management buyout, may not be possible without significant reliance on debt finance. The case for private equity is that the few shareholders with much to gain and lose have every incentive to closely and better manage their stake in the company. They will be very active shareholders with highly concentrated investments, unlike those of the average listed company with wider stakeholders, as opposed to shareholder interests, to serve. The large publicly funded private company represents therefore a very helpful competitive threat to the public company, from which shareholders (including pension funds) the economy and its growth prospects can benefit.

It is thus no accident that the number of companies listed on all the US stock exchanges has declined dramatically over recent years, by between 40% and 60% over the past 25 years according to different estimates, as pension funds and endowments have increased their allocations to alternative investments and especially to private equity funds. Private companies may well, on a balance of full considerations, serve their owners better than public companies.

The competitive threat therefore should be encouraged and not discouraged (including by SARS). The objective of tax policies should be much wider than merely protecting the tax base. Private equity, by adding to the growth potential of an economy and especially adding to the willingness of the system to bear additional risks for the prospect of additional returns, deserves no less or more than equal tax treatment.

For its errors of commission and omission, Bain and the managers it chose for Edcon, were unable to improve its operating performance. How much this equity is now worth is a matter of conjecture that can only be resolved when, as is the intention, these Edcon shares are re-listed on the JSE. The sooner the current Edcon shareholders get to know what their shares are worth, surely the better and the sooner the shares can be listed and so could pass into the hands of perhaps more active investors, the better the company can be expected to perform. 27 September 2016

Monetary Policy

Some hope of an economic revival is in the spring air

September 23rd, 2016 by Brian Kantor

The Reserve Bank, not before time, has changed its tone. It has suggested that the interest rate cycle may have peaked. From the pause in the trend to higher rates we now have talk of a longer pause in interest rate settings. If the exchange rate holds up better than R14 to the US dollar by the next time the Monetary Policy Committee (MPC) meets in November, interest rates may well be on their way down. The Bank’s inflation forecast (if not the year on year change in the CPI, headline inflation itself) will have had time to adjust lower and food price inflation will be in retreat from its extraordinarily elevated 12% plus base. How rapidly this occurs will depend on the rain. Prayers for rain are in order.

If all goes better on the inflation front, the Reserve Bank will be able to focus on something very important to the SA economy over which it does have considerable influence and that is domestic spending and lending. Its interest rate settings do predictably affect the willingness of households and firms to spend more; and the SA economy urgently needs the stimulus of more demand and lower interest rates.

These interest rates however have no predictable influence on the exchange rate, rainfall or on excise and other taxes, including fuel and sugar taxes. Nor do they affect the price of electricity except, perversely, should Eskom persuade Nersa, the regulator, that its higher borrowing and other costs are a good (actually bad) excuse for a higher tariff. Nor, as I would argue, though the MPC would disagree, do higher interest rates influence inflationary expectations for the better and/or wage demands for the better.

Inflation expected (which has remained remarkably stable and consistent around the 6% – the upper band of the inflation target level will follow inflation – not the other way round. Inflation leads and inflation expected follows, as will be further demonstrated should inflation come down because the rand has strengthened and long term interest rates decline relative to US interest rates, meaning less rand weakness expected and hence less inflation expected. This narrowing of the spread between RSA and US benchmark interest rates has been under over the past few days. It is a very helpful development.

With some help from global capital flows, the weather and the politicians (and also the rating agencies) we will see the rand hold up inflation and the inflation forecasts continue to recede. The question then will be how low can interest rates in SA go. I would suggest as low as it takes to get the growth in spending running at a sustainable 3- 4% per annum. The sustainability of such growth will depend upon support from capital inflows and so a stable rand itself. Faster growth itself will be very encouraging not only to capital expenditure by firms and the government – but to global suppliers of capital. Can we dare hope for a virtuous cycle of faster growth with less inflation? A reprise perhaps of 2003-2008, accompanied by much better control of money supply and bank credit?

SA Economy

Help or hinder?

September 21st, 2016 by Brian Kantor

GDP grew in the second quarter, despite very weak spending. Without a recovery in spending the SA economy will continue to struggle. Will the Reserve Bank help or hinder a recovery?

The SA economy, measured by GDP (the real output of goods and services) grew in the second quarter (Q2), at a satisfactory (annual equivalent) rate of 3.3%. In the first quarter (Q1) output had declined at a -1.3% annual rate. Hence the economy avoided a recession – defined conventionally as two successive quarters of negative growth. However an examination of the expenditure side of the economy reveals a much less satisfactory state of economic affairs. Total spending, Gross Domestic Expenditure (GDE) in real terms declined in Q2 by as much as GDP increased, at a -3.3% rate. The difference between GDP and GDE is by definition net exports: the difference between exports that add to domestic output and imports that substitute for domestic output. On a seasonally adjusted basis, export volumes grew very strongly in Q2, while import volumes declined enough to add a net 6.7% to the GDP growth rate.

Final demand makes up a large component of GDE. It aggregates the compensation spending by households and government and the expenditure by government agencies and the private sector on additional capital goods. This aggregate declined (by 0.1%) in Q2 – an improvement on the 2.8% decline estimated in Q1. The further component of GDE is inventories accumulated or run down. In Q2 inventories are estimated to have declined by a real R22.7bn, contributing a large negative (-3.2% p.a) to the GDP growth rate in Q2.

When the spending of households is aggregated with that of privately owned businesses on capital equipment, that is when government spending and investment in inventories are excluded from final demand, we find a similar reluctance of private households and firms to spend more. Private demand for goods and services has been growing at consistently slower rates in recent years appears and now appears to be in retreat, having declined marginally in Q2 2016, not quite keeping up with inflation, defined as the year on year increase in the GDP deflator. The supply of money and bank credit has been growing as slowly as private spending. This is clearly not co-incidental. The growth in spending and credit to fund spending tend to run together.

The performance of the economy in recent years indicates clearly that the increases in interest rates imposed on the economy since January 2014, while they have worked to reduce spending and so the growth in GDE and GDP, have not helped in any significant or predictable way to reduce inflation or inflation expected. Inflation in SA – that leads rather follows inflation expected – has been dominated by shocks in the form of a weaker exchange rate that has driven up the prices of imported goods and a drought that has reduced domestic supplies of food staples and increased dependence on imports. Higher regulated prices and taxes on expenditure have added to the supply side shocks that can drive prices higher – despite weak demand that only to a limited extent has helped to hold back prices. The exchange rate itself has taken its cue, not from interest rates set in Pretoria, but in Washington DC. It is not only the rand but all emerging market currencies that have depreciated as capital flowed to developed, rather than less developed markets, in recent years. Moreover wage rates and prices are determined simultaneously and interdependently in SA. Higher wages have come at the expense of employment opportunities as well as recent profit margins, when final demand is lacking and the firms lack a degree of pricing power.

The reality that the Reserve Bank finds so hard to recognize is that scope for an independent monetary policy to control inflation is very limited if the domestic authorities do not have any consistent influence over the exchange rate. This has been the case for South Africa as it is for most emerging market central banks with flexible exchange rates that respond to highly unpredictable capital flows. The figures below demonstrate that the common global rather than SA forces that have been responsible for almost all of the weak rand and the higher prices that have come with it. The EM Currency basket represents nine equally weighted emerging market currencies (The Russian ruble, Indian rupee, Hungarian forint, Mexican, Chilean and Philippine pesos, Turkish lira, Brazilian real and Malaysian ringgit). Though it must be added, the rand has been a distinct underperformer since 2012 – losing about 20% more than the EM basket Vs the US dollar. The current value of the rand is now (20 September) a little ahead of where it would be predicted to be – given the exchange value of the EM basket as its predictor – and so also taking into account the weaker bias against the rand.

The Reserve Bank, through its unhelpful interest rate and money supply actions, has significantly influenced the growth in spending. Higher interest rates may have reduced measured GDP growth by as much as 2% p.a. The limited feedback loop from interest rates to spending and so on to inflation has been dominated by the independence of SA interest rates and other highly unpredictable forces acting on the exchange rate and administered prices. The hope for a cyclical recovery of the SA economy and the lower interest rates that will be necessary to the purpose, rests on a degree of rand stability that will accompany a revival of capital flows into EM markets and currencies. A normal harvest will also help to hold down inflation in 2017.

It will take lower interest rates to encourage the demand for and supply of bank credit. It will take lower inflation and inflation expected to encourage the Reserve Bank to lower short term rates. It would seem self-evident, given the want of demand for goods and services and for the labour to help produce them, that the direction of SA interest rates should be downward rather than upward.

The highly competitive weak rand – now some 30% below its purchasing power equivalent value (see below) will continue to encourage exports (labour relations permitting) and discourage imports and may help sustain GDP, as it did in Q2 2016. However, given the importance of household spending for the economy, accounting as it does for over 60% of all spending and given also the further dependence of capital expenditure by private companies on the demands households make on their established capacity, any consistent recovery in the SA and the weak economy – will require the stimulus of lower interest rates. We can hope that a stable or better, a stronger rand and less inflation, makes this possible. We can also hope for a more realistic and helpful narrative from the Reserve Bank that recognises that interest rates influence growth much more than inflation and that maintaining growth rates is a highly appropriate objective for monetary policy – especially when controlling inflation is not within its control. 20 September 2016


Corporate Finance

The paradox of competition

September 19th, 2016 by Brian Kantor

The paradox of competition. You can lose because you have won the game.

When portfolio managers and active investors value a company, they are bound to seek out companies’ advantages that can keep actual and potential competitors at bay. Moreover, they seek companies with long lasting, hopefully more or less permanent, advantages over the ever likely completion, advantages that will not “fade away”, in the face of inevitable competitors.

The talk may be of companies protected by moats, preferably moats that surround an impregnable castle filled with crocodiles that keep out the potential invaders, that is the competition. Reference may be made to protection provided by loyalty to brands that translate into good operating profit margins; or to intellectual property that is difficult for the competitors to replicate and reduce pricing power. It’s a search for companies that generate a flow of ideas that lead to constant innovation of production methods and of products and services valued by customers; and those with good ideas that will receive strong encouragement from large budgets devoted to research and development that can help sustain market leading capabilities through consistent innovation that keeps competitors at bay.

Such advantages for shareholders will be revealed in persistently good returns on the capital provided by shareholders and invested by the team of managers – managers who are well selected and properly incentivised, and also well-governed by a strong board of directors, including executive directors with well aligned financial interests in the firm. Furthermore, the best growth companies will have lots of “runway” – that is a long pipeline of projects in which to successfully invest additional capital that will be generated largely through cash retained by the profitable company. By good returns on capital is meant returns on capital invested by the firm (internal rates of return: cash out compared to cash in) that can be confidently predicted to consistently exceed the returns required of similarly risky shares available on the share market, that is market beating returns.

Such companies that are expected to perform outstandingly well for long, naturally command very high values. Their high rates of profitability – high expected (internal) rates of return on the shareholder capital invested – will command great appreciation in the share market. High share prices will convert high internal rates of return on capital invested into something like expected normal or market-related returns. The virtues will be well reflected in the higher price paid for a share of the company. Thus the best firms may not provide exceptional share market returns, unless their excellent capabilities are consistently under appreciated. This is an unlikely state of affairs given the strong incentives active investors and their advisers have to search for and find hidden jewels in the market place.

Such excellent companies – market beating companies for the long run – are therefore highly likely to enjoy a degree of market dominance. Their pricing power and profit margins will be testament to this. In other words, they are companies so competitive that they prove consistently dominant in their market places.

But such market dominance – that has to be continuously maintained in the market place serving their customers better than the competition – has its own downside. It is bound to attract the attention of the competition authorities. The highly successful company – successful because it has a high degree of market dominance – may have to prove that it has not abused such market dominance. The fact that the returns on capital are so consistently high may well be taken as prima facie evidence of abuse that will be hard to refute. It may well be instructed to change business practices that have served the company well because they do not satisfy some theoretical notion of better practice. Such companies have become an obvious target for government action.

Foreign-owned companies that achieve market dominance outside their home markets may be particularly vulnerable to regulation. These interventions are designed perhaps to protect more politically influential but in reality less competitive domestic firms. Hence the actions taken by the European competition authorities against the likes of Google, Facebook and Microsoft who have proved such great servants of European consumers.

And so one of the risk of competitive success is that such success will be penalised by government action. A proper appreciation that market dominance is the happy result of true competition that has proved to be disruptive of established markets, through the innovation of products and methods, would avoid such policy interventions that destroy rather than promote competition.

Market forces and market dominance can be much better left to look after themselves, because innovation is a constant disruptive threat for even the best-managed and dominant firms. These firms will know that dominance may well prove to be temporary and so they will behave accordingly, by serving their customers who always have choices and by so doing satisfying their shareholders. 14 September 2016

SA Financial Markets

The golden question

September 9th, 2016 by Brian Kantor

Gold and gold mining companies – is there a case to be made for including them in portfolios?

Gold mining companies listed on the JSE have been enjoying a golden year. The JSE Gold Mining Index (rand value) has gained over 200% this year (see figure 1 below). This outperformance of gold mining shares has much to do with improved operating results, gold mining specifics, more than with the gold price, though in US dollar terms the gold price has enjoyed something of a recovery in 2016. In figure 3, we show the daily price of gold in US dollars and rands going back to 2006. As may be seen the rand price of gold has risen more or less consistently since 2006 while the gold price rose very strongly and consistently in USD until 2011 where-after it fell back sharply – until the modest recovery of 2016.

We show in figure 3 below how far the performance of the gold miners so lagged behind that of the JSE All Share Index until 2016. The weight of gold shares in the JSE ALSI is now about 3.1% up from 1.45% at the start of 2016. In figures 4 and 5 we compare the performance of the gold miners to other sectors of the JSE. As may be seen, the JSE Industrials have been the outstanding performers over the longer run- but not in 2016. The higher rand price of gold clearly did not translate into higher operating profits in rends or USD. As may be seen investors would have done far better holding gold itself rather than gold shares for much of this period – until very recently.

As may be seen in figure 6 above, the JSE Gold Mining Index has been a distinct underperformer since 2005 – though it outperformed briefly in 2006 and again during the Financial Crisis of 2008-09 and then again, making up for some of the lost ground again this year. R100 invested in the Industrial Index on 1 January 2005 would now be worth over R771; and in the Gold Index about R152; while the R100 invested in the All Share Index would now be worth about R423. The rand price of gold rose by 7.7 times over the same period, gaining as much as the Industrial Index as we have shown in figure 3.

The Gold Index has also been twice as risky as the All Share Index. We show daily price moves in 2016 in 2016 in figure 7 below. When measured by the Standard Deviation of these daily percentage price moves, Gold Mining Shares listed on the JSE have been about twice as risky as the JSE All Share Index in 2016. The JSE All Share Index however has proved only slightly less risky than holding a claim on the rand gold price in 2016. The same pattern holds for much of the period 2005-2016, using daily price movements. On average the JSE Gold Index, on a daily basis, has been about twice as volatile as the All Share Index and the rand gold price. Thus the risk adjusted return expected from the gold mines would have to be significantly higher than that expected from gold itself, or from a well-diversified portfolio of JSE listed shares, to command a place in a risk averse portfolio.

Doing well out of gold shares surely would have demanded exquisite timing – both when to buy and when to sell. It is not a sector to buy and hold stocks for the long term. It is a highly cyclical sector of the market, with no long term growth prospects. And as we have illustrated, investing in gold mines, rather than in gold, is much more than an investment in the gold price. It is an investment in the capability of the mine managers to extract profits and dividends out of gold mines that are the quintessential declining industry.

Gold mines run out of gold as SA gold mines have been doing consistently for many years. Deeper mines are more costly and dangerous to operate and green field expansion is subject to more expensive regulation, to protect the environment as well as miners. All these considerations help make the case for gold over much riskier gold mines, though the stock of gold available to be traded will remain many times annual output over the long run. The market for gold is a stock market rather than a flow market. It is demand for the stock rather than extra supplies that drive the price.

It would appear easier to explain the price of gold than the value of a gold mine. Since gold does not pay interest, the cost of holding gold is an opportunity cost – income from other assets foregone when holding gold. Using US real interest rates – the real yield on a US Inflation Linked Bond of 10 year duration has done very well in explaining the US dollar value of an ounce of gold since 2006. The correlation between the daily level of the gold price and the real interest rates has been as high as a negative (-0.91) (see figures 9 and 10 below). In other words, as the cost of holding gold has gone up or down (as measured by the risk free real interest rate) the gold price in US dollar has moved consistently in the opposite direction. Real interest rates in the US fell consistently between 2005 and 2011 encouraging demand for gold – then increased to a higher level in 2013, where they stabilised until declining again in 2016, providing it would seem, a further boost to the price of gold. These real interest rates reflect the global demand for capital to invest in productive assets. They have been declining because of a global reluctance to undertake real capital expenditure and so to borrow for the purpose. Low real interest rates reflect slow global growth. And so gold has been a good hedge against slow growth, as well as insurance against financial disruption.

Inflation-linked US bonds have provided some protection against the S&P 500 – the daily correlation between the 10 year TIPS yield and the S&P 500 Index was a negative (-0.43) between 2006 and 2016 while the correlation between the S&P and the level of the gold price is a positive, though statistically insignificant (0.18). The correlation of daily moves in the S&P and the TIPS yield is a positive (0.23) and negative (-0.20) between daily changes in the gold price and the S&P. As important, the correlation between daily moves in the gold price and the S&P 500 are close to zero. Gold has been a useful diversifier for the S&P Index.

This past performance suggests that gold can be held in the portfolio as a potentially useful hedge against economic stagnation – stagnation that means low real interest rates – and also as insurance against global financial crises. The case for gold shares is much more difficult to make on the basis of recent performance. The problem with holding gold shares is the difficulty and predictability of turning a higher gold price into higher earnings for shareholders. Shares in gold mining companies comes with operational risks. If the gold miners could resolve these operational issues then gold shares could become a highly leveraged play on the gold price. The share price would then reflect the increased value of gold reserves: gold in the ground as well as gold above it.

Not all gold mines will be alike. The search should be on for gold mines with significant reserves of gold and highly predictable operating costs and taxes and regulations. The more highly automated a gold mine, the better the mine will be in this regard. Gold mines with these characteristics could give highly leveraged returns to changes in the gold price – in both directions – making them more attractive than gold itself for insurance and risk diversification.


Corporate Finance

Taking a bite of the Apple

September 1st, 2016 by Brian Kantor

The European competition authorities have ruled that Apple has wrongly benefitted from a tax deal with Ireland that allowed Apple to avoid almost all company taxes on its sales in Europe, the Middle East and Africa. The €13bn company income tax Apple is estimated to have saved on the taxes has been classified as state aid to industries. Hence illegally and to be refunded to the Irish government in the first instance- plus interest. No doubt other European governments and maybe even South Africa (assuming the Treasury is not otherwise engaged) will be looking to Ireland for their share of the taxes unfairly saved on the Apple income generated in their economies and transferred through their tax haven in Ireland.

The principle that taxes should be levied equally – at the same rate – on all companies generating income within a particular tax jurisdiction seems right. But it is a principle much more honoured in the breach than the observance. The effective rate of tax (taxes actually paid on economic income consistently applied) will vary widely within any jurisdiction, with the full encouragement of their respective governments. The company tax rate may vary from country to country – in Ireland it is a low 12.5% is levied on income that may be defined in very different ways from one tax authority to another from company to company.

A company may benefit from a variety of incentives designed to stimulate economic activity generally and capital expenditure in a particular location, perhaps in an export zone or a depressed region or blighted precincts of a city. They may utilise incentives to employ young workers or to train them. Investment allowances may far exceed the rate at which capital is actually depreciating to encourage capex. And governments may well collaborate in R&D that effectively subsidises the creation of intellectual property. A further important source of tax savings comes from the treatment of interest payments on debt. The more debt, the higher the tax rate, the less tax paid or deferred. And so every company everywhere (not just Apple) manages its own effective tax rate as much as the law allows it to do. It would be letting down its owners (mostly affecting the value of their shares in their retirement plans) if it failed to pay as little tax it can.

But then this raises the issue that Apple has already raised in tis defence as has the US government. How does one value the intellectual property (IP) in an Apple device? And who owns the IP and where are the owners of the IP located? In Europe – at the head office post box in Cork or in California where much of the design and research is undertaken? Operating margins are very large – maybe up to 90% of the sales price in an Apple store. What if Apple California charged all its subsidiaries everywhere heavily for the IP that accounts for the difference between revenues and costs? Profits and income in Europe and Africa could disappear and profits in the US explode given very high US company tax rates. The reason Apple does not or has not run its business this way is obvious enough; it has been able to plan its taxes and cash holdings to save US taxes.

The insoluble problem with taxing companies and determining company income is that company income is not treated as the income of its owners – or as it would be in a business partnership. In a partnership (which can be a limited liability one) all the wages and salaries, interest, rents, dividends or capital gains are treated as income and taxed at the individual income tax rates. Total taxes collected (withheld) by the partnership could easily grow rather than decline given that there would be no company tax to shield. And the value of companies absent taxes would increase greatly, calling for a wealth as well as a capital gains tax on their owners. The problem with company tax is company tax. The world would be better without it.1 September 2016


Corporate Finance

Point of View: PPC and the debt vs equity debate

August 29th, 2016 by Brian Kantor

Is debt cheaper than equity? PPC shareholders will argue otherwise.

That debt is cheaper than equity is one of the conventional wisdoms of financial theory and perhaps practice. It appears to reduce the weighted average cost of capital (WACC). The more interest-bearing debt as an alternative to equity capital used to fund an enterprise, and the higher the company tax rate, the lower the WACC.

Yet while debt may save taxes it is also a much more risky form of capital. Even satisfactory operating profits may prove insufficient to pay a heavy interest bill or, perhaps more important, allow for the rescheduling of debts should they become due at an inconvenient moment. And so what is gained in taxes saved may be off-set (and more) by the risks of default incorporated in the cost of capital (the risk adjusted returns demanded and expected by shareholders) the firm may be required to satisfy.

Hence debt may raise rather than reduce the cost of capital for a firm when the cost of capital is defined correctly, not as the weighted by debt costs of finance, but as the returns required of any company to justify allocating equity and debt capital to it – capital that has many alternative applications. It is a required return understood as an opportunity rather than an interest cost of capital employed – equity capital included – the cost of which does not have a line on any profit and loss statement.

With hindsight the shareholders in PPC would surely have much preferred to have supplied the company with the extra R4bn of equity capital, before the company embarked on its expansion drive outside of SA in 2010, as they have now being called upon to do to pay back debts that unexpectedly came due. And had they, or rather their underwriters (for a 3% fee) not proved willing to add equity capital – the company would have in all likelihood gone under – and much of the R9 per share stake in the company they still owned on 23 August when the plans for a rights issue were concluded, might have been lost. Their losses as shareholders facing the prospect of defaulting on their debts to date have been very large ones, as we show in the figure below, but the R4bn rights issue promises to stop the rot of share value destruction.

The debt crisis for PPC was caused by a sharp credit ratings downgrade by S&P. This allowed the owners of R1.6bn of short term notes issued by PPC to demand immediate repayment of this capital and interest, which they did. Banks were called upon to rescue the company and the rights issue became an expensive condition of their assistance. That the company could make its self so vulnerable to a ratings downgrade, something not under its own control, speaks of very poor debt management, as well as what appears again with hindsight, as too much debt.

Having said that, on the face of it, the company has maintained a large enough gap between its earnings before interest and its interest expenses to sustain itself. In FY2016 these so-called “jaws” are expected to close sharply, on lower sales revenue, though they are expected to widen sharply again in 2017. According to Bloomberg, in FY2015, PPC earnings before interest were R1.660bn and its interest expense R490m, leaving R1.052bn of income after interest. In FY2016, earnings before interest are expected to decline sharply to R751m, the result of lower sales volumes, while interest expenses are expected to fall to R318m, leaving earnings after interest of R507m. Adding depreciation of R393m leaves the company with earnings before interest tax depreciation and amortisation (EBITDA) of R1.144bn in 2016 – just enough to fund about R1.068bn of additional capex. A marked improvement in sales, earnings and cash flows in the years to come has been predicted.

The rights at R4 per additional share were offered on Tuesday 23 August at a large discount of 55.5% to the then share price of R8.99. This discount is of little consequence to the existing shareholders. The cheaper the price of the shares they are issuing to themselves, the more shares they will have the presumed valuable rights to subscribe for or dispose of. Their share of the company is thus not being reduced even though many more PPC shares may be issued. They can choose to maintain their proportionate share of the company, or to be fully compensated for giving up a share by selling their rights to subscribe to others at their market value.

What is of significance to actual or potential shareholders is the amount of the capital being raised. The R4bn capital raised through the issue of 1 billion additional shares (previously 602m) should be compared with the share market value of the company that was but R5.477bn on 24 August 2016. The capital raising exercise is a large one and the success with which this extra capital is utilised will determine the future of the company.

The discount itself makes it very likely that shareholders, established or newly introduced, rather than the underwriters, will sell or take up their rights that will have some attractive positive value. The larger the discount for any given share price, the more valuable will be these rights (all other influences on the share price remaining unchanged – which they are unlikely to do.). These rights will sell for approximately the difference between the R4 subscription price and the value of the shares to which the rights are attached, between 2 September and until the rights vest on 16 September. The higher or lower the PPC share price between now and then, the more or less will be the value of the right to subscribe at R4, though such rights can only be traded after 2 September, when the share price will fall to reflect the larger number of shares to be issued.

The circular accompanying the Final Terms of the Rights Issue refers to a theoretical value of the shares once they begin trading after 16 September as R5.92 per share, that is given the share price on the day of the announcement, of R8.99. A better description of this theoretical value would be to describe it as the break-even price of the shares. This is the price that would enable shareholders or underwriters to recover the additional R4bn they will have invested in the company when the shares trade ex-rights. In other words it is the future price for the 1.6 billion shares in issue that would raise the market value of the company by an extra R4bn. equivalent to the extra capital raised – or from the R5.66bn it was worth on 23 August to R9.66bn.

Since the additional R4bn raised by the company is assured by the underwriters, the question the shareholders will have to ask themselves is whether or not the extra capital they subscribe to at R4 per share will come to be worth more than R4 per share plus an extra – say 15% p.a. – in the years to come. 15% is the sum of the risk free rate, the return on a RSA 10 year bond of about 9% plus an assumed equity risk premium of 6% p.a., being the returns they could expect from an alternatively risky investment. If the answer is a positive one, they should take up their rights, and if not they should sell their rights to others who think differently. Though any reluctance to take up the rights will reduce their value.

Until the rights offer closes on Friday 16 September and until shareholders have made up their minds to follow their rights or sell them, the target they will be aiming at (for their proportionate share of an extra R4bn of value) will be a moving one, as the PPC share price changes and as both the shares and the rights trade between 2 September and 19 September 2016. The higher (lower) the share price between now and then the higher (lower) will be this break even share price1. The PPC share price closed on Friday 26 August at R8.75, reducing the breakeven price from R6 marginally to R5.91 per share.

The value of a PPC share hereafter, initially with and later without rights, will depend on how well its managers are expected deploy the extra capital they will have at their disposal both now and in the future. Reducing the debt of the company by R3bn, as intended, appears necessary to secure the survival of the company. This reduction in debt will reduce its risks of failure and perhaps add value for shareholders by reducing for now the risk-adjusted returns required by shareholders. That is to reduce the discount rate applied to future expected cash flows.

What however will be the most decisive influence on the PPC share price over the next 10 years or more will not be its capital structure (more or less debt to equity) but the return on the capital it realises and is expected to realise. How the capital is raised, be it from lenders, new shareholders or from established shareholders in the form of cash retained, will be of very secondary importance. Unless, that is, the company again fails to manage its debt and equity competently – a surely much less complicated task than managing complex projects. 29 August 2016


1The breakeven price (P2) can be found by solving the following equation P2=(S1*P1)+k))/S2, where S1 is the number of shares in issue before the rights issue (602m) in the case of PPC and S2 the augmented number (1602m) while the additional capital to be raised, k, is R4bn. P1 is the share price before the rights can be exercised (R5.92 on 23 August) change or the share price plus the market value of the right – in the PPC case the right to subscribe to an extra 1.6 shares at R4 a share.

Corporate Finance

Competition policy in SA – in whose interest is it?

August 25th, 2016 by Brian Kantor

Mergers and acquisitions (M&A) are vital ingredients for a well performing economic system. Through M&A, the better-managed firms take care of the weaker performers leading to better use of the economy’s scarce resources. The success of M&A will be measured in the returns on the capital (debt and equity capital) so risked. The shareholders and the managers acting for the acquiring companies must hope for returns above the required risk-adjusted returns set for them in the market place. If they succeed, they will be improving the economy (improving the relationship between inputs and outputs) and adding wealth for their shareholders. There is a clear public interest in successful M&A activity.

But any such agreement reached between the buyer and seller of a whole company (or part of it) has a further hurdle to clear. The government may decide that the planned merger should be disallowed in a different public interest or, if permitted, that it should be made subject to conditions that can make the takeover more expensive and the larger business less successful. Increasingly, this has become the practice of competition policy in SA, especially when the intended acquirer is a large foreign-owned company.

What has been demanded of the foreign acquirer, even when the intended merger is judged to increase, rather than reduce potential competition in the market place, can only be described as a shakedown exercised by the competition authorities. For example, the demands made of Walmart in its takeover of Massmart and, more recently, in similar demands made of AB Inbev in its takeover of SABMiller. These are unpredictably expensive interventions in business relationships that add to the cost and risks of M&A. They will discourage such attempted activity and the ordinarily welcome flows of financial and intellectual capital accompanying M&A initiated offshore. It is perhaps good politics, but very poor business practice that is unhelpful to economic growth.

Perhaps more damaging to the economy and to the owners of businesses are the now usual conditions for approval, which stipulate that employment be guaranteed at pre-merger levels. Such demands must make it harder to realise the cost savings that a merger might otherwise make possible. A competitive economy, actively competing for labour and capital, so as to improve returns on capital and the productivity of labour through M&A, is inconsistent with guaranteed employment. There is a public interest in employing labour most productively and in labour mobility – not in guaranteed employment that benefits a few private interests.

In recent rulings, the Competition Commission has extended its reach further to the boardroom, in effect instructing merger intending managers and owners how to run their operations. To approve the merger of Southern Sun Hotels with listed hotel-owning company Hospitality, it demanded that the latter be managed independently by its own executive team “.. that would not include anyone who is involved in management in any capacity at Southern Sun”. Thus the rights and responsibilities that come with ownership were truncated. It came to a similar recent ruling, for similar reasons, the presumed sharing of presumed confidential information, on African Rainbow Capital’s deal to buy 30% of the shares in ooba — a mortgage originator controlled by SA’s biggest estate agencies.

What the Commission seems unable to recognise is that competition of the kind that most effectively challenges established firms will come from innovation and the application of technology, not from current participants and current practice. A good example of this is the large current and future threat to the pricing and other power of hotel owners and operators in Cape Town that comes from Airbnb, which has a large and growing presence in the Cape Town market.

The competition authorities in SA are in danger of overreach, if not hubris. It would benefit from a better understanding of and more respect for dynamic market forces and be much less inclined to interfere with them. And so would the economy and its growth prospects.


Tough Love

August 22nd, 2016 by Brian Kantor

National Minimum Wage Panel – do your duty and offer tough love and resist the arguments for economic miracles.

The government has (thankfully) decided to kick the National Minimum Wage (NMW) into touch. The hope must be that the panel come to advise that any NMW high enough to make a meaningful difference to the circumstances of the working poor, is a very bad idea. It’s a bad idea because it cannot offer much poverty relief (to those who keep their jobs) without destroying the opportunity for many more in SA, particularly the young and inexperienced and those outside the cities, to find work.

The problem is that even many of those who find work (mostly in the cities), at the lower end of the wage scales, remain poor. The working poor in SA have been defined as those who earn less than R4000 per month. Yet the problem is that most of those with jobs in SA earn much less than this, while a large number of potential workers are unemployed and earn no wage income at all.

According to a comprehensive recent study of the labour market in SA by Arden Finn for the University of the Witwatersrand, 48% of all wage incomes, representing 5m workers, fell below R4000 per month in 2015 and 40% earned  less than R3000 per month, about 2.7m workers out of a total employed of about 13m. The proportion of those employed who fall below R4000 are much higher in the rural areas, higher in agriculture (nearly 90%) and domestic services (95%). In mining, 22% of the work force earned less than R4000 per month in 2015, while in the comparatively well paid and skilled manufacturing sector, about 48% of the work force were estimated to earn less than R4000 per month.

How many would lose their jobs? And how many would hold on to them to receive the promised benefits of higher minimum wages? These are the numbers that would have to be estimated by the panel. They would have to allow for all the other independent forces at work, other than wages, that could favourably or unfavourably influence numbers employed. For those on the panel who believe that SA can repeal the laws of supply and demand for labour and that wages have little to do with what workers are expected to add to business revenues, and so higher minimums can happen without very unhelpful employment effects – there is a question they will have to answer.

If a higher NMW can make such a helpful difference to poverty without serious consequences for the unemployed and their poverty, why not set the NMW ever higher?  If an NMW of R4000 a month is not enough to escape poverty, why not double or treble these minimums? They must surely agree that the number of job losses would increase as the distance between current wages and the intended minimums widened. Agree, that is, that the only way to avoid extra unemployment would be to set the minimums very close to actual minimum wages in the very different locales where they are earned, a symbolic rather than a practical gesture.

The panel could turn to the well-known relationship between employment, employment benefits and output (measured as value added or contribution to GDP) in the formal sector of the SA for evidence that improved employment benefits, for those who keep their jobs, leads to less employment for the rest. GDP has grown consistently while employment has stagnated and the numbers unemployed have risen as the potential work force has grown. Yet the real wage bills have grown more or less in line with real GDP. In other words, the percentage decline in the numbers employed has been less than the percentage increase in employment benefits paid out. Nice work if you can get it and too many South African have not got it. And wages and profits have maintained their share of value added. Firms have adapted well to more expensive labour; the unemployed have not been able to do so. Their interests should be paramount in policy action.

An NMW set well above market related rewards will reinforce such trends. It will not be fair to the non-working poor nor promote economic growth, the only known way to truly relieve poverty and raise wages over time. It is the duty of economists to practice tough love – to recognise the inevitable trade-offs should a NMW be introduced. We can but hope the panel will do its duty and resist politically tempting actions that have predictably disastrous effects. After all, if we knew how to eliminate poverty with a wave of a wand (the NMW is such a wand) we would have done so a long while ago.


Emerging Markets

Explaining the strength in emerging equity markets

August 15th, 2016 by Brian Kantor

This year is proving a very good one for emerging markets (EM) after years of lagging behind the S&P 500 (see figure 1 below).


Capital flows being good for EM equities (and bonds) have also been helpful for EM currencies, including the rand, and so the JSE, while it usually performs in line with the EM when measured in US dollars, has offered well above average EM returns to the offshore investor on the JSE this year (see Figure 2 below). As we have explained in earlier reports, strength in EM equities and bonds has a consistently favourable influence on the exchange value of the rand and most other EM currencies.

The question then arises of why are EM capital markets attracting revived interest from global investors? Is it simply the search for yield in a low yield, low expected return world? Or is there more substance to the switches to EM investors are making in the form of improved economic outcomes and better growth in EM economies and earnings from EM-listed companies to come. We provide some answers below that indicate the substance behind the strength in EM equities, including those listed on the JSE.

The underperformance of EM equities since 2011 has been accompanied- by weak earnings – earnings per share that have lagged well behind those generated by the S&P 500 Index. As may be seen in figure 3, S&P 500 earnings measured in US dollars compared to EM or JSE earnings in early 2010 , are more than 80% ahead, when measured in US dollars. The underperformance of EM equities has been highly consistent with this underperformance, as has the strength of the S&P been consistent with the impressive recovery in S&P earnings.


It should however be noted below in Figure 4 that EM and JSE earnings, having suffered a severe decline in 2015 led by lower commodity prices, appear to have reached a cyclical trough and are now increasing from their low base, while S&P earnings are also now pointing higher, after declining since early 2015. This revival in average earnings must be regarded as helpful for equity valuations generally, especially in a world of very low interest rates. That EM and S&P share prices moves have been highly correlated in 2016 is consistent with a similarly higher trajectory for earnings, especially should recent trends be sustained, as has been indicated.

The similar path of JSE earnings and that of the EM average – of which the JSE contributes only a small part, about 8% – should be recognised. It goes a long way to explain the similar direction of the EM Index and that of the JSE, when measured in US dollars. The JSE behaves as an average EM equity market because JSE earnings compare very well with the EM average. This is because JSE-listed companies, including industrial companies, are highly exposed to the global economy, even more than the SA economy.


In figure 5 below, we compare the average prices investors have been paying for average earnings. As may be seen, investors in the S&P Index have enjoyed a significant increase in the average P/E multiples and seen the Index re-rate when compared to the multiples attached to EM earnings. Such reactions are entirely consistent with impressive past performance, especially when accompanied by low interest rates that surely add to the present value of future earnings or cash flows expected. But the fact that S&P earnings have become expensive by the standards of the past and EM earnings can be acquired significantly cheaper than S&P earnings, will have attracted interest in EM compnaies, especially when the global economic and earnings prospects appear to be improving.


One sign of an improved economic state can be found in the Citibank surprise Index calculated for the 10 largest economies. As we show below in figure 6, the high frequency economic data has become much more encouraging. Expectations are being surprised on the upside. These more positive surprises are clearly helping to lift the equity markets. The economic news has been improving, surprisingly so, and global equity markets are responding accordingly. The strength in equities is well explained by economic fundamentals, especially so when the threat of higher interest rates seems so distant. 15 August 2016


The Rand

The rand is mostly well explained by global forces. Yet SA specific risks have also declined to add further value to the ZAR. Long may these trends persist.

August 11th, 2016 by Brian Kantor


The rand has enjoyed a strong recovery in recent weeks. We say enjoyed advisedly. A strong rand is very helpful to households and their spending. It means less inflation (even deflation of the prices of goods or services with high import content or of those that compete with imports) and so less inflation expected in the prices firms set for their customers. If rand strength or even rand stability can be maintained, lower interest rates will follow to further encourage spending. Households directly account for over 60% of all spending, while spending by firms that supply households on capital equipment and their wage bills will take their cue from household demands. Any hope of a cyclical recovery of the SA economy depends crucially on the now more helpful direction of the rand.

Exporters may see their profit margins contract with a stronger rand. However, crucial for them will be the reasons for rand strength or weakness as the case may be. If the rand appreciates because the global economy is gathering momentum, or is expected to do so, then rand strength may well be accompanied by higher US dollar prices for the metals and minerals they sell on world markets, and vice versa, rand weakness might well be accompanied by or even caused by lower commodity prices. In which case revenues gained via a depreciated rand may well be offset by weaker US dollar prices. As has been the case for much of the past few years. Falling dollar prices for metals and minerals for much of the past few years – other than gold- have accompanied the weaker rand. And to some extent can be held responsible for the weaker rand.

Fig 1; Commodity Price Index (CRB) in USD and in ZAR


It is therefore important to identify the sources of rand weakness or strength. It is important to recognise the difference between global forces and SA-specific events that have driven or can drive the rand weaker or stronger, even though the implications for the state of the SA economy of rand strength or weakness, from whatever cause, global or SA specific, will be similar. The more risky (uncertain) the outlook for the global and SA economies, the weaker the rand and vice versa whatever the sources of more or less risk- be they Global or South African.

However if the cause of rand weakness is SA in origin – attributable to economic policies or expectations of them – those responsible for currency weakness and a consequently weaker economy can be held accountable by the democratic process. Policy makers may lose support, enough to change the direction of policy direction that could add rand strength. The rand strength that has accompanied the local government elections and a politically damaged Presidency are pointing in this direction and have made disruptive interference in SA’s fiscal policy settings less likely. Hence an extra degree of ZAR strength for SA specific reasons.

We offer an analysis that clearly can identify the causes of rand weakness or strength as either global or SA specific. The simple method is to compare the behaviour of the USD/ZAR exchange rate with that of nine other emerging market (EM) currencies that can be expected to be similarly influenced as is the ZAR by global forces. We compare an Index of these USD/EM exchange rates with that of the USD/ZAR exchange rate below (The exchange rates included in the Index are all given the same weight. The Index is made up of the Turkish Lira, Russian Ruble, Hungarian Forint, Brazilian Real, the Mexican, Chilean, Philippine Pesos, Indian Rupee and the Malaysian Ringgit). It may be seen that the weakness of the rand since 2013 has been accompanied by EM currency weakness generally. Much of the rand depreciation of recent years may therefore be attributed to global not SA specific influences on capital flows and exchange rates. It has been an extended period of dollar strength as much as EM weakness. The US dollar has also gathered strength vs the euro and the yen over this period.


Fig.2; The USD/ZAR and the USD/EM Average, 2013-2016 (Daily Data)


Source; Bloomberg and Investec Wealth and Investment


However it has not been only a matter of USD strength. As may be seen below when we compare the performance of the ZAR to the EM basket there have been periods of rand weakness – from January 2013 to September 2014- followed by a period of relative rand strength that turned into significant weakness in late 2015 when president Zuma frightened the market for the rand and RSA’s with his surprise sacking of the then Minister of Finance Nene. As may also be seen the recovery of the rand dates from late May 2016 and has gained significant momentum recently with the outcomes, expected and realized in the Local Government elections of August 3rd 2016. Since the close of trade on Friday 5th August the ZAR has gained 2.6% vs the USD while the nine currency EM average exchange rate is about 0.90% stronger vs the USD.

Fig.3; Performance of the USD/ZAR Vs the USD EM average. (Daily Data; January 2013=1)


Source; Bloomberg and Investec Wealth and Investment

A similar picture emerges when we trace the Credit Default Swaps for RSA dollar denominated debt and high yield EM debt in Fig 4. The CDS spread is equivalent to the difference in the USD yield on an RSA or EM 5 year bond and that of a five year US Treasury Bond. The credit rating of RSA debt in a relative sense can be expressed as the difference between the cost of insuring RSA debt against default Vs the cost of insuring high yield EM debt. The larger the negative spread in favour of RSA’s, the more favourable SA’s credit rating compared to other EM borrowers. As may be seen the RSA rating deteriorated in 2015 and is now enjoying something of an improved rating. Though the credit spreads indicate that there is some way to go before RSA credit attained the relative and absolute standing it had in 2012.

Fig.4; SA and Emerging Market Credit Spreads.


Source; Bloomberg and Investec Wealth and Investment


To take the analysis further we have run a regression equation that explains the USD/ZAR exchange using the USD/EM exchange rate as the single explanatory variable. The fit is a statistically good one as may be seen in figures 5 and 6.  The EM currency basket explains over 90% of the USD/ZAR daily rate on average over the three and a half years. But as may be seen in figure 4, the ZAR was significantly undervalued in late 2015. The predicted value of the USD/ZAR at 2015 year end, given the exchange value of the other EM currencies might have been R14.86 compared to actual exchange rate at that fraught time of R16.62. Or in other words SA specific risks had made the USD almost R2 more expensive than it might have been at the end of 2015.

Fig.5; Value of ZAR compared to EM Basket on 1/1/2016.


Source; Bloomberg and Investec Wealth and Investment

As we show in figure 5 this valuation gap had disappeared by August 5th 2016.  The USD/ZAR exchange rate is now almost exactly where it could have been predicted to be by global forces alone. That is to say the current exchange value of the ZAR is precisely in line with other EM exchange rates.


Fig.6; Value of ZAR compared to EM Basket on 8/8/2016 Daily Data (2013-2016 August)


Source; Bloomberg and Investec Wealth and Investment

The future of the ZAR will, as always, be determined by the mix of global and SA specific forces. At current exchange rates it may be concluded that there is no margin of safety in the exchange value accorded the ZAR. It will gain or lose value from this level with changes in SA risk or with the direction of global capital flows that determine the value of EM currencies, bonds and equities.

The global capital flows acting on the ZAR are well represented by the direction of the EM equity markets. The ZAR and other EM exchange rates will continue to take their cue from flows into and out of EM equity and bond markets. In figures 7 and 8 below we show how sensitive has been the relationship between daily moves in the ZAR and by implication other EM exchange rates, to daily moves in the value of EM equities – represented by the benchmark MSCI EM Index. We show a scatter plot of these daily percentage changes below. This relationship has been particularly close recently as may be seen in the figures below.

Fig 7. Daily % Moves in the MSCI EM Equity Index and the USD/ZAR,  June 1st 2016- August 8th 2016


R=0.75;   R squared =0.56[1]

Source; Bloomberg and Investec Wealth and Investment

Fig 8: Daily % Moves in the EM Currency Index and the USD/ZAR; January 1st 2013 – August 8th,2016


R= 0.72; R squared = 0.52

Source; Bloomberg and Investec Wealth and Investment

A further feature of global equity markets this year has been the highly correlated movements in the S&P Index and EM Indexes including the JSE- when valued in USD. (See figure 9 below) Also notable is the extent to which the JSE, when valued in USD has outperformed other EM equities as well as the S&P tis. This has come after years of EM and JSE underperformance of a similar scale- especially when measured in strong USD.

Fig.9;  Equity Market Trends; USD. Daily Data 2016 (January 2016=100)


Source; Bloomberg and Investec Wealth and Investment

Fig.10; Equity Market Trends. USD.  Daily Data 2013-2016 (January 2016=100)


Source; Bloomberg and Investec Wealth and Investment

These recent trends are a reflection of less rather than more global risk aversion- and so a search for value in equities rather than in the defensive qualities of global consumer facing companies paying predictable and growing dividends. For the sake of the SA economy we can only hope that such trends persist. If they do the opportunity may soon present itself to the Reserve Bank to lower interest rates. It should do so and immediately stop predicting higher interest rates to come. The Treasury moreover should resist the opportunity a rand aided lower petrol and diesel price will give it to raise fuel taxes. A much needed cyclical recovery will take less inflation and lower interest rates. The opportunity a stronger rand may give to lower interest rates and to avoid higher tax rates should not be wasted.

[1] R is the correlation co-efficient. The R squared is for a least squares equation  dLog(ZAR) = c+ dLog(EM) + e

Monetary Policy

Features of the SA monetary system

August 10th, 2016 by Brian Kantor

We continue from our discussion of “helicopter money” (see Point of View: Helicopters in a different form, 1 August 2016) with a description and analysis of the SA monetary system. The Reserve Bank of SA has not practiced quantitative easing. By contrast, SA banks rather than being inundated with cash and excess reserves, have been kept consistently short of cash in support of the interest rate settings of the Reserve Bank. SA banks borrow cash from their central banks rather than hold excess cash reserves with it.

The SA Reserve Bank has not practised quantitative easing (QE). SA banks have not been inundated with cash derived from asset purchases in the securities market as had been the case in the developed world. Rather, SA monetary policy in recent years has practised a pro-cyclical policy with interest rates rising and subdued base money supply growth.

SA banks do not therefore hold reserves in the form of deposits at the central bank in excess of the reserves they were required to hold. As may be seen in the figures below, by contrast with their developed world counterparts, the SA banks are kept short of cash through liquidity absorbing operations by the Reserve Bank and, more importantly, by the SA Treasury.

Also to be noted is the liquidity provided consistently to the banking system by the Reserve Bank in the form of repurchases of assets from them as well as loans against reserve deposits. Rather than holding excess reserves over required cash reserves, the SA banks consistently borrow cash from the Reserve Bank to satisfy their regulated liquidity requirements.

It is these loans to the banking system that give the Reserve Bank full authority over short-term interest rates. The repo rate at which it makes cash available to the banks is the lowest rate in the money market from which all other short term interest rates take their cue. Keeping the banks short of cash ensures that changes in the policy-determined repo rate is made effective in the money market – that is, all other rates will automatically follow the repo rate because the banks are kept short of cash and borrow reserves rather than hold excess cash reserves.

In the US, the Fed pays interest on the deposit reserves banks hold with the Fed. The ECB, by contrast, applies a negative rate to the reserves banks hold with it. In other words, European banks have to pay rather than receive interest on the balances they keep with the ECB.

The cash reserves the banks acquire originate mostly through the balance of payments flows. Notice that the assets of the Reserve Bank are almost entirely foreign assets. Direct holdings of government securities are minimal, as reflected on the Reserve Bank balance sheet. When the balance of payments (BOP) flows are positive, the Reserve Bank adds to its foreign assets and when negative runs them down. The Reserve Bank buys foreign exchange in the currency market from the banks (and credits their deposit accounts with the Reserve Bank accordingly) or sells foreign exchange to them and then draws on their deposit accounts with the Reserve Bank as payment.

And so when the BOP flows are favourable, the Reserve Bank will be adding to its foreign assets and so to the foreign exchange reserves of SA via generally anonymous operations in the foreign exchange market. In so doing it is acting as a residual buyer or seller of foreign exchange and as such will be preventing exchange rate changes from balancing the supply and demand for foreign exchange. In a fully flexible exchange rate no changes in foreign exchange reserves would be observed, only equilibrating movements in exchange rates. The exchange rate will strengthen or weaken to equalise supply and demand for US dollars or other currencies on any one trading day. The Foreign Assets on the Reserve Bank balance sheet have increased consistently over the years. Hence the balance of payments influence on the money base- on the cash reserves of the banks- has been a strongly positive one.

Without intervention in the money market, these purchases of foreign exchange by the Reserve Bank would automatically lead to an equal increase in the cash reserves of the banking system. Their deposits at the Reserve Bank would automatically reflect larger deposit balances as foreign exchange is acquired from them and their clients. This source of cash however has been offset by SA Treasury operations in the money and securities markets.

To sterilise the potential increase in the money base of the system (defined as notes plus Bank Deposits at the central banks less required reserves) the Treasury issues more debt to the capital market. The debt is sold to the banks and their customers – they draw on their deposits to pay for the extra issues of debt – and the Treasury keeps the extra proceeds on its own government deposit account with the Reserve Bank. Provided these extra government deposits are held and not spent by the Treasury – as is the policy intention – the BOP effects on the money base (on bank deposits or reserves) will have been neutralised by increases in government deposits. (The money base only includes bank deposits with the Reserve Bank. Government deposits are not part of the money base.)
It is to be noted in the figure representing Reserve Bank Liabilities, how the Government Deposits with the Reserve Bank have grown as the Foreign Assets of the Reserve Bank have increased – extra liabilities for the Reserve Bank offsetting extra foreign assets held by the Reserve Bank. It is of interest to note that about half of the Treasury deposits at the Reserve Bank are denominated in foreign currencies.


The net effects of recent activity in the money market has meant much slower growth in the money base and the money and bank credit supplies over recent years. This slow growth has been entirely consistent with weak growth in aggregate spending and GDP. Note below how rapidly money and credit grew in the boom years of 2004-2008.


One test of monetary policy is its ability to moderate the amplitude of the business cycle. The strength of the boom between 2005 and 2008 and the subsequent collapse – and the persistently slow growth in money credit and spending after 2011 – indicates that monetary policy in SA has not been notably counter-cyclical. Nor can it claim much success in limiting inflation.

The problem for monetary policy in SA is the independent (of monetary policy settings) role played by the exchange rate in determining prices. Inflation has followed the exchange rate rather than money supply and interest rates. And the exchange rate movements have been dominated by global events- flows into and out of emerging market currencies (of which the rand is one) in response to global risk.

Economic activity picked up when inflation subsided between 2003- 2005, because the exchange value of the rand recovered strongly and because interest rates declined with less inflation. Inflation accelerated in 2008-9 as the exchange rate weakened and remained high with persistent exchange rate weakness. Interest rates were moved higher after 2014 as inflation picked up and the economy slowed down, further weakening demand without appearing to do anything to slow down inflation. These dilemmas for monetary policy will persist if exchange changes remain largely driven by global forces rather than SA interest rates.

An influence on this money multiplier in SA has been changes in the banks’ demands to hold notes in their tills and ATMs. The ratio of notes held by the banks to all notes in circulation fell away sharply after 2000, thus adding to the money multiplier. This ratio has increased more recently, so reducing the money multiplier. The Reserve Bank influenced this demand for notes by the banks by deciding in the early 2000s not to include notes held by the banks qualifying as required cash reserves.

Monetary Policy

Helicopters in a different form

August 1st, 2016 by Brian Kantor

It is not helicopters but old fashioned government spending – funded by debt or cash – that will be called into action to get developed market economies going again.

The notion (metaphor) of helicopter money was first invoked by the foremost monetarist Milton Friedman and revived by Ben Bernanke, later Governor of the US Fed, to indicate how central banks might overcome a theoretical possibility that has in reality become a very real problem for central bankers today. The problem for the central banks of the US, Europe and especially Japan is that the vast quantities of extra money they have created in recent years, quantities of money that would have been unimaginable before the Global Financial Crisis of 2008, have been bottled up in the banks who have held on to the extra cash received rather than used it to make loans that would have helped their economies along.

The cash was received by the banks or their customers from the central banks in exchange for the government and other securities bought from them in the credit markets and directly from the banks themselves. The cash shows up as extra deposits held by the private deposit taking banks with their central banks – the bankers to the banks. It has been a process of money creation described as quantitative easing (QE) that has led to trillions of dollars, euros or other currencies of extra assets held by central banks – matched by an equal growth in their liabilities, mostly to the banking system in the form of extra deposits held with the central bank (see below).

But why did these central banks create the extra cash in such extraordinary magnitude? In the first place in the US it was to rescue the banking and insurance systems from collapse in the face of their losses incurred in the debt markets that led to the failure of a leading bank Lehman that might have brought down the financial system with it. In Europe it was to prevent a meltdown in the market for most European government debt that could have brought down all lenders to government – not only banks but pension funds and insurance companies and their dependents. In Switzerland the cash came from purchases by the central bank of dollars and euros that flooded into the Swiss banking system and would otherwise have driven the Swiss Franc even stronger than it has become. In Japan the extra cash was always designed to offset the recessionary and deflationary forces long plaguing the economy.The original purpose of QE in the US and Europe was to prevent a financial collapse. The second related reason was to fight recession and deflation. Extra money and the lower interest rates accompanying it are meant to encourage extra spending and extra lending to the same purpose. Extra money and lower interest rates usually do this to an economy – stimulate demand. Usually with extra demand comes higher prices and inflation.

The banks receive the extra cash directly from the central bank in exchange for the securities previously held on their own balance sheets or who may receive the extra central bank cash firstly with the deposits made by their clients when banking the proceeds of their own asset sales. Their clients deposit the cheques or, more likely, EFTs issued by the central bank in their private banking accounts and the banks then receive an equivalent credit on their own deposit accounts with the central bank as the cheques on the central bank are cleared or the EFTs’ given electronic effect. And so in this way, through asset purchases by the central bank acting on its own initiative, extra central bank money enters the financial system, a permanent increase that can only be reversed when the central bank sells down the securities it has bought.

The banks have an option to hold the extra cash rather than lend it out to firms or households, who would ordinarily spend the cash so made available. And banks in the US, Japan, England and Europe and Switzerland have done just this in an extreme way. They are holding the extra cash supplied to them by their central banks as additional cash reserves way in excess of the requirement to hold reserves.

The US Money Base shown below is the sum of currency and bank deposits (adjusted for reserve requirements) held with the central bank (see below the US Money Base that has grown in line with excess reserves held by the Fed and the extraordinary growth in the deposits held by Swiss banks with the Swiss National Bank).


And so the call for the imaginary helicopters to bypass the banking system and jettison bundles of cash that people would pick up gratefully and spend on goods and services so reviving a stagnant economy (stagnant for want of enough demand, not for want of potential output and employment that is the usual economic problem).

The helicopters however will have to take a different form. They will have to be ordered by governments and budgeted for in Congresses or Parliaments. Central banks can buy assets in the financial markets and directly from banks. They cannot order up government spending that they can help fund. That is the job of governments who decide how much to spend and how to fund their spending. Governments can fund spending by taxing their citizenry, which means they will have less to spend. This is never very popular with voters. They can fund government spending by genuine borrowing in the market place – competing with other potential borrowers – crowding them out by offering market-related interest rates and other terms to lenders. Or they can fund their expenditure by calling on the central bank for loans that, as a government agency, they cannot easily refuse to do.

In taking up the securities offered to them by the government the central bank credits the deposit accounts of the governments to the same (nominal) value as the debt offered in exchange. Both the assets and deposit liabilities of the central bank then increase by the same sum as the extra debt is bought by the central banks and the government deposit credited. As the government agencies write cheques on their deposit account – or do the EFTs on them – the government deposit runs down and the deposits of the private banks with the central bank run up. In this way, the supply of cash held by the private sector increases, just as it does in the case of QE.

And the private banks and their customers will have the same choice about what to do with the extra cash held on their own balance sheets. Spend more, lend more or pay back debts or hold the extra cash, as they have largely been doing.

But there is an important difference when the money is created to fund extra government spending. Spending by government on goods services or labour or perhaps welfare grants will have increased, so directly adding to aggregate spending. By spending more, the revenues of business suppliers and the incomes of households will have risen with their extra money balances received for their services or benefits. This is why spending by government – funded with extra money is usually highly inflationary – can be highly inflationary as it was in the Weimar Republic of Germany after World War 1 or as it was in Zimbabwe not so long ago or as it is now driving prices higher in Venezuela.

But the current danger in the West is deflation, the result of too little rather than too much spending. Inflation seems very far away, as revealed by the very low or even negative interest rates offered by a number of governments to willing lenders for extended periods of time. For some government issuing debt – at negative interest rates that produces an income for the government – is cheaper than issuing cash that gives only a zero rate of interest.

The continued weakness of developed economies suffering from a lack of demand, despite low interest rates, calls for money and debt and or money creation by governments. The call for less austerity or more government spending relative to taxes collected is being heard in Japan. It is a voice being sounded loud and clear in post Brexit Britain. The Italians are very anxious to use government money to revive their own failed banking system. The Germans with their own particular inflation demons will however resist the idea of central banks directly funding governments, but for how long? Hillary Clinton promises spending on infrastructure. Donald Trump worries about government debt – for now as far as we can tell.

How long can weak economies and very low interest rates and abundant supplies of cash co-exist? It will not take helicopters but unhappy voters to stimulate more government spending, funded with cheap debt or cash. And the voters appear particularly restless on both sides of the Atlantic and, for that matter, the Mediterranean. 1 August 2016

A fuller account of the above discussion can be found here: Money supply and economic activity in South Africa – The relationship updated to 2011

Corporate Finance

Saying farewell to holding companies and hello to low voting shares

July 28th, 2016 by Brian Kantor

Written with the fond memory of the late great Dr. Jos Gerson – a colleague and warm friend who was the complete expert on Corporate Ownership and Control in South Africa. He is missed – especially at a time like this.

For a taste of the earlier work on these issues see on the blog under Research this publication

Shareholders as agents and principals: The case for South Africa’s corporate governance system Journal of Applied Corporate Finance, 1995 8(1)


Saying farewell to holding companies and hello to low voting shares – lessons from the Pick n Pay Holding Company unbundling.

One of the last of the once numerous pure holding companies listed on the JSE, Pick n Pay Holdings Limited (PWK), is no longer with us – to the palpable delight of its shareholders. PWK is a pure holding company because its only asset was a 52.69% shareholding in the operating company, supermarket chain Pick n Pay (PIK), from which it received dividends and paid out almost all of them (after limited expenses) to its own set of shareholders. PWK incurred no debt and acquired no other assets.

Its sole purpose was an important one – at least to its majority shareholder, the Ackerman family, who held over 50% of the shares in PIK and therefore continued to control its destiny with a minority stake in the operating company of 26% (51% of 52% = 26% roughly). These arrangements, sometimes unkindly described as pyramid schemes, enabled founding families of successful listed enterprises in SA (and elsewhere) to attract capital from sources outside the family, without giving up a proportionate degree of voting rights. Family control would be loosened should more than 50% of the listed operating company be publicly owned. But this constraint could be overcome by selling up to 50% to outsiders in a listed holding company with at least a 50% controlling stake in the operating company.

This process of divesting ownership rights without surrendering proportionate control was taken to an entirely legitimate extreme by the Rupert and Herzog families who controlled Remgro. Their concern to maintain control of the operating companies of the large Rembrandt Group led to the formation of four JSE listed holding companies. Top of the listed pyramid was Technical and Industrial Investments Limited with a 60.4% stake in also listed Technical Investment Corporation Limited that held 40.56% of listed Rembrandt Controlling Investments that owned 51. 07% of the listed operating company Rembrandt Group Limited that generated all the earnings and dividends.

Just in case you thought that this did not add up to 50% ownership, the top of the listed pyramid Technical and Industrial Investments Ltd held a further 9.6% of Rembrandt Controlling Investments Ltd. In this way, by inviting outsiders to share ownership in a tier of holding companies, the founding families continued to appoint and control the managers of businesses within the large Rembrandt Group with an ownership stake in it of about 5%. It was not democracy but it was a case of capitalist acts between consenting adults.

Clearly all of the other shareholders in Rembrandt and its holding companies, as those in PIK and PWK, understood fully that by buying shares in the operating or holding companies they would be sharing in the fortunes of the operating company without ever being able to force their collective will on the controlling shareholders. That they were willing to do so was to the great credit of the founding and controlling shareholders. They were trusted by those providing a large majority of the risk capital employed to act in the interest of all shareholders in wealth creation. That the family interests in the operating assets were proportionately small but represented a large proportion of the wealth of the controlling families would be a source of comfort to effectively minority shareholders, in votes if not in claims on dividends or assets.

There are of course simpler ways of separating ownership and control than layers of holding companies. Shares in the operating company with differential voting rights can serve the same function more simply and much less expensively. But these arrangements were until recently effectively prohibited by the listing requirements of the JSE, with the exception of a few grandfathered arrangements such as applied to Naspers with its great majority of non-voting shares. With a change in listing requirements and in SA company law, Rembrandt was able to collapse its pyramids while maintaining control with unlisted B shares and Pick and Pay has broadly, with the enthusiastic approval of its shareholders, followed this example. Family control of PIK is being controlled with family ownership B shares with effectively over 50% of the voting rights in PIK.

The shareholders in PWK who are to receive PIK shares in exchange had every reason to welcome the new arrangements. They, on the announcement of the intention to proceed with the collapsing of PWK and the unbundling of its 52.69% holding of shares in PIK to its shareholders, saw the value of a PWK share increase by over 12% on the day of the announcement.

Shares in PWK, the holding company, had until then always traded at a variable discount to the value of the shares of PWK held in PIK. Or, in other words, the market value of PWK was always less than the market value of the shares it held in PIK. In 1999 this discount was as much as 30%. On 13 June 2016, before the unbundling announcement, the discount was 18.8%. By the close of trade on 14 June it had fallen to 3% after the PWK share price had gained 12.6% on the day while PIK shares lost 2% (see below).

The reasons for this persistent discount, or more particularly why it varied so much over the years, is not immediately obvious. After all PWK was but a clone of PIK. A discount could be justified by the fact that the holding company incurred listing and other expenses as well as perhaps additional STC. Consequently we calculate that PWK shareholders received less by way of dividends than the 52.69% ownership stake in PIK would ordinarily imply. We calculate from the dividend flows paid by the two companies (share price*dividend yield) that PWK received dividends equivalent to roughly 48% of those paid by PIK (see below).
Consequently the dividend yield on a PWK share consistently exceeded that of a PIK share – a lower entry price making up for the lesser flow of dividends (see below).


The value of a PWK share in which control of PIK rested may have been boosted (it was not) by the chance that a takeover bid for control of PIK via PWK might have been offered and accepted. Control of PIK would change with a smaller 50% stake in PWK – a possibility that might have attracted a control premium to a PWK share. I recall Raymond Ackerman announcing that any such change in control premium paid for the controlling stake would be shared by all shareholders, presumably in PIK as well as PWK. If so, there would have been no value to be added holding the effectively high voting rights in PWK rather than in PIK. The premium or possible discount that might be paid for the high voting 26% of PIK held by the family controlling interests in the form of B shares, would presumably not now be subject to formal approval by the full body of shareholders.

For all the variable price discount and the higher dividend yield the total returns holding a PIK share rather than a PWK share were very similar over the years. Though until the unbundling shareholders in PIK reinvesting their dividends in additional PIK shares would have enjoyed marginally higher returns than those in PWK. Though as we show below this total return gap narrowed sharply on the unbundling. A R100 invested in PIK shares in 1990 with dividends reinvested would now be worth R3,463 while the same investment in PWK would have grown to R3,397. Excellent results for long term shareholders have been provided by the managers and controllers of PIK, especially when compared to the returns received from holding the much more diversified shares that make up the JSE All Share Index.


The outcomes for PIK and PWK shareholders have not been as favourable since 2010, as we show below. With recent share price gains, PIK and PWK returns have matched those of the JSE All Share Index but fallen below those provided by Shoprite (SHP) a strong competitor and by the General Retail Index which does not include PIK and SHP. This helps make an important point. For any business to succeed over the long run, it demands that the constant threat and challenges from competition that emerges in ever changing forms be successfully withstood. This makes the owners of any business, however well established, at significant risk of underperforming or even failure. Owners sacrificing potential returns for less risk may have appeal at any stage of the development of a business.

Judged by these outstanding returns with hindsight, it could be concluded that the Ackerman family interests might have been better served by keeping the company private and not inviting outsiders to share in the company’s significant successes over the years.

Hindsight however is not an appropriate vantage point to make investment decisions. Start-ups, as Pick n Pay once was, are always highly risky affairs. Most start-ups will not succeed in the sense that the returns realised for their owner-managers exceed those they could have realised, taking much less risk working for somebody else.

But when a start-up is a proven success, the incentive for the successful owner-manager to reduce the risks to their wealth so concentrated, by effectively investing less in the original enterprise and diversifying their wealth, becomes an ever stronger one. Risks can be reduced by withdrawing cash from the original business through selling a stake in the business or equivalently by withdrawing cash more gradually from the business in dividends, cash that is then invested presumably in a more cautious, more diversified way. The Ackerman family appears to have followed this route.

An alternative approach is that taken by the Rupert and Herzog families and that is to use the successful business that is the original foundation of their wealth to fund a programme that diversifies their business risks – by investing in a variety of listed and unlisted enterprises that remain under firm family control. And to invite outside shareholders to share in the risks and rewards the family is taking with its own wealth.

Both approaches to building and diversifying wealth can clearly succeed despite (or is it because?) of the concentration of control and the differential shareholding voting rights, this may call for. It is a wise financial system that does not stand in the way of such potentially highly value adding arrangements shareholders might make with each other – that shareholders be allowed to trade off any possibility of a hostile takeover for the benefits of sharing in the rewards of great family controlled enterprises, as the Pick n Pay shareholders have just agreed to.

Monetary Policy

The end of higher interest rates is in sight – a different monetary policy narrative is still called for

July 22nd, 2016 by Brian Kantor

The end of the current cycle of rising short term interest rates in SA that began in January 2014 is thankfully in sight.

Given the continued weakness of demand for goods and services, it will take the assumption of a more or less stable rand about current rates of exchange rates to bring inflation and forecasts of inflation in 2017 well below the upper 6% band of the inflation targets. The Reserve Bank model of inflation has reduced its estimate of headline inflation in December 2016 to 7.1%, from its May forecast of 7.3%.

The Bank, which was predicting a gradual decline in headline inflation in 2017, has maintained its central estimate of inflation in December 2017 at 5.5%. It has revised lower its already weak GDP growth forecasts. It is forecasting no growth in 2016 (previously 0.6% p.a) and an anemic 1.1% p.a. GDP growth in 2017 compared to 1.3% p.a estimated previously. Our own exercise in simulating the Reserve Bank forecasting model, using current exchange rates, has generated the following forecasts for headline inflation (see below). The Governor indicated that the Bank’s own forecasts were made with unchanged assumptions about the exchange rate, hence the slightly higher estimates of inflation.


combination of very slow growth with less inflation vitiates any possible argument for higher interest rates for now and hopefully for an extended period of time to come.

Should inflation sustain a downward trend and growth in SA remain well below potential growth, the case for cutting rates to stimulate growth will become irresistible in due course. Food prices off their high levels brought by the drought have already stopped rising (according to the June CPI) and so will help materially to reduce the rate at which prices in general rise next year. The chances have improved for a very helpful inflation and interest rate surprise in the downward direction.

These developments in the currency and capital markets beg a question difficult to answer, given the impossibility of re-winding the economic clock. Did the interest rate increases imposed on a fragile economy do anything at all to hold back inflation?

Given the global forces that have driven the exchange value of the rand and all emerging market currencies weaker, it is not at all obvious that higher interest rates have made the rand more attractive to hold or acquire. Nor will interest increases have done anything at all to have offset the impact of the Zuma intervention in fiscal affairs that made the rand such an underperforming emerging currency and bond market until recently. Indeed, by further slowing down growth, higher interest rates may have discouraged investment in SA and weakened rather than strengthened the rand, while clearly discouraging the credit rating agencies and investors in the RSA bond market, leading to higher long term interest rates.

Recent trends in the rand and other emerging market (EM) currencies are shown below. We show how the rand has made some gains against other EM currencies recently. We also show that after significant weakness in 2015, the rand in 2016 has now gained against the Aussie dollar and gained even further against sterling. The impact of the Zuma intervention in December 2015 and Brexit on the rand is indicated.


What must be conceded is the role of Reserve Bank rhetoric about interest rates – explained as being bound to rise given more inflation and inflation expected. So any reluctance to act on interest rates would have had the Bank accused of being soft on inflation – so undermining its independent inflation-fighting credentials. An essential distinction that needs to be made by the Bank is about the different forces that can drive prices higher. The difference between prices that rise because less is being supplied to the economy, and prices that increase in response to higher levels of demand that run ahead of potential supplies, call for very different monetary policy reactions. It is a vital distinction about inflation that the Reserve Bank very self-consciously has refused to acknowledge.

Inflation in SA has accelerated in recent years mostly because of the supply side shocks to supplies of goods and services and the higher prices that have followed. Exchange rate shocks have caused prices to rise independently of the state of domestic demand, as has the drought that reduced the local supply of essential foodstuffs. These inevitably higher prices have further discouraged demand. Adding higher interest rates to the mixture then depresses demand even further, without seemingly doing much at all to restrain the upward march of the CPI.

What the SA economy deserved and didn’t get from the Reserve Bank was a very different narrative, one that can explain why interest rates do not have to rise irrespective of the forces driving prices higher. That excess demand justifies higher interest rates; reduced supplies do not. And therefore why sacrificing growth, for no less inflation realised, is not good monetary policy. 22 July 2016

Global Financial Markets

The markets after Brexit

July 18th, 2016 by Brian Kantor

Brexit is now seemingly a non-event for the global economy and its financial markets. A move to less quality in financial markets may be under way.

Brexit came as a large shock to the markets – but within two days of extra anxiety and an equity sell off – the Brexit effect came to be almost immediately reversed. Stock markets are now well ahead of where they ended on 24 June and are ahead of levels reached on 30 May. The benchmark MSCI Emerging Market Index on 14 July was 7.5% up on its 30 May level, fully accompanied by the JSE All Share that had lost over 12% per cent of its 30 May value (in US dollars) in the immediate aftermath of Brexit. The key S&P 500 Index has also recovered strongly. A feature of the equity markets in 2016 has been how unusually closely the developed and emerging stock market indexes have been correlated with each other when measured in US dollars (see figure 1 below).


The VIX Index that measures share price volatility on the S&P 500, simultaneously and consistently moved strongly in the opposite direction, while volatility on the JSE measured by the SAVI has remained elevated, consistent with the sideways move in the JSE when measured in rands rather than in US dollars. The volatility of the stronger USD/ZAR exchange rate has remained elevated as has, to a smaller degree, the realised volatility of the USD/EUR (see figures 2 and 3 below).
With renewed strength in emerging market equity and (especially) bond markets, emerging market currencies have shown strength against the US dollar, as we show below. We also show that the rand has performed better than the average emerging market currency, represented as an unweighted average of nine other emerging market currencies, excluding the rand and the Chinese yuan, as well as the Korean won and the Singapore dollar that enjoy a somewhat different status to the representative emerging market. The rand has gained about 10% against the US dollar and about 6% against the emerging market average since 30 May, as may be seen in figure 4.


A more risk-tolerant market place in the aftermath of Brexit has not only been helpful to emerging markets generally, but it has proved particularly helpful to the rand and the market in RSA bonds. As shown below, default risk spreads have receded for emerging market bonds, including RSA US dollar-denominated bonds. Judged by the spread between RSA yields and those of the high risk EM Bond Index, SA’s relative credit rating has improved recently as shown in figure 6.


A further important spread, that between RSA 10 year rand yields and US Treasury 10 year bond yields, has also narrowed as long term interest rates in developed markets and in emerging markets receded in the wake of Brexit. This spread represents the rate at which the rand is expected to weaken against the US dollar over the next 10 years (see figure 7 below).

The fact that most government long term bond yields declined further and immediately in the wake of Brexit – including gilt yields in the UK – indicated that Brexit was not regarded as a financial crisis, but rather as an indicator of slower global growth and less inflation to come. This conclusion was also evident in the decline in inflation-linked bond yields to very low levels.

This decline in the cost of funding government expenditure (especially in the form of negative costs of borrowing for up to 10 years for some governments) can be expected to encourage governments (not only the UK government) to borrow more to spend more and to attempt to reverse the austerity forced on them by the Global Financial Crisis of 2008 and the subsequent Euro bond crises, that were such a particularly expensive burden for European taxpayers. That burden of having to meet ever larger interest rate commitments has become something of a bonanza for European governments, faced as they are with a fractious electorate.

The sense that less austerity is now more firmly in prospect may have led investors to price in less risk when valuing equities. We have argued that a high equity risk premium is reflected in the value of the S&P 500 Index when valuation models that discount S&P earnings and especially dividends with prevailing very low interest rates. Still lower discount rates after Brexit may help explain the higher equity values. A search for yield in emerging bond markets, driving emerging market discount rates lower, may explain why more risky emerging market equities have also added value.

The very recent economic news moreover has been surprisingly good, rather than disappointing. The trends in the US economy have been particularly encouraging. The Citibank Economic Surprise Index for the US has moved significantly higher with the stronger S&P (revealing more data releases ahead of rather than behind consensus forecasts) (See figure 8 below).

The very recent news from China is that stimulus there has been working to stabilise GDP growth rates. Such more positive indicators of global growth will also have helped to modify what was already a high degree of global risk aversion before the UK referendum. Commodity prices, of particular importance for emerging economies and emerging equity markets, have recovered from depressed levels in January and have stabilised recently after Brexit (see figure 9 below).
This strength in emerging markets may be regarded as something of a reversal of the move to quality in equity markets that has so dominated equity market trends in recent years. A marked preference has been exercised for shares with bond-like qualities, revealed in the form of predictably defensive earnings flows, accompanied by relatively low share price volatility. These are qualities more easily found in developed markets but capable of adding to well above average price earnings multiples to favoured companies in emerging markets, including on the JSE. The JSE, by market value, has come to be dominated by relatively few companies with a global rather than a SA economy footprint. And the price-to-earnings ratios of these companies has risen markedly, dragging up the multiples for the JSE as a whole. We have described this class of shares that are well hedged against the rand and SA economy risks, as Global Consumer Plays.Chris Holdsworth in his Q3 Strategy Review for Investec Securities, published on 13 July has identified these trends – a preference for quality in response to lower interest rates that have left the average share price to earnings ratios well behind the elevated few (see figures from Investec Securities below).

Any further move away from quality will be very welcome to emerging market currencies, bonds and equities. It would be very helpful to the exchange value of the rand and the outlook for inflation and interest rates. It would be especially helpful to the SA economy plays that have so lagged the high quality Global Consumer Plays in recent years. Rand strength for global as well as SA-specific reasons could reverse such relative performance. Less quality may come to offer better value should global risk tolerance, even though justifiably elevated, continue to improve as it has done since Brexit.
Global Financial Markets

Making sense of S&P 500 valuations – a dividend perspective

July 15th, 2016 by Brian Kantor

Is the best measure of past performance on the S&P 500 Index earnings or dividends per share? It can make a big difference

Our recent report on S&P 500 earnings per share indicated that, adjusted for very low interest rates, the S&P 500 Index at June month end could not be regarded as optimistically valued, even though earnings had been falling and the ratio of the Index level to trailing earnings was well above average. Since then, the Index has marched on to record levels (helped by still lower long-term interest rates) to support this proposition of a market that was not very optimistic about forward earnings.

The case for regarding the key US equity market as risk averse rather than risk tolerant would be enhanced, should S&P 500 dividends rather than S&P 500 earnings be regarded as a superior measure of how companies have performed for their shareholders in recent years. As we show below, S&P 500 dividends per share have continued to increase even as earnings per share have declined, while the growth in dividends declared has remained strongly positive even as the growth rate has declined (figures 1 and 2 below).

Clearly the average listed US large cap company has been paying out relatively more of the cash it has generated (and borrowed) in dividends – rather than adding to its plant and equipment. The pay-out ratio (that of earnings to dividends) has declined from the over three level in 2011 to less than two times earnings recently (see figure 3). This, presumably, is more of a problem for the economy than for shareholders, especially when interest income has come under such pressure.

When we run a regression model to explain the level of the S&P 500 Index using dividends discounted by long term interest rates, the Index appears as distinctly undervalued for reported dividends on 30 June 2016. This is more undervalued (some 30% undervalued) than in a model using Index earnings as the measure of corporate performance – as demonstrated in our report of Monday 11 July (see figure 4 below).

On the basis of the dividend model, the market has been pricing in a high degree of risk aversion. Or, equivalently, it has been demanding a large equity risk premium to compensate for the perceived risks to earnings and dividend flows (the larger the equity risk premium, the lower must be share prices – other things held the same, that is trailing earnings or dividends and interest rates – to compensate investors for the perceived risks to the market).

The equity risk premium can be defined directly as the difference between the earnings or dividend yield on the Index and long-term interest rates. The larger these differences in yields, the larger the equity risk premium and the lower share prices will be. An undervalued market, as indicated by the negative residual of the dividend model as shown above, where the predicted (fitted) by the model value of the Index is far above the prevailing level of the market, indicates a large equity risk premium. In figure 5 below, we compare the residual of the earnings and dividend models with this equity risk premium. As may be seen, they describe the same facts: a large equity risk premium accompanied by an undervalued market and vice versa.

These equity risk premiums or under-/overvalued markets – relative to past performance, adjusted with prevailing interest rates – may prove justified or unjustified by subsequent performance, reflected by future earnings and dividends declared. Disappointing or surprisingly good earnings and dividends may flow from listed companies. It would appear that despite the record level of the S&P 500 and record levels of dividends, shareholders are currently very cautious rather than optimistic about earnings and dividend prospects.

Their expectations of dividends and earnings to come have become somewhat easier to meet. There is perhaps more safety in the market at current levels than is generally recognised.

SA Economy

Brexit so far – not so bad for the global economy

July 5th, 2016 by Brian Kantor

Having spent the first post Brexit week in London it is hard to exaggerate the disappointment, even foreboding, felt by our colleagues in the London office of Investec. A leap into a world where the known unknowns have multiplied exceedingly is naturally unwelcome to those whose vocation it is to manage risks to wealth in an as well-considered way as possible. Clearly risks to the outcomes in the real economy and the financial markets – particularly in the UK – have become greater than they were and volatility in markets is likely to be exaggerated until a clearer view of what the future may hold for Britain, Europe and the Global economy, of which the share of Britain and Europe is above 20%.

The most obvious unknown is the impact on the UK economy – though the description United Kingdom may well be an exaggeration – with the sharp regional and generational divides of the referendum revealed. The political unknowns seem unlikely to be resolved any time soon as the UK is understandably in no hurry to formally invoke the exit option. An accompanying unknown is who will lead the UK through these negotiations, the outcomes of which, to be decided in Westminster by the legislators not the voters, will surely lead to further appeals to voters by way of a general election or even a further referendum. However, under new rules the next general election will only be called in 2020 – unless a large majority of the MP’s determine otherwise. The Conservative government and no doubt the parliamentary Labour Party, in turmoil over its leader, are clearly not of any mind to go to the country any time soon.

The obvious issue for any updated economic forecast of the UK economy is the degree to which the prevailing uncertainties and the risks associated with them will undermine the confidence business and household decision makers have in their economic prospects. Less confidence will mean less spending, as investment and consumption plans are put on hold and as plan Bs are evolved. It will not take much of a deviation from trend to turn positive GDP growth into stagnation, or worse, recession. But neither the Bank of England under Governor Mark Carney nor the Treasury under George Osborne have waited for the dust to settle. They have reacted with promises of counter measures: lower interest rates and less onerous applications of the requirements of banks to reserve capital, at the expense of lending. But as Carney cautioned correctly – “there are limits to what the Bank of England can do” – if people are determined to tighten their belts in a more uncertain environment. Confidence in the future outlook for revenues and employment benefits is the all-important and fragile foundation of all forward looking economic actions. Decisions made today that are taken not only by firms, but more importantly by households, that account for 70% of all spending in the UK.

Though to be sure it is the revenue to be gained or lost from supplying financial services to Europe and the world (a particular strength of the UK economy) – despite, or is it because of, sterling rather than the euro – that is uppermost in the considerations of the City of London. A square mile that is currently in the throes of a most impressive building boom. It is very hard to count the cranes from my bedroom window overlooking much of the City.

George Osborne, the Chancellor of the Exchequer, was doing his best over the weekend to bolster confidence and enhance spending. The intention to balance the government’s budget by 2020 has been abandoned. Less rather than more austerity is in prospect – understandably so – given the encouragement provided by extraordinarily low borrowing costs. In the midst of a financial crisis the yield on 10 year Gilts dropped well below 1%. Gilts, like almost all other government bonds – including those issued by RSA – were regarded as safer, except by the rating agencies. It becomes much less of a crisis when government debt becomes still cheaper to issue rather, than as is more usually the case in a crisis, when government loans become ever more expensive to raise and austerity in a recession becomes impossible to resist.

Osborne moreover promised more than more government spending. He made the case for a sharply lower corporate tax rate of 15% – close to the 12.5% rate in Ireland – a matter of already deep anguish to Brussels who would much prefer less rather than more fiscal competition in Europe. The UK, with all its other advantages in the form of good commercial law and as a tax haven, could become an even more powerful competitor for corporate head offices.

Escaping the clutches of the Brussels bureaucrats may offer Britain many such opportunities to trade more freely with each other and with the rest of the world, while hopefully negotiating full access to trade with the European community, not only with mutually beneficial low tariffs but – more important – to reduce non-tariff barriers to trade. This is particularly the case in services that have made the European community much less of a free trading zone than it appears to be on the surface.

Clearly the biggest threat to growth to incomes and profits of companies in the UK and everywhere, including in the US, is the rising populist threat to freer trade and globalisation generally that is considered to have left important constituencies behind. The leave vote was surely a protest vote as much as a vote for independence (independence to control the flow of immigrants to the UK, who in fact have proved generally to be a source of faster growth) as well as a response to the income earning opportunities that a fast growing UK economy has provided.

For a South African analyst in London with long experience analysing volatile exchange rates, the one most obvious conclusion to draw is how helpful weaker sterling has been to absorb some of the shocks caused by UK-specific uncertainties. Sterling devalued by about 10% on the Brexit news. The sterling value of the FTSE Index has largely held its own. Shares, particularly those of the global companies very well represented on the FTSE Index, have seen a weaker sterling translate into higher sterling values, particularly when their US dollar values improved with the strong recovery registered in New York last week.

Equities can perform as currency hedges when the currency weakness represents additional country specific rather than global risks. The sterling or rather the UK economy hedges on the FTSE came, as they do on the JSE, from global rather than local economy plays.

On this exchange rate note it is encouraging to note how well the rand, in company with most other emerging currencies and bonds, held up through the Brexit crisis (see below). Some stability in commodity and energy prices were consistent with these developments. The news about the global economy since Brexit has not reflected a state of crisis for the global economy, to which emerging markets are especially vulnerable. So far not so bad.


Corporate Finance

Why companies are saving more and investing less

June 27th, 2016 by Brian Kantor

The global economy is suffering from an unusual problem of too little demand rather than the usual problem of scarcity, ie too little produced and so too little earned. Hence the relative abundance of the global supply of savings over the demand to utilise them, so causing some interest rates in the developed world to become negative and prices to fall (deflation rather than inflation) and growth to slow.

Since much of the savings realised are made by companies in the form of retained earnings and cash (that is earnings augmented by depreciation and amortisation) the question then arises – why are companies saving as much as they are rather than using their cash and borrowing power to demand more plant and equipment that would add helpfully to both current spending and future production?

In the US, where an economic recovery from the recession of 2008-09 has been well under way for a number of years, fixed investment spending (excluding spending on new home and apartments), having recovered strongly, is now in decline and threatens slower GDP growth to come.

It is not coincidental that demand for additional capacity credit by US corporations remains subdued while balance sheets have strengthened. The debts of US non-financial corporations, compared to their market values are proportionately as low as they have been since the 1950s.


With the cash retained by non-financial corporations, the financial assets on their balance sheets have come to command a much higher share of their net worth. The share of financial assets of total assets has grown significantly, from the 30% ratios common before 1970 to the well over 55% today, a ratio reached in the early 2000s and sustained since then and now seemingly increasing further.



The ability of US corporations to save more and build balance sheet strength has been greatly assisted by improved profit margins – now well above rates of profit realised in the fifties. As may be seen these profit margins peaked in 2011 at about a 12 % rate and are now running a little lower, with profit margins running at a still impressive 10% of valued added by non-financial corporations.

The lack of competition from additional capacity has surely helped maintain these profit margins, as well as cash flows and corporate savings. But it does not explain why the typical US corporation has not invested more in real assets nor why they have preferred to return relatively more cash to shareholders in dividends and share buy backs. Even so called growth companies, with ambitious plans to roll out more stores or distribution capacity, seem able and willing to fund their growth and yet also pay back more. They paying back to institutional shareholders (in the form of dividends and buy backs) who themselves are holding record proportions of highly liquid assets in their portfolios.

There is incidentally, no lack of competition between US businesses. Competition is as intense and disruptive as it has ever been. The competition to know your customer better and so be more relevant than the competition in the offerings you can make to them is the essential task facing business managers. And so part of the answer to the reluctance to add to capacity is the fact that capital equipment (hardware supported by software) is so much more productive than before. A dollar of capital equipment utilised today does so much more than it used to – meaning less of it is needed to meet current demands of customers.

It must take higher levels of demand from households and perhaps also governments to stimulate more capital expenditure and less cash retention by the modern business corporation. Capital expenditure typically follows growth in demands by households. Households in the US account for over 70% of all spending. In SA, households’ share of the economy is also all important, at over 60% of spending. It is the growth in household spending that puts pressure on the capacity of firms to satisfy demands and to improve revenues and profit margins doing so. It is the weakness of household spending in the US and even more so in SA that explains much of the reluctance to build physical capacity.

Why are households in the US and SA not spending and borrowing more in ways that would encourage more capex by firms? In SA’s case the answer is perhaps more obvious. Household spending has been strongly discouraged by rising interest rates. Until interest rates reverse direction in SA, it is hard to anticipate a cyclical recovery reinforced by capex.

In the US and SA, what will be essential to faster growth will be the confidence of households in their future income prospects. It is this confidence, much more than changes in interest rates, that is essential to the purpose of economic growth. The role of politics in building or undermining confidence in the future prospects of an economy is all important. Perhaps it is the failure of the politicians (and perhaps also central banks) to build confidence in both households and the firms in their prospects, is the essential reason why spending remains as subdued as it is.

Corporate Finance

How (not) to value a CEO

June 13th, 2016 by Brian Kantor

Alec Hogg in his Daily Insider column of 6 June had the following harsh words for Sasol’s David Constable:

“In the 2015 annual report, Sasol chairman Dr Mandla Gantsho admitted trying to extend CEO David Constable’s five year contract which expires this month. Shareholders should be grateful he wasn’t more persuasive. Together with another Canadian, Anglo’s Cynthia Carroll, Constable ranks as the worst ever CEO appointed by a major South African company.
“Soon after arriving in July 2011, the Canadian aborted Sasol’s long and costly flirtation with China, switching attention into his native North America. In Monday’s trading statement, the company said it will write down billions more on its Montney Shale Gas field, taking the loss on the Canadian investment to a staggering R11.5bn. Worse, the cost of its 40% complete Louisiana chemicals cracker has escalated to $11bn from the $8.9bn shareholders had been told.
“If more salt were needed for those wounds, it is sure to come in the remuneration section of Sasol’s 2016 annual report. Given the way these things are structured, Constable’s R50m a year package is likely to have ratcheted up still further in his final 12 months.”

But is this the right way to measure the value added or lost by shareholders over the tenure of a CEO, by reference to the losses written off or the overruns added in the books of the companies they own a share of?  What matters to shareholders is what happens in their own books; that is in the value of the shares they own. And share prices attempt as best they can to discount the future performance of a company – rather than its past – as written up by the accountants. Shareholders in Sasol will rather be inclined to compare the performance of their shares under Constable’s surveillance with that of others they may have owned. In this regard they may be grateful that Sasol, since 2012, did significantly better than other Resource stocks, but regret that Sasol did significantly worse than the JSE All Share Index.

Shareholders would have been much better off staying away from Resource companies and investing in Industrial and Financial shares, especially after mid-2014. Even the best managed resource and oil companies would not have been able to avoid the damage caused by lower commodity and oil prices – forces over which CEOs cannot be easily held accountable for. In the figure below we show the relationship between the Sasol share price and the price of oil in US dollars. This relationship become much stronger when the US dollar value of a Sasol share is compared to the US dollar price of oil. Quite clearly, the US dollar value of a Sasol share is almost completely always explained by the oil price. This is a force over which the CEO has no influence whatsoever. Incidentally, the relationship between the oil price in rands and the Sasol share price, also measured in rands, is a statistically very weak relationship. It is the dollar price of oil that matters for the Sasol share price – not the rand price – even if much of Sasol’s revenues are derived from selling oil in rands at a dollar equivalent price.


In the figure below we show the results of a statistical exercise where we compare the Sasol share price in US dollars with the share price that would have been predicted using the US dollar price of a barrel of oil as the only explanation, over the period when David Constable was CEO. As may be seen, it was only in 2013-2014, ahead of the subsequent collapse in the oil price, when something other than the spot oil price is seen to significantly influence the US dollar value of a Sasol share. Perhaps the Sasol share price then was reflecting unrequited optimism in still higher oil prices. And when this did not materialise, the usual relationship between the price of oil and the price of Sasol was resumed.


On these considerations it is hard to establish what difference a well paid or indeed even an underpaid CEO can be expected to make to the value of a Sasol given the predominant influence of the price of oil on the share price. Perhaps the major task of a CEO so captured by forces beyond its control is to avoid poorly executed projects designed to increase or even simply maintain the production of Sasol’s oil, gas and chemical output. The selection of good projects and good project management is the essential task of a company like Sasol. Perhaps Sasol, under Constable, can be fairly criticised on such grounds, as Alec Hogg has done.

Time, as always, will tell how well intentioned, designed and executed the Sasol Louisiana cracker project has been. But in the meanwhile, shareholders in Sasol can perhaps exercise a legitimate grievance about the recent performance of the company. Its share price in US dollars has performed significantly worse than that of the two oil majors, Exxon-Mobil and Chevron, that are as highly dependent on the price of oil as is Sasol. Perhaps such measures of relative stock market performance should feature in any discussion of the appropriate remuneration of a CEO.


*The views expressed in this column are those of the author and may not necessarily represent those of Investec Wealth & Investment