Issue Number 2
HERD MENTALITY: Learning at the School of Fish
Facing Your Fears
Recognising Recognising the Risk Risk the
No No Regrets Regrets Drawing Trend lines
ISSUE NUMBER 2
CONTENTS Editors Note The Herd Mentality: Learning at the School of Fish The Herd Mentality: Facing Your Fears Recognising the Risk Top Performers Modeling a Portfolio Understanding Warrants (Part One) No Regrets History of SSFs Portfolio Managers are like Zebras Technical Tip: Trend Lines Astrapak: SPEC BUY Merafe: SPEC BUY What if the US Dollar crashes? Bernake Gone Beserk
2 3 4 5 6 7 7 8 8 9 10 11 12 13 14
remnant, much like ostriches, will bury their heads in the sand, hoping that the danger would have disappeared by they time they re-emerged. Then when those first few brave investors start to return to the markets, the herd will be following behind again. Behavioural finance holds that investment markets are not completely efficient, there are often anomalies. The reason behind those anomalies has mostly to do with the emotions and behaviour of the masses – or group sentiment. This issue discusses the emotions of “fear” and “regret”. Investors do not rationally assimilate all available information, they often blindly follow what they have read, or had whispered to them in hushed tones. Consequently, markets do not behave efficiently. Sir Isaac Newton, who succumbed to the frenzy surrounding the South Sea bubble famously exclaimed: “I can predict the motion of the planets, but not the madness of crowds.”
The theme in this issue is “do not blindly follow the madness of crowds.” Although the advice is written from a South African perspective and with local investors in mind, it transcends our local market and is in fact practically regardless of where you may be trading. Some of our readers have asked for more information on single stock futures (SSF’s), contracts for difference (CFDs) and warrants and we have tried to address this need in this edition as well. I do welcome your feedback, and ask that you let us know what you enjoy about this publication. We have stuck with 14 pages, but hope to expand this in time. Sincerely
Craig Martin Editor Much like a flock of ostriches fleeing in unison, investors will run to one corner and then almost instantaneously change direction and rush through the fog of uncertainty to rapidly translate their paper losses into real losses almost in unison again. The
THE HERD MENTALITY! Learning at the School of Fish! It has long fascinated me how sentiment drives markets, and further to that, how group behaviour influences the stock market. In January and February of this year, investors clamoured over themselves to sell their shares. No buyers could be found anywhere. Weeks later everyone was following each other back into the markets. An understanding of this herd mentality can surely assist in understanding the bulls from the bears. This month’s issue of Science magazine documents an experiment in Cologne, Germany. The purpose of this little experiment is to determine how it is that humans move in herds.
The animal kingdom seems to have the movement of crowds down pat. When a school of fish move though the water, their movements are precise and synchronous. If they need to change direction they do so quickly, with no confusion of collisions. My wife and I were sitting at our favourite spot in Cape Town earlier this week and we were commenting on how beautiful the formation of geese looked. We watched them fly out over the ocean and return without once flying into each other. Certainly no human air show could compare. The Cologne experiment has shed light on the mechanisms that lie behind group behaviour. When I watched the flock of geese in flight there was clearly a leader to the “V-shaped” formation. However, it appeared as though it was not always the same bird in front.
In the animal kingdom, whether one is examining birds, fish or insects, they all move so well together because each individual is making simple decisions based on simple interactions. The magazine, Science Intelligence describes it as a “self-organised system that is as resilient as anything coordinated by even the most brilliant leader.” In 2005, there was a computer simulated experiment that concluded that it takes only 5 percent of informed individuals to steer a group in a certain direction. The Cologne experiment conducted in 2007 was intended to replicate the computer simulated experiment using live subjects. The test was to see whether the “rule of 5 percent” as in fact accurate. Of interest to me, is whether the findings of this experiment can assist us in gaining a better understanding of the movements of markets. The subjects of the experiment received simple instructions. They could move freely around the room (which was 400 x 230 feet), without communicating with anyone in anyway. They should be in constant motion and remain close to their neighbour. The 200 people in this experiment, as it turns out, end up following a similar pattern to many species of fish that are known for swimming in circles, and whose schools tend to form two concentric rings, each rotating in opposite directions. So let us go back to testing the five (5) percent assumption. A handful of subjects (all wearing yellow hats) are given instructions that are unknown to the rest of the subjects. They are to move toward a particular number on the clocklike face painted on the floor of the room. The experiment is originally conducted with just 5 subjects donning the yellow hats. This 5 out of 200 people represents just 2,5%. As you can see from the diagrams over the page, this small group cannot seem to change the pattern, or swing the group in any manner.
When ten members of the group – 5 percent in total – where yellow caps and move toward the same spot, the whole group follows. When ten members of the group – 5 percent in total – where yellow caps and move toward the same spot, the whole group follows Five percent turns out to be the crucial number, as the computer models had suggested.
This imitation of a school of fish is not limited to this experiment. The researchers also conducted an experiment to see how a group of humans react to a scare tactic. Someone plays a predator and the participants are instructed to watch the predator and to stay away from him by at least two arms lengths. The instruction to the predator is to always pursue the nearest prey. The results of the experiment are quite dramatic. The participants separate from the predator it what appears to be perfect unison and then they quickly move back together again as soon as the predator passes. There movement once again seems to resemble a school of fish. In a further experiment in the 200 person group. The scientists create a group of 20 people and give these ones specific instructions to go in a specific direction. They also create another group of 10 people with the exact opposite instructions. Interestingly, in this experiment, the human herd does not react in the way that the computer generated experiments had predicted. As the difference of intentions becomes clear to the group, you find that people alternate from one target to another. The scientists interpret this as possibly meaning that, when the two chosen goals lie close enough to each other, then members of the herd will try them both to find out which one is best.
This experiment confirms what we possible already know, namely that humans tend to follow anyone who appears to have some degree of knowledge. When you disembark from an airplane at an airport that you are unfamiliar with – what do you tend to do? You follow the crowd, as you assume that they are heading in the right direction – to the baggage claims. In my humble opinion, we saw this phenomenon displayed in the market s this year, where so-called experts were leading the market sentiment with statements about financial Armageddon and then converted almost overnight to discussions of “greenshoots” and then to the start of a “bullrun.” We are therefore no different to most species of animals in that we also tune into herd instinct. There is an unwritten rule that we follow those who appear to have some degree of knowledge. However, the facts may be quite different and we may find ourselves to be amongst lemmings heading their way over a cliff on a suicide mission. This brings me back to some of our recent performance on the stock markets. Why have our gold and platinum counters run to the extent that they have – particularly gold? Could it be the herd instinct that is moving our markets or at least certain sectors of our markets, at present?
THE HERD MENTALITY! Facing Your Fears! Birds
do it. Bees do it, and yes, even fish do it. Animals react to herd instinct. However because humans aren’t really driven by instinct, we tend to use the term “herd mentality.” This is simply the idea that the individual members of a herd behave in a similar fashion, for purposes of protection, or conformity. In the animal kingdom, those that stand out as different often get noticed or stand out and so fall capture to a predator. So, it is this concept of fear that causes animals to run in herds and I believe that it is the same emotion that causes human investors and traders to follow the crowd. There are a number of fears that investors and traders face. The one is the fear of loosing out on an opportunity. Gold is running and I am not in gold shares at the moment. Maybe I should have eight or nine percent of my portfolio there, otherwise I am going to outperform. There is the fear of loosing our money. When the markets start to fall back and fear and panic sets in, we behave like animals, and follow the crowd in selling out. We certainly don’t want to be the only ones left holding a falling portfolio. We fear standing out as different. No fund manager will get fired for owning the market. If they perform in line with the market they secure themselves a job. There is also the fear of uncertainty or the unknown. When things become a little hazy, investors run for cover. The truth is that financial markets move on fear and greed – not on economic fundamentals alone. Fear and greed are emotions that are carried in the minds of humans. Herd mentality. The notion that shares are rational does not seem to hold water anymore. So, I am very careful to say that a specific share is undervalued if the market is skittish about the company. The is however an interesting observation that I have made about fear, and this fact can help with your investment strategy.
Research that neuroscientists have developed seem to suggest that herd mentality, on the downside that is, in reaction to panic and fear - is far more powerful than the herd mentality associated with greed - herd mentality on the upside. Fear also paralyses investors and traders. How many times have you simply sat on the sideline and avoided doing anything to solve your financial situation? This is probably a fear of failure that causes this inactivity. An investor fears loosing his money far more than he fears loosing out on an opportunity by being out of a share, or out of the market. How then can we face our fears, and use this information about our emotions and our following of the crowd, to our advantage? Take the scenario of where the market is at present. Think about the investments that you hold. Now ask yourself, in the next year, how much higher do you think your portfolio of shares could move? Now, ask yourself, how much lower could your investments fall in the next year? You should now have a positive percentage return and a negative percentage return. Let’s say that both figures are the same for purposes of illustrating my point. So, let’s say that you believe that your investment portfolio has the potential to rise another 25% over the next 12 months, but it also has the potential to fall by 25% over the next 12 months. What if your shares fall in value by 25%, before they rise in value? Where would you be? Well, every 25% fall in the share price requires a 33,3% rise just to restore your original capital amount. Now, if you were out of this share and it climbed by 50%, you would be disappointed that you sold, but not as disappointed as if you stayed in the share and it had fallen by 50%. That 50% fall means that your share price needs to deliver a 100% return just to get you back to where you were before the fall. How will you handle it if your share only goes up by ten percent? Not as badly as if it dropped by 25%. We tend to cope better with missing out on some upside than we do by taking some heavy downside. My strategy is to therefore only be in long positions where the upside potential percentage return over a given period is twice the potential downside return.
RECOGNISING THE RISK!
leads us to the concept of risk. Generally the higher the upside potential return, the higher the downside potential risk. This isnâ€™t always true, but it is a challenge for investors who are all looking for the highest returns at the lowest risk. If the historic returns can be represented by the tip of an iceberg, then the risk can be represented by the large portion of ice under the surface.
The higher the return, the higher the risk, is generally a fair comment to make. In stock markets we often tend to measure risk by means of volatility. Often the shares that have offered the highest returns, or those that promise the highest returns, are those that are the most volatile. There is nothing wrong with volatility if you understand it. But, if you are like the captain of the Titanic and fail to recognize how this extra risk can affect you, you may well find yourself sinking financially.
Southern Electricity Company (Selco) was clearly the top performer over the month of October 2009. The share price moved from 11cps â€“ mainly on the back of its published results at the end of September 2009, where the company started showing earnings in its income statement. The announcement from Eskom of the possibility of a further 45% hike in tariffs was possibly also good news for this small cap. The two airlines, Comair and 1Time, also showed some good performance over October as did Sentula, who managed a successful rights issue.
MODELING A PORTFOLIO If you currently own a number of shares in different companies, how did you arrive at selecting that basket of companies? Are you well diversified? Is there any portfolio design behind your selection, or will find that most of your investments lie within a certain sector, or certain company size? Traditional portfolio design dictates that you first have a macro-economic view and make specific assumptions about things like gross domestic product growth percentages, inflation, exchange rates, interest rates and the like. With this information, you determine which sectors are likely to out-perform and design a well-balanced portfolio that contains shares of companies in those sectors. The top-down method of modeling a portfolio is undoubtedly the most popular with institutional investors, but private investors often tend to select shares using a bottom-up approach. Institutional managers tend to have the objective of firstly outperforming the market â€“ regardless of whether the market is negative or positive. There second objective is to outperform their peers, and most of their peers are tracking the market anyway. When you purchase a house â€“ you look for the best city, best suburb and then find the best house in that area. However, if you find a real bargain in another suburb, you are likely to still be interested in the prospects and may even reconsider your suburb of choice. Generally, I prefer a bottom-up approach to portfolio design where the very best companies, offering the best value, are short-listed and then selected to ensure that there is sufficient spread across different sectors. Currently, I have a short-list of around 60 shares that I am looking at. I go though this list and try and filter out 12-15 shares that display the best value at the lowest risks. My weighting in each share will be determined by the sector that they fall into. Where possible, it is sometimes also good to have a spread between large-cap, medium-cap and smallcap shares. When small caps underperform, large caps outperform and visa-versa.
UNDERSTANDING WARRANTS Introduction: Part One Warrants are options that
are issued by financial institutions and trade on the JSE. They are currently not as popular as CFDs and SSFs, but they still do have a place for speculators. Warrants can be issued over individual shares or indexes, or commodities. The terminology surrounding warrants, such as calls, puts and strikes sometimes tends to put traders off, but the truth is that they are not difficult instruments to understand. Warrants entitle the holder to buy or sell a specific number of shares in that company at a specific price, at a specific time or during a specific period in the future. Warrants differ from traditional options in that, when exercised, the shares come from the issuing company and not from another investor on the opposite side of the position. Warrants can either be "Calls" or "Puts." Call warrants give the holder the right to buy the underlying share, while a Put warrant gives the holder the right to sell the underlying share. Both these transactions must take place at a predetermined price (called the strike or exercise price) and before a particular date. Like single stock futures (SSFs), warrants are listed on the JSE and trade just like any other share. The price of a warrant is determined by supply and demand and trades freely in the same manner. However there are models that allow one to determine the appropriate value of a warrant. Theoretically the warrant should trade close to this valuation. In fact, the most influential factor determining the warrants price is the underlying share price. Purchasing a warrant is like taking a bet on where the price of the underlying share will be at a future date. If you think that the price is likely to be higher, you will purchase a Call Warrant. If you think the share price will be lower, you will purchase a Put Warrant. A Warrant always has a strike price, or exercise price and a date of that strike. So you are betting that the price will be at or better than the strike price by the strike data. The issue with Warrants is that they cannot be rolledover. They have an expiry date, and this time delay tends to add an extra element of risk to the mix. (This feature will be continued again next month)
No Regret’s Imagine that you and a few friends have purchased a lotto ticket every week for the past six months using the same numbers. To date you have not won a thing, so you decide to take it on yourself to select a new set of numbers. The switching of your numbers does not affect the odds of winning in any way. It does not increase, or decrease the risk of your numbers coming up. But, imagine what would happen should your old set of numbers now come up. Although switching numbers had no real affect on risk, it certainly had an affect on regret. Regret is an emotion that develops after you have made a decision or avoided the making of a decision. So one cannot avoid risk by simply avoiding the making of a decision. However, staying with the status quo is often more pleasing than making a bad call and seeing that your original choice would have turned out better. I strongly believe that a number of investment advisors and portfolio advisors avoiding making changes to the status quo because of the emotion of regret. Deviating from the norm, which may be a benchmark or an index, brings along the element of regret should the decision turn out badly. My solution to the problem is to phase into a decision. For example, if you want to change from a position to Anglo American into BHP Billiton – why sell out of Anglo is one go and purchase Billiton in one go. Why not phase out of one share and into the other over a period of months. The same thinking can apply to any number of other shares. If you are holding MTN, but prefer Vodacom – why do you have to face the possibility of regret by making a bad call? Phase out of MTN over a number of months and into Vodacom over the same period. If you were wrong about your decision, at least you will be pleased that you were not completely out of MTN or Anglo, and if you were right, then at least you would have had some exposure to Billiton and Vodacom. Potential regret does have an impact on your investment decisions. This strategy may be a way to manage this very real emotion.
History of SSF’s Last month we looked at the History of CFD’s, so this month we touch on the history of single stock futures (SSF’s). The first futures market was said to have started in April 1987. RMB (Rand Merchant Bank) managed
effectively acted as the exchange, the market maker and clearing house. In September 1988 the SAFEX (South African Futures Exchange) was born as was SAFCOM (South African Futures Clearing Company). This at least made the function of the exchange and the clearing house separate from the market maker. It took some time for the informal market to become official, as the Financial Markets Control Act only came into being in 1990. So, on the 10th of August 1990 the SAFEX market was officially opened, with 119 trading seats. In October 1992, SAFEX introduced options and futures and the market started to enjoy increasing trade volumes. On 1 July 2001, the JSE purchased SAFEX and this really bolstered the interest in derivatives. Today, options products account for about half of the total volume on Safex and about half of the interest comes from foreign investors and institutions. Futures were initially on indexes, agricultural commodities and popular bonds. Single Stock Futures were developed with the retail or private investor in mind and they allow for a relatively small investment to gain geared exposure to the underlying individual shares.
Portfolio managers are like zebras
A fund manager who doesn’t own most of the
In the spirit of this theme of “herd mentality”, I
the heavyweights, like Anglo, runs. If it falls, as it
have to conclude an article about the herd
has been, at least he can console himself that he
mentality of institutional portfolio managers.
is still part of the herd – earning an average
We alluded to this in the previous article on “No
index and the heavyweights, runs the risk of earning below-average performance, if one of
heavyweights, or follow the market, you are
AngloAmerican – it’s a fairly safe bet, otherwise
unlikely to have any regrets on making the
every portfolio manager in the country would
face the firing line. Wanger goes on to explain that an institutional portfolio manager not only won’t stray from the herd, he doesn’t even want to be on the outskirts of the herd.
If your goal is to match, or beat the market, then I guess you have to hold most of the Top 40 index. Ralph Wagner, a US fund manager, made a good analogy quite a few years back. He said that “zebra’s have the same problem as institutional fund managers.” He said that the zebra seeks the profit of fresh grass, and the portfolio manager seeks the profit of above-average performance. Portfolio Mangers dislike the risk of getting fired, whereas zebra’s try and avoid the risk of getting eaten by lions. So to achieve their goals, they look alike, think alike and stick close together. In other words, they move in herds. A zebra who moves outside the herd, is not confident that he will find the fresh grass on his own, he is also terrified that he will become prey.
“the zebra seeks the profit of fresh grass, and the portfolio manager seeks the profit of above-average performance. “ The optimal strategy is to stay in the centre of the herd at all times. As long as he or she, buys the popular stocks, he feels safe in the middle of the herd. What I find the funniest is that we pay these experts incredible salaries to follow the crowd. Furthermore, we pay financial advisors huge commissions to select a range of funds for us that are managed by zebra’s. They also love to tell us not to worry about the negative performance this year, as our fund has performed in line with market.
“You really can’t get fired for owning Anglo – it’s a fairly safe bet, otherwise every portfolio manager in the country would face the firing line. “
TECHNICAL TIP :Trend lines You
should be able to conduct a technical analysis
from a chart that only contains the closing price of a
This trend line shows that there was a break under the trend line, but it takes most of the low points into account. Up to a certain point, this would have been the trend line, but the share experienced some resistance. As Anglo ran into resistance and technically broke through the old trend line, one would in practise draw both the old and the new trend line, as follows:-
share. What are you analysing? Simply the overall trend of the share, and this is done using a simple trend line. However, drawing a trend line is a bit of an art form. Another purpose in drawing a trend line, is to identify where possible reversals in the trend are likely to occur. The suggestion is that in an uptrend, you should draw the line along the lowest points in the trend. So it is from lowest point, to lowest point, without letting the line cross through prices
The more times a stock touches a specific trend line, the more significant that line becomes. On the old trend line it crossed though at least on three occasions. This would generally confirm it to be a valid trend line.
If you looked at this one year graph of Anglo, you can see the trendline (in red) is clearly up. This is arguably the correct way of drawing the trend, but it is an art form, and as such, some technical
In a downward trend, you would apply the opposite
analysts might prefer to represent the trend as
rule and draw the line along the highs of prices. You
would draw this line from highest point to highest point and preferably also look for at least three points were it crosses, to confirm the trend. As I said twice already, this is not an exact science, but an art form. Next week we will tackle another technical tip â€“ namely moving averages.
ASTRAPAK: SPEC BUY Astrapak
Limited (APK) and its subsidiaries are manufacturers and distributors of an extensive range of plastic packaging products. The group has manufacturing facilities in all major centres of South Africa. The operations are grouped into various business segments and service mainly the food, beverage, personal care, pharmaceutical, agricultural, industrial and retail markets. Fundamental Analysis Astrapak reported a remarkable improvement in earnings for the six months to 31 August 2009, although admittedly this was off a low base for the restated comparable period. Revenue from continuing operations declined by 3.7% to R 1.26 billion (2008 H1: R 1.3 billion), whilst gross profit increased by 11% to R 316 million (2008 H1: R 285 million) on the back of a decrease in direct manufacturing costs due to enhanced efficiencies and group synergies. Profit from operations increased 24% to R 121 million (2008 H1: R 97 million) after allowing for distribution and selling costs, as well as other administration costs which were fairly flat when compared to the previous period. Operating margins increased to 9.6% (2008 H1: 7.5%), which the group believes can be even further improved. The reduction in interest rates, as well as improvements in working capital management resulted in a welcome decrease in financing costs to R 40,5 million. The effective tax rate reduced to a more reasonable 31.3% (2008 H1: 68.8%), with the previous period containing various once off permanent differences. The reduction in the tax charge further contributed to an improvement in after tax earnings. The improvements in operating margins and the decrease in both finance costs and taxation charges contributed towards a remarkable 829% increase in headline earnings from continuing operations to R 55.6 million (2008 H1: R 6 million). HEPS from continuing operations increased 824% to 47.1 cps, while discontinued operations reported a loss. Cash flow for the period was strong with a net cash inflow from operating activities of R 120 million (2008
H1: R 114 million). Net cash balances increased by R50.5 million (2008 H1: R 61.5 million) to bring net cash reserves to R 160.5 million (2008: R 110 million). Disposals of discontinued operations during the current year contributed towards a reduction in net debt, which improved the ratio of interest bearing debt to equity to 34% (2008: 72%). Cash inflows from pending disposals of discontinued operations will be used to further reduce debt. The groupâ€™s improved cash position and reduction in net debt has significantly strengthened the balance sheet during the current period. Prospects Management have adopted a much more focused approach to the group strategy going forward, with the flexibles businesses being disposed of and the focus now being on the more profitable rigid and films packaging divisions. The group believes that it has shown resilience in tough market conditions due its increased market share and its drive to create synergies and improved efficiencies within the group, which management will further pursue in the remainder of the year. Raw material input costs for packaging are impacted by fluctuations in the oil price, which together with electricity costs, need to be monitored and passed on to customers to keep margins intact. Although there are indications that the recession may be coming to an end, both the consumer and the manufacturing sectors are still under pressure and need to show signs of a turnaround before a recovery can be confirmed. The group believes it is well positioned to take advantage of such a recovery. Overall Recommendation The growth in earnings in the current year is largely due to certain once off costs in the comparable period and cost reductions in the current year. It is our view however, that there is a limit by how much costs can be reduced and that future growth will have to come from increased revenues and sales volumes. On a price to book ratio of 1.4 and a price earnings ratio of 8.7, APK appears to offer relative value when compared to its peers such as Nampak (NPK). The group is sure to benefit from any recovery in the manufacturing and consumer sectors and management seems to have a good handle on cost control as well as their target market. However, due to the uncertainty of the medium term outlook and the volatility of the share, we can only recommend it as a SPEC BUY. * Sheldon Barry
MERAFE: SPEC BUY Merafe Resources Ltd (MRF) is an interesting coal and ferrochrome producer. Its main asset is a 20.5% economic interest in a ferrochrome joint venture (JV) with Xstrata. The joint-venture with Sentula is really a non-event for the company at this stage. Fundamental Analysis Cyclical stocks like Merafe are extremely difficult to predict, but in order to develop an investment opinion on the company, one needs to look forward to 2010 and beyond. The truth is that visibility this far ahead is very hazy. It is not only hazy for analysts, but for the company itself.
The group has a 50% holding in Merafe Coal, that has a joint-venture with Sentula Mining. This project has made application for mining rights for the Schoongezicht and Bankfontein properties. Hopefully the licensing for the mining of these properties will take place in September 2009. Expected production is around1,5 million tons per annum. The sale of coal from this development will be to Eskom and for thermal export. However, the fact is that Merafe have not put any value on this project, and if it comes off, whatever is produced will be a bonus to shareholders. Earlier this year, the management of Merafe had to act quickly due to reduced demand. They very smartly, dropped the use of its 20 ferrochrome furnaces to only 3 furnaces. Merafe has advised the market that ferrochrome production for the Xstrata-Merafe Chrome Venture for the first nine months of 2009 would be 47% lower than the same period in 2008 as a result of this suspension of production capacity. This year, the demand for ferrochrome has risen, and the European benchmark price for the fourth quarter has been set at $1,03 per pound. This has necessitated the re-commissioning of several furnaces, and the company indicates that they are running at around 85% capacity, which would imply that around 17 furnaces are operational.
Prospects A large part of the loss in earnings stems from currency, or translation exposure. Merafe will do better when one sees a weaker Rand against the Euro and the US Dollar. The current strong Rand is therefore hurting the company, and the short-term prospects do not look all that good. A strong Rand could potentially shave 30% off what the returns may have been, had the Rand remained at around R9,50-R10 to the US Dollar When we spoke to the CFO of Merafe, Stuart Elliot, he made it clear that the opportunities for 2010 still lie in China and Asia. Around 63% of sales for the first half of the year came out of Asia. The demand for stainless steel is likely to still be there in the first half of 2010. In fact, the company saw increased demand coming out of Asia in September over August 2009. Smelters require substantial amounts of electricity to operate, and the cost of electricity at Merafe represents around 19-20% of their total costs. So this is a concern when Eskom are talking about potentially hiking electricity by 45%. Elliot does not imagine any problems with unreasonable wage demands as the company has not undergone any retrenchments. Elliot makes it very clear that Merafe do not hedge or utilize gearing. They provide a real play on any Rand weakness. If you are inclined to bet on the Rand weakening, then Merafe presents a solid opportunity.
Overall Recommendation Our view is that with the Rand fairly strong, at around R7,50 to the US Dollar, the current value of Merafe cannot be much more than 120-140cps. A weaker Rand will help bolster earnings, as will improved demand for steel in 2010. Merafe still holds a lot of risk and while we give it a SPEC BUY recommendation, it would be only on movements under 140cps. In the short term there may well be some more downside. * Craig Martin
WHAT IF THE US DOLLAR CRASHES? This
is something that has certainly been touted in non-mainstream newsletters for some months now. A newsletter called “Money and Markets” says that “up until the day Lehman Brothers collapsed in September 2008, it took the US Fed 5,012 days (13 years and 8 months) to double the cash currency and reserves in the coffers of U.S. banks. In contrast, after the Lehman Brothers collapse, it took Bernanke's Fed only 112 days to double the size of those reserves. He accelerated the pace of bank reserve expansion by a factor of 45 to 1.”
This action from the Fed has led to a serious oversupply of US Dollars. The question of whether the US Dollar is a bubble ready to burst, has also just made the front cover of Business Week. The US Dollar has fallen on average 15% against highyielding currencies since about March this year. It has fallen a lot more against the ZAR, but that is partly due to a stronger Rand and partly to carry trade consequences. The Dollar can be borrowed at near zero interest rates, and for this reason it has become the fuel for speculation elsewhere in the world. Is it really inconceivable to see the US Dollar at $2 to the Euro? I don’t believe so, in fact, it is looking very feasible at present. In fact, that may be what the US economy actually needs. A weaker Dollar will stimulate tourism and
investment in the USA. US manufacturers would be more competitive. Obviously there are numerous negative consequences too, and so the conspiracy theorists who tout that the purposely driving the Dollar lower, seem to forget that a weak Dollar will play havoc with inflation. Also a weak Dollar makes American citizens poorer because of their reduced purchasing power. Why would any government want to do that to their citizens? The US is already in a deficit of trillions of Dollars. Why make import costs higher? Surely, in the shortterm, a weaker Dollar is worse for America’s balance of payments, especially as the US import a lot. There is no guarantee that a weak Dollar will bolster export or make the US more competitive in practice. It is purely a theory, just like the theory that the Fed is actually strategizing for a weak Dollar. The article in Business Week makes the point that “the Bearish case for the Dollar takes on a life of its own. Selling begets more selling.” Speculators tend to overwhelm any support to prop up the Dollar in the short-term. The lower the Dollar falls the more confidence is lost and the less inclined financial institutions become in propping the Dollar up again. Speculation that the Dollar is heading for a fall can become a self-fulfilling prophecy if traders rush for the exit. Just like one will see a run on bank deposits when a financial institution indicates the possibility of trouble, so too can we expect a run on the Dollar. A weak Dollar would be good for gold, which is already increasing quite nicely, but it will also hurt a lot of resource companies who sell in US Dollars. The dollar's role as a reserve currency is already being challenged in Europe, in Asia, and in the Americas. In fact, at present, major oil producers all over the world are talking about abandoning the dollar as the basis for global oil contracts. If that happens, it would almost assure a further weakening of the US Dollar, as demand would reduce. There is still the view that the best debt solution will be to pay off government debts with ever-cheaper dollars and for this reason, “Washington is declaring a war on the US Dollar.” It is an awesome theory, but I wouldn’t act on this assumption just yet. * Craig Martin
Bernanke gone berserk! Even in the most extreme circumstances of recent history, the Fed never pumped in anything close to this much money in such a short period of time. • Before the turn of the millennium, the Fed scrambled to provide liquidity to U.S. banks to ward off a feared Y2K catastrophe, bumping up bank reserves from $557 billion on October 6, 1999 to $630 billion by January 12, 2000. And at the time, that was considered unprecedented — a $73 billion increase in just three months. In contrast, Mr. Bernanke’s recent money infusion is $1.007 trillion or 14 times more! • Similarly, in the days following the terrorist attacks on the World Trade Center and the Pentagon, the Fed rushed to flood the banks with liquid funds, adding $40 billion in the 14day period between 9/5/01 and 9/19/01. Mr. Bernanke’s recent trillion-dollar flood of money is twenty five times larger. After the Y2K and 9-11 crises had passed, the Fed promptly reversed its money infusions and sopped up the extra liquidity in the banking system. But this time, Mr. Bernanke has done precisely the opposite: Since he doubled the currency and reserves at the nation’s banks with his 112-day money-printing frenzy in late 2008, he has thrown still more money into the pot. With no past historical precedent, no testing, and no clue regarding the likely financial fallout, Mr. Bernanke has invented and deployed more weapons of mass monetary expansion than all prior Fed chairmen combined. The list itself boggles the imagination: Term Discount Window Program, Term Auction Facility, Primary Dealer Credit Facility, Transitional Credit Extensions, Term Securities Lending Facility, ABCP Money Market Fund Liquidity Facility, Commercial Paper Funding Facility, Money Market Investing Funding Facility, Term Asset-Backed Securities Loan Facility, and Term Securities Lending Facility Options Program.
None of these existed earlier. All are new experiments devised in response to the debt crisis. The single biggest new facility is the Fed’s purchases of mortgage-backed securities (MBS). This massive operation began on January 7 of this year with only $10.2 billion. Now, just nine months later, the Fed has bought up a cumulative total of $924.9 billion, the largest money infusion by any central bank into any single market sector of all time. Mr. Bernanke would have you believe that he can carefully control how the banks use all this free money, with an eye toward preventing a sudden bout of inflation. In practice, however, he’s doing nothing of the sort. If the bank lending were mostly to American businesses, it might at least help rebuild the U.S. economy. However, right now, the only big lending we see is to finance a new speculative fever that has swept the globe — the borrowing of cheap dollars to buy high-yield investments. The nation’s money supply is exploding. In August, money in circulation and in checking accounts (M1) expanded at the breakneck speed of 18.6 percent compared to the year earlier. That was … • Three times faster than the average M1 growth rate of the 1970s, which helped create the worst inflation of our era; • Over SIX times faster than the average M1 growth rate during the half century prior to September 2008; and • The single fastest M1 growth rate ever recorded by the Federal Reserve. The Consequences This overabundance of high-powered money flooding into the nation’s banking system and money supply can have only one consequence: To cheapen the value of each dollar you own. The solvency concerns regarding major financial institutions have now been replaced by looming solvency threats to the U.S. government itself. The debt crisis of 2007-2008 has been transformed into the dollar crisis of 2009-2010. Clearly, in this environment, following traditional investment norms with conventional investment vehicles could be dangerous; and evidently, an entirely different approach to investing is now a must. • Martin D. Weiss, Ph.D (Money & Markets)