South Africa, Africa and overseas acquisitions
Africa is the flavour of the month:
> Wal-Mart intends to buy Massmart.
> HSBC intends to acquire 70% of Nedbank.
> A recent survey of 700 of Europe's leading investors shows that over 60% intend to invest in Africa within the next five years.

We wonder how much thought has gone into this, and whether it's mainly an indication of evaporating opportunities in these companies' home markets. When the JSE deregulated in the nineties, many major American and European stockbrokers arrived here fairly promptly with large cheque books, to acquire local stockbrokers. In nearly all cases, it remains unclear who, if anyone, has benefited. As asset managers, it is not clear to us that the standard of sell-side research has improved. Further, the JSE is recognised as the best regulated securities exchange in the world, and that is entirely due it its magnificent, 100% home-grown management.
The history of some recent (partial) acquisitions is checkered. Standard Bank said as much when describing the benefits of its relationship with its Chinese shareholder as "disappointing". We are not aware of anything too thrilling to have arisen from Barclays' stake in ABSA. (In the next English -South African rugby test match, will the greater banking entity inadvertently end up being the sponsor of both teams?). We have observed in these monthly commentaries that in most cases of mergers or acquisitions, much is said about "synergies" (the most over-used word in corporate finance?) for both parties and their shareholders. Old Mutual's acquisition of Skandia does not seem to have amounted to much; far less its misadventures in America. Cross border transactions really are more difficult to implement than the involved parties tend to allow themselves to believe. We have also previously discussed the litany of failures by South African retailers in Australia. We trust that BHP Billiton's planned purchase of Potash in Canada does not become a pyrrhic victory.

Why the fascination with Africa (especially ex-South Africa) now? Has governance improved? Has regulation improved? Have currencies stabilised? Has war and famine vanished? Are water and electricity supplies more assured? We think the answer in all cases is no; hence our suspicion that the voracious appetite has to do with fashion and with diminishing domestic opportunities.

Buzzwords
We have learnt to be wary when an investment theme is crowned with a new name or acronym. All too often, this marks the beginning of the end. To cite just a few examples which have ended in tears: Nifty Fifty, RDP, WC2010 (basically meaning construction shares), Y2K, Asian Tigers and Arctic Tiger. Even though the Asian Tigers had already collapsed by the time the Celtic Tiger came along, the Irish seemed quite pleased with their new moniker. As we stand, the Irish stock exchange is down 76% from its 2007 high.

China
Netcare is in hot water for allegedly procuring kidneys from Brazilians and implanting them into Israelis in its South African hospitals. In China as much as65% of transplanted organs still come from death row prisoners. More from China: "Banks around the world are flocking to China because of its fast-growing economy. But their financial performance there so far isn't pretty. Profits in China for banks based in other countries fell sharply last year. In contrast, Chinese banks posted double-digit percentage gains in after-tax profits. The report underscores the obstacles confronting non-Chinese banks as they try to establish or rev up operations in the world's second-largest economy".

Bond trivia
Bonds had a strong quarter ended September 2010, returning 8.04%. In the nine months year-to-date, the ALBI has returned 14.11%. These seem like great returns, but they don't scratch at the surface of the record books. We discard all bond data prior to late 1989 (due to prescribed assets and monetary policy that was anything but independent). Since then, this period's rolling three month return ranks only 35thout of 247 and the rolling nine months rank only 96thout of 241. Adjusted for inflation, these rankings improve only slightly, to 28thand 72ndrespectively. Nevertheless, we expect near term returns to abate. Over the past number of months we have written about our strong expectation for bonds to beat cash. This has come to pass and is also now likely to abate somewhat.

As substantial holders of BHP Billiton on clients' behalves, we were disenchanted when the now ex Prime Minister of Australia, Kevin Rudd, announced a so-called super tax on mining companies (April 2010 commentary). His disputatious scheme appears to have cost him his job. We suspect that the mining companies played a subtle but powerful role in his departure, as did the incoming Prime Minister, Julia Gillard, who is Australia's first female PM (and first red-haired PM, as she herself chose to highlight, if you'll pardon the pun). Incidentally, two of the three CEOs of the most aggrieved mining companies (Billiton and Exxaro) are South Africans. Ms. Gillard promptly and pragmatically backpedalled on the tax and we can be sure that the end result will be a diluted version of Mr. Rudd's bizarre proposal. It did not help that Mr. Rudd could not actually articulate the definition of a super profit. Hopefully Ms. Gillard will do a better job of the enigmatically re-named Minerals Resource Rent Tax. This may be apocryphal, but we hear that one clever retort to the government's campaign to persuade voters that the proposed tax would benefit them was to point out how voters' pension funds had been considerably harmed by falling share prices as a direct result of the tax. As we write, the recovery in Billiton's share price has so far been disappointingly asymmetrical to its earlier weakness. We maintain our position that it is a great, wellmanaged business, and is demonstrably cheaper than single commodity mining shares such as those of gold and platinum producers.

In June, both Barloworld and Pick 'n Pay, announced long overdue decisions to withdraw from failed and ill-advised forays into offshore markets. The former has announced the sale of its Scandinavian car rental business (Avis) to a management consortium, while the latter announced the sale of its Australian retail operations (Franklins) to Metcash Australia.

In both instances the companies had paid handsomely some years ago to acquire underperforming businesses in sophisticated and well served markets in which management had little or no experience. They join a long and undistinguished list of South African casualties on foreign shores.

As holders of Pick 'n Pay shares, we are encouraged by this development. The price received exceeds the book value of the investment and the roughly R1.4bn proceeds will be used to finance the group's much needed establishment of a distribution centre network and the opening of stores in some of our neighbouring countries. The group operating margin, return on equity and headline earnings will show immediate improvement, while management will be able to devote their undivided attention to the domestic business.

Considering this dismal record, one wonders why the management of Weylandts, a growing unlisted South African furniture manufacturer and retailer that has just announced its intention to enter the Australian market, believes their experience will be different. The odds would appear to be stacked heavily against them.

We are often asked why we believe that the value style of investing will continue to deliver outperformance, given that its methodology and principles are so well known. The reason, we always say, is that most investors, when faced with an hysterical market, don't have the "intestinal fortitude" to follow their heads and be contrarian when the rest of their being demands the comfort of being part of the herd.

One of our founders, Douw Steenekamp, recently had an experience that perfectly illustrates this behavior. During a visit to Toronto, he was taken to visit the CN Tower, which, at 553m high (more than half the height of Table Mountain!) was until recently the tallest free standing structure on the planet. A section of the floor of the observation deck, 342m up, is constructed of glass panels allowing one a breathtaking view of the streets below. While the view was spectacular, the most interesting observation was to see how few people could muster the courage to walk onto the glass section to enjoy an unobstructed view, despite the fact that everyone is informed that the panels are certified as able to withstand the combined weight of 14 hippos.

It is, we believe, this same irrational fear that renders most people incapable of practicing contrarian value investing, despite their awareness of its long-term success.

We recently expanded a methodology that we first devised for examining the relationship between starting equity valuations and subsequent returns. Our interest here is to search for a fundamentally sound indicator (which needs to be mean reverting for statistical reasons) which has reliably foreshadowed subsequent returns of bonds relative to cash. It turns out that the shape of the yield curve fits the bill rather nicely.

Equities returned nearly 8% in March and miserable memories of 2008 are receding rapidly as the market is nearly back at its all time high. Sadly, and in accordance with historical norms, all too many investors hit the panic button near the low levels and moved out of equity markets into low-yielding money and bond markets, thereby locking in losses and foregoing the 74% appreciation in equities since the low point on 20th November 2008. Harry Markowitz's wisdom is not widely heeded.

SARB Governor Gill Marcus surprised the market by cutting the repo rate to 6.50%, its lowest level since 1981, thus tacitly confirming a market suspicion that the Bank has softened its rigid policy of purely targeting inflation, since there was scant justification to cut interest rates on that measure alone. Perhaps the strength of the rand, employment figures, GDP concerns and other issues now also weigh on the MPC. At least the inflation-targeting regime was not abandoned, as the effects of such a rash decision would have raised questions regarding the MPC's credibility.

Our favourite take on the interest rate cut was that 27 of the 28 economists polled got it wrong.

The equity market correctly appreciated Ms Marcus's modest gift. In our humble and frequently fallible view, the bond market misread the implications, as it also strengthened on the news. Presumably conventional thinking was that with a drop at the short end of the yield curve, there was scope for a drop all along the curve (opportunity cost theory). We think that a softer monetary policy implies, ceteris paribus, higher future inflation, which should be countered by higher long bond yields.

Other big news in March was the proposed merger between Momentum and Metropolitan. Some details follow, but meanwhile, three quick observations:

1. When the founders of Orthogonal Investments see promised "synergy" or "cost reduction" or "rationalisation" benefits actually accruing to a financial services merger, we undertake to collectively eat our hats. These banal words are seemingly indoctrinated into investment bankers and other advisers, with little concern for reality. Think back for instance to the megamerger of four banks that created ABSA. There were supposed to be terrific cost savings through headcount reductions, lower advertising expenses, IT savings and so on. Instead there were massive cost overruns in trying to get different computer systems to cooperate, huge new branding expenses and not least, almost insurmountable cultural differences.

2. The press releases enthused abundantly about the likely benefits to both sets of shareholders. Conspicuous by its absence was any mention of possible benefits to customers!

3. On your behalf, we have a holding in RMB Holdings, which controls Momentum through FirstRand. We think we and you will in due course be pleased to have had that management team on our side. There are some circumspective suspicions that this transaction is a first step towards an eventual exit of the founding members of the original RMB. If this transpires, we think you will be rewarded by holding the very same class of shares as those inspirational founders. At worst, they will exit at fair value; more likely, they will unlock further value. A lesson we have learnt over 20 years is to hold the same class of shares as the founders wherever possible, because holders of more liquid classes of shares with a greater market capitalisation but subordinate voting rights tend to come second in corporate activity. Our ability to take exposure through less liquid holding companies (Pikwik and RMBH for PicknPay and FirstRand respectively are current examples) is one benefit of being a boutique.

The year is possibly better characterised by what didn't happen as opposed to what did:
· the world did not enter a 1930's style depression, despite equity markets seemingly priced for this eventuality in late 2008/early 2009;
· not a single South African bank required a bail-out;
· Old Mutual did not go bust despite trading at a 70% discount to its disclosed embedded value in March 2009; and
· the Springboks did not end the year as the best rugby team in the world despite holding the World Cup and Tri- Nations trophies and beating the All Blacks three times in a row, pipped to the post by New Zealand after a dismal performance in Europe.

Mean reversion remains the remarkably powerful reality against the emotional pull of fear and greed. While the All Share Index retreated 23% in 2008 (having plummeted 45% from its highs in that year), 2009 produced a 32% total return (29% excluding dividends) and saw the index soar 56% from the low in March. In US dollar terms, the index rose 70% in 2009. An investor in the index over these eventful two years would be somewhat more grey, possibly somewhat wiser, but in almost exactly the same position as on the last trading day of 2007.

The 29% price return of the All Share Index in 2009 was provided by an 81% re-rating (from a PE of 9.5 to 17.2) combined with an earnings contraction of some 29%. From here, earnings have to grow by 22% just to reach the long run average market PE of about 14x. The fund, at a PE discount of around 31% to the market (PE = 11.8) and a dividend yield comfortably above 3% is well placed to weather any earnings disappointments that may or may not be waiting for us in 2010.

In sharp contrast to the performance of the equity market, our observation in December 2008 that there appeared to be a bubble in the bond markets was borne out by the rather disappointing ALBI return of -1% in 2009, versus a 17% return in 2008. This was despite the steady decline in inflation with CPI ending the year within the Reserve Bank's target range (of 3% to 6%). The November CPI figure of 5.8% was marginally reassuring, though tenuous. Pressure still exists on the upside given an anticipated significant increase in electricity tariffs.

As seen in the equity market, particularly in banks' advances growth, the consumer is still showing considerable strain. Private Sector Credit Extension fell 1.6% year-on-year, a significant deterioration from the previous month and the biggest decline seen in over 40 years. This despite a 450 basis points reduction in interest rates over 2009.

In these commentaries, we have frequently questioned the value of rating agencies' assessments. In July, we were pleased to learn that we are not alone, nor even as earnest about this as some. Calpers, which is the biggest private pension fund in America, announced that it had sued Standard & Poor's, Moody's and Fitch for "wildly inaccurate risk assessments" that were "seriously flawed in conception and incompetently applied". The lawsuit was filed in San Francisco on 9th July 2009. We await the outcome with interest.