The South African Reserve Bank's slow reaction to the May/June fall in the rand and the continuing increase of South Africa's negative trade balance resulted in a 7.7% fall in the rand against the US dollars in September. This compares to a 3.1% fall in the Turkish lira (Turkey's central bank raised interest rates by 4.25% during June/July) and a 1.2% Indonesian rupiah and Brazilian real decline. (For interest sake, the moves since1 January 2006 are: rand -23.6%, lira -10.7%, while the rupiah and the real strengthened by 5.7% and 7.9% respectively.)
The excessive fall in the rand reflects the sudden increase in political uncertainty about South Africa, whether it will continue to follow investor friendly and responsible growth-oriented policies or whether the socialists/populists are gaining ground.
The above is very important in making investment decisions regarding the future. Should South Africa indeed move away from investor-friendly growth policies, we face higher interest rates and a lower growth rate. Hence the period up to the presidential election will be volatile as the rhetoric from Cosatu and the ANC Youth League could drive/keep foreign investors away.
What to do?
A weak rand is not necessarily bad for Banks, but historically a weak rand has a high correlation with periods of relative underperformance. This makes sense: a weak currency implies the country is experiencing net outflows of capital, which must lead to higher interest rates, reduced economic activity and structurally higher bad debt levels.
So, investors will vacillate between the benefits of the World Cup infrastructural spend and escalating political drama in the background. In the short-term, the fall in the rand will spur growth in export-oriented companies but the inflationary impact must result in higher interest rates, this dampening consumer spending.
This brings us back to the Banks and Life Insurers. Valuations are not bad, but the quantum of 2007 earnings growth will depend on how much more interest rates will be raised.
We draw comfort from the fact that an investment in Standard Bank has generated a compound return exceeding 28% since 1982 -a period, which included extreme currency and interest rate volatility. When valuations are attractive, investors must ignore the short-term negativity and focus on the longer term.

The rand declined a further 6% against the $ during June (to R7.12) bringing the decline since 1 January to 13% against the $ and 21% against the Euro (the dollar weakened 7% against the Euro during that period). Comparing this to movements in other currencies is instructive. The Turkish lira was flat during June and declined by 17% against the $ since 1 January while the Brazilian real gained 6% in June (against the $) and was up 7% since 1 January.

It is noticeable that the rand has been one of the weakest currencies this year and currencies with large trade deficits (ie imports > exports) declined the most (also Hungary, New Zealand, etc). Emerging market currencies with strong fundamentals and specifically trade deficits, actually appreciated against the dollar.

These currency movements and the market falls, reflect the increased risk averseness brought about by the continued rise in interest rates in the US (and also many other countries). Markets have finally shifted their attention to inflation and are now worried about a) how high interest rates might go, and b) how the higher interest rates will effect the country growth rates and hence earnings forecasts of companies.

Especially Banks (along with Life Insurers and retailers) are negatively affected in this scenario. Higher interest rates remove disposable income from consumers and increase the risk of bad debts. It is then no surprise that with the exception of Nedbank (does someone have inside information about pending corporate action?) the banks declined during the period. Likewise, Life Insurers fell as well, with only Old Mutual being positive (due to its offshore exposure). Santam (a large holding in our fund) is down the most after management warned about the tough environment.

Unfortunately the uncertainty regarding higher interest rates (and their effect on consumer spending and growth) will stay with us for a few months yet. In South Africa specifically, we could still face two to three further interest rate hikes. It is unlikely that financials will outperform in this environment.

However, prices have come down and valuations are attractive again. Dividend yields are between 4.5% and 5.5% and most financials will still show earnings growth exceeding 15%. The long-term investor should find the next three months fertile investment ground, as prices react further to the unfolding environment.

Fund manager Kokkie Kooyman had a good July, with FirstRand coming top of the banks and Nedbank, which it did not own, declining 2,6%. He was also underweight Old Mutual, which was down 3,5%, and had a large weighting in Sanlam and Santam, which were up more than 4%. The decision not to hold Abil was vindicated as it fell 12%, but he missed Investec, which gained 6%. Kooyman says that if interest rates increase just a further 100 basis points, the outlook is good.

Financial Mail - 25August2006

The high gold and platinum prices and global interest in emerging markets continues to keep the rand, and in turn the financial sector, strong.

A strong rand makes it impossible for the South African Reserve Bank to hike interest rates, meaning that the good times continue to roll on. Payback time will arrive - but it keeps being postponed. In the meantime, investors are benefiting handsomely.

A few shares performed really well (dividend payouts included)during the quarter: Nedbank (+30%), ABSA, Metropolitan, Liberty, Old Mutual, Investec and Liberty International all exceeding 15%.

Among these, Nedbank and Investec appear to be overly expensive, but the prices are kept high by limited supply of shares, and in Investec's case, a very good and supportive environment.

Worst performers were Sanlam and Santam (11% and 15%respectively).

The month (and quarter) to March was a portfolio manager's nightmare. While delivering good returns for investors -we underperformed the Financial Index (a much cheaper option for investors).

This was largely due to the unexpected good performance of Nedbank and Investec (very expensive), Old Mutual (Aviva's bid for Prudential caused all UK listed insurers to re-rate), Liberty (held up well despite the resignations of Myles Ruck and Ian Kirk) and Liberty International, which jumped on the back of the March UK budget and made investing in UK REIT's more attractive.

After a month where the three top performing stocks are those which the fund has zero exposure to, one feels like saying to clients: "I'm sure you will do better by investing in an index fund."

Hopefully next month underlying valuations reassert themselves.

It seems as if international investors have re-discovered South Afica during December. Our large financial shares were significantly rerated: Firstrand +16%; Sanlam +14%; Sasfin +13%; Santam, Metlife and Abil +12%, the 'laggard' being Liberty +5%.
While the Quarter to December was just as good: Venfin +43%; Abil +21%; Sanlam +18% and Liberty +17%.
Looking back at the year we feel vindicated by our continued calls in 2004 and early this year that financials were very undervalued: Venfin +93% (corporate action), Investec +60%, Firstrand +53%, Remgro +43%, etc.
The 4 best performers in the financial sector shows that small-cap fund
managers must have had a ball: PSG + 140%, Peregrine + 120%, Capitec
+112% and Brait +100%.
With hindsight our investment mistake was not to invest in the above small-cap stocks, however, our investment stance is to invest in undervalued (financial) companies with predictable, sustainable earnings. Hence we selected Sasfin and Santam but not PSG, Peregrine and Brait where the earnings are very lumpy and dependant on the investment climate of the JSE (which can swing at a moment's notice).
That does NOT excuse us from not holding Abil (African Bank), especially as I have known management and the company for many, many years and always held it as one of my largest investments. African Bank has a team that is much focused and incredibly professional in what they do. In addition they continuously pay out the surplus cash generated to investors via dividends. Yet I sold our holdings during 2004 when I thought they were too expensive. A bad mistake by a professional fund manager who should have known better.

What to expect for 2006:
For the first time since 1998 financial shares are marginally overvalued. However, the dividend yields and earnings growth prospects are still such that they should outperform cash, bonds and resources shares.
But, investors must realize that most of the rerating has taken place. Standard Bank and Firstrand are back at P/NAV's exceeding 3x. From here on further share price gains can only be driven by earnings growth (+/- 15% per annum) and the risk exists of a derating if there is a sudden change in the global investment climate (oil shock, unexpected higher interest rates or something else that derails the current optimistic outlook on global growth).
Over the past 25 years South African banks have proven their ability to consistently grow their NAV and pay a dividend that grows every year. The economic environment for South Africa is now better than at any stage since the early 1960's (resource prices were still under pressure in the mid 1990's and our inflation and interest rates were still higher). Hence, one can't find fault with the current investment environment. Long-term investors won't be disappointed. But the short-term investors will have to temper their expectations.