Brian Kantor – Page 27

Private sector credit: No joy or danger

Bank credit and money supply statistics for July 2012, released yesterday, indicate that growth in the demand for and supply of credit and money continues at a sedate pace. The pace of growth appears strong enough to keep the economy moving forward – but at a pace that will not fully engage the economy’s potential.

In line with house prices, that are at best moving sideways, mortgage lending by the banks continues to grow very slowly, at about a 2% per annum rate. Growth in mortgage lending over the past three months however did pick up some momentum – perhaps indicating some reversal of recent trends. Without a demand from their customers for secured credit, the interest the banks have in expanding access to unsecured credit will hopefully be sustained, supplying some impetus to the economy that is sorely needed.

These trends confirm that monetary policy will stay on an accommodative course – designed to encourage domestic spending when little help can be expected from the global economy and demand for exports. Credit and money supply trends help make the argument for lower rather than higher short term interest rates. Brian Kantor

You can’t always get what you want: Is platinum mining profitable?

The Rolling Stones captured the disillusion of the 1960s counter culture in their hit song “You Can’t Always Get What You Want”. It was released in 1969 after the initial wave of 1960s optimism had surged to anger and disenchantment. The song offers practical hope by suggesting that we should strive to get what we need since we’re bound to fall short in getting what we want.

The platinum industry has been one of great hope and now disillusionment. Has it been profitable and created value? Is it profitable today and what is implied in the share prices of platinum mining companies? By answering these questions, we can begin realistically to untangle economic wants and needs.

We’ve aggregated the historical financial statements of the four largest platinum miners (Anglo American Platinum, Impala, Lonmin and Northam) and calculated the inflation-adjusted cash flow return on operating assets, CFROI®. From 1992 to 1997, platinum miners were generating an unattractive return on capital, which slipped below the cost of capital. The years 1999 to 2002 provided the first wave of extraordinary fortune for this industry. The real return on capital exceeded 20%, making it one of the most profitable industries in the world at that time. The rush was on to mine platinum and build company strategies around this effort. Lonmin bet its future on platinum.

The second wave of fortune occurred during the global commodities “super cycle” from 2006 to 2008. Again, platinum mining became one of the most profitable businesses in the world as shown in our chart. The good times ended abruptly with the onset of the Great Recession in 2009, and platinum miners saw their real return on capital drop below 2% – well below the cost of capital, i.e., the return required to justify committing further capital to the industry.

Unfortunately, operating returns have not improved much and have remained below the cost of capital throughout the global slowdown due to increasing labour and excavation costs, and lower platinum prices. Suffice to say, platinum miners aren’t producing sufficient returns to satisfy shareholders. This has resulted in cost-cutting, lay-offs and chops to capital expenditure plans. These are natural economic consequences when a business is destroying economic value by not meeting its cost of capital.

And what does the future hold? We’ve taken analyst expectations for 2012 and 2013 and estimated the real return on capital. It remains very poor at a wealth destructive level of 2%. There is no hint of a return to superior profitability in the share prices of platinum miners. At best, the market has them priced to return to a real return on capital of 6%, which is the average real cost of capital.

It looks highly unlikely that platinum miners will be able to satisfy the wants of their stakeholders. All parties should focus on what is realistically possible and economically feasible. The workers and the unions already subject to retrenchment and very poor job prospects would surely be wise to focus on job retention rather than further gains in real employment benefits. Though grave damage to employment prospects in what was once a promising industry has surely already been done, northern Europe’s response to the Great Recession remains a potential template for management and labour. The cold reality is that capital in the form of increasingly sophisticated and robotic equipment will continue to replace labour. Management will have had their minds ever more strongly focused on such possibilities by recent events.

Moreover, SA has a responsibility to the global economy to supply platinum in predictable volume: the motor industry depends on this. Higher platinum prices, while a helpful short term response to disrupted output, would encourage the search for alternatives to platinum for auto catalysts. This would mean a decline in platinum prices over the long term.

Unless the industry can come to deliver a cost of capital beating return, its value to all stakeholders will surely decline. Perhaps they will even decline to the point where nationalising the industry with full compensation might seem a tragically realistic proposition.

Nationalisation will not solve the problem of poor labour relations and the decline in the productivity of both labour and capital in the industry. It would simply mean that taxpayers, rather than shareholders, carry the can for the failures of management. To its financial detriment, government would have to invest scarce funds in a capital-intensive industry that is not generating a sufficient return. Workers might think management (subject to the discipline of taxpayers rather than shareholders) would be a softer touch, but this would lead to the spiral of greater destruction of economic value and ultimately fewer jobs. Government and taxpayers should be very wary of signing a blank cheque. All parties need to focus on what is realistically possible and economically feasible. David Holland* and Brian Kantor

*David Holland is a senior advisor to Credit Suisse and was previously a Managing Director at Credit Suisse HOLT based in London in charge of the global HOLT Valuation & Analytics group.

Interest Rates: The Marcus Put

Headline CPI inflation declined to 4.9% for the 12 months to July. This welcome lower rate of inflation does not tell the full story of the direction of prices. A year can be a long time in economic life and what happens to prices in between can be much more revealing about inflation trends. Over the past three months prices have increased very slowly – more slowly than they did a year ago, as we show below. Prices rose by 0.08% in May, 0.24% in June and 0.32% in July.

These relatively small monthly increases compared to a year before have brought down the three month rate of inflation, seasonally adjusted and annualised, sharply lower to well below 4%. ( See below)

If current trends in the CPI persist, the outlook is for an inflation rate of no more than 3.5% this time next year, as we show in the chart below. It should be noticed that monthly increases in the CPI were particularly rapid early this year, thus offering the possibility of seeing year on year inflation come down further in early 2013 (that is, if monthly increases then turn out to be below the rather high monthly increases of early 2012).

These trends could be damaged by a combination of a weaker rand and supply side disruption (drought and war) which might drive global grain and oil prices higher. If global growth gathered enough momentum to drive up metal and commodity prices generally, for demand side reasons, the rand might well strengthen to moderate such influences on the prices of imported and exported goods. Faster growth in export markets would be very helpful to the SA economy. It could bring faster growth without more inflation, because the rand will strengthen.

Slower global growth would be very likely to weaken the rand and cause the inflation numbers and outlook to deteriorate. The domestic economy will also be harmed by such trends. It would mean slower growth and higher inflation. The case for raising interest rates under such adverse circumstances is a poor one. It would mean still slower growth without any predictable impact on the inflation rate.

The Reserve Bank, under present leadership, seems unlikely to raise rates should this adverse scenario materialise. If the economy stays its present course (less inflation and growth that remains below potential growth), the case for lowering rates improves. The more hopeful scenario – the SA economy to benefit from a reviving global economy and higher commodity prices and a more valuable rand meaning no more inflation – the case for lower interest rates also improves.

And so in the light of currently lower inflation, the case for lower interest rates has improved. Furthermore it is hard to contemplate more favourable or less favourable economic circumstances that would drive short rates higher. We might describe the outlook for (lower) interest rates in SA as the Marcus Put. Brian Kantor

SA economy: Growing, but at a decelerating pace

Retail sales help confirm a welcome recovery of spending in June

Retail sales volumes reported by Stats SA last week confirm that the SA economy had a rather good month in June. Sales volumes picked up strongly, having grown very little on a seasonally adjusted basis between December 2011 and May 2012. As we show below retail sales volumes(at constant 2008 prices) recovered strongly in late 2009 from their post recession lows, picked up momentum in late 2011, but then fell away rather badly on a seasonally adjusted basis in the first five months of 2012.

We had learned earlier that June 2012 was also a good month for the banks. This is not a coincidence: economic activity tends to lead rather than follow bank lending. The banks respond to demands for credit to fund intended spending decisions by households and firms. Bank credit extended to the private sector grew strongly in June 2012, as did the deposit liabilities of the banking system (known as M3, the broadly defined supply of money). M3 almost flat-lined between December and May while bank credit grew steadily over the period and also picked up momentum in June.

The data for June 2012 may be regarded as encouraging enough to suggest no further cuts in interest rates are necessary to keep the economy going forward at a satisfactory pace. However June is a long time ago. We are more than half way through August and a month can be a long time in economic life.

Updating the state of the economy to July 2012

We do however have some useful additional information about developments in July 2012, in the form of vehicle sales and the notes issued by the SA Reserve Bank. These two hard numbers help make up our hard Number Index (HNI) of the immediate state of the SA economy (or, to put it more precisely, combining the vehicle sales with the note issue adjusted for the CPI, equally weighted, gives us the Hard Number Index). As may be seen below, both series show a very similar pattern to that of retail volumes and the money and credit numbers. They show a good recovery in activity in the second half of 2011 that accelerated towards year end. Thereafter activity flat-lined between January and May 2012 as may be seen below. It may also be seen that in July the faster pace was maintained at the higher June levels.

The Hard Number Index (HNI) – an estimate of the state of the SA economy in July

An HNI above 100 indicate growth in economic activity. As may be seen below, economic activity in SA according to the HNI continues to expand but at a slower pace. When these trends are extrapolated further the outlook is for further increases in economic activity and for the rate of increase to slow down further.

Why the HNI is a good leading indicator for the SA economy

In the figure below we compare our HNI to the Reserve Bank Business Cycle Indicator that is based on a wider number of activity indicators based on sample surveys. Both series indicate very little growth in economic activity before 2003, with numbers that stayed around 100. The measures of economic activity have been consistently well above 100 ever since 2002, indicating that the economy has grown consistently since then, though at a forward pace that accelerated until 2006; slowed down between 2006 or 2007; and then picked up forward momentum in 2010.

The two series have tracked each other very well over the years. They indicate the same time in 2010 when the pace of growth began to accelerate again rather than decelerate. The rate of change of the HNI turned down well before the Coinciding Indicator in 2006 as may also be seen. The advantage of the HNI is that it very up to date – available measured for July 2012 while the Reserve Bank Indicator has only been updated to only.April 2012.

The HNI may therefore be regarded as a very useful and up to date indicator of the SA Business Cycle. There is every indication from it that the SA economy will continue to grow in 2012-2013 but at a decelerating pace that is not likely to threaten any change in current interest rate settings. These have been helpful to date in keeping the economy moving forward, despite a weaker global economy, by encouraging household spending and the extra credit needed to sustain it. Brian Kantor

Keynesian economics and Quantitative Easing: Can they restore economic health?

The economic problem is usually one of unlimited wants and highly limited means to satisfy them. It is a supply side problem that only improved productivity and improved access to capital or natural resources can ameliorate.

Economic growth sustained over the past 200 years or so has helped many to overcome the economic problem, at least to a degree. When obesity rather than starvation becomes the major danger to individual well being in the developed economies considerable economic progress has been made.

But sometimes the economic problem becomes one of too little spending rather than of dismal constraints on spending. Too little demand is now the major problem in many of the developed economies and also for us in SA. Given the current availability of labour, plant and equipment in the US, Europe and SA, more goods and services would be produced and more income would be earned in the process of expanded production, if only economic agents would spend more. More spending is thus possible without the usual trade-offs and choices having to be made between one kind of spending or another. There is no opportunity cost to employing more resources when they are standing idle.

It was a severe lack of demand that severely afflicted the US economy and other economies in the 1930s. The US economy nearly halved its size between 1929 and 1933 and economic activity had not recovered 1929 levels by 1939. These catastrophic economic events gave rise to what has come to be known as Keynesian economics, named after the famous English economist John Maynard Keynes. Keynes in the late 1930s had persuaded much of the economics profession to agree that in the absence of sufficient demand from the private sector (firms and households) governments should fill the gap between potential and actual supply of goods and services by spending and borrowing more. In other words, he argued for expanded fiscal deficits to stimulate demand when aggregate demand was painfully lacking.

Keynesianism today

Such arguments are being made today, most prominently by Nobel Prize winning economists Paul Krugman and Joseph Stiglitz. They argue against the austerity apparently being practised by the US and European governments or recommended for them. In fact the fiscal deficits of the US and UK have widened enormously, and more or less automatically, as government revenues declined with the recession and as government spending, including spending on bailing out banks and other financial institutions, increased. But whether the larger deficits or higher levels of government spending helped to stabilise their economies, as the Keynesians predict, is not at all obvious. Arthur Laffer, in a recent Wall Street Journal article, argued that the opposite has in fact happened: that the stronger the growth in government spending, the slower the growth in GDP. He presented the following table linking changes in government spending to declines in GDP growth as evidence for this:

The UK, US, Germany and Japan, despite increased spending and larger deficits and borrowing requirements, have enjoyed one great advantage not available to Greece, Portugal, Ireland, Spain and Italy. The cost of borrowing, even of issuing very long term loans in the US, UK and Germany, has come down dramatically while the interest rates charged to Spain and Italy have risen enough to threaten their fiscal viability.

In contradiction to the Laffer evidence, it may be argued that growth would have been even slower without these increases in government spending. In the case of the Krugman-Stiglitz arguments for less, rather than more UK austerity, there is no way of knowing with any confidence what might have happened to interest rates in the UK in the absence of intended austerity. Higher interest rates would have severely further limited spending by the private and public sectors in the UK, had borrowing costs been forced higher by nervous investors in UK gilts.

The limits to government spending

The essential criticism of the Keynesian approach to recessions is that governments can only ever account for a portion of total spending. Increased spending by the public sector may well be offset by lower levels of spending by households and firms fearful of the impact of extra government spending and borrowing on their own financial welfare.

Higher interest rates associated with more government borrowing may crowd out private spending Higher taxes that will be expected to levied in the future to cover interest to be paid on a much enlarged volume of government debt may induce more private savings. Households and firms may seek to protect their own balance sheets and wealth that they believe may be subject to higher levels of taxation.

The potential limits to the ability of governments to increase total spending and the danger that firms and households and other government agencies may spend less, can be illustrated by reference to the US GDP statistics and Budget.

Of the US GDP of nearly US$14 trillion in 2011, spending by all government agencies, Federal, state and municipal governments on consumption and investment amounted to $3 trillion or 21% of GDP. Of this spending the Federal government accounted for but $1.14 trillion or about 38%.

Even when government spending is a large proportion of GDP, a high percentage of this is in the form of transfers to households and firms. So spending decisions are in the hands of these households and firms, who might feel constrained for the reasons outlined above.

Normal times would have meant no need for QE 1, 2 or 3 or for the very low interest rates that have accompanied QE (quantitative easing). The collapse of Lehman Brothers in September 2008 threatened to bring down the US banking and financial system. Flooding the system with liquidity (cash created by the Fed) is the time honoured method of preventing a financial implosion. The great free marketer and anti-Keynesian, Milton Friedman, with Anna Schwartz in their monumental work Monetary History of the US, had accused the Fed failing to respond in this way in 1930 and by so failing in its mission, allowed a preventable financial crisis to become an economic crisis of disastrous proportions. This was not a mistake Ben Bernanke (well versed as he was in monetary history), was going to make as head of the Fed.

What about the liquidity trap?

But the Bernanke-led Fed, having avoided a financial implosion, is faced with a problem that both Keynes and Friedman were very conscious of. Keynesians wrote of the dangers of a liquidity trap: that cash could be made freely available to the banking system at very low interest rates by the central banks; but if the banks were reluctant to lend and its customers reluctant to borrow or spend, the cash would get stuck with the banks or the public. The system could fall into the liquidity trap and so lower interest rates or increases in the supply of cash would do little to stimulate economic activity.

Keynesians then call for government spending. Friedman and Bernanke in their writing called upon a hypothetical helicopter to by-pass reluctant banks to spread cash around, which would be spent to help the economy recover. Bernanke came to be known disparagingly as helicopter Ben for this idea. The trouble with helicopter-induced money creation is that it would have to be sanctioned by Congress – it would have to be included in the Budget as fiscal policy. This makes it a highly impractical response.

Given an inability to force co-operation from banks to inject cash and spending into the system, the Fed and the European Central Bank have to rely on monetary policy. They would thus continue to make cash available to the banking system and to engage in QE, so keeping the financial system afloat, and to hold interest rates as close to zero for as long as it takes, until confidence and entrepreneurial spirits revive. Moreover, Bernanke has been lecturing politicians on the need to exercise fiscal propriety to help restore business and household confidence. Brian Kantor

Global markets: Becoming more cold-blooded

The Volatility Index (VIX), which is traded on the Chicago Board Options Exchange and that reflects the implied volatility of an option on the S&P 500, has been trading at very low levels recently. It has been in the mid teens, or at levels that were common before the Global Financial Crisis triggered by the collapse of Lehman Brothers.

As we show below the VIX rose to as much as 80 in late 2008. We also show how the Euro Crises drove the VIX markedly higher, though never to Lehman type levels of anxiety.

What is noticeable is just how little affected the share markets and the options traders were by the latest flurries in the share dovecote caused by weakness in Spanish and Italian debt. Judged by the behaviour of the VIX this year, the markets have not been nearly as noisy as the commentators.

We also show that where the VIX goes, so goes the S&P 500 in the opposite direction. When risks go up (as reflected by actual or implied volatility of share prices) returns (that is share prices) go down and vice versa. The correlation between daily percentage moves in the VIX and the S&P is (-0.80), which is very close to a one to opposite one relationship.

This may (hopefully) mean that we have entered a much more sanguine market place and if sustained, this degree of detachment will remain helpful to shares and what are regarded as riskier bonds. The safe haven bonds, by the same token, will not then attract the same anxious attention to the point where favoured governments have been paid by investors to take their money for up to two years rather than the other way round.

The attention of the market place may turn much more closely to the outlook for earnings and interest rates rather than the the very hard to estimate (small) probability of catastrophic financial events. These probabilities can alter meaningfully from day to day, so adding to share and bond price volatility of the kind observed post Lehman and post the Euro crises

The JSE in July: Interest rates matter

July 2012 proved to be another good month for the Interest rate plays and the Industrial Hedges listed on the JSE Top 40 Index. It was yet another poor month for the Commodity price plays as we show below.

The Industrial hedges are those large cap companies listed on the JSE that are largely exposed to the global economy and whose values are insensitive to both SA interest rates and commodity prices. British American Tobacco, SAB, Naspers and Richemont have proved highly defensive against the risks to the global economy posed by the Eurozone crisis. The cyclical commodity price plays by contrast have been much damaged by these anxieties and share market trends in July proved no exception.

The interest rate sensitive stocks, especially banks, retailers and listed SA property (all of which are highly dependent on the SA economy) have benefitted from the surprising decline in SA interest rates and especially the July cut in the Reserve Bank repo rate. We show below, with the aid of Chris Holdsworth of Investec Securities, just how significantly lower SA interest rates have moved across the yield curve in recent weeks.

The term structure of interest rates at any point in time makes it possible to infer the short rates expected by the market over the next 15 years. As we show below the rate of interest on RSA bonds with one year to maturity is now expected to remain unchanged over the next year. Then it is expected to increase much more gradually over the next few years and to remain below 7% p.a for another four years. This outlook for interest rates is very encouraging to those companies for whom interest rates are an important influence on their revenues and profits.

The market in fixed interest securities can change its mind and can be expected to do so again. Holdsworth has developed and successfully tested a theory about the forces that drive the gap between long and short rates in SA. The theory is that money supply growth rates lead interest rate moves by about 12 months. The explanation for this is highly plausible. Given monetary policy practice in SA, the supply of money (defined broadly as M3) and bank credit accommodate the demand for money and credit. Economic activity therefore leads money supply and credit growth and so subsequent moves in interest rates. In other words, economic activity leads and money supply and interest rates follow in due course.

The test of this theory of short term rates is shown below. The money supply has done a good job at predicting short rates and has done better, statistically, than the yield curve itself in forecasting short rates. The Holdsworth prediction, given recent money supply trends, is for still lower short rates to come, of the order of 4.6% p.a in 12 months’ time. The forecast of the three month rate in June 2013, implicit in the Forward Rate Agreements offered by the banks, is currently 4.9% p.a.

Whether these forecasts will prove accurate or not will depend upon the state of the SA economy over the next 12 months. The stronger the economy the higher will be interest rates and vice versa. All will be revealed by the growth in the balance sheets of the banking system, that is in the money supply broadly defined (M3). These constitute most of the liabilities of the banks and the supply of bank credit. These money and credit aggregates as well as the state of the economy will be closely watched by the Reserve Bank.

However when these aggregates are converted into growth over three months (calculated monthly), the picture looks rather different. Growth in credit supply has slowed sharply while growth in M3 remains anemic with both now at about a 4% p.a. rate of growth. Such growth rates, if maintained, would mean lower rather than higher interest rates to come. These aggregates will bear especially close watching over the months to come. Brian Kantor

The Hard Number Index: A good June

We play close attention to two important indicators of the state of the SA economy. These are new vehicle sales and the notes issued by the SA Reserve Bank. The great advantage of these data points is that they are very up to date and that they are based on hard numbers rather than sample surveys that inevitably have measurement issues.

We combine these two hard numbers to form our Hard Number Index (HNI) of the current state of the SA economy. We deflate the note issue by the Consumer Price Index (extrapolated one month ahead) to establish the real note issue that makes up half of the HNI. As we show below, the HNI has provided a very good leading indicator of the SA Business Cycle as calculated by the Reserve Bank. The recent turning points in the two cycles have coincided very closely.

The advantage of the HNI is that it provides an early indication of the state of the economy in June2012. The Reserve Bank Indicator only gives us an estimate of the state of the economy as of March 2012, for which period we anyway have the much broader GDP figures and other national income estimates.

It may be seen from the HNI that economic activity in SA continued to expand in June. The pace of growth in June, as reflected by the rate of change of the HNI (what may be regarded as the second derivative of the business cycle) has however continued to slow. Nevertheless June 2012 was a very solid month for new vehicle sales and the note issue in June showed a marked pick up compared to the note issue three months before.

As we show below, the note issue, having grown very strongly towards year end 2011, fell back between January and May 2012 only to recover in June 2012. Clearly the demand for notes is affected by the spending seasons, especially in December, and can only be interpreted with the aid of an adjustment for seasonal influences. That the value of the notes issued in June 2012 grew so strongly in response to the extra demands for cash from by the public and the banks, is an encouraging sign of improving spending propensities.

It is of interest that the note issue has grown significantly faster than the supply of bank credit or of broader measures of the money supply. This implies that these may take a similar path to that of bank credit extension to the private sector. This would suggest that the additional demand for cash is coming from the public to fulfill spending intentions rather than from the banks. It is the informal rather than the formal sector of the economy that uses cash rather than access to bank deposits as its principal medium of exchange. Therefore this may suggest that the informal sector is growing faster than the formal sector and by so doing is helping to sustain the pace of economic activity.

The Reserve Bank is likely to take much more notice of the slower growth in bank credit than the faster growth in its note issue when deciding on the right level of interest rates. It is the weak credit numbers, combined with threats to the global economy and so to export volumes and prices, which could lead the Reserve Bank to lower its repo rate next week when its Monetary Policy Committee (MPC) reconvenes.

The SA economy is still operating below its potential growth of about 4% p.a. Lower interest rates would encourage more domestic spending and borrowing and help prevent some further economic slippage (in the form of a still wide gap between potential and actual output that exports cannot realistically be expected to close anytime soon). With an improved inflation outlook it would make sense for the Reserve Bank to do what it can to help sustain domestic spending – the one potentially brighter light in an otherwise difficult economic environment. Hopefully the Reserve Bank will make a similar judgment. Brian Kantor

JSE listed retailers: Identifying impressive outperformance

JSE listed retailers listed in the General Retailer or Food and Drug Retailer sub-indexes continue to enjoy great approval from investors. They have outperformed the All Share Index since 2003 by very large margins with the Food and Drug Retailers performing especially well with this Index rising by an extraordinary 1200% over the period 1 January 2003 to 22 June 2012 compared to a still very satisfactory 400% improvement for the All Share Index.

The General Retail Index did twice as well as the All Share. Over the period January 2003- June 2012 the JSE ALSI provided an average return, including dividends, calculated monthly of 15.2% p.a., compared to 25.3% from the General Retailers and 28.7% realised by the Food and Drug Retail Index.

The sector has re-rated: prices have risen further than earnings

The outperformance by retailers was almost as impressive on the earnings front. Retail Index earnings per share have grown twice as fast as All Share Earnings, growing six times compared to the three fold increase recorded by the market as a whole (including the contribution made by retailers. The General Retailers, having seen earnings decline in the recession of 2009, have now caught up with Food and Drug Index earnings per share. Impressively the Food and Drug Retailers were able to sustain impressive growth in their earnings despite the recession.

Over the past twelve months to 22 June the General and Food Retailers, co-incidentally, both provided their shareholders with as much as a 34% return. Clearly investors continue to be surprised by the sustained excellent economic performance of the retailers. Returns of this order of magnitude are far in excess of the risk adjusted returns required to satisfy investors and therefore must represent further unexpectedly good performance over the past twelve months. But having been surprised, investors have come to expect more from their retailers, as revealed by more demanding valuations.

The Food retailers are trading at over 25 times trailing earnings and the General Retailers 18 times compared with the market as a whole that is priced at a much less demanding 12.5 times reported earnings.

Identifying the performance drivers

As we indicated in our previous report on retailers on the JSE, these companies, in growing their earnings, have realised extraordinarily good (internal) returns on shareholders capital they have invested in recent years. The accounting returns on equity capital for the latest reporting period have ranged from 20% to 49% as indicated in the table below.

Given these exceptionally good returns on capital and given what have become demanding market valuations, we thought it helpful to compare the listed retailers using three metrics. In our previous report we compared Shoprite to Pick n Pay and Woolworths. In this report we extend the comparison to Truworths (TRU), The Foschini Group (TFG) and Mr Price (MPC).

Firstly we compare the ability of the different retailers to realise cash from sales revenue. In the figure below we compare cash to sales ratios of three retailers. All three have proven ability to turn sales into cash on the balance sheet but TRU is a clear leader in this regard as may be seen.

But realising cash is not all that will determine the value of the company. It is what is done with the cash that will matter to shareholders. Investing the cash will add more value than paying it out in dividends or share buy backs, provided the returns on capital exceed their opportunity costs. Clearly the retailers meet this proviso by large margins.

We show the ratio of capex to cash flows below. By this criterion TRU ranks behind MPC and more so TFG. TFG appears as the most willing to turn cash into fixed and perhaps also working assets. But all three retailers typically invest only at best to half the cash they generate.

This reluctance, or rather perhaps the inability, to find value adding investment opportunities is demonstrated by rather tepid and variable growth in capital expenditure itself as we show below. As may be seen the rate of capital expenditure appears to have slowed down in recent years.

Conclusion

It seems fair to conclude that these listed retailers have done done much better at the operating level than they have at identifying and implementing growth enhancing investment activity. If they are to surprise the market in the future as they have done in the past, they would need to do both. Brian Kantor

Retailers: What shareholders should expect

What should investors wish of the companies they own a share of? Ideally their management is able to generate an (internal) rate of return on the shareholders capital they invest that is in excess of the opportunity cost of that capital. The larger the excess returns, the more capital the company would be encouraged to invest and the more the share market will approve of such growth over time.

This capital could be raised from operations, from issuing additional shares or by borrowing. As the company expands by undertaking value adding capital expenditure, it can be expected that the gap between the internal rate of return and the cost of capital would narrow. The potential value to be added for shareholders is a multiple of the amount invested and the spread between the internal rate of return from capital invested in working and fixed capital and the opportunity cost of that capital. The objective of the company should be to maximise the value add, not the spread between internal and required rates of return. We would suggest that the required rates of return would be about 4%-5% above the rate of interest on an RSA long dated bond. This is a lower risk premium for food retailers and higher for credit providing retailers.

SA retailers have proved highly capable of generating very high internal rates of return from their businesses. Returns realised on equity capital by listed retailers and their market-to-book values are impressively high. The share market has also registered its approval by raising the price to earnings (PE) multiples of listed retailers. The following table taken from Bloomberg indicates the range of outcomes for listed JSE retailers. Market price-to-book values range from over 9 times for Woolworths, Shoprite and Mr Price to under two times for furniture retailers. Return on book equity ranges from nearly 50% to about 20% and the PE multiples range from eight to 22 times reported earnings.

Clearly not all retailers are equal. Given the excess returns potentially available to retailers, those best able to undertake additional value adding capital expenditure for shareholders should be prized above others. If they lack such opportunities, the best they can do for shareholders would be to return capital to them either via the dividend route or through share buy backs.

We have compared three leading retailers below. We compare and examine Shoprite (SHP) Pick and Pay (PIK) and Woolworths (WHL) on two dimensions: by cash flow over capital expenditure and sales; and by growth in capital expenditure. Ideally the more capex relative to cash flow the better it is for shareholders on the assumption that the returns will exceed the cost of capital. If cash flow exceeds capital expenditure then cash will have been used to pay back debt, pay dividends or buy back shares. These are signs that management lacks the confidence or the ability to realise value adding capital expenditure.

The cash to sales ratio indicates the ability of the respective retailers to generate cash from current operations and the growth in capital expenditure provides a leading indicator of future growth. At the operational level, SHP has generated significantly more cash per unit of sales than PIK over all years since 2000 except for 2005 and 2002, by a small margin. WHL has performed much better than SHP over recent years in terms of cash flow per unit of sales, though it lagged behind SHP between 2004 and 2007.

These three retailers seem generally unable or unwilling to undertake capex in excess of cash flow, with the notable exceptions of SHP in 2005 and WHL between 2004 and 2007, when capex exceeded 100% of cash flow. No doubt the improved operational performance of WHL in recent years has had something to do with the capex undertaken earlier. What may also be important is that PIK in 2011 increased its capex to more than 100% of cash flow – something that it conspicuously failed to do before.

The growth in capital expenditure shows an uneven pace: SHP and WHL score better than PIK in this growth league.

It will be clear that SHP has been doing much more of the good stuff for shareholders than PIK. WHL has also been competing strongly with its expansion plans. PIK has lagged behind and is, by all accounts from management and its board, playing catch up (as it needs to do if it is to compete effectively).

The recent capital raising exercise by SHP, when it raised about 10% of its market value with new debt and equity, puts it in a strong financial position to fund growth. The share market is pricing all these retailers for strong growth, as indicated by current valuations, market-to-book and PE ratios. They will have to run hard and continue to grow fast to satisfy demanding market expectations. Thus having to raise additional equity or debt capital, rather than relying on internally generated cash, should be seen a positive rather than negative by shareholders. We will compare in a similar way other listed retailers in subsequent reports. Brian Kantor

Markets: A good week for global equities, RSA bonds and SA risk

Last week was very kind to global equities. The S&P 500 was up nearly 4% as were US small caps represented by the Russell 2500. The SA component of the benchmark MSCI emerging market index was up over 3% and also did better than the average EM market last week.

It was also a very good week for investors in RSA bonds, of both the rand and US dollar denominated variety. The spread between RSA Yields fell across the term structure of interest rates.

Yankee bonds and their US Treasury Bond counterparts declined by over 60bps in the week – strongly reversing wider spreads that had opened up recently with heightened global risk aversion.

The good news in the RSA bond market meant that the spread between RSA 10 year bonds denominated in rands and US Treasury Bonds yielding US dollars, also narrowed by about 20bps. This spread may be regarded as the total SA risk spread offered to offshore investors with the difference in 10 year yields representing the rate at which the rand is expected to depreciate against the US dollar over the 10 years. Should the rand weaken as expected over the next 10 years, that is at an average rate of 6% p.a, it would make little difference to borrow or lend rands or US dollars. What is gained or lost on the exchange rate leg will be made up or given up on the interest rate spread.

Sometimes known as the interest parity condition, these interest rate differences will also reveal themselves in the premiums paid for US dollars to be delivered against rands in the future, that is the premium paid for forward cover. Last week insuring against expected rand weakness became a little cheaper. If risk tolerance should improve further, both the spot rand/US dollar rate should benefit and interest rates in SA decline relative to those in the US. Brian Kantor

The Hard Number Index (HNI): The foot comes off the accelerator

Our Hard Number Index (HNI) of the current state of the SA economy indicates that economic activity in SA continues to grow but its rate of acceleration (that is, the forward momentum or speed of the economy) appears to be slowing down and may slow down further if current trends persist. In other words, while the SA economy continues to move ahead it appears to be be doing so a slower speed.

Our HNI is based on two equally weighted, very up to date hard numbers, namely: new vehicle sales released by the motor manufacturers (Naamsa) for May earlier this week and the real value of the notes in circulation at May month end. The notes in circulation figure was released yesterday in the updated Reserve Bank Balance Sheet.

This series we then convert into the Real Money Base by deflating it by the CPI (extrapolated one month ahead). The current level of the HNI and a time series forecast of it is shown below where it is also compared with the Reserve Bank’s business cycle indicator – only updated to February 2012.

In the figure below we show the change in the forward speed of the economy by measuring the rate of annual change in the HNI. This may be regarded as the speedometer of the economy. The fastest forward speed registered recently by the HNI was in late 2010. The foot has come off the accelerator gradually since then, with a further slowdown in forward momentum predicted.

As we show below, it is the decline in the growth of the supply of and demand for notes by the public and banks (adjusted for the CPI) that is slowing the forward momentum of the HNI, more than the direction of the new vehicle growth cycle, which is also trending lower. Growth in new vehicle sales has peaked, but growth is holding up rather well. May 2012 was a better month for the motor dealers than April 2012, even when seasonal factors like number of trading days are taken into account.

However the underlying growth trends are clearly pointing down, as are broader measures of money supply and bank credit growth. This is the case even though the economy may be regarded as growing slower than its potential growth. The Reserve Bank has suggested this will occur in late 2013. The money market has come to predict that the economy may take much longer to realise its potential growth. Decreases, not increases in short term interest rates are now being predicted to help the economy along. Our direction of our HNI supports such a view. Brian Kantor

An explanation of the numbers

The HNI and the Reserve Bank Indicator may be regarded as a proxy for the underlying state of the economy. When the indicator registers above a real base value of 100, the economy is producing more goods and services, it is growing, and when below 100 the economy is shrinking. Growth will then have turned negative. As may be seen from the HNI and the Reserve Bank Coinciding Business Cycle Indicator, that hovered around 100 between 1990 and 2002, economic activity did not appear to have expanded at all in SA over these years. Since then the index numbers have remained well above 100.

In 2006 -07 the HNI Index turned lower but still remained well above 100. This indicates that while economic activity was still expanding in 2008-09 it was doing so at a slower rate and that the upper point in the Business Cycle, the period of maximum growth or forward economic speed had passed. The HNI Index turned down before the Reserve Bank Indicator and then picked up forward momentum in late 2009 at exactly the same time as the Reserve Bank Index. This indicated that faster rather than slower growth was under way: the HNI more timeously and usefully than the Coinciding Indicator.

GDP provides another much more comprehensive estimate of the level of economic output and its rate of growth. But based, as it must be, on a large number of sample surveys of activity across the economy, and not on hard numbers, these GDP estimates lag well behind economic events. This is true even of the initial estimates of GDP that capture the headlines but that will be subject to significant revisions. We are already in June and national income estimates for the first quarter of 2012 still are only partly released. These lagging indicators of economic outcomes call for more up to date estimates – hence our HNI. But one does wonder about the usefulness of the Reserve Bank’s Coinciding Business Cycle Indicator, or even its leading economic indicator, that even lags behind the lagging GDP estimates themselves.

Vehicle sales: Post Marikana resilience

October proved to be another very good month for vehicle sales in SA. On a seasonally adjusted basis, an extra 675 new vehicles units were sold in October than in September. On an annual basis sales are now running at 644 505 units and if present trends are sustained, sales could be about 700 000 units by October 2013. This would leave the industry only slightly behind peak sales of late 2007.

The headline growth in sales – unit sales compared to the same month a year ago – perked up to a 10.5% rate from a sedate 1.4% growth in September 2012. This growth rate will receive most attention but the much more meaningful indicator of sales to come is the more recent growth trends. As may be seen in the chart below, the growth in seasonally adjusted unit sales compared to three months ago was at an 18.5% rate. As the chart shows, this three month growth rate picked up sharply in July 2012 and has been sustained at a very robust rate since then. The annual smoothed rate of growth appears to be trending towards a 9% rate.

Vehicle sales are the first indication of the state of the SA economy post Marikana. That unit sales could have sustained their forward momentum in the face of such a potential shock to confidence should be regarded as highly encouraging. The buyers of vehicles and the banks that finance such sales do not seem to have been much put off by the problems of the mining industry. Such resilience is surely welcome. Brian Kantor

From the global economy to the optimum SA portfolio – Why SA economy plays on the JSE deserve their improved ratings

The global economy is still the main determinant of performance on the JSE. In this note, we break the JSE into three main categories, interest rate plays, commodity plays and rand hedges, and look at how these are likely to perform according to certain global and SA market conditions.

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From the global economy to the optimum SA portfolio

SA bonds and the rand: Are the stars for SA infrastructure spending aligning?

The risks of investing in emerging market foreign currency denominated debts have continued to recede as the Eurozone debt threat to global financial markets has diminished. RSA sovereign debt is no exception in this regard. The credit default swap (five year) risk spread on RSA debt was 202 bps at the beginning of 2012 – it is now nearly 30bps lower. The spreads on Russian and Brazilian debt have declined similarly as we show below, with Brazil continuing to enjoy a significant debt premium over RSA debt.

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SA bonds and the rand 21 Feb 2012

Retailers and the JSE: explaining a success story

It seems clear that the retailers listed on the JSE are not expected to realise long term growth in earnings at anything like the rate at which earnings have been delivered over recent years. However they are no more demandingly valued today than they have been over the past 10 years. JSE retailers have provided excellent returns over the past year and they may well continue to do so.

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Retailers and the JSE Jan 2012 Monthly View

Retail spending: We told you so

Stats SA has confirmed the strength of retail sales volumes in December 2011. Strong intimations of this had been provided by cash in circulation and by the trading statements of the retailers themselves – and indeed by the share prices of the retailers themselves to which we have drawn attention.

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Retail spending we told you so 17 feb 2012

Interest rates: MPC stays in the hole it has dug for itself

(From 20 January 2012)
The Monetary Policy Committee (MPC) kept rates unchanged, as expected. We would suggest that this reveals a more dovish, growth sensitive tone with a further strong emphasis on the cost push nature of inflation (to which the Reserve Bank should not be expected to react).

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Interest rates MPC stays in the hole 20 Jan 2012

Global bond markets: Opportunity taken in much calmer debt markets

(From 13 January 2012)
SABMiller and the SA government have in recent days been able to take advantage of the appetite for fixed interest lending by borrowers with favourable credit ratings. The government was able to raise US$1.5bn of 12 year money at 4.665%. SABMiller plc was almost simultaneously able to raise over US$7bn in a variety of maturities at significantly better terms: $1bn maturing in 2015 at 1.85%; $2bn at 2.45% maturing in 2017; $2.5bn of 10 year money at 3.75% (compared with the 4.665% the government paid for 12 year money); and an additional $1.5bn of 2042 notes with a yield of 4.95%.

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Global bond markets 13 January 2012

Vehicle sales: Benz with the remover

(From 11 January 2011)
The quality of the Naamsa unit vehicle sales statistics for December 2011 has been damaged to a degree by the refusal of Daimler-Benz to release their December sales to Naamsa, citing (rather strangely) European competition authority concerns. Presumably the competition authorities could not object to the firm announcing its own sales – the practice in the US. However a “conservative” Naamsa estimate of 920 unit Mercedes sales in December has led Naamsa to estimate total unit sales of 45 200 in December 2011. To misquote Shakespeare: The vehicle sales number doesn’t alter when it alteration finds, or “Benz” (bends) with the remover to remove.

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Vehicle sales 11 January 2012