In an attempt to predict the future direction of markets, many analysts look back over history to try and ascertain patterns or trends that develop over time. This type of analysis spawned the so-called “January effect” – an observation that markets often tend to rally hard in the first month of the year. (Indeed, a study undertaken in the USA over 60 years worth of stock exchange history showed that returns in January tend to be up to 3 times higher than those for the rest of the year.) One of the reasons put forward for this behaviour is that the new year is a chance to wipe the slate clean and begin afresh. Optimism abounds, and this is reflected in higher prices.
Unfortunately, this January has proved to be anything but optimistic. After a volatile last quarter of 2007, markets started the year on the back foot, and have weakened ever since. This correction has not been confined to SA, but is rather a global phenomenon as investors fret about the deepening credit crisis, and the impact on economic growth. It is now increasingly likely that the US will slip into recession – the only questions that remain are “how deep a recession?” and “will this drag the rest of the world into recession as well?” For local investors, this period of global uncertainty has coincided with a period of weaker local growth as higher interest rates take their toll. The additional political uncertainty has created a toxic cocktail of bad news, and the stock market has reacted accordingly.
To be fair, global conditions have deteriorated, notably in the US. Financial institutions continue to write off huge amounts of unrecoverable debt stemming from over-zealous lending. To date, this debt has related primarily to mortgages, but fears are rising that credit card debt may also be vulnerable. To add insult to injury, the complexity of today’s financial products has meant that even banks themselves do not fully appreciate the risk to which they are exposed. As a result, banks have virtually stopped lending, and this is impacting on the ability of sound businesses to operate normally.
We do not believe that this is the case in South Africa. You might argue that our regular blackouts are impacting on the ability of businesses to operate normally, and we agree wholeheartedly, but this is not going to derail South Africa’s current expansion phase. In fact, the acute electricity shortage should encourage an accelerated investment into infrastructure rather than a cutback, to ensure we avoid similar capacity constraints in the years ahead. We have often argued that our infrastructure upgrade program will insulate us from normal economic cycles, and this should become increasingly evident as the year progresses.
However, I have digressed temporarily. I will come back to the outlook for the local economy later on, but the point of this article was to articulate our view on investing, and how the current economic conditions fit into that view.
How would you answer the following question: “what is the goal or aim of investing?” Answers might include, “to save for a rainy day” or “to grow my capital.” We would argue that the aim of investing is to grow your income. Income is what puts food on the table each month, and surplus income is what allows for discretionary spending on holidays, new cars and the like. It is human nature for us to measure the success of any investment in terms of the capital appreciation earned. However, we would argue that for capital appreciation to be sustainable, the income must also grow. Many financial advisors will articulate that capital growth will lead to income growth. We believe it is the other way around – notably that only by growing income will capital follow suit. This forms the basis of our investment philosophy, and is the reason why we focus much of our attention on the income, and the trends therein.
Allied to the above point is that for an investment to be considered successful, the income must grow over time, and preferably faster than inflation. An income that grows faster than inflation implies a real improvement in wealth or living standards. If income growth is less than inflation then one might just as well spend the money today, as there is no benefit in deferred expenditure. Long-standing investors will know that only two mainstream asset classes – equities (or shares) and property – consistently grow their income over time. But these also carry higher levels of risk, as they can fluctuate wildly depending on prevailing sentiment. Unfortunately, as we all know life is full of compromises, and investments are no exception. In this case, one has to compromise between securing an income that will beat inflation over time, whilst coping with the higher level of risk that inherently comes with such an investment.
The chart below shows the long term trend of the rate of growth in dividends. The trend in profits (or earnings) shows a similar pattern, although it tends to be more volatile. (We have not shown the trend in earnings on the chart in order to keep the chart simple and easy to read.)
What is worth noting is that the growth in dividends is less volatile than that of earnings. Largely this is due to the fact that many companies take an immense pride in showing a sustained increase in their dividends from year to year. So whereas earnings can be quite volatile from one year to the next, directors will often smooth out the dividend to ensure a steady uptrend. This means that dividend growth is lower in the good years, but higher than it might otherwise have been in the bad years.
Another point to note from the chart above is that dividend growth has only been negative five times since 1960 – despite the last forty five years being some of the most volatile in our history. Taking this a step further, South Africa has experienced nine economic recessions since 1960. The chart below superimposes the periods of economic recession over the trend in dividend growth. What stands out from our point of view is the fact that dividends hold up extremely well in tough times. Despite an economy in recession, and often for periods of three years or more, dividend growth remains positive. In cases where it does turn negative, it is usually much shorter than the full extent of the recession.
What does this mean for investors? We have established that income is the holy grail of investing, and that despite the volatility in share prices, income from investments in shares and property tend to hold up quite well, even in turbulent times. Provided an investor’s income needs are being adequately met through his investments, then that investor has the “luxury” of being able to shrug off adverse movements in the capital value, because his day-to-day standard of living is not altered.
Let us get back to the current economic conditions. There is no doubt that our economy has cooled over the past six months, in reaction to higher interest rates, the introduction of the National Credit Act, and a weaker global environment. This is now being exacerbated by power outages.
Yet we have commented before that we are far from recession. Growth in this quarter will be much slower, but for the year as a whole (and this assumes a steady occurrence of power outages) growth should still remain above the 3% level. Yet this level of growth is far from recession, and should ensure that companies continue to grow their profits – albeit at a slower pace than that over the past four years. We reiterate the importance of our infrastructure program to maintaining growth. Against this backdrop, our modeling suggests that earnings and dividends will continue to grow.
Over the course of the past week, the US Federal Reserve has cut US interest rates by 1.25% – a sizeable cut given that US interest rates now stand at a mere 3%. This is in reaction to much weaker growth in that country. There is still a huge level of uncertainty amongst global investors with regard to the outlook for the world economy, and as we all know, uncertainty is bad for markets. We can expect more volatile days ahead – indeed, we think the next four or five months will be more of the same for the JSE. But as this article aims to highlight, it is worth focusing on the end prize and not getting caught up in the frenzy of negative sentiment.