A sea of opportunity: Cannon Asset Managers

Adrian Saville, is the CIO of Cannon Asset Managers holds a Visiting Professorship in Economics and Finance at the Gordon Institute of Business Science. He writes that he finds deep value in the turmoil of today's markets

The typical asset price bubble is characterised by failure, greed and fraud and the stock market, credit and commodity price bubbles of 2007/08 are no exception.

In terms of the market bubble, we have seen failure on at least two fronts: there has been policy failure and company failure. Failed companies which have been taken over, nationalised or bailed out in some way include Lehman Bros, Bear Stearns, Royal Bank of Scotland, Lloyds, Citigroup, American Insurance Group, Bank of America, Freddie, Mac, Fannie Mae, Northern Rock and Merrill Lynch.

Firm failure, however, finds root in a second breakdown, namely policy failure through policies' accommodation of almost unbridled greed. As evidence of this, between 1985 and 2006, Wall Street bonuses increased tenfold. Some of the more flamboyant examples of hefty compensation are George Soros who pocketed $2.9bn last year, Ken Griffin who took home $2bn and Lloyd Blankfein with $68.5mn. By contrast, there are 1.2 billion people in the world (almost 20% of the global population) who survive on less than $1 per day.

Fraud and deception are also associated with the asset price bubble. The more spectacular fraud cases which have come to light thus far include Jérôme Kerviel (€5bn), Ramalinga Raju ($2bn), Bernie Madoff ($50bn) and Sir Allen Stanford ($10bn and counting).

Inevitably, though, the bubble burst, and the market collapse has led to a sharp economic slowdown - certainly the most severe since World War II. This, in turn, has provoked a three-pronged response from most administrations, which will have notable consequences for markets:

there is massive fiscal accommodation and government spending;

local industries are being protected from foreign competition through rescue packages, nationalisation and nationalist agendas (such as "buy America"); and

the local consumer and investor market is being aggressively stoked through low interest rate policies while money supplies have ballooned.

 This policy trilogy will inevitably lead to one outcome: rampant consumer price inflation in the fullness of time. Based on this analysis, the next bubble will be price inflation.

While these measures are easy to adopt, and might make sense given the severity of the crisis and the need to put quick remedies in place, it stands that this policy combination may have the negative long-term results alluded to. In the same breath, we know that higher price inflation stifles economic growth and country performance.  Also government spending must be funded by higher tax rates; and protectionist policies foster uncompetitive firms.

Extending this argument to the implication for investors, it must be recognized that in an inflationary environment, cash and bonds are feeble asset classes that often realise negative real returns. By contrast, commodities, some forms of real estate and equities are effective assets, generally producing positive real returns when inflation is rampant. In characteristic fashion, though, investors are currently overweight cash and bonds and underweight equities.

This is understandable from a behavioural stance: Investors are so scarred that they can no longer bring themselves to participate.  However, it makes no sense when viewed in the dispassionate light of reality.  Equities are cheap and offer an effective defense against looming price inflation.  Further, even if the inflation scenario does not pan out, equities are compellingly priced.

To understand investor aversion to equities, despite the case that can be made for the asset class, it is helpful to return to simple models that explain investor behaviour through the life cycle of asset price bubbles.  One of the most eloquent, in this regard, is the Kindleberger-Minsky model.

Economists Charles Kindleberger and Hyman Minsky described the life cycle of asset price bubbles, noting that investors repeat their behaviour. Bubbles follow a pattern of five phases: (i) the birth of a boom; (ii) the nurturing of a bubble; (iii) euphoria; (iv) financial distress; and, in the last stage, (v) revulsion.

Looking at current metrics, we would appear to be in the stage of revulsion when investors turn their backs on equities, a phase showing overwhelmingly cheap asset prices. The rapid unwinding in equity prices since the middle of 2007 has brought us to levels of valuation that are normally associated with revulsion. As evidence of this, price:earnings ratios,  including that of the JSE, are low and dividend yields are attractive.  The JSE, for instance, offers a dividend yield in the order of 5%, which is unprecedented in recent history.

Cheap markets do not stay cheap. Historically, low price:book ratios are associated with handsome equity returns in South Africa. The best five-year investment returns have been delivered by markets associated with revulsion. As further evidence of revulsion, the current JSE price:book ratio of 1.5x places the local equity market in very cheap territory. Previous lows have been:

1.4x in 2001. This was followed by a three-year return of 47% and a five-year return of 180%.; and

1.2x in August 1998. This low was followed by a gain in the JSE of 98% over the next three years and 106% over the next five years.

 The almost universal rejection that investors have shown for equities has resulted in prices collapsing into bargain basement territory. Perversely, it is often from this base that the greatest fortunes are made.

Some examples of the current outstanding opportunities on the JSE include Mondi, Telkom, Old Mutual and Grindrod.

Whilst the paper and packaging industry is under pressure at the moment, Mondi Ltd, which has a global footprint that embraces emerging markets, is expected to see its earnings recover in the fullness of time.  On a normalized earnings basis Mondi Ltd is on a price:earnings ratio of 5x and offers a forward dividend yield of 5.8%. At 2610c, the share is trading at a 54% discount to its net asset value of 5700c.  However, further opportunity is available for investors to buy Mondi Plc, which represents the identical assets, but trades at a 20% discount to Mondi Ltd. 

Telkom represents another example of sunken treasure.  The stock trades at just over R100 but is worth at least R150/share based on current market conditions.  The valuation derives from Telkom's R40 cash from the sale of 35% of its stake in Vodacom.  The balance of Vodacom is being unbundled from Telkom in the second half of May, and we value this asset at some R60/share (irrespective of its listing price).  On top of this, Telkom will retain its cash generative fixed line business, which we consider worth about R50/share on earnings of R10/share. Further, if we compare Telkom to MTN, Telkom scores better on metrics that are key for value investors: it has a price:earnings ratio of 6x compared to MTN's 12x; Telkom is on a dividend yield of 6.3% while MTN is paying a much thinner 1.7%; and Telkom's price:book ratio of 1.6x is substantially below the 2.6x of MTN.

The entire life insurance industry has been under pressure since 2007, and Old Mutual is no exception. The company's 2008 results were dragged down by its failure to hedge the US business, but its capital requirements are sound. Whether one looks at Old Mutual on an embedded value basis (1475c/share) or on a sum of the parts basis (1500c/share), at 800c the counter is trading at an enormous discount.

Our final example of buried treasure is shipping, trading, freight and financial services company Grindrod. The company had record earnings in 2008.  Whilst this will not be repeated this year, the share has been derated to such an extent that even if earnings halve, Grindrod will be on a forward price:earnings ratio of only 5x.  Moreover, more than 40% of the share price is represented by cash, meaning Grindrod is well poised to defend its position in the industry through the downturn and, perhaps even use cash for opportunistic expansion.  

But the treasure chest includes more than just companies.

The corporate fabric is changing. For example, Jack Ma, CEO Alibaba Group refers to the slowdown as 'a treasure' which is enabling the group to add 5,000 to headcount (to reach 17,000) in 2009.

New giants are rising out of emerging markets in the wake of the global crisis: China's car sales are set to grow by 10% in 2009; Indian firm Tata will sell the Nano in Europe and the US in 2011; China's Chery and Geely have shown an interest in buying Volvo; Brazil's Vale has bought assets from Rio Tinto; and ZTE (China) is a possible buyer of Motorola's handset division.

Closer to home, SAB Miller emphasizes Africa for growth opportunities. Africa represents a US$3.0bn market with many economies growing in the 4%-5% range. The brewing giant is opening breweries in Mozambique, Angola, Tanzania and The Sudan this year alone. 

In fact, Africa is playing a fresh role in the new world order. The continent is on the up and Afro-optimism is taking the place of Afro-pessimism. As Time magazine wrote in March 2009, "Africa offers more opportunity than any place in the world". This is the third fastest growing region in the world, having escaped the worst of global recession. The continent's trade is heavily cash based, which is a key factor in Africa escaping the worst of the credit crisis fallout.

Finally, there is treasure to be found in the people who have been uncovered by the crisis. The global political order has a new face in the form of Barack Obama: in his first 100 days in office, a man with no executive experience has demonstrated the ability to bring results previously out of reach.

Investors can maximize their advantage in this environment through:

•       engaging the value philosophy;

•       constructing a portfolio of assets with varied and growing earnings streams;

•       seeking shares of quality and defensiveness (balance sheet, cash, earnings protection, brand); and 

•       having a willingness to be contrarian