Volume 24Investment Insights

April 2013

Contents

Introduction 2

The Real Thing 4

Investment Strategy in 2013 and Beyond 11

Steel Schmaltz 16

Chasing Yield down a Hole 22

The Cost of Income 28

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The big news this quarter is that RE:CM is 10 years old. On the 1st of April 2003, we opened our doors for business in a tiny little office with a view of a shipyard where rusty old tubs were being (loudly) repainted. We had set up one unit trust – today called the RE:CM Global Flexible Fund – and were waiting for the phone to ring. Three days later, we had our first client, and R250 000 under management. It took us 7 months to land our first institutional client – more about that later – and we haven't looked back since then.

I'd like to thank each and every one of our clients for supporting us over the past 10 years. Without you, we would not have a business. I'd like to remind you that the quid pro quo for this is that your best interests are always top of mind at RE:CM.

Secondly, I'd like to thank our staff for providing such a stimulating place to work. It's truly a joy to walk into the office and encounter the questioning minds and eager drive to succeed that the people in the firm possess. I look forward to being part of this culture for a long time indeed.

Our first institutional client

I very well remember the meeting we had with potentially our first institutional client. From their side the meeting was lead by a young investment analyst. All sorts of interesting and difficult questions were posed, which we tried to answer as best we could. The final question, after two hours of serious due diligence, was 'Would you consider managing an equity fund for us?'At the time, we were managing only one fund, a balanced fund, so my answer was a regretful 'No'.

It was months later that I heard through the grapevine that the institution really wanted to award us the mandate and were disappointed that we'd turned them down. As we were still quite small then and any new business was quite welcome (to put it mildly), I phoned them and asked if we could reconsider our initial response. They graciously allowed us to do so and ultimately awarded us quite a large mandate.

The point of this long story is that the analyst's name was Jan van Niekerk, a young actuary who, at that time, had recently joined Citadel's investment

team. It was as a result of his due diligence that Citadel appointed RE:CM to manage the mandate. Eventually Jan became the CEO of Citadel and ultimately graduated to become the CEO of its parent, Peregrine, a JSE listed investment company. I'd like to think one of the reasons for his rapid climb up the corporate ladder was how well RE:CM did for Citadel's clients, but I think his own innate ability to come to deal with the complexities of business was a more important factor.

On 1 April 2013, Jan joined RE:CM as CEO. He has now come full circle from client to boss! He's hit the ground running (in more ways than one – he's just come back from running the Paris marathon) and I'm sure you'll get a chance to meet him sooner rather than later.

We look forward to working with Jan, as he knows RE:CM very well and subscribes to our investment philosophy and process. Daniel Malan and Lonn Potgieter continue to manage our investment team and operations team respectively. My own role will change to that of non-executive Chairman, and I'll be spending much more time on investment analysis.

A quiet BRICS meeting and tepid emerging markets

Over the past quarter, global markets have been buoyant despite continuous worrying noises emanating from the economic engine room. During the first quarter of 2013, global equities (as measured by the MSCI World Index) rose 9.9%. Global bonds actually declined by over 2%, perhaps reflecting the inflationary zeal of our monetary authorities. Unfortunately, emerging markets, incorporating the famous BRICS grouping, continued their underperformance, producing a marginal negative return for the quarter. It isn't yet clear whether the decline was in spite of, or because of, the recent BRICS summit held here in Durban, South Africa. Let's just say that if the market was waiting for an announcement of economic importance from these large economies, which are also so clearly dependent on the developed economies for growth, it was inevitably disappointed.

The big news for South African investors during the quarter was the depreciation of the rand

Introduction

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against most major currencies. Various market commentators ascribed the fall to either a vote of no confidence in the local political situation, or a reflection of our current mining woes. Our own view is that the rand has for a long time been conspicuously overvalued. What has happened is a normal adjustment to a more realistic level. There will of course be a few economists who will be able to tell us exactly what happened – after the fact.

The defensive theme plays out again

By sector, and looking across developed and emerging stock markets, we saw the defensive theme again play out. Healthcare and consumer staples outperformed while energy and materials were the two weakest sectors. This is a theme we've written about at length previously. To recap, what we see happening in markets is the following: investors don't want to go through a similar 'near-death' experience as with the financial crisis in 2008/09. The mistake they made then was to ignore good quality, dividend-paying companies and to overpay for cyclical, commodity-producing companies. Through the crisis, the share prices of good quality companies fared well, while those of cyclicals tanked dramatically. As a result, today investors only want to buy good quality dividend-paying companies – almost at any price. But in their eagerness to avoid making previous mistakes, investors are overpaying for these 'quality' companies – which will end up with the same result.

Needless to say, as value investors, we find ourselves out of step with these shifts. Our funds have continued to increase their exposure to undervalued cyclical companies and have continued to avoid expensive good quality defensive companies. Our investment philosophy states that we invest in undervalued securities, with an emphasis on quality. Examples of good quality cyclical companies are the platinum mines and the diversified mining houses. Gold companies are not good quality and we own very few gold shares. Since it's hard to find an abundance of quality in cyclical, commodity-producing sectors, where mandates allow, our funds have been building up excess liquidity in the form of cash.

With buoyant equity markets in the ascendency it's no surprise that corporate activity is starting to pick up again. In the US, Michael Dell wants to take his eponymous company private, and is facing opposition from two other bidders who have been attracted by the keen price being

offered. As shareholders of Dell, RE:CM clients will no doubt benefit from the bidding war. In South Africa, Bidvest is going hostile on its bid for the pharmaceutical giant Adcock Ingram. Again, RE:CM clients are shareholders of the target company and will no doubt benefit if there is some negotiation on the price.

A quick summary of the articles that follow

In this issue of RE:VIEW, we lead off with an article by our associate in Tokyo, Alexander Kinmont from Milestone Capital. He sets out the long-term bullish case for Japan. This is a very interesting, non-consensus view to which we subscribe.

The second article, which I wrote, sets out what we think is an appropriate investment strategy for these times. Its main components are to buy what is cheap (cyclicals, capital gains), avoid what is expensive (bonds, yield/income, defensives) and disregard the artificial distinction between income and capital gains in your portfolio.

The other three articles deal with specific aspects of this strategy. In the third article, Daniel Malan talks about global steel stocks and how cheap they've become. These stocks are a classic example of cyclicals which do not (cannot!) deliver any income at this stage, but which should realise substantial capital gains from current prices in time. It's exactly this type of investment that should be favoured by long-term investors today.

However, one should be cautious not to just buy any old cyclical company – especially when they're trying to dress themselves up as high yielding investments. This is what Sibanye Gold (recently spun out of Gold Fields) seems to be doing. In the fourth article, Richard Court tells us why we should be careful of this situation.

Finally, in the last article, Wilhelm Hertzog, in his inimitable way, shows us that disregarding the false distinction between capital gains and income yield is a winning strategy. Again, this is of particular relevance in terms of our investment strategy at this time. It bears careful reading by conservative investors.

As ever, good investing.

Piet ViljoenChairman

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The Real Thing

'The possibility of sustained decreases in business value is a dagger to the heart of value investing (and is not a barrel of laughs for other investing approaches either).' Seth Klarman on investing in a deflationary climate

Deflation has been the principal factor driving the valuations of robust businesses down to 'distressed' levels in Japan. The important question is whether or not an investment environment can again exist in Japan in which robust businesses are able to command normal valuations.

Something momentous appears to be shifting. The market's recent extraordinary move – the most sustained in 53 years − suggests it is already working its own way towards a different consciousness of where stocks should trade, one far removed from the pessimistic psychology of the past twenty years.

But before we go any further, let's examine a couple of commonplace yet surprisingly unorthodox interpretations of the current market mood.

Explaining the market's rally in conventional, but unpopular, terms

Generally speaking, the market and 'real economy' effects of quantitative monetary easing materialize only with great lags. We are, therefore, attracted to the view that the current rally is largely an artefact of the ramp-up in quantitative easing in 2011 following the earthquake, as opposed to anything the new administration has done.

This would be more or less the same pattern that was observed in 2003-2005, when Japan enjoyed its only prior period of genuinely loose monetary policy post-1992. In that instance, the 2003-4 easing (a combination of foreign exchange intervention and bank reserve growth) took 15 months before it fed – explosively − into higher stock prices. This time we waited 18 months.

This also implies that any further easing upon which the Bank of Japan (BoJ) may embark would have its positive effects only in 12 to 18 months from today.

But the lagged effect of existing easing doesn't appear to be the whole story.

The real story

To us, because we're old, the Abe administration carries the flavour of a tribute band reprising the Liberal Democratic Party's (LDP) greatest hits. However, such a trivializing reaction risks being a misinterpretation of the choices embodied in the new Cabinet.

The real story is the Senkaku Islands. For whatever reason, China now appears to believe (in the way Japan believed the same towards the late eighties) the lazy consensus that its rise is 'inevitable'. Equally (and perhaps, looking at Japan's unbroken record of failure since 1990, understandably) China seems to believe the pessimistic consensus that Japan's decline is also 'inevitable'. As a result, a China which no longer feared resistance unnecessarily overplayed its hand in respect of the Islands1.

While Japanese businesses which have over-expanded in China might fret, and traditionally anti-US elements might chafe, our sense is that there is no popular appetite in Japan for any concession towards China over the Islands. We suspect that's what was behind December's election result. If you know China is going to be rubbing up against you, you need the US, and if you need the US, you need 'the pros' – that is, the LDP − back in power.

But the shift goes further. Seen over the longer run, an external environment developing in this uncongenial manner requires that Japan has a functioning economy − as the old, late 19th century slogan had it: 'Rich Nation, Strong Army'. Perhaps

1. We focus on Japan alone here, but we recognize that China has also made similar moves against neighbours as far apart as India and Vietnam. This should lead one to reject the often-made suggestion that Japan somehow 'provoked' China.

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the best, and certainly least controversial, riposte to China would be an economic resurgence.

Internal to Japan the environment is also changed: everyone now has a zero-cost opportunity to change their position (though whether they all appreciate this yet is unclear).

Moreover, there can be no more messing about with unserious perspectives like 'reform' or any other type of 'structural' frivolity. Rather than theological disputes about 'reform', or other forms of sectional point-scoring in an apparently 'zero-sum' game, Japan quite simply needs higher GDP in order to command respect (and ultimately to pay for more weapons).

External discipline has been re-imposed.

The Senkaku Islands

It might be thought that uninhabited islands are unimportant.

The Senkaku Islands' significance is they are part of the Nansei chain. The 'historical evidence' by which China's claim is supported can be extended

to claim not just the Senkaku Islands but effectively the whole of Okinawa prefecture – and indeed a Chinese official has publicly made this assertion.

It is one thing to claim some rocks frequented mainly by seagulls. It is quite another to claim islands on which the US Marine Corps is based and possession of which by an enemy, as 1945 shows, renders Japan indefensible.

'Abe-nomics'

In retrospect, it is illuminating that, for all the adulation he received, former Prime Minister Koizumi never spawned a '–nomics'. In the backhanded, unacknowledged, way that common usages allude to the true nature of things, the absence of a '-nomics' reveals him to have been recognized as having no positive significance in the economic sphere. Likewise, his sidekick, Mr Heizo Takenaka.

By contrast, despite room for doubt as to whether Mr Abe has himself given economic questions a great deal of thought (though clearly his advisers have), 'Abe-nomics' arrived, more or less fully formed on December 16th 2012, as a reversal

Map of the Senkaku Islands

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of all prior orthodoxies. Our suspicion is that it would have arrived in the same form, though under a different name, whoever had been elected premier.

We have no doubt that 'Abe-nomics' (taken in this diffuse and impersonal sense of ditching the macro-economic shibboleths of the recent past) will 'work' if consistently applied. This represents a challenge to the 'austerian' orthodoxy which has gripped the developed world in the last few years and Japan for longer. If Japan, the first country into a recession unnecessarily prolonged by austerity, can break out, then it is open to others to follow the same path.

Of course, the number and range of voices whose commentary would be invalidated (or at least revealed to be partisan chit-chat as opposed to economic analysis) by a successful reflation in Japan means that they can be relied upon to maintain a chorus of pessimism even as Japan follows the right policy path.

While there are social and political arguments for and against an expanded role for the state in the economy, they're different from and not necessarily relevant to an economic argument that, in Japan's situation, a proactive increase in public investment, or further volumetric monetary stimulus, might be both desirable and effective. In many cases, scepticism towards 'Abe-nomics' isn't actually a discussion of Japan.

Furthermore, 'Abe-nomics' hasn't 'been tried before and failed'. Our analysis of Government spending since 1990 suggests that there have been only two premeditated attempts to use fiscal policy to reflate the economy in the deflationary period (which began in 1997). The first was 1999 – an actual recovery. The second was 2009 – also a recovery. All other episodes of an expanding deficit were involuntary − the consequence of falling tax receipts and not a rise in what the UK Government would term 'managed expenditure'.

Likewise, despite low or zero interest rates, and a prolonged expansion in the Central Bank's balance sheet arising out of stresses in the financial system themselves induced by the same Central Bank's failure to tackle deflation, the only case of genuine monetary easing post-1996 extended from January 2003 to March 2004 – a period of recovery.

The tragedy of the post-Bubble era isn't that fiscal and monetary stimulus were 'tried and had no effect', but that they were tried, did work and yet were summarily abandoned.

The policy mix with which Mr Abe is now associated is therefore both new and old at the same time. If, in contrast to the episodic and grudging use of such policy tools in the recent past, it is continuously applied for long enough, we have no doubt that 'Abe-nomics' will 'work'2.

Of course, we aren't blind to all the inefficiencies involved. But the question is one of will, and not of mechanics. Though one feels uncomfortable with the concept, the 'national will' appears to have changed.

History

Another common line of pejorative commentary about the current administration is that the Abe Cabinet somehow represents the first steps in a 'return to the 1930s.'

That such a disobliging and unrealistic tone has infected commentary about the Abe Cabinet appears to us to be an unconscious admission of the paucity of cogent, purely economic, arguments against 'Abe-nomics' (as well as a reflection of a widespread want of familiarity with Japanese history).

At a more atmospheric level, though, it might be worth considering history from a different perspective. It was Japan that built and operated the first purpose-built aircraft carrier ever commissioned − the Imperial Navy possessed 10 battleships and 10 aircraft carriers on December 7th 1941.

We might profitably examine the possibility that the reflexes which allowed this country to

2. 'Demographic' pessimism is also unwarranted. Since 1990, labour input has fallen to an extent that cannot be explained by changes in the age structure of the population. Over timeframes of relevance to investors, a declining labour force does not per se represent a significant constraint on growth because the opportunity exists for this withdrawal of labour input to be reversed. In passing, we also note that the age structure of society has enjoyed no demonstrable relationship with trends in either total public spending or even social security spending alone. Demographics is seductively determinist – but almost entirely irrelevant to investment decisions.

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build one of the world's three most powerful navies from almost nothing in little more than 25 years (a progress so rapid it had to be limited by international treaty), and then, once it was gone, to build the world's second largest economy in little more than 30 years, haven't gone away. Could they be more properly representative of Japan's potential than the dismal, dithering, incoherence that has characterized the post-1990 period?

History should teach us that (for better or for worse) Japan isn't a country to be trifled with. Our perception is that, over the longer run, China will win no friends in this region for a demarche which looks as though it has occasioned an historic normalization in Japan's military posture.

Why the geo-strategic position matters to stocks

As investors, we cannot help but note that the Berlin Wall came down seven weeks before the Japanese market's 1989 peak. What went wrong for Japan was that she became expendable. That period of strategic irrelevance appears to have come to a close.

Our reasons for seeing scope for positive evolution in the investment environment are therefore long run and secular in nature. They reflect new developments in Japan's military and strategic alignment, and the second-order effects of these in terms of trade, investment and currency policy. They will take years, not weeks or months, to play out to their full extent. They don't depend upon who is PM or Governor of the BoJ.

While for investors the critical shift is probably that Japan has acquired a strategic need for growth in order to pay for the ability to defend herself, a second dimension of the changes now afoot is that Japan potentially has a new value to the US.

Clever diplomacy (and luck) in the late 1940s assured Japan a privileged commercial position to go hand in hand with its protected strategic position under the US security umbrella.

This benign dispensation extended from 1952 until Japan became surplus to the US's requirements upon the fall of the Berlin Wall. Today, the US's increasingly evident, though never clearly enunciated, tilt towards containing China offers Japan the opportunity to become a regional counterweight of value to the US.

Such considerations are, we know, only a partial explanation of Japan's spectacular decline in the 1990s3, but to overlook or underestimate the coincidence in the timing of the fall of the Berlin Wall and the peak of the Japanese economy, while tempting, is a mistake. Not to consider the full ramifications of Japan's recovery of strategic value represents a comparable error.

This shift in the strategic regime remains – so far − little more than an opportunity or a potentiality. Clearly no one hopes for confrontation and it may yet be that the US and China find a mutually satisfactory arrangement in which Japan is of little value to anyone. That is the real threat to an optimistic general perspective on Japan.

On the Japanese side, the challenges remain immense. A whole generation has lost the habit of success; Japan's diplomatic establishment is divided; her political establishment unstable and faction-ridden; macro-economic policy designed to abort economic recovery has been orthodox for more than a decade; politicians and the bureaucracy may not be capable of providing proper interlocutors to Washington so as to seize the opportunity events have offered.

But if a new strategic bargain does emerge, even one not as fully worked out as the Cold War dispensation, one would assume that, like 1950-1989, it provides the backdrop for the re-emergence of a 'strong Japan' − in all respects.

We do see the risk that we're over-interpreting small hints and extrapolating them without decisive evidence into a view that could be dismissed as wishful thinking. Yet we are strongly convinced that the key long-range issue in deciding whether Seth Klarman's dagger still hangs over Japanese business values is when and how a changing strategic reality translates into a new macro-economic framework for this country.

We aren't deviating from our cautious and methodical, bottom-up, approach – we don't invest on a 'macro basis'. But we do see current developments as constituting a rather early stage in the normalization of investment conditions in Japan.

3. For the stock market the factor of decisive importance was over-valuation. This ceased to be a factor in 2009.

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Lest this analysis be suspected of displaying too developed a Panglossian tendency on our own part, we emphasise that our view is more that economic normalization will deliver a better investment environment in the end, than that such an environment is necessarily and immediately at hand.

Macro stabilization doesn't eliminate micro-economic risks

We're aware that we suffer from a bias which arises naturally out of what we do every day.

In our long portfolio, we deal exclusively with businesses that we judge to be fundamentally robust. We're always long-biased and we're focused on smaller capitalization stocks.

We know that we're prone to underestimating the deadweight lying on the total economy which is represented by mismanaged and under-managed larger capitalisation companies4. This is despite our taking short positions in those companies which, in addition to being rotten businesses, we judge to be materially overvalued.

4. This is the micro-economic counterpart of the macro-economic 'sectoral balances approach' as developed by Andrew Smithers.

We cannot exclude the possibility that, even following a transition to a non-deflationary economy, a large fraction of the market would still contrive to destroy business value. Even as, for instance, a weaker Yen reveals those businesses for which only the currency had been a problem, it will also bring more clearly to light those for which a macro tailwind is insufficient to overwhelm the effects of mismanagement and malinvestment.

Our defence against such a possibility is to focus on relatively straightforward, smaller businesses selling at cheaper valuations. Table 1 shows the valuation differential between small and large stocks, in this case using the TSE First Section and Second Section averages as indicative of large versus small. Small (the second section) is clearly more attractively valued.

The dagger drawing away from our hearts?

Chart 1 shows that despite its recent run, Japan remains the cheapest equity market in the world (on a properly calculated cyclically adjusted, or 'Shiller', price-to-earnings basis).

On our calculations, the market overall sells at a valuation consistent with its delivering modest but positive real, price-only, returns over the next ten years. The stocks on which we focus are

Chart 1: Topix Index – 'Shiller PE' (or Cyclically-Adjusted PE) Ratio, 1980 – to Date

Source: Bloomberg, Morgan Stanley, Milestone Asset Management

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much cheaper5. That a major Japanese company (Sony) could last month sell a single property in Manhattan for the equivalent of 10% of its then market capitalization – and no one even knew it owned the building – speaks of the degree to which Japan remains overlooked.

A slow and grudging normalisation of policy had already begun before the advent of the Abe administration. The BoJ began easing with the earthquake/tsunami of March 2011. The example of 2003 to 2005 suggests that such volumetric easing has no appreciable effect on the economy (or, indeed, on stocks) for at least 15 months.

It is nearly two years since the earthquake. While the quantum of easing this time has been smaller, one needn't adduce 'politics' as an explanation of the market's rally so far. It could be merely that the lagged effects of monetary easing were 'overdue'. This realization both keeps in check any tendency to over-interpret what has happened so far, and promises that any further easing will have its effects far in future.

A transformation in the strategic position stands behind the growth bias now being pushed by the LDP, as opposed to there having occurred some Pauline conversion in respect of economic orthodoxy either on a personal or on a group basis at party headquarters. If, as we argue, the real change in the backdrop isn't so much economic as geo-strategic, it has yet to play out.

Beyond the emergence of a growth bias, the key economic change that flows from the new geo-strategic position is that Japan, as a viable

5. The market's move this year reduced the average 'margin of safety' on our top ten holdings only from 52% to 40%. All these are conservatively financed, cash generative, robust businesses.

potential counter-weight to China, should get a different hearing in Washington now than in the 'wilderness years' which followed the end of the Cold War. This should allow an environment to develop in which the Yen can go down and stay weak – and ending Yen appreciation is the sine qua non of reflation.

As this essay suggests, we're far from being fully signed-up members of the 'Abe glee club'. We simply don't think it's necessary to be so. Any trivialising propensity to look for parallels in the illusory rally of 2005 and to attribute policy change to personages should be resisted.

We are, of course, happy to acknowledge that no change of bias on this scale is ever going to play out without opposition, and indeed, from time to time, apparent reversal. But our thesis is that the geo-strategic forces which have been unleashed are sufficiently powerful as to outlive the current PM and the next Governor of the BoJ. Ultimately, our views are largely independent of the personalities involved, the machinations of parties, or the trivial intrigues of bureaucratic interest groups.

We cannot help but remark that our intuitions would be vindicated more by Japan's outperforming in the next downturn in global markets than in her performing strongly in the near term. Changes of long-term trend usually emerge in adverse, rather than in buoyant, circumstances.

Despite these provisos, and at a high level of generalization, we suspect that the 'lost 20 years' is over − because the persistent anti-growth policy bias of that period can no longer be sustained. What that means for the broad averages in the near term we don't know. Given the timeframes over which the trends we perceive to be developing will play out, there is, we suspect, no need to rush one's response.

Table 1: Representative Valuations: Large More Expensive Than Small (End-March 2013)

(Ratio) TSE 1st Section TSE 2nd Section

Consensus Price-To- Earnings 16.5 14.3

Price-to-Book 1.3 0.8

Price-to-Sales 0.6 0.3

EV/Ebitda 10.0 6.1

Source: Bloomberg, Morgan Stanley, Milestone Asset Management

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The last 20 years gave us frequent cause to lament the truth of Seth Klarman's comment about investing in a deflationary climate quoted at the start of this article.

Could it be that that dagger has begun to draw away from our hearts?

Alexander KinmontTokyo

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Investment Strategy in 2013 and Beyond

'Doubt is not a pleasant condition, but certainty is absurd.'Voltaire

'The world seems more uncertain today than at any other time in my life.'Howard Marks, September 2012

'It must be evident that we have no enthusiasm for common stocks at these levels…However, we feel that the defensive investor cannot afford to be without an appreciable proportion of common stocks in his portfolio, even, if we regard them as the lesser of two evils – the greater being the risks in an all bond holding.'Ben Graham, The Intelligent Investor

Uncertainty calls for a robust investment strategy

As investors, there is a huge amount of uncertainty in everything we do. To deal with this uncertainty, we need a good investment strategy. There are different types of strategies − some rely on accurate forecasts of the future, others incorporate robustness to deal with the vagaries of the market. This robustness is generally achieved through diversification and intelligent asset selection.

The first type of strategy pays off big if the forecast turns out to be correct. If it's not correct, it can lead to unsustainable losses and possible ruin. The second type of strategy will do fairly well some of the time and less well during other times. But it will always ensure that the investor's capital remains intact and enjoys reasonable growth over the long term.

In this article, we discuss three issues investors face and then devise a robust investment strategy to deal with these issues.

The key issues facing investors today, which bear diligent interrogation, are:

1. The uncertain economic backdrop against which investment decisions need to be made.

2. Financial repression and its impact on the opportunity set that is available to investors.

3. The artificial distinction between income and capital gains, which causes untold asset allocation problems.

Certainty isn't a requirement for good portfolio returns

The current background against which we need to make our investment decisions is characterized by very high levels of uncertainty. This uncertainty isn't only in the minds of investors, but also in the minds of policy makers who are trying to manage our economic affairs. Richard Fisher – a member of the US Federal Open Market Committee − had the following to say in September 2012:

'The truth, however, is that nobody on the committee, nor on our staffs at the Board of Governors and the 12 banks, really knows what is holding back the economy. Nobody really knows what will work to get the economy back on course. And nobody – in fact, no central bank anywhere on the planet – has the experience of successfully navigating a return home from the place in which we now find ourselves. No central bank – not, at least, the Federal Reserve – has ever been on this cruise before.'

So, what he is saying is that nobody knows anything today. And who are we to argue?

What we do know is that, globally, we're experiencing tepid economic growth with a depressed job market. This is even happening in the BRIC markets, which until quite recently were held out as the poster children of how successful, high growth economies should be run.

Not only is the environment uncertain, but there are many, many identified – and, we're sure,

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as yet unidentified – risks out there. The fiscal sequestration, the Eurozone implosion and the politics of austerity – all of these developments (and the others we don't yet know about) represent risks investors need to be able to deal with in their portfolios.

This uncertain and risky environment directly influences the way both businesses and investors make decisions and allocate capital. When the environment is uncertain, we become timid and overcautious.

But we would warn you against spending too much time worrying about the macro-economic situation and building portfolios to deal with whatever views you might come up with. Our ability to forecast the future is highly suspect and doesn't have a very good track record. It's in our nature to extrapolate current conditions. When things are going well, we think they will continue to go well, and when things are going badly, we think they will continue to go badly. We continue to do this no matter how many times an expansion is followed by a recession or a recession by an expansion. And even if we get the future right, the superior ability of the market to collectively anticipate the future – and price assets accordingly – makes it very difficult to make money consistently from one's forecasting ability.

As Voltaire says, certainty is absurd.

Consider this: Over the past 20 years, the South African equity market has enjoyed a massive bull market, compounding at a real rate of over 10% per annum. And that 20-year period included a massive political transition – remember the rush to buy tinned goods and candles in 1994? It also included an emerging market collapse (1998), a rand collapse (2001), and a global financial crisis (2008). Every time, the big losers were concentrated holders of highly priced, popular assets. Holders of a diversified basket of cheap or fairly priced assets – what we would define as robust portfolios – have done very well over time, despite some short-term setbacks.

And therein lies our first clue as to an appropriate investment strategy for these uncertain times.

Financial repression robs investors in order to bail out the reckless

Unfortunately, governments worldwide have chosen this precise time to effect a policy of

financial repression. As Keynes so eloquently pointed out, financial repression leads to very low returns on capital. This is how he described it 80 years ago:

'It would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity value of capital. Interest today rewards no genuine sacrifice, any more than does the rent of the land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital.

Thus we might aim in practice (there being nothing which is unobtainable) at an increase in capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus.'

What he is saying is that it's in the authorities' power to reduce the return on capital to such low levels that investors have no incentive to save.

Now, to understand what our investment strategy needs to look like, we need to understand the motivations behind this euthanasia. Simply, governments worldwide owe their creditors so much that they can never repay it, or grow out of the problem, in the normal course of business. So instead, they have embarked on a program to reduce their debt levels by diminishing the value of the debt. And remember, the government's debt is the investor's asset. Think about that for a moment. This is what Keynes means when he talks about the 'euthanasia of the rentier' and what we mean when we talk about financial repression. This euthanasia can take one of three forms – debts can be reduced through inflation, deflation or abrogation (default). It isn't hard to work out which is the course of least resistance for democratically elected governments subject to a regular popular vote. It's only smaller economies − like South Africa in the mid-eighties or Argentina early in this century − that can default easily. No one wants deflation, because that would imply austerity and all its negative political connotations. Most would rather follow the inflationary lead of Zimbabwe 10 years ago, the whole Western world 40 years ago or Weimar Germany 80 years ago.

But, whichever path indebted governments follow to reduce their debt burden, it doesn't work out

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well for the rentier, or the investor in today's terminology. The investor is being slowly but surely euthanized in order to bail out the reckless and profligate, who cannot pay back their debts in the normal course of business.

This is the second clue as to how our investment strategy should look.

Conventional wisdom tends to be dangerous

Say what you want about the financial market and its movers and shakers, but they're very, very good at creating product that makes us feel smart and comfortable. And who doesn't want to feel smart and comfortable? As usual, financial markets have come up with a convenient solution to today's problem of financial repression. As usual, the solution has a name – they call it 'Quality Dividend Growth'.

Many studies can be used to prove that dividends have historically made up the bulk of investment returns, so why not buy the equity of good quality businesses (read: businesses possessing barriers to entry)? These are demonstrably able to pay growing dividends, and have an initial yield higher than that available on interest bearing assets. It's a no brainer when the government is trying to euthanize your portfolio.

Unfortunately, any student of the market can tell you that investing in line with the 'Conventional Wisdom' – the no-brainer – isn't an investment strategy conducive to good results. Historically, conventional wisdom had us investing in:

· 'Asian Tigers' in the mid-nineties, because these economies would enjoy high rates of economic growth forever.

· 'Emerging companies' in the mid to late 90's here in South Africa, as the 'death of the Blue Chip' was announced.

· 'The New Economy', at the turn of the century, because technology would change our lives, and would grow, according to John Chambers, the CEO of Cisco, 'as far as the eye could see'

· 'Rand Hedges' in 2002/03. South Africa was ex-growth, and we were selling our Clifton bungalows to buy dingy bedsits in London. Local property yielded 20%, but there was no interest. Afro-pessimism was quite fashionable.

· 'The Commodity Supercycle' in the late 2000s. China would grow forever and the build out of infrastructure in the BRICs was very resource-intensive. Commodity prices could only go up.

Chuck Prince, the CEO of Citigroup told us to continue dancing while the music was playing.

As investors, our portfolios were hit hard by these 'sure things' that we thought we understood so well and could even actually see happening around us. And here's the thing – none of these stories were false. They were all grounded in reality. Asia has grown faster than the West for the past 20 years. Small companies have performed better than big ones, technology has changed our lives and the rand is inherently a weak currency. And China continues to grow rapidly and demand ever-increasing amounts of commodities.

The problem wasn't the story. It was the price we paid to buy the assets associated with the story.

A quick word on valuation might be necessary here. Asset values are determined by the present value of the free cash flows generated by the asset over its life. Importantly, the present values of all those future cash flows are determined by discounting the future cash flows with interest rates. And the lower interest rates are, the higher – in today's money − the value of those future cash flows. So, at first glance, it seems that the policy of financial repression might serve to raise the values of assets.

But are investors genuinely better off? Our balance sheets consist of assets (our investments, house(s) etc.) as well as liabilities (any debt, future retirement obligations, future healthcare obligations). Just as current monetary policy raises the value of assets, it also serves to raise the value of liabilities. The net result being that we're no better off in real terms.

All we have are popular assets that are priced highly. And from the past 20 years' worth of investment history we all know that highly priced popular assets carry a much greater amount of investment risk than low priced, unpopular assets, whenever the crunch comes – as it invariably does in every cycle.

So we're faced with a Morton's fork. For those that don't know what a Morton's fork is – don't worry, we didn't either – it's the use of two conflicting arguments to get to the same conclusion. It's said to originate with the collecting of taxes by John Morton, Archbishop of Canterbury, in the late 15th century. He held that a man living modestly must be saving money and could therefore afford taxes,

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whereas if he was living extravagantly then he was obviously rich and could still afford them.

So today's Morton's fork looks like this: on the one hand, due to our investing in previous 'themes' our portfolios are a bit light to do the heavy lifting of generating enough income at low risk to sustain us in our retirement. We therefore need to invest in the current promising theme to correct this.

On the other hand, due to low interest rates, we're struggling to generate income through our portfolios, therefore we need to take more risk to generate income. The 'obvious' way to do this is to invest in the current theme of buying the equity of dividend paying companies, in the hope that low risk income will be generated.

At the same time as the 'theme' stocks have become very expensive, there is a group of assets that have become very cheap − the equity and debt of cyclical businesses and businesses operating in financially constrained countries. These have been knocked down to bargain basement prices. Their current cash flows are negligible, or even negative, and their positive cash flows lie too far into the future to benefit from the market's myopic low interest rate discounting activities. Interestingly, monetary policies are expressly aimed at bailing out debtors − nations, banks, and individuals. As they say in the classics, 'Don't fight the Fed!'

So the opportunity set facing investors is one of overpriced (low prospective return) desirable assets, and cheap (high prospective return) undesirable assets. Another way to put this is that we're faced with expensive income and cheap capital gains due to the overwhelming current preference of investors.

And voila! We have clue number three for our investment strategy.

Returns from capital gains and income are no different

This brings me to the third important issue we face. That is our inclination to put capital gains and income into different buckets, and regard them as completely separate. In fact they're two – albeit varying – components of that one thing called Total Return. The psychological distinction between income and capital is a fallacy: money is money, no matter the source. The level of consumption that a given investment can sustain is a function of the total returns generated by that investment

over time. Whether the return is achieved in the form of income or capital is immaterial.

Low yield environments often go hand in hand with expensive assets, as explained earlier. In times like these, it's often better to sell assets to generate 'income' rather than buying expensive income-yielding assets. Investing for total return rather than income alone has historically been a superior investment strategy, as my colleague Wilhelm Hertzog demonstrates in his article 'The cost of income' elsewhere in this issue. Investors can create exactly the same income stream as that offered by a 'yield' investment by selling a portion of their assets to fund living expenses. And they'll still be well ahead in terms of net worth at the end of the investment horizon – as long as the investments they chose don't suffer such major losses that their capital is permanently impaired.

However, it's important to realize strategies aimed at generating total returns − as opposed to pure income − have historically been more volatile than strategies focused on income. But unless their time horizon is very short, this shouldn't concern investors unduly. The odds favour those investors who can cross the emotional bridge of viewing capital as sacred and income as something to be spent.

And this is the final clue as to our investment strategy.

Successful investment strategies ignore conventional wisdom

So let's summarize what we have learned:

· Robustness is a better strategy than forecasting. · The macro environment has less of an influence

on your ultimate investment returns than the price you pay in relation to the intrinsic value of the asset.

· Financial repression is a transfer of wealth from the solvent to the bankrupt, through the mechanism of low interest rates. Get on the right side of this curve.

· Today, assets that rely on their income-generating ability for returns are expensive, cyclical assets where capital gains contribute disproportionally to total returns are cheap.

· Do not make an artificial distinction between capital gains and income. They're part of the same equation.

A successful investment strategy will thus focus on buying cheap, out of favour equities of

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businesses that are struggling cyclically and are thus being ignored by the 'income at all costs' crowd. In the interests of diversification, investors can supplement these with some hard assets that might benefit from unexpected inflation.

Another important component would be cash. This may be useful if deflation continues and causes the price of quality dividend growth equities to decline because they cannot fulfil the public's growth expectations. Such a portfolio will probably not be able to generate enough income in the short term, but this can be easily dealt with through selling a small portion of the assets each year.

As ever, the choice is clear, but hard to make.

Piet Viljoen

References:

Fischer, Richard W. (2012). 'Comments to the Harvard Club of New York City on Monetary Policy'. Available from: https://www.dallasfed.org/news/speeches/fisher/2012/fs120919.cfm (Accessed 27 March 2013)

Keynes, J.M. (1936). The General Theory of Employment, Interest and Money. London: Palgrave MacMillan

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Steel Schmaltz

Schmaltz is a Yiddish word for rendered chicken, goose or pork fat. It is used for frying or as a spread on bread in German, Austrian and Jewish cuisine.

The expression 'falling into the schmaltz pot' refers to the concept of having something good happen to you, often by sheer luck (for example being born into a good family). Someone who happens to have good luck is given the reputation of being a schmaltz. Wikipedia

'If it's that hard, then you abandon that because there's another one waiting to get in. I'm not into songs that play hard to get. I'm in for the cheap date.'Eddie Vedder, Pearl Jam lead signer / songwriter – The Fretboard Journal Number 24

'We note the replacement cost of Arcelor Mittal SA would be close to R140 per share (for new state of the art facilities). Whilst we acknowledge it may be unrealistic to expect any potential suitor to pay this amount, it's worth noting that it would be a lot cheaper to buy Arcelor Mittal SA's shares, even at a reasonable premium to the current share price, than to build a new steel plant in South Africa.'

'We currently value the core steel business at minus R17.58 per share. Although the share price is depressed, we believe it will struggle to perform if the company continues to post financial losses for the next few quarters. Downgrading to a Sell.'Excerpts from a UBS Investment Research note, November 7th, 2012

The universal unpopularity of cyclical industries could be offering value

Our various global idea screens are quite strongly indicating to us that the share prices of businesses in cyclical industries could be offering very good value. These include the cement, aluminum, paper, shipping, resources and steel industries. The obvious question is why do other investors not pile into these at present if it is that obvious? What do we see that they don't?

Or, more importantly, why could we be right, and why could they be wrong? Or even more importantly, which of these are good investments?

This has exercised our (collective) mind here at RE:CM over the past two years. The view we have developed is that, in the current global low interest rate environment, investors have become addicted to yield investments. In order to earn a yield even marginally above that available from the bond market, investors are selling out of anything that remotely smells of instability or has no 'earnings visibility'. The type of businesses they particularly despise are ones that make no money, or a loss. Of course, cyclicals have been the big losers from this 'get yield' phenomenon, with investors selling out

of them in droves and driving their share prices down in the order of 80%-90% from the peaks of 2008. What makes these situations so interesting right now is that it is so blatantly obvious to anyone that they're poor quality businesses. This was definitely not the consensus view in the supercycle story and boom/bust of 2008, but that's another matter entirely. The case for defensives and 'high quality' assets just looks so utterly convincing right now − it's watertight, no investor would dream of questioning the case for owning them. In contrast, the case for cyclicals is so full of gaping holes that a child could drive an argument through them, with conviction to boot. This ability of the consensus to present extremely high conviction – and seemingly very rational – arguments against certain holdings is a very interesting aspect of the market cycle we're living through right now.

But, that is precisely why cyclicals are currently priced so cheaply and could be sensible investment opportunities. It's no guarantee, but we think it's very likely. This is why our team has done a lot of work on cyclicals in the past two years and why we have slowly but surely increased our clients' exposure in various mandates to these types of businesses.

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Arcelor Mittal's share price reflects negative sentiment

Specifically, our clients own Arcelor Mittal, the dominant South African steel producer, as well as Arcelor Mittal, the Dutch-listed parent company. Of course, the one owns the other, but they aren't

the same business at all. Arcelor Mittal is the largest global steel producer and their investment in Arcelor Mittal South Africa is relatively small in their lives. For clarity, we will refer to Mittal SA and Mittal Global in this article to differentiate between the two.

Table 1: Selected Steel Stocks' Long-Term vs. Current Ratios

EV/Sales Price to Book Operating Profit Margins (%)

LT Average Last LT Average Last LT Average Last

ArcelorMittal (Global) 1,0 0,6 1,4 0.5 8,0 1,2

POSCO 0,9 0,8 0,9 0,7 15,0 7,9

Nippon Steel 0,7 0,5 1,1 0,7 1,0 1,6

JFE Holdings 1,1 0,1 1,5 0.8 10,0 1,4

Tata Steel 1,4 0,6 1,7 0,8 16,0 6,0

Ansteel 0,9 0,6 1,6 0,5 8,0 -2,7

US Steel 0,5 0,3 1,7 0,9 4,0 2,0

Gerdau 0,9 0,8 1,1 1,0 14,0 5,5

Nucor 1,0 0,9 2,4 2,0 10,0 5,5

Severstal 1,0 0,9 1,5 1,6 17,0 18,0

Source: Thomson Reuters Datastream, RE:CM

Chart 1: Arcelor Mittal SA and Arcelor Mittal Global Share Prices, Since 2003

Source: Thomson Reuters Datastream

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From Chart 1 it is quite clear that Mittal SA's share price decline has virtually everything to do with the state of the global steel industry as opposed to what is happening in South Africa specifically. This is a key point, because everyone in South Africa is focusing on a lengthy list of well-documented company-specific issues. These include:

· production disruptions · competition commission investigations · environmental legislation · carbon taxes · a weak domestic construction sector · Government talking about funding a new

competitor

Table 1 shows some of the very meaningful dislocations in the global steel industry from its long-term averages. In this case, we've highlighted the 10 largest globally listed steel producers by market share and compared their long-term average enterprise value (EV) / sales, price-to-book multiples and operating profit margins against the latest numbers. For all three metrics, multiples and margins are at extremely low levels compared to historic averages.

One question that immediately springs to mind is why don't we just buy all of them? Steel

production is a very fragmented industry with a relatively consolidated raw material supplier base (iron ore). This implies that steel producers don't have significant pricing power over their products and are vulnerable to a classic margin squeeze. In fact, this is exactly what has happened to them. In the past five years, as steel volumes and prices have come down, iron ore prices have increased. It's not rocket science to conclude that costs going up and sales coming down means lower profit margins and profits.

This is a very big part of our investment case, but it turns out that there are certain steel producers with hidden qualitative characteristics that make them more durable. These businesses are far better able to survive a long trough in the business cycle than many of their counterparts because they have some combination of the following attributes:

· strong long-term shareholders · low levels of financial gearing · vertical integration into their own raw material

supply chain · a natural barrier to entry in their inland location

next to a strong domestic customer base · a domestic monopoly or oligopoly pricing

environment

Chart 2: Gross Fixed Capital Formation in Japan, Europe and the US

Source: World Bank

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Chart 4: Gross Total US Share Repurchases (US$ Billions)

Source: Thomson Reuters Datastream

Chart 3: Cash to Revenue of the Largest 1,000 US Listed Businesses

Source: Thomson Reuters Datastream

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Not all steel companies are created equal

In focusing our research on the global steel sector over the past two years, it became more and more apparent to us that not all steel companies are equal − other than that they all produce steel. In fact, the more we scratched around, the more we found that not only are there many kinds of steel products, but there are significant non-steel operations hidden inside several of the listed businesses.

Yes, it's true that China has become a very large global steel producer and a net exporter of steel. As that economy has come off the boil to some extent, the impact of their companies dumping steel onto the world markets has been significant. But our view is that current low valuations of steel companies already reflect this reality.

With low levels of infrastructure reinvestment in the large US, European and Japanese economies (see Chart 2), US businesses deleveraging (see Chart 3) and buying back shares (see Chart 4), it shouldn't surprise you that global steel prices have been under pressure. We see this glass as half-full, as it implies that any form of meaningful infrastructure and business development investment in future in these regions would significantly influence global steel demand and restore equilibrium. Already there is a housing recovery happening in the US, which could be a possible leading indicator.

Our investment thesis for both of these companies relies on the following key points:

· A recovery in capacity utilization, global steel prices and profitability as the European, Japanese and US economies start spending again on infrastructure and construction.

· A recovery in public infrastructure and construction spending in South Africa as indicated by the government's recently

announced R800 billion infrastructure spending program.

· Further consolidation and/or business failure in the global steel industry as a long list of industry participants are both loss-making and over-indebted. There is an element of the capital cycle at work here. The entire global steel sector is trading at 50% of net asset value and is now effectively priced as if all these companies will go out of business. To take this to its logical conclusion, this implies that the world will choose never to use steel again. We think that this is improbable if not completely impossible.

· There are significant and very profitable non-steel business interests held in both companies that provide a floor under the valuation and relief from excessive debt funding problems. The market appears to overlook this to focus exclusively on the steel segments.

· Mittal Global has net debt but is at historically low debt to equity levels. The balance sheet has been strengthened recently by the issuance of some equity and the sale of non-core assets in response to the severe and lengthy downturn in the global industry.

· Mittal SA is at a debt neutral balance sheet position, one of very few global steel businesses in this position.

A short note on valuations

Further information supporting our valuation includes:

· The non-steel predominantly iron ore assets in Mittal Global alone account for US$ 12 per share at the current share price of US$ 12. This implies that, at the current price, one is getting the world's largest (over twice the size of its nearest competitor) steel business for nothing. That strikes us as a bargain of the first order.

· Both businesses are trading at 50% of net asset value and at far bigger discounts to realistic

Table 2: Key Valuation Metrics for Mittal SA and Mittal Global

CurrencyAdjusted

Earnings Per Share

Fair Earnings Multiple

Fair Value Per Share

Share Price

Mittal SA SA Rands 6,0 10,0 60 27

Mittal Global US Dollars 3,4 10,6 36 12

Source: RE:CM

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adjusted replacement values and merger and acquisition related multiples.

· Another way of looking at this is to calculate the earnings multiple the market places on normal earnings levels by dividing the current share price by adjusted earnings per share. On this basis, the market is valuing Mittal SA at 3.7 times earnings and Mittal Global at 4.4 times, a far cry from our fair earnings multiple of 10.0 and 10.6 respectively.

· Two recent corporate actions in the domestic steel industry put much-needed perspective on the valuations afforded by the market at present: A BEE company called Nemascore is buying Russian parent company Evraz's 85% stake in JSE-listed Evraz Highveld Steel for R3bn, valuing it at R30 per share - a substantial premium to the market price of R13 at the time; A consortium including the IDC and Shanduka bought Scaw Metals from Anglo American in April 2012 for R4.6bn. Sell-side analyst Brian Morgan of brokerage firm BNP Paribas Cadiz estimates that on a value per installed ton of capacity basis these transactions value Mittal SA in a range from R60 to R74 per share. Interestingly this

is a straight comparison calculation and does not take into account the relatively better asset quality, significantly higher market share and access to international expertise and support of Mittal SA.

In conclusion, owning cyclicals that are currently earning record low levels of profit or making losses invites ridicule. To make investments such as these work requires a solid investment business, populated with sensible investment professionals who can focus on the facts at hand, combined with clients who understand what they've bought into. We're confident that we have all of this in place, which allows us to allocate fund capital to investment ideas like these in the face of severe criticism. That is what we're paid to do − we take on the severe discomfort of the marketplace to put our clients in a position to generate the kind of investment returns they rightfully expect and demand over full market cycles.

Daniel Malan

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Chasing Yield down a Hole

'There is nothing intelligent to be said about gold. Nobody can tell you the right price for an ounce of gold. People will tell you it should go up or go down. To make any intelligent statements about investments you have to know what the right price is. You can't do that with an asset like gold, which doesn't produce any cash flow. So you can buy it out of superstition or ignore it because you are an atheist but you cannot buy it with an analytical foundation.' Howard Marks – CEO of Oaktree Capital, when asked his outlook on gold

Neal Froneman: 'Look, there's only really one way to sell a South African gold company at the moment and the strategy of Sibanye is completely different to anything else we've done in the past. We are also in the unique situation – these are mature assets, they have a long history of generating very significant amounts of cash. So the obvious way to position them is as high-dividend-yield vehicles. And as you know there is a desperate need, especially in North America and Europe, for yield – and I am not talking about underground yield, I am talking about dividend yield here.

So it's very difficult to sell these South African gold mines, even though they are high quality. But to sell it as a high-yield vehicle is certainly what we've done and it seems to have been well received.'

Hilton Tarrant: 'So is the plan for Sibanye to be one of the highest dividend payers in the industry?'

Neal Froneman: 'It has to be. It is really the only way we can differentiate ourselves.' Moneyweb interview

'Sibanye Gold may not pay dividends or make similar payments to its shareholders in the future due to various factors, including restrictions in its financing arrangements' Sibanye pre-listing statement

'The worst investment decisions have generally been made when dumb money is chasing yield' Edward Chancellor and Mike Monnelly, GMO, 'Feeding the Dragon: Why China's Credit System looks vulnerable'

'A gold mine is a hole in the ground with a liar standing by it'Mark Twain

'Despite the benefits from increased operational efficiencies, the September quarter still reflected a significant loss, mainly due to the lower grade and the strong Rand environment. An in-depth investigation revealed that the grade dilution was in line with historical averages and the in-situ grades showed a substantial difference to the mine plan.'Aflease 2003 Annual Report, CEO's Review

'We anticipate exciting developments in the new financial year as we bring Bonanza South significantly closer to production and explore the prospects for our associated Uranium assets.'Aflease 2003 Annual Report, Chairman's Review

'In addition, Uranium One operates the Bonanza Gold Project, a small, developmental-stage gold mining operation in South Africa, as a component of the Dominion Uranium Project.'Uranium One 2005 Annual Disclosure Document, Management Discussion and Analysis

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Low interest rates are prompting investors to chase yield

Both in South Africa and offshore, low interest rates are having an impact on asset prices. Low interest rates make borrowing money cheap, which increases the supply of money to the market. The need to deploy this money creates demand for assets. Too much money chasing too few assets leads to asset price inflation.

Certain investors require a cash flow from their investment in order to meet living expenses. Typically, this sector of the market comprises pensioners and retirees who rely on the income generated from assets accumulated during their working lives. Interest rates have declined to the extent that yields are now below inflation, resulting in negative real returns. These investors strive for higher yielding assets in a misguided attempt to protect the purchasing power of their earnings in the short term.

Different assets with different levels of risk require different levels of yield in order to attract investors. Risk doesn't refer to volatility, but is rather a measure of the ability of an investment to return capital and income. The greater the possibility that an asset won't be able to generate cash to repay investors, the greater the risk and the greater the yield required by investors.

This chase for yield pushes up asset prices and results in yields decreasing to the point where the investor isn't receiving commensurate returns for the risk they're taking on. Examples of this trend include investments in listed property at premiums to the net asset value of the underlying properties and companies claiming to be consistent dividend payers in order to attract investors.

The advent of gold ETFs fundamentally changed things for producers

The year 2004 proved to be a seminal time for gold producers. Before 2004 investors only had one way to get exposure to gold − that was to buy the equity of listed gold producing companies. Companies that didn't hedge the price at which they sold their gold provided investors with operational leverage to the listed price of gold.

People have always had a predilection for gold. The belief that gold is a store of value generally drives the price. Gold itself isn't consumed or used for any significant industrial purpose. Gold as an 'asset' doesn't create cash flows that investors can

discount to the present at a required discount rate to establish a fair price. Collective sentiment, as opposed to fundamentals, sets the gold price.

In 2004, the World Gold Council created one of the first gold Exchange Traded Funds (ETF). These funds, which are physically backed by vaulted gold, provided the investment public with the opportunity to obtain direct exposure to the asset class. Investors whose only aim was to have exposure to gold (as opposed to the cash flows that gold producers generate by selling gold) now had an alternative.

Overnight, gold producers had to compete for investors' capital against their own product. As ETFs have become more widely accepted, so this competition for capital has become even more onerous. Previously gold producers could attract capital based on investors' infatuation with the metal. Now gold producers have had to change how they package their businesses to continue to attract investor capital.

Historically, investors' infatuation with gold has been sufficient for investors to overlook the fact that gold producers have struggled to generate returns that meet their cost of capital. Chart 1 shows the 15-year average Return on Invested Capital (ROIC) the gold producers have generated on the capital investors provided to the companies.

Gold producers are going to have an uphill battle trying to convince investors that they can generate excess returns with investors' capital given their poor historical performance. Capitalism will ensure that capital flows away from low returns towards businesses that generate returns above the cost of capital.

Gold producers do however have an advantage over ETFs as ETFs don't pay dividends. Most ETFs are backed by actual bullion, which as mentioned previously, doesn't generate cash flow. No cash flow means no ability to pay dividends. This is the niche positioning managers of gold producers have chosen.

Sibanye Gold is being positioned as a dividend yield play

Gold Fields announced late last year that they would be unbundling their South African operating gold mines into a separately listed entity known as Sibanye Gold. After the unbundling, Gold Fields the parent company would only retain one South African asset − the South Deep mine (still

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in development stage). Sibanye consists of three deep level mines − the Kloof and Driefontein mines combined as KDC near Carletonville and Beatrix mine in the Free State.

The message portrayed in the media and fuelled by Sibanye's management team is that this is to be a dividend-paying gold producer. In a radio interview at the time of its listing, Sibanye's CEO, stated that he was aware that there was a search for yield by investors and that the company was essentially being positioned to take advantage of this demand for yield.

In Sibanye's pre-listing statement the dividend payout ratio was set in the region of between 25-35% of normalised earnings. Sibanye generated R3 billion in earnings for the financial year ending December 2012. Assuming that Sibanye achieves something similar in the 2013 financial year, the owners of Sibanye can expect a dividend of R1.02 per share using a payout ratio of 25%. This equates to a dividend yield of 7.6% on the share price of R13.30. On the surface, this looks very attractive.

Long-term operating realities call into question Sibanye's assumptions

As with most things - but especially with Gold mining - it isn't what's on the surface that counts but what's beneath the surface (pun intended). The present value of the long-term

cash flows a business generates determines its intrinsic value. As such, one swallow (or dividend payment) doesn't make a summer (or a business). A sustainable ability to generate cash is a requirement for any business. Scrutinising the mine plan provided in the pre-listing statement uncovers some interesting points:

· Grades, or the amount of actual gold in a tonne of ore, are expected to remain steady at the three operating mines

· Real underground mining costs are expected to decrease over the life of the mines

· The capital expenditure required in order to sustain the level of production is predicted to decline on a per unit of ore mined basis

These are the operational targets set out in the mine plan. In order for management to achieve these, they're going to have to arrest the declining operating dynamics for these mines. Yet the three charts that follow show a different picture. Grades (Chart 2) at all three mines have been declining steadily since the turn of the decade. Kilograms of gold produced (Chart 3) display a similar downward trajectory while operating costs (Chart 4) have soared in nominal and in real terms over the same period.

As these mines have matured, so it has become harder and harder to extract gold. Lower ore volumes run across a large fixed cost base has

Chart 1: 15-year Average Return on Invested Capital for the Major South African Gold Producers

Source: Thomson Reuters Datastream, RE:CM

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Chart 2: Historical Underground Yield at Sibanye Operations (Grammes of Gold per Tonne of Ore)

Source: Gold Fields Individual Mine Quarterly History and Annual Reports, RE:CM

led to mining costs increasing. Real increases in wages and electricity have exacerbated this trend, making marginal mines such as these even more marginal.

These dynamics make the free cash generating ability of these mines limited at current price levels for gold. There are a couple of side plots to this story. Sibanye has significant surface rock dumps that contain lower ore grades. As can be imagined, the cost of extracting gold from this ore sitting on the surface is materially cheaper than ore that is many thousands of metres beneath the surface. These surface rock dumps are highly cash generative at the current gold price. This cash could finance payments to the owners of these mines, but the expectation is that these surface dumps will only be around for two years after which the business will be reliant on the cash generated from very marginal deep level (and getting deeper) gold mining.

Not only is Sibanye's ability to generate cash flows to justify the existing dividend yield dubious, but equity holders stand behind debt holders. The pre-listing statement highlights the power of the providers of the bridge financing to prevent the payment of dividends. Sibanye won't be able to pay a dividend in calendar 2013 if, after the

dividend, the bridging finance (i.e. debt) exceeds R4 billion. In the results released for the period ending December 2012, debt was sitting at just under R4 billion.

Sibanye's management have indicated that they're revisiting the mine plan in order to improve production and cost efficiencies to improve returns and pay out dividends. The man chosen to lead this turnaround is Neal Froneman.

Careful examination of Mr Froneman's track record reveals interesting patterns

Froneman has a lot of experience in the gold mining industry. He was previously in charge at Aflease, Uranium One and Gold One International before his appointment at Sibanye. Froneman's track record at these other producers gives insight into the possibilities with respect to Sibanye. His time spent at Aflease sounds oddly familiar. Froneman was appointed CEO of Aflease at the beginning of 2003. Aflease attempted to grow by acquisition by acquiring developmental assets and exploring the potential in their uranium resource. The primary gold project under development at the time was the Modder East Gold Project, acquired in 2003. While these strategies were being pursued, the operating assets generated operating losses of

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Chart 3: Historical Production at Sibanye Operations: Kilograms of Gold Produced per Month

Source: Gold Fields Individual Mine Quarterly History and Annual Reports, RE:CM

Chart 4: Historical Nominal Operating Costs at Sibanye Operations: Rand per kg of Gold Produced

Source: Gold Fields Individual Mine Quarterly History and Annual Reports, RE:CM

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R400 million (2003) and R61 million (2004). The strong rand was blamed, but it was also noted that grades had declined in line with the historical trend and the actual grades achieved were lower than the grades in the mine plan.

Aflease was reverse-listed into Uranium One. This 'new' company claimed its focus was on developing its gold projects, but the focus was actually on the development of the uranium assets and specifically the Dominion uranium project near Klerksdorp. Uranium One was able to raise R2.7 billion of capital through a private placement of shares, public issues and the raising of a convertible debenture. Impressive for a business with a market capitalisation of C$ 527 million and operating assets that generated operating losses of US$ 27.5 million in the 2005 financial year.

This capital was raised on the back of the potential within the Dominion uranium project. It is interesting to note that Aflease referred to this project as an associated uranium project to the Bonanza gold project in 2003. Yet in 2005, after the reverse listing took place, Uranium One talked about the Bonanza gold project as a component of the Dominion uranium project. The assets are the same but the packaging has changed. And packaging was determined by whatever was popular in the market at the time.

The picture changed completely in 2008 when the development of the Dominion project was suspended and the mine mothballed. The reasons given were the declining economics of the mine and the declining price of uranium. Froneman resigned in February 2008.

He reappeared in charge of Gold One International in 2009. Gold One acquired Aflease Gold which primarily consisted of the Modder East gold project. Aflease acquired this same asset in 2003 when Froneman started out there. Again capital was raised in 2009 (R245 million) and 2011 when Gold One was sold to the Jintu consortium (R1.2 billion). Once more, a uranium project is on the cards with the joint venture between Gold Fields and Sibanye exploring the possibility of reprocessing their combined surface tailings, which contain residual ounces of gold and uranium. The common theme is that these businesses were able to continue to raise capital from investors not on the back of operational performance, but

rather on the promise of future performance from development projects. Essentially, investors bought the promise of growth whether it was by acquisition or organically and whether in gold or uranium reserves. Now the promise seems to be one of future dividends.

We see better places to find yield than Sibanye

All this goes to show how tenuous Sibanye's ability is to justify the dividend yield implied by the share price on a sustainable basis. Investing in this business based on the current yield is encouraging a permanent loss of capital.

This isn't to say that we turn our noses up at yield but rather that it isn't the determining factor. We allocate our clients' capital to an idea based solely on the difference between our estimate of the intrinsic value of a business and the price at which it is on offer for in the market place. If the business pays us while we wait for the price to revert to the business's fair value in the form of a dividend then we will gladly accept this.

Sibanye's costs are rising, their production is falling and they're price takers for their product. This brings its ability to finance future dividends sustainably under scrutiny. In comparison, Intel has a dividend cover of 2.5 times normal (sustainable) earnings and has spent roughly the same amount buying back shares as it has spent on dividends. This is the type of yield we like.

Yield itself isn't a bad thing. On the contrary, it is something investors should strive to find aslong as it is sustainable. The cash a business generates and how management chooses to allocate this determines the value of a business. But investors shouldn't chase yield at the expense of common sense. Yield will always be a product of the sensible allocation of capital − not the determinant of how we allocate capital. When the latter is the case, investors make poor decisions and may incur permanent losses of capital. We continue to strive to avoid that result.

Richard Court

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The Cost of Income

'For perhaps cultural or behavioural reasons, investors do not like to consume capital, but those holding cash are forced to do just this as inflation remains above deposit rates. However, the psychological divide between income and capital is the enemy of sound asset allocation. Great returns are made by avoiding capital losses and being in a position to buy assets when they are cheap. To be in that position, one must hold cash and accept that there are times when the most prudent thing to do is to consume capital. Financial history is littered with the wreckage of savers who 'prudently' tried to live off their income by putting their capital at great risk.'Russell Napier, CLSA Strategist, December 2012

'What if you depend on a higher return on your money and can't live on the income from 4% interest rates? In that case, I would advise people to ignore conventional wisdom and consume some principal for a while, if necessary, rather than to reach for yield and incur the risk of major capital loss.

Stick to short-term U.S. government securities, federally insured bank CDs, or money market funds that hold only U.S. government securities. Better to end the year with 98% of your principal intact than to risk your capital roofing around for incremental yield that is simply not attainable.'Seth Klarman, from a 1992 article in Forbes magazine

'Is a fixed income not a good thing? Does not everyone love to count on a sure thing? Especially every petty-bourgeois, narrow-minded Frenchman? The 'ever needy' man?'Karl Marx

'The difficulty lies not so much in developing new ideas as in escaping from old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.'John Maynard Keynes

Low interest rates incentivise risky behaviour

With interest rates currently at record lows in many markets, savers in numerous countries are finding that the interest earned on bank deposits is lower than the prevailing inflation rate. South Africa is no exception. Chart 1 shows the difference between short-term market interest rates (as represented by the South African three-month bankers' acceptance rate – comparable to money market interest rates) and the prevailing inflation rate. South Africa has seen dramatically worse negative real interest rates than we're witnessing today – but not since the late 1980's.

This of course means that the purchasing power of money left in a bank account is slowly being eroded – the longer consumption is deferred, the lower the level of consumption that the savings can support. This outcome is very counterintuitive − typically, savers are rewarded for their present austerity with the promise of greater future prosperity. What we're experiencing currently is unusual.

This unusual state of affairs is also creating a very strong, but in our opinion very dangerous, incentive − namely to 'reach for yield'. Due to the cultural or behavioural reasons referred to in the opening quote, many savers are reluctant to finance consumption out of capital. Capital in this instance is considered to be the amount of money initially invested, plus any 'spontaneous' growth over time. By spontaneous growth we mean growth achieved in the value of the investment without the investor contributing any more money directly to the investment to generate this growth. Investors are typically much happier financing consumption out of interest or dividend payments received than out of capital.

As a result, many savers are currently reaching for yield to avoid having to fund living expenses out of capital. This simply means that in an effort to generate sufficient yield from investments, investors are taking on too much risk. Whether this takes the form of credit, interest rate or business/equity risk varies from case to case. What doesn't

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vary is that the level of risk being assumed isn't proportionate to the level of return on offer.

'Consume income, not capital' is a dangerous rule of thumb if followed blindly

While the rule of thumb to 'consume income, not capital' may have served investors well in the past, we fear that it is having two very negative effects currently. Firstly, those investors who stick to the traditional income-generating investment options are being forced into gradually lowering their standard of living in an effort to make ends meet from their income. Secondly, those who wish to maintain their standard of living while not spending their capital are taking on undue risk in an effort to do so. So what are investors to do if they wish to maintain their standard of living but don't want to take on undue risk in the process? The key lies in accepting that the widely held distinction between income and capital is a fallacy.

The rate of expenditure that a given investment can sustain depends on the total return generated by the investment over time, not whether the return is being earned in the form of income payments or capital appreciation. Once an investor has accepted this fact, she is in a far better position to allocate capital sensibly and in accordance with her needs than if she tries to adhere to the 'spend income, not capital' mantra. Investing with the goal of generating the best total return over time,

within the constraints of a given risk profile, is a far superior way of allocating one's capital than to invest solely for income (or, for that matter, solely for capital growth). Determining what the best vehicle is for generating these risk-adjusted returns should be the primary consideration in any investor's mind, not whether the returns are being earned in the form of income or capital growth.

Investors who have expenditure needs greater than the income payments provided by their chosen investment vehicle can generate the cash required by selling part of their investment as the need arises. While this may feel to many investors as if they're 'eating their seed corn', the truth is that by following this strategy an investor is actually sowing the seeds for a bountiful future. In addition, selling a portion of an investment is typically a far more tax efficient way of generating cash flow from an investment than to earn interest (or, depending on the tax jurisdiction, dividends) from that investment. The discussion that follows illustrates this point.

A flexible fund aiming to generate total returns performs far better than the typical income fund while providing exactly the same cash flows to an investor

The RE:CM Global Flexible Fund is a fund that has wide flexibility to invest across many asset classes and geographies in an effort to generate the best

Chart 1: South African Three Month Bankers' Acceptance Rate Less Inflation

Source: Thomson Reuters Datastream, RE:CM

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risk-adjusted returns for investors. It is the closest reflection of our best investment view that we can offer to the average South African investor. The Fund's allocation to different asset classes has varied widely over time, but its allocation to equities has historically been the largest asset class exposure. The Fund has typically not offered a very high income yield.

As representative of a typical high yielding income fund, we selected the median fund ranked by returns generated for the ten years to the end of March 2013 (as per Morningstar) from the 'South African Interest Bearing Variable Term' fund category (formerly known as the 'Domestic Fixed Interest Bond' category). This ten-year period corresponds to the full lifetime of the RE:CM Global Flexible Fund. Note that due to survivorship bias, selecting the income fund in this way probably skews the results in favour of the income fund. Our assessment is that this hasn't contaminated our conclusions in any meaningful way though.

While the South African equity market has, broadly speaking, delivered unusually strong performance since the inception of the RE:CM Global Flexible Fund, the same is also true of the South African fixed income market. So the comparison isn't distorted too much by different conditions in the primary markets to which these two funds have been exposed1.

We assume an investor invests R10,000 in each of these two funds at the inception date of the RE:CM Global Flexible Fund (April 2003). We then recreate the exact cash flow profile from the Fund that an investor in the income fund earned over this period. So on each date that the income fund paid out income, we assume that the investor in the RE:CM Global Flexible Fund sold units in the fund to make up any shortfall in income earned between the RE:CM Global Flexible Fund and the income fund. The two investors receive exactly the same

1. Since inception, the RE:CM Global Flexible fund has delivered a return of 15.8% compounded per annum net of fees, whereas the income fund has delivered a return of 10.8% over this period. This performance differential of 5% per annum is slightly lower than the 5.5% per annum return differential between equities and bonds in South Africa for the 113 years to the end of 2012, as reported in the Credit Suisse Global Investment Returns Yearbook 2013. This suggests that the difference in returns achieved by the two funds over the period covered by our study is a reasonable reflection of the difference in returns investors can expect from such funds over time.

cash flows, but the income fund investor receives them in the form of pure income, while the RE:CM Global Flexible Fund investor receives them in the form of both income and realised capital. We then compare the value of each investment at the end of March 2013.

The result is that an investor in the income fund ends up with an investment worth R11,936 today. To put this in perspective, if the investment had kept pace with inflation, it would have grown to R16,719 – significantly more than the income fund investor is left with. By contrast, an investor in the RE:CM Global Flexible Fund will end up with an investment worth R25,876. The investor in the RE:CM Global Flexible Fund has increased the inflation-adjusted value of her investment handsomely while generating exactly the same cash flows from her investment as the investor in the income fund. The investor in the income fund has exactly the same number of units in the fund as she had at inception – she hasn't spent any capital. The investor in the RE:CM Global Flexible Fund has about 70% of the number of units in the fund that she started with, reflecting the fact that she has spent capital. But the RE:CM Global Flexible Fund investor is left with an investment worth more than twice that of the income fund investor.

Investing for total returns rather than pure income typically brings more volatility, but most investors will still be far better off

There is of course some price to pay for the higher returns generated by the RE:CM Global Flexible Fund, and that is somewhat higher volatility. Chart 2 shows that there have been periods where the RE:CM Global Flexible Fund underperformed the income fund when following this strategy of recreating the income fund cash flows. When the graph is rising, it means that the RE:CM Global Flexible Fund delivered better returns than the income fund and when the graph is falling, the opposite is true.

The RE:CM Global Flexible Fund, having carried at least some exposure to equity markets throughout this period, didn't entirely escape the volatility brought on by the global financial crisis from 2007 to 2009. But keep the following in mind:

Calculating the returns achieved by the two funds on a monthly basis gives 109 rolling one year periods over which performance can be assessed. In 79% of all of these rolling one-year periods, the RE:CM Global Flexible Fund delivered better

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Chart 2: RE:CM Global Flexible Fund Compared to Median Income Fund: Relative Returns(March 2003 = 100)

Source: Bloomberg, RE:CM

Chart 3: Returns of the RE:CM Global Flexible Fund Compared to Median Income Fund: Percentage of all Rolling Periods in which the RE:CM Global Flexible Fund Delivered Superior Returns

Source: RE:CM

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returns than the income fund. And it achieved this while delivering exactly the same cash flows to the investor as the income fund. This percentage increases to 94% of all rolling three-year periods and to 100% of all rolling five-year periods.

The argument for a flexible fund is even more compelling on an after tax basis

Looking at the numbers on an after tax basis delivers even more compelling results. For this analysis, we assumed that the investor pays income tax at an average rate of 30% and pays an effective rate of tax of 10% on all capital gains.

The tax payments that have to be made on the income earned from the income fund are substantial compared to the relatively favourable rate of tax paid on realising capital gains in the Flexible Fund. This means that the investor in the RE:CM Global Flexible Fund can sell fewer units of her investment to match the after tax cash flows from the income fund than she has to in order to match the pre-tax cash flows. She is therefore left with a greater investment in the fund at the end of the comparison period. The income fund investor would still have an investment valued at R11,936 today, but the RE:CM Global Flexible Fund investor would have an investment worth R29,714 – about two and a half times as much as the income fund investor.

In addition, because of the greater impact of taxes on the returns generated by the income fund, the

consistency of the outperformance by the RE:CM Global Flexible Fund becomes even more notable. The RE:CM Global Flexible Fund now outperforms the income fund in 83% of all rolling one year periods, 99% of all rolling three year periods, and (as before) in 100% of all rolling five year periods.

As Chart 3 demonstrates, the numbers really are compelling. Even investors with as short a time horizon as one year would be well advised to consider a flexible fund aimed at generating total returns instead of a pure income fund. And it seems that investors with longer time horizons should question whether strategies focused on generating income have any relevance for them at all.

The odds favour those who can forsake long-held but flawed beliefs

In conclusion, the data suggests that the odds massively favour those investors who can cross the emotional bridge of looking at capital as sacred and income as something to be spent. Times of low interest rates often go hand in hand with expensive assets. In such times, the prudent thing to do is to sell expensive assets. The reckless thing to do is to buy expensive assets that offer some yield as an illusory means of avoiding the consumption of capital.

Wilhelm Hertzog

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We value your input on the information we provide you. If you have any comments or suggestions regarding this brochure please feel free to contact us.

Regarding Capital Management (Pty) Ltd is a licensed financial services provider authorised in terms of the Financial Advisory and Intermediary Service Act, 2002 to provide advisory, intermediary and discretionary financial services (License number, 18834). Collective Investment Schemes in Securities (Unit Trusts) are generally medium to long-term investments. The value of participatory interests (units) may go down as well as up and past performance is not necessarily a guide to future performance. Unit trusts are traded at ruling prices and can engage in borrowing and scrip lending. The manager may borrow up to 10% of the market value of the portfolio where insufficient liquidity exists. A schedule of fees and charges and maximum commissions is available on request from the management company, RE:CM Collective Investments (Pty) Ltd (RE:CM). Commission and incentives may be paid and if so, would be included in the overall costs. The price of each unit of a Money Market portfolio is aimed at a constant value. The total return to the investor is primarily made up of interest received but, may also include any gain or loss made on any particular instrument. For most cases this will merely have the the effect of increasing or decreasing the daily yield but in an extreme case it can have the effect of reducing the capital value of the fund. A Feeder Fund portfolio is a portfolio that, apart from assets in liquid form, consists solely of units in a single portfolio of a collective investments scheme. Forward pricing is used. Funds are valued daily at 15h00. Instructions must reach RE:CM before 14h00 (except for the Money Market fund which is 11h00) to ensure same day value. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Different classes of units apply to these portfolios and are subject to different fees and charges. Unit Trust prices are calculated on a net asset value basis, defined as the total market value of all as-sets in the unit portfolio including any income accruals and less any permissible deductions (brokerage, uncertificated securities tax, VAT, auditors’ fees, bank charges, custodian fees, trustee fees and the annual management fee) from the portfolio divided by the number of units in issue. These portfolios may be closed. RE:CM Collective Investments (Pty) Ltd, Company Registration Number: 2004/027540/07, is a member of the Association of Savings and Investments (ASISA). Trustees: The Standard Bank of SA Limited, PO Box 54, Cape Town, 8000. Whilst every care has been taken in compiling this document, the information is not advice and RE:CM and/or its associates do not give any warranty as to the accuracy or completeness of the information provided herein and disclaim all liability for any loss or expense, however caused, arising from any reliance upon this information. Please note that there are risks associated with investments in financial products and past performance is not necessarily indicative of future performance. © 2013 Regarding Capital Management (Pty) Ltd, (RE:CM)

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Tel: +27 21 657 3440Fax: +27 21 674 1085Email: info@recm.co.zawww.recm.co.za