Recent economic events have resulted in a fresh wave of anxiety amongst investors in international markets. The list of events that has caused this anxiety is well documented, and includes factors as varied as Britain and Spain’s re-entry into economic recession last month; a rising likelihood of Greece exiting the Euro monetary system, a potential action that has colourfully become labelled “the Grexit”; evidence of slower economic growth in some of the important dynamic markets, especially China, India and Brazil; and the looming slowdown in fiscal spending in the United States come 2013.
TROUBLED TIMES TRANSLATE INTO TROUBLED MARKETS

This confluence of negative events has translated into sharp price falls in developed stock market indices as well as emerging stock market indices.  The MSCI Emerging Markets Index, for instance, has fallen from 109,000 points at the start of March to 90,000 points at the start of June – an almost 20 percent fall in prices in three months.  The MSCI Developed Markets Index has fallen from 132,500 points at the start of March to 115,000 points at the start of June – a 15 percent price decline over the same, short period. 

However, equity markets have not experienced this pain in isolation.  The Brent Crude oil price has fallen by almost $30 a barrel from a high of $127/barrel earlier this year; the platinum price has dropped from $1,730/ounce to $1,400/ounce and the copper price is off 15 percent over the last three months.  Even gold – a traditional safe-haven asset in times of financial stress – has experienced a price decline of $200/ounce, from a recent peak of $1,790 in March.

South African financial markets have responded in sympathy. The Johannesburg Stock Exchange’s All Share Index (FTSE/JSE ALSI) has started June about five percent off its recent high, although this masks the fact that resource stocks, which make up a substantial part of the index, have come under specific pressure given concerns about world economic growth (lower resource demand) and softer prices (lower revenue, all else equal).  Capital market stress has translated also into Rand weakness – with the currency moving from R7.40/$ to R8.50/$ over the last three months. 

Put together, this backdrop has made for a tough period for most investors, and the difficulties mentioned earlier suggest that the outlook is unlikely to brighten quickly. 

THE PATH AHEAD: MORE TROUBLE FOR ADVANCED ECONOMIES

In previous notes and reports I have written in detail about the awful state of the advanced world’s financial affairs.  Thus, whilst the recent anxiety about the advanced world’s financial and fiscal heath are stressful, worrying and acute, they should not come as a surprise.  The advanced world is financially bankrupt, and dealing with this is going to be a long, painful and protracted exercise.  This is a problem whose solution spans years – and possibly even decades – rather than months or quarters.  Just as sentiment has recently plunged lower, advanced market sentiment may rebound on the back of policy interventions – say QE3 in the United States – but this will not change the deep structural nature of the economic ailment that faces the developed world. 

By contrast, many historically poor economies are rich in six core factors that contribute to sustained gains in economic prosperity, including: access to savings and the effective investment of those savings; healthy demographic pyramids; increasingly sensible and effective policies and institutions; improving healthcare; improving education systems; and increasing economic openness that translates into a freer flow of goods, services, people, ideas, information and capital.  This cocktail of socio-economic factors will translate into sustained and substantial advancement in many of the economies that make up today’s developing world, and it is this set of countries that will shape the economic and investment landscape of tomorrow. 

In summary, the one billion people that live in the advanced world are living in essentially “sick” economic systems.  The remedies to these ailments are structural in nature and will require years, but more likely decades, to resolve.  By contrast, we estimate that there are 4 billion people living in developing economies that are richly endowed in the six factors listed above. 

BUYING GOOD BUSINESSES AT ATTRACTIVE PRICES

From an investment stance, this change in economic leadership is important.  To illustrate the point, the share price of the German-listed motor firm, BMW, has come under pressure in recent times.  Depressed prices suggest a tough environment and poor prospects, this price weakness overlooks the fact that in 2011 BMW had its best year ever, and the first quarter of 2012 was the firm’s best start to a year on record.  This outcome is influenced heavily by the fact that China’s demand for BMW vehicles grew at about 40 percent over the last year.  Moreover, Asian markets, which are displaying similar robust growth in demand, now make up a quarter of BMW’s global sales.  To my mind, the case of BMW is a superb illustrator of the distinction between sentiment-driven speculation and fundamentally-focussed investing.

In many ways, an investment in BMW captures the thoughts of my investment team at Cannon Asset Managers on how best to navigate the current turbulence.  The best time to buy is when prices are falling, not rising; and the worst time to sell is when prices are low.  Thus, we see the current environment as a buying opportunity and most definitely not a time to be selling.  That said, good investments are not just about paying the right price, but also about acquiring the right assets.  In stressed times like the present, our view is that investors will be rewarded – and will rest well – for holding good quality businesses. 

On this score, I borrow again from BMW to provide an illustration of a “good quality” business.  The company generates strong cash flow, is debt free, has a pile of cash on its balance sheet equal to 25 percent of its market value, enjoys defendable market share, is profitable and produces a return on assets and a return on equity substantially in excess of market rates.  Whilst it is impossible to know when markets will awaken to this opportunity, my many years of investing experience give me confidence that markets will awaken to this opportunity.

To my mind, the BMW example embodies all of the principles and disciplines of intelligent investing: buy when others are selling; pay a good price for good quality assets; carefully consider information and ignore noise; apply the same rigour with all other investment decisions; and come to the game armed with patience and a clear mind, because our patience will be tried and our emotions tested.

INVESTING AT HOME

To bring the argument home to South African, whilst many “investors” are selling out of their equity positions, I see current market weakness as a gift in the form of an opportunity to add to equity positions in portfolios with cash reserves.  Importantly, there are many South African-listed that have the attributes of being businesses of quality, substance and stature and that are being sold at a good price.  One such example is Hudaco Industries (Hudaco).

Hudaco is a South African group specialising in the importation and distribution of high-quality branded industrial products in the southern African region.  The group’s businesses have important competitive advantages, including exclusive rights over branded products; partnerships with leading international manufacturers; and strong positions in niche markets.  In the 15 years that I have followed Hudaco, the company has been profitable every year and has paid dividends without interruption over this period.  The balance sheet is strong, with ample cash; profitability is evidenced by a return on equity of 22 percent; and of the group’s R1.5bn in shareholder equity, R1.2bn is represented by retained profits. 

In short, Hudaco is a business of quality with strong fundamentals.  The investment case is made by the undemanding multiples, which currently translate into a price-earnings multiple of just over ten times last year’s earnings and a dividend yield of four percent. 

Hudaco is one example of the types of businesses that make for superb investment opportunities in the current climate, and the company forms an important part of the investments I look after. If market prices continue to fall, I will buy more of this great business and others.