PUBLISHED: 2003

JUNGLE TACTICS

Jacques Magliolo

Jacques Magliolo

Jungle Tactics

CONTENTS
Introduction

Part One: Capitalism, Power, Influence & Globalisation

Chapter 1: Working In An Uncompromising Global Capitalistic Society

Surviving in a global market

Socialist or Buddhist capitalism is the only answer
Summary

Chapter 2: Capitalism Theory And Practice

The theory of capitalism

What is capitalism?
What is the philosophy of capitalism?
What is a capitalist?
What is the role of State in a capitalist society?
What does capitalism have to do with freedom?
Is capitalism a fair and just social system?
How is democracy related to capitalism?
What is the opposite of capitalism?
Proud capitalists
Capitalism in practice
Does laissez-faire capitalism ultimately lead to coercive monopolies?
Does capitalism lead to worker exploitation?
Can unregulated capitalism lead to unsafe products and services?
Is the US a capitalist nation?
In South Africa, would capitalism promote racism?
Would the poor suffer without a State welfare support system?
Under capitalism, will pollution and industrial waste stop?
Should the State not provide public education?
Surely, minimum wages should be considered an absolute necessity?
Does the State have to regulate medical products?
Summary

Chapter 3: The Savage Capitalist Jungle

Privatisation of property, education and science

An ideal way to start the privatisation process
Companies should focus on core products
Is the ultimate goal only a dream?
Unions and unemployment
Production and trade in the global arena
Okay, so lets compromise
Do or die time to abolish State interference.
Summary

Chapter 4: Survival Of A Material Civilisation

Surviving the onslaught of global savages

Introducing the division of labour
Applications of economics

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Solving politico-economic problems

Economics and business
Economics and the defence of individual rights
Summary

Chapter 5: Capitalism Vs. Labour

Economics and labour

Does scarcity of labour imply there is no reason for unemployment?
The more people have, the more they want
The real economic problem
Specialisation, division of labour and society
Capitalist planning and the price system
Benefits of private ownership of the means of production
The benefit of capital to the buyers of products
The exploitation theory

Chapter 6: Smith, Marx And The Evil Called Profit

Smiths greatest failure

Classical economics wins Smith and Marx loose
Summary

Chapter 7: Capitalist Issues Affecting Investors And Entrepreneurs

The vicious cycle of interest and profits

The production problem or how to satisfy greed
In trying to help people, government becomes the thief
Theft through taxes and other legislation
Theft of national savings
Stop the theft and progress will happen
Saving and expenditure
Lets get back to simplicity
Belabouring the point

Chapter 8: A Capitalists Guide To Economics

A constant, contradictory, confusion barrage of statistics

Statistics can be our friends
Are they any good?
Summary
Exchange rates
Inflation differentials
Real exchange rates, international trade and the Balance of Payments
A capitalists explanation
Investors can create their own, specific exchange rate

PART ONE ENCAPSULATED AND EXPANDED

Part 2: Investment Strategies In A Global Village

Chapter 9: Without Information, Youre Dead

Basic tips on how to be a more informed investor

Step 1: What kind of investor are you?
Do you have the money to invest?
What are your investment goals?

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How much risk are you comfortable with?

Step 2: Start afresh and understand the basics
Economic data
Government policies
Time zones
Company Reports
New issues/dividends
Broker research reports
Sentiment
Where to find information
Information sources include
Newspapers, magazines and books
Information from the company
Stockbroker and industry information
How to evaluate information
Step 3: Creating a stock market database
Step 4: Determine your investment criteria general concept
Step 5: Refining your general investment criteria
Step 6: Assessing long-term data
Create wealth, not just income
One last check for investment
Another yardstick for the land bound
Summary
Investor check list

Chapter 10: The Internet The Investors Bible

The only way to conduct research

Searching for information

Chapter 11: If You Tame Risk, The Beast Can Be Your Friend

Risk separates investors from savers

An analysts definition
Sources of Risk
Risk is part of the investment process
Factors that multiply risk
Other market risks
Market risk is short-term risk
The risk-reward line
Risk classes
Hedging
Summary

Chapter 12: Take A Leaf From Markowitzs Portfolio Tactics

Concept of correlation
How does the investor benefit from Markowitz?
Mixing bonds and equities
Global investing and Markowitz
Global investments
The optimiser

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Chapter 13: Portfolio Lessons From The Past

A quick summary of some key points found in earlier chapters:

Lesson 1: The economists staple phase
Lesson 2: Equities have provided sound investments around the globe
Lesson 3: Beware of numbers
Lesson 4: Change is the only constant
Lesson 5: Weve said it before risk can be your friend
Lesson 6: The market will decline at some point temporally, of course
Lesson 7: Trust in your long-term strategy and ignore the Overall Index
Lesson 8: Tailor make your portfolio
Lesson 9: Jungle tactics keep the savages away

Chapter 14: Jungle Law Eat Directors Who Fail

Step 1: Identifying winners at a glance

Step 2: Analysing the winners a random theory approach
Step 3: Track records and other factors
Step 4: Winners often keep winning
Step 5: Build a better benchmarks
Step 6: Continually improve on benchmark
Step 7: Using ratios to quantify directors financial acumen

Chapter 15: Portfolio Managers Also Fall Victim To Jungle Rule

The coming of capitalism to South Africa

Beware the power suit salesman
The capitalist must be a cynic

Chapter 16: Teach Your Children The Art Of Cannibalism

Get organised
Compounding can put time on your side - an example
Lesson 1: Start early
Lesson 2: Plan for a reasonable rate of return
Lesson 3: Control costs
Lesson 4: Control taxes
Lesson 5: Have a clear, concise and well defined investment planning process
Setting Monetary Goals
Help is on the way
Putting time on your side
Time Horizon
Once again, the beast rears its head
Risk-Reward Relationship
Summary

Chapter 17: Revolution And Pigs

Enter the Pigs

Stockbrokers enter the world of competition
Change, the only constant
Haemorrhaging deposits
Monopoly and regulated industries
Mousetraps

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Chapter 18 : A Flawed Economic Miracle

Market fraud is here to stay, so live with it

Warning signals

Chapter 19: Strategic Asset Allocation

Investment policy
Market timing
Rational steps in asset allocation
Investors should take decisions in the following logical phases
To actively manage a portfolio or to use unit trusts?
The efficient market debate
Perfect World Theory
The Imperfect Market Theory
The Capitalist Model
The Capitalist system in operation
Using the CAPM
Value vs. Growth investing
The importance of investment research
Types of Research
Technical Analysis
Fundamental Analysis
An Alternative Point of View
Time to start the motors running
Spreadsheets to the rescue
Regularly re-assess performance
Start with unit trusts
The South African unit trust industry
Growth inhibitors
Management fees
Trading costs
The impact of commissions
Target a market segment
Beware: Funds can shift from value to growth
Be wary of labels
A starter's checklist
Change the portfolio to Index Stocks
Asset allocation for the conservative, moderate or aggressive investor
Categories of different portfolio security-types

Chapter 20: Creating Rules For Share Investing

Wall Street advises

Selecting shares: Creating basic, guiding principles and rules
General rules for buying shares:
Simple Time Tested Guiding Principles
Pitfalls to Avoid
Undertaking comparative analysis
Relative rating and splitting into three groups
Bears, Bulls, Stages and casinos
Going short
Options - calls and puts

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Chapter 21: Anarchists, Advice From Mum, Zen And Dog Food

More advice from mum

It's okay to be greedy
Full disclosure - something to think about
Buyers and sellers - caught in market madness
Dog food
Even computers cannot stop some traders from being completely stupid
Another market phenomenon - the anarchist
The capitalist Zen
The media's financial pornography
Some reason why investors act differently - they are different

Chapter 22: Basics In International Share Investing

Quick review
How does the international equity market compare in size with that of the US?
How are foreign shares traded?
What are the primary factors affecting returns on international shares for investors?
Many parts of the world do enjoy faster economic growth than your country (where ever you
live)
Where there's wealth creation, there's investment opportunity
Studies show international investing may help reduce the overall risk in investors' portfolios
Why invest abroad?

Chapter 23: A Guide To Global Investing

How do currencies change local market returns for global investors?

Reducing the risk of international investing?
Should foreign investment decisions be based on foreign exchange movement?
How should investor's allocate funds to international equity investments?
A long-term view
Two approaches to global share investing and diversification
An Overview of International Investing
The allure of foreign markets
Summary
Managing the risks of international investing
Integrating domestic and global investments
A dynamic global environment
Strong long-term performance from foreign markets
Developing a global portfolio
Review and modify the financial plan

Chapter 24: Investing In Emerging Nations

Emerging markets defined

Why invest in emerging markets?
Why invest in emerging markets?
New rules for the west investing in emerging markets
What does this mean for markets?
Summary

PART TWO ENCAPSULATED AND EXPANDED

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Part 3: Strategic Investment & Portfolio Techniques

Chapter 25: Traditional Formula Plans For Buying Or Selling Shares

The business and share portfolio planner

The problems in defining a business
Portfolio planning: a multilevel activity
Developing strategic investment techniques
Objective this section of the book
Framework for developing a strategy
Caveats

Chapter 26: Basic Investment Return Strategies

Using mathematics models

Financial models
Negative aspects of financial models
Positive aspects of financial models
Basic systems
The cost averaging system
The Du Pont model
Factors that influence ROI
The modified Du Pont formula
The constant rand system
A Word of Warning
The constant ratio system
Stock splits
Reverse stock split or share consolidation
Share dividend
The free cash flow method
Calculating an investor's total return
Adding other factors to the above formula

Chapter 27: Performance Systems - Economic Value Added Analysis

The Theory of EVA

EVA definitions
Value drivers: how to improve EVA
Merits of EVA
Increased capital efficiency.
Incentive tool
Summary

Chapter 28: Advanced Mathematical Formula And Matrices

The growth return matrix to assess labour intensive businesses

The asset growth rate matrix
Financial ratio matrices
The capital intensity matrix
Summary

Chapter 29 : Less Analytical Methods For Share Selection

Listen closely - what is said is often not what is meant

The Mission Statement
Market and industry characteristics
A. Long-term market potential

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B. Determining a strategic method

Using SWOT or trouble shooting methods in share selection
Trouble shooters and SWOT A logical thought process
Find the source of problem, not just the problem
Logical trouble shooters assessment process
Assessing competitors

PART THREE ENCAPSULATED AND EXPANDED

Part 4: Capitalists to the year 2020

Chapter 30: Survival And Prosperity Of Global Capitalism In The 21st Century

The closing of the century does not look so good

So, where does capitalism fit into this scenario?
Governments worsen the problem by trying to help
The long Boom
A plausible forecast to the year 2020
An economic Big Bang
Media, Internet, telecommunications and television networks combine skills
E-commerce
The cyberspace economy
Inflation is dead
Biotechnology takes off
The fourth wave - a long term view
The environmental issue
Russia and China - fall from communist grace
The European Union
The global stampede
The world economic engine changes gear

PART FOUR ENCAPSULATED AND EXPANDED

Appendix
Glossary
References
Index

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INTRODUCTION
From the outset, I must stress that this is not a book about capitalism, nor is it an economics
textbook.
It is also not my aim to compare one financial system to another or for that matter to promote
any one form of economic system. The ultimate message is simple to succeed in business, as
in all aspects of political and economic life, it is crucial to note that the world is rapidly changing
on all environmental fronts. Therefore, while the objective is to set out investment methods for
both entrepreneurs and shareholders, it does so with the knowledge that under a globalised
world it is financial suicide to ignore forces that are literally changing everything; from the way a
company operates in the global environment to the manner of political governance.
Without a political or business mindset to embrace global forces, the politician cannot budget for
changing world supply and demand factors, the entrepreneur becomes vulnerable to
international competition and the risk profile of a shareholders portfolio increases and thus
becomes more inefficiencies and less profitable.
Therefore, this is not a book for those that like to dabble in stocks or business ideas, but one
that aims to assist entrepreneurs and investors to move offshore, to defend against the negative
influences of globalisation and to do so with the sound understanding that these new forces are
uncompromising and, indeed, ruthless. However, globalisation also has a positive side, which
needs to be explored and exploited. This book is thus, ultimately, a strategic plan for long term
growth for both entrepreneur and share investor. In undertaking this project, I have come to
realise that the term portfolio is synonymous for the businessman and investor. Throughout the
book the term portfolio means the following:

For the entrepreneur: companies or divisions that make up the full organisation.
The entities that form part of the entrepreneurs portfolio.

For the investor: shares and other forms of securities (bonds, unit trusts, options,
futures, warrants etc) that form part of the overall investment.

Factors outlined in this book assume that entrepreneurs and investors have established
portfolios and that there is a reasonable level of understanding on how international markets
operate. In other words, investors can find a more basic explanation of the above factors in
numerous books available worldwide. For specific names, the two books that I have written
(published in South Africa) are available via the internet. The e-mail address is
j_magliolo@yahoo.com.
The two books are:
Share Analysis and Company Forecasting (Struik, 1995); and
The Business Plan: A Manual for South African Entrepreneurs (Struik, 1996).
There are a number of reasons for the particular structure chosen for this book.
1. There is a critical need to understand all the sections of this book. While the
shareholder or entrepreneur may want to only concentrate on the parts of the book that deal
with portfolio strategies, there is a need to understand that the fundamentals of assessing a

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company has changed in recent years. It is now necessary to understand that global factors
are affecting the way companies operate. The globalisation phenomena (outlined in Part
One) provides a solid overview of components that move businesses.

For instance, while a shareholder may not be interested in the demise of social welfare,
or the onset of privatisation or current corporate trends, an understanding of such factors
can enable him to make better informed decisions. This is best explained with the
example of the privatisation of the telecommunication industry throughout the world. Less
than a decade ago cellular telephones were only a dream, yet today this new technology
has created millions of jobs world wide and spawned a variety of other industries.

The shareholder who foresaw the long term opportunities arising from the privatisation of
telecommunications would have bought shares in technology/telecommunication stocks
and would by now have seen his shares rise to unprecedented levels. The same can be
said of the Internet industry.

The entrepreneur who foresaw the privatisation of the telecommunications industry could
have taken full opportunity by setting up alliances with foreign telecommunication
partners and established manufacturing plants and so on.

Opportunities arise from improved knowledge. How can the shareholder or entrepreneur
position himself for future growth if they do not have an understanding of how current
worldwide trends could affect their business. In addition, how can they position their
business without a fair prediction of how current trends could change in the future
(outlined in Part four).

2. This is a book of investment strategies. The only way a strategy can work is if it is used in
a logical manner. Therefore, the book starts with a macro-environmental approach (a look at
dominating world economic forces), moves to specific investment techniques and ends with
a macro-forecast of possible future trends.

STRATEGIC INVESTMENT APPROACH OUTLINED IN THIS BOOK

PRESENT MACRO
TRENDS

Economic
Political
Environment
Social
Corporate
Technological

SPECIFIC PORTFOLIO
STRATEGIES
Shareholder
Entrepreneur

FUTURE
TRENDS
Economic
Political
Environment
Social
Corporate

While all sections of the book can be read in isolation, they are also
interrelated. Each section can be read in isolation for specific needs, but should also
be read in the context of the whole book.

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GLOBAL TRENDS: PART 1

Global
Trends
Division of
labour

Smith &
Marx

Power
INVESTMENT STRATEGIES:
PART 2

Capitalism
Globalisatio
n
Information

Rules

Monopolie
s

Guide to
economics

SPECIFIC INVESTMENT
TECHNIQUES: PART 3
Formula, EVA, Strategies
Matrices, SWOT, Div cover
Competitors, splits

Risk &
Return
Internet

Capitalist
Theory
Practice

Pigs

Entrepreneu
rs

Competitio
n
Investors

Markowitz

Privatisation

Unions

FUTURE TRENDS: PART 4

Survival, Big Bang, Cyberspace, Regional co-operation, environmental issues, ECommerce, Fourth Wave, Mobile technology, Inflation , deflation, Internet, Media
forecasts to 2020

This book is aimed at the serious investor and the entrepreneur, who want to run
a successful portfolio in an ever increasing global capitalistic market.

The principles, theories and ideas presented in this book call for a society that thinks and
understands what it takes to achieve success in an increasingly growing global elite that
operates on ruthless capitalistic ideals. If such a society is to be achieved throughout the world,
a political movement pursuing a long-range programme will be necessary. The purpose of this
book is to describe the nature of global capitalism for investors and entrepreneurs and to offer
an outline of factors that affect corporations in a rapidly changing international business
environment.
Therefore, there is a need to stress that, without an understanding of factors that affect
business and share movement, investors and entrepreneurs cannot make informed decisions for
the short to long term. Among the many factors assessed, the book is split up into a number of
inter-related sections.
Part one of the book calls for a far greater understanding of capitalism, how it can benefit
entrepreneurs, investors and consumers. Despite the numerous disadvantages brought about
by the free market system, it is the one and only system that can save, in particular, emerging
nations from being relegated to economic isolation and ultimately poverty.

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It is also be stressed that it is not my intention to critic governments, their policies or

future plans (or lack thereof). to achieve growth. These have been well documented in the
numerous books, political journalists and the media.
As nations move closer to global influences, investors and entrepreneurs must give up
conventional business ideas and investment methods. Already the capitalistic jungle has had
significant influences on emerging markets and now is the time to introduce the market savage the capitalistic investor who sees opportunities instead of hazards, sees profitable ventures and
not problems. War in Africa or Asia means opportunities for weapons manufacturers, increased
vehicle sales, food for the troops and so on. To take the capitalist pursuit for wealth to its
extreme, famine means World Food Aid and this, in turn, means long distance transport
business (air, road and sea). This does not mean that the capitalist is callous, but it does mean
that the markets demand for goods and services has to be supplied by someone.
Part two moves the reader to the global village, outlining strategies for investors to tackle the
coming of capitalism head on.
Part three looks at how mathematical models and techniques for investors and the last section
looks at what will drive economic growth into the 21st century.
This is an indepth book and many theories are outlined in the following text. Some are,
admittedly, controversial, but most are aimed at being practical.

Enjoy

Jacques Magliolo

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No politico-economic system
in history has ever proved its
value so eloquently or has
benefited mankind so greatly
as capitalism - and none has
ever
been
attacked
so
savagely,
viciously
and
blindly.
Ayn Rand (The Unknown Ideal)

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Part 1
Capitalism, Power, Influence
&
Globalisation

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CHAPTER 1: WORKING IN AN UNCOMPROMISING GLOBAL

CAPITALISTIC SOCIETY
Adam Smith
Founder of the modern capitalism
1723 1790
Smith was one of the first to point out that individuals, acting collectively through markets,
could do things better, more innovatively, and more equitably than any individual or group
could manage by proclamation. Despite this knowledge, governments spent the next two
centuries and billions of dollars futilely trying to control markets. Smith's The Wealth of
Nations, published in 1776, described how an "invisible hand" snatches progress from the
seeming chaos of markets. The market is the thing, Smith said, not the people in it.
He said: "Bankruptcy is perhaps the greatest and most humiliating calamity which can befall an
innocent man. The greater part of men, therefore, is sufficiently careful to avoid it. Some,
indeed, do not avoid it; as some do not avoid the gallows."

Surviving in a global market

The number of issues that need to be considered by investors and entrepreneurs before leaping
into the global arena are stupendous, including what currency to use, which markets to target,
government interference in those markets, tax structures in those countries and
investor/entrepreneur protection from scam artists.
Yet there is a starting point for those that want to be part of global growth and its inherent
dangers - make a conscious and absolute decision to seriously want to achieve a portfolio,
business or even country that is well managed, efficient and competitive against the forces of
global corporate players. The second phase is then (and only then) to translate this decision into
definite goals.
Assuming that there is a desire to want (or feel forced) to be a part of the global
phenomenon, the way to achieving their goals is through the use of complete (and
unashamedly) exploitative capitalism. Yet, despite the spectra of global corporations ready to
move into a country and rape its resources, there is not one country, anywhere in the world,
that has a political system that professes to have the truest form of capitalism.
Over a number of generations, capitalism has been diluted through the growth of labour
and environmental movements. While free markets can operate effectively in areas where there
are unions and environmental lobbies, these factors have been seen as impeding on the
effective use of natural resources. This situation is changing under the growing spectre of
globalisation.
Socialist or Buddhist capitalism is the only answer
Since 1993, the phenomena of markets becoming global has increasingly meant that whatever
your ideology may be, whether Marxism, Buddhism, socialism, Catholic, Protestant or capitalist,
investors have had to get to grips with how the most dominant world-wide economic force
operates. There is no doubt that capitalism is dominating how products move across borders,
how countries are integrating their national economies and even where people live.
Therefore, the success of liberal or socialistic economic programmes depends on how
these are positioned to take advantage of resources locally and globally. However, an important
counter-force that has to be taken into account is the possibility that you may not be the one
raiding another country. In other words, you have to be protected against being raided, whether
you are running a country, business or portfolio of securities.
This does not mean the re-introduction of tariffs, duties or protectionism; rather there
must be a structured system to protect against the forces of international competition. By

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allowing free market forces to operate in a country, inefficiencies become targeted by internal
forces and exposed. By virtue of constantly exposing economic, political or portfolio
weaknesses, definite programmes can be established and continuously refined. Ultimately, weak
sectors of the economy will either be improved or diminished through forces of specialisation.
This happens when a country concentrates on the sectors that it has an advantage of over
competitors. The same principle applies to business, which in South Africa is now called
restructuring to concentrate on core-products.
Essentially, sell off all assets that you cannot make profitable and concentrate on those
assets that you have strength in, competitive advantages, skill, experienced staff and
entrepreneurial flair.
As an essential part of the process of achieving the desired business, economic or portfolio
system, general education must be undertaken throughout government, the public and
corporations to systematically set out the benefits and disadvantages of laissez-faire capitalism.
There may be political and economic pain before success is achieved, but there is no doubt that
ultimately the public would seek to change the existing state of society until it represented
laissez-faire capitalism.
Political and educational reform to laissez-faire capitalism would centre on the offering of
specific political proposals, which would aim to move the country toward capitalism. On the
education side, the basic problem that South Africans face is one of explaining to the people the
value of a capitalist society and the value of the specific steps required to achieve it. People will
only change their thinking and, even more reluctantly, change their political beliefs, if they made
aware and educated to the full extent of what is required to move to a full system.
Needless to say, the substance of such education is the spread of the ideas of classical
economists Ludwig von Mises and Ayn Rand, reinforced by the ideas of other pro-capitalist
economists and philosophers. There is a multitude of published works by these economists, and
I have included a list of pro-capitalist economists names in the Appendices. I suggest further
reading on these economists is important and, for those familiar with the Internet, suggest
searching for details of their works.
Part of the education system would set out details explaining:
Pre-suppositions that man is a self-responsible, free agent, capable of securing his wellbeing by means of intelligent action;
Benefits and disadvantages of capitalism;
What people must do if they want to succeed under globalisation;
Introduction of capitalism does not mean the disintegration of social welfare, but rather a
change in emphasis; and
Capitalism must proceed alongside a renewal of the philosophical foundations of a divisionof-labour.
To achieve capitalism in South Africa it is necessary for a formally organised capitalist party to
come into existence, whose primary function will actually be to serve as an educational
institution: it would have one or more book-publishing houses, theoretical journals, magazines
devoted to current issues, and schools turning out intellectual leaders thoroughly versed in
economic theory and political philosophy. All of these vehicles would be devoted at least as
much to questions of political philosophy and economic theory as to political activity.
The political proposals made should relayed to the public in numerous, short content
programmes. The intention, therefore, is not to transform society or business in a matter of
months, but over several years. It is not enough just to present long-range goals to the public,
but it is necessary to advocate a whole intervening series of short and intermediate range goals
that will represent progress toward an ultimately, full conversion to a system that will achieve
maximum utilisation of natural resources and skills.

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Under an increasingly global market, governments will have to proceed quickly to start
the process. The major political task in the years ahead will, therefore, be to continuously
formulate short and intermediate range objectives and to keep the country moving in the
direction of full capitalism by means of their successive achievement.
Each programme must be practical and explain to people that, if they want to prosper
under the coming of globalisation, they must adopt capitalism. In addition, programmes must be
presented continuously and labouriously, despite an initial refusal of people to listen. The
programme should explain to people what they must do if they are to succeed under
globalisation. In essence, it should advocate the abandoning of goals that are self-destructive.
For instance, businesses should have the financial strength not only to continue to grow
organically and through acquisition, but to avoid being the target of a takeover.
In South Africa, many businessmen talk about having available cash for takeover
opportunities, but seldom state that they have the financial muscle, the management and
director contracts to render a takeover unattractive.
A business analogy to explain why persistence must form part of the capitalists
vocabulary
In the world of engineering, lets assume that James Smith has discovered:

How to build an aeroplane that people could afford;

People would, obviously, greatly benefit from this new invention.
However, Smith cannot get manufacturers to listen to him. His business plan goes
unrewarded, banks deny him funding and he simply cannot get his aeroplane built.
Is Smith impractical because others refuse to listen to his ideas that would greatly
benefit them?
Rather, it is the manufacturers, banks and others who are impractical.
However, if Smith is to get his aeroplane to literally fly he must persist. In fact, it is
seldom that an idea gets accepted immediately. The norm is usually a multitude of
refusals before final acceptance. It may even take years, before a business plan is
accepted. By then this plan has been modified, refined and fine-tuned.

In the political-economic realm of many countries, it is often the current state of public opinion
that is impractical:
It expects that men can live in a modern economic system, while destroying the foundations
of that system. For instance, many economies believe that they can have rising prosperity an
better lifestyles, while simultaneously destroying incentives for businessmen and capitalists
to provide that prosperity. The true capitalists tell people that the less government
interference there is at every level of society, the more people will be forced to use ingenuity
and skill to become prosperous.

It is impractical and also inaccurate to assume that the masses know best when it comes to
improving systems that result in greater prosperity. The essence of true political practicality
consists of clearly naming and explaining long-range political programmes that promotes
human life and well being, i.e. under globalisation, there is little choice. Capitalism is the only
force that brings people together with enough power to make change.

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Summary:
In its the simplest terms, capitalism can be defined as the condition of possessing
capital -- the original funds or principal of an individual, company, or corporation, which
provide the basis for financial and economic operations.
The term capitalism also describes an ideology which favours the existence of
capitalists (individuals who accumulate capital which then becomes available for
investment in financial or industrial enterprises).
Labour, raw materials, the processes of production, shrewdness, self-discipline and
profit are among a host of characteristic that make up the capitalist.
It is not surprising that those who fear the effects of capitalism are usually those who
do not fully understand capitalism. A willingness to acquire a sufficient combination of
knowledge of political philosophy and economic theory should be the start of a longterm programme to take advantage of globalisation and to protect against raiders.

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CHAPTER 2: CAPITALISM THEORY AND PRACTICE

Henry Hazlitt
1894 1993
"The art of economics consists in looking not merely at the immediate, but at the longer effects
of any act or policy; it consists in tracing the consequences of that policy not merely for one
group but for all groups."

There is more to capitalism than private ownership of property, the freedom of individuals to
pursue business ventures and the desired removal of the State in the decision making process
of business. If entrepreneurs are to survive in a global environment, that is capitalistic to the
ultimate degree, it is crucial that they understand and embrace the concept of capitalism.
This section is divided into two parts, namely Theory and Practice and is in the form of
answers to popular questions relating to capitalism. I have not split the section into two as to
suggest that there is a dichotomy between the two. Theory is a reflection on the nature of
existence and the relationship between the man and that existence. Practice is a discretionary
choice of people that have alternatives.
Conclusion: Political-economic theory is an attempt by man to identify the ideal economic
system through the observance and attempt at understanding how man reacts under certain
conditions. Therefore, theory is not an idea detached from man. If a theory is correctly
formulated, it is eminently practical. After all, if theory has nothing to do with reality, then it
cannot be put into practice. Therefore, capitalism must be defended on the basis of its
practicability as long as people and the State are aware that the reason it works is because it is
good theory.

THE THEORY OF CAPITALISM

What is capitalism?
In its truest form, laissez faire capitalism means the complete separation of economy and State.
It is an economic order (or social system) that is based on the principle of private ownership of
the production means and entails a completely, uncontrolled and unregulated economy where
all land is privately owned.
However, separation of the State and economy is not an overwhelming concern, which
means that it is only an aspect of the premise that capitalism is based upon individual rights. The
politico-economic system based on the doctrine of individual rights recognizes that each and
every person is the owner of his own life and has the right to live his life in any manner he
chooses as long as he does not violate the rights of others.
Under capitalism, the individual's pursuit of his own economic self-interest simultaneously
benefits the economic self-interests of all others. The principle is that, by allowing individuals to
act unhampered by government regulations, capitalism results in wealth being created in the
most efficient manner possible. This ultimately raises standards of living, increases the
opportunities and makes available an ever growing supply of products for everyone. Therefore,
the free-market system creates more wealth for individuals, but also opportunities for everyone
else. At least, for those with a desire to take advantage of those opportunities. For instance, the
development of the cellular telephone created wealth opportunities in complimentary
businesses, including retailers of these telephones, the accessory business and provided job
opportunities for engineers, technicians, manufacturers, businessmen, entrepreneurs and the
informal sector (customised accessories)

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Alternatively, it means that as the rich become richer, the poor can become richer. It
must be understood that capitalism serves the economic self-interests of all, including the noncapitalists.
Contrary to widely held beliefs, capitalism is not a system that exploits a large portion of society
for the sake of a small minority of wealthy capitalists. Ironically, it is actually socialism that
causes the systematic exploitation of labour. Since the socialist state holds a universal monopoly
on labour and production, no economic incentive exist for the socialist state to provide anything
more than minimum physical subsistence for the workers. Exploitation is inherent to the nature
of socialism as individuals cannot live for their own sake, but exist merely as means to whatever
ends the socialist rulers may have in mind.
What is the philosophy of capitalism?
Capitalism is implicitly based on a view that believes man is competent to deal with reality and
thus possesses a faculty to reason. In addition, capitalism is the only social system that
safeguards a human's individual right to use his own mind to grasp reality and act accordingly to
better his own life. Capitalism is the only system that protect the individual person and property
of each human being.
Historically speaking, capitalism has been claimed to be consistent with the philosophies of
utilitarianism, social Darwinism and fundamentalist Christianity. Not all economists would agree
to this statement.
What is a capitalist?
A capitalist is a person who buys in order to sell for profit. However, the productive role that
capitalists and businessman serve cannot be overstated, i.e. capitalists raise productivity and
thus real wages of manual labour by means of creating, coordinating and improving the
efficiency of the division of labour.
Through competition, the efficiency of labour is continuously improved, which means
that, in a sense, capitalists are responsible for raising wages and creating employment that
serve to raise the standard of living of everyone. Furthermore, these competitive forces push
entrepreneurs to seek new and better products and ways of marketing these products. This
results in research and development departments being funded that, in turn, results in capital
investments. Stated differently, it is the capitalists that make all of the modern day conveniences
possible - from laser surgery to orchestra halls. Strangly most people take these for granted
every day, yet it is the capitalist that makes available life-saving and labour-saving technology,
that they should be regarded as some of mankind's greatest benefactors.
In a more fundamental sense, a capitalist is anyone who lives solely by his own effort and who
respects the rights of others. The capitalist can be a window cleaner, restaurateur, chef or
billionaire). The best symbol of a capitalist is the stockbroker, who buys and sells securities for
profit. Without his contribution to society, companies would not have a market to sell a portion of
their company (in the form of shares) to fund expansion or other proposed venture. That is, the
man or woman who only deals with other people on a voluntary basis. Alternatively, a capitalist
is not an exploiter nor necessarily greedy people.
What is the role of State in a capitalist society?
The only purpose of government must be to protect its citizens from force:

The protection of individual rights would be achieved through the use of a police force.

The protect the rights of citizens from foreign aggression through the military.

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To enforce contracts and settle disputes between citizens, a legislature (court system) is
necessary.

Since rights can only be violated by initiating force, the government would only use force in
retaliation of those who initiated it. Any other function of government than those listed above, no
matter what its intentions, would necessitate the violation of rights by initiating the use of force
against the people it is supposed to protect. For example, compulsory tax-supported education
forces some people to pay for the education of others for whom they would not have voluntarily
paid for.
What does capitalism have to do with freedom?
Capitalism the only system in which freedom and liberty can really exist. Under true capitalism,
an individual can set up an run a business that is in many countries controlled by the State. For
instance, if an entrepreneur wishes to set u and run a water department to supply water to
subsurbs, he would not be allowed to do so the State controls these utilities. His actions are
handicapped by the use of force - the government's legal monopoly on utility companies
prevents him from starting his own water company through the threat of force.
Freedom imposes no positive constraints on other people's actions. In a free (or
capitalist) society all men may act as they choose, so long as they do not infringe on the
freedom of others by violating their rights through force. Subsequently, it is only a government
limited to protecting individual rights that fails to violate the freedom its citizens. Since capitalism
upholds individual rights as absolutes, capitalism upholds freedom as absolute.
This is the reason why privatisation of State utilities has really become popular in first
world countries no State can run a business better than the free market can.
All non-capitalistic societies force men to live at the expense of others, i.e.
For the sake of God - a theocracy state;
For the betterment of all the States people - the welfare state
For the latest autocrat - a dictatorship.
In these States individuals are violating, in whole or in part, the freedom of others.
Is capitalism a fair and just social system?
In a social or political context, justice means that every person gets no more, and no less, than
what he gains through voluntary association with other men. A capitalist society is a just society
as all individuals are considered equal under the law. Capitalism recognizes that it is just for a
man to keep what he has earned and that it is unjust for a man, or group of men, to have the
right to take it away from him.
Since all people must live independently under capitalism, all of the material values that a
person acquires must be earned. Thus, the expression of social justice under capitalism is that
what a man earns is directly proportional to what he produces, with no antitrust laws or
progressive income tax system stifling his achievement for the sole fact the he did achieve. All
other forms of government, such as the welfare state, institutionalise injustice by legally
expropriating the property of some men and giving it to others.
There are many people who do not accept capitalism as a just system as, undoubtedly,
capitalism creates inequality. What must be realised is that it is perfectly just for a movie star to
earn more than a panel beater as the actor creates enormous profits through ticket sales,
whereas the panel beater generates very little revenue through his tiring and hard job. That is,
each of them deserves what they earn and what they earn is the result of how much wealth each
of them creates through supply and demand factors. This does not mean that the actor is
morally superior to the panel beater, because he is wealthier.

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Each man has the right to the product of his labour and it is, therefore, completely just for
the disparity in incomes to exist. The only injustice to occur would be for the government to take
money from the actor and give it to those who supposedly deserve it on the basis of their "need."
How is democracy related to capitalism?
Most people tend to think of "democracy" as a political system where all people over 18 years of
age can elect (vote) for a particular political party or individual within a political party. Once
elected, the function of a democracy is to decide how that power is specifically exercised (such
as how many policemen or judges are needed). However, the extent of that power should be
strictly defined and limited in the constitution.
In a proper capitalist nation, a constitution based upon individual rights would be
necessary to limit the actions of its citizens and the government. Under capitalism, the majority
would never be able to vote to violate the rights of the minority, no matter how large the majority
or how small the minority. Individual rights could never be subject to vote and must be
consistently upheld if capitalism is to be achieved. If the majority can do whatever it wants
regardless of the rights of the minority, capitalism cannot exist, not even in principle.
What is the opposite of capitalism?
The opposite is socialism in any form. Also called Statism, this is the concentration of power in
the State at the expense of individual freedom. The variety of political systems that violate
individual freedom are numerous and include socialism, communism, fascism, Nazism, absolute
monarchies, military dictatorships, theocracies and welfare states. These systems all violate
individual rights and institutionalise the initiation of force against citizens.
In essence, there are only two fundamental political philosophies:
Those that are against freedom of individual rights. There have been many such systems
through out history.

Those who are for freedom of individual rights. There is only one political-economic
philosophy that upholds that the rights of man as absolute and constant - capitalism.

An ideal social system must respect the nature of man and provide a context to which
the defining moral principle is the freedom to sustain one's own life by voluntary,
uncoerced choice.

Such an ideal system does exist, if only in the minds of men, but it is definitely not
socialism.

Socialism holds that man is not an end in himself, and that he must sacrifice his own
convictions for the sake of the greater good of the collective group.

Socialism requires the sacrifice of the individual mind, and hence denies the sole
means of survival of man and in fact his very nature as a rational being. Such a system
cannot honestly be held as an ideal.

Proud capitalists
Among the many proponents of capitalism, there are two thinkers who stand as virtual twin
towers in the history of pro-capitalist thought, namely the novelist-philosopher Ayn Rand and
economist Ludwig von Mises.

Rand gave capitalism a philosophic defence. She recognised and was able to connect
capitalism to individual rights, and that individuals have the moral right to live for their own

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sake. This makes her philosophy of Objectivism of utmost importance for a thorough and
consistent defence of capitalism.

The most prominent member of the leading Austrian school of economics was Ludwig von
Mises. Mises was able to identify capitalism as being the system that benefits all and not just
individuals. In addition, he was able to refute claims that capitalism leads to exploitation and
depressions and he also proved the economic impossibility of socialism.

Other major pro-capitalist economists include Austrians Eugen von Bohm-Bawerk and Carl
Menger, French economist Frederic Bastiat, classical British economists Adam Smith and
Dave Ricardo. Furthermore, economists and political philosophers such as Henry Hazlitt,
Tibor Machan, John Locke, and less consistent defenders such as Milton Friedman, FA
Hayek, and Murray Rothbard all constitute important names in the defense of capitalism.
(see appendix for a more comprehensive list).

CAPITALISM IN PRACTICE
Does laissez-faire capitalism ultimately lead to coercive monopolies?
This is one of the most common fallacies about capitalism. There is only one way to answer this
question and that is to ask what is a monopoly and how are they formed?
A coercive monopoly is exclusive control in a field of production, completely exempt from
competition and the normal laws of supply and demand. The only reason competition could ever
be absolutely barred is when the monopoly is operating in a closed market.
In such a case,
the monopoly benefits from what is called a "barrier of entry." These barriers, however, can only
come from one place, namely the government. It is only a government that has the power to
"raise" a business above the laws of the market.
In a free market, all businesses are subject to competition and therefore must constantly
be competing to stay ahead of their competition. In a global market, the situation is enhanced
and monopolies complete with other monopolies around the world. In essence, supply and
demand is more in equilibrium and a businessman can thus obtain his raw material from other
places and the dominance of the monopoly becomes limited to a region.
When the State grants a certain business a franchise, subsidy or tariff protection,
competition is legally barred. In other words, government interference into the free market is the
real source of all coercive monopolies. In fact, it is precisely these types of monopolies that
Adam Smith condemns in The Wealth of Nations.
It should also be noted that socialism, where the government has complete control over
the means of productions, is the ultimate form of monopoly. For example, in the US and in South
Africa, all utility companies are coercive monopolies. They are not monopolies because they
deliver utilities (water and electricity) better than their competitors, but rather they have been
made into monopolies through a State franchise for a particular territory. This means that no one
else is allowed to enter the utility business apart from the government and any attempt to do so
would be treated as a criminal act.
Under capitalism, the only type of monopoly that could exist is a non-coercive monopoly, i.e. one
that is earned. This status would last only as long as they were the best in their field and they
would still be subject to competition from other firms in their industry. Historically, any business
that tried to establish a monopoly in a free market through acquisition of the businesses of its
competitors (or undercutting prices by selling at a loss) has gone bankrupt.
Does capitalism lead to worker exploitation?
The simplest answer to this question is that in a capitalist society all workers are free to choose
where they work, who they work for and, in fact, whether they want to work. The worker can, at
any time, decide to work elsewhere and in whatever sector of the economy he wishes to attempt

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to enter. Of course, skills, experience and personal attributes (honesty, hard working etc) also
play a role in getting and keeping a job, but a worker who doesn't like everything about his job
doesn't mean he is being "exploited."
For someone to be exploited they have to be physically forced to work against their own
will. It is only a government, not a businessman, that has the type of power necessary to force
people to work against their own judgment.
In a free market economy, all employers must compete for the services of their employees. If an
employer offers lower salaries or poorer working conditions than other employers in a given field,
workers will seek to work elsewhere, and the employer will lose his employees. Without labour,
there is no business. This means that it is in the economic self-interest of employers to provide
higher wages and better working conditions than their competitors.
Wages are prices for the labour of individuals and are primarily determined by the
productivity of labour. It is an inevitable consequence of capitalism, through the accumulation of
capital, the widening of labour markets and an increase in the productivity of labour, that
workers' real wages rise and their choices of employment increase over time. It is thus due to
capitalism, not monopolistic unions or pro-worker legislation, that the standard of living of the
average worker has been increasing since the industrial revolution.
Can unregulated capitalism lead to unsafe products and services?
In a totally free market there are no government agencies to decide what products, foods and
services qualify as "safe." This means that under capitalism all companies would have to earn
their reputation through a demonstration of consistent quality and safety to their consumers.
Since most consumers consider quality and safety to be very important features of the products
they buy, a good reputation would be essential to success of any company in a free market. The
importance of reputation for quality would force any potential profit seeker to ensure that his
products were safe and his customers trusted him, or else they would simply purchase from
another competing company whom they do trust.
Stated differently, there is a difference between fraudulent claims that a product was safe
and the right of an individual to produce a produce. It has already been stated that capitalism is
the freedom of the individual, but not at the expense of anothers freedom. To claim that a
product was safe (when it was not) is an infringement of anothers freedom of choice.
Furthermore, the free market would prevent any "fly-by-night" scams from having any real
success because before any company could achieve real success, it must establish itself with a
good reputation for quality and safety which can take many years. For example, what investor
would take the advice of a brokerage company that just opened its doors, and with no success
rate to speak of, as opposed to a firm that has been in existence for decades with an
unparalleled reputation for quality investment advice. Thus, it should be realized that it is in the
economic self-interest for companies to provide quality products and services in order to satisfy
their customers' demand for quality and to beat out their competitors. Finally, it should be
observed that in a free market private agencies and publications, such as Consumer Reports,
would exist for the sole sake of recommending quality products and services which would help to
set health and safety standards for a given industry.
Some economists believe that it is safety regulations that actually lower the quality of
products and services. The argument is that safety regulations force companies:

To divert their capital into areas of production not first intended.

This leaves the company with less capital to invest into areas of production that was initially
planned.
This ultimately affects the overall quality of the product as less funds are used for inteded
production.

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Another argument is that the more regulation that the State sets in stone, the less effective the
whole policing system becomes. It is usually much easier for a business to obtain (illegally buy)
a government safety license than it is to actually earn a quality reputation. This leaves the
possibility of scam artists taking advantage of people, because the typical consumer is all too
willing to place complete faith in a State issued license, which could have easily been earned by
bribing an official.
Finally, safety regulations create a false sense of security and promote consumer
irresponsibility as these discourage the need for consumers to be responsible for their own
choices. The essence of capitalism is the need for individuals to be responsible for their own
actions.
In addition, all forms of government regulation, whether they are personal or economic, are
violations of an individuals rights. As controversial as it may be, if a company wants to sell
cheap and unsafe products and people are willing (and with full knowledge) to buy them, then no
one has the right to stop them from doing so.
Is the US a capitalist nation?
Capitalism means the complete separation of economy and state, and the US economy is far
from being separate from the US State, which has imposed many pro-worker laws, i.e. minimum
wage laws and all public services and regulatory agencies. These are all anti-capitalistic as they
represent the government interfering into the economy, infringing upon the voluntary association
of individuals and thereby violating their rights (which are the foundations of capitalism).
The US can properly be referred to as a "mixed economy," which is a mixture of freedom and
controls, or free market with socialist policies.
In South Africa, would capitalism promote racism?
Many fear that under a system of laissez-faire capitalism, many employers will refuse to hire
minority or black workers even when they are better qualified for the job or, alternatively, hire
minority or black staff to fill quotas even if these employees are less qualified. It is capitalism that
operates so as to make all forms of irrational discrimination economically unsound and it is State
intervention into the economy that impedes poorer minorities from achieving economic
advancement.
The driving force behind all economic activity under capitalism is the profit motive, i.e.
firms want to maximise profits at all times. Simply stated, it would not be economically viable to
hire workers who are less qualified. Conversely, if a racist employer was willing to pay higher
wages for white workers or if he was willing to hire less skilled workers for less pay, he would be
at an economic disadvantage in a competitive market place where other companies could afford
to offer cheaper services or products than him as they were not practicing racism in their hiring
practices.
In other words, if a company wants to maximise profits and be highly competitive, they
would be forced by the market to leave their racism at home, i.e. the profit seeking businessman
is a minority's greatest ally against economic injustice.
Example: Company WHITE LTD has the following characteristics:

The company employs 100 staff.

The owner is racist.
He is willing to pay whites 25 cents more per hour to work for him.
In a forty-hour work week, with fifty work-weeks in a year, he will lose R50,000 a year (0.25
cents x 40 working hours x 50 weeks x 100 staff = R50,000).
This employer's racism is costing him a new small fortune each year.

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Conclusions
All anti-profit legislation limits profit.

A heavily taxed business impedes minority advancement, as employers make less

profit and thus are unlikely to expand their businesses in the short term.

Minimum-wage laws artificially raise wage rates and cause employers to hire less
workers, the impact of which is always felt on the poorer and least educated.

A welfare system allows minorities, who could otherwise get jobs, to live off welfare
payments.

These payments serve to stagnate the ability of the recipient as, even if the welfare
income is higher paying than a job would be, in the long term the recipient does not
acquire the abilities that could promote him to better jobs in the future.

It should be noted that anti-discrimination laws that force employers to hire minorities
serve only to increase tension between races and do not achieve any permanent form
of stability.

Would the poor suffer without a State welfare support system?

Simply described the welfare it is a system that permits government to steal from most of
citizens to give it to others on the basis that those with more wealth have a duty to serve those
with less. There is nothing that can justify the violation of rights, especially not the "need" of the
recipients of grand scale theft.
The goal of the welfare system is to help certain citizens when they "need" financial help
in order for them to become productive members of society. However, this noble intention is
actually debased when welfare starts to create a class of dependents. Once again, it is the State
that is the source of the problem and not capitalism.
If the State was really concerned with poverty it should realise that capitalism has raised man's
standard of living, created more opportunities for economic advancement and done more to
increase human happiness than any other system ever could. Without the welfare state, those
unfortunate individuals who could not support themselves would have to rely on private charities.
In capitalist society, however, these individuals are necessarily a small minority and have always
been in more capitalistic periods throughout history. However, no advocate of capitalism could
morally justify an immediate abolition of the welfare state. A planned conversion would be the
only appropriate action.
Under capitalism, will pollution and industrial waste stop?
One of the fundamental principles of capitalism is the private ownership of property. Logically,
people tend to look after personal possessions and there is no reason to assume that the same
would not apply to rivers, nature reserves and wild game farms. In fact, South Africans have
amply displayed the successful principle of capitalism for game farms. When privately owned,
these farms are well maintained and continuously replenished with animals.
However, when public property belongs to everyone, no one person takes care of it and
property with no real owner is easy to pollute. If all property was privately owned, no one could
dump in a river that they owned a section of, as the waste would drift into another person's part
of the river and violate their property rights.
The same applies to beaches and oceans. If the ocean was divided up into privately
owned portions, then no one could pollute their part of the ocean without the pollution spilling
into someone else's property. If the beaches and parks were privately owned and the owner
charged for people to use his land, then it would be in his economic self-interest to keep his

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beach or park clean and pollution free so people would frequent his property more than his
competitors.
Should the State not provide public education?
The concept of free education for all may be a noble one, but it does not work. Government
schooling in South Africa has become a bureaucratic nightmare and the proliferation of private
schools is a good example of the free market identifying a need and supplying that need.
The State assumes that its proper function is to provide education for some of its citizens
at the expense of others. It seems that the States concern is misplaced. Instead of placing the
educational system in the hands of the private sector (even if it subsidises schools fees for
poor), which can do a better job of establishing the needs of country and supplying those needs
(place emphasis on subjects needed in the market), it attempts at controlling the whole system,
i.e. types of subjects taught, how children act, where they sit, stand and when they can eat, play
and other unnecessary social engineering methods.
Teaching is selective, therefore it should be up to the parents to send their children to
schools who teach in the manner they deem best. It should not be up to pressure-group
influenced politicians to decide the content of a child's education, and therefore his mind.
The US education system is a perfect example of State interference and the deteriorating
standards, which have become nothing but a vast, expensive and unsuccessful bureaucracy.
In an industrial society there is a very real economic need for education. If educational
institutions had to compete for the value that is attached to the diplomas offered, educational
standards would necessarily rise. Like all goods and services provided in the free market, quality
education would become a service that would be available to nearly all of the population
because of its high demand. In essence, fees would ultimately drop and the education provided
would be for children who wanted (free will) to attend schools. Teachers would not have to
spend hours on children who resent being at the school.
Many socialists would deny that fees would ultimately drop to reasonable levels. The
same was said of the computer industry and the high cost of home computers. Within a short
period, competition resulted in cheaper and more powerful computers being made every few
months. Just imagine what it could for education. Schools would be competing with each other
to provide the best education at the lowest price to all consumers.
Conclusion: The free market can do anything cheaper and with higher quality than the
State can, except provide protection from force. The state necessitates bureaucracy and
waste, because inherent in all government operation is a grave split between service and
payment. The high level of service arrears in South Africa is a prime example, which
means there is little or no incentive for government to ever improve the quality of its
services.
Surely, minimum wages should be considered an absolute necessity?
The intention behind minimum wage laws is to stop employers from offering wages that are
considered to be too low and thus raise the standard of living of all people. The concept fails in
its attempt to protect workers, as these laws actually end up creating more unemployment.
Example: If the State set the minimum wage at R5.00 per hour, what does that mean?
It does not mean that everyone who wants to work would start out on that hourly wage. It
means that those who can get work would start out on that wage.

Anyone who believes that his labour is worth less than R5.00 per hour cannot get a job.

In a country with high unemployment and an extremely high lack of skills, supply of labour far
exceeds demand, but the free market principle is restricted. The businessman, who has a

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budget to follow, will hire labour at the cost that meets that budget. If he has 100 workers
who work eight hours a week, his weekly wage bill is R20,000. However, if he could give
jobs to workers that wanted only R4.50 an hour, he could hire more people.

The consequence of more people employed is a higher demand for basic goods and
services and, therefore, higher growth in industry to provide these goods. This means more
employment and the cycle repeats itself.

When minimum wages are increased, the businessman often pushes up his prices, which is
inflationary and, again, minimum wage laws have stifled economic advancement.

The result is that it is usually the poor who would be willing to work for less than the
minimum wage, and if they cannot find jobs, they cannot better themselves.
Minimum wage laws violate the freedom of two people (or two groups) to enter into a
voluntary association with each other and actually ends up hurting those who they
are intended to protect, the worker.

Does the State have to regulate medical products?

Regulation of medical products is an attempt by the State to intervene in the free choices of
individuals regarding what medical products they should consider as safe. The State feels that
the public should be treated like children and looked after in every aspect of society and life. In a
free market, it would be in the economic self-interest of a medical product or drug company to
only release safe products so that they would earn the trust of the public and they buy their
products more often.
Summary
Wealth is not a static quantity, it is created.
Many people falsely believe that, in a capitalist society, humans compete through the
marketplace for a static quantity of wealth in which the economic gain of one person is
necessarily to the economic detriment of another.
This view leads to the logical conclusion that those who are wealthy became so simply by
depriving others who are not as wealthy.
Under a division of labour capitalist society, wealth is created through the efficient use of
labour (skilled to unskilled) and capital (including technology). The drive for higher profits
leads to better systems, greater efficiency and a lowing of costs and higher living standards
for all.
By rearranging the physical world in such a way that values can be placed where they did
not previously exist, wealth is created.
Under capitalism, one man's economic gain is also another man's economic gain.
Individuals have the right to compete for a given quantity of resources.
Thanks to capitalism and the division of labour a system exists to create wealth for even the
most ignorant and inept person to be able to live.
This economic principle has been easier to grasp since the industrial revolution, which
created a level of material abundance on earth.

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CHAPTER 3: THE SAVAGE CAPITALIST JUNGLE

Friedrich Hayek
1899 1992
"We must show that liberty is not merely one particular value, but that it is the source and
condition of most moral values. What a free society offers to the individual is much more than
what he would be able to do if only he were free. We can therefore not fully appreciate the value
of freedom until we know how a society of free men as a whole differs from one in which
unfreedom prevails."

A while back a colleague, who is also a trader, suddenly stood up and started to yell. He
continued to scream and shout for at least six or seven minutes, bringing nearly the whole staff
into the dealing room to see what was going on. I looked at him and asked him why he had
screamed?
He replied that he had just hugely profited from going short. This means that he had
sold a share that he believed would drop in price and bought it back at a lower level and thus
profited from the difference in prices. Now, this does not seems unusual but he had made the
sale of shares that he didnt have, which is quite legal and common in stockbroking. The
question asked, though, was what did he think the influence of his actions would have on the
company concerned?
For instance, would the drop in share price result in a mass sale of the share, would the
company be perceived by the market as possibly having failed in a venture after all, shares do
indicate investor sentiment, which is driven by speculators, market rumours, analytical reports
and the media. Bottom-line? Would his action result in a self-fulfilling prophecy forcing a share
down by the market results in a investor confidence diminishing, pressure mounting on the
company to prove themselves and thereby making a mistake?
My colleagues answer? Whats your point? I smiled and replied: None whatsoever,
comrade capitalist. The company did fail, but for poor financial management.
The point is that the capitalist society that has to be achieved in a global village is a society in
which individual rights are consistently and scrupulously respected. My colleagues right to sell
the share (even one he did no possess) for whatever reason has to be respected no matter
how savage it may seem.
US economist Ayn Rand asserts that the desired society is one where:

The role of government is limited to the protection of individual rights.

Government can, therefore, only uses force in defense and retaliation against the initiation of
force.

Property rights must be recognised as a right of the individual.

No-one should be made to suffer for his success by being sacrificed to the envy of others

All land, natural resources and other means of production should be privately owned. This
means privatisation and outsourcing of all main central, provincial and local government
utilities.

The size of government should be less than 10% of what it now is in terms of government
spending.

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In a sense, this is a reversal to Adam Smiths 18th century proposals. Rand is one of a number of
economists advocating the State should consists of the no more than defense, state, justice and
treasury.
All that would remain is a greatly reduced executive, legislative and judicial branches with
radically reduced powers. Similarly, businesses need to streamline, reducing staff compliments
through mechanisation and computerisation, creating more efficient structures, sale of non-core
assets and improving managerial controls. These have already taken place among South
African companies in preparation for the coming of capitalism or, in other words, the onslaught of
globalisation.
If these brief remarks can serve as a description of a desired capitalistic state, it is
important to briefly outline a series of political proposals for its actual achievement. These are:

Privatisation of property, education and science.

Freedom of production and trade.

Abolition of the welfare state.

Abolition of the income and inheritance taxes.

Pro-capitalist foreign policy.

The above headings are discussed in the following text.

Privatisation of property, education and science
Privatisation is the most fundamental basis to start creating a pro-capitalist political programme.
In addition, it is also the basis to explain how a pro-capitalistic political programme can be
strategically implemented.
Under a capitalistic programme, privatisation should include all State-owned lands,
utilities and natural resources (except military bases, police stations, and courthouses). For
businesses, it is important to understand that the establishment of capitalism and the ensuing
privatisation, means opportunities throughout industry, i.e. telecommunication, electrification,
post office, water works, forestry, oil, coal, mines, games farms, airports and the media. These
are opportunities that would be gained though tenders, which in South Africa means
persuading government that you have the capital, structures and systems in lace to promote
employment and the advancement of the previously disadvantaged classes.
Privatisation of all of these things is part of the ultimate goal and entrepreneurs must be sure
that they understand all aspects of their involvement in the process. For instance, as soon as a
privatisation venture is announced, foreigners will make a bid - these are companies with years
of streamlining, operating efficiencies and all the capital needed to make a solid and highly
probable tender.
Ultimately, privatisation should include undersea mining operations and fishing. This step
would provide the opportunity for businessmen to re-establish a connection between capitalism
and science, technology and economic progress. The more businessmen own, the better they
would tend to look after their investment. Of course, there are entrepreneurs who are not
successful. The market would destroy these entrepreneurs and move the venture (property, river
etc) to another businessman.
US economist George Reisman, in his book Capitalism: a treatise on economics stated it this
way:

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Linkage of the campaign for privatisation with an assault on the environmental

movement would be instrumental in re-establishing capitalism in the minds of the
public as the system of progress and improvement advocated by men of reason, and
the opposition to capitalism as the manifestation of ignorance, fear, and superstition.
Reisman believes that he is, in fact, the complete capitalist. He calls the environmentalist and
socialist opposition to capitalism a movement to return the world to the Dark Ages and a system
of feudal privilege.
An ideal way to start the privatisation process
Numerous economists suggest that an ideal way to start a privatisation campaign could be the
sale of cellular-telephone channels and the railway system. To varying degrees these are
already in private hands. In these two cases, privatisation would merely be a matter of carrying
forward something that already exists to an important conclusion.
The public could be persuaded that the sale of the cellular network and the railway
system, as it could be explained that private ownership would create an incentive for the cellular
and subway's management to attract customers and thus to improve the safety and efficiency of
the system. Such a campaign would represent the first start of an offensive to prepare for
globalisation.
Companies should focus on core products
For companies, the perfect starting point is to determine what their core product is, which could
encompass different variables. For instance, the chief executive officer of a major
newspaper/magazine retailer in South Africa told me that their core product was any good that
could increase the number of people walking through their stores. Another chairman said they
saw their core product as anything that could be retailed, while yet another director told me
that core product meant a focus on the item that contributed the majority of sales.
All were significantly different in meaning, but all had one thing in common the directors had
made a conscious decision to concentrate and grow on a specific segment of their business.
Both the economic thrust and change in business targets should be based on the principle of
economic superiority and private ownership. Ultimately, the cumulative effect would be to tend to
establish that principle as correct in the public's mind.
The more directors tell the investing public of their plans and the better privatisation plans
are outlined in the media, then success in lesser projects should help in establishing a
foundation for accomplishing the objective of full privatisation in the near future. Directors use a
similar psychology when making a major announcement.
Take, for instance, the example of an engineering company that is about to undertake a major
restructuring of all its divisions. Once the board of directors have made the decision, the next
step is to make an announcement to the public. However, instead of making an outright
statement in the press, stating that they are about to undertake a restructuring and then to
provide details, the company issues a cautionary announcement, warning shareholders that the
company could be making an announcement that could affect the share price and that
shareholders should trade with caution.
They are warning shareholders that they are about to make an announcement? A week
later, they release details of the announcement. For investors, there is a process here that
needs to be explained. First, the announcement is just that an announcement yet the share
price often moves upwards. Nothing has been done or even commenced. No restructuring has
taken place, but the share has risen on the back of a positive announcement.
As the company undertakes its restructuring, expenses and possible problems are incurred. In
addition, a major restructuring most often takes more than 12 months to complete, which means

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that investor interest diminishes, as the company does not meet financial expectations. During
this phase investors should buy the share as it declines. The next step is for the company to
consolidate its restructuring and the financial start to benefit from the restructuring, which filters
down to earnings per share. The share rises as shareholders and other investors scramble for
more shares. It is then time to sell.

Profit Time-Line
Shares affected by restructuring

Period prior release of results

Results released.
Full benefits of
restructuring still
12 months away.

Share
Share stagnates prior
announcement

Share
declines
Consolidation
phase
Cautionary

Period prior results

Share stagnates

Share

Detailed Announcement

Share increases
Results reflect
full benefits of
restructuring

12 to 18 months
Time Scale

Note: Business and government should expect resistance to such drastic change. Nevertheless,
if persistent victory will be the final outcome, especially if the fight (public, unions, staff and
shareholders) is based on correct abstract that translate into higher benefits and profits. In
addition, it is not easy to survive for 12 to 18 months as a director when the share is falling.
Directors who display this kind of conviction are worth following as investors. They will display
the entrepreneurial flair that will survive globalisation and the coming of capitalism.
If the State can make constant progress in its intellectual influence over unions and
environmental lobbies, it cannot fail to ultimately possess major political influence.
However, the State will loose that influence if it cannot move easily from the theoretical to
the benefits of the practical.
Is the ultimate goal only a dream?
To have freedom from government imposed protection on production and trade implies the
ultimate abolition of all government interference. For instance, the abolition of all labour
legislation, licensing laws, competitions board interference and minimum wage and other

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imposed legislation. It suggests the abolition of all agencies involved in international trade and
migration. Essentially, there would be no cross-border trade restrictions, nor the limitation of
people moving across country borders to find employment.
While the complete lifting of such controls on production and trade may seem unrealistic
and, in South Africa, a complete dream, most of the above have already taken place in Europe.
This continent aims for a single currency, tax structure and banking system. Its citizens can
move across borders without restrictions and can work in foreign European countries without
problems.
There are, however, still laws pertaining to labour, antitrust legislation and minimum
wages.
Unions and unemployment
Without sprouting capitalistic rhetoric, there is a way around the serious economic problem
around mass unemployment. Capitalists believe that the problem of unemployment is the result
of government restricting the freedom of individuals to offer and accept a lower wage rate that
would make full employment possible.
Unions do have role, especially in improving working conditions, which ultimately lead to higher
productivity. However, in a country with 30% unemployment, the question remains whether
South Africa can afford to have a union dictating wage negotiations and continually threatening
strike action. The restrictions allowed and even promoted by government include minimum-wage
laws, extreme pro-union legislation, unemployment insurance and welfare legislation.
Abolishing these laws and establishing the freedom of production and trade should be presented
as the solution to this problem. Capitalists believe that this is a solution that would enable the
voluntary, self-interested actions of individuals to establish the terms on which everyone seeking
employment could find it.
Union reaction to this statement would be that capitalists want to exploit labour. This is a debate
that fills books on its own, but it is sufficient to say that scarcity of raw materials and services
dictates price via the demand for such products and the ability of the market to fill that demand.
In other words, if a 10 people are needed for a particular job and 1000 people apply, then the
person offering the job can offer the position at a lower price. The supply of labour outweighs
demand. However, if only two persons respond to the advert, the company offering the job
would have to increase its price offer to attract more people. The following graph illustrates this
concept, which can be used for to calculate share prices.
The Supply Demand model

Supply
A

P1

B
E

P*

PRICE

P2

Demand

QUANTITY

Q1

Q*

Q2

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Explanation:
The demand line represents the buying plans of a particular product, eg. The shares of
Company XCF Ltd.

The supply line represents sellers of the shares of Company XCF Ltd.

Point E is the complete equilibrium between suppliers and buyers. This means that the
demand for the share (quantity) lies on line Q*E and the price buyers are willing to pay is
P*E. This is called the complete equilibrium between buyers and sellers.

Now, lets assume that shareholders are not interested in the company, and the demand for
the share is Q1A.

Production and trade in the global arena

In the same vein, investors and businessmen must take the initiative in calling for a widening of
economic freedom as the solution to the problems South Africa faces in international trade. This
means the final lifting of exchange controls and the expanding of cross border trade.
Interestingly, even US economists believe the inability of major American industries to compete
with foreign goods is the result of government intervention and that the remedy is not the
imposition of further intervention (protectionism through tariffs and quotas), but the repeal of
existing intervention.
For example, pro-union legislation causes artificially high wage rates and holds down the
productivity of labour, thereby causing an artificially high level of costs for American
manufacturers. The tax system and inflation have prevented the introduction of more efficient
machinery and thus have also contributed to the artificially high costs of American
manufacturers, as have numerous government regulations.
Similarly, the freedom of production and trade could be presented as the means of sharply
reducing the cost of housing, thus making it possible for government to expedite its affordable
decent housing programme. The abolition of pro-union legislation, building codes, zoning laws
and government agencies that withdraw land from development would all serve to reduce the
cost of housing, as would the abolition of property taxes.
In fact, the freedom of production and trade based on supply and demand factors can
also be explained as the means of improving quality of medical care, improving tourism facilities,
attracting foreign skills and, where there is a skills shortage, force business to undertake training
programmes.

Instead, masses of people in South Africa demand to know what new programmes the
government is undertaking to solve, among others, market shortages, lack of sufficient
skills, providing electricity for all, building millions of homes, solving crime, promoting
tourism and supporting unions.

It is time to stop government programmes and activities to help individuals.

Globalisation will force individuals to be able to act in their own self-interest and there
is no time for the State to try and help everyone. Globalisation will not wait for "What
can the government do for me?" but it will demand action from entrepreneurs,
businessmen and investors.

The global phenomenon shows that companies have to be financially sound and possess strong
management to compete (or survive) against the global giants. South Africa recently saw a host

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of mergers in the banking sector take place in expectation of the coming of competitive
international pressures. Therefore, abolition of the antitrust laws would mean more competition,
greater efficiency and lower prices and no longer monopolistic controls of market supply and
demand variables.
Okay, so lets compromise
Realistically, immediate and total abolition of government intervention will not take place. There
is no political party in South Africa that could get enough support from the electorate to carry out
liberalisation of production and trade.
It is thus more realistic to work out programmes for a partial liberalisation as a temporary
compromise. For instance, instead of advocating the full freedom of the housing industry
(including abolition of housing subsidies) it would be more appropriate to launch a campaign for
a much more limited deregulation, i.e. With the advice of private insurance companies, mortgage
lenders and construction contractors, government could decide what building code requirement
to modify or abolish.
This does not mean that capitalists advocate inferior housing. It does, however, suggest
that many people throughout the world expect their government to build houses for them.
Instead, if the State provided the means (make land and materials available) for people to build
homes, they would both acquire a skill and a home. Such a step would eventually lead to less
people needing affordable housing and the overall housing bill for the State should fall.
If such a campaign was properly conducted, it would help to make people aware that it
was government intervention that was responsible for the high cost of housing.
Government force, rather than the profit motive of business, would come to be
established in the public's mind as the evil that must be controlled and
progressively eradicated.
Do or die time to abolish State interference.
Strangely, prior to the 1994 election the African National Congress advocated retaining control
over the factors of production. Then during the run up to the election, they started moving away
from socialistic rhetoric towards more free market systems. What was previously unheard of in
South Africa, the country partially lifted exchange controls, announced a privatisation policy and
that local government would start to outsource a number of its divisions.
So, if these significant changes did take place, why is it impossible that further
liberalisation of the economy can take place? The answer is not simple, but what is certain is
that South Africa will be, like all countries around the world, forced by market forces to change
towards more free market principles. It is widely believed around the world that, if the public
possessed philosophic and economic understanding of how trade and production would improve
without the assistance of the State, the procedure to abolish such interference would be easier.
However, a change in political attitude towards free markets must be based on the
principle of individual rights and that pressure-group (such as environmental lobbies) are
inherently self-defeating.
Economist Murray Rothbards (1926 1995) aptly summed up mans ability to run an economy
without (or minimal) government restriction as follows:
"In sum, freedom can run a monetary system as superbly as it runs the rest of the
economy. Contrary to many writers, there is nothing special about money that requires
extensive governmental dictation. Here, too, free men will best and most smoothly supply
all their economic wants. For money as for all other activities of man, liberty is the mother,
not the daughter, of order."

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Summary: Seven basic rules of economics

RULE 1: SCARCITY
The worlds economic pie is limited. As there is only so many products to go around and
everyone wants more than they have, what one person gets, another cannot have. That
means virtually every good produced, every action taken has an opportunity cost.
RULE 2: SUBJECTIVITY
Value and price are subjective issues. This subjectivity means that the publics likes and
dislikes are different and, as value and price are subjective conditions, the public is thus
willing to pay different prices for what they buy. From the sellers side, prices are determined
by demand for goods and production costs, which depend on the subjective value of the
resources.
RULE 3: INEQUALITY
No one said that life has to be fair. Differences in natural abilities, acquired skills, individual
effort, political influence and parental wealth mean that some have more income, wealth and
control over resources than others.
RULE 4: COMPETITION
Competition is good and, ultimately, a competitive market is an efficient market. Competition
among buyers and sellers brings out the best in them and in the economy. Less competition
among sellers creates higher prices for buyers (and vice versa).
RULE 5: IMPERFECTION
Nothing is perfect and never will be. While some problems can be fixed, many cannot.
Markets have deficiencies that can be corrected only by government action, but government
has many flaws, which often prevents corrective actions and even worsen the economic
condition.
RULE 6: IGNORANCE
No one knows everything. Information is a scarce commodity. Acquiring information, like
producing any good, entails the opportunity cost of limited resources. Those with more
resources can secure more information. Sellers, who have a good, usually have more
relevant information than buyers who want it.
RULE 7: COMPLEXITY
There is more than meets the eye. Every action has many effects, some intended and
obvious, others unintended and more subtle. Any action that is good for one person is likely
to be bad for another. One person's expense can be another's income.

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CHAPTER 4: SURVIVAL OF A MATERIAL CIVILISATION

Ayn Rand
(US economist, philosopher and novalist)
"The fundamental difference between private action and governmental action lies in the fact
that a government holds a monopoly on the legal use of physical force. It has to hold such a
monopoly, since it is the agent of restraining and combating the use of force; and for that
very same reason, its actions have to be rigidly defined, delimited and circumscribed; no
touch of whim or caprice should be permitted in its performance; it should be an impersonal
robot, with the laws as its only motive power. If a society is to be free, its government has to
be controlled."
Intellectual freedom cannot exist without political freedom; political freedom cannot exist
without economic freedom; a free mind and a free market are corollaries).(From The New
Intellectual")

Surviving the onslaught of global savages

In the 20th century, it has typically been defined as the science that studies the allocation of
scarce means among competitors. Another way of looking at economics is as a system that
creates wealth through labour, whether forced, free market, derived as a result of unskilled,
skilled or a combination of the two.
In other words, individuals produce or help to produce services or products that are
demanded (needed) by the general public. Therefore, the importance of economics is
inextricably linked to the specific importance of wealth and material goods to humans and their
well-being.
Obviously, human life depends on food, clothing, and shelter. Moreover, experience
shows that there is no limit to the amount of wealth that practically all civilised men and women
desire and that the greatest part of their waking hours is actually spent in efforts to acquire it, i.e.
earn a living.
Conclusion: Production of wealth vitally depends on how labour is set up to operate efficiently
within a country and companies and is an essential characteristic of every advanced economic
system. It underlies practically all of the gains ascribed to technological progress and the use of
improved tools and machinery. In addition, its existence is indispensable for a high and rising
productivity of labour or, alternatively, a poorly structured division of labour is a leading
characteristic of every backward economic system.
It is the division of labour that introduces a degree of complexity into economic life that
makes it necessary for unions, business and the State to continually search for a compromise
that will be the best for the country as a whole especially under a global system that advocates
(and demands) a truer balance between supply and demand. Essentially, a business that needs
product X can obtain that product from another part of the world and not incur additional costs.
Companies will ultimately not control markets, but will compete against companies
elswhere in the world. This means that conglomerates will compete not only against other
conglomerates, but also against market forces. A company hampered by labour problems,
expensive force, strike action and low productivity will be destroyed in a globalised,
streamlined world that will be ruled by free market principles.
Introducing the division of labour
Definition: Division of labour results when people start to specialise in different skills levels. It is
essentially when people do not try and do everything for themselves, i.e. be farmer, hunter,
collector, carpenter, painter, writer etc.

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Many economists today would agree that one of the most important dominant forces behind
productivity (and improving productivity) is the division of labour (discussed in greater length
later in the book). Despite the importance of knowing how to split up human energies and skills
to obtain the greatest productivity return for the benefit of all, this division of labour is still limited
to first world economies. The dominant form of achieving improved productivity in most of the
world, which includes Asia, Africa and most of Latin America, is largely self-sufficient production
of farms.
There is a powerful argument for capitalists working closely with the State and labour unions:

Firstly, humans depend on the production of wealth to improve their living standards.

However, production of wealth in turn depends on the division of labour to achieve higher
productivity to increase wealth.

In turn, the division of labour cannot exist or function automatically and thus depends on the
laws of the country concerned.

A country can alternatively adopt laws that make it possible or difficult for the division of
labour to grow and flourish.

For all three pillar of business to achieve success (labour, State and free market principles) it is
crucial for all three to act with complete honesty and flexibility when making decisions that bear
directly on economic life. It is thus clearly necessary that citizens understand the principles that
govern the development and functioning of the division of labour, i.e. understand the principles
of laissez faire economics.
If all three pillars do not have a full understanding of the absolute need to undertake free market
principles in a country, it becomes a matter of time before that country goes into a destructive
downward spiral. For instance:

Where unions demand more and more stringent labour laws (including higher minimum
wages), it places a strain on productivity and thus wealth creation. Business often retaliates
by streamlining, downsizing and even closing down some factory, warehouse or retail outlet.

When business do not keep promises or do not negotiate with unions in good faith, unions
often call for strike action. This leads to a vicious circle where neither union or business win.

If the State legislates minimum wages, maximum working hours, sets trading times or
undertakes actions (outsourcing or privatisation) without proper due diligence, unions and
business could protest and even take legal action against the State.

The above could ultimately stop all further economic progress and cause economic decline.

Conclusions:
Without a proper understanding of the principles of economics, people in an advanced,
division-of-labour society are in a position analogous to that of a passenger in an aeroplane
trying to fly the craft with no understanding of how it works, but nevertheless continues to
randomly push buttons in the hope that one of these will safely land the plane.

In the absence of sound knowledge of free market economics and how it applies in the
global arena, first world countries will be perfectly free to enact measures (currency
depreciation and price controls) against South Africa and other emerging nations. These

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countries feel free to experiment with the supply and demand of such nations currencies, buy
or sell massive amounts of securities on world bourses and so on the list is endless.

Note: The importance of economics is directly related to how this civilisation will propser in
the future. However, in the absence of the extensive division of labour many countries
possess, the production of modern medicines and vaccines, the provision of modern
sanitation and hygiene, and the production even of adequate food supplies for our present
numbers, would simply be impossible.

Applications of economics
Solving politico-economic problems
After years of applying economic theory in the world of finance and macro-environmental
analysis, I have come to realise that economics, particularly free market principles, can logically
be applied to solve many problems; from political to business, answers can often be found in
economics. On the basis of the knowledge it provides, economics offers logically demonstrable
solutions for politico-economic problems.
For example, the correct economics policies can:
Stop present-day problems such as inflation, inventory shortages, recession and mass
unemployment.

Turn capital depletion into capital accumulation.

Change falling productivity of labour into a positive one.

Economics can also serve as a guide to solving problems. For instance:

1. Where shortages exist, look for government controls limiting the rise in prices;
2. When there is unemployment, it indicates government interference in preventing a
decline in wage rates; and
3. Whenever a depression exists, look for a preceding expansion of money and credit.

Economics and business

Despite popular beliefs, economics is not a science of quantitative predictions and cannot be
used as a reliable means to predicting what the price of shares will be in the future. However, a
knowledge of economics does provide an important intellectual framework for making business
and personal financial decisions.
For example, a businessman who has a sound understanding of economics is in a better
position to:
Identify profit opportunities.
Convince venture capitalists to fund his project.
Draw up the necessary business plan to focus the business in a professional manner, which
includes setting up profit targets, how to achieve these objectives and how to fund the
project.
Once the business has broken even, the entrepreneur can make efficient decisions relating
to possible future demand for his product.
He can then followed that decision with a planned action to determine how to supply that
demand in the most cost efficient manner.
Similarly, an individual investor who understands economics is in a vastly better position to
protect himself from the consequences of such things as, among others, inflation, deflation,
globalisation, new competitive forces and privatisation.

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The most important application of economics to business and investment is that only a
widespread knowledge of economics can assure the continued existence of the very
activities of business and investment.

A socialist society is governed by the belief that profits and interest are incomes derived from
"exploitation," and individuals cannot (in fact, forbidden) to engage in business or investment
activity. Ultimately, business activities can only endure and flourish in a society that understands
economics and which is therefore capable of appreciating its value.
Economics and the defence of individual rights
Knowledge of economics is indispensable to the defence of individual rights. A thorough
knowledge of economics is essential to understand why individual rights in the economic sphere
is not harmful to the interests of others, but is in fact in the interest of everyone. Indeed, the
nature and importance of economics imply that study of the subject should be an important part
of the general education of every intelligent person.
Summary
Economics exhaustively demonstrates that in a division-of-labour, capitalist society, one
man's gain is not another man's loss, but is, in fact, actually other men's gain.

Economics demonstrates that the rational self-interests of all men are harmonious. In so
doing, economics raises a leading voice against the traditional ethics of altruism and selfsacrifice.

A capitalist society provides individuals with an indispensable means to fulfil the ultimate
ends of his own personal life and happiness.

A knowledge of economics is indispensable for anyone who seeks to understand his own
place in the modern, global world.

It is a powerful antidote to unfounded belief of being either a victim or perpetrator of

"exploitation" in a system that is immoral, purposeless, or chaotic. Such unfounded feelings
rest on an ignorance of economics.

The feelings pertaining to alleged exploitation rest on ignorance of the productive role of
various economic functions.

Economics provides a benevolent role for such institutions as the division of labour, private
ownership of the means of production, exchange and money, economic competition, and the
price system.

In opposition to feelings of alienation, economics explain the foundations of the enormous

economic progress that has taken place in the western world over the last two centuries. In
addition, it provides demonstrable solutions for all of the world's major economic problems.

The above discussion, of course, is totally in opposition to the widely believed claims of Marx
and Engels, that the economic system of the modern worldcapitalismis the basis of
alienation. Indeed, ignorance of economics reinforces feelings of alienation and allows the
alleged deficiencies of the economic system to serve as a convenient rationalisation for the
existence of the problem.

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CHAPTER 5: CAPITALISM VS. LABOUR

David Ricardo
1772-1823
Ricardo maintained that the economy generally moves towards a standstill. His analysis is
rooted in a modified version of the labour theory of value He held out the belief that the rate of
profit for society as a whole depends on the amount of labour necessary to support the workers
who farm. This model breaks land down into categories based on average fertility rates. The
most fertile land naturally produces more food than land of poorer quality. As a result it
commands a higher rent.

Lets reiterate: Capitalism is a social system based on private ownership and obtained through a
division of production. It is illustrated by an individuals pursuit and desire for material wealth
under a system of free market participation and it is further characterised by saving and capital
accumulation, exchange and money and the profit motive.
In addition, capitalism is identifiable by the freedom of economic competition and
economic inequality, the price system, economic progress and the pursuit of better systems to
increase wealth. However, all characteristics show that an essential feature of successful
capitalism is based on how a division of labour is achieved. Alternatively, economics study of
the consequences of government intervention and of socialism shows that collective, State
controlled labour results in an impairment (or outright destruction) of the division of labour.
Remember that in a globalised business world, labour, technology and capital become
increasingly merged and the boundaries between these factors of production become blurred.
For instance, businessman Smith has problems staffing his accounting department for
whatever reason (strike, lack of skills in the country or region) he can outsource his entire
accounting function to another country, anywhere in the word. Through technology and
particularly the use of the Internet, businessmen can find skills for practically any job function
without the constraints of the threat of strike action.
Economics and labour
There is a simple economic principle that technology can not entirely replace labour in a
capitalistic society. Essentially, the more capital intensive a company becomes, the more labour
becomes available and therefore the cheaper the unit cost of labour should be. In turn, the
cheaper it becomes, the more profitable (wealth creation) it is for business to use labour.
In addition, the more labour a business uses, the greater the volume of sales that can be
achieved and, in turn, more wealth. Indeed, the application of more labour is the only
fundamental requirement for increasing the supply of wealth. For instance, a normal work day is
about eight hours long. This means that a company could have three continuous shifts of eight
hours each and thus produce three times more products per month. The week can also run for
the full seven days, all year round.
There is a caveat to using more labour. The more labour that is employed, the less is
available for additional hire. As supply diminishes, the cost of hiring becomes more expensive
and this suggests that the scarcity of wealth implies a more fundamental scarcity of labour.
The fundamental scarcity of labour is apparent in the obvious fact that most workers would like
to enjoy an income many times greater than the amount of hours that they are capable of
undertaking. When income is dependent on the amount of hours worked, a workers income is
directly linked to his stamina, ability to concentrate for long periods of time and tiredness. This is
assuming, of course, that a company was willing (or permitted) to let workers work for as long as
they wanted.

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This is just another way of saying the utmost goods and services he is capable of
producing are far less than the goods and services he would like to consume. Taken collectively,
peoples desire to be able to spend five or 10 times more than they now can afford to spend is
an indication that everyone would like five or 10 times more work performed than is now
performed. In the present state of technology and productivity of labour (output per unit of
labour), this is how much additional labour would need to be performed to produce the larger
volume of output people would like to be able to buy.
Example:
Assume that the South African government legislated that the average worker must earn a
minimum annual salary of R100,000 instead of R20,000 a year.

In addition, the government also legislates that no-one is to save this money, i.e. they have
to spend the full R100,000.

The only way that earning and spending R100,000 a year instead of R20,000 a year can be
made possible is through a five times increase in the amount of goods being produced. Only
then would prices not rise in the face of five times more spending to buy goods.

In a given state of technology and productivity of labour, this would be possible only if five
times as much labour could be performed, which, of course, is itself impossible. Thus, the
supply of labour that people can provide falls radically short of the supply whose products
they would like to have.

Does this mean that labour is scarce? For South Africans this does not seem to make sense.
In 1998, this country has an unemployment rate of more than 30%, compared to the USs
3%. In a capitalistic sense, labour becomes scarce when the State enforces minimum wage
structures. This means that the supply of labour does not correlate to demand for labour. If
so many people are unemployed, the dsire to work must be great, so the price for such
labour must be low. So, in quantitative terms, labour is aplenty, but in value terms, labour is
scarce.

It has been suggested by some union members that, instead of increasing labour numbers,
the same effect could be achieved (earn more by working longer hours) if the government
would print enough new and additional paper money. There is nothing to be gained from
such a procedure. It is accompanied by rising prices, which prevent the higher incomes from
having any greater buying power than the smaller incomes did before.

Does scarcity of labour imply there is no reason for unemployment?

Unemployment can either be:
voluntary and chosen by the individuals concerned, because they prefer to wait to find better
terms of employment or because they simply prefer leisure; or
involuntary, where it is forcibly imposed on them. Unemployment is forcibly imposed through
the unjust demand of too high a level of money wage rates by the government or by
coercive labour unions operating with the sanction of the government.
Under free, competitive forces and at full production capacity, full employment within
a company (or country) is automatically generated. What economists are trying to
explain is that size of a population (and an increase in its size) does not reduce
scarcity of labour, as every new person bring with him/her their own desires and thus
demands, i.e. no single person can produce enough to meet own desires.
The more people have, the more they want

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As productivity rises and a workers standard of living improves, that worker tends to acquire a
growing desire for leisure. As a result, not only does the desire for wealth grow as the ability to
produce it increases, but also the amount of labour the individual is willing to perform decreases.
This represents an additional cause of the continuing scarcity of labour.
Therefore, the fundamental economic need of humans is this man needs to overcome
limits imposed on production by the scarcity of labour. For instance, in farming man discovered
that if different types of crop are grown alternatively on the same piece of land, it does not need
to lay fallow for a period of time. Thus man was able to increase the productivity of that same
piece of land without using additional labour. Technology has done the same thing in the
mechanisation of the motor industry. More cars are being produced today than ever before, with
the use of less labour.
There is only one solution to the problem of the scarcity of skilled labour. Man must
continuously raise productivity levels in business, transport, services etc. That is, continuously
increase quantity and quality of the goods that can be produced per unit of labour. The rise in
the productivity of labour is the only conceivable way that man can obtain the progressively
greater amounts of wealth desired.
The real economic problem
The real economic problem is, therefore, how to continuously raise the productivity of labour to
increase production and enjoyment of goods per capita. Subsidiary to this problem is what many
economists call the scarcity of resources.
I call this a subsidiary problem, because man has the ability to overcome problems by
creating solutions economic and business. For instance, when South Africa faced a worldwide
petroleum embargo, the government set up a company to convert coal into oil. This company,
called Sasol, is todays one of South Africas largest industrial groups, that successfully converts
both oil and gas into petroleum.
For the global market this has many important implications. For instance, no one person
or company can claim that they have complete dominance over a particular market. There will
now always be someone, somewhere in the world that will be able to offer an alternative, maybe
even a better and cheaper alternative. Information flows extremely fast (almost instantaneously)
over domestic and national borders, freely and efficiently. The global investor thus has an almost
limitless potential to use natural resources around the world.
There is no doubt that in every possible way, with no valid objection, the solution for
the economic problem is capitalism. For investors and entrepreneurs who do not
understand this concept, here is the concept stated in another way: Go global, before
the capitalistic markets force you to do so. In addition, competition is no longer a
domestic affair, but an international one.
Specialisation, division of labour and society
Europe is about to become united, and mankind will have the first example of a continent,
consisting of different skills, languages, currencies and customs, become united with a single
currency, tax rate and other issues. This united continent will provide economists with true
geographical specialisation of the division of labour.
Europe will become a powerful body of countries that specialise in the spheres that they
are strongest in. In addition, efficiency and productivity should increase and a united trade force
in a capitalist world.
Here is the trend that I have been tracing since the early 1990s. For a country to succeed
in a capitalistic global society, the following applies:

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1. First, get your own economic house in order (see page .).
2. Establish a domestic trading band. The US, Canada and Mexico have a successful
cross border trade agreement, while Europe is becoming united and South Africa is
creating the Southern African Democratic Community.
3. Once established and efficient (and only then), move into the global market.
Conclusions:
Specialisation improves productivity as humans can concentrate their collective skills (as a
country) on the products they understand best. However, specialisation can also be
improved with the use of machinery and other methods of production.

Specialisation and a united country does not mean a return to government organised labour
movements. In fact competition among the member results in the move towards that
particular industry most likely to succeed, i.e. it is pointless for France to compete against
Germany in the luxury car market, while Germany would do better to concentrate on making
cars than growing, cultivating and making Champaign.

It can thus be stated that the principle of specialisation in no way lessens or contradicts the
existence of free economic competition. In fact, specialisation benefits both countries as,
when skills are applied to a single product, costs are reduced, productivity is increased and
efficiencies improved.

The effect of specialisation and free economic competition is to improve efficiency of the
division of labour. It enables a country to provide everyone with the opportunity to work and
produce in the area in which he is best suited and to increase the output per unit of labour,
especially on the part of individuals of lesser ability. Thus it enables everyone to enjoy a
higher and continually rising standard of living.

Capitalist planning and the price system

Division of labour in the planning process is possible only under capitalism, due to the existence
of the price system. Under capitalism each individual plans his own particular sphere of
economic activity, but he plans on the basis of a consideration of prices, i.e. prices he will
receive as a seller and must pay as a buyer.
For example, I changed career paths from journalist to industrial analyst when I contemplated
the vast difference in income that I could expect to earn from stockbroking. A prospective home
buyer changes his plan concerning which neighbourhood to live in when he compares house
prices in the different neighbourhoods. Businesses change their plans concerning product lines,
methods and locations of production and every other aspect of their activities, in response to
profit-and-loss calculations.
Investors look at risk to return ratios and determine which shares to buy. They often
change their minds when risks between different shares are considered.
All of these changes represent the adjustment of the plans of particular individuals and
businesses to the plans of others in the economic system. That is to say, it is the demand for
highly skilled, accurate business analysis of listed companies, rather than how much people are
willing to pay for newspapers that cause the higher incomes in some industries over others.
It is the plans of others willing and able to pay more to live in certain neighbourhoods,
and less to live in certain others, that determine the relative house prices confronting our home
buyer.

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The overwhelming majority of people have not realised that all the thinking and
planning about their economic activities that they perform in their capacity as
individuals actually is economic planning.
Benefits of private ownership of the means of production
The influence of the division of labour on private ownership of the means of production, is almost
universally ignored. Typically, people think of privately owned means of production as being of
benefit only to owners. People believe that so long as wealth remains concentrated in the hands
of a relatively small number of capitalists, the capitalists alone benefit from it. For the great mass
to benefit, it is believed, the wealth of the capitalists must first be taken away and given to the
masses, or be held by the government and used for the collective good of all.
So, deeply rooted are such convictions that it is often thought to be a sufficient refutation
of the arguments of an advocate of capitalism to intimate the size of his bank balance or share
portfolio. It is evident that many people believe that capitalists only benefit themselves and other
capitalists.
Even the alleged friends of capitalism often share the conviction that private ownership of
the means of production and capitalism serve only the capitalists: very often their notion of how
to fight the spread of communism is first to create more capitalists. Only then, they believe, will
there be a sufficient number of people with an interest in opposing communism. These
statements are not true.
The benefit of capital to the buyers of products
The first thing that must be realised is that in a division-of-labour society, all private property that
is in the form of means of production, i.e. use of capital serves everyone. In a division-of-labour
society, the means of production are not used in producing for their owners' personal
consumption, but for the market. They are used in producing goods that are sold.
The physical beneficiaries of this private property are all those who buy the products it
helps to produce. In other words, it is the general buying public who are the physical
beneficiaries of the capitalists' capital.
Example: Who are the physical beneficiaries of the automotive plants of the US-giant motor
company General Motors. That is, who physically receives the products of these plants? Is it the
shareholders and directors of General Motors? Of course not. The number of GM's cars that is
produced for the capitalists who own GM is relatively insignificant. Almost 100% of General
Motors' auto output goes to people who do not own a single share of its stock or a single one of
its bonds. The same is true of every other business enterprise.
Indeed, the proportion of General Motors' output that is purchased by investors, out of
the proceeds of profit achieved by GM, is virtually negative when compared with the proportion
that is purchased by wage and salary earners. It is wage and salary earners who consume the
overwhelming majority of the automobiles, television sets, housing, furniture, food, and clothing
and almost every other consumers' good that is produced.
Thus, the overwhelmingly greater part of the physical benefit derived from the privately
owned means of production in a capitalist economic system goes to the workers of the means of
production, i.e. to wage and salary earners.

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Conclusion:

In a division-of-labour society, a person does not have to own the means of

production in order to derive a benefit. One has only to be able to buy the
products.

It is only in a non-division-of-labour society, in which there is little or no

production for the market, in which the producer and the consumer are almost
always one and the same person, that privately owned means of production
benefit only their owners, or virtually only their owners.

This general benefit, it should be realised, applies to all of the means of production, not merely
to those that are employed in the direct production of consumers' goods, e.g. The benefit of the
steel mills that produce the steel that enters into GM's cars goes to the buyers of the cars, along
with the benefit of the auto plants, as does the benefit of the iron mines that contribute to the
production of that steel, and the benefit of the factories that produce iron-mining equipment.
The exploitation theory
Adam Smith discussed at length (In the Wealth of Nations) the essential conceptual framework
of the exploitation theory. This framework is the belief that wages are the original and primary
form of income, from which profits and all other non-wage incomes emerge as a deduction with
the coming of capitalism.
The framework and its supporting beliefs easily lead to the assertion of the wage earner's
right to the whole produce. Thus, Adam Smith opens his chapter on wages, with the following
words:
The produce of labour constitutes the natural recompense or wages of labour.
In that original state of things, which precedes both the appropriation of land and the
accumulation of stock, the whole produce of labour belongs to the labourer. He has no need to
share his income with either owner or State.
Smith:
But this original state of things, in which the labourer enjoyed the whole produce of his own labour,
could not last beyond the first introduction of the appropriation of land and the accumulation of stock.
It was at an end, therefore, long before the most considerable improvements were made in the
productive powers of labour and it would be to no purpose to trace further what might have been its
effects upon recompense or wages of labour.
As soon as land becomes private property, the landlord demands a share of almost all the
produce that the labourer can either raise or collect from it. His rent makes the first deduction
from the produce of the labour which is employed upon the land.

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CHAPTER 6: SMITH, MARX AND THE EVIL CALLED PROFIT

KARL MARX
German social philosopher and revolutionary
(1818-1883)
With Friedrich Engels, a founder of modern socialism and communism. The son of a lawyer, he
studied law and philosophy; he rejected the idealism of Hegel but was influenced by Ludwig
Feuerbach and Moses Hess. His editorship (1842-43) of the Rheinische Zeitung ended when the
paper was suppressed. In 1844 he met Engels in Paris, beginning a lifelong collaboration. With
Engels he wrote the Communist Manifesto (1848) and other works that broke with the tradition
of appealing to natural rights to justify social reform, invoking instead the laws of history
leading inevitably to the triumph of the working class. Exiled from Europe after the Revolutions
of 1848.

Smiths greatest failure

Despite being the father of capitalism, Smith failed to see the productive role of businessmen
and capitalists and the importance of private ownership of land. There are two main problems in
Smiths thinking:

Division of labour and its resultant rise in productivity, has no connection with the
activities of capitalists, nor with private ownership of land. Smith believed that the only
effect of the activities of capitalists (and private ownership of land) is that it denies to the
wage earners the ability to keep the whole produce of their labour or its full value.

It must be remembered that in the 1700s division of labour did not exist to the extent that it
does today. It is possible that in his day labourers could work for themselves and keep the
fruits of their labour. Today, however, division of labour vitally depends on the activities of
capitalists in, for instance, coordinating and improving efficiency of the work place,
complexities of management, personnel, marketing, sales, strategies, global competition and
avoiding hostile takeovers.

Workers buy to produce and not to sell for a profit. Therefore, in a pre-capitalist economy the
incomes the workers receive are wages and no income is supposed to be profit. It is only in
a capitalist society that profit emerges.

These two notions constitute the conceptual framework of the exploitation theory and are the
starting point for Marx's detailed development of the exploitation theory.
Marxs theories are complex and run into several hundred pages, but boiled down, he stated in
Das Kapital that there is no exploitation when workers buy commodities, produce an item to sell,
use the money to buy more commodities and so on. Exploitation is derived when there is a
profits or "surplus-value."
Surplus-value emerges with the development of capitalism, when the capitalist expends
a sum of money in buying materials and machinery and in paying wages. He then produces a
commodity, which is then sold for a larger sum of money than was expended in making it. The
difference between the money the capitalist expends and the money he receives for the product
is his profit and is the exploitation of workers. According to Marx, profit is the sum of money
stolen from workers.
Profits, then, according to both Smith and Marx, come into existence only with
capitalism, and are a deduction from what naturally and rightfully belongs to the wage
earners.

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Note: This is not the exploitation theory, but the conceptual framework on which exploitation
theory was built. The actual exploitation theory is based on two further doctrines:

Adam Smith - labour theory of value

David Ricardo- the iron law of wages.

Both were distorted and used by Marx to complete his exploitation theory, written in the
Communist Manifesto.
Classical economics wins Smith and Marx loose
Classical economics provides the basis for demonstrating the enormous errors in the conceptual
framework of the exploitation theory. It implies that it is false to claim that wages are the original
form of income and that profits are a deduction from wages, which becomes obvious when the
following definitions are assessed:

Profit - excess of receipts from the sale of products over the money costs of producing them.

Capitalist - one who buys in order subsequently to sell for a profit.

Wages - money paid in exchange for labour.

Therefore, on the basis of these definitions it follows that, if the world was made up of only
worker, there would be no wages as wages implies being paid by someone else for the sale of
labour. Thus, in the pre-capitalist economy imagined by Smith and Marx, all income recipients in
the process of production are workers.
The irony is that the income of those workers is not wages, but profits. So, even Marx
was promoting profit and the whole of his Das Kapital was thus written and based on an
incorrect premise. To avoid exploitation workers must own all the factors of production. It follows,
then, that workers are their own bosses, so they cant earn wages, but instead profits.
While these workers do not buy commodities to sell at a higher price, the money they get
for their services still constitutes an income and not a wage. Further, these workers are selling a
commodity and not their labour, thus they earn sales revenues, not wages. In addition, they are
not capitalists, and are not employed by capitalists, so there is no buying for the sake of selling
and thus there are no money costs to deduct from those sales revenues.
Profits that exist in a capitalist society are not a deduction from what was originally wages. On
the contrary, the wages and the other money costs are a deduction from sales revenues or from
what was originally all profit.
The effect of capitalism is to create wages, which reduces the amount of profits, which in
turn increases due to the amount of expected higher level of productivity that results from the
hired labour. Thus, capitalists do not impoverish wage earners, but make it possible for people to
be wage earners. They are responsible for the very existence of wages in the production of
products for sale.

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Summary:
Both Smith and Marx were wrong.

Wages are not the primary form of income in production - profits are.

In order for wages to exist in the production of commodities for sale, it is first necessary
that there be capitalists.

The emergence of capitalists does not bring into existence the phenomenon of profit.

Profit exists prior to the emergence of capitalists, who bring into existence the
phenomena of productive expenditure, wages and money costs of production.

To produce and sell one's own products, one would have to own one's own land, and
produce one's own tools and materials. Few people could survive in this way.

The existence of capitalists makes it possible for people to live by selling their labour
rather than attempting to sell the products of their labour.

Thus, between wage earners and capitalists there is in fact the closest possible
harmony of interests, for capitalists create wages and the ability of people to survive
and prosper as wage earners.

If wage earners want to increase their income (in wages or in profits), they have offer
employers more; either better experience, greater technical skills or improved
education.

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CHAPTER 7: CAPITALIST ISSUES AFFECTING INVESTORS

AND ENTREPRENEURS
Julian Simon
"But in the longer run, the elemental forces of people's desires to carve out a good living for
themselves and for their families, to have children and raise them happily and well-educated, to
employ one's talents and energies and to possess their fruits - these forces will eventuate in
government policies that allow people these fundamental freedoms."

The vicious cycle of interest and profits

During a presentation on globalisation, economies and stock markets, a businessman asked me
if it was possible to make a profit and still benefit from high interest rates. Now, I knew where the
argument was leading and, instead of falling for the usual belief that a general increase in profits
reduces the rate of interest, I stared at the businessman (in silence) for a short while. Not long
enough to make him feel uncomfortable, mind you, but long enough to lure him into a false
sense of security.
He thought that he had caught me out early on in the presentation and, instead of giving
him the answer he was looking for (I suppose he was trying to be clever, or embarrass me,
whatever) I said no!
Instead: That depends on how good an entrepreneur you are! He remained quite after
that possibly as the laughter from the other delegates would have drowned him out
In view of the prevalence of the belief that higher profits reduce interest rates, here is an
explanation:

The common belief is based on supply/demand factors. When companies make high profits
in a country, more money enters the banking system as profits are deposited. In turn, the
banks have a higher reserve of cash and interest rates are dropped to attract lenders.

There is some truth to the belief, but supply and demand factors (in this case) often apply
only in theory.

An increase in the quantity of money will reduce the rate of interest, but only temporarily.

There are a number of reasons why interest rates often do not decline despite higher profits:
1. The supply/demand theory in relation to higher profits assumes that these profits are
actually deposited into banks. There are many times when this does not take place. The
funds are often used to pay shareholder dividends, undertake an acquisition or more
realistically in South Africa to reduce gearing (pay debt).
2. When the cash does enter the banking system, borrowers spend the cash on, among
others, debt, new equipment, machinery, commodities, new vehicles and holidays. The
outflow of cash from the bank is often so quick that reserves are depleted before interest
rates can decline. Lenders use the cash, which begins to raise sales revenues and profit
margins and, thus, the rate of profit. This rise in profits is accomplished on the back of
credit lending and this expansion results in banks raising interest rates and not dropping
them.

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3. To prevent the rate of interest from rising in the face of a higher rate of profit (through
credit purchases), an acceleration in the rate of credit expansion would be necessary.
The effect of such an acceleration would be a still more rapid rate of increase in the
volume of spending and thus in business sales revenues, with the result that profit
margins and the rate of profit would rise still higher, which, of course, would operate all
the more powerfully to raise the rate of interest.
4. To prevent the rate of interest from rising at this point, it would be necessary for an ever
increasing rate of credit expansion. This would cause higher profits and the vicious cycle
of profits and interest goes on.
The mistaken notion that increases in the quantity of money reduce the rate of interest is
largely the result of thinking of the rate of interest as "the price of money" and then applying
the principle that increases in supply reduce prices. A more accurate description of the rate of
interest than the price of money is the difference between the money that is borrowed and the
money that is repaid.

Example: Investors should thus not think of the payment of a 10% interest on a one year loan of
a R1000 as a price for the borrowing of the thousand dollars, but as the difference between the
R1100 that will have to be repaid and the R1000 that is borrowed.
If investors thinks of interest this manner, then it is not surprising that interest rates turn
out to be higher rather than lower as the consequence of an increasing supply of money.
The production problem or how to satisfy greed
A fundamental problem in economics is how to continually increase production in the face of
limitless needs, but limited resources - particularly in a globalised world with rapidly growing
numbers of people.
Following on previous chapters, where the central importance of the division of labour in
raising the productivity (specialisation) was examined, it is time to assess how production and
supply create purchasing power and thus demand for goods and services. It is also important to
look at the effects of the following on supply/demand factors:

Excess aggregate supply over aggregate demand.

Mass unemployment.

Classical economist Say states it this way: Real wages are determined by production, just as
the real demand for goods is determined by production. In fact, if expanded, real wages and
thus the average worker's standard of living are determined by the productivity of labour.
In trying to help people, government becomes the thief
It is crucial to realise the extent to which government intervention undermines capital
accumulation, and with it the demand for labour and resultant productivity, i.e. real wages and
the general standard of living.
Around the world, governments impose taxes and duties to carry out and maintain their
ever expanding bureaucracies. These taxes, which include personal income, inheritance,
corporate and capital gains taxes, are paid mainly with funds that would otherwise have been
saved and productively expended by both entrepreneurs and employees.
The outcome of governments interference in the economic process effectively reduces
the demand for capital goods and the demand for labour by business enterprises. In turn, it
reduces the economic degree of capitalism and the degree of capital intensiveness in the
economic system.

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State consumption expenditure and of those to whom it gives money replaces expenditure for
capital goods and labour by business enterprises. Therefore, this government action reduces
the freedom and ability of employees to spend money earned on goods and services that they
need, i.e. in many instances the consumption expenditure is in essential products.

Theft through taxes and other legislation

Alternatively stated, the use of taxes changes the direction of demand for goods and services.
The existing ability of the economic system to produce therefore diverted as follows:

From the production of capital goods to the production of consumers' goods, i.e. if
employees had more to spend, there would be greater pressure on business to fill that
demand and this would lead to capital investment as businesses expanded production
capacities to meet the increased demand.

From the production of consumers' goods (bought by employees) to production of

government related goods.

These taxes threaten the economic system's ability to progress and its ability to produce
sufficient capital goods to replace those that are used up in production. South Africa had a
negative gross domestic investment growth during the 1980s, despite the high taxes leveled
against employees and business. Where did the taxes go to, if the infrastructure was not
been maintained or improved? The funds were expended on fighting a war against the
African National Congress and trying to bypass international sanctions. In other words, taxes
were wasted and lost forever.

The following is a brief outline of how taxes and other State imposed legislation affect free
market economics:

Taxes, subsidies, anti-conglomerate laws and pro-union legislation greatly undermine the
incentives to introduce improvements in efficiency in the economic system. The impact of
these restrictions is a net reduction in the output per unit of capital goods, i.e. natural capital
rejuvenation is retarded.

Taxes reduce the entrepreneurs reward for economic success and, thus, discourage the
efforts necessary to achieve it. Simultaneously, subsidies provide no incentives for the
businesses and citizens who receive these, to improve their standards of living, i.e. it
perpetuates inefficient methods of production by holding down the productivity of capital
goods.

Taxes also substantially reduce the force of competition in the economic system. It creates a
near closed market for established firms that have already accumulated substantial capital.
These are now made threatened by new competition, since the potential competitors are
prevented from accumulating capital. Alternatively, stringent State legislation makes it more
difficult for small firms to comply with regulations, so less small businesses can get off the
ground.

The antitrust laws in the US and the Competition Board in South Africa stand in the way of
business mergers that would achieve important economies of scale - and thereby render
production more efficient in a global world that thrives on competition and productivity and
price strategies. Mergers make possible a more efficient use of capital, by removing
duplication and directing resources to more productive means.

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Pro-union legislation enables unions to prevent (through treats of unproductive strike action)
a business from implementing labour-saving machinery. This prevents business from
increasing total output that otherwise could be produced by the same quantity of labour
working with the existing quantity of capital goods. In so doing, legislation holds down the
size of the output that is available to meet whatever relative demand may exist for capital
goods.
Every government regulation that raises costs, also reduces the output of the economic
system and thus the efficiency with which existing capital goods are employed. Thus, any
government regulation that raises the average unit cost of producing goods and services is
accompanied by a corresponding reduction in aggregate output.

Theft of national savings

Government budget deficits and social and welfare security, also operate to reduce saving and
productive expenditure. Deficits are financed by borrowing from the public (as opposed to the
printing of money) and represent a diversion of the countrys savings (or used as capital) to the
financing of the government's consumption.
If the governments deficit is financed by the creation of money, then add an unwanted
inflationary pressure to the equation. Therefore, inflation-financed deficits undermine capital
formation. In a country that is fast becoming a welfare State, South Africa is creation the
misconception that people will always be looked after. This leads people to reduce their
provision for the future, in the belief that their needs will be provided for by the government.
Meanwhile the government uses social security contributions for their own purposes that
eventually leads to capital accumulation being undermined.
Stop the theft and progress will happen
Free market economists agree: To restore economic progress and rising real wages around the
world (including in first world countries), a radical reduction in government intervention is crucial.
This includes Government. spending, taxation, regulation on business, pro-union legislation and
anti-monopolistic laws.

What is necessary is a programme to phase out taxes (personal income, inheritance,

corporate and capital gains tax) and the whole of the welfare state.

This must be coupled to an equally massive reduction in government regulation.

Such a programme would be enough to make people work harder and produce more in the
knowledge that the more they earn, the more the keep. Other possible outcomes include:

More new companies would be started and be able to grow rapidly and challenge the
established firms, if they could plow back most of their profits. All firms would improve in
efficiency if they were free of restrictive regulations.

The rate of innovation and technological progress would increase.

Thus, along with a sharp rise in the relative production of capital goods, the productivity of
capital goods would also increase and the maintenance proportion correspondingly
decrease.

This combination of a higher relative production of capital goods and reduced maintenance
proportion would assure a sharply higher rate of capital accumulation. It would restore a
rising productivity of labour and rising real wages, i.e. real wages would increase on the

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strength of a rise in the demand for labour made possible by the reduction in government
spending, taxes, and deficits.
This is clearly the path to the long-term economic recovery of, in particular, emerging nations.
The effect would be to lift the these countries out of stagnation and restore it to rapid economic
progress, i.e. to rapidly rising real wage rates and a rapidly rising general standard of living.
Regrettably, but understandably, ignorance and war in most emerging nations means
that there is very little hope that such an economic programme will be adopted. However, after
numerous macro-economic report for stockbrokers, I have seen economic changes never before
believed possible. The bottom line is that many of these changes have occurred as a result of
the markets forcing the change and not as a result of pre-determined government instigated
economic policy.
Therefore, while many of the theories, comments and suggestions made in this book
seem unlikely to happen in the near term, the astute investor and entrepreneur will be aware of
such opportunities in other parts of the world. Remember that under globalisation even the
strongest company is just another company competing in small arena the markets thus rule
the day and there is no stopping this amorphous mass.
Conclusion: While it is unlikely that emerging markets will remove tax laws and welfare
systems, many remarkable, free market orientated changes are already taking place.
Privatisation, outsourcing, streamlining of the civil service, the creation of a regional trading bloc
(SADC) and a joint, linked sub-Saharan African Stock market. These were all unheard of before
(especially for Africa) and the implications for business and investors are vast. It is possible for
the very poorest of countries to rise out of poverty and to prosper.
For prosperity to occur, it is imperative for governments in emerging markets to become
more efficient in the use of the capital goods it possesses. However, in addition to efficient use,
it is also important that the State devotes a proportion of capital (and accompanying labour) to
the production of new, more technologically advanced capital goods, such as machinery etc.
Saving and expenditure
While studying economics, I often thought that economists throughout history of capitalism
tended to unnecessarily complicate issues. For instance, the factors that make up the process of
spending and income. Surely, if a consumer buys a product, he has done so out of a need or
desire for that item. The seller has made that item to supply the demand for such a product.
Simple? Not for some economists, who see the simple example above as follows:
In buying consumers' goods, the purchaser buys more than consumers' goods. He buys all the
means or factors of production, however remote, which have directly or indirectly contributed
to the production of the consumers' goods one buys. In addition, factors of production embraces
labour along with capital goods, produced in the past, present and future. To confuse matters
even further, some economists suggest that, in buying a given good, one buys the subsequent
goods that will be produced by means of it and that in some sense one buys or pays for things
that are physically unrelated to the consumers' good one buys, but that the seller buys with the
money one spends in buying from him.
Indeed, the confusion reigns. Such confusions grossly exaggerate the role of consumer
spending in the economic system. They make it appear that consumption expenditure is the total
of expenditure, that incorporates the expenditure for capital goods and labour. However, in
reality these are made only by business firms, with funds that are not consumed, but saved and
productively expended, i.e. Expenditure incurred as a result of the production process is
expenditure incurred for the purpose of making future sales. It includes all expenditures incurred
by a business in the use of capital and labour.

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Moreover, the inability of people to see the role of saving and productive expenditure is
compounded by a further set of confusions, which leads them to believe that saving is
synonymous with hoarding. Indeed, with such an exaggerated view of the role of consumption
expenditure as constituting virtually all spending, there is nothing left for the view of saving
except to regard it as hoarding.
The purpose of the present section is to set matters straight for capitalists and investors alike. By
showing the investor a system of aggregate economic accounting that, unlike contemporary
national income accounting, reflects the full volume of production and the full volume of
spending that takes place in the generation of revenue or income, the investor obtains a clearer
understanding of the investment process.
For instance, some shareholders keep their portfolios simple. They have a percentage
set aside to trade market opportunities, while still investing for the future. Others complicate
matters, believing that the future income stream from dividend payments will finance present
market opportunities. Yet there is no way of determining whether companies will pay dividends
and, if they do not, they will have shifted the percentage of their portfolios set aside for trading
and thus place their entire long-term future plans in jeopardy
Lets get back to simplicity
The first point that must be driven home to entrepreneurs, economists, businessmen, teachers,
market gurus, capitalists, monks or whoever, is that the demand for Product X is the demand for
Product X, i.e. the demand for any good or service is simply and only a demand for that good or
service. In buying anything, all that is bought is that item that the seller has made for sale and
delivers to the buyer for a monetary remuneration - and absolutely nothing else.
It is necessary to explain and illustrate this proposition even to the point of belabouring it,
because investors and businessmen often take on new ventures based on future possibilities
without having a clear understanding of the present investment situation. Over a century ago,
John Stuart Mill advanced the essentially similar proposition that "demand for commodities is not
demand for labour." His exposition was both clear and, unfortunately, highly prophetic in its
recognition that the proposition "is, to common apprehension, a paradox" and thus "greatly
needs all the illustration it can receive."
Belabouring the point:

Demand for commodities is not demand for labour. The demand for commodities
determines in what particular branch of production the labour and capital shall be employed;
it determines the direction of the labour; but not labour itself, or of the maintenance or
payment of the labour. These depend on the amount of the capital, or other funds directly
devoted to the sustenance and remuneration of labour.

Shadow entities and shadow purchases. Entrepreneurs sometimes speak about future
events as if they were taking place in the present.

Example 1: A baker will say I produce 300 loaves or bread and 20 cakes a day. What he
really means is that, if nothing goes wrong, he can produce on average - those quantities
every day.

Example 2: Company X buys Company Y, because it will result in synergies between the
two, reduce overheads, limit competition in this market and provide skills we currently lack.
What Company X has actually done is buy assets with the potential to add growth in the
future.

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There is no guarantee that:

1. The skills acquired will like their new management and not resign.
2. The synergies anticipated assume that there are some cross selling opportunities or
demand generated by one division will push demand for another. These synergies
may quickly disappear if a foreign competitor enters the local market.
3. The reduction of overhead often does occur, through the rationalisation and
merging of head offices, marketing departments, accounting functions and staff cuts.
However, businessmen often omit the possibility that merging these functions will not
go smoothly and costs involved could become prohibitive.
4. To limit competition could evoke problems from the Competitions Board, delaying the
acquisition for months, costing the company millions of rands in lost revenue. It also
excludes the potential of foreign competition taking place, i.e. cross border trade is
growing rapidly in a globalised world, especially with the multinationals looking for
new dumping grounds for their products.

I have seen companies make detailed announcements in the press of an acquisition. At the end
of the advert, investors find the following statement: the acquisition is subject to due diligence to
be carried out in the next three months.
In a word, these entrepreneurs are making assumptions that may never occur. Indeed, in
investment and business dealings beware of people who dwell in a world of shadows.

The need for capital. If the demand for consumers' goods really were a demand for factors
of production, then one would have to explain why it is necessary to possess capital before
starting any business undertaking. If it really is the consumers rather than businessmen who
pay for the factors of production, then businessmen can immediately do away with wages,
i.e. the worker can get paid when his product is old. The truth is, of course, that before
entering into any business operation, one must possess the funds required for the purchase
of the necessary factors of production.

Buying the inputs or buying the output. If one does buy the factors of production when
purchasing a good or service, is it possible to also buy both inputs and output? If one buys
the final product (output), it is precisely because one has not bought the inputs (factors that
make up the final product). The whole focus does not seem to have a logical thread.

Profits, productive expenditure, sales and costs. All business activity is carried on for the
purpose of earning a profit. Yet, there are those economists that persist in complicating
issues, pointing out that earnings for one company is a cost for another. In other words,
productive expenditure constitutes revenue or income payments for one enterprise, but also
bears an equivalent relationship to business sales revenues and to business costs.

To elaborate these points, investors should consider the following facts:

1. The demand for capital goods is simultaneously business expenditure and sales
revenue. The two are identical as capital goods are sold by business enterprises as well
as bought by business enterprises.
2. If expenditure in one company equals revenue in another, can a country ever produce
positive net profits? The confusion centres on terminology, equating revenue to profits.
Profits is the surplus of revenue over expenditure, so it is possible for a country to show a
net positive profit.

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3. Terminology and jargon are part of the business and investment worlds, forever changing
and evolving. It is crucial that entrepreneurs and investors must become fully conversant
in these languages.

Prices and profits. Remember supply and demand? As production increases, excess
supply over demand caused prices to fall. However, the drop in prices do not necessarily
reduce the rate of profit, i.e. higher production may be accompanied by an equal increase in
demand, i.e. move into new local and foreign markets.

The relationship between net investment and profits. Is the rate of profit and net
investment positively related? Here are the definitions of both issues:
Profits

Sales revenue

costs

Net
= Productive
costs
investment
expenditure
Where:
1. Productive expenditure = expenditure by business firms for capital goods and
labour.
2. Costs = the difference between the additions to business assets constituted by
productive expenditures (for plant, equipment, inventory and work in progress),
and the subtractions constituted by depreciation and cost of goods sold.
Therefore, the actual reason the rate of profit is low in a depression is the same as the reason
net investment is low, i.e. productive expenditure has fallen, taking sales revenue with it, while
costs, especially depreciation costs, fall only with a lag.
By the same token, in the recovery from a depression net investment and the rate of
profit both improve together. For every rand by which productive expenditure rises relative to
costs, creating net investment, sales revenues rise relative to those same costs, creating profits.
Likewise, for every rand by which costs fall relative to productive expenditure, also creating net
investment, those same costs fall relative to sales revenues, creating profits.
The mathematical implication of this virtual rand-for-rand equivalence between additional net
investment and additional profits is that the rate of profit (also called marginal efficiency of
capital) must actually rise with the rise in net investment.

For example, if in the depths of a depression, aggregate profit in the economic system is 10,
while total accumulated capital is 1,000, then the average rate of profit is a mere 1 percent. But if
now net investment increases by, say, 50, then aggregate profit increases from 10 to 60. At the
same time, of course, the total accumulated capital of the economic system rises to 1,050. The
average capital outstanding over the period becomes 1,025--viz., the average of 1,000 and
1,050. The unavoidable implication of these facts is that the average rate of profit rises from 1
percent to almost 6 percent!
As indicated, the rise in the rate of profit that must accompany more net investment in the
recovery from a depression, has its counterpart in the fall in the rate of profit that accompanies
the wiping out of net investment in the descent into a depression. In the latter case, the plunge in
productive expenditure not only drives productive expenditure below costs, making net
investment negative, but equivalently reduces sales revenues relative to the same costs. This
drives profit in the economic system below net consumption.

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CHAPTER 8: A CAPITALISTS GUIDE TO ECONOMICS

Murray Rothbard
1926-1995
"In sum, freedom can run a monetary system as superbly as it runs the rest of the economy.
Contrary to many writers, there is nothing special about money that requires extensive
governmental dictation. Here, too, free men will best and most smoothly supply all their
economic wants. For money as for all other activities of man, liberty is the mother, not the
daughter, of order."

The preceding chapters summed up the basics of what capitalism means. Now, here is a
warning to those budding capitalists that want to take a walk into the global arena. Such
pedestrians must always be on guard during any economic expedition, especially when passing
under the window of the Reserve Bank in Pretoria.
There is always a chance that documents the thickness of encyclopdias will come
flying through a window, possibly sending a barrage of glass slivers and economic statistics
haphazardly onto the street. The same can be said of the Minister of Finances office window. In
both cases, the incident is usually followed by a tired, haggard looking economist looking
through the remaining shards of glass to adamantly declare that there's absolutely, positively NO
RECESSION!
But just in case - We'll recheck the numbers just in case there really is one. We just
cannot be sure, can we?
A constant, contradictory, confusion barrage of statistics
It is safe to say that the complex, multi-gazillion, dollar-based world economy has a great
number of economic statistics, variations to these numbers and, depending on an individuals
standpoint, explanation to the statistics. To make matters worse and to confuse businessmen
even more, a multitude of government agencies and a veritable plethora of assorted nongovernment number crunching companies have all seen fit to provide investors with statistics on
everything in the economy that can be measured, counted, quantified, or surveyed.
How do you make sense of this stuff?
Statistics can be our friends
The assorted statistics that you see on the business page and occasionally splashed on the
front page of newspapers are nothing more than tidbits of information about the economy. When
used properly, they can help investors make better informed decisions as consumers, workers
and taxpayers. The following highlights reasons why statistics are important:

Economic statistics keep track of the economy. They explain whether the economy is in
an expansion, a recession, cyclical or in a sideways motion.

By monitoring the status of the economy, they provide government with information on what
sorts of policies can be used to fix whatever problems the economy is having. No-one
can guarantee that the State actually fixes the problem.

Provide consumers with information that can be used to make informed market-related
decisions, .e. when to buy/sell a house, buy a car or when to change jobs.
However, these statistics must be viewed with a skeptical eye. While statistics are
relatively accurate, they are not perfect and are often misused. It is crucial that
investors consider the source of he information.

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A list of important statistics (see The Business Plan: A manual for South Africa for a
comprehensive outline of important statistics relating to South Africa)
The following are some of the most commonly reported economic statistics:

Stock market indices: Worldwide, investors look to the Dow Jones industrial average as an
indicator of stockmarket trends. This is usually referred to as the "Dow," and is an index of
the prices of 30, corporate stocks trading on the stock market. The 30 stocks include
industrial companies like IBM, General Electric and General Motors. There are also Dow
indices for transportation companies and utility companies.
On the surface, these indices tell us whether stock prices are rising, falling, or remaining
unchanged. Underneath they suggest what is happening to business profitability and the
overall health of the economy. Other important stock market indices include the UK FT-100,
Japans Nikkei Index, the Hong Kong Hang Seng, The French Cac-40 and the German Dax.
For South Africa, important indices are the Overall Index, The Financial Index, The All Gold,
The Industrial Index and the Allsi-40.

Standard & Poor's 500. This is an index of 500 stocks, compared to the Dow's 30. As such,
it is a broader measure of overall stock market prices. Other stock price indices commonly
reported are Amex and Nasdaq, based on a different groups of stocks, but they have the
same general interpretation.

Unemployment rate. Every quarter the Reserve Bank releases a host of statistics in its
Quarterly Review. One such statistic is the unemployment rate, which is the percentage of
the official workforce that is out of work. Government has admitted that this statistic is only
an indicator. For instance, are employable people, who do not wish to work, considered
unemployed? At what age should someone start to work? Each country has its own set of
qualifications to fall into the "official" category of employed person. The official
unemployment rate is prone toward erroneously not counting some who are unemployed
and including others who are employed.

Consumer price index. This statistic measures prices in the economy. In particular the CPI
is an index of prices of objects that are typically bought (or affect purchase) by consumers. It
includes things like cars, VCRs, prescription drugs and petrol, but excludes commodities that
the majority of consumers do not buy, like tanks or fighter planes. Essentially, the
government sets up a basket of goods which is a pre-determined number of consumer
goods.
The economists keep track of the prices of these goods and a price increase over a year
constitutes a rate of increase in the overall price of the basket called inflation. For instance,
if average prices have risen by 5% over a one year period, then we can say that the inflation
rate is 5%.

Misery index. There has been a growing use of this statistic to indicate the overall problems
caused by inflation and unemployment. The misery index is calculated by adding the two
rates. For instance, if the inflation rate is 3% and the unemployment rate is 6%, then the
misery index is 9%.

Gross domestic product. This statistic measures all production taking place in the
economy during the three month period. In particular, GDP measures how much production
takes place within the boundaries of a particular economy regardless of who does the

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producing. Other useful measures that come out with GDP every three months are national
income and personal income, which indicate how much income the public get from
producing all of that GDP.

Real gross domestic product. This measure is GDP adjusted for inflation. While GDP
(nominal or current GDP) is the total amount of production measured in terms of actual
prices each year, real GDP uses prices from a previous year. This lets people know how
much the physical production changes from one year to the next without muddling things up
with higher or lower prices. A by-product of calculating real GDP is another, less common,
measure of an economy's price level and inflation; the GDP price deflator.

Index of leading economic indicators. It is a composite of several other measures that all
tend to move up or down before the rest of the economy. Some of the more noted measures
included in this index of leading indicators are stock prices, passed housing permits,
consumer credit and the supply of money. Each of the individual measures and the
composite leading indicator tend to fall (as an indicator) three to six months before the onset
of a recession and begin to rise with the same lead time before a recession is over.

Lagging and coincident economic indicators. The index of leading indicators is actually
only one of three similar measures. The other two are: coincident indicators that tend to
move with the overall economy and lagging indicators that follow behind by a few months.
Overall, these three sets of indicators give us a good idea of when a recession has started
and when it has ended.

Consumer confidence index. This statistic is an index of the degree of confidence

consumers have in the economy. It is compiled by asking a sample of consumers, in a
scientifically valid manner, a series of questions about the economy. The answers are then
indexed to indicate the fraction that are relatively confident in the economy. This statistic can
be quite useful as consumer spending is a large part of our economy. If consumers are in a
deep, blue funk over the economy, they will not spend and the economy stagnates.

There are scores of other statistics that measure an assortment of everything that can be
measured in the economy. They include, among others, the money supply, savings, trade deficit,
industrial capacity utilisation, building occupancy, interest rates and commodity prices.
Are they any good?
Investors must always remember this: no information, whether weather forecasting, campaign
promises or economic statistics can ever be absolutely correct. Economic statistic should,
therefore, be viewed as indicators and not as sacrosanct. A few of the more common sources of
error to be wary of when using economic statistics are:

Sampling error. Statistics based on some sort of a sample includes a built-in margin of
error. Although 67% of a sample say that they're confident in the economy, the actual
number for the overall population might be 63% Therefore, a sample is a scientifically
constructed guess that is close, but with a chance of being off the mark a bit.
Computing problems. Even when a statistic is based on measuring everything, like gross
domestic product, there's a chance that someone added the wrong numbers, or added
instead of subtracting.
Deceit and chicanery. Every so often government-generated statistics conveniently support
one political view or candidate over another.

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Summary:
When using economic statistic, be wary.
It should be considered as only one bit of information that can help you make a
decision.
Consider the source of any economic statistic.
A lot of people are prone to twist statistics in pursuit of a political agenda. Don't be
fooled.
Economic statistics are great if used properly, but can be deadly if misused.

Exchange rates
South African investors and entrepreneurs alike are awaiting the final lifting of exchange controls
with bated breath. Local investors have seen listed companies venture offshore, yet that seems
to be contrary to exchange control regulations. In addition, it is not quite clear in the minds of
investors whether the removal of exchange controls is positive or not. What does it mean and
why is it essential for global capitalism to have free access to cross border trade?
To understand the behaviour of exchange rates, it is often useful to view them as
consisting of two parts:

A real exchange rate.

A component that reflects domestic and foreign inflation differentials.

Most important, however, is an appreciation of the crucial role that market expectations play in
whether exchange controls are necessary? One foreigner recently said to me that he was not
prepared to invest in a country that still had exchange controls. But these only affect South
Africans and not foreigners, I stated and his reply was unexpected. I cannot invest in a country
that believes it necessary to treat the public like children. There must be something inherently
wrong with such a system.
It is thus important to understand the role of exchange rates in the economic process.
Everyday more than US$1.2 trillion worth of foreign exchange changes hands around the globe,
an amount that far exceeds the daily value of world trade. About 83% of these transactions
involve US dollars, but not all involve US citizens.
Relatively small changes in the prices of these US trades occur, but around the world
exchange rates can have immediate and profound effects on economic events, ranging from
family holidays to corporate profits. Large changes can result in governments imposing
exchange controls, as recently demonstrated in Southeast Asia. Yet, despite the importance of
exchange rates, most people find their behaviour unfathomable.
Economists often view the nominal exchange rate (the foreign currency price of a US dollar) as
the product of the real exchange rate and a component reflecting the difference between
domestic and foreign inflation. Economists estimate these, because of their influence on
international competitiveness. This dichotomy between a real exchange rate and an inflation
differential has proved useful for understanding the following:

Complex connections between economic fundamentals and nominal exchange rates

Appreciating the role of monetary policy in determining exchange rates.

This economic critique is not a technical guide, but a quick tour of exchange rates:

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The first part considers the role of inflation and monetary policy in determining exchange rate
movements.

The next section utilises balance-of-payments concepts to illustrate the economic role of the
real exchange rate.

The final, but perhaps most important, part of the narrative introduces the crucial role of
expectations.

Inflation differentials
An exchange rate is the relative price of one nation's money versus another's. For example,
US$1 can buy nearly R6. If the South African Reserve Bank prints more Rands (than people
actually wish to hold) and at a greater pace than the US$, the value of the Rand will fall relative
to the US$.
Ignoring the difficulties associated with expectations and perceptions of monetary policy,
the dynamics underlying the Rands depreciation might proceed as follows:

Faster money growth creates inflationary pressures in South Africa.

This causes people to shift their purchases away from Rand-based goods toward the now
relatively less expensive US goods.

To acquire US goods, however, people must first convert their Rands into US$.

The increased demand for US$ (and the greater supply of dollars) will bid up the value of the
Rand relative to the US$ in the foreign exchange market, i.e. the Rand will depreciate
against the US$.

Holding others things constant, this US$ depreciation will continue as long as the South
African inflation rate exceeds the US inflation rate. It will tend to match the inflation
differential between the two countries.

If, for example, Germany's inflation rate is 2% a year and the US inflation rate is 3% a year, the
dollar will depreciate by 1% a year against the mark, other things being equal. This has two
important implications for monetary policy:

Monetary policy ultimately determines only domestic inflation rates, i.e. a central bank that
wants to engineer a depreciation of its currency can do so by creating more money than its
trading partners and thereby generating a higher inflation rate.

Any resulting exchange rate depreciation will ultimately offset the inflation differential
between the two countries. However, a monetary induced depreciation cannot secure a
competitive trade advantage and the real exchange rate will remain unaffected in the long
term.

Any trading gains from undertaking a US$ depreciation are purely transitory and last
only until prices fully adjust.

Economists refer to the relationship linking exchange rate movements and inflation rates
across countries as relative purchasing power parity (PPP).

Recent estimates suggest that once disturbed, PPP takes an average of eight years to
become re-established.

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There are two likely interpretations of the assessment that it takes eight year for PPP to return to
normality:
The price of goods adjusts slowly to monetary shocks, i.e. monetary policy is able to affect
the real exchange rate in the short term.

Non-monetary events, such as productivity shocks (strike action or significant changes in

production methods) or changes in preferences for domestic versus foreign goods, are the
real causes for PPP being disturbed, i.e. this perspective draws attention to the
determination of real exchange rates.

Real exchange rates, international trade and the Balance of Payments

By assuming that world inflation rates and expectations are constant, we can focus on the real
component of the nominal exchange rate. This will change in response to any economic event
that affects the real demand for (or supply of) traded goods and international investments. To
understand the connection, however, one must first understand balance-of-payments
accounting.
The Balance of Payments is a record of all transactions between residents of one country and
residents of the rest of the world. For instance, anything that creates a debit item in the South
African Balance of Payments creates a supply of Rands (and a demand for foreign currency) on
world markets . When South Africa imports a German car or machinery, South Africa must first
acquire marks in the foreign exchange market. It buys marks by selling Rands.
Likewise, anything that creates a credit item in the South African Balance of Payments,
such as the sale of domestic maize, generates a demand for Rands (and a supply of foreign
currency).
A country that incurs a current account deficit is consuming more of the world's output than it is
producing. Its imports are a debit item in its current account, creating a supply of its own
currency. Such a country must pay for its extra current consumption by giving foreigners
financial claims on its future output (stocks, bonds, bank deposits, and so on).
The resulting foreign capital inflows are credit items in the Balance of Payments and
represent a demand for dollars. Current account and capital account balances must offset each
other exactly, i.e. neither an excess supply nor an excess demand for dollars exists. This does
not mean that the capital account only responds passively to the current account.
When individuals make decisions about importing, exporting and investing abroad, each
of these decisions affects the Balance of Payments independently. If at any time the collective
intentions are not consistent with equilibrium in the accounts, attempts to enact these plans will
cause the real exchange rate to change. The exchange rate adjustment in turn forces people to
re-evaluate their plans in such a way as to pull the current and capital accounts into balance.
Other economic variables, like real interest rates, might also shift and contribute to the process.
Contrary to popular belief, the mere existence of a current account surplus or deficit implies
nothing about how dollar exchange rates will behave. A country may incur a current account
deficit through various routes, each with different implications for its exchange rates.
The following example assumes that domestic demand for foreign goods initially
increases. The following will take place:

Imports will expand

The current account deficit will grow

The Rand will depreciate.

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The Rand depreciation will encourage a counterbalancing inflow of foreign capital by making
South African financial securities more attractive to foreigners.

This holds that the Rand depreciates when the South African trade deficit widens.

Alternatively, suppose that an improved domestic investment climate draws an inflow of

foreign capital. The Rand will appreciate, making domestic goods expensive relative to
foreign goods and striking a balance between increased capital inflows and the larger trade
deficit.

This second case connects a Rand appreciation to a South African trade deficit.

All economic events that affect the real demand for (or supply of), traded goods and financial
investments can potentially determine the level of real exchange rates. While almost any
economic variable would seem a possible candidate, real interest rate differentials, productivity
differentials, trade restraints, tax rates, and relative preferences for domestic versus foreign
goods seem key.
I have discussed nominal exchange rates as the product of a real component and an inflation
differential, identifying or alluding to fundamental economic variables that most economists
regard as important to the determination of exchange rates.
Although exchange rates bear some long-term correspondence to fundamentals, the
relationship is not close in the short or medium term.
A capitalists explanation
For the capitalist, here is an explanation of exchange rates using asset prices.
Definition of asset pricing:
Current price of an asset

present discounted value of expected income

stream of asset over its lifetime.

Capitalist definition of inflation:

An exchange rate

present discounted value of all relevant

fundamentals (including current fundamentals)
and their expected future values.

This is the reason why foreign exchange traders are successful. They have strong incentives to
acquire every piece of information about current and anticipated economic developments that
could possibly influence exchange rates. To be successful, traders current quotations must
incorporate all available, relevant data, and only new information that causes revisions in
traders' expectations will influence exchange rates. This implies that previously anticipated
changes in monetary policies or other fundamentals will not affect current exchange rates; only
unanticipated changes will.
One might expect profit-seeking exchange dealers to formulate their expectations, and
therefore their exchange quotations, without making systematic errors. To the extent that they
can do so, revisions to their quotes will be fairly random and will impart a zigzag pattern to
exchange-rate movements. Over time, a net change in one direction or the other may emerge
as exchange rates adjust to persistent shifts in underlying fundamentals. On a day-to-day basis,
the exchange rate will bounce-in a seemingly random manner-around any such path.

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Although exchange traders are highly effective users of information, they probably are not
perfectly efficient. Indeed, why would trade occur, especially in such large volumes, if all traders
had identical information at all times? For one thing, information about economic fundamentals
(both its acquisition and its interpretation) is costly, which may explain why many foreign
exchange traders generate profits from technical trading rules, instead of from models based on
economic fundamentals. Many of these rules project past trends into the future. Such trading
rules could increase short-term volatility. As time passes and as information becomes freely
accessible, traders may increasingly respond to fundamentals.
Initially, however, traders may not be linked to fundamentals in a fixed or even consistent
way.
Investors can create their own, specific exchange rate
If an investor has substantial funds tied up in Germany (or any other country), he can create his
own exchange rate.

Divide the German Consumer Price Index (CPI) by the South African CPI.

Construct an index number for this ratio.

If possible, choose a base year for the index that represents an equilibrium.

The index will fall when South African inflation exceeds German inflation.

Multiply the nominal exchange rate by this index of consumer prices to obtain the real
exchange rate. The real exchange rate equals the nominal exchange rate in the base year.

Conclusion
Over the 25 years since dollar exchange rates began to float, economists have learned to
garnish their exchange rate predictions with humility.

Many economists probably feel secure in forecasting that a country with a relatively high
inflation rate will eventually see its currency depreciate in foreign exchange markets.

Few, however, would venture to forecast a time path for the adjustment or estimate the long
term exchange rate implications of most other economic variables.

Nevertheless, international trade and capital flows continue to grow, despite the periodic
trepidation about movements in dollar exchange rates.

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PART ONE ENCAPSULATED AND EXPANDED

Capitalist habits that investor should cultivate
In 1996 I was invited to attend a Stephen Covey three day course, held by listed retailer
Wooltrus CEO Colin Hall. The course was directed at leadership, business, life experiences,
power, chaos theory, globalisation and many other issues. While there was no direct relationship
between investment trading and Halls overall life experience list, I discovered that there are
some definite similarities and differences.
It is well known that normally successful business approaches do not work in investment.
Additionally, life in general requires involvement and interrelating with other people, while trading
is a more solitary endeavour. I have compiled a short list of successful habits for investors.
Understand what really makes up markets
The markets are called chaotic systems by some US market gurus. Chaos theory is the
mathematics of analysing non-linear and dynamic systems. According to one such guru, Edgar
Peters (author of Chaos and Order in The Capital Markets), mathematicians have conclusively
shown markets to be non-linear, dynamic systems. Among other things chaotic systems can
produce results that look random, but are not.
However, on extremely important aspect of chaos theory is that, after chaos comes
greater efficiency and controls. For instance, emerging markets crashed in 1998, with Japan
facing its worse recession since the Second World War and the world stock markets followed
suit. Many economists and industrial experts on global markets made the following statement:
Global deflation and the volatility of emerging markets has brought on a global recession.
Yet, these statements focus on a narrow aspect of the problem. There is certainly a world
deflation problem but the problem is concentrated in specific industries and not in all sectors
across te globe. In fact, prominent World Bank economists admit that there is still a greater
problem of inflation than deflation. Yes, the Far East is facing currency problems but that is not
a consequence of globalisation, but rather internal excesses of the past, that were promoted by
first world demand. Now the IMF states that investors should invest in a country with
sustainable, long term GDP growth of three to five percent and not the 15% achieved in the
past. In other words, excesses of the past had caught up with the Far East.
Unsuccessful and frustrated equity dealers want to believe there is an order to the markets.
They think prices move in systematic ways that are highly disguised. Many want to believe they
can somehow acquire the "secret" to the price system that will give them an advantage. They
think successful trading will result from highly effective methods of predicting future price
direction.
The truth is that the markets are not predictable, except in the most general way.
Successful trading does not require effective prediction mechanisms. Successful trading
involves following trends in whatever time frame chosen and the trend is an edge. If an investor
follows a trend with proper investment strategy methods and good market selection, he will
make money in the long run. In conclusion, market price movement is highly random, but there
is a long term trend component attached.
There are two related problems for traders:
Following a good method with enough consistency to have a statistical edge.
Following the method long enough for the edge to manifest itself.
Analyse personal trading behaviour and keep to strategic plans
Investors move funds into equities with a view to making money, but often do not have a long
term plan in mind. After awhile some investors speculate and find that they are making money
faster than their financial advisors have recommended. For these investors, the trading process

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has become fascinating, entertaining and intellectually challenging. Pretty soon the motivation to
make money becomes almost subordinated to desire of making more money, quicker and with
less regard for risk.
Ultimately, the market catches up with most speculators, especially those with expanded
egos. The kinds of trading behaviours that are the most entertaining are also the least effective.
In addition, investors must be wary of depending on others for their success. As recommended
in my book The Business Plan: A manual for South African Entrepreneurs, be part of the entire
planning system. Obviously, investors need help from stockbrokers, advisors, computer vendors
and in analying statistical databases. It is important to control the whole of the planning and
strategic process and depend on others only for clerical help or to support your own decisionmaking process.
Do not become obsessed with failures. This is an easy trap to fall into. No matter what
happens, you put yourself into the situation. Therefore, you are responsible for the ultimate
result. Until you accept responsibility for everything, you will not be able to change your incorrect
behaviours.
Trade only with proven methods
When applied consistently, most trading methods do not work. The best an investor can hope for
is a few, well-chosen methods. Investors must be skeptical of everything they read and must
acquire the ability to test any trading method before these are used. It is also important to
become proficient in the use of computer systems that test a particular approach or a variety of
approaches. Learn the correct way to test and evaluate trading approaches.
Investors must develop an approach that works for them and one which makes them feel
comfortable. There are four cardinal rules in trading.

Trade with the trend.

Cut losses short.
Let profits run.
Manage risk.

These may be well known cliches, but virtually all losing dealers violate these rules consistently.
Trading with the trend means buying strength and selling weakness. Most traders are more
comfortable buying weakness and selling strength, the essence of top and bottom picking.
Investors must emphasise those markets that they know the best. It is simply impossible
to know (expertly) all markets. Keep to those best known and, over time a statistical edge will be
maximised.
Never over trade an account
The pervasive hype that permeates the industry leads people to believe that they can achieve
spectacular returns if only they try hard enough. However, risk is always commensurate with
reward and the bigger the return pursued, the bigger the risk that must be taken.
Rule of thumb
Investors should expect an equity decline of about 50% of annual profit expectation.
Thus, if an annual return of 100% is expected, the investor should be ready for a
decline of 50% of his equity.
Almost no one can keep trading a method through a 50% decline.
It is better for investors to initially aim for smaller returns until he is an expert in his system, so
that he can trade through tough periods. An experienced money management executive has

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stated that professional money managers should be satisfied with consistent annual returns of
20%.
If talented professionals are satisfied with such a low percentage, what should South
African investors expect? Personally, I believe it is realistic for a good mechanical system
diversified in good markets to expect annual returns of between 30% and 50%. This would still
result in occasional declines of about 25% of the equity value.
Manage risk
There are a number of possible risks that can be managed. In a later section of this book, I
discuss risk in greater detail. It is thus sufficient to state that even the champion capitalist must
manage the following risks:

Manage the risk of ruin when creating a trading plan or system.

Manage the risk of trading when selecting a market to trade.
Manage the risk of unusual events that could stall the entrepreneurial or investment process.
Manage the risk of each individual business transaction or investment trade.

The risk of ruin is a statistical concept that expresses the probability that a bad decision (made
when tired, hassled, in heavy traffic, time constraints or because a friend told you to do
something) will completely wipe you out.
The following example is based on the assumption that an investor will gain or loose the same
amount on each trade. While unrealistic, the example is used to explain the risk of ruin problem:
Mathematically, if an investor risks 10% of his account on each trade, chances are that
he will be completely wiped out before long. If his trading method is 55% accurate, he still has a
12% chance of being wiped out before doubling his capital, i.e. if he risks 10% of capital per
trade.
In order to reduce the harm caused by unavoidable strings of losses, you must keep the
amount you risk on each trade to about 1% or 2% of capital. This may make trading with small
accounts difficult, but an investors chances of avoiding meltdown from a bad series of trade are
good. However, trading with small stops is usually ineffective.
Market risk is a major factor to avoid. Some markets are, for instance:
More volatile and more risky than others, e.g. futures and commodities trading.
Comparatively tame, eg. gilts.
More subject to global risks, eg. currencies have a greater chance of overnight deterioration
that increases risk.
Lower liquidity.
Investors with small accounts (or strategies for the long term) should not trade in large
(exceptionally large) amounts. If need be, use options to hedge large trades and investors
should never feel that they have to trade any market that might make a move. Emphasise risk
control over achieving big profits.

The most important element of risk control is simply to keep the risk small on each trade.
Always use stops, i.e. cut losses when the market falls by 1%.
Always have your stop in the market, i.e. order your financial advisor to sell when a
share reaches a certain level.
Never give in to fear or hope when it comes to keeping losses small.
Never risk more than 1% or 2% of capital.
Preventing large individual losses is one of the easiest things a trade can do to maximise
chances of long-term success.

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Stay for the ride

Never change long-term strategy based solely on short-term market performances. Many traders
have such an ego attached to their trading skills that they cannot handle losses. Several losses
in a row are devastating, which causes them to evaluate trading methods and systems based on
very-short-term performances.
Statisticians tell us that there is no statistical reliability to a test unless you have 30
events to measure. As we saw in the above discussions on capitalism and labour, strings of
losses are as certain as government inefficiency. Thus, the trader who chucks his system after
four losses in a row is doomed to spend his trading career changing from one system to another.
An investor should never start trading a system, that he has devised, based on only a
few trades. In addition, investors must be wary of loosing confidence after a few disappointing
trades. Performance should be evaluated on many trades and only after three years of results.
Keep trading in correct perspective and as part of a balanced life
Trading is always emotionally intensive, whether an investor is making or loosing money.
Investors must beware of becoming too elated during successful periods, as one of the biggest
mistakes traders often make is to increase their trading after an especially successful period.
This is the worst thing you can do, because good periods are invariably followed by awful
periods. If trading is increased just before the awful periods, twice the money will be lost than
initially gained.
The following is a short list of advice:
Know how to increase trading in a growing account. This is perhaps the most difficult
problem for successful traders, i.e. skill grows with experience.
Be cautious when increasing exposure to the market.
The best times to buy shares are after market losses.
Don't become too depressed during downturns or strike action threatening to affect a
companys profits. A market always turns and strike action always gets resolved.
Reading Steven Covey and listening to Colin Hall made me realise that making money on the
stock exchange is a lot like lifes experiences. Everybody has different emotions, at times happy
and at others sad and depressed. When investors are losing, they often think about giving up
trading completely or changing jobs. With a little practice, however, the successful investor
learns to control both emotional extremes. Sure, investors will probably never control them
completely, but at least they should not let elation and despair cause them to make unwarranted
changes in their strategic approaches to investment decisions.

Capitalism there is no way back?

Ingenuity, new prosperity, middle-class striving are familiar Western culture values. Interestingly,
these capitalistic values have started to appear on the frontiers of third world economies. Millions
of people in these undeveloped economies, together with a growing desire for capitalist values,
has resulted in a revolution taking shape. Not a war mongering-type revolution, but one that will
transform the global economy well into the next century.
Already, capitalism is flourishing in regions as diverse as Asia and former Latin American
dictatorships. Economists have been astounded at the level and pace of globalisation, with
affluence lifting millions out of poverty, inflation being brought under control and constitutional
democracy sweeping through Central Europe, Russia, Latin America, Korea and Taiwan. Ideas
transmitted by the Internet are prying open even authoritarian regimes.
Why is all this happening now?
The death throes of communism clearly gave birth to the era, leaving most nations with only one
choice: join the market economy. The implications are huge for rich and poor alike. Many are
living poorly, of course, but just as many are thriving.

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In addition to being global, capitalism has created an Information Revolution. As powerful

data networks spread across the globe, developing nations will be drawn into the borderless
information economy. These changes are creating new opportunities for profits and
entrepreneurs are in hot pursuit of these opportunities. Yet there is still much uneasiness about
the new era. In this new age, corporations will force change upon employees as executives
pursue a global vision. Harsh trends will include a much more diverse body of shareholders and
managers, constantly changing partners and allies in the quest for new technology and markets
and an emphasis on rapid product development.
Advanced skills will be needed in this volatile atmosphere. The essence of those skills
will be an ability to move capital around the world and to quickly transfer skills and knowledge to
companies in remote parts of the world.
Will optimism about 21st century capitalism ultimately prove misguided?
There are millions of people who will not benefit, at least directly. In its most unbridled form,
capitalism delivers wealth, but it does not distribute equitably. Resentment against capitalism
could provoke a backlash against free trade, but capitalism has proven its resilience over the
competing systems of fascism and communism. It has already been able to transform itself to
accommodate dozens of cultures worldwide and there is little chance of capitalism failing.

Capitalist strategies in the stock market

Over time, I have gathered experiences in a number of financial fields, including business
development, industrial analysis and investment strategy. These have led to many complex
reports, presentation of macro-environmental factors to the investment community, specific
share analysis and a multitude of indepth research projects. Among the many rules that have
become part of every day use, the following is a combination of entrepreneurial and investment
advice. It is not comprehensive and really serves as a conclusion to the above chapters and also
as a precursor to Part Two: Investment Strategies in a global village.

In business, own the entire system.

Be a Carnegie do not buy imported rubber to make shoes if you can find a good farm
location and grow rubber trees.

Plan farms in conjunction with stores and factories.

Businessmen (and investors) can negate profits by paying the long distance transportation
costs. In 1991 I undertook a hostile corporate takeover plan for a listed Cape Town industrial
company to advice how to acquire the entire group of one of his competitors. This group
was based all over the country and had to transport the raw material to the factory (Eastern
Cape to Johannesburg), which - in turn - had to transport the semi-finished goods
(Johannesburg to Cape Town) to the assembly plant. After much analysis, the ultimate
recommendation was to buy out the competitor, asset strip the group and thus acquire a
higher net worth than share price or cost of acquisition. An alternative benefit was the
removal of a competitor from the market and thus grabbing market share.

Entrepreneurs should not be too concerned with the appearance of their office. The heart of
the financial district is popular among businessmen, but are extremely expensive. The edge
of the city offers much cheaper building costs. If the entrepreneur has a factor, set up office
at the factory. It makes the workers believe (or at least think) that management is hands on.

Assess companies with focus and aggressive management. Over time, it should pay nice
dividends.

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Keep an eye on the stock market, especially looking for a corporate buying a large stake in a
rival, It is a prelude to a takeover. Buy some stock in the target corporation yourself.

An investor will benefit from the rising stock price as the takeover move along and when the
two entities have merge, the investor will own shares in the parent.

Get away from using imported products and material as soon as possible. When the supplier
moves, it creates havoc with your supply lines and costs rise.

When you first move a new product into a city, do not expect it to do well. As a rule, it will
have to compete against local competition for awhile. If prices are lowered, a small loss on
the product is made, but market share can be attained quickly. Price can be increased later
and customers normally keep buying your now-pricier product.

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Part 2
Investment Strategies
in a
Global Village

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CHAPTER 9: WITHOUT INFORMATION, YOURE DEAD

Before and after an investor makes an investment, he should gather and use information. He
will want to know such things as earnings history, risk factors, quality of management, and
opportunities for future growth and income in order to select appropriate investments. After a
share is bought, it is important to track the investment's market price and earnings compared
to other investment options.

Making investment decisions in a global market does not have to be laborious, complicated or
difficult to understand. The basics are still the same as investing in the local market. Nothing has
changed choice of where to place your cash. A good investor gathers information on markets he
or she is about to venture into, no matter where that market might be. The mechanism of your
research is the same for any market and, thanks to the current technology, market data on
worldwide economic trends, political movements, project funding mechanisms, the World Bank
and the International Monetary Fund (IMF) data and even specific company information is easily
available.
In the past gathering data was a monumental task and analysis was time consuming. For
instance, assessing the viability of investing in Company XYZ Ltd. meant keeping daily press
cuttings on that company, writing to the registrar of companies (or to the company) for a copy of
its annual report, accessing economic trends by becoming a member of associations that collate
data (e.g. government statistics on inflation, producer price indices, money supply data etc.) and
keeping a close eye on stock prices by telephoning stockbrokers.
Today, an investor can access all this information through a computer, enabling better,
quicker and more accurate decision making. With this data, we can begin to see clearly what is
going on. With a "clean" database and a modern computer, researchers can sift and sort,
analyse, and test hypotheses. In addition, all this information is instantly available worldwide,
which means that investors can be anywhere in the world and are no longer restricted to living in
financial capitals.
Too much data can also be confusing. Where does one start? Should the investor assess global
trends first, or should the domestic market be a priority? The answer depends on the investor,
the amount of money to be invested and the needs of that investor.
Although investor need differ, they should always base decisions on a sound
understanding of economic, political business and technology trends in the home country. The
same is necessary for investing in stock markets. Understand equity, commodity and debt
markets. It is crucial in the initial stages to gain a firm grasp of indices, what the levels are,
where they have been and what the trend will be in the short to medium term. It is important to
comprehend and become similar with statistics before trying to analyse international market
booms or crashes. Start by understanding what makes stock markets work, followed by creating
your own database. This is not complex and can be done using a basic spreadsheet.
Basic tips on how to be a more informed investor
Always remember:
No investment is risk free.
It is always an investors personal responsibility to make a careful, independent assessment
of his financial situation and investment goals, before making any investment.
Assess all investment products offered and never be rushed into making a decision.
It is imperative that the serious investor builds up a financial library to assist him in
developing an investment strategy.
There are many factors that an investor should know before making an investment decision
and many are described in this book. Here are a few indicators that a proposed investment
opportunity may not be all that it is touted to be:

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Unsolicited phone calls offering an investment opportunity that you just cant pass up or
we can do a full portfolio analysis for you for free. These cold calls must be guarded
against.
A promise of high return with little risk.
The salesperson indicates they and/or the offering of investments are not a legally
registered financial services company.
No disclosure documentation is provided to you or what is provided fails to disclose,
among other things, the risk of the investment, the promised rate of return and the
intended use of the offering proceeds.
High pressure sales tactics.

Remember: Before investing, you should always consider contacting the Registrar
of Companies to request any registration information as well as any disciplinary or
other enforcement information concerning the investment and the person offering it
to you.
Step 1: What kind of investor are you?
Before you start on drawing up an investment strategy, find out what kind of investor you really
are. For instance, are you aggressive, can you be patient enough to be a long term investor, do
you have enough money to invest without placing undue stress on your family or are you simply
moderate? The following basic questions are enough to effective determine the type of investor
you are.
Do you have the money to invest?
AN investors financial well being depends on careful planning. Many financial advisors will be
adamant
that you must start investing NOW. Of course, the sooner an investor starts the investment
process, the better and easier it will be to accumulate greater wealth in the future, but that is not
always possible.
Assess whether making an investment at this time is the best use of your money. Here are
some things to consider:

Do you have enough money to cover personal family expenses?

Are you carrying adequate life, disability, property and liability insurance?
Would it be wiser to use extra funds to pay off debts or reduce your mortgage rather than
making investments? If the expected rate of return in the market is 15% and your
mortgage interest payments are 18%, it would be better to pay off the mortgage.
If you have money available after meeting these basic financial needs, you are ready to
think about your investment goals.

What are your investment goals?

The investor must decide why he want to invest and what he wants to achieve. Once he has
determined his your investment goals, he will find it easier to choose an investment that will
meet his needs. Here are a number of investment reasons:

To meet short-term goals, eg. saving for a deposit for a house or a car. Investors with
short-term goals often invest in certificates of deposit (CDs) or money market mutual
funds.
To earn investment income, which will supplement your other income. Gilts, preferred
stocks or income mutual funds might be appropriate if investment income is your goal.

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To achieve long-term growth so that you will have money for your children's education or
for your retirement. Suitable investments for a long-term growth include common stocks
and equity mutual funds.
To minimise taxes. Investing in an Retirement Annuity (RA) may be one way to minimise
current taxes.
Once an investor has determined investment goals, he must decide how much risk he is
willing to take to achieve his goals.

How much risk are you comfortable with?

Different investments have different levels of risk. Keep in mind that an investment offering a
higher return always carries a higher level of risk than one offering a lower return. For example,
unit trusts are relatively safe, but generally pay lower rates of return. Ordinary shares of growth
companies are riskier they have the potential for greater gains, but also greater losses.
Decide how much risk you are comfortable with. Are you a conservative investor,
concerned above all about safety of your capital and stability? Are you an aggressive investor,
prepared to take higher risks for the possibility of greater returns? Or are you a moderate risktaker, falling somewhere between?
Investing your money shouldn't be an experience fraught with anxiety. Determine how much risk
you are comfortable with and choose your investments accordingly. Once you have a clear idea
of your investment goals and how much risk you are willing to assume, you are ready to start
looking at specific investments.
Basic test to discover the type of investor you are.
QUESTIONS
Do market fluctuations keep you awake at night?
Are you unfamiliar with investing?
Do you consider yourself more a saver rather than investor?
Are you fearful of losing 25% of your assets in a few days or
weeks?
Are you comfortable with the ups and downs of the securities
markets?
Are you knowledgeable about investing and the securities
markets?
Are you investing for a long-term goal?
Can you withstand considerable short-term losses?
Key: If the answers to the above questions were:
More
YES
THAN
No
More
No
THAN
YES
Equal
YES
AND
NO

=
=
=

YES

NO

Conservative investor
aggressive" investor
Moderate investor

Risk tolerance varies from one investor to the next. Indeed, two individuals with identical
investment objectives, time frame, and financial resources, may possess polar opposite risk
personalities. Gauging your tolerance for risk requires some knowledge of the financial markets
as well as an honest appraisal of what level of risk you are willing to accept.
The next step is to start a knowledge base to understand the financial markets.

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Step 2: Start afresh and understand the basics

The behaviour of stock markets is influenced by a multitude of factors at any one time. These
can be psychological, economic, political or social in nature and of international, regional or
national significance. Some can be of a long-term nature, while others may be temporary or
short-term, real or imagined. The basics of understanding stock markets is outlined in great
depth in my first book, Share Analysis And Company Forecasting (Struik, 1995). It is therefore
sufficient to briefly outline some of the major factors that could affect share prices.
Economic data
The almost constant stream of data and statistics that reflects the health (or otherwise) of the
world's economies, released by governments, provides an important background of the
environments in which listed companies operate.
In this age of hi-tech telecommunications, the release of fundamental data such as GDP
growth, money supply, inflation, unemployment, balance of payments and even the anticipation
of release, can markedly influence the direction of the market.
Government policies
The Australian Federal Government, through the implementation primarily of monetary and fiscal
policies attempts to steer the economy along a path of sustainable growth. By controlling official
interest rates, the supply of money in the economy, taxation and government expenditure, the
government can influence the level of production in the economy, employment and profitability.
The share market will react to these changes.
Any change in government expenditure is closely watched by the market for its effect on
economic growth and money supply.
Time zones
As different international markets trade in different time zones, an effective 24-hour continuous
market in currencies and commodities has emerged and the introduction of computerised trading
has resulted in this trend encompassing share trading around the world. So, the influence tends
to flow from one market to the next with sentiment, if not direction, being carried across the time
zones.
Company Reports
Each listed company is required by the Johannesburg Stock Exchange Listing Rules to report on
a variety of matters, in particular on any information that is material to, or likely to influence the
share price. These reports cover profit results, exploration and working capital reports, changes
in substantial shareholders or personnel, shift in a company's activities and any news of
importance that would affect the market valuation of that stock.
It is not necessarily only the release of information to the market by a company that may
move the share price, but also the anticipation of that report, particularly if it is expected to be
significantly positive or negative to the share price. The largest share price movements occur
when there is a significant discrepancy between market anticipation and actual company
financial results.
New issues/dividends
New issues of shares by existing listed companies have an effect not unlike dividends. A listed
company that wishes to raise capital may choose to sell new shares to existing shareholders at
a discount to the current market price. This is known as a Rights Issue. When a company opts to
issue new shares to existing shareholders without asking for payment, this is known as a Bonus
Issue.

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Broker research reports

Stockbroking firms employ research analysts who, among other duties, prepare reports on the
economy, the market, relevant items of interest and, in particular, the outlook for specific
companies.
The publishing of these reports can influence share prices, especially if the reports are
strongly written as to encourage shareholders, or potential shareholders, to act one way or
another, buying or selling. These reports are not released at any specific time, but tend to
closely follow the release of information such as, among other, company reports or changes to
government policy.
Sentiment
Sentiment is what is left when you have considered all the above mentioned influences. Do
these influences inspire confidence or make you nervous? Do you want to buy or sell, given
current circumstances and future expectations?
In a perfect market, all investors or potential investors would have access to all
information at the same time. However, this is not an ideal world, we do not have a perfect
market and investors make buying and selling decisions for different reasons. This human factor
is one of the things that makes investing in shares so fascinating.
Where to find information
Information about the economy, about sectors of the market, about individual companies and
their shares is widely available, and accessing it can help you manage your portfolio. As you
look at the information sources, remember that you are looking for two levels of information:

Background information on the share market and the environment in which it operates.
Information on individual companies and their future prospects.

When you buy shares in a listed company, you are buying part of a business. Information you
collect should help you assess the past performance and future prospects of this business. You
need to be able to determine how the company generates its sales, incurs its expenses and
derives its profits.

Information sources include

Newspapers, magazines and books
The daily papers have financial pages that show the number of shares sold, in which
companies, and all price movements from the previous day. In addition, these newspapers have
stories about international and local economic trends, political and legal moves on stories about
various industries, all of which may affect share prices or individual companies.
Information from the company
A great source of information is the company itself. You can check your company's performance
against all the other information you have available. If dividends fall, if sales drop, if the share
price slides, these are stronger pieces of information than any article or government statistic.
Stockbroker and industry information
Once you start investing regularly, you should try to establish close relations with a stockbroker,
which has a strong research team. The result of the research of these specialists into specific
companies shares is available to clients of the firm in the form of written reports and also verbal
advice.
A number of newsletters and research or statistical bulletins are also issued by
stockbrokers, industrial and commercial sources, the stock exchange and the government. For
example, statistics on various industries is collected and published by the Central Statistical

Jungle Tactics

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Services, The South African Reserve Bank and The South African Council of Business. This can
be valuable background information, but is usually published much later than much of the other
information you can gather.
How to evaluate information
Investors should ask themselves what they need from this mass of information that is available
to them about the economy, the share market, industry sectors, companies and share prices.
Part of the difficulty will lie both in the volume and the quality of the advice offered.
In the financial press and journals investors will find articles that are written by journalists
who have often obtained their information from different sources. They will write their articles
from differing outlooks and voice different opinions. Some of the factors you will need to
consider in reading these articles include:

Source.
Relevance.
Degree of opinion.
How recent was the information obtained.
How useful was the story.
Interpretation, bias and emphasis.

Once you have read all the articles, create a database. File articles, research reports and
statistics.
Step 3: Creating a stock market database
The following spreadsheet highlights the type of data that can be easily accessed from South
African daily newspapers. The spreadsheet shows the information that can be accessed and
includes formulae to calculate daily market movements.
Basic explanation of how spreadsheets work (using sample spreadsheet set out below).
The first step to understand is that a formula placed in one of the blocks in a spreadsheet has a
position indicator. For instance, C2 represents the value 210 or, alternatively, the value of 210 is
found in block C2. Each block is thus represented by a row (numbers) and columns (alphabet
letters).
Example: An investor wants to use a spreadsheet to calculate the value of his three
shares (it could be 1,000 shares in eight different countries, using an exchange converter etc).
He wants to have the value of the three shares displayed in Block F2.
His first task is to open up a spreadsheet and to give that spreadsheet a name, so that
he does not have to repeatedly draw up a new spreadsheet every time he wants to calculate the
value of his shares. Next, he sets out the spreadsheet so that he types in the words shares, 1,
2, 3, portfolio value and the value of his shares.
In block F2 he types in the formula: =sum(C1:C3)
The formula is the sum of blocks C1 to C3. Formula are usually the same for different
spreadsheets, with some variation. As the investor improves his use of spreadsheets, he will be
able to insert percentage formula, ratio analysis, highlight sections of the portfolio, undertake
mapping etc.

1
2
3

A
Shares

B
1
2
3

C
111
210
709

Value of portfolio

1030

Jungle Tactics

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The following spreadsheets are samples and must be customised to the wishes of the investor.
Essentially, the investor should have knowledge of:
1. The local market (main indices and sector indices).
2. Foreign markets (US, UK, Germany, France and markets in the Far East, such as
Japan and Hong Kong).
3. Commodities (gold, platinum and copper).
4. Currency markets (Rand/US$ exchange rates).
5. Debt market (gilt rates, repo rates etc.).
In addition, the long term investor will have a spreadsheet that is annually based, but also
include a column to include the latest date. This enables the investor to know how the markets
and his portfolio are performing (daily, weekly or monthly).

Statistics @January

1996

1997

1998

1996

1997

1998

Latest Date
No.
% change

LOCAL MARKET
Overall Index
Industrial Index
JSE Gold
Other Indices
JSE: Volume
Value
Shares up
Shares down

Statistics @January

No.
FOREIGN MARKETS
FT 100
Dow Jones (Industrial)
Dax
Cac
Hang Seng
Nikkei

Latest Date
% change

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Statistics @January

- 81 -

1996

1997

1998
No.

Latest Date
% change

COMMODITIES
Gold
London pm fix:
Hong Kong close
Other
Platinum fix
Copper A cash
Oil & fuel prices
IPE Brent (July)
IPE Brent (Aug)

Statistics @January

1996

1997

1998

Latest Date
No.
% change

1996

1997

1998

Latest Date
No.
% change

1996

1997

1998

CURRENCIES
Rand relative to:
US Dollar
Pound sterling
Dollar relative to:
Yen (100)
DM

Statistics @January
DEBT MARKET
90 day BA
E168
R150
Repo rate
US 30-year bond
Liquidity

Statistics @January

No.
SECURITIES
Shares
Gilts
Options
Future
Cash
Value of property

The creation of a database will enable the investor to improve:

Regular understanding markets movements.
Movement of local markets relative to foreign markets.
A general understanding of markets.
Create a database that can be used to draw graphs.

Latest Date
% change

Jungle Tactics

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Create a database for future reference.

Step 4: Determine your investment criteria general concept

While it is important to understand stock market movements, it is not enough to become
successful. The next step is to quantify a desired rate of return. Investors must ask whether they
want to invest for fun and to speculate in shares, do you want steady long-term capital growth or
do you need to live off dividend income? The general trend among investors is for immediate
growth.
If we are going to delay the urge for immediate wealth, then a balance must be struck
between a reasonable prospect of dividend growth and profit. People looking for profit can
choose from a number of markets, including traditional investments in shares or bonds.
However, there are also options, futures, money market instruments, commodities and other
more exotic derivatives which are freely traded and totally liquid. An investor might want to
consider real estate, fine artwork, stamps, coins, antiques or other valuable tangibles.
Each market can be broken down into smaller sub-markets and the list could become
endless. In addition, each segment has distinct properties which an investor should understand
before investing. This book concentrates on the equity markets, but this does not mean that
other markets must be ignored. Market advice is to gain knowledge in other sectors over time
and then to move into those markets.
Different markets have produced vastly divergent average rates of return over the
decades. In the short term, on a fairly regular basis, markets will vary around an average or a
mean. These short-term variations are usually caused by aberrations, such as overpriced
shares or under-performance of some indices. However, when viewed from the long-term
perspective, it can be seen that short periods of over or under-performances are ultimately
reversed. Looking at the long term data provides investors with a fair platform for evaluating
markets and also establishes an evaluation tool to build a portfolio and to estimate future
reasonable equity movements.
Note: It is crucial to determine an investment criteria before building a portfolio. It is also
pointless to continually change that focus and this should only be done when personal
circumstance warrant such a move, e.g. do not change focus to take advantage of a short term
buying opportunity. Rather, set a percentage of total funds aside for speculative purposes.
Changing the structure of a portfolio should be done when personal circumstances change (e.g.
marriage, children, and old age) or based on changes taking place in local and international
markets (e.g. lifting of exchange controls to permit buying shares in foreign markets).
Step 5: Refining your general investment criteria
There is a fundamental principle in stock markets that suggest before buying any security (bond,
option, equity or futures) investors should carefully assess and investigate long-term data. This
gives investors a yardstick to measure whether something is too good to be true. If you are strict
in your application of your own long-term investment principle, you will buy a lot less pie in the
sky; remember to first look at long-term growth trends. This does not mean that investors cannot
take advantage of short-term market aberrations. This is discussed under asset allocation later
in this book, but it is sufficient to say that the investor should have a small percentage of the total
portfolio set aside for speculative purposes.
Investors are sometimes their own worst enemies and behave in an extraordinarily short
sighted manner. Foolish investors insist on making their long-term decisions based on very
recent experience and usually end up running from gloom and doom to euphoria. In the process,
basic discipline flies out of the window and, ultimately, their overall long-term investment growth
declines. Remember that a long-term outlook will always stiffen your resolve to stick with well
investigated and thought out investment plans.

Jungle Tactics

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Step 6: Assessing long-term data

The first question many investors ask is Why the long term? After all, South African stock market
analysts and political commentators repeatedly assert that the long term in this country can be a
little as a year. Weeks before the first democratic elections in 1994, the country moved daily
from optimism to threats of civil war. Yet, the long term does provide investors with a range of
reasonableness.
Therefore, long-term data provides investors with some very useful standards. The mid1980s and 1990s have been especially good to both stocks and bonds. In contrast, the late
1970s and early 1980s saw economic gloom. Opec cut off oil, sending prices to nearly US$70 a
barrel from the low US$10s. Many governments saw their deficits mushroom, inflation soared
and interest rates climbed to unheard of heights. Industry became bloated and even the US
could not compete effectively in international markets.
The markets forced the pace of change. Excesses of the past had come home to roost
and only stricter monetary and fiscal policies steadily brought down world inflation and interest
rates. Industry painfully modernised and became competitive.
Alongside the change in governments need to control markets to one of managing
economies, came unrealistic expectations. Many investors set themselves up to endlessly chase
rainbows as they expect returns of as much as 40% a year. As they fail to attain unrealistic
goals, they often move from advisor to advisor or scheme to scheme, to their detriment. In the
process, they inadvertently destroyed any possibility of achieving their long-term goals.
By placing faith in an accumulation plan based on a higher than realistic rate of return
projection, these investors may be setting aside far too little to meet their long-term goals. Many
establish withdrawal plans based on rates of return they cannot achieve in order to finance
lifestyles they can no longer afford. They run the risk of loosing their capital.
It is easy to become bogged down in statistics and clever analysis. Too much analysis can be as
confusing as too little. For instance, is it wiser to invest offshore than to invest in the local
market. After all, foreign markets came with different sets of investment criteria, varying cost
structures and too many unknown factors. Yet, it is this scenario that is being foisted on
investors through the phenomena of globalisation. As exchange controls are lifted in South
Africa, investors here are also having to face the reality of whether to invest offshore or in South
Africa.
Be wary of being overly analytical. A successful analyst knows that he has to start
sometime and avoid believing that he does not have enough information to make a decision. No
matter how much data some analysts have, it is simply never enough. No matter how many
options that are considered, there might be a better one. In the end, nothing gets done.
Unfortunately, unlike an accounting or engineering problem, investment data changes every
minute and the investor will never have all the data and so risk can never be eliminated.
Research can suggest superior strategies, but never perfect ones. Investors who wait for
perfect solutions may never get started.
Investors can no longer afford to play it safe in familiar territories, with known risks. The
following example highlights the crucial need to move into foreign markets. There are first a
number of assumptions that have to be taken into account, followed by a look at the
performance of international stock markets.
Assumptions:
The criteria for investment is not political risk, but purely to assess investment returns.
The equivalent money investment is assumed for local and foreign markets.
Growth in the FT 100 (UK), Dow Jones Industrial (US) and the JSE Industrial Indices are
used to highlight average growth rates that could have been achieved over a stipulated
period of time.

Jungle Tactics

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It is assumed that there were no economic, financial or political restraints to investing

offshore. This is to highlight future options for South Africans, once exchange controls are
finally removed.
The determined investment period is taken from 1990 to 1998. The time frame is important
as it was in 1990 that South Africa unbanned the African National Congress and other
political parties. It was thus the start of being accepted back into the global arena.
Actual exchange rates are used for the example.
Assumes no cost of transfers or brokerage rates.
Assumes no income from dividends.

Example:

Country
where
investment is made
Stock Market Indices
used
Investment Amount
Exchange
rate
at
January 1990
Investment
amount
using rate of exchange
Date of investment
Date investment ended
Indices at January 1990
Indices at end-May
1998
Growth of Indices

J. Smith

M. Roberts

S. James

South Africa

USA

UK

Johannesburg
Stock
Exchange Industrial Index
R1 million
-

Dow Jones Industrial

Index
R1 million
Rand/US$ = R2.50

FT 100
R1 million
Rand/UK = R4.12

R1 million

US$400,000

UK242,718

January 1990
May 31, 1998
2795
9229

January 1990
May 31, 1998
2659
8970

January 1990
May 31, 1998
2437
5865

230%

237%

141%

Looking at percentage increases can be confusing and the above rates of return would seem to
suggest that it is wise to have first invested in the US, followed by South Africa and then the UK.
Second impressions investors often get are that if the amount of research and cost it takes to
invest in unknown companies in a foreign country are taken into account, it would simply have
been better to invest all funds in South Africa. This is particularly true when the percentage
difference is as small as seven percentage points.
However, if other factors are taken into consideration, including the effect of exchange
rates, inflation and interest rates, then a different picture arises.
Create wealth, not just income
Investors have to determine real rates of return. The first step is to subtract the average inflation
rates from the above rates of return. If we do not account for inflation, we are just fooling
ourselves. We want to be wealthier, not just have more inflated rates of return. This means tax
rates must also be taken into account.
A rate of 30% is assumed for all three countries as rates have changed substantially and
include various forms of taxes for the different countries over the determined period; while
average marginal tax rates were often much higher during the period covered, shares offer the
prospect of both deferral of tax and capital gains tax, which is not built into this simplistic model.

Jungle Tactics

- 85 -

Growth of Indices
Capital growth
Value of total investment
Less inflation (ave. 1990
1998)
Value of investment prior
tax
Tax (ave. 30%)
Net investment
Exchange rate @ end-May
1998
Value of investment in
Rands

J. Smith

M. Roberts

S. James

230%
R2.3 million
R3.3 million
R287,100
(@ 8.7%)
R3,012,900

237%
US$948,000
US$1.35 million
US$42,200
(@ 3.2%)
US$1,306,800

141%
UK342,232
UK584,950
UK16,963.5
(@ 2.9%)
UK567,986

R903,870
R2,109,030
-

US$392,040
US$914,760
Rand/US$ = R5.15

UK170,396
UK397,591
Rand/UK = R8.34

R2,1 million

R4.7 million

R3.3 million

One last check for investment

Would it be better to invest the R1 million in the safe haven of a banking savings account?
Assuming a compounded growth prime rate of 20.25% a year for the full review period of
January 1990 to May 1998, the following rate of return would have been achieved:
Initial Investment
R1 million
Compound growth (@ 20.25% a year: 1990 to R2.1 million
1998)
Total investment
R3.1 million
Less inflation (ave: 1990 to 1980 @ 8.7%)
R269,700
Pre-tax investment
R2,830,300
Less tax on interest (@ 45%)
R1,273,635
Net investment
R1,6 million
Due to the effect of compounded interest, what seems like a relatively small initial percentage
ends up being as high as 210% (R1 million to R3.1 million) over the review period. However, if
inflation and tax are taken into account, the difference in the rate of return between equities and
risk-free investments is vast.
Have we learnt anything from all this? In fact, much has been assessed and learnt. Should
South African investors keep their money in the bank, place these in South African shares or
invest overseas. The answer will differ between investors, but the following is a broad guideline.

Have a long term view.

Keep to that long term view. This does not mean that investors cannot have a set
percentage of funds available for speculative purchases.
Create your own asset allocation (see later chapters).
If your view is positive about the country youve invested in, keep to your asset allocation. If
the view is pessimistic, average out of South Africa. In other words, transfer funds out of
your portfolio over a period of time, until you achieve the level that you feel comfortable with.
In essence, the higher the level of negativity, the less (even no funds) remain in the country.
Over time, diversify into numerous countries. Do this as knowledge of new stock markets is
gained.

Jungle Tactics

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Another yardstick for the land bound

There is another yardstick for investors who wish to keep their investments in one country, called
land bound. In addition to compound savings, it is useful to compare stock market returns to the
relatively risk-free debt instruments, such as gilts, Convertible Debentures and annuities.
Investments in equities usually offer long-term returns that are sufficient to overcome inflation. In
addition, these are traded daily and thus the share prices will fluctuate in value. Market
fluctuations enable investors to average their investments (see Chapter on mathematical
formula). This means that when prices go down, the investor with a positive long term view can
acquire the share at an ultimately long-term discount.
If the investor cannot handle market fluctuation, savings are a better option than the
equity market. However, a saver who places his funds in main bond issues (the R150 or E168)
will actually see his savings shrink, if the effects of tax and inflation are deducted from his
proceeds. In South Africa, investors who opt for the bond market should abandon long term
hope of achieving an after-tax, after-inflation rate of return. Neither does the stability of CDs
translate into long-term security. Viewed from this perspective, the government-guaranteed
savings plans are not wise, conservative or responsible. They are actually almost guaranteed to
shrink in value.
Remember, interest rates are high during periods of inflation and a progressive tax eats
away more at the higher nominal rates of return. In addition, these zero-risk rates of return are
very closely tied to inflation rates. So if you just want to keep up with inflation, you can
accomplish that limited objective with debt instruments.
SUMMARY
Another way that investors can look at data is to assume that the inflation rate is a
negative starting point. For instance, if the inflation rate was 10% in 1995, investors
should target 20% in 1996 to achieve a real return of 10% (return minus inflation). The
inflation rate is thus a useful yardstick to determine a target minimum long-term rate of
return.

Long-term data provides investors with a necessary "reality check." Prudence and realism
would dictate use of the more conservative data for planning. If we get more, we will all be
pleasantly surprised. No matter how you look at the data, equity returns ultimately swamp
anything available in savings or debt instruments. Only equity offers investors the
prospect of real rates of return.

Answer questions to the following Investor Checklist:

Investor check list

Does the investment meet your personal investment goals?
Whether you are investing for long term growth, investment income or other reasons, an
investment should match your own investment goals.
Are claims made for the investment realistic?
Some things really are too good to be true. Use common sense and get a professional
opinion when presented with investment opportunities that seem to offer unusually high
returns compared to other investment options. Pie in the sky promises could spell investment
fraud.
Do you understand and accept the risks involved with the investment?
Every investment involves some element of risk. You should know what these risks are and
be prepared to accept them. If you can't afford the risk, don't take it.

Jungle Tactics

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Are you putting too much money into one investment?

Putting all your eggs in one basket is a risky proposition. If the investment fails, you stand to
lose everything. Wise investors put their money into a variety of investments to achieve a
balanced portfolio and to spread their risk around.
Can you sell the investment when you want to?
Find out if you can sell the investment and, if so, how. Can you sell it through an exchange
where sales are made easily and quickly--or do you have to find a private buyer who may not
be so easy to find when you want--or need--to sell in a hurry?
Are you familiar with the conditions that apply if you withdraw from the investment?
Find out if there are any restrictions or penalties that apply if you want to withdraw from or
sell the investment in the future. Sometimes you end up paying a substantial penalty if you
want to cash out early.
Has the seller given you written information that fully explains the investment
Make sure you get proper written information, such as a prospectus or offering circular,
before you buy. The documentation should contain enough clear and accurate information to
allow you to evaluate the investment.
Have you read the disclosure information about the investment?
Reading the written information carefully is one of the most important steps in making wise
investment decisions.
Do you understand the investment after reading the information?
Don't commit to an investment you don't understand. Get professional advice if you have
trouble figuring out from the promoter's written information just what the investment is all
about

If you do make an investment, have you kept copies of the written information and all
records of your transactions in case there are problems in the future, and for tax
purposes?

Jungle Tactics

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CHAPTER 10: THE INTERNET THE INVESTORS BIBLE

Common knowledge is useless: Everybody knows that shares provide growth; this is the
assumption of almost all pundits, and, inevitably, most investment advisers. In reality, the
experience offered is only based on the rising side of a business cycle. As a result, most people
assume that rising prices are a way of life. They are not. Falling prices are perfectly normal. It
is just that euphoria causes forgetfulness and, therefore, to outperform the market an investor
needs access to global information resources the Internet is that source.

Investors need information. Not only information on South African companies, trends, market
changes, corporate finance and governance, but also on international trends. The emerging
market crash in 1998 indicated that South African investors need to know more about world
trends, volatility factors that affect global markets and a dire need for information on first world
economies.
For instance, the US market is dominated by low inflation, low unemployment and falling interest
rates, while Europe is joining hands in a powerful integrated market that could become a global
capitalist force in the year to come. There is only one efficient method of obtaining information
on any subject known to mankind the Internet.
There are numerous books in the market on how to operate the Internet and it is not my
intention to provide even a guideline in this book. However, I do provide a basic structure for
research through as breakdown of Internet sites (web addresses). These will change over time
and investors will find many more links to other sites from the ones recommended in the
following text.

The only way to conduct research

The methodology of research differs between analysts worldwide. However, the basis is always
a logical progression:

Macro research: Background research on a specific subject and the environment it operates
in (local and globally).
Micro research: Indepth analysis of specific subject.

Example: Investor wishes to buy shares in South African listed oil company Engen Ltd.
MACRO: Search the archives of business newspapers and magazines for general
background on:
A specific company, i.e. Engen Ltd
The sector that a specific company operates in, i.e. Engen operates in the South
African chemical & oil sector.
Competitors, i.e. Shell, Caltex, BP, Total, Sasol and others.
Get the graph of the share and the investor should ask his stockbroker (or advisor) for
an explanation of major share movements, i.e. Malaysian company Petronass takeover
of Engen saw the price fluctuate before the announcement as market speculation took
place.
Global oil trends: Information could be obtained from international petroleum magazines,
the OECD, World Bank or IMF.
If the investor intends to undertake a serious investment in a specific share, he must
undertake research of the holding company (Petronas) and obtain the annual report of
the specific companies.

MICRO: Obtain specific information, which includes:

Financial year end reports, i.e. web sites like E-Data and BFA supply this information.
Corporate changes.

Jungle Tactics

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Risk-to-return profiles.

Before investing in a share, investors should understand fundamental factors that affect a
particular business for at least the past 18 months.
Searching for information
There are two basic ways of searching for a subject:
Using a search engine. Each engine has its own pre-requisites and the investor must first
read the instructions. For instance, engines like Yahoo, AltaVista, InfoSeek and Lycos have
different pre-requisites for searching, i.e. some engines permit multi-word search, while
others do not. There are many search engines available and many more will become
available in the future. However, the one that I use most often, as it combines a host of other
engines in its search is called:
HuskySearch

http://huskysearch.cs.washington.edu

Using a web address. This is a direct link to a web site and the following text highlights
some important addresses. Note that all Internet systems enable users to save a site
address in a bookmark. So, if you are surfing the Internet and come across a site that you
would like to return to at some later stage, click on add to bookmark.
Publications: South African media

Web Address

AP Update
Business Day
Business Times
Cape Business News
Mail & Guardian
Search The South African Press
South African Broadcasting Corporation
South African newspapers: General
The Financial Mail
The Star
The Sunday Independent
Times Media Limited: combination of a number of
media

http://www.newsday.com
http://www.bday.co.za
http://www.btimes.co.za
http://www.cbn.co.za
http://www.mg.co.za /mg
http://gogga.ru.ac.za
http://www.sabc.co.za
http://ecola.com/news/magazine/af/za
http://www.fm.co.za
http://www.star.co.za
http://www.sunday.co.za
http://www.netassets.co.za

Publication: International media

Web address

Black Enterprise
Business Week
CNN
Financial Times
Fortune
Hong Kong Standard
International Herald Tribune
International Press: General sites
Investment Week Online
Los Angeles Times
Petroleum Economist
Reuters Home Page
The Economist
The G-7 Report
The Guardian
The Sydney Morning Herald
The Times
Time Magazine

http://www.blackenterprise.com
http://www.businessweek.com
http://cnn.com
http://www.ft.com
http://www.pathfinder.com/fortune
http://www.hkstandard.com
http://www.iht.com
http://www.york.ac.uk/student/osa/press
http://www.invweek.co.uk
http://www.latimes.com
http://www.newhert.com/pe/homepage
http://www.reuters.com
http://www.economist.com
http://www.g7report.com
http://go2.guardian.co.uk
http://www.smh.com.au
http://www.the-times.co.uk
http://www.pathfinder.com/time

Jungle Tactics

The Sunday Times (UK publication)

Wall Street Journal
World News
World's Emerging Markets

- 90 http://www.sunday-times.co.uk
http://www.wsj.com
http://www.tradeport.org
http://www.businessmonitor.com

Companies (listed and unlisted)

E-Data
Mbendi: Listed & unlisted African
companies
McGregor BFA
Share prices & JSE Indices
Top South African Companies: 1998

Web address
http://www.edata.co.za/edata
http://mbendi.co.za/coaf.htm

Bourses and markets

Web address

Dow Jones Markets

Emerging Markets
Bank of America
Global Investment Index
JSE
World Indices

http://www.djmarkets.com
http://www.emgmkts.com/toc/toc.htm
http://www.bankamerica.com
http://home.pi.net:80/~toorop
http://www.jse.co.za
http://www.trustnet.co.uk/indices

Stockbrokers

Web address

Bank of America
DMG
General Brokers Page
Full list of South African stockbrokers
JP Morgan
Smith Barney Access
Sumitomo

http://www.bofa.com/econ_indicator/wallov.html
http://www.dmg.co.za/Research
http://www.best.com/~magus/brokers/index.html
http://www.jse.co.za
http://www.jpmorgan.com
http://www.smithbarney.com
http://www.sumitomocorp.co.jp/index.html

Economics

Web address

Department of Finance
Economic Forecasts & Review
Economic history
Economic Outlook: U.S. and the World
Economy-Wide
Encyclopedia of the New Economy
Far Eastern Economic Review
General Economic Topics
Global Financial Data Sample Data Series
IMF World Economic Outlook
Institute for International Economics
InvestorGuide: Economics
Standard & Poor of Data Releases
Surf Sites For Economists & Capitalists
The SA Economy
US Department of Commerce

http://www.finance.gov.za
http://www.dirus.com/Economic/EconomicMonthly
http://www.econ.cam.ac.uk
http://www.newyorklife.com
http://www.census.gov/econ/www/widemenu.html
http://www.hotwired.com/special/ene/index.html
http://www.feer.com
http://www.mlinet.com/mle/ec_5100.htm
http://globalfindata.com
http://www.imf.org
http://www.iie.com
Http://www.investorguide.com/Economics.htm
http://204.151.55.106/calendar.htm
http://staff.uwsuper.edu/homepage/rbeam/Web.htm
http://www.infobahn.co.za/stats.htm
http://www.doc.gov

http://www.bfanet.com
http://www.sharenet.co.za/webgraph_en.htm
http://www.fm.co.za/topco98/index.htm

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Economic organisations

Web address

CSS
IMF
Joint Bank-Fund Library Network
National Bureau of Economic Research
OECD Statistics
Sacob
Sapia
SARB
United Nations Home Page
US Federal Reserve
World Bank

http://www.css.gov.za
http://www.imf.org
http://jolis.worldbankimflib.org
http://nber.harvard.edu
http://www.oecd.org/statlist.htm
http://www.sacob.co.za
http://mbendi.co.za/sapia/index.htm
http://www.resbank.co.za
http://www.un.org
http://www.bog.frb.fed.us
http://www.worldbank.org

Politics

Web address

ANC
General political sites:
IFP
National party
Nedlac
SA government

http://www.anc.org.za
http://www.w3.org/pub/DataSources/bySubject/politics/O
verview.html
http://www.ifp.org.za
http://www.natweb.co.za/index.htm
http://www.nedlac.org.za
http://www.polity.org.za/gnu/gnuindex.html

Investor tools

Web address

Coopers & Lybrand South Africa ETaxman

Finance Tools: Ratio Analysis
Financial Encyclopaedia

http://www.za.coopers.com/e-taxman/e-taxman.htm

Investment Research - Stocks,

Commodities, Technical Analysis
The Online Handbook

http://www.cybersolve.com/analysis.html
http://www.euro.net/innovation/Finance_Base/Fin_encyc
.html
http://www.thegroup.net/invest/ichome.htm
http://home.netscape.com/eng/mozilla/3.0/handbook

Examples: Research into oil industry, with particular reference to listed South African oil
giant Engen:

Background check on Engen (historic news events): The Internet sites of Business Day,
Business Times, and The Financial Mail and Top 100 companies (Business Times and Financial
Mail).

Specific research into Engen: The Internet sites of E-Data (Actual annual reports), the
company site (if it exists), analysis (McGregors/BFA Network) and share price movement
(Share Net).
Sector research: Association (Sapia web site), for industry trends, Government site
(white/green papers on the Petroleum Industry).
World research trends (IMF, OECD, World Bank).
Research on new holding company Petronas (Petronas site).

Summary:
The use of the Internet is the easiest, cheapest form of communication, gathering
information and reaching directors and experts (in all fields) across the globe.
In addition to the Web, the Internet provides users with e-mail facilities (a mailing system
to communicate across the Web) and other systems of gathering information.
For investors who wish to communicate with me, my personal e-mail address is:
magliolo@icon.co.za.

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CHAPTER 11: IF YOU TAME RISK, THE BEAST CAN BE

YOUR FRIEND

Risk: in an investment, the uncertainty that you will get an expected return. In insurance, the
uncertainty whether a loss will occur.
Risk tolerance: a person's capacity to endure market price swings in an investment.

Here is a truism: everybody is risk averse. Although it is rational and normal to be concerned
about investment risk, it is not reasonable to become so concerned that it develops into fear. It is
this exaggerated fear that keeps too many people from making appropriate and logical
investment choices.
Use this knowledge to your advantage. Keep calm during not only strong bear trends, but
also strong bull runs. It is as easy to get caught up in the feeling of euphoria during bull runs, as
it is to become irrational during bear runs. Remember the lesson learnt in the previous chapter: If
you stick to your well thought out, pre-determined, long-term investment philosophy, short-term
investment risk should be minimised.
Conventional wisdom that the stock market is treacherous and dangerous, certainly contributes
to the problem. The reality is that this expression is often incorrect. In fact, shares have been a
highly reliable engine of wealth for long-term investors (as observed in the previous chapter). In
this section, it is concluded that market risk is almost exclusively a short-term phenomenon that
declines over time. Actually, not being part of the market may be one of the biggest risks of all.
South African investors have probably the best example world wide of this fact. Between 1990
and 1998, which saw the Industrial Index rise by over 200%, the market was hit by extreme
levels of positive and negative news; the unbanning of political parties, the failure of peace
negotiations with the collapse of Codesa, the assassination of Chris Hani (secretary general of
the South African Communist Party), massacres at Boipatong and Shell House and pre-election
bombings. On the positive side, the general election in 1994 was peaceful and the Apartheid
years came to an end.
The following section investigates risk, which investors perceive to be a beast in the
market. Where does it come from, how it is measured and how it can be managed? This
information can be used to construct an efficient portfolio, which aims to obtain the maximum
amount of return for any level of risk or achieve the investors long-term targeted rate of return
with the least amount of risk.
The starting point to understanding risk and thus taming the beast is to imagine an
investment world without risk. Under such a scenario, all returns are known and thus certain.
Investors would, naturally, decide that the higher the return, the better. Presented with two
investment choices, all investors would chose the option offering the higher rate of return and
the second option would thus cease to exist. Everyone would get the same investment result
and no one could aspire to a higher rate of return.
Risk separates investors from savers
If risk is introduced in one of the above investment choices, the results become variable. True
choice now exists, but investors are faced with a dilemma. They can opt for a known result, but
the desire for higher returns becomes tempting. The investor is trapped between wanting a
certain result and wanting more. Some investors will select the known result, but others will
decide to go for the higher rate of return even if there is an associated risk.
Acceptance of risk is what separates savers from investors. The successful investor must come
to terms with the implications of accepting risk and accept that he cannot have it both ways. He

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cannot hope for higher returns without accepting positive and downward fluctuations. Remember
a long-term investment strategy incorporates and makes allowances for downward fluctuations.
However, it is crucial to a sound strategy that the risk tolerance be determined before the
portfolio is started (see asset allocation chapter).
The amount of additional return that must be offered to an investor in order to pry him away from
his known result is called the "risk premium." One reason that investors change their risk
premiums as a result of recent events goes a long way towards explaining market excesses.
An analysts definition
Stock market returns can be described as random distributions with a strong upward bias. Over
a long period of time, returns in a market (or a particular sector of the market) remain fairly
constant. This is called the mean or average long-term return. However, there will be periods
when the market underperforms (or overperforms) the long term upward trend. These
fluctuations are often followed by the market returning to the mean. The principle is that
investors will buy shares when they perceive the market is undervalued or sell shares when they
think the market is overvalued.
This action by investors results in the market returning to the mean. It's important to
understand that risk does not necessarily mean a loss. All investments vary a little from year to
year, even savings accounts, so they have a measurable risk. However, in the case of a savings
account, a loss is never expected.
Other markets will have different rates of return and, therefore, different averages or
levels of mean also called the standard deviations.
Sources of Risk
Risk comes from several sources:
Risk the following three are discussed under Asset Allocation

HIGH RISK
Futures/Options &
Commodity trading

Step 2: Move into high

quality Index stocks
(Indexing), Real estate
and aggressive growth
unit trusts

MEDIUM RISK

Step 1: Unit trusts, government securities,

savings, bonds, Treasury Bills and mutual
funds; low exposure to equity market.
Financial
Plan

Financial records, Budgets, Goals,

Property, Insurance, Pension plan

FINANCIAL FOUNDATION

LOW RISK

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The above diagram shows low to high risk these can be further split into:
Business risk: A company could go bankrupt and leave shareholders with worthless
investments.
Market risk: Even if you have a strong company, a bear run can reduce the share price.
Interest rate risk: The value of bonds varies inversely with interest rates. Shares and other
property are also affected by general interest rates.
Inflation risk: Your investment may not keep pace with inflation, resulting in a decrease in
wealth.
Currency risk: Foreign holdings may change in value as exchange rates fluctuate.
Political risk: Governments can do something to harm the economic climate. This can vary
from raising taxes, revolution, war, or confiscation of property, to imposing a minimum wage.
Investor behaviour: Incorrect timing or share selection may not produce a return sufficient
to cover portfolio costs and may introduce additional risk to the portfolio.
Risk is part of the investment process
Each risk can be alleviated and managed using well-defined techniques. The ideal is to manage
a portfolio to achieve the maximum level of return at any level of risk. In other words, achieve
goals with the least risk possible and develop a strategy that has the highest probability of
success.
In the real world, investors define risk in a variety of ways. Mention risk and many will
begin to imagine total, irrevocable, total loss of their capital. The first issue is to assess
fluctuation which, it must be stressed, does not result in loss of capital.
Fluctuation is just fluctuation, not loss of capital. Here is an example that should make
the difference clear. Let's say you believe your backyard contains gold. After a million rand of
drilling expenses, it turns out there is no gold. No matter what you do or how much more money
is ploughed into the project, no gold is discovered. Bottom-line? Your money is gone. You have
had an irrevocable loss of capital.
Let us say you took the same million rand and bought a diversified stock market portfolio.
You then have an unusually bad result the first year, and lose 70%. Well, calm down. All you
really had was an interesting fluctuation and not a capital loss. You will only have a permanent
capital loss if you sell while the market is down. Remember, markets have always recovered in
the past and will recover in the future.
Past history indicates that all you must do to recover and go on to acceptable profits is to
hang tight. While an individual stock can certainly go to zero value, entire markets don't. Except
for war or revolution, I am unaware of any market that has gone down without recovering. As
long as we expect the value of the world's economy to continue to grow (even at low levels,
albeit for a short time) the value of the securities markets will reflect that growth. Equity investors
will profit and will be rewarded handsomely for enduring the aggravation that risk entails.
The latest example is the October 1997 Crash, which saw the US Dow Jones decline by
nearly 20% in less than three weeks. The Crash came after months of speculation that the Far
East was overvalued, had structural problems with its banking sector and global deflation would
cause the world to enter a severe economic recession. After less than three months, the market
had recouped all its losses and had made gains on the pre-October 1997 Index.
Factors that multiply risk
There are numerous factors which cause capital losses. In addition to selling when the market is
down, the type of shares and markets invested in could play an important role in determining the
final outcome of a portfolio. For instance, investing in a few shares or in a few sectors can be too
concentrated and could result in lower returns than other shares or markets. Involvement in
higher risk shares or sectors can also result in lower returns than the mean.

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Some factors do magnify risk. For instance, speculation in high risk non-equity markets
like Options, Futures and Commodities carry an inordinate amount of financial reward or loss
risk. Many speculators have been wiped out in the past. Ironically, these markets exist to allow
business or investors to hedge risk and insure themselves against an adverse move in the
equity market. Used in this manner, hedgers can usually accomplish their goal at a nominal cost.
Other market risks
Treasury Bills have low returns and little risk. Called T-Bills or TBs, these instruments have
never had a loss, but neither do they provide investors with meaningful real returns. In addition,
long-term T-Bs have displayed surprising volatility as interest rates change or on the rumours of
a change in interest rates. Many investors with "safe" government or corporate bonds have been
shocked to see how much their capital account varies as interest rates change.
Commercial bonds show some increased risk, but still have disappointing returns.
Turning to stocks, the JSE Industrial Index shows an increased amount of risk, but has
generated meaningful real returns despite high political and business risks. Small company
stocks have even higher returns, but also have the highest amount of variation. Not everybody
wants to endure this much fluctuation in their accounts.
Market risk is short-term risk
Successful investors know market risk is a short-term phenomenon and that it decreases
dramatically over time. The longer we hold a risky asset, the more risk decreases. Even the
highly reputed and well documented US-based Standard & Poor (S&P) 500 Index, shows that
the longer investors hold an asset, the lower chance they have of making a loss in the long term.
The S&P 500 shows that there has never been a loss during any single 15-year period since
1926.
However, the pattern of returns does change as the length of time an investment
continues, i.e. from one to five years, 10 to 15 years and 15 to 20-year holding periods. There is
much less variation during longer holding periods, while the chance of loss is reasonably high
(as much as 30%) in any first year, but that risk diminishes rapidly over time. Even during the
Great Depression of the 1930s there was not a loss while holding blue chip stocks for at least a
15 year period.
So, market risk does decrease over time. Even the risk of inflation decreases over time.
The chance of beating inflation starts out better with stocks and rises to almost certainty at 20
years. No one who held the S&P 500 for any 20-year period since 1926 has ever failed to beat
inflation. The chance of beating inflation with bonds is lower than with stocks in early years and
falls sharply over time.
The risk-reward line
If a risk to reward line is plotted, we come up with the risk-reward line we all know intuitively
exists. Note that markets are far too efficient to allow higher rates of return without increased
levels of risk. In other words, it is extremely unlikely that an investor is able to find an investment
with high returns and low risk. There is simply no high return investment without high risk. If
investors keep this rule in mind, most of the boiler-room operations would be out of business
overnight and many of the horror stories we have heard would never happen.
As we have seen, there are several ways investors may view risk. They might want to consider if
the real risk is the failure to meet their goals. If so, they will want to construct portfolios that have
the highest probability of meeting their objectives. The paradox they must deal with is that what
appears risky in the short term turns out to be very conservative in the long term. The longer
your time horizon, the more certain you are that stocks will outperform alternatives. Given the

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higher rates of returns associated with stocks and the strong probability of attaining those
superior returns, what long-term investor would want to be protected against that?
An appreciation of risk will make you a better investor. Remember that risk is real and it
is built right into the investment process and risk should not prevent you from making rational
investment choices. Still, it's the central problem in investment management.
Most investors have probably realised by now that with risk in equities so closely related to a
holding period, time must be a very important dimension of the investment problem. A
professional portfolio manager will pay close attention to an investors personal time horizon to
meet specific needs. No one can eliminate investment risk, but there are effective techniques to
manage different types of risk.
Risk classes
Before the different classes are outlined, investors should note that while nobody can entirely
avoid risk, investors can choose the type of risk they wish to bear. In addition, investors should
expect to be compensated for risk and that without risk no one can expect rewards above the
zero risk rate of return.

Business risk is the risk of an investment being wiped out by a business failure. However, a
business need not fail to cause your holdings to be unprofitable. It can come on hard times,
which will severely affect the value of its securities. Even large, established institutions or
industries can decline and fade as their products become obsolete.
Indeed, under globalisation some industries find themselves unable to compete efficiently in
a shifting global economy. However, this risk can be almost reduced to the point of
insignificance. Diversification is the basic investor protection strategy, which offers the only
free lunch in the investment business. If an investor owns a single share and that company
goes broke, the investor has lost his entire portfolio. If the company that went broke is only
one-tenth of one percent of the investor's portfolio, the investor will hardly notice. Single
companies do go bankrupt, but entire markets do not.

As the number of positions held increases, business risk falls rapidly. However, it is crucial
for investors to understand that expected rates of return do not fall as a result of
diversification. Only the variation around the expected rate of return falls. Note that variation
is risk. Investors are never compensated for a risk they could have diversified away.
Securities are priced assuming that investors hold diversified portfolios.
The rational investor will consider the merits of each investment before including it in their
portfolio. Investments should have attractive risk-reward characteristics as well as add a
diversification benefit to the portfolio.

Market risk: There is no method of diversifying market risk. No matter how well an individual
company performs, its price may be affected by broad local and global market trends.
Therefore, the argument that market risk is primarily a short-term problem signifies that
equity investments are not suitable for short-term obligations.
Therefore, it is important to have all financial obligations sorted out before setting up a
portfolio of shares. It would not be professional to sell shares at a loss because you needed
to cover an expense that should have been anticipated. Markets do not all move in the same
direction at the same time. A properly diversified portfolio should have shares in contracyclical sectors (see chapter on Markowitz).

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Interest rate risk: As interest rates rise, the value of existing bonds fall and the cost of
leverage for listed companies rise and shares become less attractive to investors. Even if
risk premiums don't change, the zero risk rate goes up with high interest rates. The resulting
higher return requirements will cause share prices to decline.
In addition, high interest rates are often associated with inflation expectations, which are
generally a sign that the economy is not healthy. Interest costs will impact on some
businesses much more than others. Financial institutions and highly leveraged companies
will suffer. Higher costs to finance real estate will have a major impact on that market.

Political Risk: From central to local government, the impact of interference in business can
be substantial. Analysts often equate political risk with international or emerging market
investing, but first world markets are just as sensitive. Political risks include tax, trade,
regulation, education, social policies and delivery of municipal services. A government's
attitude on capital and business sets the stage for either success or failure of its economy.
However, political risk is not always negative. In a country where political risk is falling,
investors can expect earnings in the economy to increase as the economy expands, but on
the back of higher price:earnings ratios. For investors with cast iron nerves, look for
economies where political risk is extremely high, but expected to decline, e.g. conversion
from dictatorship to free market. As political risk falls, the economy expands and with it the
markets.

Currency risk: In the global market, investors quickly discover the risk of currency
fluctuation. Even if investors chose not to invest in foreign markets, they could not avoid
currency risk. If the value of a local currency declines, imports become more expensive,
prices are increased and consumer spending patterns change and in many cases
(depending on how much the currency devalues), inflationary pressures result in an interest
rate hike.
Global equity holders are affected in a different manner. For instance, if a South African
shareholder had stock in Company XXX, a brewer based in the US, what would the net
effect be of a 10% currency devaluation in South Africa?
Sales, operating profit and attributable profits of Company XXX would only be affected if it
sold its products in countries that had a currency devaluation. If all its products are sold in
the US, for instance, and it obtained all its raw materials at little change in costs, there
should be no effect on the share price. However, if the investor sold his shares, he would be
paid in US dollars, which when converted into rands would provide him with 10% more
rands. This is called a rand-hedging stock as it provides the holder with some protection
against currency devaluations.
Portfolio managers attempt to develop global strategies based on the relative impact of
currency shifts in different industries, i.e. exports and tourism are bolstered by a falling
currency, while imports become less affordable and foreign holidays less attractive.
Many foreign governments have tied their currencies to the dollar and, as the dollar falls,
their exports also become more affordable and the trend contributes to their economic
development. Most commodities are still quoted and traded in US dollars. Companies,
industries and countries that are heavy commodity users will benefit from a falling dollar. For
instance, if a German company consumes large amounts of oil, and if the dollar is weak
against the German mark, their price of oil will decrease even if the nominal price of oil

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remains flat. That company will experience lower costs and higher profits. These profits
should increase the share value of the firm.
American investors holding foreign stocks will profit, or at least offset some of their losses in
domestic holdings. The long-term dollar weakness has been a distinct advantage to
America's international investors. As with most market trends, there are occasional periods
of reversal. But the average American's fear of currency risk would appear unjustified in the
light of other benefits of foreign investment.
Hedging
In the short term, currency risk can offset local market gains. Or, even worse, local market
losses could be compounded by currency losses. So every global investor must decide whether
he wishes to hedge against currency fluctuations. In most developed markets and some
emerging nations fluctuations can easily be hedged against all market fluctuations; currency risk
is only one factor. For instance, a perfectly hedged foreign bond portfolio would perform exactly
like a T-Bill minus the transaction costs of the hedges.
Portfolio managers are sharply divided on the subject of hedging. Some take the position
that currency risk will work itself out in the long run and the price of hedging is not worth it.
Others believe that they can properly forecast currency swings and add value while reducing
risk.

Conclusions
As you can see, portfolio managers have a full menu of techniques to reduce risk. Many rely on
forecasts, and the result will be only as good as the forecast. All rely on diversification, while
some depend on hedging.

Summary
Distinguish between saving and investing: Saving and investing are seemingly
interchangeable terms. However, there are several important distinctions between the two.
Savings: the accumulation of money to meet a short-term goal, i.e. holiday. Savings
includes bank accounts and certificates of deposit, which pay a fixed rate of interest. Money
market mutual funds are also considered a savings vehicle, although these have yields that
fluctuate.
Investing: Unlike saving, which imply safety and conservatism, investing means taking a
measured degree of risk with your assets in pursuit of higher returns over a longer time
period. Investment programs based on stocks and bonds have offered higher returns than
safer investments, but they also decline in value from time to time.
Key Differences:
Investing means putting money to work to make more money by capitalising on economic
growth.
Saving means putting money aside, often to earn interest that generally remains stable
regardless of economic growth.
Investing exposes your money to some level of risk.
Saving offers safe storage for your money.
Investing offers the potential for realising capital gains (or losses) when you sell your
investment.

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Saving offers no potential for capital gain (and minimal risk of loss) when you close your
account.
Investing measures success by the amount of your total return.
Saving measures success by the interest you earn.
Investing has rewarded patience in the past with total returns that outpace inflation.
Saving offers a stable, but low level of income that historically has failed to outpace
inflation.

Establish a foundation for investment: Before an investor can build up an investment

programme, it is critical to lay the foundation with a short-term savings plan. Short-term goals
are monies you may need within five years. Many financial planners recommend an emergency
fund of three to six months' worth of living expenses, especially in South Africa, where
retrenchments and redundancy are commonplace. Add to that your savings for other short-term
goals before setting your investment strategy.

Savings should be accessible and safe. Common choices are bank accounts, CDs, and
money market mutual funds. For investors willing to take some risk, short-term bond funds are
an alternative. Once a short-term savings plan has been established, the foundation is set for
building a sound, long-term investment programme.

This is set out in the next chapter.

Jungle Tactics

CHAPTER 12: TAKE

PORTFOLIO TACTICS

- 100 -

LEAF

FROM

MARKOWITZS

Harry Markowitz
1990 Nobel winner of economics
The basic concepts of portfolio theory came to me one afternoon in the library while reading
John Burr Williams's Theory of Investment Value. Williams proposed that the value of a stock
should equal the present value of its future dividends. Since future dividends are uncertain, I
interpreted Williams's proposal to be to value a stock by its expected future dividends. But if
the investor were only interested in expected values of securities, he or she would only be
interested in the expected value of the portfolio; and to maximise the expected value of a
portfolio one need invest only in a single security. This, I knew, was not the way investors did
or should act. Investors diversify, because they are concerned with risk as well as return.
Variance came to mind as a measure of risk. The fact that portfolio variance depended on
security co-variances added to the plausibility of the approach. Since there were two criteria,
risk and return, it was natural to assume that investors selected from the set of Pareto optimal
risk-return combinations.

Harry Markowitz received the Nobel prize for economics for his theories of modern portfolio
tactics, which highlight new and better methods of controlling risk. In his Modern Portfolio Theory
(MPT) he starts out by assuming all investors are risk averse and defines risk as a standard
deviation of expected returns. The difference between his thinking and previous other portfolio
theories is he believed that, instead of measuring risk for a specific share, risk should be
measured at the portfolio level.
Therefore, each individual investment should not be examined on the basis of its
individual risk, but on the contribution it makes to the entire portfolio.
In addition to an assessment of risk and return, Markowitz believed it is important to assess how
investments can be expected to move together or, said differently, how investments correlate to
one another. Today, many portfolio managers use his portfolio techniques for asset classes
instead of individual stocks; thus constructing globally diversified portfolios.
Concept of correlation
Correlation is a very simple concept. If investments always move together, there is perfect
correlation, and that is assigned a value of +1. If they always move in opposite directions, there
is perfect negative correlation, and that value is -1.
If you can tell nothing about the movement of one investment by observing another, they
have no correlation, and that relationship is assigned a value of 0. Of course, two investments
can fall anywhere in the spectrum between +1 to -1 in relation to one another.
Take, for example, the correlation of two retail companies. Both the companies are
affected by interest rates, cost of labour, technology, consumer purchasing power and cost of
fuel. Investors could expect (barring growth from acquisitions) that the share prices of these
companies would have a similar movement throughout the market cycle and, therefore, these
two shares could be considered to have a strongly correlation.
However, there are factors that can be negative for one industry, but positive for another.
In the above example, if the price of oil rises, oil multinationals would benefit, but retailers are
expected to suffer. As a result, the price of their stocks should move in opposite directions and
these have a low, or negative, correlation.
How does the investor benefit from Markowitz?
Lets assume there are two high-risk, high-return investments in different parts of the world. In
addition, the second investment has perfect negative correlation with the first. Every time the first

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share price moves upwards, the second will decline, and vice versa. If we put these two
investments in a portfolio, will the combined portfolio have high return and zero risk?
Short-term gains in one holding are perfectly offset by losses in the other investment.
However, because the underlying trend in both investments is a high return, the combination has
a high return. Can this be true? In reality, investors will never find two holdings with perfect
negative correlation, but the good news is that they don't need to.
Any correlation less than a perfect positive correlation will reduce the risk in the portfolio.
However, investors must understand that risk has not been removed.
For the first time, investors are able to construct portfolios free of the old risk-reward line. In
mathematical terms, the portfolio has a rate of return equal to the weighted average rate of
return of the holdings, but the risk may fall below the weighted average of the portfolio.
Investors have now gained an important lesson: Diversification is good, but the extent of
the benefit depends on how the portfolio is constructed. For instance, investors would have a
better diversification benefit by including a multinational oil company and a retailer in their
portfolio than by holding two retailers.
While classic diversification reduces business risk, Markowitzs diversification can
actually serve to reduce market risk. Ideally, investors will want investments that combine
attractive risk-reward characteristics with low correlation to other investments.
Markowitz called the optimum combination of investment holdings "efficient" and any other
combination of holdings will result in a lower return at the same level of risk. If a graph was used
to depict efficient portfolios relative to the various levels of risk, the resulting line of best possible
combinations would be called the "efficient frontier." This falls above the old risk-reward line.
Every point on the efficient frontier offers the investor the highest return for a particular level of
risk.
The Markowitz process allows the investor to approach the investment decision from two
perspectives:
Determine acceptable level of risk and then seek the optimum level of return. For instance,
an investor might want to be 90% certain there is a limit of a 10% decline in value during any
one year. An advisor can then construct a portfolio which has the highest possible expected
return within that risk criteria.
Alternatively, the investor can first determine a required rate of return and then assess a
portfolio to do that at the least possible risk.
Markowitzs theories are powerful tools to manage risk and construct portfolios to meet various
constraints, but the theory has substantial limitations and isn't a cure for risk.

Summary:
Markowitz believed investors act in a rational manner and, given the choice, would opt for:
A similar portfolio with the same return as the one they have, but with less risk;
A portfolio with a higher return than the one they have with the same risk;
For a given level of risk, there is an optimal portfolio with the highest yield; and
For a given yield, there is an optimal portfolio with the lowest risk.
Investors with efficient portfolios are those which have yields that can be increased with no
resultant increase in risk, or portfolios with risk that can be lowered with no resultant
decrease in yield.
Another definition of an efficient frontier is a portfolio whose yield can no longer be increased
without increasing the risk and whose risk cannot be lowered without lowering the yield.

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Mixing bonds and equities

If Markowitzs intention was to diversify a portfolio to have securities with different correlation,
then surely it would make sense to as a final step to diversify some of the equity into bonds?
It is thus important to understand what bonds are and how they work. This is followed by a
practical example.
In a booming stock market, investors get caught up in an adrenaline rush. Equity values rise
daily, so why should investors care about the effect of non-equity markets on their investments?
Conventional investment wisdom is to have a portfolio that is diversified to include bonds,
options and futures. Anything less is considered long-term financial suicide for the benefit of
short-term gains.
What are bonds, how do they work and what are their benefits. A bond, also called a gilt,
is a loan made by the purchaser to the issuer. For instance, if the South African government
wants to build an underground railway network and needs R5 billion to complete the project, it
can raise the money by issuing bonds to the market, either local or foreign.
Lets assume that the State calls this bond issue Rail100, which has a face value of R10
million each, with a maturity date in 2020 and the bond carries a coupon rate of 15% a year.
This means that the State will issue 500 million bonds at R10 million each for a period of 22
years, and will pay holders an interest rate (coupon rate) of 15% a year. What does all this mean
for investors?
Firstly, investors can acquire bonds at R10 million each and earn interest of 15% a year
for a period of 22 years, after which the State will buy back the bond for R10 million each. The
only variable is usually the interest rate, which will fluctuate according to market perceptions of
how the project is being completed. For the State, the advantage is that it can raise the funds
needed to build the railway, without digging into tax income.
In addition, the investor is not bound to keep the bond, but can sell it to other investors in
the bond market, much like buying and selling shares. Bonds are bought and sold through the
Bond Market Association of South Africa. The State will often provide an additional benefit to
investors, to entice them to acquire the bond. In the above example, they could offer the R10
million bond for R9 million, which is a discount rate of 10% or R1 million. The bond holder would,
therefore, pay R9 million for the Rail100 and, for the 22 years receive the interest rate and, on
maturity, receive R10 million for the bond.
So, in the open bond market, the investor chooses from the range of bonds available,
which have different maturity periods. In addition, he can check the quality of his investment by
assessing the credit-worthiness of the organisation issuing the bonds. The credit worthiness of
an institution is that institutions ability to pay back the debt (buy back the bond), and consists of
an assessment of the quality of its cash flow. Bonds are rated by credit rating agencies, like
Moody's and Standard & Poor's. The highest ranking is AAA, which is given to issuers with the
best credit. The lowest ranking, D, is given to issuers who have defaulted on their loans.
Two main reasons why bonds are important choices are that they offer a steady stream
of income, which will outperform bank accounts or money market funds in the long term and,
secondly, they serve as protection for a portfolio against declines in the stock market.
On the negative side, bonds are affected by unpredictable economic indicators, like the
recent interest rate hikes and falls. Whenever interest rates go up, the value of existing bonds
goes down. In addition, the price volatility of a bond depends on its maturity. The longer the
maturity of a bond, the greater its sensitivity to interest rates. Short-term bonds (those that
mature in two to five years) are the least risky. Intermediate term bonds (maturities of five to ten
years) experience larger price fluctuations.
Here is a general guide on the effect of economic statistics on bond rates:
When inflation (CPI) increases, bond rates move down. Inflationary conditions reduce the
future value of fixed rate securities.

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A decline in Gross Domestic Product pushes bond rates up. When economic growth slows,
the Reserve Bank usually allows interest rates to decline.
An increase in money supply reduces bond rates. A higher money supply generates fears
the Reserve Bank may tighten monetary growth by allowing short-term interest rates to rise.
A worsening of unemployment statistics causes bond rates to rise. A lack of expansion
means the Reserve Bank is likely to loosen credit policy to allow rates to come down.
A rise in PPI causes bond rates to fall. Higher demand for goods and prices causes the
Reserve Bank to allow rates to go lower.

Bonds diversify an investors portfolio. Like share prices, bond prices go up and down, but these
are generally considered a lower risk investment.
A practical example
James Smith retired five years ago and lives off the income derived from a portfolio of shares.
His primary concern is the safety of his capital and income. However, over the past five years
inflation has started to whittle away at the purchasing power derived from his income, which is in
the form of twice yearly dividend payments. While he has no intention of doing anything that
could risk his capital base, he has become aware that he needs more income. So, how does he
improve his financial situation, without risking either his capital or income flow?
Problem: Smith is stuck on the old risk-reward line and his combination of shares has become
inefficient, with risk high compared to meagre total returns.
Before the advent of MPT, the traditional answer would be to increase the yield by moving
further out into the risk spectrum through the purchase of sound second-liners, then third liners
through to speculative shares. Each category has a growing risk factor attached to it. However,
by using Markowitzs MPT, Smith can expand his list of options. From his start position on the
risk-reward line, any movement either upward (more return) or to the left (reduced risk) improves
his position.
If a different combination of cash, shares and bonds are added, it is possible to improve returns
without increasing risk, or to dramatically reduce risk without sacrificing returns. There is also the
strange phenomena that some risky shares can actually reduce the risk in the total portfolio. This
occurs when cash, bonds and shares move in different directions during market cycles (low
correlation). Remember Markowitzs focus is that the risk level of the portfolio as a whole should
be considered more important than any separate component of the portfolio.
Global investing and Markowitz
Now, Smith wants to expand his portfolio of South African domestic shares to include
international stocks to improve his financial position. He is comfortable with equity risk, but would
like to improve his returns, or lower his risk.
There are various mixes of domestic large stocks and foreign large stocks of developing
nations (also called emerging economies). The foreign stocks have a higher return and risk
(except for First World economies) than the South African market. As foreign stocks are added
to a domestic portfolio, returns often increase and risks decrease. An optimum level of foreign to
domestic securities depends on the investors long-term vision. However, the optimum level for
any investor should be about 60% domestic to 40% foreign shares.
Essentially, the more pessimistic the investor becomes as to the future of his home
country, the more securities should be moved from the domestic to the overseas markets. It
must, however, be stressed that the shifting of shares must be a long-term plan and not as a
result of short-term risk factors. In addition, securities should only be moved overseas once the
investor has gained sufficient knowledge of that countrys markets.

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The combination of lower risk and higher returns is the reason that global diversification is
essential for all investment portfolios.
Global investments
International investing has two key benefits for investors, namely higher returns and a strong
diversification effect. The reason is that global markets have an extremely low correlation with
First World markets and, therefore, this diversification effect lowers risk at the portfolio level.
MPT is certainly a great leap forward in our ability to construct rational investment plans.
However, it is crucial for investors to understand and always remember the following about the
MPT:
It is just a good investment tool and must, therefore be used with judgment.
It does not eliminate risk.
It allows investors to build more rational investment plans and control risk.
It is not a substitute for judgment and in fact requires great judgment for its proper
application.
When dealing with any investment method, investors should bear in mind that no tool works
every day, week, month or year. Constant patience, vigilance and discipline are required if the
process of MPT is to succeed. Investors must note that MPT is based on the analysis of past
results and there is no guarantee that the future will hold the same trend. Therefore, short-term
returns will always remain random and variable.
The optimiser
So, investors around the world have practically unlimited options in their choice of investments.
How does that benefit the investor? While we may be rapidly moving toward a global economy,
individual economies and markets still respond to local conditions and politics.
There are a number of computer generated optimisation" programmes readily available
to financial planners and portfolio managers that will quickly and easily solve the math problems
associated with MPT. It is important to note that far too many investors rely on the output of a
computer programme, which they do without considering the input and programming problems.
Of course, if it is derived by a computer, surely it must be right?
The MPT process is particularly vulnerable to data input distortions. For each asset or asset
class, we must enter the expected rate of return, risk and correlation to every other asset class.
This leads to two problems.

The data changes every day.

A marginal change in an input of any of the three factors could have a major impact on the
suggested allocation. Even if we assume all the data going in is accurate, we could still have
problems.

The optimiser believes he has the solution to these problems. This type of investment adviser
identifies the one most efficient asset you have and then suggests you put all your resources in
that particular asset. This immediately leads to a gross violation of the diversification principal. In
practice, most advisors restrain the programme to reasonable asset allocations.
If an investor is in constant contact with his advisor, who changes the inputs frequently, another
strange abnormality often creeps into the process. Under-performing assets could start to show
lower rates of return and higher risk and a computer programme will immediately signal a sell
recommendation. The reason is not a market one, but rather directed at higher transaction costs
as a result of frequent updates and the resulting frequent trading.
The increased transaction costs are often far beyond the benefits that MPT can offer and
the computer shows a sell signal. Most investors do not need that kind of advice, especially if

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they follow their long-term investment ideology. How often an investor needs to update market
data and what time frames are used, becomes a matter of personal judgment. The computer
simply cannot solve that problem for you.
In the case of global investing, if we examine monthly or quarterly data, we will get different
results than if we use annual data in a time series. Similarly, if a 10-year time frame is used,
different results are obtained than if a three or five year time period is used. While it is often
better to have a diversified portfolio, the optimum ratio of foreign to domestic investment will
change with each different set of data observations.

Summary
Most advisors in South Africa use historic data to calculate expected rates of return and
risk inputs.

However, there are analysts who will forecast future earnings growth based on their
research or feelings and change a portfolio on current sentiment, rather than retaining a
long-term approach to share selection.

Alternatively, it would be unwise to discard the optimisers views outright.

A better approach would be to use long-term information to structure a portfolio and then
to test the results against the optimisers share choices. Rather than sell assets that are
under-performing in the short term, as the optimiser programmes might suggest, we use
re-allocation to increase positions in down markets and decrease positions in markets that
have had strong short-term results.

Ultimately, forecasts remain notoriously difficult and often unreliable.

Therefore, judgment must always be required before selecting your long-term portfolio. To
stay with your convictions during strong bear trends requires discipline, particularly when
faced with intense media speculation and hype.

Always remember that discipline leads to acceptable long-term investment results. As

long as the world economy continues to grow, patient investors will profit.

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CHAPTER 13: PORTFOLIO LESSONS FROM THE PAST

Every Bull Market is followed by a Bear Market and every bear market is followed by a bull
market: What happens as either a bull or bear market proceeds, is a conversion process. Those
who do not believe, change their minds as events unfold. Those who would not go near a stock
market, decided they liked it as prices rise. At the top there is nobody left to convert. In a bear
market, people refuse to believe what is happening, but are converted by experience. So at the
bottom, everyone believes that no-one should invest in shares.
Ultimately, it is this conversion process that investors must be wary of as panic sets in
when prices fall and euphoria becomes the order of the day when prices rise. Beware!

Over the past 30 years, research techniques and portfolio management systems have changed
drastically. If the investor is to survive in a globalised world, it is important to understand not only
how globalisation will affect portfolios in future, but also a few basic concepts from the past.
However, before lessons from the past, the following is a brief outline of the previous
chapters.
A quick summary of some key points found in earlier chapters:
Capitalism is the greatest wealth-creating mechanism ever devised.

As each of us goes about serving our own interests, the value of the world's economy
increases.

The markets, which are an integral part of capitalism, rise to reflect the increase in the
world's economy.

We expect this trend to continue.

Markets offer all investors the best opportunity to participate in the growth of the global
economy.

Risk should not be avoided, because it offers an investor the opportunity for higher returns.

Equities offer investors the highest real returns over time.

Most investors cannot expect to meet their reasonable goals without accepting some level of
market risk.

The impact of market timing and individual security selection pale by comparison to asset
allocation.

The greatest share of the investment process and attention should be devoted to the asset
allocation decision.

Risk can be actively managed.

Diversification is the primary investor protection.

Asset allocation between shares, gilts and cash allow investors to tailor portfolios to meet
their risk tolerance.

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MPT offers investors the chance to obtain efficient portfolios that maximise their returns for
each level of risk they might be able to bear.

Investors must accept and expect reasonably regular market declines, which are natural. At
worst, downturns have negligible affect on long-term investors; at best they may represent
buying opportunities.

It is vital investors maintain a long-term perspective and exercise discipline.

Markets are efficient and attempts to either time the market or select individual securities
have not been effective or reliable methods of enhancing returns or reducing risk.

Active management cannot demonstrate sufficient value added to offset their increased
costs.

The world economy is expanding, but the world's stock markets will continue to be an
efficient mechanism to capture this growth in share value.

Past performance of investment managers is not a reliable indicator of expected future

performance.

Cost is a major controllable variable in investment management. Low cost is strongly

correlated to higher investment returns. Management fees, transaction costs and taxes all
serve to reduce investor return. Costs must be rigidly controlled.

Lesson 1: The economists staple phase

Investors operate in a world that is continually changing and an acknowledgement must be
made that few variables are under our control. Economists often precede forecasts with all
things being equal, which means their forecasts are based on variables not changing in the
future. Investors have to adopt the opposite stance using a phrase like having taken numerous
possible risks into account etc. Changing variables does not mean we cannot build a sound,
long-term strategy.
In essence, a sound strategy is one that attempts to maximise returns for the risks
investors are willing to take. Over time, learn from mistakes and systematically whittle down risks
and costs of being wrong. In the short term, every portfolio will be "wrong" a great deal of the
time.
Lesson 2: Equities have provided sound investments around the globe
In South Africa, investors still cannot invest directly in foreign shares. However, once exchange
controls are lifted, it will be crucial to change the Asset Allocation to a Strategic Global Asset
Allocation." This is a long-term strategy in which investors divide their available wealth among
the world's desirable asset classes. The first task is to decide on which assets to include or
exclude. In this book we concentrate on assets that are liquid (easily converted into cash) and
marketable securities, i.e. shares. For investors who have property, that is not a problem. Set
the value of the property aside and concentrate on the share side of your portfolio, which can be
updated daily. In addition, these securities can be converted into cash within one week.
Other asset classes are excluded for different reasons. Most individuals will not be
comfortable or do not understand options, commodities, futures and the more exotic derivatives.
No matter how sophisticated investors judge themselves, as a general rule they should restrain
from investing in things they do not fully understand.
The last 20 years have been good to equities globally, but political risk has played a major role
in converting many traders into speculators. During this period, there was the all out war in Iran

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in 1990, prior to that there was nuclear confrontation and the fall of the Berlin Wall. Globally,
there was low inflation, high inflation, booms, recessions and depressions, high and low interest
rates. Currencies around the world were weak, then strong and stock markets around the world
boomed and crashed several times during the last two decades.
In short, investors had plenty to worry about when going through those times. Whether
investors depended on courage or faith or analytical ability, remaining fully invested in a
diversified portfolio was a key element to success.
The past 20 years has seen portfolios change and todays investment structures are designed
with the leading edge of financial research. However, variables change and the investor should
continually assess new and possibly better investment and portfolio tactics. As new tools are
developed, these will usually first be available to large institutions and investment advisors, but it
is only a matter of time before these tools are available at local retailers. One means of keeping
up to date with latest analytical tools is to ask investment advisors about their computer
programmes. Often the speed at which these filter down to the retail level is purely a function of
demand.
The Internet can help in providing such advice. In particular, look for academic research
from the economics and finance departments of the major universities that now maintain sites on
the Web. As you educate yourself, demand better strategies, lower costs, and better research.
Lesson 3: Beware of numbers
Over the past two decades, investors have been conditioned to think of market timing, stock
selection and portfolio performance as the fundamental keys to success. These beliefs are
deeply ingrained in South Africa, so even superior investment strategies like Strategic Global
Asset Allocation will take some time to get used to. In fact, some analysts consider the global
arena too risky and unknown for South Africans. However, globalisation and the coming of
capitalism to South Africa necessitate a radical change in the way portfolio managers operate.
For instance, investment advisors are expected to have an opinion on where the market
is going and, therefore, investors look to these experts for advice. The problem is that the
market is saturated with financial experts. Through the media, investors are exposed daily to
countless different opinions about the market, trends and recommendations. Their indicators
and forecasts can point to a possible "correction." They tell investors to retreat to the "safety" of
cash, which allows these experts to look responsible, conservative and even caring. In addition,
often the first question people will ask is: "What was your performance last year?" Those
numbers become the chief yardstick to determine whether the advisor is good or bad. Very
seldom will the investor ask: "What's the best long-term allocation?" or, "How much risk do I
need to take to meet my goals?"
In a global market, investors can diversify between countries and not only sectors. This
means short-term views are speculative and not analytical to provide long-term growth. The
following example highlights the problem of using growth rates as the chief yardstick:

Mr M. Brown has R1 million invested in a newly listed company on the JSE, called Zextra
Electronic Ltd. At a price of R1 a share, Brown owns one million shares in Zextra. In the first
year of operation, the company landed a multi-billion rand contract with neighbouring states
to set up satellite stations. By the end of the first year, the companys share has moved to
R2.20 a share and Brown has achieved a return of 120% on his investment.

Mrs. J. Dawson had R1 million invested in the Far East and shifted her funds to First World
markets just before the 1997 stock market crash. Her portfolio looks exceptionally bright,
showing a 40% return on a share that climbed from R100 a share to R140 a share.

Both shares show phenomenal returns. Yet both sets of figures distort the true nature of the
return on these investments. Browns investment return is off a low base and the longer he holds

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the share the worse his investment return (in percentage terms) will become. For instance, if the
share rises by another 120 cents in the next year, the share will have climbed to R3.40, which is
an increase of 54%. Another 120 cents in year three will mean a share price of R4.60, which is
an increase of 35%. To use percentage increases as a yardstick brings its own problems. That
is, off a low base the company has to continually increase earnings to achieve the same rate of
capital return. This is an impossible task in the short term, but if the investor had bought the
share for the long term then he could see the share rise to R6, which means he would have
achieved a 500% rate of return.
Dawsons investment is off a high base and a 40% return is substantial. However, she
will be hard pressed to find another investment that will offer a 40% return in the next year.
If the investor is told by a portfolio manager that a companys attributable profit has climbed by
30%, the investor must insist on the base that this percentage is made. For instance, if the
company had a profit of R1 million in Y1 and R1.3 million in Y2, this is very different to a
company that has a 30% growth rate of a base of R1 billion in Y1. If the number is in the low
figures (thousands or low millions) then it can be said the company achieved a 30% growth off a
low base of R1 million. If the amount is in the high millions or in billions then it can be said that
the company achieved a 30% growth off a high base of R1 billion.
Summary: It is more prudent to concentrate on a portfolios long-term potential than on shortterm gains. This does not mean investors should miss out on market aberrations. Set aside
portions of funds to speculate, but do not use the entire portfolio as the optimiser would
suggest.
Without tools to evaluate risk or choose between alternative strategies, investors often
feel they are left with just one number to compare performance; year-to-date or last year's
performance figures are the only criteria for measurement. If investors believe those figures
alone determined a successful investment plan, they should buy the previous years topperforming unit trust and ignore market signals. Unfortunately, this approach is often the worst
way to form a strategy.
Lesson 4: Change is the only constant
Building a successful investment plan to meet globalisation head on will require a fundamental
change in the way investors think about strategy and performance objectives. The word strategy
implies a conscious effort to achieve stated goals. Their concern should be to at least meet their
minimum acceptable return levels without taking excessive risk.
The way an asset-allocation is designed will determine returns for short and long-term periods.
In addition, risk and returns will be driven more by the investors asset allocation than by
individual share selection or market timing. Any asset class can and will have extended periods
of significant under-performance from its long-term trend. Similarly, there will be periods when
the portfolio will outperform the market trend. Of course, investors can play it safe and stay with
mutual funds or unit trusts, or they can have some risky assets in their portfolios. Why have risk
related shares?
Lesson 5: Weve said it before risk can be your friend
The reason is this: When risk is measured at the portfolio level, a risky asset with a low
correlation to other assets in the portfolio can actually reduce risk in the portfolio. A diversified
portfolio offers much higher returns per unit of risk than does a single blue chip share.
Over the long term, investment markets and portions of markets generally sort themselves out.
In the short term, it is not unusual to see a negative sloping, risk-reward line, i.e. the market fell
and shares under-performed relative to gilts or T-Bills. The investor with a long term return

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objective must know that down (and up) swings exist, but these are always temporary and have
little impact on the way to meeting your goals.
Statistically, small stocks have a higher return and risk than second liners or blue chips. For
reasons mentioned above, it is never safe to talk about a companys performance in terms of
percentage rates. In the international arena, even size of companies become relative. For
instance, Anglo American Corporation is considered one of our largest blue chips with a market
capitalisation of nearly R54 billion. Yet, compared to some overseas companies Anglo looks like
a beginner. For instance, US based company General Electric has a market capitalisation of
US$311 billion, which is worth R1.6 trillion (end-May 1998 exchange rate: US$1 = R5.15). Also
in the US, Microsoft has a market capitalisation of US$288 billion (R1.5 trillion) and General
Motors US46 billion (R237 billion).
In addition, emerging nation stock have a high return profile, but also high risk. These are
primarily large growth areas, but they also fall considerably below the large first world blue chip
stocks when a crisis hits emerging markets. This was amply highlighted during the 1997 Stock
Market Crash.
NOTE: What is important is how much risk the portfolio has and that it is reasonably
conservative. In addition, this book is about strategy, which also implies a long-term approach.
Even the "best" long-term strategy will not be the best each year and since we are dealing with
equities and associated risk profiles, it is important to understand that even the "best" strategy
does not provide investors with a guarantee against occasional negative periods.
Lesson 6: The market will decline at some point temporally, of course
Investors often refer to risk as the chance of the market falling. There is no doubt that no-one
likes to see their shares decline, but if they are quality stocks, losses should ultimately turn into
gains. It must be stressed that investors have to wait for the market to turn before gains are
achieved. This comes only after a long term period.
Investors also seem to have any number of mental yardsticks that they employ
relentlessly either against themselves or their financial advisors during periods of underperformance. Investors not only want to outperform convertible debenture rates, but they want to
do that every day. Here is a truism not even a superior portfolio will outperform debenture
rates every day or every year.
In other words, reality will rears its ugly head just when you think the bull run will
continue. The last 30 year period has been characterised by falling interest rates, falling inflation
and superior stock markets, but during this period there were also the dismal 1973-74 years and
the October 1987 and October 1998 stock market crashes.
No one should base their planning on high annual returns every year. As a rule of thumb,
investors should expect long-term results of about eight to 10 percent above the inflation rate. If
you do better, celebrate! Just do not base your whole strategy on attaining returns which are so
much higher than normal.
Lesson 7: Trust in your long term strategy and ignore the Overall Index
Investors often have one more mental yardstick for comparison. The temptation to second guess
yourself or your strategy is enormous. Investors are, after all, quite human, and they believe,
quite reasonably, that they should have it all. For instance, often they want to "beat the Overall
Index." We have gone to a great deal of trouble to build a portfolio that is better (in the long term)
than the Overall Index, which tends to have a relatively low return per year. For instance, if you
take all the performance of all the sectors of the JSE and look at the annual performance of
each sector relative to each other, you will find another obvious lesson. The Overall Index
usually lies somewhere in the middle, i.e. it is the average of all the sectors, which means the
negative and positive growth rates of the sectors.

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If 10 sectors moved up by 20% and five fell by 12%, what would the Overall Index growth
rate be? Assuming all the sectors had the same weighting, then the Overall Index growth would
be 9.3%, which lies midway between the 10 stock that moved up and the five that declined.
An investors strategy is to seek out asset classes that have a higher rate of return and very low
correlation with domestic large company growth stocks. It therefore stands to reason that this
type of portfolio will not track with the Overall Index. There will be times that the Index will
outperform even a superior portfolio.
Investors often tend to narrowly focus on any yardstick which is exceeding their portfolio
performance for the moment. Unless investors can focus on their own goals, risk tolerance and
strategy, performance becomes an impossible moving target. Investors must understand that a
superior portfolio will under-perform from time to time, no matter what mental yardstick they are
using.
Lesson 8: Tailor make your portfolio
Investors who desire higher risks and rewards can reduce the proportion of bonds in their
portfolio. Once they get to zero bonds they have two potential courses to follow if they still want
higher returns. First, they could shift the asset allocation to more value and small company
stocks and, secondly, include emerging market stocks in their portfolio.
Lesson 9: Jungle tactics keep the savages away
There are a number of survival lessons, which are described as follows:
Do not do totally insane things with your money. The Orange County disaster was the
perfect example. Part of the portfolio was a derivative investment that underpinned how
investors can make irrational decisions. The portfolio manager had offered a bond to
investors that paid interest at a rate that was determined by a formula: 10.85% less the sum
of the German mark, Swedish krona and Italian lira swap rate plus the British pound and
Swiss franc. In other words, the interest was divided by a factor of five.

Never borrow short and lend long. In fact, you should not borrow to make investments.
Borrowing multiplies your risk. If you borrow R1,000 to buy R2,000 worth of stock, then you
will double your original money (minus interest charges) if the stock rises 50%. However, you
will lose your entire stake if the stock falls by 50%.

Make appropriate investments. A consultant must always be with a legally recognised

stockbroker or institution. In addition, it is important to continually check your own finances,
check figures never take anything at face value. In other words, trust less and ask more.

Never have a preconceived scenario and fall in love with it. Never have an absolutely
unshakeable belief that economic variable will move your way, that interest rates would
continue to fall and that shares will always be positive or negative.

Never implement a strategy without an exit window. When providing a portfolio manager
with an order to buy or sell shares, make sure there is a stop-loss technique, i.e. always set
a definite price (say, 20% below cost) for a sell order.

Always keep the share scrip under your control. Too many investors have found that the
manager has disappeared with your scrip.

Do not buy anything you don't understand. If you do not understand Future, Commodity
trading, Options, Derivatives or gilts stay out!

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Don't judge an investment simply by its track record. Some companies produce
spectacular returns in the first two years of operation, but run into problems later on. The key
for an investor is not merely to look at what has been done in the past, but to understand
why the company has been so successful.

In the market, no good thing lasts forever. This has been said many times, if you touch
hot investments, you'll get burned.

Believe in amateur stock market sayings and die. These include:

Knowing which stocks to buy and when to be in the market is the key to investment
success.

A good investor can predict which way the market is going and which stocks will profit the
most.

This power is held by just a few wise men.

These wise men will readily share their power with you for a nominal cost.

This minor cost will be repaid many times over by enhanced performance.

However, one must always avoid the charlatans who give false advice. A wise man is
one whose stocks go up, and a charlatan is one whose stocks go down.

Knowing when the market will fall is a prime concern to the successful investor.

One should leave the market when it is about to go down in order to preserve ones
principal investment, i.e. the capital amount.

Successful investors trade often and dart in and out of the market or a particular stock
with uncanny skill.

Their portfolios benefit from a hands-on approach.

It is easy to spot good companies through an examination of financial data and to

determine what the stock in those companies should be worth.

An astute investor can apply superior insight to make big killings on mis-priced stocks.
Using his superior insight he will be able to take action long before other investors catch
on.

Studying past price movements is an aid to predicting future price movements. This skill
can be applied to both individual stocks and the movement of the market as a whole.

Economic predictions are reliable and form another strong foundation for success. It is
reasonably easy to select good advisors and managers, because their past track record
is a reliable indicator of future success and skill.

Given all that, many investors tend to think of the investment process in the following terms:

What shares should I buy?

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Should I be in or out of the market now?

When should I sell my stocks?

Which manager should I hire? Or, what mutual fund should I buy?

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Unfortunately, almost all of this conventional wisdom is wrong. It does not do us any good to
think of investing in these terms. In fact, it creates problems and keeps us from enjoying the
fruits of a game strongly tilted in our favour.
In the next chapter, it is important to consider the merits of the investor's obsession with
individual stock selection and market timing. Just how much do these two elements of the
investment process contribute to overall success or failure? Is there a better way to think about
investing?

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CHAPTER 14: JUNGLE LAW EAT DIRECTORS WHO FAIL

Sooner or later, all directors, traders, analysts and portfolio managers make mistakes. Winners
rectify these mistakes quickly and, when mistakenly bullish turn bearish. Conversely, if
bearish and wrong adjust to the trend. Never not let pride, stubbornness or prejudice blind
judgement if planned actions are incorrect. Learn to change with the global tide, otherwise the
capitalist markets will

In South Africa, investors tend to shy away from confronting directors if they believe they have
not performed in a responsible manner. As shareholders they have every right no matter how
few shares they own to telephone the company secretary, financial director, managing director
or even the chairman of a company and ask questions.
For the global player, it is important to ask and to insist on satisfactory answers, on a
daily basis. However, given the inherent reluctance of South Africans to demand an audience,
there is another way to assess the effectiveness of directors. In fact, often directors are not
reachable as a direct result of their heavy work load and not because they are irresponsible.
There must, therefore, be an alternative method to assess the effectiveness of directors.
Even in an efficient market, measuring performance for management results requires a
benchmark. What is the right benchmark?
Step 1: Identifying winners at a glance
If it is assumed that the board of directors is responsible for the direction, growth and future
prospects of a company, it is fair to assume that a comparison of that company relative to its
sector index for a set period is valid. This test of managements ability is crude. For instance,
not all food companies within the food sector of the JSE buy, sell or produce the same products.
One company may be strong in the export market, another may be labour intensive and yet
another may have many food ranges. In addition, the more companies within a sector the higher
the degree of difference between the markets and environments these companies operate
under. There is also a greater difference if time spans are increased.
A single year may account for extraordinary results. If the last year was an extraordinary
one, with high profit growth, low debt and substantial cash flow, this will show up in all time
periods. The results will appear to be far more consistent than they actually were. For instance,
a company that had nine average years, but a great 10th year will look good for the past one,
three, five and 10 years. If the great year had occurred during the first year, then the ten-year
result would look good, but the one, three and five-year periods will only look fair. This presents
a far different picture, even though the results are the same. It is thus important to adjust for
consistency of results.
Therefore, this test may be fair, but it still needs refinement. For one thing, investors
need to adjust for risk.
Step 2: Analysing the winners a random theory approach
Is it possible to conclude that companies which beat the sector averages are wise and others
are fools? By extension, can the people who invested with companies that outperformed the
indices also claim to be winners? Is it possible that these winners could have been predicted? A
truism in statistical analysis is that probability theory will always account for a number of winners
and losers in any random series of events.
The example often used to demonstrate probability theory is, if one person tries to toss
heads with a coin for 100 rounds, it is likely that he will succeed 50 times. However, it does not
mean that the more times the coin is thrown, the greater are the chances of him getting the
desired results. Every time he throws, he has an equal chance of success, but also an equal
chance of failure.

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If it is assumed that markets are efficient, it can be expected that a random distribution of
results will show there are some winners and also some losers. Probability theory demands it.
Therefore, how does an investor know which director to trust, who to follow and how much to
invest in that company?
The answer is never easy and there are a multitude of ways to assess the situation, Firstly, in an
efficient market there are large numbers of buyers and sellers, which means that market
perception of a directors ability is reflected in the share price. For instance, if the company does
not perform, or the directors are involved in a scandal, investors are likely to sell the share. A
large volume of sales often sends the share price downwards. After all, nobody wants to invest
in a company that does badly.
Secondly, to offset the problem of number distortions, use growth averages rather than
direct comparisons. For instance, instead of comparing the 1997 profit growth rate of Food
Company ASD against the 1997 Food Index growth rate, use a period of time, i.e. a three or
five-year period. This means that the average growth rate of Food Company ASD would be
compared to the average growth rate of the index.
Thirdly, use a constant performer counter system to determine the best of the best. The
following example highlights the best performers for investor Robertson. Remember that this is
the random approach and does not take a multitude of factors into account, namely track record,
new acquisitions planned for the new financial year or specific types of food industry the
following companies operate under.

Investor Robertson believes food companies will benefit from economic growth, higher
purchasing power and South Africas largest mutual companies becoming listed companies.
This is called demutualisation.
There are 10 companies listed on the Food Sector of the JSE.
The growth performances for the last three years of trading of these 10 companies is
outlined below,.
Companies and Index (% growth on previous
year)
Index
Companies
1
Aberdare Ltd.
2
Jacksons Ltd.
3
K&L Suppliers Ltd.
4
Kenton Mills Ltd.
5
Bobs Wholesalers Ltd.
6
Chief Group Ltd.
7
H&H Holdings Ltd.
8
Plantations Holdings (SA) Ltd.
9
George Latina Galley Ltd.
10 The FoodStore Ltd.

Here are some investment options:

Year 1

Year 2

Year 3

+12.0

+14.5

+16.9

+33.9
-10.0
-4.0
-9.0
+4.2
+32.7
+11.9
-44.4
-31.0
+1.1

+36.7
+10.0
+3.0
-12.0
+5.8
+21.0
+14.0
-11.9
+18.4
-9.0

+39.7
+0.8
+1.5
-45.0
+22.5
+43.0
+15.5
-1.0
-32.0
-90.0

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Should investors buy shares in companies with positive annual growth rates?
LIST A
Bobs Wholesalers Ltd.
Aberdare Ltd.
Chief Group Ltd.
H&H Holdings Ltd.

Should investors buy shares in companies with positive growth during the past two years?
These companies could have turned problems around and could continue to perform well in
the near future.
LIST B
Jacksons Ltd.
K&L Suppliers Ltd.

Should investors buy shares in companies with rates that surpass the previous years?
LIST C
Aberdare Ltd.
H&H Holdings Ltd.

Assuming that investors want winners, which are expected to continue to perform in the future,
there are a number of options:

From list A: Aberdare and H&H.

From list B: None
From list C: Aberdare and H&H

Conclusions
From list A: Aberdare has outperformed the market and shown constant growth, while Bob may
have performed well, but the question remains whether the past year was an aberration and more
history is needed before an investment decision can be made. Chiefs has outperformed the
market, but growth is erratic and it too needs to prove itself to investors. H&H has shown constant
growth and while underperfoming the sector, is close enough to warrant further investigation.
From list B: Jackons is too erratic and K&Ls growth is far to low to be considered to be a viable
investment option.
From list C: Aberdare and H&H prove themselves again.
Aberdare and H&H would be the best options for investors.

Step 3: Track records and other factors

If management skills add value, can past performance give an indication of how these directors
will perform in future? Do winners repeat? How successful will investors be if they only buy the
funds with the best past three-year track record? There is no guarantee directors will repeat past
performances, nor is there a certainty the company will continue to outperform the index. It is up
to the investor to keep personal records of directors performance during the financial year.

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Step 4: Winners often keep winning

In an efficient market, it would be difficult for the same winners to keep winning, as investors
have a multitude of choice and can become extremely particular in their investment decisions.
Yet, the very short term (less than two years), winners often do repeat. In a sense, winners are
almost like fashion statements. William F. Sharpe, a Nobel Prize winner in economics, believes
this statement is true for the short term. He says it takes time for an efficient market to sort
through the host of factors that help to make up investors decisions on which shares to buy and
sell. So, if director Jones is popular this year, he could be next year; the year after that remains
debatable.
For instance, if an investor owns a large amount of Building & Construction shares and in
a specific year, the sector index climbs by an unbelievable 40%, he could use this sector
performance as a benchmark, thus doing well during the investment phase of an economic
upswing (the last of three main phases of a cycle). However the performance benchmark could
deteriorate during the subsequent years of slowing GDP growth.
Many portfolio managers suggest that chasing last year's winner does nothing more than
position your portfolio with next year's potential loser. After all, it is easy enough to pick last
year's winner, but not so with next year's winner.
Step 5: Build a better benchmark
We can build a benchmark for just about any market or portion of a market. For example,
suppose we divided all the publicly listed stocks in South Africa into 10 different sizes by market
capitalisation on one axis, and ten different segments based on debt:equity ratio on the other
axis. We now have 100 different possible sub-markets. We could call each sub-market an
investment style and each style could have its own index or benchmark.
If we studied the performance of each style, we would find they are sharply different from each
other. Each style would have distinctly separate identities. For instance:
Rates of return could vary substantially between the sub-markets.
These sub-markets could exhibit different risk or standard deviations.
Each could also have a different correlation from the other.
Each style could go through a market cycle with dramatically different results for each time
period.
Conclusions:
There is not just one domestic market, but many.
Many portfolio managers confine themselves to a distinct market segment. For instance,
they may be large-cap value, mid-cap growth or small-cap market. This is the area of the
market they claim to know best and believe has the greatest potential. In any event, over
time most of the performance they obtain may simply be attributable to where in the market
they invest.
Investors can design precise benchmarks.
The investment style of portfolio managers around the world has become more important
than management prowess.
Even when a director beats his competitors, investors cannot be sure growth was a direct
consequence of the directors ability, right market conditions or just dumb luck.
Step 6: Continually improve benchmarks
Even within a carefully defined style, investors are still faced with a wide variation of results in
both the short and long term. Part of this is attributable to style differences within the markets,
but a large amount of variation can also be attributed to sector or window dressing by portfolio
managers. In South Africa, 90% of shares are owned by large institutions, which means the

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weight of funds at their disposal can (and often does) move share prices. Window dressing is a
term used when portfolio managers buy shares to boost the performance of their portfolios.
The following example assumes that portfolio manager Jakes is a new manager and the
shares he has set up in a new portfolio, i.e. no capital growth exits on the shares. Jakes has
10,000 shares in AAA Ltd., which he bought at R100 each. The value of his portfolio is therefore
R1 million. If he uses the institutions weight of funds to buy 10,000 more AAA Ltd., which are
difficult to obtain (called tightly traded shares), the net worth of his portfolio could rise.
Assuming that Jakes was able to buy 10,000 more AAA Ltd. shares at an average price of R130
a share, the value of his portfolio rises to 20,000 shares at R130 a share. Remember that the
original shares are now also worth R130 a share. In essence, Jake has made a net profit from
buying more expensive shares.
A. Cost of Jake acquiring AAA Ltd. shares.
Shares
10,000 shares
10,000 shares
Total cost

Price
at R100
at R130

Value
R1,000,000
R1,300,000
R2,300,000

B. Value of Jakes portfolio

Shares
Original shares held: AAA Ltd
Shares bought: AAA Ltd
Total shares held: AAA Ltd.

Quantity
10,000
10,000
20,000

Share Price
R100
R130
R130

Value
R1,000,000
R1,300,000
R2,600,000

C. Profit made by increasing the portfolio

Profit

=
=
=
=

Total value of shares

cost of shares
R2.6 million
R2.3 million
R300,000
13% increase in value of the portfolio

When investors build investment strategies, a benchmark, style, or passive approach may be
very viable. After all, what's wrong with top-quartile results of unit trusts? All other things being
equal, when given a choice between actively managed funds, investors should opt for the one
with the lowest cost, widest diversification and lowest turnover.
In fact, investors have actually returned to the thesis that asset allocation is much more
important than focusing on a particular share, timing or directors performance. In fact, there are
mathematical methods of assessing a directors ability.
Step 7: Using ratios to quantify directors financial acumen
There are many methods to determine whether a director is undertaking the right (and profitable)
strategies that will improve shareholder wealth. The following is a set of efficiency ratios, that
must be assessed in conjunction with Part Three: Strategic Investment & Portfolio Techniques.
The first and simplest technique is an assessment of working capital. A low working
capital indicates lack of efficiency and work priorities and often poor management skills. The aim
is to determine how much and how capital is tied up in the firm. The following ratios can be used
to determine management efficiencies:

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RATIOS TO DETERMINE DIRECTOR ABILITY

1
2
3

Stock turn
Accounts receivable days
Accounts payable days

Group turnover
Accounts receivable
Accounts payable

average stock
(turnover 365)
(turnover 365)

Stock turn: The ratio is used to determine whether management is efficient in its control of
particular current assets. This ratio reveals the ability of management to buy inventory that
will sell quickly and highlights management's inability to control different lines of stock.
However, it is imperative that investors look at trends over a number of years. The reason is
that an increase in the ratio may not mean that the problem is one limited to only a particular
firm, but could be an industry trend, i.e. sales falling off generally.

Accounts receivable days: The first step is to determine daily sales, which is achieved by
dividing the company's turnover figure by the number of days in the year (365); even if the
firm does not operate every day of the year. The accounts receivable figure, which is listed in
the balance sheet, under current assets, is divided by the subdivided turnover figure. The
result is in days and the higher the number, the longer it takes a company to collect its debt.

Accounts payable days: This figure is obtained from the balance sheet, under current
liabilities. It is calculated in the same manner as account receivable days. In this instance,
the higher the number of days, the longer it takes the firm to pay its debts. The ideal is for a
company to collect its debts at a quicker rate than it is paying creditors. This would release
some pressure on cash flows and also assist in improving liquidity.

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CHAPTER 15: PORTFOLIO MANAGERS ALSO FALL VICTIM

TO JUNGLE RULE
Some portfolio managers suffer from a great handicap. They are either chronically bullish or
chronically bearish all the time. This can be an expensive trait, as it means being wrong about
half of the time. Those that do not learn to recognise signals and adjust to them do not last long
in the globalised world of stock markets.

The more portfolio managers investors meet, the more confused they are bound to get. Each
manager will point (compellingly, I might add) to reasons why his or her methods are the best.
There is no reason why their tales may not be true.
Here are some solid arguments:
Growth managers assume that rapidly increasing sales, profits, and/or market share will lead
to a rapidly growing share price.
Value managers argue convincingly that overlooked or out of favour companies will provide
steady growth, while high dividends and a large asset base will ensure downside protection.
Small company managers speak fondly of discovering just one or two of tomorrow's Ford,
Microsoft or Shell.
Large company managers favour liquidity and well established companies.
Mid sized company investors argue second-tier companies offered stability, growth potential
and the opportunity to exploit market inefficiencies.
The few foreign stock managers will try to convince investors that international investing is
the only option under a globalisation scenario.
All these arguments do, in fact, have strong merits. However, when questioned about ethics,
work methodologies and accountability, investors will discover that many managers lack
common stock market or accounting definitions, often do not have appropriate yardsticks and (in
numerous instances) do not have the necessary technical tools to measure performance or risk.
This does not mean these managers do not achieve acceptable and positive results. The caveat
is that comparisons are difficult to make and managers use different skills, time frames, quantity
of funds and even different management techniques, which are mostly recognised and accepted
worldwide.
Investors could hardly be blamed if they did not find solid guidance from stock exchange's gurus.
The truth is, all these gurus are competing and in the capitalistic jungle not one will tell an
investor enough (in cold, hard fact) about how they achieve results. In a competitive world, after
all, telling could be giving secrets away.
The answer, is for investors to have their own set of prerequisites. If the manager accepts these,
stipulate them in writing. If the manager does not accept the prerequisites, find another
manager.
Some of the prerequisites are:
Stipulate the type of shares (sectors) you wish to have in the portfolio.
Always keep share certificates in your control (this is for a long term portfolio).
Make absolutely sure the manager does not have carte blanche to trade your portfolio.
Stipulate degrees of buy/sell orders, i.e. "if a share falls 10% call me to get permission to
sell/buy."

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The coming of capitalism to South Africa

Institutional portfolio managers across South Africa have had a rude awakening since the
change in government in 1994. In addition to having to change portfolios to reflect global trends,
domestic political, business and financial trends have forced managers to change strategies to
account for the rapidly changing nature of corporate South Africa.
Many heads of investment departments admit that old rules no longer apply. For instance, prior
to the 1994 election, there seemed to be a business brotherhood, in partnership with
government. Analysts knew that certain contracts often went to specific companies. Now, a
general consensus is that, to survive in the new South Africa, market experts will have to
become more street wise and understand politics.
Politics will continue to dominate markets for a long time. The implication is that the new
government is not bound to the old order's methods of handling political, economic, financial and
business issues and that it has very different priorities.
This has been highlighted often since 1994 and includes the reconstruction levy of 5% imposed
on individuals and companies during the last Budget and government's commitment to the
Reconstruction and Development Programme. Essentially, market forces are influenced by
undefined rules - and often surprising moves - by government. To complicate comprehension of
present portfolio management thinking, many believe there is little and a mostly unsubstantiated
link between our market and those overseas.
Despite major warning signals from the local and US market, many portfolio managers
are not changing their way of handling billions of rands worth of pension and provident funds,
which will ultimately lead to disaster. While it is understood that institutions are not traders in the
sense that they normally take short-term views, there is a desperate need for these financial
houses to move in line with international trends. That is, managers must be able to adapt to the
clients' needs. If clients want to speculate in the market or if they want secure, long-term slow
and steady growth, a portfolio manager should be able to construct a portfolio to meet these
needs.
The next step, therefore, is to ascertain whether a portfolio manager can actually undertake
promises made or do they make promises just to get business. Some do, others don't. The next
section looks at how to avoid pitfalls in selecting a portfolio manager.
Beware the power suit salesman
Will investors never learn? Is an extra percentage point worth the risk of losing all your hard
earned savings? In a desperate attempt to stretch the purchasing power of a continually
weakening currency, many investors (particularly pensioners) look for alternate ways to increase
their savings. Consequently, many fall prey to con artists and often end up losing all their
savings.
The first step in choosing a portfolio manager is to understand that nobody - absolutely
nobody - can protect an investment better than the investor himself. It is quite logical, actually,
when it is considered that stockbrokers, analysts and portfolio managers do not have the same
vested interest as the investor. While experts use their ability and skills to manage a portfolio
efficiently, they cannot (and never will) provide a guarantee of success.
So how do investors protect themselves against unscrupulous and unethical financial
advisers? Who are these financial con artists and how can investors identify them?
A good starting point is not to be fooled into believing that someone is an expert, because they
are proficient in the use of financial and technical jargon. Understanding finance and the ability
to accurately buy and sell shares is very different.

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Being impressed by someone wearing a power suit, who is using a number of visually
pleasing computer graphics to illustrate expertise, is another danger signal, which can leave the
unsuspecting investor with a worthless or rapidly depreciating share portfolio.
It is therefore important that investors are aware that not all portfolio managers are skilled
in the profession of share management. In 1991, I joined a small portfolio firm in Cape Town
and, before signing the standard contract, the managing director assured me that: "Your task will
be to acquire new portfolios and to manage them."
However, I quickly discovered that "acquire and manage" meant to only find new business. The
problem lay in salary being inextricably linked to the number of clients I brought into the firm and,
more importantly, to the value of their portfolios. In effect, to earn about R5,000 a month, I would
have to sign new monthly clients with share portfolios amounting to over R1-million.
These portfolio managers have no incentive to manage portfolios once the client has
handed over control of his shares. Not surprisingly, the firm has since being taken over by
another financial services company.
Quick access to information is always a trade mark of such firms. A registered portfolio firm can
legally buy the names, addresses and telephone numbers of any shareholder registered in
South Africa. In addition to shareholder registers, stockbrokers send portfolio management firms
all their research in the hope that trading will be conducted through them and they will thus
obtain brokerage commissions.
For instance, if ABC Portfolio managers received six stockbrokers' analytical reports
recommending that investors buy South African Breweries shares at present prices, the firm
could easily use this information to advise their own existing clients to buy this share.
However, they can also use this information when approaching new shareholders. An
example would be to buy the register of all SAB shareholders and send a selected number of
these investors a summary of the stockbrokers' SAB analysis and, as claimed in a newsletter,
"we can do similar analysis on all your shares". The next step is to wait a reasonable period and
then to contact the client and, as salesmen do so well, persuade the investor to "come and see
our operations. It will cost you nothing".
There is an understanding among these managers that, once a client is impressed by the
individual's stock market knowledge (which he obtained from stockbrokers' research) and the
firm's computer setup, it is only a matter of time before the investor hands over his total share
portfolio.
Of course, many portfolio firms do not use this method of operation and it would be wise
for investors to scrutinise them before selecting a portfolio manager.
The main areas to investigate, before choosing someone to manage a portfolio, are not
complicated.

Always keep share certificates in your name, so the portfolio manager cannot sell your
shares.

Investigate the company's reputation in the marketplace. Telephone stockbrokers and major
financial institutions and ask whether the company you are considering has a proven track
record.

Find out who the company's major shareholders are. If the shareholders are major
institutions, banks or listed companies, there is less likelihood of portfolio managers being
salesmen.

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You can eliminate many of the potential problems you might encounter by simply avoiding
the commission-based salesman. In one stroke you eliminate the vast majority of conflicts of
interest between yourself and your advisor.

Things aren't always what they may seem. Some brokers advertise themselves as "fee
based" planners and advisors, but these charge a fee for making recommendations and take
commissions on the products they sell. This is the worst of all possible worlds; paying fees to
a commission-based salesman does not guarantee objectivity or eliminate any conflicts of
interest, it just lets him get paid twice.

Third Party Custodian: Use the services of a large stockbrokerage to hold your assets. In
case there is a problem with your account, the house has a problem, not you.

Limited Power of Attorney: Never allow an advisor the power to withdraw from your account.
Disbursements, other than fees, should always go to your bank account. A limited power of
attorney allows your advisor to trade on your behalf without running the risk of having your
hard-earned assets disappear.

The capitalist must be a cynic

So, who does the investor choose to run in a portfolio? The first obvious consideration is to only
use institutions of sound reputation and financial solvency. Do not add additional risk by being
attracted to that extra 0.5% promised income.
For the investor who is just starting out, keep things simple by investing in a single type
of unit trust. This provides the investor with time to get to grips with understanding of how the
market works, what he can expect from the fund manager (consolidated monthly statements and
an annual consolidated tax statement) and he can also get to know the manager. For instance,
the major stockbrokers and institutions have the necessary tools to build a first-class, globally
diversified, low-cost asset-allocation plan within a single type of unit trust.
Investors must also avoid funds that promise high turnover, high expenses, high
minimum investment amounts or annual account charges.
As the fund grows, investors must move away from the single type unit trust. Once the fund
reaches R100,000, it is time to move into asset allocation. Investors must still keep things
simple, as most stockbrokers of note will consider this amount too small to bother with. However,
there are a multitude of unit trusts and the investor can select unit trusts to suit his asset
allocation.
Again, this give the investor time to get to know the manager and for the manager to get
to know the investor, his needs and aims.
It goes without saying that an investor should expect his advisor to have an in-depth
knowledge of finance, but there is no harm in questioning him about qualifications
and investment philosophy.
Here are a number of simple questions:
1. How would they use Modern Portfolio Theory to reduce risk?
2. How much foreign exposure would they recommend?
3. Do they believe in diversifying into emerging markets?
4. How do they view the growth versus value debate?
5. What do they think about market timing?

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6. How much diversification do they think is essential?

7. What are the limitations of CAPM?
8. What particular asset allocation plan do they recommend that will most likely meet your
needs?
9. How do they measure correlation between asset classes?
10. If the investor suspects that the advisor's knowledge consists of only jargon, walk out.
The important thing is to know what questions to ask and never be intimidated.

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CHAPTER 16: TEACH YOUR CHILDREN THE ART OF

CANNIBALISM
No grist can be ground with water that has run past the mill
This quote is not attributed to a specific person, but was popular on Wall Street in the 1960s. It
means that investors must forget investment mistakes and the lost opportunities of the past.
These are gone forever. Instead, plan an investment strategy now for the present and for your
and you childrens future. Forget those things that are past and press ahead.

When youre single, saving seems easy and budgeting even easier. However, when marriage
and children come along, the odds of keeping to a budget become more difficult. Obviously, the
more people in a family or group of investors, for that matter, the more views and differences
there are bound to be on how to budget or invest.
This brings into play the question of investing in the stock market for your children or
placing funds in a bank and enjoying the benefits of the magic of compounding. It looks like
magic because rather than increasing in a straight line, compounding investments increase
geometrically. Not only does the principal investment increase each year, but this year's
earnings become next year's principal and accrue even more earnings. The process repeats as
long as the money is left to grow. As a result, what seem like small differences in input generate
giant differences. In other words, what appears to be a small change in rate of return, or slightly
longer time period, will make the difference between poverty and comfort in your and your
childrens old age.
Get organised
Before you start any long-term investment plan, get your basic financial house in order. No one
should invest until they have at least a six month cash reserve for emergencies, the proper
insurance protection and the basic legal documents. Emergencies can include unexpected
hospital bills, property damage and even retrenchment. It will not do you or your family any good
to get a 30% rate of return if you lose your job, wreck your car, die, or disabled tomorrow. In a
very real sense, life and disability insurance buy you time.
Compounding can put time on your side an example
Suppose that for 10 years, you deposit R1,000 into an account at a reasonable 10% rate of
interest. Your investment will grow to R15,937.42 by the tenth year. At this point, you stop
making contributions and you intend to leave this investment for your childs retirement. In other
words, the cash will remain in the bank at 10% for the next 55 years. The fund will grow to
R3,013,115.83 over that period.
To adjust for inflation, we assume that about 3.5% of the nominal yield was eroded. The
"real value" of the accumulation in terms of rands at the start of the investment process is
R322,027.60. The "real value" of the inflation-adjusted income available to you is R20,931.79 for
the rest of your life. We are assuming that you withdraw 6.5% beginning at age 65, and leave
3.5% to grow to hedge the inflation rate. All of this was accomplished with a total cost of only
R10,000. Compounding had worked its magic.
Now let's assume that R1,000 is deposited a year for 55 years. This will accumulate
R1,880,591.43 for your childs retirement. Waiting 10 years has cost the accumulation more than
R1.2 million, even though R55,000 has been contributed to the programme.
Stated differently, if you want to still accumulate R3,013,115.83, a total of R1,602.22 per
year must be contributed for 55 years at 10%. The total cost of the programme has grown to
R88,121.94.

Jungle Tactics

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Let us change the example again. You are 20 years old, just out of university and want to save
for your retirement. How much must you save each year at 10% to accomplish the same goal at
age 65? The answer is that it will take R4,191.26 per year. The price is going up, but it is not yet
out of reach.
What happens if you wait even later?

At age 30 the annual cost of meeting your goal has grown to R11,117.51 a year.
Age 40 there are 25 years remaining to age 65 and your cost to fund your retirement
supplement is now R30,637.58 per year.
Age 50 means there are only 15 years to go until your planned retirement, but you will need
to deposit R94,823.14 each year to achieve your targeted retirement fund.
Age 60 finds that R189,059.14 is required each year to fund your retirement plan and it is
clearly out of the question. Many people find themselves in this situation and the common
reaction is to wonder how it will feel to still be working at 80.

Lesson 1: Start early

The first lesson we learn from our little exercise is to start investing early. It is not always
possible to do this, but remember that the earlier you start, the easier the burden. In addition,
you are more likely to have a successful outcome. In fact, it is never too early to invest for
retirement, but it can get too late. It is extremely easy to put off retirement planning; there is
always a good excuse, so be aware and try not to let it happen to you. The cost of reaching your
goal does goes up each day.
Lesson 2: Plan for a reasonable rate of return
Getting a reasonable rate of return on investments depends on an individuals perception, the
country of origin, place of investment and risks attached to the investment. While 10% may be a
fair rate in the US, in South Africa it would be breaking even if inflation is taken into account. In
addition, far too much money is committed to safe and low risk institutions and far too little to the
higher risk, higher return classes. Start with a target percentage return and change that over the
years. The continual investment will make it easy to change up or down a percentage point.
Given that risk in an equity portfolio falls as time horizon increases and a retirement plan
certainly has a long-term horizon, investors should consider shifting assets to where they will get
higher rates of return. That means fewer bonds, CDs and annuities and more shares. Within the
share classes, research indicates that a higher percentage of funds should go to value
companies, small-cap shares, international rand-hedge stocks and emerging markets. These will
increase rates of return. Properly mixed, these asset classes should generate significantly higher
than 10% returns without undue risk.
Lesson 3: Control costs
When many portfolio managers talk about return, the one negative aspect they tend to
concentrate on is risk. Yet cost can also have a major impact on an investment programme.
Markets are reasonably efficient and it is unlikely that you can beat them by much over time.
After all, each market can only return so much, but that return is reduced by cost. Investors must
adopt an effective cost control programme as part of an overall strategy. In a global investment
plan, with the many risks and costs attached, be careful not to have costs that exceed returns.
Lesson 4: Control taxes
One of the least understood costs in an investment portfolio is tax. In the real world, most of us
have to pay tax, and many times our investment plans increase our tax burden. Each time we
receive an interest payment, the Receiver of Revenue wants his cut. In addition, overseas

Jungle Tactics

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markets have capital gains tax and taxes on dividends. In South Africa, companies pay a tax on
dividends paid to shareholders, called Secondary Tax on Dividends (STD).
While tax can become a problem, it does not have to be crippling. In many cases, taxes
on investments can be minimised by deferring the liability to another time. The longer investors
can defer paying a tax, the longer they will have funds to re-invest and have the compounding
effect work its magic.
The following example highlights the concept of real compound growth:

Kenny Lawrence and Ralph Oven both have R100,000 to invest a year for three years.
Both Lawrence and Oven intend to invest the money with a bank at an annual compound
growth rate of 10%.
Both investors are in the highest tax bracket, which equates to 30% tax on all interest
received.
Lawrence prefers to remove the interest yearly, while Owen intends to withdraw the full
interest at the end of the third year.

Tax liability:
1. Lawrence (withdraws interest annually)
Years

Investment

Year 1

R100,000.0
0
R100,000.0
0
R100,000.0
0
R100,000.0
0

Year 2
Year 3
TOTAL

Interest
received*
R10,471.30
R10,471.30
R10,471.30
R31,413.90

Total

Withdraw

R110,471.3
0
R110,471.3
0
R110,471.3
0
R131,413.9
0

R10,471.3
0
R10,471.3
0
R10,471.3
0
R31,413.9
0

Tax liability Net

balance
R3,141.39
R100,000.0
0
R3,141.39
R100,000.0
0
R3,141.39
R100,000.0
0
R9,424.17
R100,000.0
0

Conclusions:
Lawrence earned R31,413.90 in interest and paid R9,424,17 in taxes.
This means that his investment has earned him a net R21,989.73.
This equates to a 22% net return over three years.
2. Owen (withdraws interest at the end of the three year investment period)
Years

Investment

Year 1

R100,000.0
0
R110,471.3
0
R122,039.0
9
R100,000.0
0

Year 2
Year 3
TOTAL

Interest
received*
R10,471.3
0
R11,567.7
9
R12,779.0
9
R34,818.1
8

Total

Withdraw
-

Tax
liability
-

R110,471.3
0
R122,039.0
9
R134,818.1
8
R134,818.1
8

R110,471.30

R122,039.09

R34,818.1
8
R34,818.1
8

R10,445.4
5
R10,445.4
5

R100,000.00

Conclusions:
Owen earned R34,818.18 in interest and paid R10,445.45 in taxes.

Net balance

R100,000.00

Jungle Tactics

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This means his investment has earned him a net R24,372.73.

This equates to a 24.37% net return over three years.

* Formula for compound interest:

x12

T = D (1+(interest/12))
Where:
T = Total investment, which is the capital amount plus interest received
D = Monthly investment deposit
N = period of years that the investment is to take place. This is multiplied by the
compounded period. In this case by 12 months. Note that interest is divided by the same
amount, i.e. if the interest was compound daily, interest would be divided by 365 days and
n would be multiplied by 365.
So, who is better off?

While Lawrence paid marginally less tax, his overall investment return is less than Owens.
This is a result of annual withdrawals, which inhibited the compound effect on a higher
annual amount (interest on the previous years interest).
While both paid a 30% tax rate on interest, as a percentage of the total value of investments
at the end of the three year period, Lawrence paid less tax. This is due to the effect that
R100,000 has on a small investment amount, compared to the much larger final portfolio of
Owen.
There is another alternative. Investors can also withdraw annual interest received, pay the
tax on the interest and re-invest the funds back into the same institution. However, the
benefit of doing this is marginal.
The above factors become more pronounced over the longer term. This is highlighted by the
following three investment options.
For the best advice on tax, which includes among others, forming a closed corporation, trust
account, other types of firm, it is best to consult a tax expert, who can advise you about
offshore funds and tax implications of investing in other countries.

Jungle Tactics

Figures
in Rands

- 129 -

OPTON 1
No annual
withdrawal
Capital +
interest

OPTION 2
Withdraw interest
annually
Interest Annual
Tax

OPTION 3
Withdraw interest, pay taxes and re-invest
remaining sum
Capital Interest
Tax
Amount to
re-invest

Year 1
Year 2

110,471.31
122,039.09

10,471.31 3,141.393 100,000

10,471.31 3,141.392 107,329.9

10,471.31
11,238.84

Year 3

134,818.18

10,471.31 3,141.392 107,867.2

11,295.1

Year 4

148,935.41

10,471.31 3,141.392 107,906.6

11,299.23

Year 5

164,530.89

10,471.31 3,141.392 107,909.5

11,299.53

Year 6

181,759.42

10,471.31 3,141.392 107,909.7

11,299.55

Year 7

200,792.01

10,471.31 3,141.392 107,909.7

11,299.55

Year 8

221,817.55

10,471.31 3,141.392 107,909.7

11,299.55

Year 9

245,044.75

10,471.31 3,141.392 107,909.7

11,299.55

Year 10

270,704.13

10,471.31 3,141.392 107,909.7

11,299.55

Year 11

299,050.39

10,471.31 3,141.392 107,909.7

11,299.55

Year 12

330,364.87

10,471.31 3,141.392 107,909.7

11,299.55

Year 13

364,958.39

10,471.31 3,141.392 107,909.7

11,299.55

Year 14

403,174.30

10,471.31 3,141.392 107,909.7

11,299.55

Year 15

445,391.91

10,471.31 3,141.392 107,909.7

11,299.55

Year 16

492,030.26

10,471.31 3,141.392 107,909.7

11,299.55

Year 17

543,552.25

10,471.31 3,141.392 107,909.7

11,299.55

Year 18

600,469.27

10,471.31 3,141.392 107,909.7

11,299.55

Year 19

663,346.25

10,471.31 3,141.392 107,909.7

11,299.55

Year 20

732,807.26

10,471.31 3,141.392 107,909.7

11,299.55

Year 21

809,541.76

10,471.31 3,141.392 107,909.7

11,299.55

Year 22

894,311.35

10,471.31 3,141.392 107,909.7

11,299.55

Year 23

987,957.43

10,471.31 3,141.392 107,909.7

11,299.55

Year 24

1,091,409.47

10,471.31 3,141.392 107,909.7

11,299.55

Year 25

1,205,694.30

10,471.31 3,141.392 107,909.7

11,299.55

3141.3918 7,329.9142
3371.653124 7,867.19062
2
3388.531081 7,906.57252
3
3389.768221 7,909.45918
2
3389.858902 7,909.67077
2
3389.865549 7,909.68628
1
3389.866036 7,909.68741
8
3389.866072 7,909.68750
1
3389.866075 7,909.68750
7
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8
3389.866075 7,909.68750
8

Jungle Tactics

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OPTION 1

OPTION 2

OPTION 3

Capital + interest

R1,205,694.30

R361,782.7

R381,595.1

Total interest
Tax
Net income
Tax as % of interest
As % of interest +capital

R1,105,694.30
R331,708.29
R773,986.01
30.0%
27.5%

R261,782.7
R78,534.8
R183,247.9
30.0%
21.71%

R281,595.1
R84,478.52
R197,116.6
30.0%
22.14%

Summary
The best way to ensure you have the funds when you need them is to set up an automatic
deduction each month. Have a stop order on your salary and make sure that these funds go into
a pension scheme; preferably one that has a link to the stock exchange. This will put the
tremendous power of compounding to work for you and painlessly reinforce your wise decision
to start now. If you need further discipline, just remember that the only thing worse than being
dead may be to have outlived your money.
Above all else, put time on your side, start early, invest for high rates of return, control
costs, control taxes, use compound growth rates and make sure you keep to these goals.
Lesson 5: Have a clear, concise and well defined investment planning process
Many investment advisors divide the planning process into five clearly defined steps.
1. Set goals
2. Asset allocation
3. Manager selection
4. Monitor asset allocation and make changes
5. Report
Actually, we all know the steps cannot be separated, and instead of a straight line, we should
think of the process as a continuous loop. But the five-step process will give us a good
framework for discussion as we begin to develop investment strategies.
A clear definition of objectives, time horizon and risk tolerance goes a long way towards
suggesting the appropriate investment strategy. The better we can define our objectives, the
better plan we can craft to meet them. The more precisely we can define our goals, the better we
can design a plan to meet them as well. It's not enough to say: "I want to make a lot of money,"
or "I don't want to take a lot of risk."
Of course, in real life you might normally be expected to have several distinct financial goals,
each with different parameters. For instance, a newly married couple is likely to have very
different goals than an older couple who may be focused on retirement and estate conservation.
Each objective may have different time horizons and risk parameters.
In line with investment objectives set out in previous chapters, the monetary goals set out in the
following text is aimed towards that objective. However, the lessons we learn can be applied to
any investment goal.
Setting Monetary Goals
Setting monetary requirements for each goal is a straightforward process and can be outlined as
follows:

Jungle Tactics

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As a first step, make an inventory of all your resources, including pension plans, social
security, other existing investments and immovables. Add in any other planned investments.

Project your income needs and capital needs in today's Rands. In other words, estimate the
average inflation rate in 30 years time.

Add an appropriate inflation adjustment. This will give you a target in inflated Rands.

From this information you can determine your minimum required rate of return on your
current assets and planned investments.

This required rate of return must be feasible and attainable and within your risk tolerance.

If the rate of return is not feasible, go back and make adjustments in your lifestyle or
increase your planned investments. Above all, be realistic when you write down your longterm requirements.

Often investors feel driven to take excessive risk when they are unable or unwilling to invest
enough to meet their goals. They become prime targets for con artists with inflated promises.
The elderly often become victims of fraud when they see that their existing assets will not be
enough to support their lifestyle. Then they lose everything.
Age and financial situations will impact on how investors set their goals. It's silly for 25-year-olds
to attempt to exactly forecast their retirement budget. At that age, few of us know how our lives
and careers will develop. In addition, the very long time frames mean that if our estimates of rate
of return, inflation or expenses are off just a little, the resulting error will be enormous. While our
future may be a blank sheet, the need to provide for it is not.
Finally, we can design a portfolio with an expected rate of return adequate for your needs. Most
of you will find that you must develop a required rate of return higher than bonds and savings
can generate. The next question is: Can you live with the risk required to meet your goals? If you
cannot, go back and adjust your lifestyle or increase planned investments.
Help is on the way
If this sounds like a complicated exercise, do not panic. There are dozens of software packages
to do these calculations. Many available programmes allow for instant comparisons of alternative
scenarios. You will be able to see instantly if your assets will support your desired lifestyle and
what rate of return is necessary to keep you from running out of funds. We can also determine
how much risk you will have to assume to get the desired rate of return.
These progammes make quick work of budgeting, social security forecasts, inflation
adjustments, assets available, time to go to objective, rates of return required to meet objectives
and risk required to meet rate-of-return requirements. You can build in known expenses like
university (or any other expense, such as buying a TV or a new vehicle) and expected future
receipts like sale of a home or inheritance. You can see the effects of tax-rate changes, and play
"what if?" with investment returns or risk levels.
In addition, these programmes do a great job of pulling together many elements of the
problem and can graphically illustrating the possibilities.
Putting time on your side
As we saw in the last chapter, it is vital to begin investing as early as possible, and small
periodic savings early in our career will grow to meaningful balances given the magic of
compounding. So, 25-year-olds may be content with a goal of saving 20% of their gross income,
obtaining a rate of return of at least five percentage points over inflation, and avoiding taxes on

Jungle Tactics

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their investments. If they continue this discipline throughout their careers, they may reasonably
expect to attain financial independence and security.
The idea of saving 20% of your gross pay may seem a little revolutionary to many of
today's consumers. Given the multitude of credit cards from banks and retailers is difficult to
image consumers resisting the temptation to spend. Remember that no matter how little you
think you earn, many others earn much less. The end result is clear, if you do not establish the
discipline to live on less than you make, no one else can do it for you us and no amount of
investment advice will help.
All investors with access to a tax-favoured retirement plan offering a current tax
deduction, as well as tax-deferred accumulation for the life of the plan, should take maximum
advantage of this opportunity. It will reduce the real cost and increase the benefits of hardearned investments. In many countries, South Africa included, certain types of pension plans
offer some tax deduction. Ask a tax expert to assist to take full advantage of these benefits.
When youre in your 20s, retirement may seem far off and almost impossible to forecast financial
needs, determine where you would like to live, in what style, what size house you want, how
many children you will have to put through university and other needs. However, when you get
closer to 50 it gets easier to forecast retirement requirements, as you will have some assets to
inventory. You will thus be able to put numbers to your requirements, including assets available,
extent of needs, past investment success, time remaining to retirement, future investment levels
and required rates of return.
There is still some hope for those with retirement plans. It is not too late to begin a serious
investment programme. As you approach retirement, planning can become more refined and
precise. All along the way you will need to adjust constantly, particularly under a globalised
world and increasingly merging stock markets. You may develop new requirements or need to
incorporate new research into your plans. A good plan is flexible, but focused and disciplined at
the same time.
Time Horizon
Time horizon is a critical factor in investment planning, but often not properly understood. Time
horizon ends when you plan to liquidate an entire portfolio to meet a goal. For instance, if you
are saving for a down payment on a house in two years, the time horizon left is two years.
However, if you are investing for retirement, the time horizon is the rest of your life.
One of the most insane ideas regularly foisted upon investors is the idea that retirees
should invest only for income and become more conservative. In other words, invest in blue
chips for the dividend income and safety. Under a globalised world, this no longer applies. For
instance, in 1998 South African blue chips were hard hit by global factors (Asian crises, stock
market corrections and international companies entering this country) and many of these
companies passed up paying dividends. To make matters worse, some saw share prices fall
radically.
The following is clear: a horizon under five years becomes a speculative one in the stock
market. In the short term, risk to your retirement plan is too high. Remember that market risk
falls as the time horizon increases and analysis shows that actually falls as the square root of
the time horizon. That means that the difference between the best case/worst case expectations
for a one-year time horizon is only one-third as large after nine years, or one-fourth as large after
16 years. With a very long time horizon, the worst case expectation in the stock market may be
better than the best case with "safe" assets.
Retirees who anticipate living off their capital should consider that they have two time horizons.
In the short run they will need income and in the long run they will need a growth of capital and
income. They should arrange their asset allocation accordingly.

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Once again, the beast rears its head

Risk tolerance is the final dimension of the goal setting process. Retirees face a far greater risk
of outliving their capital than losing it in a properly designed, equity-based, global assetallocation plan. On the other hand, excessive risk at the portfolio level can lead to real and
permanent losses. Where a risk is extremely high (speculative shares), an investor will need to
achieve the highest rate of return per unit of risk. So, even if an investor has a high tolerance for
risk, he should aim to get rich, or at least achieve financial independence, not generate cheap
thrills.
What often happens when the inevitable market decline occurs, investors begin to feel
betrayed and frightened. In this frame of mind, investors are ready to do the worst possible
thing: sell and retreat to the "safety" of cash. All thoughts of long-term objectives vanish. The
investor locks in losses and paper losses become real. The recovery will come and he will have
lost his long-term objectives.
Market risk means that sometimes your equities will go down. No-one can really
determine when that will happen. In essence, if you are in the market, get used to the idea.
Alternatively, if you cannot get used to the idea, do not invest in shares. It is therefore better to
have not been in the market at all than to panic and sell when the market slumps.
Investors should decide in advance how much risk they are willing to tolerate. This can be
defined in many different ways. For instance:

An investor could say that he wants to be 95% certain that he will never have a loss
exceeding a given amount.

The global investor could accept a risk level that is mid-way between the S&P 500 and local
short-term bonds.

He could also tolerate whatever risk is required to achieve a long-term result of 3% better
than the S&P 500.

Risk-Reward Relationship
A clear statement of objectives, risk tolerance and time horizon should be reduced to writing and
should form the first portion of a policy statement for your investment strategy. Every plan should
have a policy statement, which should be reviewed regularly (at least once a year). This
statement will help the investor to focus on achieving his goals, which will in turn help him keep
a clear head in times of panic selling. If investors think they can administer long-term investment
plans without stressful days, they are simply not ready to enter the world of stock exchanges.
The next step in developing a strategy is to begin to formulate an asset-allocation plan
that will satisfy the requirements we have just laid down.

Jungle Tactics

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Summary
Most South Africans face financial pressures and the struggle is often based on two
fronts:
1. The need to pay for todays expenses.
2. The need to plan a financial future for themselves or those who depend on them.
They also face a maze of investment choices.
Here are some basic advice from successful investors:
Steps to successfully setting up a portfolio include:
Make a plan
Get the help you need
Remember time is on your Take a long-term view
side.
Diversify
Think globally

Put compounding to work

Set realistic expectations
Review your plan.

A portfolio should match both where you are now and where you want to be when you
retire.
The challenge is to find the proper mix of investments with just the right amount of your
money in a variety of investments.
To find the investment mix that's right for you, start by understanding investment
essentials, outlined below. The focus of the book is to expand on each of these issues, in
detail and mathematically.

Jungle Tactics

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INVESTMENT ESSENTIALS
1. Make a plan
Know what your goals are

How much can I afford to invest?

How much risk can I tolerate?
How much time do I have to invest before I need the
proceeds of my investments?
Do I need income now or can I focus on growth of capital?
Am I investing for my own needs, or for others, such as my
children's education?
How much control over my financial future do I want?

2. Expert advice
Get the help you need
Assess the reputation and investment approach of the
funds' managers and investment advisers.
Choose a fund or fund manager that shares your view.

3. Timeframe

4. Risk tolerance

5. Diversification

6. Review plans

Remember that time can be on your side

Investing in stocks and bonds should provide positive
returns over longer periods of time.
Understand the value of time, but having patience to
ride through down markets is a quality that will keep
you from bailing out of a good investment at the first
decline in price.

Higher rewards usually denote higher risk

If the long-term return of the stock market is about
10% a year, don't aim for 15%, unless you have the
capital to withstand higher risk

Locally and internationally

Look beyond investments in your home economy.
Chances are that other countries and their stock
markets have more growth potential.

Things change
Go back periodically and take another look at the plan
to make sure it fits your current perspective.

Jungle Tactics

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Summary

Managing Risk: The key step in managing risk is to decide how to allocate investment funds
among the three primary classes of financial assets, namely cash reserves, gilts or shares
or a combination of these.

The first step should always be to assess asset classes briefly before investigating potential
risks and rewards. Once this has been completed undertake an Asset Allocation. Keep in
mind that risk is always present in investing. Risk cannot be eliminated, but it can be
managed. There are three basic pointers to keep in mind:
Diversification can protect you against risks from a single stock or bond, but not against
market and inflation risks.
Shares have historically offered the highest annual returns, but with substantial
short-term market risk.
Time has a moderating influence on stock and bond market risk. The longer you
hold an investment, the more likely it is you will earn a positive return.

Cash reserves: offer stability and provide income that rises and falls with short-term interest
rate movements. These include Treasury bills, bank deposits, Convertible Debentures or
Money market instruments

Bonds (also called gilts): interest-bearing debt obligations issued by corporations,

government (Central to local) and utilities. Bonds represent a loan to the issuer and provide
income during their lifetime, plus a promise to repay principal upon maturity. Although bonds
generally offer higher and steadier income than cash reserves, their principal value
fluctuates as interest rates change. In general, when interest rates rise, bond prices decline,
and when interest rates decline, bond prices rise.

Shares: these represent ownership interest in a corporation. Stocks offer the potential for
current income (from dividends) and capital growth (from an increase in value). However,
stocks are more susceptible to short-term price risks (that is, stock prices fluctuate
sometimes sharply - over shorter periods of time).

Balancing Risk and Reward:

While shares and gilts may offer higher returns than cash reserves, they also expose you to
higher levels of risk. This risk-reward trade-off is a key consideration in investing: in order to
pursue higher returns, investors must be willing to assume additional risk.

Individual shares and gilts expose investors to specific risk, i.e. the risk that problems with an
individual company or bond issuer will reduce the value of your investment dramatically.
Specific risk can be eliminated through diversification using unit trusts or mutual funds.

Diversification among many stocks and bonds will greatly diminish the impact of a single
stock or bond. However, diversification does not remove risk from market movement caused
by investor perceptions.

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CHAPTER 17: REVOLUTION AND PIGS

Ludwig von Mises
1881-1973
"Peace is the source of all social relations.... He who wants to preserve life and health as well
and as long as possible must realise that respect for other peoples lives and health better
serves his aim than the opposite mode of conduct."

The previous chapters have armed investors with the basics to achieve financial success.
However, implementing a strategy is as critical as understanding and designing one. As in the
past, the future will be strewn with difficulties; political, socio-economic, financial and business.
These obstacles will come the investors way, but as long he knows what to expect these should
be easily solved or avoided. From Wall Street to the JSE, financial gurus say the same thing the process of change is still just beginning.
Before looking at strategy implementation, investors need to understand how exchanges
began, so as to be able to identify similar future events in other countries, possibly in emerging
markets.
Some 300 years ago, the Dutch bought a piece of land today known as New York. The Dutch
aimed to use this location to trade with the New World, first selling and buying) basic
commodities through harbour facilities. Over time, new companies were formed and investors
were invited to assist (buy a portion of) these fledgling ventures. These purchases of paper were
certificates of ownership or debt, which were later called stocks and bonds. The certificates were
placed on open-air tables and investors wandered the area examining, buying and selling these
certificates.
Enter the Pigs
The trading area became popular and small camps developed, bringing traders and their goods.
This included goats, cattle and pigs. The latter often ran wild through Dutch trading areas and
soon became a problem, knocking over tables and trampling on the certificates. This led to a
wall being built to keep the pigs out. Later, the street where the trading took place was named
after the wall and, in time, the area grew to become the financial capital of the world.
Early on, the securities traders formed an association to govern their business
transactions. It was decided that the association should have a monopoly on trading and no
traders could undercut the prices of their competitors. Traders who violated the agreement were
banished from the association, which effectively ended their careers. This arrangement greatly
enriched the traders, but certainly could not have been considered unusual given the business
climate at the time. At least there was very little recorded dissent or comment from economists
on the negative implications for market efficiency. Later, the trade association was given
government sanction and commission price fixing became the law of the land.
In South Africa, a similar event started to emerge in the late l980s. The banks started to
complain that the JSE had a monopoly on share trading and threatened to start up their own
stock exchange. This eventually led to the introduction of automated trading (end of the open cry
system), and the entrance of foreigners into the previous inner circle. Banks and foreign
stockbroking firms were then permitted to become local traders.
The Big Bang had come to South Africa.
Stockbrokers enter the world of competition
In May, 1975 the US Securities Exchange Commission (SEC) began allowing negotiated
commissions. The event was greeted with predictions of doom by the brokerage houses.
Somehow these pure symbols of capitalism believed they could not survive competition. The

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same event took place in South Africa in 1996. Across the world, exchanges found themselves
being dragged into the real world of competition.
Initially, the benefits of negotiated brokerage were unevenly distributed. Large institutions
could immediately trade blocks of stock for a tiny percentage of previous costs. Small investors'
trading costs actually increased at the retail brokerage houses. However, discount brokers
appeared offering sharply lower trading costs to retail investors. At first, discount brokerages
provided few services, but eventually quality and quantity of services increased. Basic economic
theory became reality as competition resulted in further reduced prices, increased quality of
service and greater consumer choices.
Change, the only constant
As expected, the opening of the doors to allow foreigners into the inner circle was the start and
not the end of change for stockbrokers. Banks, insurance companies and mutual funds are
cutting into the JSEs traditional turf. This change was not just confined to the brokerage
industry. Stockbrokers have started to fight back. Many have, in turn, applied for banking
licenses. Banks too, have changed, moving strongly into the insurance industry and the large
insurers, not to be outdone (or was it a result of competition) have announced that they are to
become listed companies. South Africa calls this demutualisation.
In the good old days, stockbrokers sold shares, insurance brokers sold insurance and
bankers took deposits and made loans. Today everybody does everything and it is difficult to tell
who the players are.
Haemorrhaging deposits
When interest rates began rising globally during the 1970s and 1980s, banks found themselves
haemorrhaging deposits. To compete against the money markets, deposit interest rates became
free floating in most countries, that is, except in South Africa, where interest rates were still a
function of the Reserve Bank. Internationally, banks found themselves in the unfortunate
position of paying high rates to depositors, while many of their older loans were fixed at very low
rates. Banks were encouraged to make high-risk loans and enter other lines of business to
increase their earnings.
To make matters worse, the 1980s saw inflation rates skyrocket, unemployment rise to
unprecedented heights, war break out and an oil embargo that pushed the oil price to over
US$70/barrel. These resulted in many banks having to be bailed out by government initiated
programmes funded by taxpayers. Today, banks have adjusted to a system where they pay
reasonable rates to depositors. While banks have not exactly rushed to increase deposit rates,
the availability of money market funds enforces a market discipline that keeps rates at
reasonable levels.
In South Africa, interest rates became free floating in 1998, with the introduction of the
Repo rate (discussed in Part Two of this book).
Summary: All this change comes at a price. It takes investors a while to sort out the new
benefits. The trade-offs are overwhelmingly favourable. Astute investors look beyond traditional
sources will be richly rewarded with lower costs, increased options, and fewer conflicts of
interest.
Monopoly and regulated industries
Many regulated industries share common characteristics. A great many people get paid far too
much to do too little. The 1980s saw UKs Prime Minister Margaret Thatcher, introduce
privatisation policies that aimed at re-igniting capitalistic desire in that country. Regulated
industries seem to promote a stifling of innovation and consumers pay far more than they
should.
Stock exchanges are the same. Prior to May 1975 (in the US) and November 1996 (in
South Africa), price competition in the securities industry was illegal. Commissions were fixed

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and competition revolved around peripheral services such as research or other advice. Prices for
services were bundled together and investors paid for the research and other services whether
or not they wanted them.
The discount brokerages unbundled services and slashed pricing. Investors who had the
time and inclination to go it alone, reaped enormous benefits. For instance, several years ago,
brokerage houses offered to trade and hold shares in their accounts. Initially, they charged a
small transaction fee to cover the cost of the service. More recently, however, they have
introduced a no transaction service fee for selected portfolios.
Redeeming shares involved much the same process and time. Funds could be out of the
investors control for extended periods, while in the mail, waiting for redemption, or waiting for
cheques to clear. Transferring from one portfolio to another was a nightmare of paperwork and
delay. Managing a diversified portfolio was a complex task indeed.
Today, automated trading comes with electronic share certificates and a single account can hold
many funds or families of funds. Share transactions are cleared overnight and transferring
requires the push of a single computer button. The brokerage provides a monthly consolidated
report and managing portfolios become a reasonable task.
South Africa is in the process of introducing electronic share certificates (called STRAIT).
Mousetraps
In todays society, building a better mousetrap is not an easy task. Even a better system of
trading (as displayed by electronic trading improving liquidity to over 10% from a previous 1.5%)
was vehemently resisted by stockbrokers.
New ideas have to be proved to the public, manufacturers and consumers. Businesses
are not likely to just roll over and give up their market share. It will fight to maintain business as
usual. Even if the new mousetrap eventually replaces the old one, the older company still has
many options and can be a thorn in the side of progress.
Under a free market system, the stronger system will ultimately survive. Consequently, if
the older product is more profitable, the company will attempt to maximise sales of the older line
as long as possible. Taking this course maximises profits and buys time to adjust to the new
environment.
From Wall Street to the JSE, traditional brokerage houses simultaneously resist change and
attempt to improve services. They are clearly being dragged kicking and screaming to the party.
Even if they wanted to, traditional brokerages have some formidable problems about joining the
new world as costs in terms of property, systems and people is enormous. They will never be
able to compete on a cost basis with discount brokers and independent advisors.
Better mousetraps are available and market share is flowing at an ever increasing rate in
that direction. In many ways, 20 years after May Day, the process of change is still just
beginning. As more investors vote with their feet, they are further transforming the industry in
their favour. The one and only thing that stock exchanges really understand is loss of market
share.

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CHAPTER 18 : A FLAWED ECONOMIC MIRACLE

The capitalist system is the economic miracle of the world, but even miracles are imperfect. The
capitalistic jungle is neutral, it does not care the slightest bit about the investor, consumer, rich,
poor, white, black, man or woman. It neither wants to destroy or reward you, it just is what it is.

Stock markets are the same. The devouring beasts and the delicious bounty are both there. One
way or another, investors and their money are going to be in that jungle. The best advice,
therefore, is to find a guide (a stockbroker, that is) which has survived stock market crashes,
booms, political and business upheaval and has a well established reputation.
Advisors are there to point out pitfalls that might help ward off disaster and to take full
advantage of the capitalist system and stock exchanges around the world that make up an
integral part of the system.
In a very real sense, the markets are always under construction and self-improving.
Consumers always want more and better deals. By demanding better, consumers force change.
There are, and always will be, flaws in the capitalistic system. Investors must discover how to
work around these flaws or turn them to their advantage. This chapter is devoted to showing the
investor how to avoid unnecessary disasters as investment strategy is executed. In particular,
risk that is not market related and that could separate you from your hard earned money, is
discussed. To be more precise, scams, rip-offs, conflicts of interest and other dastardly deeds
are investigated.
Market fraud is here to stay, so live with it
In 1990/1991 the Masterbond scandal hit South Africa and many pensioners lost their hard
earned savings. During this period, the JSE uncovered a front running operation and a number
of arrests were made, but millions of rands were lost by institutions.
In 1997/8, some of the US's largest brokerage houses had to settle multi-million dollar
claims for fraudulent sales practices, inappropriate investment recommendations, failure to
supervise account executives and churning of accounts. Each year, boiler room operations
swindle thousands of unsuspecting investors out of millions of dollars in total scams. Thousands
of investors have complained that banks misrepresented mutual funds as governmentguaranteed investments.
The list is almost endless. Yet these catastrophes do not need to happen. The following is a list
of basic precautions that could prevent tragedies in future.

Never give any investment advisor a general power of attorney over your account. Use a
limited power of attorney to authorise your advisor to make trades within your account for
your benefit.
There is never a reason to name an investment advisor as owner, contingent owner, or joint
owner of your account. It should not be possible for any other person to ever receive a
disbursement from your account. Your brokerage or trust company should only disburse to
you at your home address or to your bank account.

Insist on confirmation of all account activity and statements directly from your custodian.
Check your statements for unusual or unauthorised activity.

Never use your investment advisor's address as your address to receive statements.

Select strong custodians for safekeeping of your assets. Use major brokerage houses or
trust companies that are properly insured, audited and regulated.

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If it sounds too good to be true, it probably is. The markets are far too efficient to allow for
excess profits in excess of the risks taken. Con artists almost universally appeal to investors'
greed and unrealistic expectations.

By now the investor should have a good feel for a range of reasonableness in various
investment markets. Consider carefully whether a guide is needed. Many investors should not
try to go it alone. Investing funds professionally is a full-time job. It takes specialised knowledge
and significant resources. It is a full-time job just to keep up with the research. Investors should
evaluate whether they have the skill, judgment, discipline and experience to do a proper job.
After all, the investment plan is their future.
Warning signals
Companies that pay consultants on commission are a warning signal to immediately avoid this
company. This type of company is open to a host of potential consumer abuses, including
serious conflicts of interests, inappropriate investment recommendations, extremely high costs
and excessive portfolio turnover. With all the hidden agendas possible in the sales environment,
it would be extraordinarily naive to expect objective advice.

Brokers are given extra incentives, such as Rolex watches and all expenses paid holidays,
to sell special high-profit-margin products with little regard to their suitability for customers.

Firms push brokers to recommend in-house mutual funds, where the firm earns
management fees, instead of funds run by outside managers. Most in-house funds have
mediocre performance records.

Many firms recruit top (rated) analysts from other firms with huge up-front bonuses and
extra-high commissions. That gives the producers an added incentive to promote excess
trading.

Firms do not provide customers information on the overall return on their investments and
aggregate commissions they have been charged. The brokerage system is inadequately
policed and rife with built-in and undisclosed conflicts of interest between broker and
customer.

Large brokerage houses are very complex businesses. What you see at your local office is just
the tip of the iceberg. But the retail operation is essential to support many of the more profitable
lines of business. Commissions are the mechanism that allow the house to manipulate the
broker.
Summary

The common thread that runs through many of the worst abuses is the commission-based
system of compensation. Commissions create a conflict of interest between the broker and
client.

New listings generate lots of fees for brokerage houses. Strangely enough, this is not called
commission, but corporate finance fees.

So far, cash payments to stockbrokers have been described. Many firms offer deferred
compensation in addition to direct commissions. Invariably, these plans are tied to
proprietary products and other high profit offerings. Private offices, secretaries, titles and
other perks depend on selling enough of the right type of investments.

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The single driving ethic and obsession in the stockbroking industry is money. Commission
rands, not client returns or satisfaction measure success or failure. Most stockbrokers can
tell you to the cent what they earned in commission last year; few have little notion what their
clients made as a result of their advice.

These conflicts of interest are not incidental to the business. Rather, they are a fundamental
part of traditional commission-based transaction-oriented brokerage. While there are many
talented and ethical people in the business, the system is fundamentally flawed. It makes it
difficult for stockbrokers to carry out financial advice. For instance, a stockbroker who
practices a long-term, buy and hold strategy is not liable to remain long in the business. They
can never get paid for recommending that a client do nothing at all, but we all know that
often that is the best course of action. Finally, a broker who institutes a rigorous cost
containment and control programme for his clients has just signed his own retirement
papers.

Surely, you say, the value of these professionals' advice makes up for it? Not always. Some
stockbrokers research efforts are a fine justification for excessive trading and a defense
against litigation for the house.

While many brokers and analysts are intelligent, it is not a requirement for the job. Neither is
advanced or even related education. Several successful brokers I know have never seen the
inside of a college or taken a finance course. Once the formality of the stockbrokers exam is
out of the way, the real training begins. In those commissioned-based institutions, the inhouse training courses could fairly be described as 10% product knowledge, 90% sales
training, then get on the phone and sell. The technique described as either smiling or
dialling," or "dialing for bucks" is the fundamental education for new entrants.

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CHAPTER 19: STRATEGIC ASSET ALLOCATION

Indices mislead: Indices are constructed to provide a measuring point for portfolio
comparisons. For fair comparison, investors must manage their portfolios the same way that
the index is managed.
For instance, the UKs FTSE-100 is the most widely followed "blue chip" index. It is rebased every three months. Companies that have fallen below 100th in market capitalisation are
dropped, while those rising into the top 100 replace them. To avoid excessive change, there is
some leeway at the margins. The result of this process is that the Index slowly acquires a life of
its own. Most investors do not sell a share because it has dropped out of the index. Their
portfolio declines, while the index, carried along by its new rising stars, advances.

There are four main elements that can contribute to improved investment results:
Investment policy
Individual security selection
Market timing
Costs
By using a rather straightforward regression analysis, investors are able to attribute the
contribution (or lack of it) to each of the four elements.
Investment policy (another name for asset allocation)
This is defined as the average base commitment to three asset classes: shares, bonds and
cash. For instance, a pension fund might have a mix of 60% shares, 30% bonds, and 10% cash.
(Most investment advisors use the term asset allocation rather than investment policy.)
Market timing is then determined by variations around the base commitments. If a pension fund
changed its commitment to the three asset classes over time, it was assumed to be an attempt
to profit from market timing.
Given that this book looks at investing in the global arena, it was necessary to move away from
the South African securities markets to highlight how investment policy works on the world
stage. Therefore, the indices used as global indicators are as follows:
For share performance: The Standard & Poors 500 Index (S&P 500), which assesses the
top 500 US companies among these are the worlds largest conglomerates, i.e. General
Electric, Microsoft and Macdonalds.
For bonds: The Lehman Brothers Government/Corporate Bond Index
For cash: The US 30-day Treasury Bill.
In addition, these indices are applied to 10 different portfolios, using a different mix of shares,
bonds and cash.
An assessment of these portfolios using the above indices over a five year period is able to
explain 95% of a pension fund's performance based solely on knowing its investment policy. The
biggest single factor explaining performance was simply the investment policy (asset allocation)
decision that determined how much a fund should hold in shares, bonds or cash.
That left less than 5% of the difference in results to all other causes, which included
costs, market deviations and cyclical conditions.

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Conclusions: Attempts at market timing almost always resulted in a reduction of return and
individual stock selection on average resulted in a reduction in the funds returns. In addition,
there is usually a wider variation in individual stock selection impact than in market timing and
attempts to actively manage the portfolios actually cost the average fund 1.5% per year when
compared to just buying and holding the appropriate indices.

The lesson from the use of 10 portfolios and the three global indices is that institutions and
investors are increasingly turning to global asset class investing. If the vast majority of
investment returns can be attributed to an asset allocation decision, should investors not
concentrate their efforts where they will have the most impact?
Asset class investing, which is investing and making commitments to sectors rather than
individual securities, is a fundamental shift in emphasis from what most investors understand.
Rather than ponder over whether to purchase Anglo or IBM, investors should decide how many
assets to commit to specific sectors. Rather than being concerned with market timing, investors
should be thinking about long-term commitments to chosen asset classes.
Rational steps in asset allocation
A. Investors should take decisions in the following logical phases:

Level of risk tolerance.

Which specific markets to enter. Another way of looking at step two is to decide which
markets you do not want to invest in and then turn the investment decision towards those left
over.
What proportion of assets to put in each selected market in order to meet goals within risk
tolerance.

In terms of ultimate results, these are by far the most important decisions investors have to
make. The impact of asset allocation or investment policy outpaces all other decisions.
B. To actively manage a portfolio or to use unit trusts?
This depends on the individual investor. Today, the asset class decisions are more complex than
just a choice on shares, bonds or cash. There are literally hundreds of unit trusts (and
combinations thereof) and more are constantly being proposed. Each incurs different
combinations of risk, reward and correlation to the others. Putting the asset classes together to
meet your goals is where the bulk of the heavy work should be done. Another name for asset
class investing is Indexing, which is discussed later in this chapter.
Looking forward, a strategy should yield superior results while limiting risk for long-term
investors in almost any economic environment short of civil war or total global economic
collapse. The combination of Strategic Global Asset Allocation and MPT (with an appreciation of
the cross section of expected returns in various parts of the world's markets) offers investors the
highest shot at making their objectives a reality.
The efficient market debate
Debate about the efficient market boils down to the consideration of one of three models.
At one end of the spectrum, the perfect world" market theory, where no one can ever get
information that is not already known to the market. Even insiders cannot benefit from their
position.
The "imperfect market theory states that insiders will always profit from price sensitive
information.
The "capitalistic model" is a rapid, electronically charged system that serves investors with
the quickest and most astute abilities to make global decisions on a split second notice.

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Perfect World Theory

In a perfect world there would be lots of buyers and sellers, homogeneous products, perfect
knowledge and instantaneous spread of new information. In this market, prices are determined
by the independent judgment of thousands of buyers and sellers. New information reaches
buyers and sellers instantly, prices adjust immediately and neither side can expect an economic
advantage. The market is perfectly efficient.
However, in this perfect market, no amount of additional research will improve an
investor's position. All information about each share and its economic prospects is already
known. Prices settle into equilibrium at a level that reflects both the market rate of return and the
additional risk each security carries. All that is necessary for an individual investor to attain an
appropriate rate of return is to buy and hold a diversified portfolio. The individual investor need
not exhibit superior skill in order to match the most sophisticated institution. Furthermore, an
individual's portfolio can never under-perform. The market has set the appropriate price and the
risk level for each security.
The Imperfect Market Theory
Only the most naive would think that insider trading has been eliminated and that investors are
moving closer towards the Perfect World. It must be conceded, however, that as information
spreads more quickly and wider afield, it becomes more difficult to profit from insider trading and
harder to conceal it from regulators. Therefore, while occasional violations will continue to occur,
the impact on the markets is probably minimal. It must be pointed out that this relates mostly to
insider knowledge of a specific companys activities and not to groups of traders banding
together to defraud the market through front running and other means.
The Capitalist Model
How quickly and effectively information spreads is at the heart of the debate over just how
efficient markets are. Even if investors have never heard the term "efficient market," they form
strategies and view their alternatives based on opinions about the efficiency of various markets.
In a capitalistic society, price is the determining factor between supply and demand. In
stockbroking the same principles apply and, in order for markets to properly set prices there
have to be willing buyers and sellers. Should one side possess more information than the other,
then we must expect that that side has a tremendous advantage. We must then expect the
holder to utilise this additional knowledge to extract "undeserved profits."
Markets are the very heart and soul of the capitalistic system. The system's invisible
hand not only sets prices, but determines how goods and services are distributed and
encourages further growth of the system with benefits for all. For markets to work at all, there
must be a general feeling that they are fair.
In organised markets, governments and regulators go to a great deal of trouble to ensure
that both sides operate on a level playing field. Ideally, no one should have an advantage, which
requires government intervention through implementing disclosure laws, setting accounting and
financial reporting standards, monitor for compliance, prohibiting insider trading and setting the
rules for licensing brokerages, dealers and advisors.
That said, around the globe stock exchanges are rapidly moving to electronic trading. In
South Africa, the JSE introduced the JET system in November 1996. Today, there is no longer
an open cry system, where dealers can discuss deals. Every transaction is completed via
computer. In essence, a trader enters a buy or sell order on the computer and that deal is
usually completed within seconds.
The Capitalist system in operation
When arriving at an agreed buy-sell price investors also have to assess the risk in a particular
asset and compare that risk to the market as a whole. There are a number of pricing models that
can be used to achieve this, which I discussed in Share Analysis & Company Forecasting
(Struik, March 1995).

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However, it is important to expand on the most widely known model, the Capital Asset
Pricing Model (CAPM), which examines the volatility of an individual share in relation to the
market as a whole. The model assigns the additional volatility (a factor called Beta) and
assumes that stocks will be priced to reflect both market risk and the particular risk of the
individual stock. CAPM and Beta are brilliant concepts, but do suffer from flaws.
Asset pricing and expected returns are directly related. Risky assets have lower costs and
higher expected returns than less risky assets. No market is perfectly efficient, but securities
markets are pretty close. Today, as we have all observed, information spreads worldwide at the
speed of light. Millions of people have access to the same information simultaneously. Millions of
traders constantly monitor data for pricing aberrations around the world. Where such pricing
discrepancies exist, they are almost instantly closed by normal arbitrage. Thousands of
computers continuously screen prices against multiple criteria, formulas, and models to detect
pricing deficiencies. Hundreds of analysts may follow a single stock. There are very few secrets.
What are the chances that investors will be able to develop a single investment idea that
hundreds or thousands of others have not previously considered? If others have already acted
on a similar concept, their knowledge must be factored into the price of the share. Is it ever
possible to get an investment edge, and, if so, can investors use that edge reliably enough to
make a difference to their portfolios? In the real world, transaction and tax costs are high, and
we would have to be right often to overcome high trading costs. The cost of research is also
high.
If nobody did research, then major global market discrepancies would occur. Simple
research should lead to giant gains, but with so many players, the point of diminishing returns
may be far behind us. The researchers, economists, strategists and analysts around the world
make the market extremely efficient. Not perfect, but efficient.
Using the CAPM
Under the CAPM model, share prices and expected future returns are related to market risk and
a unique risk that each stock has, called "Beta." This is a measure of the volatility of the
individual stock in relation to the market as a whole.
Over the years portfolio managers around the world learnt to love using the CAPM. They
found it relatively easy to understand and, in turn, explain it to clients. However, there is one
small problem: Beta does not do a very good job of explaining either price or returns. In
particular, CAPM and Beta leave large anomalies in two areas, namely small companies and
low-priced companies that have higher than expected returns.
There must, therefore, be a better way of explaining returns. Beta is a single-factor
variable, but if combined with size and book-to-market (BTM) ratio, beta does the best job of
explaining share performance. BTM is the ratio of a firm's book value per share (also called net
asset value, which is shareholders equity divided by shares issued) to its share price. Stated in
another manner, BTM is the inverse of price-to-book (P:B) values.
A firm with a high BTM has lots of assets per share compared to a low-BTM firm.
Analysis shows that high-BTM firms have characteristics associated with "value" and low-BTM
firms tend to be "growth" firms. Growth and value are often confused. While everyone seems to
agree that Microsoft is a growth company, value seems to be in the eyes of the beholder. BTM
provides an objective measure.
Value vs. Growth investing
High-BTM firms (value companies) seem to have:
Low price:earnings ratios (p:e).
Low return on equity.
Low return on assets.
Slow or no growth of sales.

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Disappointing profits and often other discouraging financial results.

Even though they have large assets, the market has driven down the price of their share. It
addition, directors often have a precise idea of how to generate additional business growth,
so many high-BTM firms often have high dividend covers. In essence, many use the
attributable profits to fund acquisitions. Usually these acquisitions add to quality earnings
and its net worth (value of underlying assets) is usually worth more per share than the share
price.

Low-BTM firms (high growth) are the opposite. They have:

High p:e ratios.
High return on equity and assets.
Usually, they have histories of exponential growth of profits, sales, market share and
other healthy, desirable attributes.
Generally they have so many investment opportunities internally that they do not pay
high dividends. Yet they are often not healthy companies.

Note: Growth companies grow mainly via acquisition, while value companies grow via mainly
organic growth or acquisitions that add to quality growth.
Despite many studies around the world showing the BTM is a better measurement of a
companys potential, economists, analysts and portfolio managers around the world hang-on to
the CAPM, vehemently defending this model.
One of the implications of CAPM was that the "super efficient" portfolio, the one which
generated the most return per unit of risk, was the total world market basket. An investor who
wanted more or less risk could take this global market index and either leverage it or water it
down with a "risk-free" asset. This led to the spread of global indexing as an investment
technique. Now, with BTM analysis investors can do considerably better than the world-market
index by heavily weighting their portfolios with value stocks.
Many portfolio managers argue that CAPM is a better measurement of efficiency, as they
believe the difference in pricing and performance is due to cost of capital. For instance, a large
company can borrow money from the bank or issue bonds, and will thus generally have to pay a
lower interest rate than a small company, because of the lower risk it appears to offer. In the
same manner, if a large company issues shares, it will generally command a higher price than a
small company. Therefore, large companies have a lower cost of capital.
Similarly, well-run firms have a smaller cost of capital than poorly run or stressed firms.
High cost of capital means depressed share prices and translates into higher expected returns.
The buying of sick companies is another way to diversifying a portfolio.
By acquiring sick firms, the investment philosophy suggests that, when these companies
do turn around, the returns generated will exceed the glamour of having Microsoft or Anglo
American shares in the portfolio. Of course, the assumption is that these sick firms will turn
around. The thinking is that a firm with a sound business market and clients, but is not
performing, is an easy target for takeover by a better run and managed company. It appears that
investors have been paying too much for growth firms and too little for value firms.
Value stocks appear to perform equally well in global markets. By examining managers'
styles (as defined by the size and BTM ratio of their portfolios), we have another powerful tool to
evaluate management effectiveness. We can examine the pattern of a portfolios past
performance and make a very close guess as to the portfolio composition.
By incorporating explanations of share returns based on size and BTM ratios, investors
are able to more confidently predict expected returns when modeling portfolios. This
methodology represents a measurable improvement over using unadjusted, raw-data past

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returns as the expected future rates of returns. Historical raw data is subject to unusual nonrecurring, uneconomic events that can dramatically distort its usefulness as a forecasting tool.
Improved rates of return forecasts will lead to much improved optimisation models and betterperforming, lower risk portfolios.
Conclusion: While long-term data would strongly suggest the superiority of small-company and
value investing to maximise returns, investors must still be aware that growth and the larger
blue chip companies offer long-term market growth. In the short run, we can expect significant
year-to-year variation. Accordingly, it appears wise to continue holding some of both in a wellconstructed plan to minimise risk at the portfolio level. However, the best available data
indicates that a higher representation of value and of small company stocks in equity portfolios
will handsomely reward long-term investors who target high growth rates.

The importance of investment research

The more important issue is whether research and active management can add value to a
portfolio. If markets are efficient, all the research in the world should not improve an investor's
results. If research is a factor, then it can be a valuable addition. Today there are numerous
indices that measure the performance of various markets and parts of them. Investors can also
generate other indices to capture a more specific portion of a target market. Indices have no
transaction, management, or other costs and are always fully invested. Remember, though, that
the Overall Index growth usually reflects the average growth of its components, i.e. it is made up
of the sector indices.
It is thus better to use a sector index as a comparison for a selected number of shares in
a portfolio. For the investor who does not have funds to hire a manager to look after his portfolio,
the use of a comparison to specific indices is one way to assess individual performance. After
all, managers cost money, both in management fees and transaction costs. Not counting taxes,
management is generally assumed to cost at least 2% per year. If the investor pays taxes, the
constant buying and selling will create substantial tax liability, which becomes a heavy drag on
performance.
In theory, if markets are inefficient, good managers will overcome all the direct and
indirect costs they generate and add value through astute exploitation of market inefficiencies to
produce superior results. These managers rely on research, experience, intuition and superior
skill to decide what and when to buy and sell.
Types of Research
Market research is divided into two categories: technical and fundamental.
Technical Analysis
This is the analysis of share prices and their historic movements. By plotting past movements,
technicians believe they can discover repetitive patterns that will suggest valid buy and sell
"signals." Discovery of the right signals will lead to effective market timing.
Technicians use all sorts of data and combinations of data to generate their signals. They
will study, among others, consumer confidence, interest rates, yield curves, market volume,
short sales, odd lot volume, ratios of new highs to new lows. There are as many arguments for
as against the use of historic patterns to determine future share movements. Whether right or
wrong, these technicians generate huge trading volume which, in itself, often moves share
prices.
Fundamental Analysis
Fundamental analysis concerns itself with examination of the firm and the economy. It looks at
financial data, sales forecasts, market share, quality of management, expansion plans, new
products, competitive position, economic forecasts and other data to search out the true value of

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companies and their financial prospects for the future. Fundamental research also has a
fundamental problem: forecasting. The market and economic environment is far too complex to
allow for accurate forecasting even if we have perfect data and insight. At best we have a very
poor understanding of how the economy and the world's markets work. Even worse, noneconomic events pop up randomly to confuse us further.
Events such as assassinations, natural disasters or coup-de-tats can make a shambles
of the best forecast. As a result, earnings and interest-rate forecasts are at times so inaccurate
that analysis becomes laughable. This is the reason that thousands of analysts around the world
have started to subscribe to an alternative method of analysis, the Economic Value Added
(EVA) system that was created and promoted by Joel Stern a partner in a US financial
advisory firm that specialises in strategic financial policy, corporate finance and human resource
value management. This is discussed in the next chapter.
An Alternative Point of View
Detractors of the capitalistic model point to the strange behaviour of markets. For instance, it is
argued that the market could not have been right both before and after the October 1997 Crash,
when the Dow Jones Industrial lost 12% of its value in less than a week and regained these
losses within three months of the crash. They miss the point. Nobody is saying that the market is
always right, or even rational. The real point is that if markets are efficient, it is very unlikely that
you, or anybody else, will be able to consistently out-perform the market.
Another problem with the capitalistic model is clearly not all markets operate by the same
standards. Very small companies have fewer analysts, and some issues are thinly traded.
Foreign and emerging markets have different disclosure and financial reporting criteria,
enforcement may be lax, or corruption endemic. Some markets do not even have insider trading
restrictions. All of these complaints are valid and all give comfort to portfolio managers who
argue that they can exploit inefficiencies to obtain above-benchmark returns.
The reality about globalisation is that if markets are not efficient, managers should have an easy
time beating their benchmark.
Time to start the motors running
The asset allocation decision is the practical phase of the investment process. Having decided
on an appropriate plan, the quest now turns to finding suitable funding vehicles to best represent
each asset class. Mutual funds are almost the ideal building blocks to construct a globally
diversified investment strategy. The previous chapters have set the scene for the practical phase
and now it is time to get down to the task of fund selection.
The first (obvious) observation is the rise of the unit trust industry in South Africa. It
provides the small investor with the perfect starting point for the creation of an investment
portfolio. In essence, unit trusts have become popular because they offer huge advantages to
small (defined as those with less than R5 million to invest) and large investors.
However, before looking at unit trusts, it is important to look at building a spreadsheet to
keep the value of a portfolio updated.
Spreadsheets to the rescue
Build a spreadsheet that assigns a percentage for each asset class and fund in an asset
allocation plan. You want to be able to fill in the total value of the account, so that the spread
sheet can calculate the desired asset class and individual fund values for you.
The spreadsheet can also be used to countercheck the orders placed with the manager.
It is simple to confuse an order to increase industrials by 10% and increase industrials by
100%. In other words, place an order and wait for confirmations. Check these against orders
and keep them for your records. The investor should receive a prospectus before entering a new
fund. Take the time and make the effort to read them.

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The investor should receive an annual, consolidated tax statement.

1
2

A
PORTFOLIO

Date
acquired

Price when
Acquired
(cents)

Present
value
(cents)

Amount
of share
bought

3
4
5
6
7
8
9
1
0

TOTAL PORTFOLIO
VALUE
On
acquisition

Share 1
Share 2
Share 3
Share 4
Share 5
TOTAL

02/08/92
02/08/92
13/02/93
20/04/93
12/10/94
-

111
2020
9
3000
900
-

115
3012
14
4200
1200
-

Update
d

1,000
10,000
30,400
220
10,020
GROWTH VALUE

Formulae
Block
E4

Formula
=sum((d4/c4)-1)*100

E5

=sum((d5/c5)-1)*100

E6

=sum((d6/c6)-1)*100

E7

=sum((d7/c7)-1)*100

E8

=sum((d8/c8)-1)*100

F9
G4
G5
G6
G7
G8
G9
H4
H5
H6
H7
H8
H9
H10

=sum(f4:f8)
=sum(F4*C4)/100
=sum(F5*C5)/100
=sum(F6*C6)/100
=sum(F7*C7)/100
=sum(F8*C8)/100
=sum(G4:G8)
=sum(F4*D4)/100
=sum(F5*D5)/100
=sum(F6*D6)/100
=sum(F7*D7)/100
=sum(F*D8)/100
=sum(H4:H8)
=sum((H9/G9)1)*100

Explanation
Calculation of percentage increase between share price (bought
present value)
Calculation of percentage increase between share price (bought
present value)
Calculation of percentage increase between share price (bought
present value)
Calculation of percentage increase between share price (bought
present value)
Calculation of percentage increase between share price (bought
present value)
The addition of the total number of shares bought (i.e. volume)
Calculation of value of shares when purchased
Calculation of value of shares when purchased
Calculation of value of shares when purchased
Calculation of value of shares when purchased
Calculation of value of shares when purchased
Addition of total value of portfolio when shares were bought
Calculation of value of shares - updated
Calculation of value of shares updated
Calculation of value of shares updated
Calculation of value of shares updated
Calculation of value of shares updated
The addition of the total value of portfolio updated
The percentage increase in the value of share portfolio

vs.
vs.
vs.
vs.
vs.

Regularly re-assess performance

The investor should secure an appointment with his manager at least once a quarter. Once the
investor has received the updated portfolio, checked it against personal records and is satisfied
that there are no errors, it is time to evaluate progress. This does not mean that evaluation has
to be complex or confrontational. The meeting should be used to evaluate the portfolio.
Assess whether the assets are still close to the asset allocation goal. If not, it may be
time to reallocate back to the original goal, which accomplishes two objectives:

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It keeps the original risk profile. Logically, over a long period of time, some assets will grow
faster than others and, if not checked, the mix of assets would change after a while.
Remember that when the mix changes, the risk profile changes and the long term objective
is partly lost. The resulting portfolio will not be optimum, or within the desired risk tolerance.

It forces the investor to consider new acquisitions and what to sell. Depending on the mix of
assets being held, a periodic reallocation could add as much as 1% to 2% to the annual
average performance.

Of course, re-allocation may involve transaction costs and/or a tax cost.

How often should an investor re-calculate the balance of his? There is no sense in re-balancing
a portfolio daily if the aim is long-term growth. There is, however, a need to check that the mix
has not changed. It is suggested that an investor check the whole portfolio every six months, but
keep a close watch on the speculative portion of the portfolio. It would thus be a good idea to
have two spreadsheets - a portfolio for speculative shares and another (complete) portfolio that
includes the speculative portion of the portfolio. In this way, if the value of the speculative portion
of the portfolio has risen to constitute more than 10% (or whatever the target is), then some
shares should be sold and the funds placed in longer term shares.

A. Start with unit trusts

Unit trust companies are good capitalists. After all, they have spent huge sums on advertising
and public relations to educate investors all the advantages. They have been very successful in
getting their message across. Traditionally, investors have thought of diversification, low cost
and access to strong management as the chief advantages of unit trusts.
The first two are true: where else can an investor buy a portfolio containing hundreds or
even thousands of individual issues across a market with as little as R500? In addition, the fee
structure is moderate and not crippling. The small investor thus has a chance to set up a
portfolio and accumulate wealth.
The question of management ability has already been discussed, but if the investor is
convinced managers can add value, then by pooling these funds with thousands of other
investors, the investor can attract the attention of the best talent available.
If the investor does not believe managers can add value, they can invest in index or
passively managed funds. As designers of a superior investment strategy based on strategic
global asset allocation, investors should select unit trusts that allow them to very tightly control
their portfolio.
All the money flowing into unit trusts often results in the media expressing concern that, once the
flow slows, the market will crash. The theory is that, once bears arrive on the market, individual
investors will start panic selling. The resulting sale of unit trusts will trigger a liquidity crisis and a
vicious, unending downward spiral in the market. The core of this argument seems to be that
unit trust investors will behave irrationally as they are small investors. The suggestion is that
these investors have unit trusts because they do not understand enough of the market to invest
directly in shares. This is, of course, nonsense. The evidence points to large institutions, traders
and speculators as being equally liable to panic.
In fact, unit trusts are simply replacing other investment mechanisms that are less
efficient and economical for investors. Whether invested in unit trusts or individual issues, all
investors must restrain themselves from irrational behaviour during occasional, inevitable and
temporary market decline.

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Summary: Unit trusts are gaining market share, because they are a better investment medium
for the small investor to start a portfolio. However, it must be stressed that start is the operative
word. Once investors have enough funds to move directly into the market, they should do so.
How does the unit trust industry work. Once understood, the investor can develop a few simple
criteria to drive their selection decisions. This procedure is fairly straightforward and it allows you
to gain control of the total investment process.
The South African unit trust industry
The local market offers investors a choice of over 150 unit trust funds, which is a small number
when compared with the international market. These unit trusts are split into 13 sectors and
categorised according to type of assets which, in turn, can be grouped into three areas - equity,
income and managed funds.
A brief description of each of the three groups is outlined:

Equity funds, which invest in shares listed on the stock market. These are split into five
types:

General equity funds that invest in a wide range of shares on the JSE. This is the perfect
starting point for an investment strategy as they are established, have a lower risk and
provide a broad-based knowledge of stock market movements.

Index funds can be used as the second step in the strategy, i.e. before moving to index
stocks, use index unit trusts to build knowledge of the index stocks. These unit trusts
strive to track the performance of a targeted JSE index.

Specialist equity funds, which concentrate on specific types of shares, i.e. mining, gold,
financial and industrial funds.

Specific funds which invest in various specified market sectors. The investor can build up
knowledge of sectors before moving into the stock market.

Smaller company funds which can be used to boost the percentage growth of the
portfolio.

Income funds are invested in interest-bearing securities, such as gilts.

Managed funds, which offer a mix of the above types of funds, i.e. equities, fixed-interest
assets and property. This sector is split into managed prudential and managed flexible funds.

Growth inhibitors
As in all investments, there are a number of costs that investors should be aware of. The
following is an outline of the main types of costs that have to be taken into account when setting
up an investment strategy. Without doubt, cost is an important consideration for investors and is,
contrary to popular belief, one of the few areas over which investors can exercise a great deal of
control.
Management fees
Every unit trust has a management fee, which you are entitled to know of. Insist on full
disclosure when approaching the fund manager. This fee goes to pay the normal expenses of
running the management team and the business. It includes postage, printing, rent, salaries,
accounting, electricity, telephones and equipment.

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Trading costs
In certain types of funds, trading costs are not included in the expense ratio and are not
disclosed. Investors can often determine the extent of these fees from the portfolio turnover.
Some funds seldom or never trade, while some may turn the entire portfolio over several times a
year. Trading cost vary from market to market.
For global investors with shares on the New York Stock Exchange, trading costs are
generally very small. However, when investing in small companies, foreign or emerging market
shares or bonds, trading costs can be steep. Note that in foreign markets, particularly in the US,
trading costs fall directly on the fund and when a fund buys a share, it carries the share on the
books at cost, including commission. When it sells, it shows the net receipts after commission.
Unless one can demonstrate a very positive benefit from trading, and most managers can't,
small turnover is good.
Therefore, internationally the net cost of running any unit trust is the expense ratio plus
the trading costs.
The impact of commissions
Some funds are sold directly to the public, while others are sold by salesmen. The second type
of fund has to find a way of paying the salesperson. A number of interesting arrangements have
developed to solve that problem. The sales charge is usually an up front percentage deduction
from the total investment. There is also a monthly management fee, which is sometimes
deducted quarterly.
Target a market segment
The next step to building an investment plan is to make sure that funds selected must reliably
capture the performance of the market or segment of the market that the investor has specified
in his model. This is not the time to forget what has been learnt about risk, return and correlation
of shares, particularly when based on the size of the firm and the share's book to market ratio.
Remember that this information was crucial in designing the asset allocation plan.
To control an asset allocation plan, investors must assess funds that can be defined
within their own parameters. These could be unit trusts, high growth funds, sector related funds,
risk-free market funds and many others. For instance, a general rule is that across most of the
world's economies, a countrys smallest 20% of companies have about a 5% higher expected
rate of return than the largest companies over long periods.
Of course, this return comes with a higher risk and a correlation with other asset classes.
For instance, if an investors asset allocation strategic plan states the following share
distribution:
15% in small companies
30% in blue chips (industrials)
20% in blue chips (financial
shares)
10% in cash for market
speculation
25% in mining shares
The advisor is bound to get securities in the above proportion. Once again, the problem of
relative comparison rears its head. The investor has to be sure that the advisor understands
what he means when he says small. Make it perfectly clear that small means invest in
companies with a market capitalisation of more than a R1 million, or invest in companies with a
market capitalisation of less than R10 million. Remember that one person's definition of a small
company may vary considerably from anothers.

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Similarly, the concept of value also draws in the relative comparison problem. Value is
more difficult to define than size. There are many managers who call themselves value
managers, but own portfolios of stock with very low book-to-market ratios. If an investor wants a
strong value representation, he must create a portfolio with at least 30% of shares based in
values stocks.
Beware: Funds can shift from value to growth
In South Africa, many directors have moved their companies into the international arena in an
attempt to create a rand-hedge element to their firms. After all, the more dollars a company can
earn the higher the rand value at the companys financial year end. However, it is disconcerting
to find that a fund an investor has selected to represent small companies has suddenly
purchased a stake in a large foreign conglomerate. Does this make turn a value firm into a
growth company?
Not necessarily. Many value companies have divisions that have ample growth
opportunities. When a company shows signs of being larger than the prerequisite set out in the
investment strategy plan, it is up to the investor to change the portfolio to keep it within his
boundaries. For instance, if a small company suddenly acquired a much larger entity and
became a R100 million market capitalisation company and way beyond the small means less
than R10 million market cap, the investor must either sell this share or another share (in a
different sector) to regain the percentage set out in the plan.
The movement of shares in and out of the investors criteria should be viewed on a
periodic basis and not when the investor is in panic. For instance, if the small company becomes
larger, this is not necessarily negative. The investor wants capital and dividend gain for the
long term. While a foreign acquisition may boost financial performance, this is not certain. It is up
to the investor to make the decision and to move on. The changing investment scene does,
however, skews the model badly.
The tendency of managers to wake-up one day and decide that an entirely different
market segment looks more attractive than where they are is called "style drift." This is without
doubt the natural enemy of the asset allocation plan as there is no way to control risk if the
investor does not know what is in the portfolio or if the portfolio changes radically without any
advance notice.
Be wary of labels
Traditional labels and prospectus categories are not much help. Often categories are arbitrary
and ambiguous and many portfolio managers have their own definition of "growth and income"
and "growth" or "equity income" funds. The reason for the use of categories is to enable fund
rating services to compare fund performances. The funds often respond by re-defining their
objectives to fit a category in which their relative performance is better.
Defining the investment manager's style provides us with a great deal more useful
insight, such as the average company size and growth/value characteristics of the portfolio.
Once the investor has made an asset allocation decision, he must have absolutely no interest in
the fund manager's market forecast. The investor must insist that the manger stays fully invested
in the market (as pre-determined) at all times. The decision on the exposure level has also been
made and attempts by the manager to time sales or purchases in the market are unacceptable.
The unit trust is simply a building block for an investment strategy and the more
predictable the building block, the better the finished structure.
Conclusion:
The portfolio managers mission is to stay fully invested, widely diversified, to keep costs
down and reliably capture the performance of an assigned market segment. If the manager
strays from the assignment or attempts to market time, the manager must be replaced
immediately. In addition, if the manager fails to match the assigned market performance, the
manager should be replaced. However, it is not appropriate to blame the manager if the class

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of share chosen by the investor (against the managers advice) does not perform.

There is an alternative for investors who trust their portfolio managers. For this type of
investor, the active managers might add value. The following table is a checklist for investors
to develop a fund selection process for each individual asset class.

A starters checklist

Decide on a mix of active and passive techniques, i.e. your aim should be 70% unit trust,
20% equities and 10% cash initially.
Once the investor has grown in confidence, develop a long term strategy and reduce the unit
trust component to around 10%.
Define the market as tightly as possible, i.e. large, small, foreign, emerging markets, Asia,
Japan, Europe, etc.
Make sure the manager stays fully invested and within the assigned market.
Define the style of companies to invest in, i.e. growth vs. value. (A strong value tilt should
enhance performance and reduce risk.)
Check expense ratio. (The lower, the better. Remember that, however, some markets cost
more than others).
Check portfolio turnover. (The lower the better.)
Compare performance to appropriate bench mark and competitive funds. Try to understand
any variation from bench mark. (There is always a reason. Higher returns mean higher risk).

It does not have to be perfect to be great. Get started. Do not wait for it to be perfect. It never will
be and you will still be waiting when you are old and broke. The important thing is to get started
on a sensible plan and exercise the discipline to carry it out. Start small and build over time. If
the choices are not perfect, do the best you can.

B. Change the portfolio to Index Stocks

Once the investor has become familiar with share movements (using unit trusts), the next step in
performance monitoring is to build an asset allocation plan portfolio using only index stocks. This
is the start of building a real understanding of how shares work. It will help the investor
understand the total performance of a portfolio and put it in perspective.
There is, however, no difference in the mechanics of running an index stock portfolio to a
unit trust portfolio.
During any form of portfolio review, the investor should strenuously resist the temptation to
replace a disappointing fund with he latest fashion shares. Continually changing a portfolio is
unlikely to improve performance and will result in a losing strategy. It is crucial to understand that
fund evaluation and performance monitoring are tactical in nature.
There are only two times to change the asset allocation plan.

New, better analytical methods become known: When a new fundamental method of

assessing shares and portfolios comes is promoted in the media, among analysts and by the
academia, distinguish between proven, tested, academic, industry research and complete
nonsense.

Moving into the global arena: When the investor moves from a domestic bound portfolio to a

global one, it becomes important to understand and distinguish between:

First World market, where the company invested in is bound to that specific country, i.e.
Company AA which is listed on the London Stock Exchange and operates only in the UK;

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First World market, where the company invested in is listed in that country, but has
operations in other markets, i.e. Company AA which is listed on the New York Stock
Exchange and has operates divisions in other First World markets and/or emerging
markets.

Conclusion:
The investor must understand the new markets that is targeted in the globalisation of the
portfolio. This may include markets in countries like Thailand, Malaysia, Singapore, Hong
Kong, Brazil, Mexico, Argentina, India, Pakistan, Hungary, Russia, Poland, Turkey and
Jordan.

Understandably, given the start slowly philosophy, investigate funds that have concentrated
investments in a few of these smaller, less-developed countries as this might offer a strong
diversification effect.

Indexing
In 1995, the US media hailed the concept of investors adopting an indexing strategy as the new
investment force in stock markets. The reason was mainly due to the result of indexing in that
year. For the 12-month period ending December 1996, the S&P 500 Composite Stock Price
Index outperformed 75% of all general equity funds.
Obviously the success of such a strategy needs to be assessed.
What Is Indexing?
"Indexing" simply describes an investment approach that seeks to parallel the investment returns
of a specified stock market benchmark, or index. The investment manager attempts to replicate
the investment results of the target index by holding all - or in the case of very large indexes, a
representative sample - of the securities in the index. There is no attempt to narrow industry
sectors in an attempt to outpace the index, which means that indexing is a really a passive
approach emphasising broad diversification and low portfolio trading activity.
Indexing, in its simplest form, thus means buying all of the stocks (or index stocks) of a specific
sector, instead of trying to pick winners and losers. Index Investing is an investment strategy that
emphasises very broad diversification within and among different asset classes using index
funds.
Asset classes or specific sectors are defined as categories of shares with similar
characteristics, eg. furniture, motor or electronic companies. Such a portfolio would consist of all
the shares (or the Index stocks) in an asset class. For example, the All Share Index represents
shares of South African listed companies, but the All Share 40 Index fund owns all 40 shares in
the index and in the same percentages.
Indexing is also called passive investing or asset class investing.
The benefits of Indexing
Indexing eliminate the risks, costs and uncertainties that are associated with actively
managing a portfolio, i.e. picking specific shares and picking these at the right time (market
timing).
Lower costs and less taxes ultimately lead to higher returns and, therefore, less risk. This
combination is the closest thing investors get to a "free lunch" in investing.
Indexing is easy to manage as it is a more simplified portfolio, which in turn leads to:
Freedom from stockbrokers;
No market timing decisions; and
No subscriptions to newsletters and ratings services are necessary.

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An indexed portfolio only needs an occasional rebalancing for risk control. Essentially, the
investor who has chosen a specific sector and purchased all shares (or Index stocks)
within that sector, needs to assess whether the rate of return is acceptable, i.e if 10% is the
desired rate of return, and the indexing strategy yields 8%, then the investor should look at
another sector and assess the possibility of Indexing that sector.
Cost advantages of Indexing
Investors should note that indexing is really not suited to investors who have a long-term
strategy to achieve realistic returns, but higher than sector or overall market averages. If markets
do operate efficiently, then it is impossible for all investors in the aggregate to outperform the
overall stock market.
The very basis of capitalism is that there will be those (those skill, luck or both) that outperform
and those that will underperform the average return of the market as a whole. Therefore,
investors who gain a fair share of that investment average still have investment associated costs
to pay and, therefore, earn less than the overall market return.
The question is how much do these costs reduce returns? Obviously this changes around, but
first world trends and statistics do suggest that Indexing results in a two percentage point
reduction in costs.
Therefore are two important factors to remember when undertaking an Indexing strategy:
All mutual funds have costs in the form of the fund's expense ratio (including advisory fees,
distribution charges, and operating expenses); and
Portfolio transaction costs (brokerage and other trading costs).
Example: The impact of costs, based on the assumption of a 10% gross return on
investment.
Conventional Mutual Fund
Expense Ratio
Add: Transaction Costs
Total Costs
Gross return
Less: Total costs
Net Return

%
1.3
0.7
2.0
10.0
2.0
8.0

Low-Cost Index Fund

Expense Ratio
Add: Transaction Costs
Total Costs
Gross return
Less: Total returns
Net Return

%
0.2
0.1
0.3
10.0
0.3
9.7

The average general equity fund in the US has an annual expense ratio of 1.44% of investor
assets. In addition, traditional mutual fund managers have high portfolio activity; the industry
average fund's portfolio turnover rate is 77% per year. The trading costs associated with such
portfolio turnover may be expected to subtract another 0.5% to 1% annually. On aggregate, fund
expenses and transaction costs for the typical fund take a hefty bite out of the pie.
In contrast, one of the key advantages of an Index fund should be its low cost. An index fund
should:

Pay only minimal advisory fees.

Keep operating expenses at the lowest possible level.
Hold portfolio transaction costs to minimal levels.

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Indexing should, therefore, logically leave a larger share of the pie for investors. However, actual
results mostly show the benefits gained from Indexing are small when compared to investing
directly in specific shares. In addition, investing in Sector Indices (eg. The South African
Chemical & Oil sector) also shows that the investor may gain from less risk, but ultimately
achieves less capital growth.
Over time, broad stock market indices outperform Indexing strategies
The graphs and table below shows total returns of the South African Industrial and All share
Indices (to illustrate general market growth) and the strategy of Indexing the Chemical & Oil
Index.
ALL SHARE INDEX

1985 - 1998

DATE
20-09-85
21-09-98

INDEX
1170
4752

+306.50%

INDUSTRIAL INDEX

1985 1998

DATE

INDEX

20-09-85
21-09-98

954
5276

+453.0%

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CHEMICAL & OIL INDEX

1985 1998

DATE
20-09-85
21-09-98

INDEX
513
1253

+144.20%

Conclusion: An investor who believed that a long term strategy of Indexing the South African
Chemical & Oil Sector would provide superior returns would have been disappointed.
All Share

Industrial

OIL

20-09-85
21-09-98

1170
4752

954
5276

513
1253

Growth (%)

306.50%

453.00%

144.2

Indexing as a long term strategy

Indexing should never be considered as a means of speculating in the market or as a short term
investment strategy. Indexing is a solid long term method of providing investors with a means of
buying shares and understanding how these shares move, why some within the same sector
succeed while others fail.
Indexing's main appeal, then, is not to investors who expect to make a "killing." Instead, the
strategy should attract long term investors who seek a very competitive long term investment
return through broadly diversified portfolios. Such investors find in Indexing a high degree of
relative predictability in an uncertain stock market.
Nothing assures absolute returns, of course, but index investors can feel confident that their
investment should not be a dramatic underperformer relative to other funds investing in the
same type of securities in any year. Therefore, over the long term, index funds should provide
reasonable performance.
Indexing's tax advantage in overseas markets
An indexing strategy has one advantage that is often overlooked. For overseas investors, mutual
fund returns are calculated before taxes and, since Indexing requires less portfolio turnover than
actively managed funds, there is a strong tendency for index funds to realise and distribute
modest capital gains to shareholders. As distributions are taxable for overseas shareholders, it is

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clearly an advantage to defer their realisation as long as possible. Investors in South Africa do
not pay tax on dividends.
Indexing can be more than merely selecting Indices
Investors can implement a wide range of distinctive investment strategies through Indexing and
can efficiently allocate funds to:
AN INDEXING INVESTMENT STRATEGY

Asset
classes
specific

Selecting a

Markets

or

Local
Index Funds
(Mutual
funds)

Foreign
Blue Chips/
Bonds

Combination
of groupings

Consideration
s in choosing
a strategy

Step 1

Step 4

Step 2

Step 3
Investor profile
1. Objectives.
2. Risk
tolerance.

Large, medium, or small companies.

"Value" or "growth" stocks.
International stocks.
Fixed-income investments.

Blue Chips
In the US the best-known equity index is the Standard & Poor's 500 Composite Stock Price
Index. This index is made up by shares of large-capitalisation blue chips and it covers about
66% of the US stock market capitalisation. It provides a solid foundation for investors moving
into the US stock market.
However, stated differently, the S&P 500 Index overlooks 33% of all US shares, which
represent small and medium-sized companies. Therefore, as an initial strategy, investors moving
into the US can do no better than the S&P 500 Index. However, ultimately the intention must be
to move beyond the S&P 500 to the entire US stock market.
For investors with more specific objectives (eg. Pensioners looking for dividend income), it is
possible to acquire a stake in value or growth shares through Indexing, i.e. Standard & Poor's
Corporation and BARRA Associates enable investors to marry the benefits of traditional value
and growth equity investing with those of indexing.
For instance, investors looking to invest in small capitalisation shares while
simultaneously using an Indexing strategy to minimise the impact of trading, the US-based
Russell 2000 Index is the most widely accepted benchmark.
International Indexing

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The most widely recognized benchmark for the major international markets is the Morgan
Stanley Capital International (MSCI) - Europe, Australasia, and Far East Index (called EAFE ).
The Index is made up of shares of more than 1,000 companies located in some 20 foreign
countries.
Over the 10 year period ended December 31, 1996, the EAFE Index outperformed 37%
of all professionally managed international equity mutual funds. Note, however, that this Index
was heavily weighted in Japanese stocks, which rose sharply in some years during the period.
Many active managers either reduced their Japanese positions, or held a small commitment to
Japanese stocks.
Emerging markets Indexing is a relatively reliable way for investors to mitigate the impact
of dramatic price swings in any one particular market, and to reduce the impact of the high
trading costs in these markets. The MCSI-Select Emerging Markets Free Index consists of 14
stock markets, i.e. six in Southeast Asia (Hong Kong, Indonesia, Malaysia, the Philippines,
Singapore, and Thailand), three in Latin America (Argentina, Brazil, and Mexico), three in
Europe (Greece, Portugal, and Turkey), Israel and South Africa.
Bond Indexing
Investors who prefer the bond market over equities, or for those advocating Markowitzs contracyclical principles, there is an Indexing bond strategy. In South Africa, the market is relatively
small and benefits are thus minimal, but foreign markets offer more benefits. For instant, the
unmanaged Lehman Brothers Aggregate Bond Index represents the entire US bond market and
comprises of US Treasury and Government agency securities, mortgage-backed obligations and
investment-grade corporate bonds.

Some forewarnings about Indexing

Forewarning 1: Part of the index fund advantage is derived from being 100% invested in shares
at all times. Since most equity funds maintain cash reserves of 5% to 10% of net assets, they
tend to loose ground to index funds in the bull market in stocks during the 1980s and early
1990s. In periods of market declines, index funds, of course, can be expected to have somewhat
larger declines than funds maintaining cash reserves.
Forewarning 2: There will always be actively managed funds that outpace index funds over long
periods. The problem in selecting actively managed funds is, naturally, identifying in advance
those that will be superior over time with any consistency.
Forewarning 3: Indexing is a strategy that has been applied to many different categories of
investing. It provides an efficient way for investors to participate in broadly diversified portfolios.
Nonetheless, many investors will continue to be attracted to the distinctive investment
philosophies and strategies offered by the wide range of actively managed funds. A suitable
compromise may be to build equity and bond portfolios (or even combine them through a
balanced approach) with a "core" holding in an appropriate index fund. Around that core
investment, an investor may select specific actively managed funds that appear likely, in the
investor's judgment, to add incremental investment performance over the long run.
Using Indexing in a portfolio
Index funds are suitable vehicles for any investment goal - from saving for a child's education to
building a nest egg for a secure retirement. Whatever the objective, index funds may be
employed under one of the following three approaches:

An "All Index" Approach

A "Core" Approach
A "Market Participation" Approach

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An "All-Index" Approach
For the utmost simplicity, an entire investment programme could be composed solely of index
funds, or for some investors, one index fund. Indeed, a broadly diversified, low-cost portfolio of
stocks and bonds may be comprised by a single balanced index fund.
A "Core" Approach
Index funds can serve very well as the "core" of an investment programme. Under this strategy,
investors may invest 60%-70% of assets in an appropriate index funds - stock and bond. Then,
invest the remaining 30%-40% in actively managed funds that have potential to provide superior
investment performance over the long-term. Core investing assures that a significant portion of
an investment programme will match the market, while providing the opportunity to seek marketbeating performance.
A "Market Participation" Approach
Index funds are a simple way to complement or diversify an existing investment programme. An
investment programme consisting of South African shares could be diversified by an
international fund. An international equity index fund is a convenient, cost-efficient means of
participating in the foreign equity markets.
Please note these hypothetical investment programmes are examples only. A personal
investment programme should reflect an investors own investment objectives, risk tolerance and
time horizon.
Reasons not to use Indexing
There are reasons for selecting actively managed funds over - or to complement - indexed
funds:
To Follow a Specific Strategy
To Avoid Being Fully Invested
To Pursue Superior Active Management
To follow a specific strategy
An investor may want to invest a portion of a portfolio in a fund that follows a specific, welldefined strategy or that concentrates its holdings in a market sector. Corresponding index funds
may not be available. Examples include aggressive growth funds, equity income funds, or health
care, gold, energy, or other sector funds.
To avoid being fully invested
By their nature, index funds are always fully invested. During market downturns, index funds can
be expected to decline by the same amount as their target indices. Actively managed funds
typically hold some cash reserves, which may be increased in anticipation of a decline. While not
always successful, that strategy (or the fund's customary cash position) may temper declines in
down markets.
To pursue superior active management
In any given period, some actively managed funds will outpace index funds. There are some
managers with outstanding abilities who have, in the past, earned superior returns with
reasonable consistency. Many investors are driven by a desire "to do better than average" by
attempting to select future top-rated funds. Confining investments to index funds foregoes the
opportunity of participating in a top-performing fund (even if only for a short period) or of
investing with an accomplished portfolio manager. Of course, identifying star managers in
advance has proven to be extraordinarily difficult, so active management also involves a
substantial risk of underperforming the average.

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Asset allocation for the conservative, moderate or aggressive investor

The following are portfolio asset allocation suggestions and includes foreign investment. This is
discussed in later chapters. Note that these are suggested allocations and every individual
should structure their portfolios in a manner that enables them to sleep well at night. In essence,
when an investor cannot sleep, because he is worried about his shares, it means that he is too
heavily invested in certain types of shares (possibly speculative shares) or his strategy is not the
correct one for him.
The following portfolio allocations use a time frame of three years, 10 years and 30
years. These portfolios are based on the categories outlined below.

Categories of different portfolio security-types

Aggressive shares: Capital appreciation funds, Venture Capital shares, emerging market
shares, Specific global funds and shares.

Conservative shares: Growth and income unit trusts, blue chip shares (first world countries)
and conservative growth funds.

Fixed income: Long-term convertible debentures and long gilts.

Hybrids: Balanced funds, asset allocation funds, high yield gilts, equity income funds, global
gilts and emerging country debt funds.

Cash: Money market funds, liquid savings accounts (cash in the bank) and short-term
convertible debentures.

The following portfolios are for Conservative, Moderate and Aggressive investors:
Types of securities
(figures in %)
Conservative shares
Fixed Income securities
Aggressive shares
Cash
Hybrids
TOTAL
Types of securities
(figures in %)
Conservative
Fixed Income securities
Aggressive stocks
Cash
Hybrids
TOTAL

THE SHORT TERM PORTFOLIO (three years)

TYPES OF INVESTORS
Conservative
Moderate
Aggressive
25
20
10
40
40
40
0
10
30
30
20
5
5
10
15
100
100
100
THE LONG TERM PORTFOLIO (10 years)
TYPES OF INVESTORS
Conservative
Moderate
Aggressive
25
20
5
30
30
20
20
20
50
15
15
5
10
15
20
100
100
100

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Types of securities
(figures in %)
Conservative
Fixed Income securities
Aggressive stocks
Cash
Hybrids
TOTAL

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THE LIFE-TIME PORTFOLIO (30 years)

TYPES OF INVESTORS
Conservative
Moderate
Aggressive
25
20
5
25
20
10
30
50
70
10
0
5
10
10
10
100
100
100

Summary:
The longer the portfolio time horizon, the less cash-type securities are in portfolios of any
kind.

Even the most conservative investor holds very little cash, but he does hold a large
portion of funds in fixed income securities.

The shorter the time span, the higher the risk of investing. Therefore, even the
aggressive investor, who is seeking to maximise profits as quickly as possible, holds
conservative shares and fixed income securities.

The investor must keep a long-term goal firmly in mind while having the flexibility to
evolve as new research provides better solutions to the risk management problem or
new market opportunities present themselves.

Discipline remains the key to success for long-term investors, i.e. falling into a panic trap
of selling during bear markets or buying during strong bull markets.

A successful investment strategy involves patience, discipline and periodic reviews that
must be viewed as an opportunity for fine tuning and occasional modest course
corrections, not radical revision and second guessing.

Selecting shares is discussed in the following chapter.

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CHAPTER 20: CREATING RULES FOR SHARE INVESTING

Golden rules are merely old, general rules of thumb. Each rule usually has an exception and
often a rule that is the exact opposite. Remember this when creating a personalised set of
investment rules.

There is a story about a businessman who had a thriving multi-million rand business in 1996. He
gloated in the media about the book value of his profits, business and personal investments. He
intimated that he could do no wrong. To improve his portfolio, he pledged the lot to his bankers,
borrowed to the hilt and bought only the best investments.
To begin with, prices rose steadily, but he did not know, like many thousands other
investors, that a market correction was about to hit the market in October 1997. Had he known
this, he would have cut his losses when prices were on the slide.
Instead, he tried to rescue his business by mortgaging it to the bank. Things went from
bad to worse and he had to sell his investments. He shot himself.
Investor greed is often compounded by a relative time problem. Market downturns hurt a
lot more than good times feel good. It is many times more painful to see a portfolio lose 1% than
it is pleasant to see it gain 1%. It also feels longer. Without doubt, two years of continuous
decline, under-performance and even sideways movement feels like a lifetime. As we have
seen, even a superior portfolio will go through occasional extended periods of disappointment.
To make things even worse, no matter how bad things may get for investors, somewhere
somebody is making money.
So, the temptation to boost growth is powerful. If others can make money, why
not me? Perhaps it is time to try something else? The following text looks at general principles in
investing, from Wall Street to the JSE.
Wall Street advises
The following are some time tested, age old pearls of wisdom, which US experts religiously follow. There
are two main rules and two converse rules which are used primarily as mechanisms to detect sudden
changes in bull or bear markets.

The first rule tells investors to avoid shares that do not move in bull markets. The logic to this
rule is based on the general perception that if insider traders avoid the share, there must be something
inherently wrong with the company. Opinion is that insiders would sell the share if it moved at all.

The converse of the first rule, to buy shares that do not move down in a bear market, also
applies. If a share has strong support during adverse trading conditions, it should provide investors
with substantial capital gains when the market turns. In fact, of all the mechanisms used by experts,
this rule provides the best and most reliable advice in stock exchange circles.

The second rule states that when a bear market turns to bull, buy the share that has gone down
the most and the share that has gone down the least. These may sound contradictory, but an
assessment shows investors this advice is sound as it represents the two extremes of the market.

Firstly, shares that have gone down the most are expected to turn with the next bull market and,
secondly, shares that have fallen the least obviously have strong shareholder support and should - once
the bear market has run its course - move upwards on that support.

The converse indicates that when a bull market turns to bear, sell the stock that has gone up the
most and the least. A share that has rocketed during a bull run will have the greatest potential to fall,
while the share that has climbed the least has no support and is expected to fall with the new trend.

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Finally, while not a rule, US advisers suggest investors should buy during strong bear trends and sell
during bull runs. The logic is that it is too late to sell when everyone else is, but that shares display
future upward potential during bear trends.

After all, strong market trends reflect investor sentiment towards shares and does not indicate that listed
companies are financially unsound. If this is the case, shares are bound to correct at some future date and
the investor will eventually regain losses or make profits.
Selecting shares: Creating basic, guiding principles and rules
Investment, as distinct from speculation, is a long-term operation. This is the essence of this
book, but if investors are to select shares for the long term, how do they go about selecting
them? The first challenge was to set up a portfolio of unit trusts, followed by investing in index
stocks.
The time has come to select specific shares, across sectors and around the world (global
factors affecting shares are discussed in later chapters. The following rules and principles are
meant as guiding mechanisms and will vary between investors, according to their specific needs
and objectives.
The guidelines are split into:

General rules.
Guiding principles for certain times.
Guiding principles for uncertain times.
Tested investment practices.
Pitfalls to avoid.

The rules of regularly adjusting the portfolio, according to economic conditions, apply to all the
following rules.

General rules for buying shares

Rule 1: The company's business has to be stable and within an expanding industry.

Rule 2: A market capitalisation of not less than R10 million.

Rule 3: Earnings growth (eps) must be steady for at least a three year period and dividend
payments should be at least half the earnings growth, i.e. the company policy should be at
least a two times dividend cover.

Rule 4: Sound, entrepreneurial flair must be displayed by management.

Rule 5: Buy whenever possible through rights issues as these almost invariably cheapen a
share.

Rule 6: Buy quoted shares that have a ready market.

Rule 7: There is no mathematical formula for deciding the right price. It is a matter of
judgment, but good news can push up a share price and bad news can depress it. Timing a
purchase or sale needs patience. There is, however, a formula to calculate a fair price.

Jungle Tactics

Price:earnings
ratio

- 167 =

Share price

eps

Therefore, if the p:e ratio and eps are known factors, then the formula can be adjusted as
follows:

Share price

Price:earnings
ratio

eps

For instance, if Company LLL is trading at a p:e ratio of 10 times and latest eps is 50 cents, a fair
share price is 500 cents. If the market price is less, the share is trading at a discount to its fair
value. If the share is higher than the fair value, it is trading at a premium. The formula can also
be used as a means of working out a future price. For instance, if the investor believes the
current p:e ratio is fair, a 15% increase in eps could see the above example achieve the
following share price:
Share price

=
=

Price:earnings
ratio
10

=
=

10
575.50 cents

Eps

(50 cents
growth)
57.5

15%

The share price is forecast to be 575.5 cents within a 12 month period.

Rule 8: Ascertain all the company's activities as one subsidiary may wreck profits for a few
years.

Rule 9: Avoid industries with indifferent records, such as motor or textiles.

Rule 10: Choose consumer goods shares in preference to capital goods and shares that are
capital rather than labour intensive.

Rule 11: It rarely pays to give a second chance to a company that has had a setback which
cannot be explained by general industrial conditions.

Interesting situations can develop when the ratios do not all move in the same direction. A
steady decrease in the price ratio before the declaration of dividends might imply some
intelligent selling. This record is good in that it helps one to decide whether the price of a share
is expensive or cheap.

Simple Time Tested Guiding Principles

If you are new to investing and the financial markets, it is important to recognize one of the truths
of investing: stock and bond prices move up and down. While it may be difficult to accept these
fluctuations, the tougher part for many investors is coming to terms with yet another investment
truth: there is little you or anyone else can do to predict with any degree of accuracy when, how
fast, and how much prices will decline -- or bounce back.
Since market volatility is always present in stock and bond investing, it is the sensible
investor whose investment program is always prepared to deal with market movements. Once

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you've developed an investment mix that suits your personal investment goals, time horizon, and
risk tolerance, you should stick with it. In other words, find what works for you and "stay the
course", even through the most trying conditions.
Easier said than done, right? To assist investors, here are simple guiding principles to consider
prior to investment actions. Investment in equities does not have to be difficult, especially if you
follow a few simple time tested practices and avoid a few common pitfalls.

Don't panic. It is human nature to panic at the first sign of trouble in the market. The natural
reaction is to become nervous and want to revise the investment portfolio. Bear trends tend
can even cause most experienced investor to have second thoughts. I stress again, any
losses incurred are only "on paper" until you actually sell your shares. Getting caught up in
market fever might encourage you to buy when the market is high and to sell when markets
are low which is the reverse of a common sense approach.

Ignore market fever. Whether up or down, market direction must never dictate a portfolio
mix. When creating a sound long-term investment program, rely on:
1. Investment goals.
2. Time horizon (how long you will be investing.)
3. Risk tolerance (how comfortable you are with market ups and downs.)
4. Financial situation.

Don't abandon securities you believe in: It is enticing to sell an investment that falls in
value without warning. Resist the temptation. Over time, shares have offered the highest
returns and the greatest protection against inflation. Gilts offer higher income, but are
subject to changes in interest rates. Cash reserves (such as money market funds and CDs)
may protect your savings against daily price declines, but do little in the long run to preserve
the spending power of savings.

Avoid quick changes to a portfolio: As a general rule, do not make sudden shifts in your
portfolio the market is falling. Most experts will tell you that moving your money from shares
and bonds to more conservative investments in hopes of avoiding a loss or finding a gain is
seldom successful.

Invest regularly: There is some truth that stock markets are like casinos, especially when
an investor commits a large lump sum of money to shares and bonds in a one-time
investment. It is often better to invest gradually, making necessary changes over time in the
allocation of assets to shares, gilts and cash reserves. If the investment continues to worry
you and is keeping you awake at night, "sell to the sleeping point." Gradual moves should be
limited to 15 percentage point increments, i.e. An investor with a portfolio consisting of 80%
shares and 20% gilts, can move (if equities are worrying him) to a 65% share, 20% gilts and
thew remainder in cash. This practice is called cost averaging and allows investors to buy
more fund shares when prices are low and fewer shares when prices are high (discussed in
later chapters).

Be diversified: Maintaining an investment mix of shares (for growth), gilts (for income) and
short-term reserves (for stability) is a sensible way to hedge against many of the risks
associated with investing. Today's topsy-turvy markets serve to emphasise the benefits of a
diversified investment mix. Without doubt, when you diversify, the rewards associated with
one asset class (for instance, income from bonds) can help to offset the risks from another
(such as a decline in the price of shares).

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A key benefit of unit trusts or mutual funds is their diversification, which enables investors to
have a stake in many shares and/or gilts through a single fund; locally and overseas.
However, it is also wise to diversify among different types of assets by including shares, gilts
and money market funds in a portfolio. This lowers your risk of losing money because of poor
performance by one market.

Look before you leap: Every listed company is required to send potential investors a
prospectus. Read it carefully, checking the fund's objective, costs and long-term
performance in comparison to its competitors. Call the company and speak to the directors
(the company secretary is usually available) and ask questions about anything issues you do
not understand.

Reinvest your earnings: When you buy shares, you can have your earnings (dividends)
sent to you or automatically reinvested. By electing the latter, you turn your earnings into
principal which can then generate more earnings. Reinvestment is an effective way to help
your investment grow faster.

Be realistic: The returns achieved by the three classes of financial assets (shares, gilts and
cash) over the past 10 years have provided investors with substantial capital gains. Looking
ahead, however, it is important to have realistic expectations and not to assume the high
returns of the past decade will be repeated in the next decade.

Remember "no pain, no gain." The pursuit of higher returns is always accompanied by
higher risk. When you invest in shares or gilts, you should expect losses in some years.
However, over the long haul, past results have proven that short-term risks have been worth
taking when aiming for higher long-term gains.

Be patient: As an investor, your greatest ally is time. Once you select your personal
strategy, stick to it, even when markets decline. The exception is when circumstances
demand some readjustments. Over time, risk of losing money declines and the potential for
profit increases.

Reassess periodically. Market movements change the value of your investments. It is

important to maintain the portfolio percentage mix by regularly rebalancing the portfolio. Do
this at least once a year.

Pitfalls to Avoid

Keeping "all your eggs in one basket." When an investor keeps all his money in one asset
class (in other words, exclusively in shares or gilts), he assumes additional risk of losing
money in any given year. Equity and gilt markets are driven by different forces and thus it
makes sense to keep some assets in each class to counterbalance a potential downturn in
one market.

Failing to understand your own investments. If you invest in securities you do not
understand, you risk being the victim of:
Poor planning (if the fund does not suit your needs).
High costs (if fund fees are higher than competitors).
Faulty or fraudulent management.

Investing on a friends advice. The markets are not horse racing circuits. By investing
haphazardly, an investor runs the risk of losing money to poor timing or incomplete
information. Past performance is not necessarily a reliable indicator of future performance,

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especially over the short term and many novices often use this means of predicting the
future.

Get rich quick. Some investors try to "beat the market," by buying into the latest topperforming fund. However, few funds consistently outperform the broad markets over the
long haul. So, consider index funds for a core portion of your portfolio. Given their low costs,
relative performance predictability and diversification, index funds represent an ideal
foundation on which to build an investment programme.

Failing to assess your risk tolerance. If you're determined to enjoy higher returns, but you
can't sleep well at night because of the potential of considerable losses to your investment
program, stop torturing yourself. Find your "comfort level" by shifting to a more conservative
asset mix.

Panicking at short-term losses. Many investors panic at the first sign of a decline in the
value of a specific investment. Stay focused on your long-term portfolio and ignore shortterm declines.

Ignoring investment costs. Over the long run, costs can have a dramatic impact on your
investment return. In addition, if you do not require the services of a broker and adviser, it
makes no sense to pay an advisor to buy mutual fund shares.

Undertaking comparative analysis

A comparative analysis should always be made of the following before a share is bought:
1. Earnings growth.
2. Quality of assets and growth rates.
3. Total capital employed.
4. Plant and premises location, type and convenience to suppliers and highways.
5. Whether full production has followed the expenditure of a new acquisition.
6. Check current market statistics against latest company results.
7. Quality of cash flow (which is depreciation charged plus profits retained).
The above include:
1. A description of the company.
2. The sector the company is listed under.
3. The share price.
4. A rating relative to the sector and to the overall index.
5. Earnings and dividend yields percentages for the last two years on the equities.
6. Highest and lowest price for last 12 months.
Relative rating and splitting into three groups
In addition to information, it is important to determine whether a stock is close to a 12 month high
or low and if it is trading at a premium or discount to the sector. The following table is easy to
draw up and should accompany any analysis.

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Motor Parts Holdings Limited

Stock exchange
Sector
Share price
12 month high/low
NAV
Shares in issue
1998 EPS (cents)
EPS growth
Dividend cover
Company P:E ratio
Sector P:E ratio
Overall Index p:e ratio
Company p:e ratio vs.:
Sector
Overall Index
Tax rate
Return on equity (ROE)
Return on capital employed (ROCE)
Return on net assets (RONA)
Operating profit margin

1998
Johannesburg Stock Exchange
Motor
3759 cents
4500 cents and 2760 cents
3900 cents
100 million (forecast unchanged for next financial
year)
210 cents
18.9% a year for the past two years
2.1 times (unchanged over the last four annual
periods)
17.9 times
18.3 times.
14.8 times
Fair
Premium
29.0%
18.0%
21.1%
14.9%
12%

The above provides the investor with an understanding of a cross section of the company being
assessed. It has rates of return, which can be used in conjunction with the p:e ratio and the
relative performance of the share to the indices (to calculate the p:e ratio of an index, use the
inverse of the earnings yield, which is displayed in any financial newspaper or magazine). The
latter issue needs some explanation.
If the companys p:e ratio is divided by the sector or overall index p:e ratio, the investor
can estimate whether the share could re-rate or de-rate in the near future. Conclusions to the
above example are:
The share is trading between its 12 month high and low. It thus has some possible upward
momentum.
The share is still trading at a discount to its net asset value.
The tax rate is close to the maximum rate of 35%, which means it is unlikely that the
company will pay a higher proportion of taxes in the following financial year, which would
reduce eps growth.
Its returns on capital, equity and net assets are high enough to conclude that it is more likely
to re-rate upwards than downwards.
It is trading at a fair premium to the sector, but at a premium to the overall index. It can be
concluded that the company is unlikely to be re-rated, but also unlikely to be de-rated.
A forecast share price for the next 12 months could therefore:
Share price

=
=
=
=

Company
ratio
17.9 times
17.9 times
4968.83

price:earnings

Eps

x
x

(210 cents x 18.9% growth)

249.69

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Therefore, the 12 month future price could be 4968.3 cents. Depending on the amount of
research undertaken, the investor will gain a valuable insight into the company. It is up to the
investor to determine whether the company will achieve the same rate of eps return as the
previous year (analysts usually spend months in undertaking this calculation) and whether the
p:e ratio will remain unchanged (or change and to what level).
Once an evaluation has been undertaken, the security should be split into three broad groups:
Gilts

Other fixed- Equities. These should further be split into the various financial
interest
and industrial groups, the groups and sub-groups being
stocks
separately totalled and percentages to the fund shown.

Explanation
The performance since the last review of the various groups should always be checked
against the movements in the relative share price indices.

Each review should show the rate of interest earned on the fund so that the appropriate
comparisons can be made.

Earnings and dividend yields for the last two years give an idea of dividend and earning
trends, while the highest and lowest prices for the last 12 months test a recent purchase and
highlight price movements.

At the risk of boring investors, here is a repeated warning: even a large fund regularly
reviewed should not call for much action and it is necessary to resist the temptation to make
changes for the sake of change. The objective of the periodic review is, therefore, merely to
confirm that the fund is invested on the right lines, i.e. to look for any weaknesses and to
deal with them.

Does the division between fixed interest and equities need any adjustment? For a fund
heavily committed to equities, it may still be right to shift a modest proportion into bonds. The
value of gilts for the highly profitable operation of switching is sometimes overlooked.

Bears, Bulls, Stages and casinos

In 1990, I inadvertently upset a businessman by suggesting that today, why dont we have lunch at
Johannesburgs latest casino? Where is it? he asked, is it at the Carlton? Maybe somewhere in
Sandton, an upmarket Johannesburg suburb?
I took him to a restaurant at the JSE. To say that he was upset would be a gross understatement.
Jokingly, I added that, of course stock markets are casinos. If not, what are they?
A dealer stated it this way: The exchange is a perfect place for gamblers. The thrill of
outsmarting colleagues when buying or selling shares, is just the beginning. There are other financial
instruments that are practically unknown to the public, but are nevertheless traded on stock exchanges.
What are, for instance, nil paid letters. Analysts describe these as an actual letter received by an
existing shareholder when a rights issue has been announced. When a company wants to issue shares, it
offers its existing shareholders a right to buy them before they are offered to the rest of the public.
If the company decides to offer one new share for one existing share being held by the
shareholder, it means the investor will receive a letter to inform him that he has the right to buy the same
quantity of new shares he already holds.
This letter is called a nil paid letter. The right to buy new shares in whatever ratio is not enough
for dealers. A mechanism has been devised and established by stock exchanges to enable investors to trade
these rights (nil paid letters).

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If the company share is in high demand there is a strong likelihood that the letters will trade above
nil cents. While it may seem insignificant and not involve great sums of money, take note of the following
example. If Anglo decides to explore for gold in South America and needs R1 billion. It decides to raise
the funds through a rights issue in South America and through the JSE. Their intention is to offer existing
shareholders in South Africa one share for every one held.
SA Mutual owns over 20 million shares in Anglo. If the nil paid letter trade at one cent and SA
Mutual decides that the project is too risky and sells these letters on the trading floor. For simply selling
letters (the right to buy shares) it stands to make R220,000.
Of course, trading in equities can be very limiting, so other exchanges are formed to trade in the
risks associated with investing in those sectors and particular equities. The Futures and Options Exchanges
do exactly that. The first enables investors to decided today how particular sectors of the market will
perform in the future and the second enables investors to today acquire a right to sell or buy an index
movement in the future. Sounds complicated? But then again so is horse racing to many people.
So what is the difference? A gambler takes risks that he does not need to. Some brokers
talk about their "big gambling clients," but they really mean investors who speculate on the grand
scale. However, techniques used by speculators in trading company shares and to take a profit
on the way, are threefold:

When a speculator judges that the market is too pessimistic, he plays "bull" and buys the
shares in the expectation of selling them quickly.

When the speculator is pessimistic and thinks the market is too high, he behaves as a "bear"
and sells shares only in order to buy them back later at a lower price.

When a new share arrives in the market, the speculator expects a rush for the shares, so he
becomes a stag" and subscribes for shares that he will then sell quickly at a profit over the
original issue price.

In passing, let us be clear about distinguishing between a speculator and private investors with
portfolios. This can be summed up in two main issues, namely the question of resources and
time-scale.
The two provide a complete distinction between how each sort of investor behaves. The
speculator does not hold onto shares he buys. He keeps the volume of shares being bought and
sold turning over and over. He has no interest in dividends and is concerned only with capital
profits.
The second distinction follows from the first. Once a speculator has built up a credit
record with a broker, he has seven days to pay for the shares. This usually means the
speculator buys a share that he believes will move up before the seven days are over. He can
then sell the share and make a profit. However, credit does not stretch indefinitely and the
speculator has to be quick in and out bear, bull or stag. When a speculator predicts that a share
price will fall, he becomes a bear of that particular share. For various reasons the speculator will
not find profits so easy as when he is a bull.
Going short
The time delay between buying shares and having to pay for them has given rise to another
casino-type mechanism, called going short. For instance, a speculator believes that Stock Z will
fall in price, so he sells that share believing he will be able to buy it at a lower price. He has sold
share that he does not own. If, at the end of the seven days, the speculator has not been able to
buy the shares at a lower price, it means he has sold shares he did not have and does not have
the shares to supply to the buyer.
In market jargon he has been "un-covered", which means that he has literally caught
short of the shares he will have to produce to settle the stockbroker's books. So, on the day that
he is due to provide the share certificates, he has to actually buy the same number of shares at

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any price. His stockbroker has to put in an order to buy at the latest price, which could be as
high (or higher) than he originally sold the shares.
Going sort can also be described as a bear sale. The opposite of going short is going
long, which is usually used by dealers to describe the purchase of a share. For instance, one
dealer would ask: Whats your position on Anglo? The answer could be Im long. This would
indicate that the second dealer is a buy of Anglo shares.
Options - calls and puts
There is another technique that speculators use to make money. The technique of subscribing
for shares in a new issue - buying at the original issue price - and selling on the day the shares
are first dealt in. This is called stagging a new issue.
In this case, the speculator must make a rough guess about how the new issue will
appeal to investors at large. This does not mean that stags always win. Stags can lose heavily in
some circumstances just as easily as they can gain. If the price of a new issue is a shade too
high and the yield too low, an issue of the most impressive company in its field can fail.
For investors who have an urge to speculative (and have set aside a portion of their long term
portfolio for this purpose), but insist on having a specially designed safety net, the stock market
has a system called "option trading". This is a method of backing your judgment on how a share
will behave three months or six months ahead.
If the investor is confident that a share will rise in price under this system he does not go
bullish and buy the share. The investor can merely go to his broker and ask him to get an
"option" on the share in question; it is this option, and not the share, that is bought. It is called a
"call" option. The reverse-style of operation, where an investor believes that a share price will fall
in some months ahead, a "put" option can be bought.
The attraction of options is that an investor can limit his capital outlay. It prevents him
from losing anything more than the option money and it may enable him to make a sizeable
profit. The investors job, on declaration day, is to tell (or declare to) the stockbroker whether he
wants to exercise his option - that is to say, whether the investor will take up and pay for the
shares at the (approximate) price prevailing when you took out the option.

Reservations on speculative activity: When the market is in a bear trend, investors should
not hold a grudge against the bears for forcing down the price. Bears activity is not the
cause of a market decline as they are merely profiting by it. Once the institutional forces
(causing the market to fall) have spent their force, no army of bears can prevent the
investors shares from climbing.

When the recovery begins, you'll owe it to the bulls to have spotted the possibilities in
advance and to have revived interest in yours and everyone else's shares.

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CHAPTER 21: ANARCHISTS, ADVICE FROM MUM, ZEN AND

DOG FOOD
To succeed in life, undertake and become proficient in two different careers. This is the way of
the Samurai from the Book of Five Rings.
Once proficient in a chosen career, start to understand the makings of an investment portfolio
until then, you could end up doing neither well your chosen career, nor running a portfolio.

The jungle is never far away. Investors only have to listen to the radio to know that market
savages lurk around every corner. I remember being at an Investment Analysts Society meeting
in Johannesburg, when the director of a medium sized company said that unfortunately, we had
to undergo a downsizing programme this year. Clothed in nice, comfortable terms, he really
meant the acquisition of a competitor had to be merged into his company and this meant that
staff had to be retrenched, offices and factories merged or closed. By unfortunately he really
meant he wished he had taken over this competitor years before.
As realistic and pragmatic investors we can thrive and prosper in the capitalistic jungle,
but only if the investor is prepared to use every opportunity available in the market. Improve your
investment, protect it and continually seek ways to grow that investment. Improvements do not
have to be difficult or complex. Consider the following:

In the international market, refuse to deal with firms which disregard shareholder rights. A
loss of market share will do more to force listed companies to develop ethical business
practices than any new law.

Develop a solid, professional relationship with a specific investor advisor.

Develop a journalistic approach to questioning directors. In writing a story, a reporter will

ask Who, what, where, when, how and why? He will continue to ask these questions until
he is satisfied with the answer. In other words, the investors mission is to explore company
issues, learn the right questions to ask, and the investor must realise that he has an absolute
right to the answers. Then we can avoid those who either refuse to answer or give the wrong
answers. (See chapter on non-analytical methods).

A remarkably good system for judging the ethical behaviour of directors comes from the
continuous advice given to their youngsters. Of course, this sets a much higher standard
than simply complying with the law or following regulations. For instance, a mother will tell
her son not to talk so much, how can you learn anything if you dont listen. Listen to the
directors. Not only what they say, but how they say things or state issues.

The gulf between compliance and ethical behavior can be enormous. A US stockbroker once
remarked that ethics means getting through the day without being indicted."

Heres another of mums truisms: be fair in everything you do.

The capitalist thinks slightly differently be fair in everything you do, but make sure that
the things you do are an advantage to you. Or, stated differently, make sure the things you do,
do not affect you negatively. For instance, given the enormous amount of funds that have been
invested in unit trusts, why has there not being a sharp reduction in expenses as a percentage
of assets under management?
There are some justifiable reasons for an increase in expenses. New asset classes such
as foreign, emerging market and small capitalisation companies (particularly in the venture
capital market) are more expensive and difficult to trade. Funds that cater to smaller investors

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often have higher expenses than funds with higher rand-value investments, but in all fairness
an investor who owns one share is still a part owner of the company he has invested in. There is
absolutely no reason why a company would not send that one-share investor all company
information, circulars, notice of meetings and AGMs and prospectuses. Given economies of
scale and efficiencies possible by technology, there is just no excuse for increases in expense
ratios charged by unit trust companies or mutual funds.
Demand your right to information, whether it is a company, mutual fund or portfolio
manager. After all, it is your money.
More advice from mum
In 1984, I was studying with a friend at his home, when we decided to take a break. After 15
minutes, my friend suggested that weve done enough work, so lets pack it in for the day. His
mum overheard him and warned him not to be cute, and get back to your studies.
Left to their own devices, many investors often get a little too cute for their own good.
The world's markets offer an easy way for long-term investors to profit from the expansion of the
globe's economy. Follow the strategy set out in a long term investment policy, which is in
essence - a buy and hold" strategy. There is little that is more simple in life.
The problem with such a strategy is that it is not exciting. The investor thus gets bored
and, believing he is an expert in stock analysis, he may venture outside his own long term
target. Poor soul! Investors who believe they can pack it in for the day lack knowledge, have no
real plan, not enough discipline, no benchmarks and no clue. In other words, they have no
chance of long-term success. Le us reiterate the most basic principle investors should have
learnt by now building a superior portfolio is hard work. This is not a contradiction. Although a
portfolio must be left alone (buy and hold), understanding market trends,
economic/political/financial factors that affect stock markets, building up statistical databases
and understanding what makes directors and their companies tick, is time consuming and there
is no time to pack it in for the day.
An American stockbroker encapsulated it this way: If the stock market is a train, do you
want to get off at the next station, or do you want to stay on until the end of the journey?
Its okay to be greedy
Be a true capitalist. Be greedy! It is possible for a smart investor to develop a strategy to have
his cake and to eat it too. Since November 1996, stockbrokers have started negotiating fees for
transactions. It is possible for investors to negotiate a transaction fee as low as 0.35% of the
deal. In the case of a portfolio, especially large ones, negotiate monthly fees, about research,
monthly statements and nominee accounts. The latter enables the investor to build a portfolio
without declaring this to the tax man tax laws change all the time and it would be wisest to get
advice on this issue.
Investors will quickly discover they are often far better off paying a transaction fee with a
large stockbroker than paying a smaller fee to a small stockbroker. In many cases, the advice
received from the international stockbroker is worth more than the fee paid. Essentially, the fee
is usually recovered within a year.
Be warned! Although commissions may now be fully negotiable, the practice of ignoring
the small investor still remains. In addition, investors are sometimes pressurised to buy or sell
and are, therefore, driven to take excessive risks - and thus move away from meeting their longterm goals. They become prime targets for scam artists with inflated promises. The elderly often
become victims of fraud when they see that their existing assets will not be enough to support
their lifestyle. Then they lose everything. We saw this happen with the Masterbond fiasco in
1991.
Summary: With some help, investors can design a portfolio with an expected rate of
return adequate for their needs. It is relatively easy to develop a required rate of
return that is higher than bonds or savings, but can the investor live with the risk

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required to meet a desired standard of living? Time to be realistic. If it is not possible,

the investor must adjust the desired long term lifestyle or improve the planned
investments.

Full disclosure - something to think about

Investors pay commissions and fees, so they have a right to expect their portfolio manager,
investment advisor or fund manager to act on their behalf. Unfortunately, it is downright stupid to
blithely make that assumption. Efficient markets are the central core of a free-market economy,
which fosters the optimum distribution of goods and services and result in the maximum wealth
creation for the entire society. However, the market is imperfect and opportunists will always try
to take advantage of market anomalies.
If there was a perfect market, everyone would have exactly the same information and
there would be no advantage. Therefore, full disclosure should be an appropriate standard. In
South Africa, such standards are being established, but in other more remote markets in the
world, there are often few disclosure standards. Without full disclosure, investors are deprived of
the necessary information to make informed decisions. The result is often higher costs and less
wealth created in the long term. This does not mean that trading in remote markets cannot be
profitable, but it does mean better analytical systems to detect market opportunities. Risk is often
high and it takes speculative nerves to trade in these markets.
Lack of disclosure does not mean the investor is powerless. Western markets are among the
most efficient in the world and, in a highly competitive environment, there is always something
that can be done to get results. Talk to the media, the ombudsman or the Johannesburg Stock
Exchange personnel department. Make a noise and send the company a strong message. Bad
publicity in the West can have a significant impact on the companys share.
Investors must keep themselves informed. Nobody has the same interest in seeing investments
succeed than the investor.
Buyers and sellers caught in market madness
There is a stock market contradiction that never fails to amuse. While it may be okay to be
greedy, when dealers get caught up in a market madness panicking when bears roar and
greedily buying during bull runs they are reprimanded by their stockbroker bosses.
There is no skill in buying or selling shares during strong bull or bear markets, but it takes
unprecedented courage to go against mass hysteria and buy when others are selling. Across the
world, dealers repeatedly do the same thing; when markets climb, investors pour money in and
when market fall, investors take money out.
There is no other clearer evidence of a less profitable strategy a classic buy high and sell
low! What is worse, this process is repeated regularly. Investors simply cannot restrain
themselves from continuously changing their portfolios.
In fact, investor behavior is often so weird they throw away years of long term strategy to
ultimately achieve dismal results. Industrial psychologists around the world have tried to
understand what makes them function. Strangely, no matter how much time or money it takes to
draw up a long term plan to meet an investors specific requirements, their perceptions and
expectations are substantially influenced by their market experience of the last few months and,
in some instances, the last few days.
Former South African Reserve Bank Governor General Gerard de Kock said that when
markets are doing poorly for a number of months, South African investors begin to believe that
these markets will continue to do poorly forever and they begin to sell. If they have been doing
well, investors become euphoric and begin to believe that this time it is different and the markets
will continue to be bullish forever. The higher the market price goes, the more they want to buy.

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Dog food
Here is a simple example to illustrate how some investors mix buy and sell signals.
Every month Johnny buys a 10 kg bag of dog food. He pays R25 a bag and the price has
stayed unchanged for the past six months. As the months go by, Johnny believes the price of
the 10kg bag will rise it has to, it simply must and he begins to wonder whether he should
buy two or maybe three 10kg bags at the end of the next month.
At the end of the month Johnny goes to the market, holding his breath. Has the price
gone up? Why, didnt he buy more bags the previous month? He gets to the market and he
cannot believe it that the price has actually dropped. What does he do now? Does he buy five or
10 bags? Does he buy the normal one bag and enjoy the saving? After all, dog food does have
a long shelf life.
Surely the sensible thing to do is buy more than one bag and take advantage of a lower
price, which simply means that lower prices equal an advantage for consumers. In the stock
market, dealers act in horror at a drop in price, but for the long term investor, a lower price must
be seen as an advantage. Stated differently, stocks have a long shelf life and investors should
buy them in order to use them a long time in the future. Instead of seeing temporary low price as
an opportunity to buy a share that could grow in the future, the investor sees the lower price as
an indication to sell his own stock. Assuming an investor had a certain share in his portfolio,
surely he must have believed that this specific share had a long term potential. A temporary
market aberration should be an opportunity and not a disaster in the making.
Even computers cannot stop some traders from being completely stupid
Despite the availability and use of powerful computers, why do so many traders still lose? A wellknown answer is that dealers are too close to the market and, consequently, cannot be
objective.
A colleague once remarked, smiling, that broker X had jumped off the top of a cheap
hotel in an extremely poor suburb of Johannesburg. This person was what I term an ultra-bear,
which means that no matter how well or bearish the market is doing, he believes the market will
crash, crash and crash again. The broker had committed suicide, because he was not prepared
to face losses he was rumoured to have made. My colleague was, essentially, happy in his
misery. The markets were crashing and he was right it had only taken 18 months of hearing
him constantly proclaim the coming of doom.
What have you got to say now? He said. The Overall Index is still higher than when
you started your doomsday cries, I said and walked away. As dealers, both broker X and my
colleague were concerned with weekly and daily statistics and had lost sight of the big picture.
Investors had seen - despite a multitude of negative and positive political factors,
financial and business turmoil and progress and personal freedom for all with the general
election in 1994 - the Johannesburg Stock Exchange Overall Index rise by over 200% and The
Dow Jones rise by some 300%. An eight percent decline in one day could be classified as a
crash, but it hardly compares with the higher, long-term growth achieved over 18 to 24 months.
When an investor changes a portfolio weekly, he is making the assumption that during
the next week the markets will behave like the last week. In other words, the best parameters for
a forecast period of time, is unlikely to be the historic trend that has just occurred.
All investors, in all markets around the world, go through losing periods - no matter what type
of approach chosen or preferred. Performance cannot improve by constantly changing their
strategic approach to managing investment portfolios. Since there are many more losing
approaches than winning ones, investors actually decrease their chances of success by
frequently changing systems.
The best advice I ever received from a successful stockbroker: If you want to be a doorman, be
one at the Hilton. In other words, if I wanted to be successful I should know what advice

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investors want and give it to them. Be specific and keep to that clients desires. If he wants
textile stocks, you can advise against these, but if he wants them give it to him!
Alternatively, if you want to be a global player, you have to be in the international arena.
Remember that the same rules apply for all markets. If an investor can trade for an extended
period in a wide variety of markets, he is likely to be successful, although success in never
guaranteed.
This works as, although markets change their short-term patterns, they tend to show
similar long-term trends. That is your edge. If an investor plays the trends, he is likely to succeed
in the long run. Attempting constantly to modify your system to mimic the changing patterns of
the recent past will not improve your chances of success.
It will more likely ensure failure.
Another market phenomenon the anarchist
In addition to the usual bulls, bears and stags found in stock markets, a new type of dealer has been
making inroads in the market. This is the anarchist, a trader who invests in the stock market only when
there is violence and strike action, which disrupts production to the point of anarchy.
Such dealers are always sure that the market will bounce back once the strike has been resolved.
These investors follow a basic Wall Street Stock Exchange principle: shares should never be sold on
account of a strike, because strikes are always temporary and the market always corrects after the event).
The logic is that major South African companies are unlikely to suffer from the strike action as
they are too established to be broken by unions. During strike action, investor perception is that the
companys future profits will be affected (sometimes the perception is that the damage will be
irreversible). Investors sell the share and the share price falls. However, these strikes are usually resolved
and the long term effect on company results is minimal, the results eventually improve and the share price
betters pre-strike levels.
Bearish investors usually believe that such strikes will start country-wide union action across all
sectors of the economy, crippling GDP growth and bringing on a stock market crash.
The capitalist Zen
In the calm life of the Zen practitioner, there is opportunity in everything. The true capitalist
should see everything as an opportunity. A company director recently said he was moving my
operations strongly into Africa. Africa? With all the war, famine, lack of transport facilities and
accompanying problems?
When I expressed concern, he said that someone has to transport World Bank famine
relief food to the drought ravaged areas. The same goes for coffins, oil, dry commodities or any
other item. Business usually responds well to can-do positive active management. If a business
cycle turns down, there are a multitude of things a smart businessman can do. He can make
more telephone calls, hire more sales people, buy advertising, change the product, have a sale,
fire the sales manager, buy the competition, increase commissions, or move to a better market.
Active management is the key to success in business.
Investing is a different, but not completely different animal. It can be a very passive
activity, somewhat Zen-like. Markets only respond to a buy or sell activity if many thousands of
shares are traded. An individual investor is unlikely to move a market with a mere 100 shares.
Markets have their own flow and this becomes pronounced when investing in the global arena.
Here is a crazy suggestion. If you have a good strategy in place, the best single thing an
investor can do during bear trends is nothing! Let those panicking dealers endure stress, ulcers,
heart attacks and even suicide! All kinds of self-defeating behaviour comes to mind. The investor
can fire the advisor, liquidate the account, move to another stockbroker and sell the funds.
Or can he refrain from doing anything.

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The medias financial pornography

Stockbrokers have daily morning meetings, where analysts, portfolio managers and dealers
discuss the previous days trading, statistics, that mornings company results, research to be
released that week and anything else deemed important. Despite the continuous mumbling
about the lack of professionalism in the South African media, stockbrokers continue to court
journalists.
One stockbroker said that what the popular financial media puts out could properly be
called financial pornography. It's not bad for your wealth, it has no redeeming social value, he
said. Yet there is nothing new about what the media wants or is trying to achieve.
It is a mistake to believe that they are on a collective mission to educate the public.
Rather, their mission is to sell newspapers, magazines or air time on radio and television and
this means mass appeal. In South Africa, the financial news appeals to a miniscule section of
the population and, therefore, less importance is placed by the media bosses than on, say,
politics or crime.
The media has the added problem of the relentless deadline pressures to come up with
new stories every day, every week, or every month. The pressure means less time to undertake
in-depth analytical stories, investigative features or even controversial issues.
For instance, the media has seldom (if ever) covered the Modern Portfolio Theory (MPT),
which they would consider too complicated for the great masses of the South African public to
follow. After all, it is dull, has limited human interest appeal and is not likely to sell a lot of
newspapers
This does not mean that there are no highly experienced journalists in South Africa. It
simply means that there are too few.
Some reason why investors act differently they are different!
The subject of money always evokes an emotional response. Investors buy shares for many
different reasons and purposes and at times their decisions are not logical or based on anything
more than a gut feeling. Consider the following types of shareholders:

Blue chip buyers: Many shareholders believe blue chip shares (usually conglomerates) will
always be a solid, more profitable long-term investment. This is not always true in the light of
the unbundling taking place in South Africa. In addition, these companies have a number of
listed subsidiaries operating in different sectors, which means that all the subsidiaries are
unlikely to produce positive results at the same time. The holding company's results are,
therefore, negatively affected by those subsidiaries which are not making a profit. Therefore,
it could be preferable to buy shares in the subsidiaries that are making a profit, rather than
the holding company.

Happy in ignorance: Clearly, many investors are uninterested in understanding the way
markets work. That, in itself, is fine, but then they should get a portfolio manager to maintain
and control the share portfolio.

The control freak: The opposite of the above are the individuals who knows it is important
to understand the market. While he does not have time to understand how markets work, he
still does not want to give up control of his finances.

Inherited shares: For sentimental reasons, some shareholders hold on to inherited shares,
despite all warning signals that the company has no long term prospects. The shares
ultimately become worthless. Instead of seeing the share as an investment, these investors
allow their emotions to cloud their judgment. Sometimes they are shocked to find their
shares have lost all value and are no longer traded on the JSE.

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The serious investor: This shareholder buys and sells shares for long-term profit and looks
at all variables that could possibly affect the share price. This is the investor who buys with a
specific plan in mind and seldom acquires shares without a degree of certainty that he will
achieve above average returns on his investment. Another form of serious investor is one
that enjoys investing as a hobby. They join clubs, pour over newspapers, faithfully make
charts, build spreadsheets, subscribe to newsletters, surf the Internet's newsgroups and
never let their eyes stray far from the JSE share prices. For these types, investing is not only
the means to achieving a comfortable and secure life, it is their life.

Speculators: Discussed in previous text, it is sufficient to state that these investors are
prepared to take high risks in the hope of gaining substantial profits. An old Wall Street
axiom states that the perfect speculator must know when to buy shares and when not to buy;
more importantly, he must know when to sell once he has bought a share.

The director's nightmare: Discussed in Share Analysis and Company Forecasting (Struik,
1995), this type of investor buys a single share in every listed company on a specific stock
market. This enables the investor to direct access to company reports, the directors would
be obliged by law to answer any query he has over any project the company undertakes, he
would be permitted to attend shareholders' meetings and ask questions during such
meetings. He would even be allowed to vote. All this information would place him in a better
and more informed position to acquire those shares which he would then consider to have a
future profitability.

The Gambler: Closely related to the speculator is the gambler. However, gamblers are
hooked on the excitement of the trade and win, lose or draw, it is the action that counts and
not trading with an investment philosophy in mind. Many start with a few trades in individual
stocks, then quickly move onto options, commodities and futures.

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CHAPTER 22: BASICS IN INTERNATIONAL SHARE INVESTING

A key component of any appraisal of the future is a review of the current and past economic
situation, since these represent the basic starting conditions of the underlying constraints to
likely developments and policies. (Pete Richardson, OECD Research Department, 1997).

Whether an investor recently became interested in international investing or are a seasoned

global investor, a quick review of some basics about foreign shares should help investors assess
their current investment strategy and future long-term plans.

Quick review
How does the international equity market compare in size with that of the US?
There is a misconception among investor that the US and a few other European countries are
the only investment destinations worth considering. What is not apparent is that more than 50%
of the world's equities (measured by market capitalisation) originate and trade outside of the US.
How are foreign shares traded?
There is no global stock exchange, but information about the various national or regional, first
world or emerging, markets is available to international investors every day through computer
networks and satellite communications. The Internet is the first and obvious choice for investors
to gather data on a prospective investment in a foreign country.
What are the primary factors affecting returns on international shares for investors?
The principal factors are the same anywhere in the world. All markets are affected by among
others, the outlook for corporate earnings, interest rate and credit market conditions,
unemployment levels, crime, actual and forecast inflation, pace of economic growth and
exchange rates. Naturally, the price of each share also reflects the financial health and
prospects of the underlying company as well as current investor sentiment towards the share
market.
There are, however, important differences between domestic and foreign investing that
can increase overall risk. Many countries are considerably less stable politically than, for
instance, the US or the UK. Many also have much less diverse economies. Political or economic
upheaval in some countries often jeopardise foreign investments. It is therefore crucial that the
overseas investor continually monitor and interpret the internal developments of the country or
countries he has investments in.
Financial information about specific companies can be harder to obtain since accounting and
financial disclosure practices can vary widely from first world standards. Primary research is thus
an absolute necessity.
The aspect of foreign investing that probably generates the greatest daily concern is the
impact of currency translation. Initially, the local currency must be converted to the foreign
currency to purchase a foreign security. Subsequently, share price quotations, share dividends
and sale or redemption proceeds must be converted from that currency back into your local one.
Foreign exchange rates fluctuate constantly with changes in each currency's supply and
demand situation, which means that currency movements can increase or decrease the value of
the investment even if the security's price remains unchanged.
For instance, a South African investing in France would first convert Rands into Francs
and then purchase his desired investment. On sale of that investment, Francs are then
converted back into rands. If the Rand has depreciated relative to the Franc, then the investment
has earned less than expected. The opposite can also happen, if the Franc depreciates relative
to the Rand.

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Many parts of the world do enjoy faster economic growth than your country (where ever
you live)
These countries are expected to for several years. Many parts of the world are enjoying faster
economic growth than Canada -- and are expected to for several years. A major feature of the
emerging global economy is a narrowing of the gap in economic power between the developed
countries -- such as Canada , the U.S. and Britain -- and the developing countries. While
Canada's gross domestic product will inch ahead by about 2% this year, others are expected by
many economic reports to race ahead.
Where there's wealth creation, there's investment opportunity
With the economic shift, there's been a massive shift in stock market capitalization. At the end of
the 1960s, North American companies represented more than 70% of world capitalization of
about US$929 billion. By 1994, companies outside North America had the lion's share -- about
62% of a market of almost US$13.5 billion.
Studies show international investing may help reduce the overall risk in investors'
portfolios
There are risks in every investment and global investing can add others, such as political,
economic, currency and local market risk. Yet, a portfolio that is diversified across domestic and
a variety of global equities actually helps reduce overall volatility of the portfolio over time.
Why invest abroad?
If investing overseas is complex and fraught with high political, currency and economic risk, why
invest offshore at all? A principal advantage of investing overseas is diversification, which
provides shareholders an opportunity to enhance heir overall return, while actually reducing risk.
Trends in foreign stock markets generally do not correlate well with bull or bear market
cycles in first world markets. While one or more foreign markets may at any time be moving in
the same direction as, for instance, the US, longer-term correlation is low. This means that
diversifying beyond a single market, such as the US, should reduce the overall volatility of your
share portfolio over time. In addition, it is likely that equity markets in one or more foreign
countries will outperform US shares each year. Taken as a group, foreign shares often (but not
always) generate higher returns than US shares.

The important point is that US and foreign markets often do not mirror each others cycles.
Therefore, combining US and foreign stocks cushions the investor's overall share portfolio
against the full impact of potential down markets in one country or another. This is the
Markowitz principle in full swing.

From 1988 through to 1997, for instance, performance leadership varied from one year to the
next. In 1988, 1990, 1993, and 1994, foreign stocks outperformed US shares in US$ terms,
while in the other years they underperformed.
Taking a longer view, foreign shares have provided mostly higher returns than US shares
as measured by 10 rolling 10-year periods through 1997. Of course, a portfolio manager may
obtain significantly different results by investing in a mix of securities that differs from the broad
market indices shown in the chart below.

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FOREIGN VS. US SHARES

(Cumulative 10-year returns in US$)
10 year period
ended:
90

91

92

93

94

95

96
US shares
Foreign shares

97

100%
200%
300%
400%
500%
600%
CULUMALTIVE RETURNS IN PERCENTAGE

700%

800%

How do currencies change local market returns for global investors?

One way is to compare returns before and after currency conversion for a security or index for a
particular time period. The example below shows returns from shares in four countries during the
three months ended March 31, 1998. During this short period, the US$ was mixed against
foreign currencies. This means that in some cases a unit of a foreign currency converted into
fewer dollars than previously, thus reducing returns on foreign holdings for US investors, and in
other cases the opposite occurred.

THE IMPACT OF CURRENCY FLUCTUATIONS ON FOREIGN SHARE

RETURNS FOR US INVESTORS
Local market
return
Czech
Republic
Germany
Japan
Singapore

Local currency vs. US$

Return
to
investors

+4.9

+1.3

+6.3

+20.4
+4.7
-1.9

-2.8
-2.5
+4.3

+17.0
+2.1
+2.3

US

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This example shows that shares in the Czech Republic provided a 4.9% return to local investors
during these three months. Since the Czech koruna appreciated against the US$, the gain
translated into more US$s, thereby increasing the return to US investors to 6.3%. In Singapore,
stocks fell slightly for the quarter, but the Singapore dollar rose enough against the US$ to offset
the local market's losses during this period and provide a small gain for US investors. In
contrast, local market returns in Germany and Japan were reduced by the US$'s strength
against the deutschemark and yen, respectively.

GLOBAL PROFILE
DEVELOPED vs. NON-DEVELOPED MARKETS

16%
19%

84%
81%

Share of World Economy

(GNP)
Developed markets

Share of World Population

Non-developed
markets

Reducing the risk of international investing?

Portfolio managers often use sophisticated hedging techniques to cushion the impact of
potentially negative currency fluctuations. Hedges usually involve entering into contracts to
purchase or sell a particular country's currency in the future at a price agreed upon when the
contract is bought, thereby "locking in" a known price. This is also called forward cover. Thus, an
investor could maintain a position in, say, French shares or gilts without being exposed to
fluctuations in the value of the French Franc. Conversely, forward contracts permit an investor to
be exposed to a currency expected to be strong, such as the deutschemark, without having to
invest in German securities.
It is important to note that hedges also limit the possibility of benefiting from gain as well
as avoiding losses.
Risks arising from political or economic differences, as well as from potential difficulties
of obtaining information, can be mitigated by diversifying share investments across a range of
countries and industries and through research by experienced professionals.
Should foreign investment decisions be based on foreign exchange movement?
Although currency conversion can have considerable impact on total equity returns (on the
upside or the downside), these effects do diminish over time. The dominant long-term influences
on share prices are the track record of each individual company and local equity market
performance. Investing in foreign stocks should not be viewed primarily as a way to "play" the
currency markets, but rather as part of an investors long-term investment strategy.

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How should investors allocate funds to international equity investments?

It makes sense to have a majority of an international equity exposure in a core fund that has a
broadly diversified portfolio of well-established companies in that country. This diversification
gives the fund manager the flexibility to allocate assets to the most compelling regions outside
his domestic country. If an investor has a particular interest in a certain region, he may want to
put some assets in a more specialised fund, such as one emphasising small companies or a
single country or region.
As stressed before, without the conviction to ride out potentially tough periods, an
investor should be cautious about investing in funds with narrower focuses, as these may have
greater price volatility. This is especially true for funds targeting less developed (emerging)
markets, many of which are in Latin America, Africa and the Far East. Such funds have the
potential for exceptional gains, as these countries, which account for much of the world's
population, but little of its wealth, seek to raise their living standards. At the same time, emerging
markets funds involve high risk, as progress in these countries may be erratic and setbacks
severe. Such investments demand patience and an extended time horizon.
A long-term view
There is no reason why foreign shares should not be rewarding over time, provided that
worldwide growth and trade are not disrupted for an extended period. New investment
opportunities are constantly appearing around the globe.
The collapse of Asian economies in 1997, after years of superior growth, will force
regional companies to restructure and become more globally competitive. China represents
tremendous long-term potential, even though its economy has been affected by problems in
Asia. Japans economy, deep in recession and burdened with enormous bank debts, is being
pressured further by Asias weakness. Some of the keys to its recovery include a full reckoning
of those debts and market-opening measures, such as the recent Big Bang deregulatory
reform of the financial sector.
Europe is receiving increasing attention as 11 European Union (EU) countries will integrate their
economies more tightly with monetary union in 1999. The new common currency, the Euro,
could rival the US$ if EU members remain committed to economic growth, low inflation, and
fiscal discipline. Some Eastern European nations have made significant progress toward
capitalism and could join the EU early in the 21st century. In contrast, Russia and other nations
are struggling to overcome resistance to painful reforms.
In Latin America, political and economic reforms have been encouraging, and the commitment to
privatisation should drive the regions long-term growth. However, the potential for regional
volatility remains high as Asias economic turmoil erodes confidence in these emerging markets.
While an investor should always keep in mind the risks of international investing, he should also
consider its significant advantages. Diversifying through foreign shares can help smooth the
fluctuations of an investor's overall equity portfolio and offers the opportunity to participate in
dynamic overseas companies and economies that may be growing faster than their US
counterparts.
Two approaches to global share investing and diversification
Investors who wish to diversify their portfolios by adding foreign stocks typically do so through
mutual funds that contain foreign assets. Since investing in distant and often very dissimilar
markets is a difficult challenge for most individuals, the professional management and wide
diversification of mutual funds or unit trusts does provide a good solution.

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One of the basic decisions is whether to choose a global fund, whose investments include first
world and foreign stocks, or an international fund that is made up of all foreign (except perhaps
for short-term debt securities held in the cash position) shares. Each approach has advantages
and disadvantages.

A first world global equity fund: This usually has significant assets in first world stocks,
and since these and foreign markets often move in opposite directions, this mix of assets
may result in a smoother ride for the investor, i.e. potentially less up and down price volatility.
In addition, a global fund is less exposed to changes in the value of the investors currency
(eg. US$) versus other currencies, since most global funds are held in US$. Finally, the
manager of a global fund will make incremental shifts between US and foreign assets to
maintain a desired allocation or to reflect a market outlook. Investors with only US and nonUS funds must make such adjustments themselves if they wish to maintain a particular
diversification range.

An international equity fund: These offer greater exposure to the potential risks and
rewards of foreign markets, including the effects of changes in the value of foreign
currencies versus the dollar. Changes in the dollar's value can be a positive or negative for
the fund, but either way they raise the fund's risk and reward profile compared with a global
fund.

To assist investors to decide which is more appropriate for a particular situation, consider the
following two questions:
How well diversified is an If a portfolio could benefit from broader holdings of US
investors
current
share as well as foreign stocks, a global fund could be a
portfolio?
profitable approach. If the portfolio already has a wide
spectrum of first world shares, an international fund
would provide greater diversification.
Is the investor comfortable Adding foreign stocks can help smooth out the
taking higher risks to achieve fluctuations in a portfolio, since foreign and US shares
potentially higher rewards often move independently. If an investor can accept
over time, or does he prefer a higher risk for a portion of his assets to pursue higher
lower-risk approach?
returns, an international fund may be appropriate.
Nevertheless, if he is more comfortable with a lower-risk
profile, a global fund may be a better way for him to
achieve the benefits of foreign diversification.

An Overview of International Investing

The allure of foreign markets
A desire for diversification may be behind some of this demand for foreign funds. Foreign
markets represent about 53% of the world's capitalisation and are driven by widely varying
economies and growth rates. Thus, by investing solely in US stocks, investors forego the
opportunities offered by more than half of the world's stock markets.
Since global markets are driven by forces that are different to those affecting US
markets, the annual returns of the foreign markets generally differ from those of the US. This
does not mean that foreign markets always outpace first world markets. It means that while one
market rises, the other often is in decline.
For example, in 1993 the world's markets, as measured by the leading benchmark of
foreign stocks, called the EAFE Index (Europe, Australasia, and Far East), rose by 32.94%,

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compared to the US market. Measured by the S&P 500 Index, the US market posted a return of
10.08%. In 1997, however, the EAFE Index was outpaced significantly by the U.S.: +2.1 versus
+33.4%. The table below gives you a sense of how the returns of the international markets have
differed from those of the US market over the past ten years.

Annual Returns
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988

EAFE
+2.10%
+6.36
+11.55
+8.06
+32.94
-11.85
+12.50
-23.20
+10.80
+28.59

S&P 500
+33.40%
+22.96
+37.58
+1.32
+10.08
+7.62
+30.47
-3.10
+31.69
+16.61

In order to achieve a greater level of diversification, some investors are placing a portion of their
investment programmes in the overseas markets. By employing this strategy, investors reduce
the risk that any single market will cause a considerable decline in the overall value of their
investment programme.
In addition to broader diversification, global markets offer the potential for high rewards.
Through the 10 year period to end-December 1997, the EAFE Index returned +6.56% compared
to the +18.05% return of the S&P 500 Index. While this return advantage may not continue in the
future, investors should consider expanding their investment horizon beyond their borders. As a
general guideline, investors should limit their international holdings to about 20% of the share
portion of their programme, as the risks of investing overseas are high.

Summary

Forecasting returns from financial markets is, at best, a difficult enterprise. The added
complication of exchange rates makes it doubly difficult to forecast the results from foreign
bourses or to predict the "right time" to invest in or to sell foreign shares.

Given this difficulty, investors who wish to diversify their portfolios by participating in foreign
stock markets may find that The Cost Averaging System (outlined in Part Three of this book)
is the safest way to go about the

The unpredictability of foreign investment returns and the historically wider fluctuations in
foreign securities markets also make broad diversification a good idea for US investors in
foreign stocks.

Spreading funds across several different countries, and several different currencies, will
reduce the risk of loss from market turmoil or currency changes in any one nation's market.

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CHAPTER 23: A GUIDE TO GLOBAL INVESTING

Serious financial crises are not a new phenomenon, and they will occur again and again in
future... globalisation of financial markets will raise the risk of crises taking place in future.
(IMF, 1998)

Managing the risks of international investing

Although the strong performance that foreign securities markets occasionally experience is
attractive, international investing includes some specific risks. While some of the following types
of risk have been discussed in previous chapters, these are set out in relation to how they affect
foreign investing methods.
Currency Risk: For investors getting their first taste of international investing, one of the most
mysterious aspects is currency risk. Stocks or bonds purchased in another country are paid for
in that countrys currency. Later, when they are sold, the investor receives payment in the local
currency which then must be translated back into his currency.
The differences between the conversion periods (buy and sale of shares) are discussed
in previous chapters and it is thus sufficient to state that the exchange rate could result in the
performance of a foreign investment in local currency terms can add or subtract to the capital
growth or capital loss of the investment over a given time period.
Most currency changes have historically tended to cancel each other out over time, so
long-term investors, who have well-diversified portfolios, probably do not need to be as
concerned about the daily activities of the world's currency markets.
Liquidity Risk: In some overseas markets, particularly smaller ones, there may not be many
buyers of shares. It may thus be difficult to sell significant amounts of some securities without
pushing the price of the security significantly down. Thus, if investors want to sell a share, they
may have to sell it for much less than expected some of which may have better long-term
prospects.
Information Risk: Access to reliable information is the key to making good investment
decisions. Information, however, can be difficult to gather when it comes to, for example, a
company based in Spain, Brazil or South Korea. In addition, in many countries, securities
regulations are appalling and do not include formal regulation stipulating that companies provide
information of profits, losses or debts. However, global markets are forcing such foreign
countries to amend their regulations.
Volatility Risk: As many overseas markets tend to experience much more sudden, and
sometimes very large, price changes than first world markets, they are said to be more volatile.
Over the five-year period through 1993, for example, Brazil's stock market fell by more than 50%
on four occasions. At other times, though, the Brazilian stock market increased by 50% or more
in a few weeks.
Political Risk: For instance, Canada has been operating under the same system of government
for more than 125 years. That lends a measure of stability to our economic, business and
investment environment that not all nations can claim.
In some foreign countries, a democratically-elected government can be (and is often)
overthrown and replaced with an authoritarian system. Fortunately, however, the trend in recent
years has been in the other direction:
1. Government-controlled economic systems are being replaced by market economies
2. Newly-elected democratic governments are privatising businesses that were once
owned or controlled by the state.

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3. However, in some of these countries, business and investment policies can change
rapidly as government leaders, in response to changing conditions or political
pressure, change course from time to time.

Integrating domestic and global investments

Global investing should be an integral part of a well-diversified, long-term investment programme
that takes into account risks and opportunities associated with foreign investment.
A dynamic global environment
If an investor feels safe and wishes to remain in, for example, the US market there is nothing
wrong with that. Globalisation does not mean that an investor has to invest in the international
arena, but it does mean that he will not take advantage of the vibrant growth opportunities that
rests outside the US. The simple answer is that a truly global economy is emerging and, among
the most important trends taking place, are efforts by countries around the world to:

Make their capital markets more available to global investors.

Reduce the rate of government spending and borrowing.
Privatise and/or outsource government-controlled enterprises that supply products and
services, i.e. oil, electricity and telecommunications.
See Chapter 24: Investing in Emerging nations.

Companies around the world are changing (streamlining, merging, specialising etc) to
remain competitive in an increasingly efficient, technologically sophisticated and opentrade oriented global economy.

Corporate restructuring efforts in Europe, for example, have only just begun. Improving
corporate earnings in Europe - home to the largest single bloc of consumers in the world
- should help fuel economic growth rates and stock market performance around the
world.

Strong long-term performance from foreign markets

First world economies are relatively stable, growing at steady GDPs of between 2% and 5% a
year. Developing nations, on the other hand, are growing more quickly. As globalisation takes
rout in these markets, capitalists (hungry to supply growing material desires) emerge and,
consequently, create rapidly developing economies. However, whether these economies
continue to grow depends on the actions of governments in these countries, hence the added
risk profiles of investing in these nations.
Emerging markets, including the Pacific Rim, Latin
America and China, may offer particularly strong long-term opportunities due to their high level
of growth potential and the shift towards free-market policies.
Looking ahead, if Asia continues to grow at twice the rate as the rest of the world, by the
year 2040, at least 50% of the global economic output will be produced in Asia (compared to
24% in 1989).
Developing a global portfolio
A financial plan is a tool to help you reach your goals. Investing in the global arena does not
mean that all the principles outlined in previous chapters are forgotten. For instance, Markowitz
correlation theories, long-term planning and risk-to-return profiles still apply. In addition, a
financial plan works best if you keep it simple, use realistic income and expense estimates and
periodically review and adjust the plan to reflect changing conditions and goals. A common
mistake people make is to prepare a financial plan and then fail to put it into action or to change
the plan as circumstances alter the investors needs.
Review and modify the financial plan

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A financial plan should never be static. It is a tool to help investors reach financial goals. Keep
reviewing and modifying the plan to account for significant future events, such as globalisation.
For investors who have not invested overseas before, there are five key suggestions for
developing a global portfolio.

Global investing is not an alternative to domestic investing. Rather, global investing

should be seen as a way to achieve greater diversification and, over the long term, the
possibility of less risk and greater return than might be expected from strictly domestic
investing.

Start small. If you have not invested overseas before, do not move all (or even a large
percentage) of an investment portfolio into international investments at once. In chapter nine
it was concluded that, without information, the investor is dead in the market. The same
applies to the international arena. Gather information about the desired country through the
Internet (chapter 10) and, as knowledge is gained, increase that percentage. Advice is to
start with a marginal percentage, say between 3% and 5%, and to increase that exposure
over time to a percentage the investor feels most comfortable.

Stay patient and develop a long-term view. Many foreign markets, especially some of the
emerging markets, have experienced rapid growth. However, as these economies and their
businesses make their own adjustments to global competition, they have also experienced
large and rapid declines in prices. Over the short term, global investments may be
substantially more volatile than some of the domestic investments. However, over the long
term (five to ten years), these markets should offer the potential for superior returns.

Go back to basics. One method to start the global diversification programme is to

commence with foreign unit trusts, move to Indexing and finally shift the funds to equities. In
this manner, the investor should get the broadest possible diversification and benefits of
overseas investing, while gathering knowledge on global markets. However, investors must
always remember how these new investments fit in with their overall financial plan, risk
tolerance and the level of comfort with what is, at first, unfamiliar territory.
In essence, investors should not make significant investments in global funds until they have
learned enough about them to fully understand the risks and feel comfortable with them.

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CHAPTER 24: INVESTING IN EMERGING NATIONS

The economies of east Asia (at the centre of the 1997/98 financial turmoil) have been some of
the most successful emerging market countries in terms of growth and gains in living
standards (IMF, 1998).

In 1993, the world's emerging stock markets produced total returns that averaged about +75%
and thus captured the attention of many investors looking for potentially greater rewards beyond
US and other first world established markets. The emerging market crash in 1997 and 1998,
however, provided a dose of reality to performance-hungry investors.
In this section, emerging markets are examined to put in perspective the investment
potential and risks of these markets.
Emerging markets defined
The term "emerging market" describes the stock market of a developing country. In contrast to
the relatively mature stock markets of the US, Western Europe and Japan, emerging markets
may be characterised as less developed, with relatively small amounts of stock outstanding.
Typically, emerging markets operate in countries with low per-capita income and many are
moving away from primary sources of production to an industrialised economy. In addition, many
are moving away from a socialist based economic system to a free-market economy.
The primary investment appeal of emerging markets has been their high rates of
economic growth, combined in some cases with valuations that appear reasonable by
comparison with valuations in more developed markets. Long-term economic growth rates in
emerging markets are projected, on average, to be twice or more the growth rates of economies
in developed markets.
Why invest in emerging markets?
Factors have been discussed at length in the previous chapter and include potentially higher
returns and a broader portfolio diversification.
Each of these reasons deserves careful consideration by a prospective investor.

Potentially higher returns: Two emerging markets, Brazil and Chile, produced total returns
exceeding 40% in 1994, and seven emerging stock markets doubled returns in 1993, while
at least 12 other markets rose that year by 50%. Such gains reflected optimism about rapid
economic growth and, in turn, corporate profits. Much of the optimism receded in 1994 and
early 1995 when steep losses were experienced in many emerging markets. The level of
pessimism reached a high in 1997 and 1998, when it became clear that the extremely high
growth rates of the past decade had been achieved at the expense of prudent economic
policy. In other words, excesses of the past had caught up with many developing Asian
economies.

However, new rules for investing have been set by the IMF for investing in these nations
(see end of this chapter). In addition, if long-term economic growth continues to outstrip that
of developed nations (albeit at a much reduced rate), the emerging markets should still
provide a source of above-average long-term returns.

Broader portfolio diversification: In the 1960s, the developed economies of Europe, the
Pacific Rim and North America accounted for 97% of the world's stock-market capitalisation.
However, by the end of 1994, that figure had fallen to 91%, as the emerging market
countries' share of world market capitalisation continued to grow.

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The table below shows the relative size of the world's stock markets, based on their market value at year-end 1997,
and the relative size of numerous emerging markets. Emerging market countries have widely varying economies,
growth rates, and stages of development. Thus, their markets' movements have historically had a very low correlation
with market movements in developed economies, or even among themselves. In other words, when one market is
going up, there is a good chance that another is going down. As a result, a small investment in emerging markets may
offer investors an opportunity for increased diversification that has, in the past, led to lower overall portfolio volatility.

Country:
1997 full year statistics
(in alphabetical order)

Capitalisatio
n

Trading
volume

US$million

US$million

Argentina
Australia
Austria
Brazil
Bulgaria
Chile
China
Cote dIvoire
Czech Republic
Denmark
Egypt
Estonia
France
Germany
Ghana
Hong Kong
Indonesia
Italy
Japan
Kenya
Korea, South
Kuwait
Malaysia
Mexico
Mongolia
Oman
Panama
Peru
Philippines
Portugal
Romania
Russia
Singapore
South Africa
Spain
Thailand
Trinidad & Tobago
Turkey
UK
US
Venezuela
Zimbabwe

59,252
696,656
35,724
255,478
2
72,046
206,366
1,228
19,529
93,766
20,830
1,088
674,368
825,233
1,130
413,323
29,105
344,655
2,216,699
1.811
41,881
25,888
93,608
156,595
54
7,108
2,175
17,586
31,361
38,954
630
128,207
106,317
232,069
272,730
287,813
3,117
61,090
1,996,225
11,308,779
14,581
1,969

GLOBAL AVERAGE

23,541,385

Source: Financial Times, Economist & IFC Year book 1997

Number
of listed
companie
s

Index gain or
loss

25,702
310,869
24,630
203,260
0
7,445
369,574
24
7,055
46,878
5,859
1,484
405,523
1,029,152
47
489,365
41,650
198,235
1,251,750
104
170,237
34,576
147,036
52,646
15
3,880
42
4,033
19,783
20,932
268
16,632
63,954
44,893
453,016
1,297,414
134
59,105
829,131
10,216,074
3,858
532

136
1,219
139
536
15
295
764
35
276
237
650
22
683
700
21
658
282
235
2,387
58
776
74
708
198
434
114
21
248
221
148
76
208
303
910
384
404
24
257
2,046
8,851
91
64

24.8%
13.1%
18.8%
44.8%
0%
-2.2%
31.8%
23.3%
-8.2%
43.2%
21.3%
39.6%
24.5%
41.2%
41.8%
-20.3%
-37.0%
58.0%
-21.2%
0.1%
-42.2%
40.5%
-52.0%
53.9%
135.5%
136.1%
59.4%
25.6%
-41.0%
45.0%
-24.3%
153.5%
-31.0%
-6.2%
42.2%
18.1%
110.5%
257.6%
19.7%
31.1%
29.4%
-18.1%

19,484,706

40,593

14.2%

In local
currencies

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The global figure includes all the stock exchanges around the world. The countries in the above
table are a sample of first, third world and developing economies.. In 1997, countries with the
highest returns were developing nations, including Turkey (257.6%), Russia1 (53.5%), Oman
(136.1%), Mongolia (135.5%) and Trinidad & Tobago (110.5%). Indicative of the volatility of
emerging nations, the bottom five returns were also from emerging countries, namely Singapore
(-31.0%), Indonesia (-37.0%), Philippines (-41.2%), South Korea ( -42.2%) and Malaysia (52.0%).
First world markets were more conservative, with the US achieving a 31.1% return, UK
19.7%, Germany 41.2% and France 24.5%.
Risks of investing in emerging markets?
Emerging markets, generally, involve much higher risks than those associated with developed
stock markets. Investors preparing to commit capital to an emerging market should be aware of
at least four primary risks, including volatility, illiquidity, political and foreign exchange risks.
Some of these risks are common to all foreign investments; others are unique to
emerging markets or are exhibited to a far greater degree than in developed markets.

Volatility Risk: Developing nations are historically volatility. For instance, Brazil produced a
spectacular total return of +64.3% in 1994, but produced a -21.0% return in 1995 and a
44.8% return in 1997. Turkey, on the other hand, had a total return of -50.5% in 1994, but in
1995 rebounded to gain +47.7% in 1995 and produced a spectacular 253.6% return in 1997.
Comparatively, first world markets performed more steadily. The US had a 31.1% rise for the
year to end 1997, despite a 12.9% decline in October that year. Similarly, the UK had a
19.7% rise, after the FT 100 fell by 11.2% in October 1998.
For long term investors, the Dow Jones has shown a 10 year historic growth including the
October 1998 crash of 180%.

In addition, emerging markets are immature, often vulnerable to scandal and manipulation, and
are also characterised (in many instances) by a lack of strong government supervision.
Accounting, disclosure, trading and settlement practices may at times seem overly complicated
or, alternatively, practically non-existent.
Against this backdrop, many emerging markets have had to cope with unprecedented
capital inflows (and subsequent outflows) in recent years. The sudden movement of highly
speculative, short-term capital has the potential - as seen in Mexico and other markets - of
taking with it much of a market's price support.
Such sudden flights of capital in 1997 and 1998, triggered by loss of confidence in emerging
markets, can spread instantly to other more developed markets even when those markets have
quite different political and economic conditions. When stock prices plummeted in Mexico and its
currency collapsed in late 1994 and early 1995, the pain quickly spread to other emerging
markets in Latin America as some nervous investors pulled money from Argentina, Venezuela,
and Brazil, and speculators bet that currency and stock market declines would spread.
More recently, capital was withdrawn from Asian markets when news of financial turmoil
in Japan became evident in 1997. Investors withdrew from emerging markets, but also from first
world markets. The Dow Jones fell by 12.9% in October 1997 and has continued to be volatile,
despite having a fundamentally sound economy inflation is practically non-existent, inflationary
pressures are minimal, Budget deficits non-existent and unemployment at a historic low of 3%.

Illiquidity Risk: Emerging markets are generally small and, compared to developed
markets, often illiquid. A country's entire market value, or capitalisation, may be less than
that of a single large US company, and many companies in some markets are closely held
family businesses. Some markets have fewer than 200 companies listed and total daily
trading volume often reaches only a few million shares a year.

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By comparison, there are over 8,000 companies listed in the US and annual trading volume
is over US$10 billion. Therefore, it is fair to conclude that, globally, emerging markets are
illiquid. Buy or sell orders may be only partially filled, or may remain unfilled, with the
possibility that subsequent prices paid or received may be significantly different from
previous trades.
Some countries also restrict foreign investments. In Taiwan, for example, foreigners are
permitted to own only a specified class of shares, which may be available in limited
quantities. In Chile, foreign investors must wait at least a year to withdraw capital from the
market.
Political Risk: Many countries with emerging markets are especially prone to such political
risks as coups, assassinations or paralyzing power struggles.
Governments moving toward democracy may be grappling with long-standing political and
social problems and sudden retreats toward socialism often occur. However, investors must
be aware of the risk of economic policy changes that could be unfavorable to external
investors, i.e currency controls, taxation revisions, or even expropriation of foreigners'
assets.
Currency Risk: Movements in the world's currency markets can have a dramatic effect on
returns earned abroad. High returns from rising stock prices could be turned into losses from
falling currencies. One of the primary causes of currency risk in emerging markets has been
runaway inflation. Annual inflation rates of 1,000% or more are not without precedent. While
there have been some dramatic successes in controlling inflation recently - notably in
Argentina and Chile - a potential resurgence of inflation remains a threat to currency stability.

New rules for the west investing in emerging markets

Prior to placing large funds in developing countries, it is important to understand new investment
pre-requisites that have been brought on by globalisation and the volatility caused by this
phenomenon. Investors must know and understand the new pre-requisites set out by the IMF in
1997, which is set out in the following text.
Invest in emerging markets that have undertaken the following policies:
Deregulation of key industries, i.e. State controlled enterprises (transportation, Oil).
Privatisation of State-owned industries, i.e. airline, telecom and banking.
Introduction of stringent fiscal measures.
Removal of price subsidies and trade barriers.
Introduction of tight fiscal and monetary policies.
Enhanced international competitiveness.
Stabilisation of exchange rates.
Manageable inflation.
Increasing the resources available to the private sector.
Decreasing foreign debt burden.
Reliable and viable investment alternatives.
Given the above investment criteria, it is unlikely that global investors will retain the same
percentage split between the different emerging nations and it is expected that Asia will receive
substantially less priority in the future. This is particularly true in view of there being no
significantly restructuring of the banking system, introduction enhanced disclosure laws, tighter
monetary and fiscal policies and thereby more stable exchange rates.
What does this mean for markets?
Financial markets have never appreciated uncertainty. This is reflected in increased volatility in
almost all financial markets. Volatility feeds fear and increases risk. When this happens,

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investors look for safer investment options. Value becomes more important than growth and
major adjustment in valuations and pricing occur.
Market conditions vary to find an appropriate balance between fear and greed. Greed
dominated the market until April this year with a huge surge towards high growth stocks. This
investor greed has rapidly been replaced by fear after one emerging market after another
tumbled, until global markets became so unstable that established low risk markets of the
industrialised world could no longer ignore the threat. Currently, fear rules the markets.
This is a time to be cautious. But it is also a time to be brave, because huge opportunities are
beckoning. Recession is about change and adapting to new circumstances. A recession would
be no different. The faster the adjustment takes place the faster South Africa can move forward
to prosperity.

Summary
The effect of emerging markets on first world shares
In US$ terms, emerging markets have no direct influence on American investors who hold
only US stocks. US stocks are priced in dollars, so the exchange rate of the dollar does not
alter the value of stocks to US investors.

However, the indirect effects of currency fluctuations on US stocks are mixed.

1. A cheaper currency helps some US companies by making their products less expensive
for foreign buyers or by increasing the dollar value of profits generated by overseas
operations.
2. A depreciated dollar can hurt US firms by raising the cost of imported parts or raw
materials and of wages and other operating costs overseas.
3. Conversely, when the dollar is rising in value, it makes it cheaper for US companies to
conduct business overseas.
4. However, a rising dollar reduces the value, in dollars, of a US company's profits
generated in Japanese yen or German marks.

Similarly, fluctuations in exchange rates may affect US share prices by changing foreign
demand for US securities. The dollar's long-term decline erased, for some foreign investors,
a big chunk of the returns from US stocks over the past decade. This has caused some
foreign investors to shy away from US stocks.

Alternatively, foreign investors who believe the dollar's value will continue to rebound may
find US stocks attractive, since a rising dollar will magnify, for foreigners, the returns on US
stocks.

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PART TWO ENCAPSULATED AND EXPANDED

Portfolio managers
Investor should start out with realistic expectations.

They must understand and know what advisors can and cannot do, i.e. avoid advisors who
say they can always time the market correctly, always pick individual stocks, protect against
loss and guarantee success.

Advisors should never be allowed to intimidate investors.

Set the trading parametres for the portfolio manager.

Follow the pattern of long-term strategy carefully.

Once parameters are understood by both parties, it is time for the advisor to design the asset
allocation plan that offers the highest probability of long-term success.

As a fiduciary of the investor's funds, a prime responsibility of the advisor is to control total
costs.

Having determined goals, set a strategy, and implemented the plan, the next step is to set
out future requirements, i.e. performance reporting, portfolio updates, consolidating
statements, account supervision and continuing research.

The consulting process never ends.

Properly devised and executed, the consulting, design and implementation process should
lead to substantially better long-term performance.

If an advisor motivates clients to invest, steers them into the right markets and assetallocation plans to meet their needs, communicates reasonable expectations and over time
helps the clients to exercise the discipline required to ultimately meet their goals. His service
will be well earned.

Reality bites
The general public is poorly prepared for retirement.

South Africans are among the worlds worst savers.

Despite investors being repeatedly told to address the problem, high unemployment, apathy,
greed and ignorance all work quite naturally to keep investors locked into their mind-set.

Individual investors often innocently place their faith and future in exactly the wrong hands.
The social, political, financial, economic and business sea of information (often
contradictory), results in confusion and investors end up floating and drifting, usually reaping
predictably poor results.

A lack of ability and necessary skills often result in fatally flawed investment strategies, an
overwhelming majority of investors place their hard-earned savings in the wrong markets
and then fail to come close to a market return.

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Not all is lost

Investors have better and more choice in the local and global market.
While the knowledge of better investment systems exist, the benefits have yet to filter down
to the masses. This will take place when investors abandon preconceived notions, then take
and use the systems that modern finance provides.

New economic and financial theory has totally changed the investor's paradigm. Mutual
funds and unit trusts have appeared with just the right building blocks to execute the
improved strategies. Deregulation, unbundling, demutualisation and privatisation have added
new opportunities for investors.

Modern communications (cellular phones and the Internet) has liberated investors from the
requirement to physically inhabit the local stock exchange.

New technology has placed sophisticated and powerful management tools on the investor's
desk top.

Before investors can act effectively, they must banish their misconceptions and vanquish the
conventional wisdom.

Investing is a multi-dimensional process.

For starters, investors must consider risk, return, time horizon, and correlation before they
can construct an appropriate investment allocation plan. Important points are outlined below:

Advantages of investing in equities:

1. An investor can start an investment portfolio with a relatively small investment and build it
up.
2. The portfolio can be designed to encompass a number of different industries or sectors.
3. A well designed portfolio can provide the right balance between income and capital gain
to suit an investors circumstances from time to time.

Managing a portfolio: Managing investments will prove less time consuming if an investor
has identified the investment allocation that will satisfy his long-term objectives and priorities.
Once a strategy has been adopted, the effort required to manage the investment portfolio will
vary significantly between individuals, but will be significantly easier than if the strategy
changes daily.

Maintaining a portfolio: A multitude of investors spend many hours in planning an

investment strategy, but once the portfolio is in place many tend to forget about it. This
complacent attitude is a sure way to kill any equity portfolio. To achieve the maximum return,
it is important to constantly examine the investments (as a whole and individual shares)
ability to perform through periodic reviews.

Return: Only equities offer investors a real rate of return sufficient to meet their realistic
long-term goals. In other words, fixed income and savings-type asset classes do little more
than offer a "safe" way to invest. They offer a means of having funds available for market
opportunities.

Risk: This is the only reason that every investor would not prefer equities for their long-term
investments. One of the most appropriate ways to measure risk is to use the variation
around an expected rate of return. Higher variation is generally associated with higher
returns in the investment world. Risk can never be avoided. For long-term investors, failure

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to assume reasonable risk may guarantee that they will never achieve reasonable financial
objectives. In other words, the biggest risk may be being out of the market.

Diversification is the primary method to protect investors. The risk of business failure is
almost a non-issue in a properly diversified portfolio. Viewed from a slightly different
perspective, the market never rewards investors for taking risks that could be diversified
away.

Correlation: New investment theory indicates that some types of diversification are better
than others. Harry Markowitz demonstrated that by combining risky assets that do not move
at the same speed or cycle, risk is reduced at the portfolio level. Markowitz's work resulted in
the Modern Portfolio Theory (MPT) and for this he was awarded the Nobel Prize for
economics.

MPT revolutionised investment techniques. By examining each investment based on its

contribution to the portfolio rather than just on its individual risk and reward, investors can
fashion portfolios that fall above the traditional risk-reward line. Within certain limits (over
longer periods), investors can simultaneously increase rates of return and reduce risk.

Time Horizon: To design an appropriate plan investors need to understand time horizons.
Risky assets are not appropriate with short time horizons. An investor who is forced to sell a
security at a loss (to cover a known debt) has committed a market sin. However, this does
not mean that investors cannot have risky securities in a long-term portfolio; risk is lowered
with longer time horizons.

Efficient Markets: Embedded into MPT is the concept that markets are reasonably efficient.
Stock prices for risky assets are driven down until the expected rate of return provides the
necessary return to buyers. Investors will demand a rate of return which equals a risk-free
rate of return, a market-risk premium and a premium for the unique risk associated with the
investment.

Start the investment process now: To do this investors must formulate a meaningful
investment plan, learn investment discipline and reform their own behaviour.

Investors without the time, inclination, or resources to administer their investment programme
should consider delegating the duty to a qualified financial advisor. The vast majority of
investors simply cannot afford the free advice they have been giving themselves. Investing is a
serious business and it is unlikely that investors will stumble on reasonably efficient portfolios
by themselves.

Three ways in which investors benefit financially from investments:

1. Dividends: Distribution of part of a company's net profit to shareholders, as part owners
of the company. Most large industrial companies pay dividends twice yearly and these
dividends have tax advantages. The long-term investor re-invests these dividends into
the market.
2. Capital Growth: An increase in the market value of a company's shares over the total
cost of those shares. It usually reflects the growth in the company's profits and assets,
but it can also be affected by a change in market sentiment towards the share.

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3. New Issues of shares: Also called a right-issue, such new shares are usually offered at
a discount to existing shareholders, based on a predetermined ratio, without having to
pay brokerage. A company may also make a "Bonus Issue" to shareholders at no cost.
The value of your portfolio can be assessed daily through newspaper share lists. An investors
portfolio can be altered at any time to allow for changing industry or economic trends. Shares
can often be used as security for borrowings, including borrowings for additional share
investment.
Marx was wrong: Capitalism is the revolution of the 21st Century and beyond. The
market itself is the greatest wealth-generating mechanism the world has ever seen. A
properly diversified portfolio of the world's equities will harness the tremendous
power of the growth in the global economy for the investor. Riding that wave, rather
than fighting it, is the ultimate investment strategy.

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Part 3
Strategic Investment
&
Portfolio Techniques

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CHAPTER 25: TRADITIONAL FORMULA PLANS FOR BUYING

OR SELLING SHARES
Imagination is more important than knowledge. Knowledge is limited. Imagination encircles
the world." Albert Einstein.

The business and share portfolio planner

An investors and a businessmans investment portfolio should match both where they are now
and where they want to be at a predetermined time in the future. The challenge is to find the
proper mix of investments with just the right amount of your money in a variety of investments.
For the entrepreneur, strategic planning means the right mix of businesses today, but
also detailed and specific plans for future expansion (via acquisition). Similarly, the investor must
have the right mix of shares in his portfolio, but he must have a strategic plan for his future, i.e.
does he want to move offshore, increase risk exposure and move into other securities.
Based on investment results achieved over time and the strength of portfolio strategy,
investors may want to become more involved in the decision making process of portfolio
management. The preceding chapters looked at strategies for investing in shares, but what is
needed to wrap up this book is a strategic approach to analysis. In other words, a look at
strategic investment analysis that looks at factors that fundamentally affects businesses and, in
turn, their performance and thus share prices.
Therefore, the following section can be of benefit to:

Entrepreneurs: to assess their own businesses and/or to assess prospective acquisitions.

Investors: to assess and re-assess their portfolios and to investigate new share purchases.

The strategic management process requires that the approaches are mobilised and made
implementable by an appropriate framework which results in goals and objectives accompanied
by a set of action plans, targets and responsibilities.
The success or failure of an investor or corporation depends on the success or failure of the
individual business units that make up the corporate or investment portfolio. The performance of
each individual business unit depends on the competition that takes place in the market place.
Remember that rivalry occurs at the individual business unit level rather than at the corporate
level. On the investment side, each share affects the overall performance of the portfolio.
Therefore, the performance of the individual business unit is a function of the criteria for
strategic success in a given served market. The overall performance of a corporation/portfolio is
essentially the sum of the corporation's ability to handle the aggregated results of the individual
business units serving separate markets.
Note: For the remaining pages of this book, the word portfolio stands for both shares and
businesses, i.e. a Group consists of a portfolio of businesses and an investors portfolio is
made up of shares in separate companies.

Business of share definition is, therefore, the very heart of the strategic planning process at the
corporate, the portfolio, and the individual business levels. The lines delineating businesses
(sectors they operate in are continuously change over time) are in dynamic flux and are drawn
and redrawn as a result of conscious actions and spontaneous responses to competitive action;
locally and globally. I believe that the astute strategist must realise the potential impact of the
factors affecting the definition of the business (or shares) and the implications of these factors
for effective strategic management.

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The problems in defining a business

The starting point of strategic planning hinges on the definition of the business. Once a business
has been defined, the following fall into place:
Competitors can be identified.
Opportunities forecast.
Specific strategies laid down.
US business guru Peter Drucker (1954) has repeatedly stressed in his books that the
significance of a correct definition of the core businesses as a starting point in strategic planning.
This combines the macro-environmental aspect of the company (is it significantly affected by
politics, business, finance, economic or technological trends), but must provide a specific short
term function, an outline of long term plans and how the company will achieve long term plans.
In addition, the strategy should be practical and useful to the business concerned. For instance,
it would be pointless for investor Henry to spend three months researching the emerging market
of Nigeria, if he had no intention of investing outside South Africa.
However, management does not have the luxury of divorcing theory from practice. Once
a portfolio strategy has been adopted, the continual changing of the strategy is undertaken by
assessing the potential of future events changing, i.e. through theory, safer practical solutions
can be found by avoiding potential dangers.
Portfolio planning: a multilevel activity
When analysing a portfolio, management tends to first look at the companys aggregate
performance. The next step is to look at the individual businesses to identify weak and strong
areas to recommend how these can be changed (or not) to accommodate the existing
organisation structure.
The overall effect is to have a set of guidelines for setting competitive strategy
based on:
A balanced portfolio of businesses or shares.
An analysis of portfolio trends.
An evaluation of competitor's portfolios.
The development of target portfolios.
In defining what a business/share portfolio is, some assumptions have been made. The
following lists provide some understanding of the complexities in defining a business and thus
etting up a portfolio of businesses or shares:
Portfolio assumptions:
Levels of market segmentation affect the positioning of businesses and thus profit returns
and share prices.
Inflation clouds the picture, affecting net returns and share performance.
Foreign exchange variations cause problems, especially when the portfolio consists of
businesses or shares in foreign territories.
Some planning criteria, such as future tax considerations, are often difficult to assess as tax
laws are continually changing.
The organisational structure rarely reflects the strategic business units concerned.
The overhead cost allocation problem and its attendant accounting procedures are a
headache. It is always better to simplify issues as far as possible.
Motivational problems occur and can lead to strike action. These problems are often not
quantifiable and are thus difficult to assess and forecast.
Practical considerations prior to setting up a portfolio:
It takes time to adapt and adopt portfolio planning systems.

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Portfolio planning is a multilevel activity with levels of aggregation.

Shared experience effects must be identified, i.e. combination of two head offices,
administration offices and marketing departments can reduce overhead costs; these are
quantifiable.
The focus should always be long-term, but appropriate short-term sensitivity analysis is
important.

Strategic portfolios provide a number of benefits:

These provide guidelines to achieve the optimum financial structure.
Provides a means to achieve a maximum profitable allocation of resource.
Avoids minimum rate of return in which the assumptions are manipulated.
Avoids strategic traps and investments in managerial ego.
Gives guidelines for growth.
Helps pinpoint the black holes in a companys finance.
Fundamental questions that portfolio planning models seek to answer:
Should the company/investor be in a specific business/share?
Should new businesses/shares be added?
Which businesses/shares should be sold?
Which businesses/shares should be targeted in future?
In short, the issue addressed is the allocation of resources around a portfolio of businesses
associated with the strategic needs and objectives of the total organisation.
The most famous of the earlier planning models, namely the Du Pont model and the Cost
Averaging system (outlined in the next chapter) can be successfully used in conjunction with
growth matrices to assess relative market share and market growth rate and business growth
rate and market growth rate.
Although successfully applied, the techniques so come in for some criticism, due to the
reality that the corporate and share strategic world does not necessarily reduce down to
variables.
Multi-fold portfolios are conducted via planning matrices that comprise of two or possibly
more independent dimensions. The models are used as an aid in the decision making process
regarding the allocation of resources among individual businesses or share portfolios. The
overall planning criterion is usually the maximisation of cash flow and optimum return on
investment both factors are crucial in the analysis of share portfolios.
Summary
All of the above techniques are based on some implicit or explicit measure of long-run return
on investment or assets, or on expected profitability.

They are very closely related. All the techniques attempt to appraise the external
environment and the corporate competitive edge.

The models can be made highly specific, but have limited applications and are timeconsuming. The approaches include market share and profitability analyses, projections
based on alternative strategies and utility functions and product performance analyses.

Each type has its own specific strengths and weaknesses for different applications.

Testing for strategic sensitivity: Future reality is stochastic and an analysis of strategic
sensitivity helps to pinpoint vulnerabilities based on potential environmental and internal
changes.

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Product life cycle theory: The product life cycle is one of the most widely used, abused and
contested concepts in setting strategy. It has been conclusively proved and disproved.
However, it remains a key building block in setting strategy and as such is worthy of detailed
analysis.

Matrices enable entrepreneurs and investors to set guidelines for the allocation of resources
around a portfolio of businesses or securities markets.

Matrices can also be used to address, among others, issues relating to profitability and asset
structures.

Putting it all together: Techniques chosen by entrepreneurs and investors must logically lead
to a framework for mobilising the theory into a practical system for planning, screening new
opportunities, and providing feedback. The ultimate goal is the creation of an action plan that
supports and implements a strategic plan.

Summary
The key to analysis is the correct definition of the business and its served markets. A
number of important analytical tools exist, including sensitivity analysis, Du Pont systems
and a number of matrices.

Developing strategic investment techniques

Over the years, there have been numerous methods developed to help investors determine
when to buy or sell shares. Despite the proliferation of computer programmes available, these
methods are still valid and are outlined in the following chapters. However, it must be pointed out
that this section is advanced and, while I do try an keep issues easy to understand, aimed at
investors who aim to become self-reliant in the investment game or to ultimately trade shares as
a career. The systems outlined in this section include:

Basic systems

Cost averaging
Constant rand
Constant ratio
Du Pont system

Entrepreneurial-based analytical system to measure performance

Economic Value Added (EVA) analysis

Advanced mathematical matrices

The growth return matrix (relates the growth rate of the business with its return
on assets)
The return on assets/asset growth rate matrix (relates ROA to growth in ROA).
Financial ratio matrices (relate financial ratios such as return on sales and return
on investment)
The market dominance/capital intensity matrix (relates relative market share to
the capital intensity of the business).

A number of techniques have been developed to aid in the strategic planning process. Ideas
have been evolved and used successfully by a number of major stockbrokers and corporations. I

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have created a number of strategic systems that can be used by both investor and entrepreneur,
especially to account for the onslaught of global capitalism.
Indeed, investors and entrepreneurs should expect that a planning process will
continuously change and improve. In addition, the concepts outlined in the following chapters
will continue to provide an ongoing conceptual basis for share selection and entrepreneurial
planning.
Experience has shown that the quality and effectiveness of strategic planning in the
management process depends strongly on an understanding at all levels of management of its
purpose, use and benefit in managing the firm. This necessitates that a framework for setting
strategy at the corporate level should be consistent with strategy set at the individual business
and the served market level.
Once a business is defined at various levels a number of strategic management
techniques can be used to address the issues of competitive position and market attractiveness.
The result should be an integrated strategic plan that leads to objectives and a framework that
terminates in the setting of action plans and responsibilities.
Strategic management or investment planning depends on the selection of significant market
opportunities to achieve the long-term objectives of the firm or investor. It is also important to
manage future strategic changes that are necessary to capitalise on all opportunities.
Strategic management requires that entrepreneurs or investors are able to:
Identify market opportunities.
Establish priorities for investment.
Pre-plan changes in shares or products.
Formulate and implement strategic plans.
Optimally allocate resources to the strategic asset allocation.
Manage and control change.
Continually re-assess a portfolio.
Continually assess the shares/companies sectors to ensure that these trends fit with those
of its sectors.
In other words, strategic management is the matching of the organisation's resources, its
distinctive competencies, strengths and weaknesses, with environmental opportunities and
threats in the face of local and global competitive action and the management of the
changes necessary to sustain the competitive advantage.

The key rationale for strategic planning:

Strategy can and should be deliberately determined and specifically articulated
The implementation process can and should be managed.
This implies that the formulation and execution of strategy is uniquely affected by external
opportunities, internal strengths and constraints, the organization culture and the value
system of the dominant coalition.
It is an essential element of strategic investment and entrepreneurial management.
It is involved in the development of the long-term objectives of the firm or share portfolio.
The strategic plan is a basic tool of strategic management and, therefore, a competent
strategic plan should specify:
The market priorities used for the allocation of resources or the securities asset allocation.
The assumptions used to determine priorities.
The changes necessary to capitalise on the market opportunities.
The time-table for change.
The strategic plan should provide the point of reference for measuring deviations from:

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Expected environmental conditions.

Expected progress in implementing change.

The strategic plan should describe:

The objective of the company or investor: assign growth objectives and investment priorities
to strategic served markets. These growth objectives should form the basis of a commitment
to the desired business mix (asset allocation) to achieve the long-term objectives of the
organisation or investor.
The implementation details that can be used to achieve the desired market position.
The desired changes in business or share variables.
Strategic management of a portfolio or shares/businesses takes place on several levels:
The corporate or portfolio level.
The given strategic business or specific share level.
The sectors of individual businesses.
All successful strategic plans must be coherent and integrate all three levels to prevent conflict:
The preferred market sector is the starting point for strategy development.
The organisational structure may affect the responsibilities for making changes in key
variables, but the nature of most changes will be the same.
The organisation or portfolio structure is a variable under the control of the entrepreneur or
investor.
Strategy developed at the corporate or portfolio level must be related to and integrated with
strategy development at the individual business level to produce a coherent, integrated,
corporate or portfolio strategy that prescribes the key changes in the portfolio of businesses, the
resources required and the capabilities needed. These are then implemented.
The same linkage should apply between the individual business segment level and the
various market sectors. The integration between the corporate/portfolio level of planning and the
individual business/share level is shown in the following diagram.

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`
STRATEGIC MANAGEMENT IN A MULTI-FOLD ORGANISATION OR PORTFOLIO

STRATEGY DEVELOPMENT
AT:
Portfolio or corporate level
Objectives
New opportunities
Funding ventures

AT:
Business or Share level
Current market
1. Objectives
2. Strategies

EVALUATION OF STRATEGIES
Current businesses or shares

Portfolio or Corporate

INTEGRATED CORPORATE STRATEGY

Changes in funding

MANAGEMENT OF
CHANGE

Changes to portfolio of shares or

businesses

Changes in skills

Objective this section of the book (Part Three: Investment Strategies)

The framework adopted in this text is aimed at providing a technique oriented basis for setting
strategy at the corporate and portfolio level, but taking cognizance of the integration of the
individual businesses or shares comprising the portfolio.
Framework for developing a strategy
The key areas of relevance are outlined in great depth in The Business Plan: A manual for
South African Entrepreneurs (Struik 1996). It is sufficient to say that a framework should consist
of:
The definition of the business.
The evaluation of strengths and weaknesses (first part of a process called SWOT analysis).
The forecasting of opportunities and threats (second part of a process called SWOT
analysis).
The definition and evaluation of these core concepts conditions the analysis of market
attractiveness and competitive position. Strategic intent arises out of the SWOT analysis. These

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statements are then made manifest in plans necessary for changes in key variables and the
expected results.
Competent analysis of this area includes such aspects as social, political, legal,
economic, labour and technological change. The executive dilemma is that investors and
entrepreneurs cannot analyse everything and the choice of the variables to be included is
critical. It is suggested that only the key environments that impact on the business or shares
should be addressed. Difficulty in filtering the information is often encountered and the reality is
that the strategic response to weak signals could mean the difference between success and
failure.
The formulation of a suitable strategy begins with the identification of opportunities and
threats in the environment in the changing areas of:
Technology
Economics

Social change
Politics

Legal change
Labour

The primary rule in strategic management is to lead from strength and to eliminate weaknesses.
One approach used is to analyse all the key functions within the business. In the average
manufacturing operation this would entail analysis in the functional areas of finance, marketing,
production, R&D, personnel, leadership, culture, and any other relevant core competence
required.
To summarise, the approach entrepreneurs or shareholders should take is to analyse:

Market attractiveness of buying a company or specific share.

Competitive position of the proposed company or share acquisition.
The strategic positioning of portfolios of businesses or shares.

Caveats
Dangers exist in the simplistic application of many of the strategic management techniques. Too
naive an application of a given model often causes problems and even failure. The areas
covered in further chapters include:

Techniques that aid the analysis of competitive position and market attractiveness.
Various portfolio planning techniques.
A framework for strategic management.
Defining the business: The definition of the business and its core markets is the starting point
of strategic management. Given the definition, competition can be identified, strengths and
weaknesses analysed and opportunities and threats forecast. The business definition problem
is at the very heart of strategic analysis.

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CHAPTER 26: BASIC INVESTMENT RETURN STRATEGIES

There are literally hundreds and thousands of investment systems to attempt at determining the
future of a companys or its share performance. From the simplest of ratios to the most
complex models, return strategies are best used as what if scenario planners. Never forget
that in the real world the economists staple phrase everything else being equal is a
dangerous share philosophy to adopt.

Using mathematics models

A simulation model is a system of mathematical equations, logic and data that describes the
relationships between financial and operating variables. A simulation model is one in which:

One or more financial variables appear (expenses, revenues, investment, cash flow, taxes,
and earnings).

The user can manipulate (set and alter) the value of one or more financial variables.

The purpose of the model is to influence strategic decisions by revealing to the decision
maker the implications of alternative values of these financial variables.

Financial models
These are basically "what-if" models that attempt to simulate the effects of alternative
management policies and assumptions about the firm's external environment. In addition,
models can be deterministic or probabilistic. The first type does not include any random or
probabilistic variables, whereas the second incorporates random numbers and/or one or more
probability distributions for variables such as sales and costs.
Financial models can be solved and manipulated computationally to derive current and
projected future implications and consequences. As a result of technological advances in
computers (such as spreadsheets, graphics, database management systems, and networking),
more and more companies are using modelling systems.
Negative aspects of financial models
Models are abstractions of reality and there is thus no guarantee of perfect correlation
between the model and future prospects.

Variables used in models are usually limited and critical events unfolding elsewhere in the
world could influence reality in unexpected ways.

Many models are industry specific, whereas many groups have divisions in different
industries.

Even the best trend analysis is only a contingent forecast. It is up to the astute analyst to
realises that the future is unlikely to mirror the forecast.

Finally, most strategic planning techniques produce forecasts that are essentially
representations of the expected or desired future at any given point in time, i.e.

Positive aspects of financial models.

The use of sensitivity analysis can give the company information on:
Where strategic plans are most susceptible to deviations from the forecast.

Whether the company is still on target, given changing current trends.

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The use of sensitivity analysis is really threefold:

1. For planning purposes: to assess the impact on the expected performance criteria due to
possible changes some variables.
2. For measurement purposes: to assess whether the strategic plan is still on target.
3. For control purposes: to predict the amount by which control variables must be changed to
keep the company on target.
Sensitivity analysis should be able to answer all three questions of:
The impact of given possible changes.

The measurement of progress on an exception reporting basis.

The estimation of control actions.

The key to useful sensitivity analysis is the ability to answer all three questions in the context
of the strategic determinants of the business. This means that impact, measurement and
control must be quantified in relation to the core business criteria.

Basic systems
The cost averaging system
Cost averaging is an investment method in which a constant rand amount of shares is bought at
regularly spaced intervals or, alternatively stated, a time diversification strategy. This method
may be used for stock deemed to be a good long-term investment
Equation:
Average
price

Total market price per

share
Total
number
of
investments

By investing a fixed amount each time, more shares are purchased at a low price and fewer
shares are purchased at a high price. This approach typically results in a lower average cost per
share because the investor buys more shares of stock with the same dollars
An investor invests R100,000 per month in ABC Company and engages in the following
transactions
Date
6/1
7/1
8/1
9/1
10/1
TOTAL

Investments
$100,000
100,000
100,000
100,000
100,000
500,000

Market price per share

$40
35
34
38
50

Shares purchased
100000/40 = 2500
100000/35 = 2857
100000/34 =2941
100000/38 =2632
100000/50 =2000
12,930

The investor has purchased fewer shares at higher prices and more shares at lower prices. The
average price per share is:

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5

39.4

With a total investment of R500,000, however, 12,930 shares have been bought, resulting in a
cost per share of

500,000
12930

38.67

On 10/1, the market price of the stock (R50) exceeds this average cost, reflecting an attractive
gain.
This is probably the simplest plan among the three. This system consists of investing a constant
dollar amount in common stocks over a long period of time at fixed intervals. The fixed intervals
means weekly, monthly, annually, or some other time period as long as it remains the same.
For example, a person might invest R500 per month in common stocks. Or this same
person might invest R3,000 every six months. The idea is to invest smaller amounts of money
on a regular basis. It is a long term system. The theory is that stocks can always be sold on the
average for more than they cost. It does not get you in and out of trades. It only gets you in
trades.
The person must have a steady amount of income coming in and be willing to invest over a long
period of time. This system shouldn't be used on just one stock. The investor may want to
choose five or six different stocks to invest in this way. One or two different stocks could go
down constantly. However, a properly diversified portfolio will go up eventually.
This system doesn't mean that you should keep under-performing stocks in your
portfolio. By all means, get rid of the dogs. There is a school of thought that says an investor
should not purchase stocks with this program when they reach very high (overbought)
conditions. However, when a person does this, they may spend the money elsewhere, it is
difficult to tell when stocks are too high, and the investor may not continue the program. I
recommend that if stocks are at a level where they may be too high, the money should be
invested in stocks which do well in a declining market. An example is utility stocks.
Some advantages to this method are: The average cost of shares purchased is usually less than
the actual market price. The investor eliminates the possibility of buying too many shares when
the price is too high. Also, periodic declines in the stock market provide buying opportunities at
lower prices.
Some disadvantages are: The possibility of liquidating the portfolio when stock prices are
low. This could cause a portfolio loss. One way to minimize this danger is to plan to liquidate the
portfolio several years before the actual liquidation time. This gives the investor time to pick and
choose the best times to liquidate each holding. Another disadvantage is that the investors
income might not be as steady as would be hoped. This could curtail purchases at times that are
attractive for additional purchases. Another disadvantage is that the investor might try to time his
purchases. This turns him into more of a speculator than an investor. Another disadvantage is
that the person may be tempted to use the investment money for something which comes up
(e.g. new car, home repair, etc.) and is also quite important.

The Du Pont model

As a shareholder, the return a company is providing on your funds (return on equity) is a key
consideration in judging the performance of the firm's managers. Du Pont analysis provides a

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framework to show how management of a company's operation and its financial structure
impacts on return on equity.
Du Pont analysis derives its name from the Du Pont corporation, which developed and
began using this approach in the early 1920s. This system of analysis highlights the interaction
between a company's operation and its capital structure. It gives investors a tool with which to
judge the performance of management on a few levels. It also helps to remind investors that
ratios should not be examined in a vacuum, but studied to see how they affect the overall
organization.
The Du Pont system combines the income statement and balance sheet into either of
two summary measures of performance, i.e. return on investment (ROI) or return on equity
(ROE). There are two versions of the Du Pont System.
The first version of the Du Pont formula breaks down return on investment (ROI) into net profit
margin and total asset turnover

ROI

Net profit after taxes

Total assets

Net profit margin x total asset turnover

Net profit after taxes

Sales

Sales
Total assets

Factors that influence ROI

Explanation
The top portion of the worksheet deals primarily with the income statement (good operations
management), while the bottom portion emphasizes the balance sheet (prudent use of

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financial leverage). This separation highlights that return on equity is affected by firm
profitability and balance sheet structure.

Sales, interest income (other income), cost of goods sold, selling and administration
expenses, interest expense, and taxes are entered from the income statement to determine
net earnings (or net income on some financial statements). Net earnings divided by sales
gives us the profit margin. It might be worth noting that Sara Lee did not break out
depreciation as a separate line item on its income statement, so we left that cell blank. Data
from the statement of cash flows or even changes in accumulated depreciation can by used
to determine the depreciation, but for the purpose of DuPont analysis it was not important to
break the information out.

As you work with different companies, you will find slight variations in how they present their
financial statements. The worksheet, with its other categories, should prove flexible enough
to deal with the variations or it can be easily modified to conform to the variations.

Asset data from the balance sheet is entered to determine the total assets. For Sara Lee,
other assets include trademarks, investments in unconsolidated companies and intangibles.
Dividing sales by total assets gives us asset turnover. Asset turnover times profit margin
provides the return on assets.

The liabilities from the balance sheet are entered to determine the total debt. For Sara Lee,
other current liabilities consist of notes payable, current maturities of long-term debt and
current obligations under capital leases. The other liabilities box includes long-term
obligations under capital leases, deferred income taxes and other liabilities. Total debt
divided by total assets provides the financial leverage figure. Financial leverage refers to the
percentage of total assets financed through debt.

Dividing return on assets by one minus financial leverage computes the return on equity.
Examining the interplay between the ratios is the key behind DuPont Analysis. Return on
equity can be increased through higher return on assets or a higher degree of leverage-more debt relative to assets. The high degree of financial leverage is how buyout artists
hope to make big profits when they take on huge amounts of debt in acquiring companies.
The risk in the strategy is that the company will not generate enough cash flow to cover the
interest payments. Proper use of financial leverage can help increase the return on equity.

Return on assets can be increased with higher profit margins or higher asset turnover.
Margins are improved by lowering expenses relative to sales. Asset turnover can be
improved by selling more goods with a given level of assets. This is why companies try to
divest assets (operations) that do not generate a high degree of sales relative to the value of
the assets, or assets that are decreasing their sales generation.

When examining profit margins or asset turnover, it is important to consider industry trends
and compare how a company is doing within its industry. A supermarket chain, for example,
would tend to have low profit margins, but make it up in high turnover.

The modified Du Pont formula

The second version of the Du Pont formula, also called the modified Du Pont formula, ties
together the ROI and the degree of financial leverage as measured using the equity multiplier,
which is the ratio of total assets to stockholders' equity, to determine the return on equity (ROE).

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ROE

- 215 =

Net profit after taxes

Stockholders' equity

Net profit after taxes

Total assets

ROI x Equity multiplier

Total assets
Stockholders' equity

Conclusions:
The Du Pont formula provides a lot of insights to financial managers on how to improve
company profitability and investment strategy. Specifically, it has several advantages over the
original formula (i.e. net profit after taxes / total assets) for profit planning. They are:

The importance of turnover as a key to overall return on investment is emphasized. In fact,

turnover is just as important as profit margin in enhancing overall return.

The importance of sales, which is not in the original formula is explicitly recognized.

The breakdown stresses the possibility of trading margin and turnover, since they
complement each other. Weak margin can be complemented by strong turnover, and vice
versa

It shows how important turnover is as a key to profit making. In effect, these two factors are
equally important in overall profit performance

The formula indicates where there are weaknesses -- margin, turnover, or both

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The constant rand system

In using the constant rand plan, where the amount invested in shares remains constant over
time, a well diversified portfolio is essential.
If an investor believes that, for example, he can live off the dividend income that R1
million can earn per year (after tax on the interest earned from the dividend in the bank), then
every time dividends are paid to this investor, he withdraws the income. In addition, if capital
growth pushes the value of the portfolio above the R1 million, the investor sells the shares to
keep the portfolio at a constant R1 million.
Conversely, if share prices fall and the value of his portfolio drops below the R1 million,
he would deposit funds into the portfolio to maintain the R1 million level. In addition, the investor
may re-assess the portfolio on a regular time interval and do one of three things. Either he
withdraws the cash in excess of the R1 million, pays in cash to raise the portfolio back to R1
million or he can change the level of constant system.
One of the greatest benefits of this system is that it forces investors to buy shares when they
are falling and sell when they are rising. The disadvantage to this type of system is that a
certain degree of timeliness is involved in determining when to initially set the system up. In
addition, a period of constantly rising or declining prices does not work well. The system
works best when prices fluctuate above and below the original level.

A Word of Warning
While Rand-cost averaging is a sensible investing strategy, it does not assure a profit nor
protect against a loss in declining markets, or against a loss if the investor stops the
programme when the value of an account is less than cost.
Investors should also consider their financial ability to continue making purchases through
periods of low price levels.
There is no method of investing that can guarantee a profit if an investor decides to sell at
the bottom of the market. However, the potential for a high return on an investment is
increased with long-term commitment to rand-cost averaging.

A Risk-Reducing Strategy: Along with being a simple strategy to follow, dollar-cost

averaging can reduce your investment risk, too. Suppose you have $10,000 to invest in the
stock market. You could invest the entire amount immediately - as long as you are prepared
for the potential for substantial loss. If, for example, you had invested $10,000 in the stock
market at the beginning of 1973, your investment would have dwindled to $6,270 by year
end-1974 - a 37% decline. And if you had the fortitude to ride out one of the worst bear
markets in history, it would have taken another two years for your investment to recover its
original value. So, for risk-averse investors who want to guard against committing substantial
assets at the "wrong" time, dollar-cost averaging is a prudent approach.

A Disciplined Approach: A commitment to dollar-cost averaging ensures that you are

investing regularly - even in the face of market declines. If you wish to follow this approach, it
might be a good idea to establish an automatic program that many fund sponsors offer to
investors at no charge. In this way, your installment investments are made without your
intervention - through regular transfers from a bank account or exchanges from a money
market fund account. In addition to providing your investment program a measure of
discipline, you'll protect yourself from your emotions - and the natural tendency to cease
investing - in a sour market.

The constant ratio system

This system has the investor maintaining a constant percentage ratio in his portfolio between
shares and gilts. For instance, if the ratio is 30% shares and 70% gilts, when share prices rise,

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some are sold and gilts are purchased. As share prices decline, gilts are sold and shares are
bought.
Profits can be made if share prices fluctuate above and below the 30% line.

Stock splits
At times listed companies will declare a stock split, which is usually done to improve liquidity. For
instance, if Company UU Ltd. has one million ordinary shares in issue, at a share price of 100,00
cents, it is unlikely that there will be too many investors trading the share. There are two
reasosns:
The share is expensive.
There are not enough shares in issue.
The company would decide on a split ratio and announce to the public what that split will be,
when it will take place etc. Essentially, if the split is 10:1 it means that for every share that the
investor has, he will now own 10 shares, i.e. the share has been split into 10 shares. However,
the price is also split in the same ratio and the share is now worth 1,000 cents. The investor has
more shares, but at a lower price, i.e. the value of his investment has not changed, but there are
now more shares in the market to trade.
For investors, the opportunity to buy a share (at R10) that was R100 is an opportunity
that many often cannot resist. However, there is no guarantee the share will rise in price after a
stock split, but if the split is not too server (100:1), the share often does rise.

Reverse stock split or share consolidation

The opposite of a share split is a reverse split. When a company undertakes a share
consolidation, it consolidates a number of shares for one share, i.e. consolidates 100 shares for
one. This does not increase the market capitalisation of the company. In addition, the share
price increased.
The investor is no better off before or after the consolidation. Except that the company
hopes that the higher stock price will make the company look better and thus more investors will
purchase the shares and the stock price will rise as more people buy it. Again, there is no
assurance that a company's share will rise in price after a reverse split. Many times it will
decline. There is no way to predict what will happen.

Share dividend
There are many occasions when a companys dividends is not paid regularly and, at other times,
the company will offer a share payment instead of a cash dividend. Assume a company declares
a 10% share dividend. This means that for every 10 shares of a person owns, he gets one new
share as a dividend. If a corporation has 1,000,000 share of common stock outstanding and
declares a 10% stock dividend, the corporation will have 1,100,000 shares of stock outstanding
after the stock dividend is paid.
The individual investor maintains his proportionate share and the same total book value
in the company. While book value per share will be less, due to more shares in issue, his
investment in the company remains the same.
Basically, the company is capitalising its earnings. For the long term investor, the
benefits of accepting a share dividend in an increase in his portfolio that will have future dividend
and added capital growth.

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The free cash flow method

Specialists in Leverage Buyouts (or takeovers) look at this amount in planning their strategy.
Free
flow

cash

= Cash
flow

capital expenditures

Dividends

= operating cash flow - interest expense - income tax expense

= Net income + depreciation

Where Dividends = dividends per share * number of shares.

The difference between the levels of fixed assets over two periods is an estimation for
Capital Expenditure.

Calculating an investors total return

One of the most commonly asked questions posed by investors to traders and portfolio
managers is:
"How well am I doing with my investments?" If the question really meant a simple
increase or decrease in the value of a portfolio, the formula would be a simple percentage
calculation, as highlighted by the following basic example:
Example:
Ken Rodney invests R111,200.00 with Institution V for a period of nine months.
Institution V placed all the funds equally in two companies, namely Company DD and
Company GG.
Company DDs share is valued at 930 cents a share, while Company GG is valued at 8200
cents a share.
The investment equates to 5,979 shares in Company DD and 678 shares in Company GG.
In the nine months since Ken invested the money, the share price of Company DD has risen
to 1390 cents a share, but Company GG has seen its share fall marginally to 8100 cents a
share.
No additional shares have been acquired or redeemed during the investment period.
At the end of nine months, Kens portfolio is as follows:

Details

Dates

Portfolio

Shares Price

Rands

Initial entry level

Initial portfolio (value):

02/04/1998
02/04/1998

5979
678

930 cents
8200 cents

Current portfolio (value):

03/01/1999

5979
678

1390 cents
8100 cents

Capital gains/(losses):

03/01/1999

Company DD
Company GG
Total
Company DD
Company GG
Total
Company DD
Company GG

49.5%
(1.2%)

R111,200.00
R55,600.00
R55,600.00
R111,200.00
R83,108.00
R54,918.00
R138,026.00
-

Capital gains
Capital growth

03/01/1999
03/01/1999

R26,826.00
24.12%

Capital gains is the monetary value of his investment gains.

Capital growth is the value of his investment growth in percentage terms, i.e. a percentage
figure that represents the change in the total value of a fund account over a period of time.

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However, in addition to capital gains, an investor must also factor in:

The reinvestment of dividends per share paid from net investment income.
The reinvestment of distributions per share paid from net realized capital gains.
The change in net asset value over a specified time period.

Calculating the total return for your fund investment is relatively straightforward (assuming no
additional purchases or redemptions were made during the period)). To determine your total
return, simply take the difference between your account balance at the end of the period and
your account balance at the beginning of the period, and then divide by the beginning balance.
Multiply the result by 100 to arrive at the percentage figure. The formula is shown below:
Total
Return

Ending Balance - Beginning Balance

X 100

Beginning Balance
Using the above example:
Total Return

Ending Balance - Beginning Balance

Beginning Balance

X 100

Total Return

138,026.00 - 111,200.00
111,200.00

X 100

Total Return

0.2412410071942

X 100

Total Return

24.12%

Stated differently, the above formula for percentage returns can be determined as follows:
Total Return

((Ending Balance/Beginning Balance)-1) x 100

Total Return

((138,026.00/111,200.00)-1) x 100

Total Return

((1.2412)-1) x 100

Total Return

0.2412 x 100

Total Return

24.12%

Adding other factors to the above formula

The above example uses a basic formula to calculate percentage returns. Now the investor
needs to add dividend income, share sales and acquisition during the period. Note that is it
statistically inaccurate to take a cumulative total return figure and divide by the number of years
in the period to arrive at an average annual total return (just as it is inaccurate to add together a
series of average annual total returns to find a cumulative total return). The reason:
compounding, which is discussed in Chapter ..
Example:
Ken Rodney invests the same as in the first example, namely Company DD and Company GG,
and in the same amounts.
Add to the above example:

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1. Company DD declares a dividend of 400 cents a share for the six months to end
December 1998.
2. Company GG declares a dividend of 1000 cents a share.
3. In addition, Rodney buys 10,000 shares in Company XX, at 320 cents a share, and
sells all these shares at 370 cents two months later. The cash is kept in his account.
The above example now changes to:

Details

Dates

Portfolio

Shares

Price

Rands

02/04/1998
02/04/1998

Company DD
Company GG

5979
678

R111,200.00
R55,600.00
R55,600.00

Bought during period

03/06/98

10000

Portfolio value at end of

period:

03/01/1999

Company XX
Total
Company DD

930 cents
8,200
cents
320 cents

Initial entry level

Shares kept for
period (value):

full

Dividend income
Company GG

5979

678

Dividend income
Company XX
Bought at
Sold for
Cash on hand
Interest (six
months)*
+Total
Capital
gains
remaining portfolio :
Total capital gains
Total capital growth

for

03/01/1999

Company DD
Company GG

03/01/1999
03/01/1999

1,390
cents
400 cents
8,100
cents
1,000
cents

R32000.00
R143,200.00
R83,108.00
R239.16
R54,918.00
R6780.00

10,000
10,000
-

320
370
-

R32,000.00
R37,000.00
R5,000
R1028.24

151,073.10

24.12%
10.82%

R39,793.62
35.78%

+ Total = Value of Company DD (+dividend) + Company GG (+dividend) + Cash on Hand

+ interest on that cash.

Compound interest is calculated as set out in chapter . Interest is compounded per

month, for six months, at a rate of 19% pa.

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CHAPTER 27: PERFORMANCE SYSTEMS - ECONOMIC

VALUE ADDED ANALYSIS
If youre not using EVA to help you decide whether to buy a competitor, sell a division or build a
new plant, then how can you be sure your decisions are maximising your shareholders wealth?
(Joel Stern, creator of the EVA system of analysis).

Although Economic Value Added (EVA) has attracted a great deal of attention in recent years, the
underlying concept is not new. EVA is simply a measure of a company's return on capital relative to its
cost of capital. The primary goal of any company should be to generate taxed profits that are high enough
to:
Cover the returns required by both creditors and shareholders; or
To cover the cost of debt and equity.
Effectively, EVA quantifies the amount of shareholder wealth created by companies.
While EVA is not a panacea and is not applicable to all industries, the methodology can aid in the process
of share selection as it forces investors and analysts to ask such critical questions as:
What is a company's true cost of capital?
How efficiently is capital being allocated throughout a firm?
How can a company boost shareholder value over the longer term?
Given the ongoing transformation of ownership within the equity market (in South Africa we have seen
unbundling and refocusing taking place in the 1990s), EVA-type analysis of shareholder value will
become increasingly significant in the future. It should help make company management more cognisant
of the need to deploy their assets more efficiently. For investors, the use of EVA can help in share
selection, through the choice of shares that will have increasing economic value in the future.
The Theory of EVA
The concept of EVA is fairly straightforward.
EVA = Return on capital The capital charge for any given company.
The basis for incorporating the cost of capital is that a company should generate taxed profits that are high
enough to cover the returns required by both creditors and shareholders. The difference to traditional
financial systems, such as EPS, ROE and free cash flow, EVA is a more accurate means of quantifying
shareholder value, as it measures the returns on investment beyond the cost of debt and equity capital.
Since other measures only include the cost of debt, EVA is a truer reflection of economic profit.
The precise definition of EVA is:
EVA = Net operating profit after tax (NOPAT) the capital charge*
where:
1. Capital Charge = weighted average cost of capital (WACC) x Invested Capital
2. WACC = average cost of capital or the opportunity cost of capital.
Therefore EVA = NOPAT (WACC x Invested Capital)
Note:

Shareholder wealth is created when EVA is positive or when NOPAT exceeds the capital charge.

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Wealth is destroyed when EVA is negative or when NOPAT falls below the capital charge.

Before analysing the practical implications of EVA, it is necessary to define some of the basic concepts
related to EVA including NOPAT, capital employed, cost of capital and the competitive advantage period.
EVA definitions
NOPAT. The rationale behind NOPAT is that net operating income must be adjusted to reflect cash
income rather than book-accounting figures. These adjustments include items such as after-tax interest
expenses, changes in deferred taxes, minority provisions, and the amortisation of intangibles.

Capital Employed. This includes all assets used in running a business. For the purpose of calculating
EVA, capital is adjusted so that it includes debt, deferred taxes, minority interests, preferred equity,
common equity, accumulated amortisation and non-current liabilities.

WACC. Under EVA, a charge is placed on all capital employed, including debt and equity. While the
taxed cost of debt is simply the average interest expense adjusted by the tax rate, the cost of equity
capital is based on the CAPM, using the risk-free rate (usually the bond rate) and a required return
equal to the Beta of the stock multiplied by the market risk premium.

Cost of Debt = Average Interest Expense x (1 - Tax Rate)

Cost of Equity = Risk-Free Rate + (Beta x market Risk Premium)

The WACC is calculated by multiplying the cost of debt and equity capital by their market value
proportions in the balance sheet.

Competitive advantage period (CAP). This is the period that a company is expected to earn excess
returns on incremental capital. Defining the length of the CAP for a company is highly subjective and
depends on, among others, the rate of industry growth, potential barriers to entry, brand name, pricing
power and cost advantages. Once this period is over, it is assumed a company will provide constant
shareholder value as either competitive pressure will drive prices and returns downward or the
company will no longer be able to find value-creating investment opportunities.

The CAP typically ranges from five to 30 years. A CAP of five years would apply to a company operating
in a mature market, with no barriers to entry and no particular name brand. On the other hand, a CAP of
30 years could be applied to a company with a strong brand name that is unlikely to disappear within the
foreseeable future.
Value drivers: how to improve EVA
The absolute level of EVA is much less significant than the direction of change. For instance, turning a
negative EVA less negative is as valid a way to create value as to make a positive EVA more positive. The
goal is always to increase EVA. There are essentially four ways to boost EVA, which are also referred to
as the "value drivers":

Operating efficiency. Find ways to cut costs, save taxes and raise profits without increasing capital.
Value-added growth. Invest in projects that add positive net present value, which is the only way a
company can increase EVA over the long term.
Balance sheet rationalisation. Sell assets that are worth more to others, trim marginal and
unprofitable lines of businesses or products.
Cost of capital reduction. Normally debt is less expensive than equity as the interest expense is tax
deductible, whereas dividend payments are not around the world. In South Africa, a company pays
Secondary Tax on Dividends (STD), which individuals do not pay. Within certain limits, therefore,
raising debt and buying back stock to increase the leverage ratio can reduce the cost of capital.

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Merits of EVA
The main advantages are its applications as a measure of financial performance and also as an internal
management framework. The perceived merits of EVA include:
Increased capital efficiency.
An incentive tool.
Advantages over conventional measures.
Increased capital efficiency.
EVA motivates managers to consider the cost of capital in every decision and to appropriately weigh the
trade-off between earnings growth and return on invested capital. Since investments should not be made
unless it can deliver a positive EVA, companies demand less capital and existing capital is used more
efficiently. This leads to higher asset and inventory turnover. EVA helps make managers more cognisant
of the need to use their assets more diligently, creatively and effectively.
Incentive tool
One of the most important functions of EVA is its role as an incentive and motivation tool. To transform
corporate behaviour away from an emphasis on size towards profitability and efficiency, altering
corporate performance objectives alone is not enough. To make this transition successfully, performance
objectives must be accompanied by a fundamental change in the underlying compensation structure.
Compensation schemes at companies that apply EVA are based on the ability of managers to
generate positive EVA in their respective operating divisions. Under a typical EVA compensation plan,
bonus awards are linked directly to increases in EVA. Unlike traditional bonus schemes, however, there
are no caps to the bonuses - in either direction - to match the actual risk and reward profile of an investor.
As a result, an EVA bonus plan attempts to emulate ownership at all levels in a company, thereby aligning
the objectives of managers and shareholders.
An example: EVA vs. EPS
Conventional financial measures such as EPS, ROE and free cash flow are limited as measures of value
creation as they are static and ignore the cost of equity capital required to generate earnings.
To illustrate the drawbacks of the EPS approach, we can show that profitable firms are not
necessarily value creators. The following example shows that Company TRX can be profitable while
destroying value.
Company TRX assumptions:
NOPAT = 60
Capital employed = 1000
The capital structure is comprised of 50% equity and 50% debt
Cost of equity = 10%
Cost of debt = 5%.

EPS approach: Net profit is calculated as follows:

EPS = NOPAT - taxed interest expense
EPS = 60 12.5
EPS = 47.5

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EVA approach
EVA = NOPAT Capital Charge
EVA = 60 62.5
EVA = - 2.5
However, under the EVA approach, the capital charge is the weighted average cost of both debt and
equity. While the cost of debt is 12.5, the cost of equity is 50, resulting in a total capital charge of 62.5.
Subtracting the capital charges from NOPAT yields a negative EVA of 2.5. While the company may
appear "profitable" in an accounting sense, it is actually destroying, not creating, shareholder value.
Another shortcoming of the EPS-based valuation method is that earnings can easily be manipulated by
accounting decisions. For example, EPS and ROE can be significantly affected by such factors as
treatment of reserves, depreciation policies, and valuation of inventories.
Factors that have driven the higher return on capital include:
Increased productivity through the ongoing substitution of capital for labour.
A stronger focus on managing inventory and receivables.
More flexible use of labour.
Capital costs have declined partly as a result of balance sheet restructuring, as equity has been retired via
share repurchases and replaced by less expensive debt. Moreover, corporate compensation programmes
have become increasingly tied to share prices and this has motivated management to think like owners and
focus on return on capital as a means of increasing shareholder wealth.
Specifically, finance market deregulation, globalisation of trade and heightened competition have
had the effect of restraining inflation and limiting over investment by companies and, as a result, countries
like the US have been able to enjoy a prolonged and stable economic and profit expansion.

Summary
By Measuring Return on Capital relative to Cost of Capital, EVA quantifies the amount of
shareholder wealth created by companies.

Compared with EPS, EVA has had a higher correlation with share price movements.

To become efficient companies have to become more conscious of the true cost of capital,
especially equity capital, and seek ways to reduce capital costs.

Companies must withdraw from unprofitable businesses or product lines, sell assets that do not
generate a sufficient return and invest only in projects that can add positive net present value.

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CHAPTER 28: ADVANCED MATHEMATICAL FORMULA AND

MATRICES
The danger of using mathematical formula rests in using them blindly, excessively and
depending on them without an investigation of tiresome fundamentals. Be aware that figures
can be misleading, even distorting, and often blind entrepreneurs and investors from making
sound acquisitions based on experience and skilled judgement.
To avoid using formula is as short-sighted.

The aim of this section is to set out advanced mathematical systems to enable investors to create their own
filter systems for deciding what share to buy. There are many systems outlined in hundreds of books
worldwide, but the following four systems are enough to provide investors with a sound basis to make
financial decisions.

The growth return matrix to assess labour intensive businesses

BUSINESS GROWTH RATE

High

HOLD

MANAGE

MILK

SELL

10%

Low
High

20
%

Low

RETURN ON ASSETS (ROA)

Definitions:
Return on Assets: This is the amount of profits a company has made relative to the total
amount of assets its has, i.e. Fixed assets, current assets, Investments and share
incentive schemes. The ROA criterion should be pre-tax return on productive assets.
This is done to measure the return capabilities of the business itself, instead of the
leveraging ability or tax shield associated with the business. However, depending on the
investor, the ROA criterion could be attributable profits or headline earnings. Formula:
(Profit Assets) x 100

Business growth rate: This is the rate of growth in turnover relative to the growth of the
sector. Simply stated, when a companies turnover growths at a higher rate than the
industry it operates in, it can be assumed that it has gained market share. Similarly, if
Company Xs share price rose by 12% in the past 12 months, while its sector index
(comprising of all the companies in the same/similar business arena) achieved a growth
of 7%, it can be assumed that Company X has outperformed the Index. . Formula:
{Turnover (Year 2) Turnover (Year 1) - 1} x 100

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Aim of matrix: Used to assess real rate of growth of a company or of a share, in low capital
intensity industries or in service related businesses. These businesses are often
characterised by low value added. As a result, costs and, by implication returns, are not
strongly affected. Therefore, market share is difficult to define.

Assumptions undertaken in setting this matrix filter: Business growth of 10% per annum
in real terms is an acceptable cut-off point and a 10% return on assets has been chosen.
This is the average long-run inflation rate in South African of 10%, which is acceptable as a
cut-off point between high and low returns on assets.

There are four strategic categories to consider: Hold, Milk, Manage or quit and Sell.

HOLD: Businesses with high market growth rates and good returns are in a strong position
to make a useful contribution to the portfolio of companies or shares. This is the quadrant
to aim for and to defend, i.e. High returns on assets and growing market share. Investors
should be wary of companies that succumb to the temptation to maintain a price umbrella
and thus inviting competitors into the arena. A moderate growth strategy is advocated.

MILK: If the business growth rate is close to the industry growth rate, the correct decision to
make is to hold market share, while milking the profits with the ultimate aim of moving the
assets into higher profit areas. If the industry is growing faster than the business unit (or
specific share), management or the investor should be selling the product. However, if the
investor believes that new technological innovation will provide the company with a long-term
advantage over competitors, then the investor should Hold the share. For the entrepreneur,
R&D could move the company from the milk quadrangle to the Hold sections of the diagram.

MANAGE: Where a business is growing well or a share price is increasing, but relative to the
sector is actually breaking even, the manager/investor has two options.

He can sell the business/share and place the cash in a bank and earn a higher return on
his assets than being in business.
He can manage the portfolio to improve the rate of return.

The entrepreneur must decide whether the low profit rate can actually be compensated by
some realistic promise of higher future returns. This can be achieved by appropriate
alteration to pricing policy, R&D and by better and more efficient cost controls. The investor
must decide whether it would be better to be in another stock (within the same sector) or to
move to another sector. Long-term strategic plans must always be kept in mind.

Sell: A company that offers neither growth nor returns should be sold. Often trying to
manage such a portfolio of businesses or shares is a loosing battle. In addition to loss of
capital growth, there is an opportunity cost of funds being in a loosing company.
Conclusions:

Capital growth from the high business growth-high asset returns businesses should be
used to strengthen the existing portfolio and, where possible, to fund the high business
growth companies, that have low asset returns but have high future potential.

A low growth rate business with a high return on assets is used to produce cash for
reinvestment in a high growth rate, high potential business with low returns.

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ASSET GROWTH RATE

The asset growth rate matrix

HIGH

INVEST

SELECTIVE
INVESTMENT

HOLD/
ACCUMULATE

SELL

LOW

HIGH

LOW

RETURN ON ASSETS (ROA)

Definitions:

ROA: As stated above.

Asset Growth Rate: Simply, it is the rate of growth in the value of all assets under
management. Formula: {Assets (Year 2) Assets (Year 1) - 1} x 100

Aim: This matrix utilises the return on assets and the growth rate of the assets in setting
strategy for financial instructions. It appears that the matrix has an as yet unpublished role in
the real estate industry, where the two key investment criteria are returns on the assets
employed and the asset growth rate.

This matrix is, in many respects, similar to the growth return matrix; except that it assesses
the grow of assets and not sales relative to profits made from the investment of these assets.
Once again guidelines as to the choice of cut-off rate is suggested to be 10% above inflation,
which is assumed to be the boundary between high and low asset growth rates. The same
applies to the return on assets dimension.

The strategic categories to consider are: Invest, Hold, Selective Investment and Sell.

INVEST: An accumulation of assets, but also a growing percentage return of these assets to
profits is the desired target for investors and businessmen. However, there is always the
chance of a foreign, more efficient competitor moving into the arena or the introduction of
technologically improved mechanisms that render the company obsolete. In addition, it is
important note that high returns and growth rates in assets does not mean a company
generating cash or paying dividends. The ability of a company to increase cash flow
depends on how much cash is used to generate a growing percentage return from the use of
assets. In general, capital intensive businesses do not generate much cash.

It is important to note that entrepreneurs use this method to increase their companys asset
base, while maintaining a check on the quality of that asset base. There is always a danger

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of a company moving from a value company to a growth company. A value company is

one that has high, quality earnings growth, while a growth company is one that see high
earnings growth through acquisition and the quality of the assets is often suspect.

HOLD/ACCUMULATE: A company that can achieve a high rate of ROA, without a

accompanying increase in also a desired target for entrepreneurs and portfolio managers.
The following strategic guidelines need to be adhered:
The company should be expanded or shares accumulated if the low asset growth does
not lead to loss of market share.
Investors must check out the accounting policies of the investment concerned. If a
company has a policy of continually writing down assets (excessively), it is obvious that
the ROA would grow, while the asset base fell.

SELECTIVE INVESTMENT: A low return on assets, without an increase in asset base

provides the astute investor with a strategic dilemma. In general, these businesses need to
be funded if they are to continue operating. It is the decision of the entrepreneur/investor
whether to continue funding the business or selling the company in whole or in part.

SELL: Businesses with both a low return on assets and a low rate of growth in assets should
be sold. If a business does not obtain a greater return on assets than its potential asset
growth rate, it becomes a candidate for liquidation.

If a companys ROA and asset growth rate do not exceed the rate of inflation, the company
becomes a bottomless pit of expenses, cash outflows, growing gearing and liquidity drain
on other assets.

It therefore important that investors and entrepreneurs become aware of a company

displaying these traits.

The only exception is when an entrepreneur buys a company displaying such signs, if the
intention is to sell the parts of the company to derive a quick profit.

Low

Priority

Medium

Attractive

High

Turnover growth rate

Financial ratio matrices

High

Attractive

Rectify or
Sell

Rectify or
Sell

Sell

Medium

Low

Return on Investment

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Matrices can be constructed using the key financial ratios chosen by management as
important indicators of a business' strategic success. This two-dimensional matrix uses
return on sales and return on investment as the two strategic measurement criteria.

Businesses that should receive priority tend to perform well on both dimensions.
High investment returns from low sales is absolute priority, i.e. for each additional unit of
sale there is a higher proportional return on investment.
High investment returns from medium sales is still an attractive investment.
Medium to low investment returns coupled with moderate to low sales returns are targets
for selling. In some instances, the situation can be rectified and the returns improved
through new technology or cost cutting exercises.
Businesses with both a low return on investment and a low return on sales become
candidates for disinvestment. The same can be said for high returns-sales and moderate
returns-sales. This is due to the actual growth in investment not improving and, over
time, market share could be lost. If inflation is taken into account, the shaded areas
represent a declining investment for the entrepreneur or portfolio manager.
Financial ratio matrices should find more favour and applications in industries that differ from
the average business due to asset structures and complex markets. The use of selected key
ratios helps to tailor the planning matrix to address the unique problems of the businesses
concerned.

The capital intensity matrix

In business, relative market share has been found to be strongly correlated with high profitability
and hence potentially high cash flows. Similarly, studies have shown that capital intensity is
negatively correlated with profitability and cash flows.
For instance, asset strippers usually have high relative market share, but are also highly
capital intensive. As a result, a balancing effect occurs and these businesses often have only a
moderate return on investment. Cash flow may not be especially high even in mature
businesses, due to the need to support the underlying capital intensity of the business. In high
growth markets these businesses are likely to have cash outflows. Asset stripping is not always
an attractive option and management should rather aim at improving value added divisions or
products of a firm, improve product quality, capacity utilisation and improve the management of
working capital.
Undertaking such improvements should reduce the relative capital intensity and move
the business towards improving cash inflows. However, when a manager has determined that a
specific company should be sold, the portfolio often improves substantially and the study of the
characteristics of the portfolio after such deletions is a very meaningful exercise.
Attempts should be made to gain market share by improving, among others, product
quality and service levels to improve cash inflows.

Summary

The growth return, asset growth rate, financial ratio and capital intensity matrix form
valuable strategic decisions tools in forming an opinion on market dominance, how
capital or labour intensive a company is and asserting control over failing companies.

The decision criteria tend to be based on profitability rather than on cash flow. Decision
making for a portfolio of businesses or shares is a creative exercise and there is no
doubt that a plethora of portfolio techniques will make their appearance in the future.

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CHAPTER 29 : LESS ANALYTICAL METHODS FOR SHARE

SELECTION
"Despite my appreciation of structural models in forecasting, I do not believe in mechanical
model-based forecasting, estimating the model and letting it make the forecast without
intervention of the forecaster. (Laurence Meyer, Member of the Board of the US Federal
Reserve, 1998)

Over time, if the investor is wise, he will gain experiences in understanding people. After all, it is
people who make decisions regarding the direction of their companies which, in turn, affects
company results and thus share prices. There no real path or logical format that can be applied
to understanding people, particularly if they have something to hide.
However, I have already stated that under global capitalism directors will have less
places to hide and the markets will wipe out inefficiencies and poor direction (or at least hammer
their share prices). The astute investor will not want to be near the crash when it happens. The
following text points out some factors (not mathematical) methods and issues to consider before
buying or selling shares.
Listen closely what is said is often not what is meant
In 1996, a colleague (a stockbroker) and I interviewed the directors of a Cape Town based Food
listed company. The directors said that everything is positive, and we can achieved 25%
growth this year. Despite their attempts at conveying a positive message, they seemed uneasy.
After the discussion, my colleague turned to me and said that he was going back to the
office to advice clients to continue to accumulate the share. He then asked me for my advice.
This is what I said: I believe that they (the company) is about to be de-listed, with head
office using this company to reverse list another operation, possibly the Johannesburg-based
holding company. He looked at me, slightly confused and, shaking his head, asked me how I
had concluded that scenario. The directors had avoided any question relating to head office.
Precisely! They had avoided any question relating to head office, which immediately
made me suspicious. In addition, having gathered the necessary information on the company
prior to the interview I knew:

Head office were planning to move other food operations into Africa. They would need a
listed vehicle to fund such a venture.

Head Office were not content with the bad publicity that the Cape Town listed company had
received in the recent past. They had negotiated in what unions considered bad faith and a
de-listing would remove the company from public scrutiny.

Part of the holding companys plans (announced in the press) was to take greater control
over our subsidiaries to unit us in a single, focused mission. Therefore, understand what the
companies Mission Statement means and ask the directors whether that mission has
changed and query what that new direction is.

Within three weeks of my statement to my colleague, the holding company announced a delisting of the Cape Town firm. I had proved myself to our institutional clients, yet all it took was
gut feel and listening closely. In other words, try to know that people often say more by not
speaking at all. If you are listening you can get an investment edge.

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The Mission Statement

A mission statement is necessary for a company to give focus to their strategy. Essentially, a
Statement enables business to bring people together with a focused, common ideology and
direction. In addition, the company can make sure that the whole strategic planning process is
integrated throughout the entire group.
The mission statement must be set in two ways:

Broadly enough to allow for corporate evolution. Investors must understand that a company
continually changes form, but that form should always comply with its missions statement. If
a company looses focus, it is often reflected in its share price.
Focused enough to provide individuals with clear understanding of what is required of them.
Often management omit the largest part of the workforce, which is the physical labour part of
the business. Have a mission that incorporates all staff and thus make the entire workforce
feel that they are a part of the organisation. A solid mission statement can keep workers and
employers united and avoid strike action, loss of productivity and avoid a falling share price.

If the mission statement is too macro, it results in blue sky type planning, which should be
restricted to Boardroom brainstorming sessions. A statement that is too narrow results in
channel vision and foregone opportunities. This implies that a statement should be created,
developed and coordinated by the strategic business unit of the company.
Market and industry characteristics
Another non-mathematical method of determining whether a company has a suitable strategy is
an investigation of the opportunities and threats that the company faces in the environmental
factors within which it operates; including, politics, economics, finance, global threats and
opportunities, technology, social change and labour issues.
The dilemma strategists face is what factors to include and exclude when setting up key
criterion for decision making. One approach is to create a filter system (explained in great detail
in The Business Plan: A Manual for South African Entrepreneurs, Struik 1996). Essentially,
investors and entrepreneurs through skills and experience are able to identify key
characteristics of the environment arising out of product life cycle and other major factors that
affect business. Some key filters include characteristics of the markets, competitors, market
fragmentation, entrepreneurial flare of management and possible synergies arising out of a
takeover, acquisition, merger etc.
Stated differently, a company, market or share is considered attractive if its potential for
providing a significant contribution to objectives (mission statement) can be met, i.e. earnings
growth, cash flow, return on investment or assets, dividend income or capital growth.
There are two aspects to the strategic evaluation of, among others, a company, share or market.
An evaluation of the future growth potential (through opportunities, synergies or new
contacts) of the company, the market a company operates in or its share price.
To derive at a few possible strategic methods and to determine which strategic system is
likely to be successful.

A. Long-term market potential

The following factors are some possible filters that an entrepreneur or investor can use to
determine the attractiveness of a market, company or share. In essence, the profitability of the
investment.

Market size:
Entrepreneurs large companies should only entertain target investments that are large
enough to represent a worthwhile fraction of the firm's turnover and profits. An

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investment that will add 1% to turnover is marginal, but if it brings significant synergies to
its other divisions, then it should be considered for acquisition. Small firms with limited
resources should avoid large markets unless there are indications that a defensible niche
can be found.
Investors buy shares in companies that are tradeable or about to become more
tradeable. If the company is profitable, but not tradeable, the investor could struggle to
sell his shares. The situation is even worse if the company is not making profits.

Historic market growth rate:

Entrepreneurs - This is an aid to assessing the historical dynamics of the market and its
strategic implications. However, it is only a market indication and change can take place,
depending on legislation, exchange controls, economic fundamentals, political
interference or privatisation.
Investors This rate is extremely useful when assess a company for potential
investment. For instance, if Company X has been underperforming the market by 10
percentage points over the last five years, it is reasonable to assume that in the next
financial year it will most probably achieve the same results. This is most realistic if
Company X has not undertaken significant rationalisation, or acquired major assets or
changed its pricing structures. Remember, this chapter looks at non-formula ways of
assess a company. So, if the market is forecast by market experts to achieve a 25%
growth in 1999, it can be assumed that Company X will achieve a 15% growth rate. The
next step is to increase their pricing structure by the previous years inflation rate and to
multiply this figure by the 15% growth in volumes. The answer is a forecast 1999
turnover for Company X.

Industry price structure:

Entrepreneurs The price dynamics of an industry, whether it is price insensitive or
controlled, will have implications for the attractiveness of a potential corporate deal.
Investors in calculating turnover, the basic rule in forecasting is to multiply price and
volume to determine turnover. The same principle can be used as in the previous bullet
point. If the company has a price structure that is higher or lower than the industry
average, that difference can be used in the analysis of future turnover.

Forecast market growth rate:

Entrepreneurs The forecast future potential for the market may well be one of the
factors most important to the assessment of market attractiveness. There are numerous
mathematical methods of assessing future growth rates (discussed in other chapters of
this book), but a non-formula method is to take a five year and three year compound
growth rate and use this rate for the latest forecast period. If no major event took place in
the market to change the historic growth rate, it is very likely to remain within that range.
Investors A similar approach can be used by investors.

Current phase of life cycle:

Entrepreneurs The life cycle stage provides an insight into the potential dynamics of
growth, cash flow, funding, competition and a large number of strategic variables
identified by both product life cycle theory and the key findings of a strategic programme.
Investors identify the market and cycle phase of the company invested in (or to be
invested in) and determine whether the company is about to enter the recovery phase or
about to enter the recessionary phase of the business cycle. Astute short-term traders
should be able to sell at the top of the cycle and buy at the bottom. This is different to the
share price cycle, which is determined by profits, but also market sentiment.

Competitors:

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Entrepreneurs The nature and intensity of competition will be indicated by specifically

size and amount of competitors in any given market. Other filters include price sensitivity,
closed markets, aggressiveness and mobility of competitors and entrance of global
competitors. A competitor analysis is provided in later text.
Investors this is part of a risk-to-return profile that is used to determine whether the
market will re-rate or de-rate a company in the future.

Industry profitability:
Entrepreneurs This provides a measure for competitive pricing.
Investors To invest in a company that is in a profitable industry usually places a cap
on possible future losses. To identify a profitable future industry is not easy. To take an
historic view is dangerous and to assume that an industry will behave in a similar fashion
to the previous year is fatal. It is better to identify industries in the recovery phase of the
economic upswing and to further test their business cycle position within the economic
upswing. Once an investor has determined that a companys business cycle is in an
upswing, within the recovery phase of the economic cycle buy, buy and buy some
more.

Profitability trend:
Entrepreneurs This endorses the outcome of the above analysis. However, a loss
maker is always difficult to turnaround.
Investors - What makes you (the directors) think that you can do something better than
the previous directors (of the loss maker)? This is the question that the market will ask
and the answer will often be ignored. The market usually does not like companies to
move into the mold of taking over loss makers (even if perceived to be white knights). Of
course, there are many exceptions to the rule and the entrepreneurial capability of
management must be taken into account.

Industry capacity:
Entrepreneurs A measure of industry capacity highlights over and under-capacity and
benefits or threats accompanying a possible venture.
Investors Always identify whether a company has the capability to handle moving into
a new industry, whether the current industry capacity is over utilised this must affect
profits in the medium term and make investment decisions accordingly.

Fixed capital intensity:

Entrepreneurs A highly capital intensive industry has implications for overall
profitability and the potential to restrict competitors from moving in. The other side of the
coin is that it could prevent a company from moving in, and the costs of trying to
penetrate such a market could be extremely prohibitive.
Investors For investors, a highly capital intensive business, with sound order books
and new machinery removes the threat of strike action. However, it is important to ensure
that the necessary skills are available to the company to undertake maintenance and
repairs.

High working capital requirements:

Entrepreneurs High levels of working capital could be a drain on profits. It could also
provide a competitor to move into that industry and take control of the business. This is
possible where a business is able to manage its working capital by just in time deliveries
and quality control during production.
Investors High working capital requirements are a source of high gearing and thus the
leverage capability of the form is diminished. This often results in the share price
diminishing.

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Unions:
Entrepreneurs High levels of union activity or unfavourable labour practices (minimum
wages, short working weeks and restrictive business practices) modify industry
attractiveness.
Investors While labour strikes do affect profits and thus share performance, there is an
old Wall Street Axiom that states that investors should never sell their shares on the
basis of a strike action. Ultimately, the strike must be resolved and the share should
return to previous levels.

The above list is not detailed, but it should provide some pointers for evaluation. The
characteristics aid the assessment of the long-term growth opportunity or threat of an
investment.

B. Determining a strategic method

For almost two decades, managers have been learning to play by a new set of rules. Companies must be
flexible to respond rapidly to competitive and market changes from the local arena and now also from
global markets. It is important that companies set realistic benchmarks, but to continually review these to
achieve best possible performance out of employers and employees. In addition to outsourcing techniques
to gain efficiencies, companies must nurture and expand their core products.
There are many strategists that advocate Positioning of a companys products and business
focus in the market as the heart of sound strategy. Today, with global markets and technology closing in
on emerging nations, this strategy is too static and restrictive. It is true that many barriers to competition
are being removed as regulation ease and markets become global, making it possible for companies to
better position their products on the global stage. However, in many industries companies are far too
diversified and become targets of massive competition on many fronts. The directors often try to defend
all business divisions and end up loosing everything.
Therefore, the simplest method to use (in addition and not apart from mathematical formula) is the
SWOT analysis.

Using SWOT or trouble shooting methods in share selection

Trouble Shooting is the gathering of information to determine (through a systematic and logical thought
process) what is wrong with a company. In determining what is wrong improves the companys ability to
fixing the problem and, ultimately improves the share price. To determine whether a company acquisition,
joint venture or whether to buy a specific share, a SWOT analysis should be undertaken. The letters stand
for Strengths, Weaknesses, Opportunities & Threats and relates to an potential investment.
For instance, entrepreneur Jakes wants to buy a truck dealership to expand his existing operation.
Before he entertains the thought of a setting up a meeting with the directors of the sale company, he must
ask the questions: What are the Strengths, Weaknesses, Opportunities and Threats of undertaking such a
venture.
When all available facts have been assimilated, a solution can be determined, but must be tested
against a base. In other words, play devils advocate and look for every possible thing that can go wrong,
but also everything that can go right. This non-mathematical system should provide entrepreneurs and
investors with a method of using knowledge more effectively to solve a problem. Some analysts say that
Trouble Shooting or SWOT is just common sense; but, so what? If it solves a problem, such as whether to
sell or buy a share, then it has been useful and profitable.
Trouble shooters and SWOT - A logical thought process
A trouble shooter does the following:

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Finds the cause of the trouble. He does this quickly, efficiently and economically through a clear cut
strategic plan. An investor who has a well developed filter system in place can identify anomalies in
the market and take advantage of them. He can also assess proposed changes made by management to
turn a company around.
Once a problem and the cause of that problem has been identified, the trouble shooter is able to
provide a set of guidelines to corrects the problem. It is important that the cause and not just the
problem is ironed out.
In setting a strategic road to correct the anomaly, the trouble shooter must make sure that new
problems are not created. For instance, if a company is loosing market share and the problem has been
identified as poor management of certain divisions, it is pointless to simply hire new management.
The new directors must be able to fix the problem and not just manage.
Every time a change is made to a portfolio of companies or shares, there is a risk of creating new
problems. In other words, a successful trouble shooter exercise must be carried out properly and correct
the first time round. Doing it right means creating and implementing a strategic method that covers
identification and solving the cause of a problem and curing that cause.

Find the source of problem, not just the problem

Definition: a problem can be described as a deviation from a norm.
Therefore, investors and entrepreneurs must know what the norm is, before they can identify what
the source of the problem. For instance, in 1990 a South African furniture company called Rusfurn
declared an earnings per share growth that was phenomenal. Yet, the market had not reacted to the high
earnings growth and, therefore, a possible problem was identified. The norm should have been a positive
market reaction, and the lack of market interest pointed to a possible problem. The next step was to
identify the source of the problem to determine whether management could (or would) fix the problem,
which would see the full benefits filter through to share price. In other words, what was the source of the
problem, could it be fixed and would that change market sentiment?
After a systematic assessment of the company including liquidity check, efficiency assessment
and leverage investigation, the source was discovered. The company had a debt-to-equity ratio of 150%
and several million convertible debentures (into debt) near to conversion date. The companys gearing
would rise to over 300% within a six month period. The market was rightly sceptical.
Less than a year later the company had been broken up and sold to various parties.
Identify the source of the problem = What should be happening vs. What is happening

Logical trouble shooters assessment process

Specify the problem: have a precise, clear picture of the trouble. In describing what the problem is,
identity, location, time and size has to be set out.

Identify the problem: ask what is causing the problem and what is wrong with it?

Locate the problem: ask where is the thing when the trouble is noticed?

Time the problem: ask when was the trouble first noticed?

Measure the problem - ask how many units of the thing have the trouble? this question
obviously applies only if you are dealing with a group of related things.

The same rules apply when drawing up a SWOT analysis See The Business Plan: A Manual For South
African Entrepreneurs (Struik, 1996).

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Assessing competitors
Strategy cannot, and must never, be set in a vacuum. Strategic action always evokes
competitive response and, therefore, to keep a competitive edge, it is important to understand
who these competitors are; draw up a profile to include resource bases, constraints and
strengths and weakness. A SWOT analysis of competitors should improve the efficiency of
strategic choice.
In complex situations it may not be so easy, for example market boundaries become
blurred across global market boundaries. However, potential entrants must also always be
identified. These could be subsidiaries of diversified companies in related markets or with related
markets or with related products.
There are seven areas that must be assessed in a competitor analysis:
Structures
Strategic
perspectives

Financial resources
Potential strategies

Strengths
Strategic responses

Weaknesses

Structures: An analysis of a competitor's organisation structure provides valuable

information. The subsidiary of a centralised holding group usually has less strategic leeway
than a single company. The management style, size and freedom of movement of the
holding company over the subsidiary is thus important. If the company concerned is a
division of a large, concentrically based and centrally planned parent, opportunities may exist
for targeting these competitors. In other words, find the weakness and use the information
constructively.

Financial resources: Assess the competitors income statement, balance sheet loss, cash
flow, ratios (leverage, profitability, liquidity, efficiency) and capital structure. In addition, look
at whether the competitor is a broad-based company or a single product line company. What
does the competitive portfolio look like?

Strengths: An analysis of the competitor's key strengths is vital if the competitor is

competent he should lead from strengths, thus allowing his strategic moves to be forecast
and pre-empted.

Weaknesses: These constitute the competitor's soft underbelly. The analysis should
pinpoint where the competitor is vulnerable or potentially vulnerable to attack. Weaknesses
must be identified so that they may be exploited creatively in the market place.

Strategic perspectives: The competitor's perceptions of his strengths, weaknesses,

opportunities and threats are needed, as they help to highlight potential competitive action
that the competitor may take to exploit perceived strengths or shore up weaknesses.

Potential strategies: As unbelievable as may be, competitors often repeat previous

strategies. Signals of strategic intent can be gleaned from the media or even the competitors'
own annual reports. The analysis of a competitor's existing generic strategies provides
insight into his likely future moves.

Strategic responses: Given competitors' potential strategic moves, what are the potential
strategic responses to parry any given move?

Competent competitor analysis: This provides a basis for setting strategy dependent on
not only an introspective analysis of strengths and weaknesses, but also on an evaluation of

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the competition. Pre-emptive assumptions regarding competitors' structures, resources,

strengths and weaknesses, as well as strategic perspectives and potential strategies, render
strategic responses more likely to succeed in the face of competitive actions.

PART THREE ENCAPSULATED AND EXPANDED

Companies, strategy and operational effectiveness

Operational effectiveness and strategy are both essential to superior performance, which, after all, is
the primary goal of any enterprise. However, these work in very different ways.

A company can outperform rivals only if it can establish and maintain something that is different to its
competitors. To be effective, the company must deliver greater value to customers or create
comparable value at a lower cost or do both. If successful, the company will deliver greater value,
which allows it to charge higher average unit prices. Or, greater efficiency can result in lower average
unit costs.

Ultimately all differences between companies in cost or price derive from the hundreds of activities
required to create, produce, sell and deliver their products or services, such as calling on customers,
assembling final products and training employees. Cost is generated by performing activities, and cost
advantage arises from performing particular activities more efficiently than competitors. Similarly,
differentiation arises from the choice of activities and how they are performed. Activities, then, are the
basic units of competitive advantage.

Operational effectiveness means performing similar activities better than rivals perform them. It
includes practices that allow a company to better use its inputs by reducing defects in products. In
contract, strategic positioning means performing different activities from rivals' or performing similar
activities in different ways.

Some companies have a competitive edge as they eliminate wasted effort, employ more advanced
technology, motivate employees better, or have greater insight into managing particular activities.

The productivity frontier is constantly shifting outward as new technologies and management
approaches are developed and as new inputs become available. Notebook computers, cellular
telephones, the Internet and new software have redefined the productivity frontier for sales-force
operations and created rich possibilities for linking sales with such activities as order processing and
after-sales support.

Hoping to keep up with shifts in the productivity frontier, managers have embraced continuous
improvement, empowerment and change management. In addition, outsourcing and the cyberspace
economy reflect the growing recognition that it is very difficult to perform all activities as
productively as specialists.

As companies move closer to the cyberspace economy, they can improve on multiple dimensions of
performance at the same time.

Constant improvement in operational effectiveness is necessary to achieve superior profitability. Few

companies have competed successfully on the basis of operational effectiveness in the long term.
Competitors can quickly imitate management techniques, new technologies and input improvements.

Another reason that improved operational effectiveness is insufficient is more subtle and less
analytical. Strangely, the more benchmarking companies do, the more they look alike. The more that
rivals outsource activities to efficient third parties, the more generic those activities become. As rivals

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imitate one another's improvements in quality, strategies converge and it becomes difficult to
compete.

An Optimal Stock Selection Strategy

On average, investment returns obtained by the average investor do not match even those of
the popular indexes and averages. Although the universal goal is to "buy low and sell high,"
more often than not many investors find themselves doing just the reverse.
The reason: extremes of fear and greed characterise investment failure. I have described
the basics of investing, in the local and global markets, looked at kinds of investments to avoid
and how to select a portfolio manager yet, despite the investor reading multitudes of financial
advice, panic and greed still rule decision making. So, forget the basics and, well, die a slow
investment death.
The following is the last advice for investors.

Portfolio tactics
Re-balancing the portfolio
Once an investor has developed a long-term investment strategy, it is crucial to conduct periodic
re-balancing, which means bringing the asset allocation back to its original target.
To bring your portfolio back to its original, pre-determined mix:

Sell the investment that exceeds its recommended percentage and invest the proceeds in
the other investments.
Add new money to the investments that are below their recommended percentage.
In a mutual fund setting, direct dividends from the investment that exceeds its recommended
percentage to the investments that are below its target allocation.

The reason that it is necessary to rebalance a portfolio is to maintain a steady allocation

between shares and gilts. Rebalancing should be undertaken at least once a year, although
some dedicated investors adjust their portfolios monthly or quarterly.
Adjusting Financial Plans in Times of Change: A long-term strategy does not imply a passive
approach. Changes in life do occur and a plan to fine tune the portfolio is thus necessary. The
following are examples of instances when an investor may consider changing his investment
portfolio.
Changing careers: Changing jobs, incomes, retirement or an inheritance may change the focus
of a long term portfolio. The investor may want to be less conservative and more moderate or
aggressive. The different portfolios are set out in previous chapters.
An income change: A change in household income may lead to an adjustment in the amount
earmarked for investment.
A family change: A marriage, divorce, birth or death could also have profound, yet quite
different, effects on your investment planning, and may necessitate a review of your investment
strategy.
A change in monthly expenditure: Paying off a major expense may enable an investor to reexamine his financial status. The higher disposable income may permit the investor to start (or
increase) a rand-cost averaging programme.

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A change in age: The closer to retirement an investor gets, the more important it is to re-assess
the portfolio on a regular basis.

A Final Consideration

Regardless of the re-balancing method selected, remember that a sale of shares,

or the shifting (between securities) in the asset allocation fund, could result in
capital gains or losses.

These gains or losses can occur in both the local and the global markets.

So, for the global fund manager, the expected benefits of any planned rebalancing activities should be considered along with their resulting tax
consequences.

It is usually to the investors advantage to forestall the payment of taxes for as

long as possible.

This enables him to benefit from compounding of returns on sums that otherwise
would have been paid to the tax collector.

Taxes are, therefore, another reason why so many investors will find a fixed-mix
approach the preferable, and simplest, solution to asset allocation.

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Part 4
Capitalists
to the
year 2020

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CHAPTER 30: SURVIVAL AND PROSPERITY OF GLOBAL

CAPITALISM IN THE 21ST CENTURY
To abandon the fabulously successful capitalistic system that promotes co-operation in the
pursuit of individual self-interest and replace it with one whose essential characteristic is the
government's pointing a gun at people's heads precisely in order to prohibit them from
pursuing their self-interests and to compel them to act against their self-interests is an act of
colossal self-destruction. The global capitalist jungle is unlikely to permit socialism to spread.
Instead, it will grow and multiply there is no way back! In fact, the existence of the evils of
economic crises and mass unemployment are a major violation of capitalism.

The closing of the century does not look so good

Emerging markets around the world saw growth rates slashed and financial turmoil become the
norm in 1997 and 1998. Countries like Thailand, Indonesia, Malaysia, South Korea and Russia
are all suffering from the effects of currency devaluation, widespread bankruptcies and
insolvencies, actual or impending bank failures, collapsing stock markets and mounting hunger
and unemployment.
Despite high growth rates in recent years, even Venezuela, Mexico, China, Brazil and
Argentina may find markets harsh and uncompromising in the years to come. Let us not forget
that the worlds second largest economy, Japan, may also be heading for the worst recession
since the Second World War. To make matters worse, former eastern bloc countries have for
some years suffered from extremely high levels of unemployment.
In a word, the world appears to be heading straight for the closest thing to the conditions
of a global depression, last seen in the 1930s.
So, where does capitalism fit into this scenario?
Many economists, analysts and traders around the globe assume that the current financial
disarray is the result of capitalism and, on that assumption, ask if capitalism can survive in the
face of them, especially in countries that until recently were socialistic or belong to the
Communist bloc.
True capitalists will split the issue into two:
Capitalism is affected: Yes, suffering is taking place in these countries. These economies
are (in some instances) in deep depression, with mass unemployment, large scale and
protracted human suffering taking place. If the citizens of these countries believe that their
fate would be materially better if they were to establish or re-establish some form of
dictatorship over the economic system, then capitalism will suffer as a movement towards
dictatorship takes place.
Capitalism is not to blame. The fundamental question, however, is not what people will do
on the basis of the ideas they hold, but whether or not those ideas are true. Is capitalism
responsible for depressions and mass unemployment? Is it responsible for today's crises
and mass unemployment?
If one understands the nature of capitalism as outlined in Part One of this book, it becomes clear
that capitalism is not the source of the financial problems of the former communist countries.
Capitalism is a politico-economic system based on private ownership of the means of production
and characterised by the pursuit of material self-interest under freedom.
The freedom that characterises capitalism is freedom from (above all) the initiation of
physical force by government. Under capitalism, government exists to protect the individual
citizen from the initiation of physical force. Under such freedom, individuals are able to use their
minds to improve the world and take advantage of opportunities to make a living for themselves.
His efforts are almost always enormously aided by the co-operation of other people, who are the

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suppliers of everything he buys and the customers or employers for the goods or labour that he
sells. Under capitalism, each individual obtains the co-operation of others by means of a process
of voluntary exchange, in which both parties gain.
To blame capitalism for the tragic circumstances of countries in depression, mass hunger
and unemployment is to assume that individuals cannot think for themselves and to conclude
that mankind has no initiative or desire to better himself. In addition, the desire to increase
wealth is not, in itself, the important final process of capitalism, but the start of a process that
creates wealth for others that is crucial in promoting and hailing the capitalistic system as the
only way to move into the 21st Century.
The greatest, most extensive manner for all people to benefit from an economic system is
through the efforts of entrepreneurial efforts of man to improve his own standards of living.
These fortune builders introduce new and improved products and methods of production,
which is the source of earning a high rate of profit. The fortune builder saves and reinvests
the far greater part of his high profit and thus employs more people, pays for their labour and,
thus, enrich their standards of living.

Governments worsen the problem by trying to help

In trying to alleviate the problem of mass unemployment by allowing free market policies to take
place (reducing wages, making companies more competitive, attracting foreign investment) and
undertaking additional capitalist policies, governments waste precious time in blaming
capitalism for their economic woes. In looking for a scapegoat, governments compound their
economic problems. They find no practical solutions, while hampering the free market to
undertake efficient use of resources to solve supply-demand imbalances and thus resolve
overall poverty.
However, it is easier to panic and undertake radical economic change than to let go of
despotic political power. Foolishly, the government of Malaysia in 1998 imposed a series of
restrictions totally abrogating the right of foreigners to transfer dividend income to another
country. Whose money is it anyway?
Following a pro-capitalistic policy will enable these countries to recover and to return to
the path of rapid economic progress that within a single generation can lift their populations from
poverty to the prosperity of a modern country. That, obviously, is a radical, but also a rational
choice. What they will actually do is another matter.

The long Boom

Strange how investors change their minds so quickly. In the early 1980s investors around the
world began to believe that the first world is in economic decline, with good jobs disappearing,
poverty swelling and crime out of control. In addition, that period was characterised by conflicts
erupting all over the planet and major environmental warnings of global warming and ozone
depletion.
By the late 1980s, however, the Berlin Wall had fallen, the Soviets communist world
domination plans lay in tatters and the Apartheid region in South Africa was finally running out of
steam. The new decade was heralded by surging stock markets and a US economy that
boomed. Investors around the world were adopting a new philosophy, that America was finally
getting its economic act together and the global economy was not such a dangerous place to
invest in after all.
By the mid-1990s investors began to believe that they were witnessing the beginnings of
a global economic boom on a scale never experienced before. European and US economists, in
particular, began to say that the world had entered a period of sustained growth that could
eventually double the world's economy every decade and bring increasing prosperity for billions
of people on the planet.

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Then the bubble seemed to burst. The Far East crashed and investors withdrew, panicked, from
other emerging markets. The US, UK and other first world countries stock markets suffered as
well. Economists began to doubt themselves, with some economists even calling for action to
avoid global recession. Did the bubble actually burst? Many economists believe that radical
economic change creates chaos in the world markets, but this chaos is resolved through better
and more efficient systems of trade and, therefore a better world-wide correlation between
supply and demand factors. In essence, conglomerates will eventually no longer controls
markets, but rather the markets will find better sources of raw materials from around the world.
There is, in fact, no reason why investors cannot believe that the economic thrust into the
new century will not last well into the 21st Century. Many pundits believe that investors are now
riding the early stages of a 25 year wave of year run of a greatly expanding economy that will do
much to solve seemingly intractable problems like poverty and to ease tensions throughout the
world.
In the developed countries of the West, new technology will lead to big productivity increases
that will cause high economic growth - actually, waves of technology will continue to roll out
through the early part of the 21st century. This is already taking place, boosted by the relentless
process of globalisation. National economies and the integration of markets will drive the growth
through much of the rest of the world. An alignment of an ascendant Asia, a revitalised South
America and an integrated Europe (Russia included) will together create an economic
juggernaut that pulls along most other regions of the planet.
In other words, new technology will transform the world into the beginnings of a global
civilisation that will blossom through the coming century.
A plausible forecast to the year 2020
Mankind is ready to expand on the five great waves of technology:
The personal computer boom of the 1980s.
Growth in telecommunication technology, from fax machines to cellular phones to future
satellite telephones.
Bio-technology.
Nano-technology a longer term vision.
Alternative energy: development of cheap fuel sources that will help industry improve profit
margins, while assisting the environment.
The scenario is not based on wishful thinking. After reading literally hundreds of pages and also
many interviews with World Bank and IMF delegates via the Internet of course - a number of
unassailable trends were determined. IN fact, enough time had elapsed to enable a plausible
prediction of their ultimate outcome. For instance, the rise of Communist China as a world
economic force simply cannot be stopped. This is not to say that there are not huge unknowns
and also critical uncertainties, but the trend has been set and there is no going back.
Many colleagues have called me a pessimist in the past, and therefore, developing a positive
scenario was not the intention. The aim is to outline a long term scenario for investors. It is
simply unfair to advise investors to have a long term strategy, without first developing a
scenario of the future.

So, I suspended my disbelief and placed strength in the philosophy of global capitalism.
Investors who suspend their disbelief open up to possibilities and future profits. Take, for
instance, how people must have felt during the onset of the Second World War. What future was
there for people living in that era? From a political to social to economic and to plain survival,
people came through to see the world evolve. Man stood on the moon, technology has speeded
up transport, changes the workplace and even sport. A vision of the future must take into

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account the positives and the negatives. However, to identify trends and to take these through to
conclusions is not easy and does involve discussion with many experts.
The ultimate scenario, however, is your own.

An economic Big Bang

Two specific developments in 1980 started a process that is expected to have profound
consequences for the global economy:

The introduction of personal computers.

The break-up of the telecommunication system called Bell (discussed below).

These events started the technological wave that will eventually fuel the long boom to 2020.
Between 1980 and 1990, the use of personal computers moved from the arcade game
to a tool that can be used equally at home or at the office. Now, the micro-processor chips used
in computers is being embedded in many other tools and products, such as cars. Within a
decade, the computer chip has progressed to the point where its power is doubled every 18
months. By 2010, experts believe that Intel will be able to build a chip that holds a billion
transistors, which is about 100 times the complexity of the most advanced integrated circuits
being designed today. By 2015, reliable simultaneous language translation will be in place; with
immediate consequences for the multilingual world.
In 1982, the break-up of Bell triggered a frenzy of entrepreneurial activity. Companies like MCI
and Sprint raced to build fibre-optic networks across the country. By the early 1990s, the trend of
voice communication moves to data transfers (The internet) and these companies shift
emphasis.
Computers and communications become inextricably linked, feeding off each others growth.

By the late 1990s cellular phone systems and all-purpose personal communications services
arrive first with vast antennae networks on the ground. Soon after, the big satellite projects come
online.
The relationship between these technologies leads to a major economic explosive. This
takes place in a direct and indirect manner.

Direct: jobs are created by the vast growth in the Internet commerce, already being called ecommerce.
Indirect: On the most obvious level, hardware and infrastructure companies experience
exponential growth, as building the new information network becomes one of the great global
business opportunities around the turn of the century.

Media, Internet, telecommunications and television networks combine skills

The process that follows is simply extraordinary: The media industry, together with Internet
companies and television networks come together to launch an unbelievable move to turn your
television set into a semi-computer. In essence, a viewer will be able to use a television to obtain
information on the programme they are watching, i.e. sports, economic, finance, politics etc.
Press a button and up pops a menu do you want information on the sport teams currently
playing, do you want to send a message, do you want to see replays etc.
This is called Interactive Television and it is the future of technology. The Internet
companies enable the transfer of information to the television, while the media companies store
archives to enable viewers to gain access to information etc.
E-commerce

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The safe encryption of messages on the Internet has already been successfully implemented,
enabling safe financial transactions in cyberspace. Electronic cash and commerce are safe and
gaining ground daily. By 2000, online sales are forecast to reach US$10 billion and, five years
later, 20% of Americans shop for groceries via the Internet.
A typical capitalist trait is the creation of new businesses alongside the introduction of
new technological sources. For instance, the cellular telephone system introduced the need for
repair experts, related product retailers, salesmen, technicians to service and maintain the
infrastructure and so on.

The cyberspace economy

Businesses and organisations around the world have increasingly started to move information
via the Internet. Organisations around the world include The US Federal Reserve, The IMF,
World Bank, The OAU, OECD and many others. Listed and private companies place information
on the Internet; some place secret access codes for clients, while others supply details about
their products.
People working in all kinds of fields, including education, government, estate agents,
doctors, stockbrokers and non-profit organisations have gone into cyberspace. With every
facet of human activity being transformed by the use of the Internet to communicate, search for
information and make new friends or clients easily, efficiently, inexpensively and globally improvements in efficiency and productivity improve.
History has proved that fundamentally new technologies generally do not become
productive until a generation after they are introduced. This was highlighted by the introduction
of personal computers in the workplace. Yet, cyberspace is proving to be he exception. The
phenomenal speed at which businesses and organisations have begun to use the Internet is
indicative to the need for a global network that works off a local phone call. The ability to search
for information world-wide is without doubt an unbelievable discovery and innovation. In
stockbroking, for instance, a portfolio can be place on the Internet with private access codes,
enabling a client to enter the site and see how his portfolio is performing; and he can do this
from anywhere I the world, providing- of course that he has a computer with Internet access
and a telephone to plug into.
US economists have even suggested that, by 2000, government will adopt a new
information-age standard of measuring economic growth. Not surprisingly, actual growth rates
are higher than what had registered on the industrial-age meter. The US economy is growing at
sustainable rate of 4%, which has not been seen since the 1960s.
Inflation is dead
Wars across the world, oil price surging to nearly US$70 a barrel and militant labour unions
caused major inflationary pressures in the 1970s. The following decade saw governments
internationally introduce tighter monetary policies that quickly harnessed inflation and, within a
decade, lead to a negligible inflation rates.
Strangely, globalisation and international competition added to the downward pressure of
inflation. A journalist once asked me: If US companies are successfully going global, and their
turnovers are increasing, does that not mean greater demand on resources and, therefore,
greater inflationary pressures? In fact, there are two reasons why the opposite happens:

To be called a globalised company, the company must derive at least 50% of attributable
earnings from foreign sales and the company must have an overseas manufacturing unit.
However, this does not mean that the company has to derive the higher sales from the local
market. In fact, most of the foreign sales are derived from the overseas operation, thus
reducing demand from the local market the shift in focus from the local to the foreign
market reduces demand for raw materials in the domestic country.
Therefore, by 2000, policymakers finally understand that an economy can grow at much
higher rates and still avoid the spiral of inflation.

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Biotechnology takes off

Many economists believe that biotechnology (the third wave of technology) will occur in the year
2001. Medical experts say that mans efforts to map out human genes will trigger a series of
breakthroughs in stopping genetic disease and this should lead to a booming industry. Demand
for such medical aid increases when the baby boomers begin retiring en masse in 2011.
The industry becomes a significant job provider for years to come, adding to the
standards of living of many millions more across the world. To add to the economic boom, the
biotech revolution also affects the agricultural sector. Essentially, genetics leads to more precise
breeding of plants and breeding livestock. The process started in 1997, when Dolly (the cloned
sheep) in the UK startled the world and kicked off the reality of biotechnology.
The fourth wave a long term view
The fourth technological wave, nano-technology, enables scientists and engineers to figure out
reliable methods to construct objects one atom at a time. This means that the field of microsurgery takes off, enabling basic human cell repair to take place. However, nano-technology is a
long term venture, with most products being produced much more efficiently in future.
The environmental issue
All four waves of technology will cause a surge of economic activity. In the industrial era, a
booming economy would have a severe strain on the environment, but biotechnology creates
much less pollution. After all, moving information through cyberspace (rather than physically),
has a much less impact on resources. However, these increasing efficiencies do not offset the
demand on raw materials (and energy) derived from the booming global economy.
It is growing demand that heralds the growing need for alternative energy sources. At
least, on the petroleum side, better systems enable engineers to find new sources of oil (in
hostile conditions, like deserts) and also enable them to better exploit known reserves.
AN alternative scenario - in the longer term is the move away from fossil fuels to
hybrids powered by gas turbines. This means that cars use natural gas to power the onboard
generators, which then drive the electric motors at the wheels. This scenario is liked to hybrids
ultimately moving to using hydrogen fuel cells, i.e. simplest and most abundant atom in the
universe, hydrogen becomes the source of power for electric generators.
Just think - no exhaust fumes, no carbon monoxide. The theory is not science fiction. The
basic hydrogen-power technology was developed as far back as the Apollo space programme,
though then it was still extremely expensive.
These long-term scenarios see industrial markets throughout the global economy boom and
boom and boom some more.

Russia and China - fall from communist grace

There are two people that history will ultimately reflect as having a significant impact on
globalisation. Russias Mikhail Gorbachev in 1980 helped bring down the Russian Empire,and
with it, the end of the Cold War. In addition, he initiated political change that includes the
democratisation of eastern Europe and Russia itself. He did this through two concepts, namely
Glasnost and Perestroika. These mean Openness and Restructuring, which are both ingredients
for the long global economic boom.
The second is China's Deng Xiaoping. While his actions were not as radical as
Gorbachevs, he did initiate a concepts of openness and restructuring of the economy. This
process of opening up - creating free trade and free markets - ultimately makes just as large a
global impact.

Japan: This country boomed in the 1980s, as its use of meticulous, methodical economies of
scale made it a world power. However, as the decade came to an end, Japan failed to

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change as the rules of the global economy changed to favour more nimble, innovative
processes. Over the next 10 years, Japan watched the US move successfully to the
cyberspace economy and begin to adopt the model in earnest.

China: In 1978, Deng started to liberalise the communist economy and China started the
process of gathering economic force that will see it produce and consume at least 20% of
the worlds products by the year 2020. Its economy is growing at a torrid pace, with the entire
coast of China convulsed with business activity and boomtowns sprouting all over the place.
Capitalism has come to China, symbolising the end of its socialist ideologies and a
transformation to a real economic world power. However, China still a long way to go, still
using draconian measures to stem political uprising.

The European Union

After the Cold War, the dismantling of Eastern Europe and the reintegration of the two Germany
into one, Europe at large has to reintegrate itself, both economically and politically. First, focus
was on integration of West and East, followed by dismantling of war zones and the move from
communism to the free market enterprise system.
Now, the European Union is being formed and Europe moves toward the establishment
of one truly integrated entity, with among others - a single European currency, called the euro.
Europe has gone through much pain in the last two decades, but it is now on the edge of
becoming a true global power.
There are, however, still some problems. A large part of Europe has welfare states, and
the transition part of the requirement of the Union is an economic restructuring that is painful.
This restructuring, both of corporations and governments, has much the same effect it had on
the US economy. The European economy will surge and many new jobs are created.
For 15 years, Russia has been stumbling along in its transition to a capitalist economy,
periodically frightening the West with overtures that it might return to its old militaristic ways.
There are economists at the IMF that believe that Russia will emerge in about 2005 with the
basic underpinnings of a solid economy. Enough people are invested in the new system, and
enough of the population has absorbed the new work ethic, that the economy can function quite
well.
The global stampede
The future of first world, Western nations in developing market economies and free trade is
important. The path for the rest of the world seems clear - openness and restructuring. Russia
and China have undertaken such policies and there are many countries that look to these two
nations for guidance. It is thus only a matter of time before third world nations undertake
massive programmes of deregulating, privatisation, opening up to foreign investment and cutting
government deficits. Collectively, they sign onto international agreements that accelerate the
process of global integration and, therefore, fuel the long boom.
There are already two major agreements signed globally that points to the future of
globalisation:

The Information Technology Agreement, in which almost all countries trading in IT agree to
abolish tariffs by 2000.
The Global Telecommunications Accord, in which almost 70 leading nations agree to rapidly
deregulate their domestic telecom markets.

The consequence of these two developments is multi-fold. First, computers and

telecommunications starts to spread to developing countries, followed by improved productivity,
performance, and quality. Prices fall, purchasing power rockets, demand for goods rise,
companies expand and employment thus rises.

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The world economy sees GDP rise from the 1980s 3% a year and the early 1990s 4% to
between 6% and 10% a year over the next decade. Continued growth at this rate is forecast to
double the size of the world economy in under a decade.

The world economic engine changes gear

Fundamental shifts in technology and the means of production always changes the way the
economy operates. History is scattered with such examples. Perhaps, though, the most classic
one is the transformation of the agricultural society into an industrial society. The invention of the
motor, and the ensuing Industrial Revolution led to a new economic model, namely capitalism.
With it came social upheaval, urbanisation and profound political change. The same dynamic
holds true with the latest shift, to a cyberspace economy, based on digital technologies.
A more basic explanation rests with, non-other that evil called money. When markets
boom, more people get rich, even the poorest benefit from lower prices and almost everybody
sees their standards of living improve. In fact, anyone from business to churches to
government can directly benefits from a system in which you can pick up a phone and reach
across the world. By the end of this century, almost everyone will understand that the
fundamentals of the worlds economic engine has changed gear. The cyberspace economy is
one driven by global capitalists and those left behind will suffer. The global capitalist jungle is
there for everyone, but those who do not adapt, will get eaten by the capitalists savages.
They have arrived and there is no gong back.

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A NEW GLOBAL, CAPITALIST CIVILISATION

IS ABOUT TO BE BORN

The world is forming a new society - a global civilisation. One that

is different to those that arose on this planet before.

It is not just a Western imposed culture on others. Rather it will

be a strange blend of many cultures, yet not a destruction of
singular cultures.

I believe that the world will work together at least on n

economic front both either by mutual agreement of forced by
the global capitalist jungle.

Yes, it is something as yet undetermined, not yet born. In fact,

one that will benefit all mankind.

In 2020, information technologies will have spread to every

corner of the planet.

Real-time language translation will be reliable and cross

continent businesses will be done at a push of a button. The
great cross-fertilisation of ideas, the ongoing, never-ending
planetary conversation will have begun.

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PART FOUR ENCAPSULATED AND EXPANDED

The following 13 reasons are fundamental for a higher US (and thus world markets)
stock market for the short term, that will boost the forecast to 2020. After that? Well, who
knows?

Savings: The Baby Boomers are saving for their college education and their own retirement.
78 million people will turn 50 in the next 15 years. Comment: This will drive continued funds
into equities.

Corporate profits: Corporate earnings are good and will continue to improve as less
pressure is placed on supply/demand factors due to globalisation. Comment: The stock
market thrives on low inflation

PE ratios: PEs are slightly higher than normal from a historic standpoint and have room to
go higher. PEs for the S&P 500 have historically ranged from 17 to 23 times and are
currently at about the 20 times level. High PE's are being offset by quality earnings growth.
Comment: PEs have room to move upwards and are not out of line from a historical
standpoint.

Inflation: There is low inflation and it will continue to decline as conglomerates source
materials globally. Comment: The stock market thrives on low inflation.

Economy: The economy is strong and is expected to stay this way. Technological changes
(outlined in this book) over the next decade will dwarf what investors have seen in the last
ten years, creating many opportunities for growth. Comment: This lays the groundwork for a
healthy stock market.

The US Budget: The budget has been balanced and the political fallout will be very positive.
Comment: This legislation has passed Congress and the ramifications of this will be felt over
the next few years. At the current level of economic growth it appears that the budget deficit
will be brought to zero by early 1999, much faster than anticipated. Comment: Politically, this
is powerful news. Increased fiscal responsibility from the US Government is a good trend
and will be a further impetus for higher valuations for equities.

Interest rates: Interest rates are moving lower. By late 1998 or early 1999 US rates should
be in the fours. Historically, bonds trade about 300 basis points higher than the inflation rate,
currently running between 1.0% and 1.25% per year. Inflation may drop further. Comment:
Lower interest rates is a stock market stimulus.

Equity market: On average, US$18-20 billion per month has been moving into the market
for the last 34 months. This money must find a home. In addition, there are few alternatives
for the investment dollar - there are fewer real estate investment choices, few oil and gas
partnerships, virtually no tax shelters and no precious metals investments like there were in
the 1980s. Comment: This trend will continue and will be a driving force for a rise in equity
prices.

Social Security Funds: Social Security is in serious trouble and it has to be privatised within
the next 3-5 years. Part of that fix may be to invest some of those monies in equities.
Greenspan mentioned this before Congress and there is various debate now about allowing
2% of SS monies to be placed into equities Comment: Additional funds flowing into equities
should produce higher equity prices.

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Stock Supplies: Continued major corporate stock buyouts are reducing the supply of stock,
which increases the demand for the existing stock. Exxon, for example, has bought back
32% of its stock since 1983 and announced another buyback. Compaq announced a 100
million share buyback. Disney announced a 400 million share buyback. GM may buy up to
10% of its stock back each year for the next few years! Comment: Corporations are using
their free cash flow to invest in their own stock rather than paying dividends, which are
double taxed. These buyouts create strong pressure for upwards price moves. These are
massive buybacks.

IRA Investment Limits: Congress has passed the Roth IRA law that provides investors with
the ability to invest funds and allow them to grow tax-free. Comment:This will force more
money to be moved into equities over the next decade.

Capital Gains Taxes: Congress lowered capital gains taxes again in July, 1998. Comment:
Historically, lower taxes have been good for equities.

The Internet: The growth of the Internet is giving investors from around the world quick and
inexpensive access to markets and information. Trading activity and commerce are likely to
increase rapidly as the Internet further permeates our lives. Comment:The Internet will
continue to produce wealth for those individuals and corporations that are forward thinking.

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APPENDICES
PRO-CAPITALIST ECONOMISTS
Pro-capitalist economists can be found in the writings of the British and French classical
economists and the Austrian neo-classical economists. Most other schools of economic thought
are mostly misguided criticisms of the positive truths established by the classical and Austrian
schools. A list of classical economists is outlined below:

Franois Quesnay
Richard Cantillon

Adam Smith
Charles Holt Carroll
David Hume
David Ricardo
James Mill
Jean-Baptiste Say
John R. McCulloch
Lord Overstone
Mercier de la Rivire
Nassau W. Senior
Pierre Du Pont de Nemours
Robert Jacques Turgot
Robert Torrens
William Gouge

Carl Menger
Eugen von Bhm-Bawerk
FA Hayek
Frank Fetter
Frank Knight
Frederic Bastiat
Friedrich von Wieser
Henry Hazlitt
Hermann Heinrich Gossen
Irving Fisher
John Bates Clark
John Bright
John Cairnes
John Stuart Mill
Knut Wicksell
Ludwig Lachmann
Ludwig von Mises
Murray Rothbard
Philip Wicksteed
Richard Cobden
WH Hutt

17th to 18th century

1694-1774
1680-1734
18th to 19th century
1723-1790
1799-1890
1711-1776
1772-1823
1773-1836
1767-1832
1789-1864
1796-1883
1720-1793
1790-1864
1739-1817
1727-1781
1780-1864
1796-1863
19th to 20th century
1840-1921
1851-1914
1899-1992
1863-1949
1885-1972
1801-1850
1851-1926
1894-1993
1810-1858
1867-1947
1847-1938
1811-1889
1824-1875
1806-1873
1851-1926
1906-1990
1881-1973
1926-1995
1860-1927
1804-1865
1899-1988

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William Stanley Jevons

- 253 1835-1882

GLOSSARY

Acceptance Date: Time limit given to a prospective shareholder to accept an offer of shares
in a "rights" issue (discussed below).
Account: A trading period whose dates are fixed by the stock exchange authorities.
Accounts Payable: Bills which have to be paid as part of the normal course of business
Accounts Receivable: Debt owed to your company from credit sales
Accumulated Depreciation: Total accumulated depreciation reduces the book value (formal
accounting value) of assets. The value of an asset is reduced each month by a
predetermined amount and time frame. An asset worth R100, depreciated by R10 per
month, would be written off over 10 months.
Acid Test: A ratio used to determine how liquid a company is. It is determined by subtracting
short-term assets from accounts receivable and inventory, which is then divided by shortterm liabilities.
Agent: where a member acts on behalf of a client and has no personal interest in the order.
All Or Nothing: means the full order must be executed immediately or, if it is not possible to
do so, the order must be routed to the special terms order book.
Allotment Letter: Formal letter sent by a company to the investor to confirm that it will
allocate him shares in a new issue.
Arbitrage: a purchase or sale by a member on his/her own account of securities on one
stock exchange with the intent to sell or buy those securities on another stock exchange to
profit by the difference between the prices of those securities on such stock exchanges.
Asset Swap: a transaction which complies with all the requirements of the South African
Reserve Bank in respect of an asset swap.
Asset Turnover: Sales divided by total assets. Important for comparison over time and to
other companies of the same industry.
At Best: an order to be transacted in a manner that will, in the discretion of the member
executing the order, achieve the best price for the client.
At Market: an order to be transacted immediately against the best opposite order in the
order book at the time of making such entry.
Authorized/Issued Share Capital: While the authorized share capital is the maximum
number of shares a company is permitted to issue over time, the issued share capital is the
actual number of shares in issue. These figures are specified in pre-incorporation
agreements (memorandum and articles of association). Investors can find these figures in a
company's annual report.
Bad Debts: An amount payable by debtors, which the firm determines is irrecoverable.
Balance Sheet: A statement which shows a company's financial position on a particular
date.
Bear Sales: the sale of listed securities of which the seller is not the owner at the date of
sale.
Bear Trend: When supply of shares outstrips demand and prices start to fall. If this trend
continues for a number of weeks, the general sentiment becomes bearish and prices
continue to fall.
Bid (Buyer's Price): offer to buy a number of securities at a certain stated price.
Bid, Not Offered: When shares are sought, but none are available. The opposite would be
"offered, not bid."
Book Value: The net amount of an asset shown in the books of a company, i.e. the cost of
purchasing a fixed asset less the depreciation on that asset.
Break-Even Point: The unit sales volumes or actual sales amounts that a company needs
to equal its running expenses rate and not lose or make money in a given month. Break-

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even can either be based on regular running expenses, which is different from the standard
accounting formula based on technical fixed expenses.
Broker: The name given to a natural person recognised by the official stock exchange.
Institutions will, from 1995, be able to become corporate members.
Brokerage: commission charged by a member for the purchase or sale of securities.
Broker's Note: a note which a member is required to send to a client recording the details of
a purchase or sale of securities.
Bull Trend: When demand for shares outstrips supply and prices start to rise. If this trend
continues for a number of weeks, the general sentiment becomes bullish and prices continue
to rise.
Burden Rate: Refers to personnel burden, the sum of employer costs over and above
salaries, including employer taxes and benefits
Capital: This is also known as total shares in issue, owner's equity or shareholders' funds.
Capital Assets: Long-term assets, also known as Fixed Assets (plant and equipment).
Capital Expenditure: Spending on capital asset (also called plant and equipment, or fixed
asset).
Capital Input: New money being invested in the business. New capital will increase your
cash, and will also increase the total amount of paid-in capital.
Capital Structure: Usually refers to the structure of ordinary and preference shares and long
term liabilities.
Cash: The bank balance, or checking account balance, or real cash in bills and coins.
Cash Flow: A statement which shows the net difference between cash received and paid
during the company's operating cycle.
Closing Price: the last sale price or a higher bid or lower offer price for a particular security.
Collection Period (Days): The average number of days that pass between delivering an
invoice and receiving the money.
Collections Days: See Collection period
Commission: The brokers charge a fee for buying and selling shares, which is brokerage or
commission earned on a deal.
Commissions Percent: An assumed percentage used to calculate commissions expense
as the product of this percentage multiplied by gross margin.
Convertible & Redeemable: Preference Shares: An alternative mechanism to ordinary
shares. It enables companies to issue other shares, which can either be bought back from
investors or converted into ordinary shares at a latter date.
Corporate Finance Transaction: a transaction which is entered into in writing and requires
public notification in the press in terms of the listings requirements of the JSE.
Cost Of Sales: The costs associated with producing the sales. In a standard manufacturing
or distribution company, this is about the same as the costs for people delivering the service,
or subcontracting costs
Creditors: People or companies that you owe money to. This is the old name for accounts
payable.
Crossed Market: where a bid price is higher than the offer price for a security
Cum Or Ex-Dividend: After a company has declared a dividend, it would close its books to
start paying dividends. The share will be marked ex-div, which means that any new
shareholder will be omitted from the past year's dividend pay out. Before the company
declares a dividend payout, the share will be assumed to include possible dividends or to be
cum-div.
Current Assets: Those assets which can be quickly converted into cash and include
accounts receivable, stock and debtors book. These are often called liquid assets.
Current Debt: Short-term debt, short-term liabilities.
Current Liabilities: A company's short term debt, which must be paid within the firm's
operating cycle, i.e. less than one year.
Debentures: A bond which is not secured by fixed assets.

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Debt And Equity: The sum of liabilities and capital. This should always be equal to total
asset.
Debtors: People or companies that owe your company money. It is the old name for
accounts receivable.
Depreciation: An accounting and tax concept used to estimate the loss of value of assets
over time. For example, cars depreciate with use.
Dividend Yield: ratio of the latest dividend to the cost or market price of a security
expressed as a percentage.
Dividends: Money distributed to the owners of a business as profits.
Earnings: Also called income or profits, earnings are the famous bottom line: sales less
costs of sales and expenses.
Earnings Yield: ratio of net earnings per security to the market price expressed as a
percentage.
EBIT: Earnings before interest and taxes.
Equity: Business ownership; capital. Equity can be calculated as the difference between
assets and liabilities.
Fill Or Kill: the full order must be executed immediately or otherwise cancelled
Financial Notes: Information explaining financial figures (balance sheet, income statement
and cash flow).
Fiscal Costs: Running costs that take time to wind down: usually rent, overhead, some
salaries. Technically, fixed costs are those that the business would continue to pay even if it
went bankrupt. In practice, fixed costs are usually considered the running costs.
Fiscal Year: Standard accounting practice allows the accounting year to begin in any month.
Fiscal years are numbered according to the year in which they end. For example, a fiscal
year ending in February of 1992 is Fiscal year 1992., even though most of the year takes
place in 1991
Fixed Assets: Includes all fixed (immovable) assets, namely property, vehicles, machinery
and equipment. It cannot usually be converted into cash within the firm's operating cycle.
Going Concern: A company which is operating, i.e. has not stopped producing goods or
providing a service and one which has not been placed under liquidation or curatorship.
Goodwill: An intangible asset reflected in balance sheets, which indicate an excess over
market value for assets paid by the firm.
Gross Geographic Product: A statistic which shows the remuneration received by the
production factors (land, labour, capital and entrepreneurship) for their participation in
production of goods and services in a defined area.
Gross Margin: Sales less cost of sales.
Gross Margin Percent: Gross margin divided by sales, displayed as a percentage.
Acceptable levels depend on the nature of the business.
Immediate Deal: a transaction in a listed security where settlement is to take place the next
business day.
Income Statement: A statement showing net income or loss for a specified period.
Interest Expense: Interest is paid on debts, and interest expense is deducted from profit as
expenses
Inventory: This is another name for stock. Goods in stock, either finished goods or materials
to be used to manufacture goods.
Inventory Turnover: Sales divided by inventory. Usually calculated using the average
inventory over an accounting period, not an ending-inventory value.
Inventory Turns: Inventory turnover (above).
Jobbers: These are the market's share merchants. They deal only with brokers and other
jobbers (i.e. not with dealers) and their main function is to maintain a market by quoting a
price.
Labour: In Business Plans the word "labour" often refers to the labour costs associated with
making goods to be sold. This labour is part of the cost of sales, part of the manufacturing

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and assembly. In economic terms, labour often denotes the sale of a skill to produce a good
or service.
Letter Of Acceptance: The investor may receive such a letter if the company accepts his
application for shares.
Liabilities: Debts; money that must be paid. Usually debt on terms of less than five years is
called short-term liabilities, and debt for longer than five years in long-term liabilities.
Limit Order: an order which may only be effected at prices equal to or better than the price
on the order.
Liquidity: A companys ability to pay short-term debt with short-term assets
Listing: official granting of a listing of a company's shares on the JSE.
Local Counterparty Transaction: a transaction where a member trades as a principal with
a person in South Africa other than a member.
Location: In a Business Plan the term denotes a place of work
Long Term Assets: Assets like plant and equipment that are depreciated over terms of
more than five years, and are likely to last that long too.
Long Term Interest Rate: The interest rate charged on long-term debt. This is usually
higher than the rate on short-term debt.
Long Term Liabilities: This is the same as long-term loans. Most companies call a debt
long term when it is on terms of five years or more.
Management Of Investments: the management of investments on behalf of a client, by a
member or an approved person.
Market Capitalisation: Used to denote a company's size and is calculated by multiplying a
company's issued share capital by its current share price.
Market Indicators: statistics that give an overall picture of how the market is performing.
Market Maker: a member which negotiates dealings in blocks of securities
Marketable Securities: All instruments legally permitted to trade on the JSE. These include
shares (ordinary and preference), gilts, futures and options.
Marketable Securities Tax (MST): the tax imposed in terms of the Marketable Securities
Act of 1948 in respect of every purchase of marketable securities through the agency of or
from a member at the rate of 0.25% of the consideration for which the securities are
purchased.
Materials: Included in the cost of sales. These are not just any materials, but materials
involved in the assembly or manufactured of goods for sale.
Monopoly: When one company controls and dominates a particular company.
Net Cash Flow: This is the projected change in cash position, an increase or decrease in
cash balance.
Net Profit: The operating income less taxes and interest. The same as earnings, or net
income.
Net Worth: This is the same as assets minus liabilities, and the same as total equity.
Odd Lot: any quantity of securities which is less than a round lot (Krugerrands do not have
odd lots).
Offer (Seller's Price): price at which a dealer is prepared to sell securities on the market.
Oligopoly: When a few companies controls and dominates a particular market.
Order: an instruction to buy or sell a specified quantity of a security.
Ordinary Shares: Commercial paper issued to investors to raise capital. Investors hold
these shares as part owners in the firm.
Other Short-Term Assets: These are securities and business equipment .
Other ST Liabilities: These are short-term debts that dont cause interest expenses. For
example, they might be loans from founders or accrued taxes (taxes owed, already incurred,
but not yet paid)
Overheads: Running expenses not directly associated with specific goods or services sold,
but with the general running of the business

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Paid-In Capital: Real money paid into the company as investments. This is not to be
confused with par value of stock, or market value of stock. This is actual money paid into the
money as equity investments by owners.
Paper Profit: A surplus income over expense, which has not yet been released, i.e. share
prices which have increased above the price at which they were bought, but not yet sold.
Par Value: The nominal value of a share and is an arbitrary amount placed on the share by
the company.
Payment Days: The average number of days that pass between receiving an invoice and
paying it
Payroll Burden: Payroll burden includes payroll taxes and benefits. It is calculated using a
percentage assumption that is applied to payroll. For example, if payroll is R1,000 and the
burden rate 10 percent, then the burden is and extra R100. Acceptable payroll burden rates
vary by market, by industry and by company.
Plant And Equipment: This is the same as long-term assets, or fixed assets, or capital
assets.
Portfolio: a schedule, normally computer generated, listing the relevant details in respect of
the securities held by an investor.
Price Earnings (P/E) Ratio: the market price of securities divided by its earnings. It
expresses the number of years' earnings (at the current rate) which a buyer is prepared to
pay for a security
Principal Transaction: a member trades with a counterparty or another member.
Product Development: Expenses incurred in development of new products; salaries,
laboratory equipment, test equipment, prototypes, research and development, etc.
Profit Before Interest & Taxes: This is also be called EBIT, for Earnings Before Interest
and Taxes. It is gross margin minus operating expenses
Receivable Turnover: Sales on credit for an accounting period divided by the average
accounts receivable balance.
Registration: A new shareholder is registered when his name is placed on the role of
shareholders for that specific company.
Renunciation Date: The company sets a date by which the shareholder has to decide
whether he will take up the rights issue.
Retained Earnings: A figure which shows the sum of a company's net profit less dividends
paid to shareholders.
Return On Assets: Net profit dividend by total assets. A measure of profitability.
Return On Investment: Net profits dividend by net worth or total equity, yet another
measure of profitability. Also called ROI.
Return On Sales: Net profits dividend by sales, another measure of profitability.
Rights Issues: There are a number of methods which a company can use to increase the
size of it share capital. If it decides to offer its existing shareholders first option on the issue,
it is called a "rights" issue. The dealers would note that such an issue is in progress as it
would be quoted as cum-capitalisation and after completion of the issue it would be noted as
ex-capitalisation.
ROI: Return on investment; net profits dividend by net worth or total equity, yet another
measure of profitability.
Round Lot: the standard unit of trade - in all equities : one hundred shares
Sales Break-Even: This sales volume at which costs are exactly equal to sales
Sales On Credit: Sales on credit are sales made on account, shipments against invoices to
be paid later.
Scrape Value: An amount left after an asset has been fully depreciated, i.e. If an asset of
R115 is depreciated by R10 per month over 11 months, the scrape value would be R5
Securities: includes stocks, shares, debentures (issued by a company having a share
capital), notes, units of stock issued in place of shares, options on stocks or shares or on

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such debentures, notes or units, and rights thereto, and options on indices of information as
issued by a stock exchange on prices of any of the aforementioned instruments.
Settlement: Procedure for brokers to close off their books on a particular transaction. The
client is expected to pay for his new shares on or before the settlement date and he, in turn,
can expect to be paid (on selling shares) within the same period. (also called the Settlement
Period).
Short Term: Normally used to distinguish between short-term and long-term, when referring
to assets or liabilities. Definitions vary because different companies and accountants handle
this in different ways. Accounts payable is always short-term assets. Most companies call
any debt of less than five-year terms short-term debt. Assets that depreciate over more than
five years (e.g. plant and equipment) are usually long-term assets.
Short Term Assets: Cash, securities, bank accounts, accounts receivable, inventory,
business equipment, assets that last less than five years or are depreciated over terms of
less than five years.
Short Term Notes: This is the same as short-term loans. These are debts on terms of five
years or less.
Splitting Of Shares: At times a share could become too expensive for the private investor,
at which time the company may decide to split or sub-divide the shares into smaller denominations. The aim is often to make the shares more tradeable and, at times, this
increases the share price on positive sentiment.
Spread: the differential between a bid and an offer price.
Stag: An investor who buys shares in a pre-listing or rights offer with the intention of selling
those shares at a profit as soon as trading starts.
Starting Year: A term to denote the year that a company started operations
Stock Exchanges Control Act Of 1985 (As Amended): an Act of Parliament in terms of
which stock exchanges in South Africa are governed. The Act is administered by the
Financial Services Board.
Tax Rate Percent: As assumed percentage applied against pre-tax income to determine
taxes.
Taxes Incurred: Taxes owed but not yet paid.
Tick Size: the specified parameter or its multiple by which the price of a security may vary
when trading at a different price from the last price, whether the movement is up or down
from the last price.
Unit Variable Cost: The specific labour and materials associated with single unit of goods
sold. Does not include general overhead.
Units Break-Even: The unit sales volume at which the fixed and variable costs are exactly
equal to sales
Write-Off: Debt that cannot be collected and finally written-off as bad. The debt is a loss to
the company, and the greater the level of bad debts, the less likely an entrepreneur will be
able to obtain bank financing. Maintaining bad debts to a minimum is seen as the ability of a
company to run efficiently and to have efficient systems in place.

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