No accident that 30% of Chief Executives and 90% of Finance Directors on the JSE are Chartered Accountants

 

Chartered Accountants [CAs(SA)] continue to dominate the directorships of South Africa’s largest listed companies.

 

Independent research into the qualifications of board directors of the 200 largest companies listed on the JSE ltd reveals that 35% of the 2215 directorships are held by CAs(SA). This is a slight increase on the 2010 figure of 32.3%.

 

Unsurprisingly they also dominate the lead finance role in listed companies, with almost nine out of 10 (89.6%) finance directors or chief financial officers having qualified as chartered accountants. This represents a significant increase from the last survey in 2010 when 78% of finance directors had qualified as chartered accountants.  

The global search for yield will continue to see investors viewing Africa with interest this year, despite corporate governance and other concerns about the continent.  To the end of November last year, the FTSE/JSE All Africa (ex-South Africa) 30 index, which tracks the top 30 stocks on the continent, returned a remarkable 33.96% in US dollars which amounts to 41.45% in Rand terms.  Looking at individual bourses, Rwanda stands out with a return of 56.05%, followed by Uganda at 37.30% and Kenya, which rewarded investors with 33.78%.

 

These returns notwithstanding, investing in Africa should be approached as a long-term strategy, and this won’t change in 2013, says Fulu Makwetla, a consultant at RisCura, a global investment consultant and financial analytics provider.  “Together, the lack of liquidity and the volatility of African markets, many of which are classed as ‘frontier’, dictate an investment horizon of at least 5 years,” Makwetla says.

 

Their volatility is demonstrated by the fact that last year’s strong returns were preceded by a year of negative returns in 2011, when the index returned a dissatisfying -28.15% in US dollars. While this is disappointing, when converted into Rands this amounts to – 12.29%.

 

Makwetla says pension funds are viewing African investments as a diversification strategy, as Africa (ex –SA) returns show a low correlation to other markets, including South Africa.  “When it comes to a choice between African markets and emerging markets, we would choose Africa, as it is less correlated to South Africa, itself an emerging market.”

 

With Regulation 28 now giving pension funds leeway to invest up to 25% outside the Republic, and an additional 5% in Africa, Funds could essentially invest up to 30% in Africa. RisCura is advising its clients to at least consider an investment into Africa (if they haven’t already), to the tune of about 5% depending on the governing investment strategy of the Fund, even if they aren’t investing the remaining 25% in other markets.   

  

It’s no secret that Africa is where the growth will be for the foreseeable future.  GDP rates of anywhere between 7% and 10% depending on the country, compare extremely favourably to the 2% expected for the Eurozone and the USA, and around 3% for South Africa.  Further, African equities are a lot cheaper, with PEs averaging around 7.   

 

“Africa’s potential is enormous.  The continent is where China was 30 years ago, and India was 20 years ago, with a similar population to both those countries, but with vast amounts of undeveloped land, not to mention Africa’s rich resources.”

 

Beyond commodities and agriculture, Makwetla says a growing consumer theme has emerged on the continent.  As a result, sectors such as telecommunications, retail and, of course, banking, will all benefit. 

 

However, many investors wanting exposure to the continent will continue to seek it through the JSE, says Makwetla.  They know that companies such as Shoprite, MTN and Mr Price, to name only a few, have rapidly growing footprints outside of SA’s borders, and the Rand is more liquid than other African currencies.

 

“But when you compare the price of our market to the low PEs of most African markets, it’s definitely worth investing some percentage of your portfolio in Africa ex-SA, even though it comes with political and geographical risk, and potentially high levels of volatility.”

Companies listed on the JSE have faced significant changes in the way they report. The Companies Act has allowed for summarised financial statements to be sent to shareholders, and the listings requirement for integrated reporting (through King III) has resulted in the traditional lengthy annual report being reduced into a concise, understandable report on material connected issues.

 

And the good news for users of company reports – who have faced increasing volumes of financial and non-financial information over the years making it difficult to distil the key information – is that the integrated reports of companies are likely to slim down even further as companies place more of their detailed topic-specific information on their websites with links from their integrated reports.

 

The Integrated Reporting Committee (IRC) of South Africa commissioned a research survey of the 2011 integrated reports of the top 100 companies listed on the JSE. The objective was to examine the status of integrated reporting in South Africa given that most listed companies have produced at least one integrated report with many releasing their second. The research survey was undertaken by the College of Accounting at the University of Cape Town.

 

Professor Mervyn King, the chairman of the IRC, says that the uptake of integrated reporting in South Africa is very encouraging and that South Africa can be proud that it is leading the world in this area. “Integrated reporting is designed to give a better and more holistic view of a company than historical financial statements alone. An integrated report shows the connections and inter-relatedness between a company’s strategy, essential resources and stakeholder relationships, risks and opportunities, performance and its future outlook.”

 

The research found that 78% of the companies had changed the name of their annual report to ‘integrated report’. Dual listed companies, in general, did not call their reports ‘integrated’, but many included integrated information. Five local companies continued to call their report an annual report.

 

Of the companies that produced an integrated report, 60% included a statement that the report had been endorsed by the board, although in many cases this endorsement should have been given more prominence in the report given its importance.

 

The research found that most companies (82%) have not yet availed themselves of the Companies Act concession to publish summarised financial statements, opting to include the full annual financial statements in their reports. This is expected to change, though, as some companies have been held back by the necessity to change their founding documents to allow for summarised financial statements.

 

There is a wide range in the length of the reports. The longest was 456 pages and the shortest was just 46 pages, with the average being 179 pages. The average length of the reports of the 18 companies that included summarised financial information was much shorter at 124 pages. The length of the summarised financial statements ranged from one page (both Kumba Iron Ore and AngloGold Ashanti) to 34 pages (Imperial Holdings) with the average length being 11 pages. This should be compared to the average length of 70 pages for the full annual financial statements.

 

40% of companies make reference in their integrated reports to the availability of detailed sustainability information that can be found either in a separate publication or online. This approach goes some way to achieving the desired conciseness of an integrated report. An area that is crucial to achieving a concise report is the company’s determination of materiality. This aims to ensure that only information important to an assessment of how the company made its money and its ability to sustain value creation is included in the report. These are crucial factors in deciding what information should go into the integrated report or should rather be included in one of the more detailed topic-specific reports. Only eight companies explained their materiality process in their reports.

 

The research found that a wide diversity exists in the nature of the integrated reports. While guidance is available there appears to be some confusion on the shape and format of an integrated report. In January 2011, the IRC issued a discussion paper on a report framework. This paper fed into the discussion paper issued by the International Integrated Reporting Council (IIRC) in September 2011. A final framework is expected from the IIRC in late 2013, with a draft framework being issued early in 2013 which will be open for public comment. The IRC has said that its future local guidance will be in line with that of the IIRC.

The researchers found that while the vast majority of companies switched to calling their reports ‘integrated’, this did not necessarily mean that the report complies with the principles of integrated reporting or that the company practises integrated thinking (connecting financial performance to the key non-financial drivers, for instance natural resources and employee stakeholder relationships, on which the performance depends).

Some of the companies stated in their reports the benefits they had received from integrated reporting, including:

• Santam integrated report 2011

“Integrated reporting has improved our awareness of the opportunities for stakeholder engagement that could benefit the business and contribute to sustainability.” 

 

The research survey made no attempt to evaluate the quality of the 2011 integrated reports issued by the listed companies.

Investment managers define risk in different ways.  Some define it as volatility, while others define it as being different. According to Allan Gray, however, the most important risk in investing is the risk of permanently losing money. 

 

Volatility essentially measures how much an investment’s return varies from its average over time. By defining risk as volatility, the relationship between the intrinsic value of an investment and its price is downplayed, as is any intrinsic risk of the company’s operations or financial structure, says Mahesh Cooper, director of Allan Gray.

 

“The problem with using volatility as a gauge of risk is that it is mostly an indicator of changes in the perceived value of an investment based on the fluctuations of historic return patterns. It therefore gives you no sense of the possibility of an intrinsic looming threat to returns.”

 

Another popular interpretation of risk is that risk is being different, as measured by tracking error. Tracking error is the statistical amount by which the returns of a particular share differ from those of a benchmark.  A share whose returns differ widely from a specific benchmark (usually an index) is considered to have a high tracking error and is therefore considered high risk.

 

“We accept that for an investor whose objective is for returns to mimic an index, tracking error is a relevant risk measure. However, for an investor aiming to create long-term wealth, defining risk as tracking error simply doesn’t make sense,” says Cooper.

 

“To us, however, investment risk is not about how variable a share’s returns are over history, either versus its own average or that of any pre-selected benchmark. It is simply the probability of permanently losing money from an investment.” 

 

He says it’s important to be aware not only of the possibility of loss, but also of the potential magnitude of the loss. If a fund has a long-term history, investors can assess the largest peak-to-trough decline in returns over the life of the fund, also known as the ‘maximum drawdown’. It’s also important to consider how long it takes an investment to bounce back following a decline.

 

Benjamin Graham, the father of securities analysis, maintained that a potential decline in the price of a share does not ultimately raise the risk of loss if the decline is temporary and if the probability of selling during the decline is low. Graham applied the concept of risk solely to a loss of value, which may be realised through actual sale; caused by a significant deterioration in the company’s position; or, more frequently, may be the result of overpaying for an investment relative to its true intrinsic worth.

 

“Since our primary definition of risk is the probability and the extent of capital loss, we always try to invest in businesses when share prices are well below our assessment of the company’s intrinsic value and we are offered some protection should things turn out worse than we forecast – in other words, a margin of safety exists.”

 

Cooper says Allan Gray believes that to invest where value is exceptional is not only the lowest risk, but also the most rewarding strategy. “In our opinion, the best predictor of returns is the price you pay for the investment relative to its intrinsic value and risk.”

 

If a particular investment appears overpriced, Allan Gray considers it risky and won’t purchase it for their clients. “Conversely, we consider it prudent to invest in assets that we believe offer exceptional value even if they are out of favour and not represented in the average portfolios. This means that our portfolios often differ markedly from those of the average investment manager.” 

A new method of integrated accounting and reporting will allow companies to place a monetary value on the environmental effects of their products, says professional services firm PwC.  “A paradigm shift is required by companies in the way they currently do business and account for all costs and report to stakeholders. The importance of comprehensive stakeholder reporting has been brought to the fore in the wake of the recent economic uncertainty, social disparity and environmental degradation,” says Jayne Mammatt, an Associate Director within PwC’s Sustainability and Integrated Reporting Department.

 

There are signs that at least some institutions worldwide are taking the issue of sustainability reporting seriously. Sports and lifestyle firm Puma, with the support of PwC and Trucost, recently launched the results of its first product level Environmental Profit & Loss (EP&L) accounts, which place a monetary value on the environmental impact of products. “The accounting method is designed to give a better understanding of the environmental impact of the company and boost its competitive position in industry,’ says Mammatt. Currently accounting practices do not make recognition for the lost value of natural systems destroyed by the industry and as a result they are not protected by market forces.

 

The results compare the environmental impact from cradle to grave of a conventional shoe and T-shirt with more suitable alternatives and illustrate how a sustainable approach to production reduces the impact on the environment by a third compared to conventional products. The analysis focused on the environmental effects caused by greenhouse gas (GHS) emissions, waste and air pollution, as well as the use of natural resources such as water and land along the entire value chain from the generation of raw materials and production processes to the consumer phase when customers wash, dry, iron and finally dispose of the products.

 

Mammatt says: “By putting a value on even one product’s environmental impacts, it brings into sharp focus the debates over commodity pricing, natural resource scarcity and supply. Even as an emerging methodology, it challenges conventional business thinking – and consumers’ views – on how we measure and monitor the embedded environmental value and impacts of what we buy.

 

She says that the EP&L accounting method is the way in which integrated reporting is likely to head in the future. Mammatt anticipates that companies in South Africa will follow suit, particularly in the light of stricter regulations, rising energy prices and widespread resource scarcity. “Although it’s a novel field for financial accounting, it is a significant step for companies that are likely to be followed, given the requirements of the King III Report on Governance and the JSE Listing Requirements relating to integrated management and reporting.”

Two schools of thought are currently at odds in debating the investment approach best suited to the volatile climate we find ourselves in.

 

The first of these is the promotion of a passive approach; investing in a basket of shares or securities that replicate a market index. Here you may have heard of Exchange Traded Funds (ETFs) or “index trackers”; funds which may be comprised of a number of different securities in aiming to emulate a specified market return. For example, you can invest in the Satrix 40, an ETF listed on the Johannesburg Stock Exchange which aims to replicate the performance of the FTSE/JSE Top 40 index. Effectively, an index tracker seeks to match market returns as closely as possible.

 

On the other hand, we have fervent proponents of active management, who deem it possible for professional asset managers to outperform the market. Active managers rely on extensive research, professional judgment and their own industry experience to actively buy, hold and sell securities in seeking to generate alpha (returns in excess of a market index). Unfortunately, however, a large number of managers find it difficult to consistently deliver on this objective.

 

For this reason, index trackers and ETFs in particular have made up a substantial portion of the international market for a good number of years already – and they do have their advantages. For a start, they are generally (but not always) more cost-effective, due to simpler administrative requirements and the absence of active management (which results in lower transaction fees and a saving on research costs). These investments are usually also very liquid, offer a wide variety of choice as a number of different indexes can be tracked and, although limiting performance to that of the market, do at least offer market exposure (as opposed to alternatives such as bank deposits that offer no potential to benefit from market growth).

 

However, there are disadvantages to this type of investment as well. Consider that by merely matching market returns, all fees you pay on your investment – in lowering these returns – will mean that you ultimately underperform the market. Furthermore, with no fundamental or qualitative overlay, you remain directly dependent on the market at all times. When the market drops, the value of your investment automatically falls with it without offering the opportunity to try and generate positive returns.

 

Research shows that active managers tend to underperform the market (especially the FTSE/JSE ALSI) when it runs. Conversely, these managers tend to generate alpha when the market falls. What is interesting to note, however, is that neither a passive or active approach is successful all of the time.

 

This is illustrated in the graph below, which compares the rolling 12-month return of the Domestic General Equity sector, as defined by the Associating of Savings and Investments South Africa (ASISA), to the rolling 12-month return of the Johannesburg Stock Exchange (as represented by the FTSE/JSE All Share Index) between July 2002 and June 2012. The former can be seen to represent returns which would have been generated by following an active approach and investing in an actively managed unit trust. The latter represents returns which could have been generated when following a passive, index tracking approach (i.e. matching the market). In instances where the graph runs above zero, an active approach would have outperformed the market. Conversely, when the graph runs below zero, an active approach would have underperformed the market. As is evident when considering these sector averages, neither approach would have trumped the other consistently over the full length of the period in question. In fact, there were distinct periods when either approach would have been preferable.

Source: Morningstar Direct

 

However, it is worth noting that when comparing the actual returns of four high-quality equity funds (each managed by a different single manager available on the PPS Investments platform) for the same period, all these funds outperformed the general market throughout. This shows that, over the past decade, it would have been possible to identify first-class active managers that were able to beat the market consistently.

Source: Morningstar Direct

 

Of course, appropriate manager selections would then have been critical, and unfortunately not all single managers would have been able to deliver this performance. A suitable alternative, therefore, may be to combine the two approaches and to consider them complementary as opposed to mutually exclusive. In this way, as markets move both up and down, you will be able to ensure that a portion of your portfolio runs with the market as it climbs, while an active manager offers protection when markets fall. By gaining market exposure from a passive investment at a reasonable fee, you further stand to reduce the overall cost of your portfolio. Finally, by employing both approaches, you gain an additional level of diversification and position yourself favourably in targeting returns in excess of industry benchmarks.