November 2009 Issue Number 2

HERD MENTALITY:

Learning at the

School of Fish Facing

Your Fears

Recognising

the Risk

Recognising

the Risk

No Regrets No Regrets Drawing

Trend lines

CONTENTS

Editors Note 2

The Herd Mentality:

Learning at the School of Fish 3

The Herd Mentality:

Facing Your Fears 4

Recognising the Risk 5

Top Performers 6

Modeling a Portfolio 7

Understanding Warrants (Part One) 7

No Regrets 8

History of SSFs 8

Portfolio Managers are like Zebras 9

Technical Tip: Trend Lines 10

Astrapak: SPEC BUY 11

Merafe: SPEC BUY 12

What if the US Dollar crashes? 13

Bernake Gone Beserk 14

EDITOR’S NOTE

Much like a flock of ostriches fleeing in unison,

investors will run to one corner and then almost

instantaneously change direction and rush through

the fog of uncertainty to rapidly translate their paper

losses into real losses almost in unison again. The

remnant, much like ostriches, will bury their heads in

the sand, hoping that the danger would have

disappeared by they time they re-emerged.

Then when those first few brave investors start to

return to the markets, the herd will be following

behind again.

Behavioural finance holds that investment markets

are not completely efficient, there are often

anomalies. The reason behind those anomalies has

mostly to do with the emotions and behaviour of the

masses – or group sentiment. This issue discusses the

emotions of “fear” and “regret”.

Investors do not rationally assimilate all available

information, they often blindly follow what they have

read, or had whispered to them in hushed tones.

Consequently, markets do not behave efficiently.

Sir Isaac Newton, who succumbed to the frenzy

surrounding the South Sea bubble famously

exclaimed: “I can predict the motion of the planets,

but not the madness of crowds.”

The theme in this issue is “do not blindly

follow the madness of crowds.”

Although the advice is written from a South African

perspective and with local investors in mind, it

transcends our local market and is in fact practically

regardless of where you may be trading.

Some of our readers have asked for more information

on single stock futures (SSF’s), contracts for

difference (CFDs) and warrants and we have tried to

address this need in this edition as well.

I do welcome your feedback, and ask that you let us

know what you enjoy about this publication. We

have stuck with 14 pages, but hope to expand this in

time.

Sincerely

Craig MartinCraig MartinCraig MartinCraig Martin Editor

NOVEMBER 2009 ISSUE NUMBER 2

THE HERD MENTALITY!

Learning at the School of Fish! It has long fascinated me how sentiment drives

markets, and further to that, how group behaviour

influences the stock market. In January and February

of this year, investors clamoured over themselves to

sell their shares. No buyers could be found anywhere.

Weeks later everyone was following each other back

into the markets.

An understanding of this herd mentality can surely

assist in understanding the bulls from the bears.

This month’s issue of Science magazine documents an

experiment in Cologne, Germany. The purpose of this

little experiment is to determine how it is that

humans move in herds.

The animal kingdom seems to have the movement of

crowds down pat. When a school of fish move though

the water, their movements are precise and

synchronous. If they need to change direction they do

so quickly, with no confusion of collisions.

My wife and I were sitting at our favourite spot in

Cape Town earlier this week and we were

commenting on how beautiful the formation of

geese looked. We watched them fly out over the

ocean and return without once flying into each other.

Certainly no human air show could compare.

The Cologne experiment has shed light on the

mechanisms that lie behind group behaviour. When I

watched the flock of geese in flight there was clearly

a leader to the “V-shaped” formation. However, it

appeared as though it was not always the same bird

in front.

In the animal kingdom, whether one is examining

birds, fish or insects, they all move so well together

because each individual is making simple decisions

based on simple interactions. The magazine, Science

Intelligence describes it as a “self-organised system

that is as resilient as anything coordinated by even

the most brilliant leader.”

In 2005, there was a computer simulated experiment

that concluded that it takes only 5 percent of

informed individuals to steer a group in a certain

direction. The Cologne experiment conducted in 2007

was intended to replicate the computer simulated

experiment using live subjects. The test was to see

whether the “rule of 5 percent” as in fact accurate. Of

interest to me, is whether the findings of this

experiment can assist us in gaining a better

understanding of the movements of markets.

The subjects of the experiment received simple

instructions. They could move freely around the room

(which was 400 x 230 feet), without communicating

with anyone in anyway. They should be in constant

motion and remain close to their neighbour.

The 200 people in this experiment, as it turns out,

end up following a similar pattern to many species of

fish that are known for swimming in circles, and

whose schools tend to form two concentric rings,

each rotating in opposite directions.

So let us go back to testing the five (5) percent

assumption.

A handful of subjects (all wearing yellow hats) are

given instructions that are unknown to the rest of the

subjects. They are to move toward a particular

number on the clocklike face painted on the floor of

the room.

The experiment is originally conducted with just 5

subjects donning the yellow hats. This 5 out of 200

people represents just 2,5%. As you can see from the

diagrams over the page, this small group cannot seem

to change the pattern, or swing the group in any

manner.

When ten members of the group – 5 percent in

total – where yellow caps and move toward the

same spot, the whole group follows.

When ten members of the group – 5 percent in total

– where yellow caps and move toward the same spot,

the whole group follows Five percent turns out to be

the crucial number, as the computer models had

suggested.

This imitation of a school of fish is not limited to this

experiment. The researchers also conducted an

experiment to see how a group of humans react to a

scare tactic.

Someone plays a predator and the participants are

instructed to watch the predator and to stay away

from him by at least two arms lengths. The

instruction to the predator is to always pursue the

nearest prey.

The results of the experiment are quite dramatic. The

participants separate from the predator it what

appears to be perfect unison and then they quickly

move back together again as soon as the predator

passes. There movement once again seems to

resemble a school of fish.

In a further experiment in the 200 person group. The

scientists create a group of 20 people and give these

ones specific instructions to go in a specific direction.

They also create another group of 10 people with the

exact opposite instructions.

Interestingly, in this experiment, the human herd

does not react in the way that the computer

generated experiments had predicted.

As the difference of intentions becomes clear to the

group, you find that people alternate from one target

to another. The scientists interpret this as possibly

meaning that, when the two chosen goals lie close

enough to each other, then members of the herd will

try them both to find out which one is best.

This experiment confirms what we possible already

know, namely that humans tend to follow anyone

who appears to have some degree of knowledge.

When you disembark from an airplane at an airport

that you are unfamiliar with – what do you tend to

do? You follow the crowd, as you assume that they

are heading in the right direction – to the baggage

claims.

In my humble opinion, we saw this phenomenon

displayed in the market s this year, where so-called

experts were leading the market sentiment with

statements about financial Armageddon and then

converted almost overnight to discussions of

“greenshoots” and then to the start of a “bullrun.”

We are therefore no different to most species of

animals in that we also tune into herd instinct.

There is an unwritten rule that we follow those who

appear to have some degree of knowledge. However,

the facts may be quite different and we may find

ourselves to be amongst lemmings heading their way

over a cliff on a suicide mission.

This brings me back to some of our recent

performance on the stock markets. Why have our

gold and platinum counters run to the extent that

they have – particularly gold?

Could it be the herd instinct that is moving our

markets or at least certain sectors of our markets, at

present?

THE HERD MENTALITY!

Facing Your Fears!

Birds do it. Bees do it, and yes, even fish do it.

Animals react to herd instinct. However because

humans aren’t really driven by instinct, we tend to

use the term “herd mentality.”

This is simply the idea that the individual members of

a herd behave in a similar fashion, for purposes of

protection, or conformity. In the animal kingdom,

those that stand out as different often get noticed or

stand out and so fall capture to a predator.

So, it is this concept of fear that causes animals to run

in herds and I believe that it is the same emotion that

causes human investors and traders to follow the

crowd.

There are a number of fears that investors and

traders face.

The one is the fear of loosing out on an opportunity.

Gold is running and I am not in gold shares at the

moment. Maybe I should have eight or nine percent

of my portfolio there, otherwise I am going to

outperform.

There is the fear of loosing our money. When the

markets start to fall back and fear and panic sets in,

we behave like animals, and follow the crowd in

selling out. We certainly don’t want to be the only

ones left holding a falling portfolio.

We fear standing out as different. No fund manager

will get fired for owning the market. If they perform

in line with the market they secure themselves a job.

There is also the fear of uncertainty or the unknown.

When things become a little hazy, investors run for

cover.

The truth is that financial markets move on fear and

greed – not on economic fundamentals alone. Fear

and greed are emotions that are carried in the minds

of humans. Herd mentality.

The notion that shares are rational does not seem to

hold water anymore. So, I am very careful to say that

a specific share is undervalued if the market is skittish

about the company.

The is however an interesting observation that I have

made about fear, and this fact can help with your

investment strategy.

Research that neuroscientists have developed seem

to suggest that herd mentality, on the downside -

that is, in reaction to panic and fear - is far more

powerful than the herd mentality associated with

greed - herd mentality on the upside.

Fear also paralyses investors and traders. How many

times have you simply sat on the sideline and

avoided doing anything to solve your financial

situation? This is probably a fear of failure that

causes this inactivity.

An investor fears loosing his money far more than he

fears loosing out on an opportunity by being out of a

share, or out of the market.

How then can we face our fears, and use this

information about our emotions and our following of

the crowd, to our advantage?

Take the scenario of where the market is at present.

Think about the investments that you hold. Now ask

yourself, in the next year, how much higher do you

think your portfolio of shares could move?

Now, ask yourself, how much lower could your

investments fall in the next year?

You should now have a positive percentage return

and a negative percentage return. Let’s say that both

figures are the same for purposes of illustrating my

point. So, let’s say that you believe that your

investment portfolio has the potential to rise another

25% over the next 12 months, but it also has the

potential to fall by 25% over the next 12 months.

What if your shares fall in value by 25%, before they

rise in value? Where would you be?

Well, every 25% fall in the share price requires a

33,3% rise just to restore your original capital

amount.

Now, if you were out of this share and it climbed by

50%, you would be disappointed that you sold, but

not as disappointed as if you stayed in the share and

it had fallen by 50%. That 50% fall means that your

share price needs to deliver a 100% return just to get

you back to where you were before the fall.

How will you handle it if your share only goes up by

ten percent? Not as badly as if it dropped by 25%.

We tend to cope better with missing out on some

upside than we do by taking some heavy downside.

My strategy is to therefore only be in long positions

where the upside potential percentage return over a

given period is twice the potential downside return.

RECOGNISING THE RISK!

This leads us to the concept of risk. Generally the

higher the upside potential return, the higher the

downside potential risk. This isn’t always true, but it

is a challenge for investors who are all looking for the

highest returns at the lowest risk.

If the historic returns can be represented by the tip of

an iceberg, then the risk can be represented by the

large portion of ice under the surface.

The higher the return, the higher the risk, is generally

a fair comment to make.

In stock markets we often tend to measure risk by

means of volatility. Often the shares that have

offered the highest returns, or those that promise the

highest returns, are those that are the most volatile.

There is nothing wrong with volatility if you

understand it. But, if you are like the captain of the

Titanic and fail to recognize how this extra risk can

affect you, you may well find yourself sinking

financially.

TOP PERFORMERS

Southern Electricity Company (Selco) was clearly the

top performer over the month of October 2009. The

share price moved from 11cps – mainly on the back

of its published results at the end of September 2009,

where the company started showing earnings in its

income statement. The announcement from Eskom of

the possibility of a further 45% hike in tariffs was

possibly also good news for this small cap.

The two airlines, Comair and 1Time, also showed

some good performance over October as did Sentula,

who managed a successful rights issue.

MODELING A PORTFOLIO

If you currently own a number of shares in different

companies, how did you arrive at selecting that

basket of companies? Are you well diversified? Is

there any portfolio design behind your selection, or

will find that most of your investments lie within a

certain sector, or certain company size?

Traditional portfolio design dictates that you first

have a macro-economic view and make specific

assumptions about things like gross domestic product

growth percentages, inflation, exchange rates,

interest rates and the like. With this information, you

determine which sectors are likely to out-perform

and design a well-balanced portfolio that contains

shares of companies in those sectors.

The top-down method of modeling a portfolio is

undoubtedly the most popular with institutional

investors, but private investors often tend to select

shares using a bottom-up approach.

Institutional managers tend to have the objective of

firstly outperforming the market – regardless of

whether the market is negative or positive. There

second objective is to outperform their peers, and

most of their peers are tracking the market anyway.

When you purchase a house – you look for the best

city, best suburb and then find the best house in that

area. However, if you find a real bargain in another

suburb, you are likely to still be interested in the

prospects and may even reconsider your suburb of

choice.

Generally, I prefer a bottom-up approach to portfolio

design where the very best companies, offering the

best value, are short-listed and then selected to

ensure that there is sufficient spread across different

sectors.

Currently, I have a short-list of around 60 shares that

I am looking at. I go though this list and try and filter

out 12-15 shares that display the best value at the

lowest risks. My weighting in each share will be

determined by the sector that they fall into.

Where possible, it is sometimes also good to have a

spread between large-cap, medium-cap and small-

cap shares. When small caps underperform, large

caps outperform and visa-versa.

UNDERSTANDING WARRANTS Introduction: Part One

Warrants are options that are issued by financial

institutions and trade on the JSE. They are currently

not as popular as CFDs and SSFs, but they still do

have a place for speculators.

Warrants can be issued over individual shares or

indexes, or commodities.

The terminology surrounding warrants, such as calls,

puts and strikes sometimes tends to put traders off,

but the truth is that they are not difficult instruments

to understand.

Warrants entitle the holder to buy or sell a specific

number of shares in that company at a specific price,

at a specific time or during a specific period in the

future.

Warrants differ from traditional options in that, when

exercised, the shares come from the issuing company

and not from another investor on the opposite side of

the position.

Warrants can either be "Calls" or "Puts." Call

warrants give the holder the right to buy the

underlying share, while a Put warrant gives the

holder the right to sell the underlying share. Both

these transactions must take place at a

predetermined price (called the strike or exercise

price) and before a particular date.

Like single stock futures (SSFs), warrants are listed on

the JSE and trade just like any other share. The price

of a warrant is determined by supply and demand

and trades freely in the same manner. However

there are models that allow one to determine the

appropriate value of a warrant. Theoretically the

warrant should trade close to this valuation.

In fact, the most influential factor determining the

warrants price is the underlying share price.

Purchasing a warrant is like taking a bet on where the

price of the underlying share will be at a future date.

If you think that the price is likely to be higher, you

will purchase a Call Warrant. If you think the share

price will be lower, you will purchase a Put Warrant.

A Warrant always has a strike price, or exercise price

and a date of that strike. So you are betting that the

price will be at or better than the strike price by the

strike data.

The issue with Warrants is that they cannot be rolled-

over. They have an expiry date, and this time delay

tends to add an extra element of risk to the mix.

(This feature will be continued again next month)

No Regret’s

Imagine that you and a few friends have purchased a

lotto ticket every week for the past six months using

the same numbers.

To date you have not won a thing, so you decide to

take it on yourself to select a new set of numbers.

The switching of your numbers does not affect the

odds of winning in any way. It does not increase, or

decrease the risk of your numbers coming up.

But, imagine what would happen should your old set

of numbers now come up.

Although switching numbers had no real affect on

risk, it certainly had an affect on regret.

Regret is an emotion that develops after you have

made a decision or avoided the making of a decision.

So one cannot avoid risk by simply avoiding the

making of a decision. However, staying with the

status quo is often more pleasing than making a bad

call and seeing that your original choice would have

turned out better.

I strongly believe that a number of investment

advisors and portfolio advisors avoiding making

changes to the status quo because of the emotion of

regret.

Deviating from the norm, which may be a benchmark

or an index, brings along the element of regret should

the decision turn out badly.

My solution to the problem is to phase into a

decision.

For example, if you want to change from a position to

Anglo American into BHP Billiton – why sell out of

Anglo is one go and purchase Billiton in one go. Why

not phase out of one share and into the other over a

period of months.

The same thinking can apply to any number of other

shares. If you are holding MTN, but prefer Vodacom –

why do you have to face the possibility of regret by

making a bad call? Phase out of MTN over a number

of months and into Vodacom over the same period.

If you were wrong about your decision, at least you

will be pleased that you were not completely out of

MTN or Anglo, and if you were right, then at least you

would have had some exposure to Billiton and

Vodacom.

Potential regret does have an impact on your

investment decisions. This strategy may be a way to

manage this very real emotion.

History of SSF’s Last month we looked at the History of CFD’s, so

this month we touch on the history of single

stock futures (SSF’s).

The first futures market was said to have started

in April 1987. RMB (Rand Merchant Bank)

managed this market informally. They

effectively acted as the exchange, the market

maker and clearing house.

In September 1988 the SAFEX (South African

Futures Exchange) was born as was SAFCOM

(South African Futures Clearing Company). This

at least made the function of the exchange and

the clearing house separate from the market

maker.

It took some time for the informal market to

become official, as the Financial Markets Control

Act only came into being in 1990. So, on the 10th

of August 1990 the SAFEX market was officially

opened, with 119 trading seats.

In October 1992, SAFEX introduced options and

futures and the market started to enjoy

increasing trade volumes.

On 1 July 2001, the JSE purchased SAFEX and

this really bolstered the interest in derivatives.

Today, options products account for about half

of the total volume on Safex and about half of

the interest comes from foreign investors and

institutions.

Futures were initially on indexes, agricultural

commodities and popular bonds.

Single Stock Futures were developed with the

retail or private investor in mind and they allow

for a relatively small investment to gain geared

exposure to the underlying individual shares.

Portfolio managers

are like zebras In the spirit of this theme of “herd mentality”, I

have to conclude an article about the herd

mentality of institutional portfolio managers.

We alluded to this in the previous article on “No

Regrret’s” in that if you follow the

heavyweights, or follow the market, you are

unlikely to have any regrets on making the

wrong call.

If your goal is to match, or beat the market, then

I guess you have to hold most of the Top 40

index.

Ralph Wagner, a US fund manager, made a good

analogy quite a few years back. He said that

“zebra’s have the same problem as institutional

fund managers.” He said that the zebra seeks

the profit of fresh grass, and the portfolio

manager seeks the profit of above-average

performance.

Portfolio Mangers dislike the risk of getting

fired, whereas zebra’s try and avoid the risk of

getting eaten by lions. So to achieve their goals,

they look alike, think alike and stick close

together. In other words, they move in herds.

A zebra who moves outside the herd, is not

confident that he will find the fresh grass on his

own, he is also terrified that he will become

prey.

A fund manager who doesn’t own most of the

index and the heavyweights, runs the risk of

earning below-average performance, if one of

the heavyweights, like Anglo, runs. If it falls, as it

has been, at least he can console himself that he

is still part of the herd – earning an average

performance.

You really can’t get fired for owning

AngloAmerican – it’s a fairly safe bet, otherwise

every portfolio manager in the country would

face the firing line.

Wanger goes on to explain that an institutional

portfolio manager not only won’t stray from the

herd, he doesn’t even want to be on the

outskirts of the herd.

“the zebra seeks the profit of fresh

grass, and the portfolio manager

seeks the profit of above-average

performance. “

The optimal strategy is to stay in the centre of

the herd at all times. As long as he or she, buys

the popular stocks, he feels safe in the middle of

the herd.

What I find the funniest is that we pay these

experts incredible salaries to follow the crowd.

Furthermore, we pay financial advisors huge

commissions to select a range of funds for us

that are managed by zebra’s.

They also love to tell us not to worry about the

negative performance this year, as our fund has

performed in line with market.

“You really can’t get fired for owning

Anglo – it’s a fairly safe bet, otherwise

every portfolio manager in the

country would face the firing line. “

TECHNICAL TIP

:Trend lines You should be able to conduct a technical analysis

from a chart that only contains the closing price of a

share. What are you analysing?

Simply the overall trend of the share, and this is done

using a simple trend line. However, drawing a trend

line is a bit of an art form.

Another purpose in drawing a trend line, is to identify

where possible reversals in the trend are likely to

occur.

The suggestion is that in an uptrend, you should draw

the line along the lowest points in the trend. So it is

from lowest point, to lowest point, without letting

the line cross through prices

If you looked at this one year graph of Anglo, you can

see the trendline (in red) is clearly up.

This is arguably the correct way of drawing the trend,

but it is an art form, and as such, some technical

analysts might prefer to represent the trend as

shown below:-

This trend line shows that there was a break under

the trend line, but it takes most of the low points into

account. Up to a certain point, this would have been

the trend line, but the share experienced some

resistance.

As Anglo ran into resistance and technically broke

through the old trend line, one would in practise

draw both the old and the new trend line, as follows:-

The more times a stock touches a specific trend line,

the more significant that line becomes. On the old

trend line it crossed though at least on three

occasions. This would generally confirm it to be a

valid trend line.

In a downward trend, you would apply the opposite

rule and draw the line along the highs of prices. You

would draw this line from highest point to highest

point and preferably also look for at least three

points were it crosses, to confirm the trend.

As I said twice already, this is not an exact science,

but an art form. Next week we will tackle another

technical tip – namely moving averages.

ASTRAPAK: SPEC BUY Astrapak Limited (APK) and its subsidiaries are

manufacturers and distributors of an extensive range

of plastic packaging products. The group has

manufacturing facilities in all major centres of South

Africa. The operations are grouped into various

business segments and service mainly the food,

beverage, personal care, pharmaceutical, agricultural,

industrial and

retail markets.

Fundamental

Analysis

Astrapak reported

a remarkable

improvement in

earnings for the

six months to 31

August 2009, although admittedly this was off a low

base for the restated comparable period.

Revenue from continuing operations declined by 3.7%

to R 1.26 billion (2008 H1: R 1.3 billion), whilst gross

profit increased by 11% to R 316 million (2008 H1: R

285 million) on the back of a decrease in direct

manufacturing costs due to enhanced efficiencies and

group synergies.

Profit from operations increased 24% to R 121 million

(2008 H1: R 97 million) after allowing for distribution

and selling costs, as well as other administration costs

which were fairly flat when compared to the previous

period. Operating margins increased to 9.6% (2008

H1: 7.5%), which the group believes can be even

further improved.

The reduction in interest rates, as well as improve-

ments in working capital management resulted in a

welcome decrease in financing costs to R 40,5 million.

The effective tax rate reduced to a more reasonable

31.3% (2008 H1: 68.8%), with the previous period

containing various once off permanent differences.

The reduction in the tax charge further contributed to

an improvement in after tax earnings.

The improvements in operating margins and the

decrease in both finance costs and taxation charges

contributed towards a remarkable 829% increase in

headline earnings from continuing operations to R

55.6 million (2008 H1: R 6 million). HEPS from

continuing operations increased 824% to 47.1 cps,

while discontinued operations reported a loss.

Cash flow for the period was strong with a net cash

inflow from operating activities of R 120 million (2008

H1: R 114 million). Net cash balances increased by

R50.5 million (2008 H1: R 61.5 million) to bring net

cash reserves to R 160.5 million (2008: R 110 million).

Disposals of discontinued operations during the

current year contributed towards a reduction in net

debt, which improved the ratio of interest bearing

debt to equity to 34% (2008: 72%). Cash inflows from

pending disposals of discontinued operations will be

used to further reduce debt.

The group’s improved cash position and reduction in

net debt has significantly strengthened the balance

sheet during the current period.

Prospects

Management have adopted a much more focused

approach to the group strategy going forward, with

the flexibles businesses being disposed of and the

focus now being on the more profitable rigid and films

packaging divisions.

The group believes that it has shown resilience in

tough market conditions due its increased market

share and its drive to create synergies and improved

efficiencies within the group, which management will

further pursue in the remainder of the year.

Raw material input costs for packaging are impacted

by fluctuations in the oil price, which together with

electricity costs, need to be monitored and passed on

to customers to keep margins intact.

Although there are indications that the recession may

be coming to an end, both the consumer and the

manufacturing sectors are still under pressure and

need to show signs of a turnaround before a recovery

can be confirmed. The group believes it is well

positioned to take advantage of such a recovery.

Overall Recommendation

The growth in earnings in the current year is largely

due to certain once off costs in the comparable period

and cost reductions in the current year. It is our view

however, that there is a limit by how much costs can

be reduced and that future growth will have to come

from increased revenues and sales volumes.

On a price to book ratio of 1.4 and a price earnings

ratio of 8.7, APK appears to offer relative value when

compared to its peers such as Nampak (NPK).

The group is sure to benefit from any recovery in the

manufacturing and consumer sectors and

management seems to have a good handle on cost

control as well as their target market. However, due

to the uncertainty of the medium term outlook and

the volatility of the share, we can only recommend it

as a SPEC BUY. * Sheldon Barry

MERAFE: SPEC BUY Merafe Resources Ltd (MRF) is an interesting coal and

ferrochrome producer. Its main asset is a 20.5%

economic interest in a ferrochrome joint venture (JV)

with Xstrata. The joint-venture with Sentula is really a

non-event for the company at this stage.

Fundamental Analysis

Cyclical stocks like Merafe are extremely difficult to

predict, but in order to develop an investment opinion

on the company, one needs to look forward to 2010

and beyond. The truth is that visibility this far ahead is

very hazy. It is not only hazy for analysts, but for the

company itself.

The group has a 50% holding in Merafe Coal, that has a

joint-venture with Sentula Mining. This project has

made application for mining rights for the

Schoongezicht and Bankfontein properties. Hopefully

the licensing for the mining of these properties will

take place in September 2009. Expected production is

around1,5 million tons per annum. The sale of coal

from this development will be to Eskom and for

thermal export.

However, the fact is that Merafe have not put any

value on this project, and if it comes off, whatever is

produced will be a bonus to shareholders.

Earlier this year, the management of Merafe had to act

quickly due to reduced demand. They very smartly,

dropped the use of its 20 ferrochrome furnaces to only

3 furnaces.

Merafe has advised the market that ferrochrome

production for the Xstrata-Merafe Chrome Venture for

the first nine months of 2009 would be 47% lower

than the same period in 2008 as a result of this

suspension of production capacity.

This year, the demand for ferrochrome has risen, and

the European benchmark price for the fourth quarter

has been set at $1,03 per pound.

This has necessitated the re-commissioning of several

furnaces, and the company indicates that they are

running at around 85% capacity, which would imply

that around 17 furnaces are operational.

Prospects

A large part of the loss in earnings stems from

currency, or translation exposure. Merafe will do

better when one sees a weaker Rand against the Euro

and the US Dollar. The current strong Rand is therefore

hurting the company, and the short-term prospects do

not look all that good.

A strong Rand could potentially shave 30% off what

the returns may have been, had the Rand remained at

around R9,50-R10 to the US Dollar

When we spoke to the CFO of Merafe, Stuart Elliot, he

made it clear that the opportunities for 2010 still lie in

China and Asia. Around 63% of sales for the first half

of the year came out of Asia. The demand for stainless

steel is likely to still be there in the first half of 2010. In

fact, the company saw increased demand coming out

of Asia in September over August 2009.

Smelters require substantial amounts of electricity to

operate, and the cost of electricity at Merafe

represents around 19-20% of their total costs. So this

is a concern when Eskom are talking about potentially

hiking electricity by 45%.

Elliot does not imagine any problems with

unreasonable wage demands as the company has not

undergone any retrenchments.

Elliot makes it very clear that Merafe do not hedge or

utilize gearing. They provide a real play on any Rand

weakness. If you are inclined to bet on the Rand

weakening, then Merafe presents a solid opportunity.

Overall Recommendation

Our view is that with the Rand fairly strong, at around

R7,50 to the US Dollar, the current value of Merafe

cannot be much more than 120-140cps.

A weaker Rand will help bolster earnings, as will

improved demand for steel in 2010. Merafe still holds

a lot of risk and while we give it a SPEC BUY

recommendation, it would be only on movements

under 140cps. In the short term there may well be

some more downside.

* Craig Martin

WHAT IF THE US

DOLLAR CRASHES? This is something that has certainly been touted in

non-mainstream newsletters for some months now.

A newsletter called “Money and Markets” says that

“up until the day Lehman Brothers collapsed in

September 2008, it took the US Fed 5,012 days (13

years and 8 months) to double the cash currency and

reserves in the coffers of U.S. banks.

In contrast, after the Lehman Brothers collapse, it

took Bernanke's Fed only 112 days to double the size

of those reserves. He accelerated the pace of bank

reserve expansion by a factor of 45 to 1.”

This action from the Fed has led to a serious

oversupply of US Dollars.

The question of whether the US Dollar is a bubble

ready to burst, has also just made the front cover of

Business Week.

The US Dollar has fallen on average 15% against high-

yielding currencies since about March this year. It has

fallen a lot more against the ZAR, but that is partly

due to a stronger Rand and partly to carry trade

consequences.

The Dollar can be borrowed at near zero interest

rates, and for this reason it has become the fuel for

speculation elsewhere in the world.

Is it really inconceivable to see the US Dollar at $2 to

the Euro? I don’t believe so, in fact, it is looking very

feasible at present.

In fact, that may be what the US economy actually

needs. A weaker Dollar will stimulate tourism and

investment in the USA. US manufacturers would be

more competitive.

Obviously there are numerous negative

consequences too, and so the conspiracy theorists

who tout that the purposely driving the Dollar lower,

seem to forget that a weak Dollar will play havoc

with inflation.

Also a weak Dollar makes American citizens poorer

because of their reduced purchasing power. Why

would any government want to do that to their

citizens?

The US is already in a deficit of trillions of Dollars.

Why make import costs higher? Surely, in the short-

term, a weaker Dollar is worse for America’s balance

of payments, especially as the US import a lot.

There is no guarantee that a weak Dollar will bolster

export or make the US more competitive in practice.

It is purely a theory, just like the theory that the Fed

is actually strategizing for a weak Dollar.

The article in Business Week makes the point that

“the Bearish case for the Dollar takes on a life of its

own. Selling begets more selling.”

Speculators tend to overwhelm any support to prop

up the Dollar in the short-term. The lower the Dollar

falls the more confidence is lost and the less inclined

financial institutions become in propping the Dollar

up again.

Speculation that the Dollar is heading for a fall can

become a self-fulfilling prophecy if traders rush for

the exit. Just like one will see a run on bank deposits

when a financial institution indicates the possibility

of trouble, so too can we expect a run on the Dollar.

A weak Dollar would be good for gold, which is

already increasing quite nicely, but it will also hurt a

lot of resource companies who sell in US Dollars.

The dollar's role as a reserve currency is already

being challenged in Europe, in Asia, and in the

Americas. In fact, at present, major oil producers all

over the world are talking about abandoning the

dollar as the basis for global oil contracts. If that

happens, it would almost assure a further weakening

of the US Dollar, as demand would reduce.

There is still the view that the best debt solution will

be to pay off government debts with ever-cheaper

dollars and for this reason, “Washington is declaring

a war on the US Dollar.”

It is an awesome theory, but I wouldn’t act on this

assumption just yet.

* Craig Martin

Bernanke gone

berserk!

Even in the most extreme circumstances of recent

history, the Fed never pumped in anything close to this

much money in such a short period of time.

• Before the turn of the millennium, the Fed

scrambled to provide liquidity to U.S. banks to

ward off a feared Y2K catastrophe, bumping

up bank reserves from $557 billion on October

6, 1999 to $630 billion by January 12, 2000.

And at the time, that was considered

unprecedented — a $73 billion increase in just

three months. In contrast, Mr. Bernanke’s

recent money infusion is $1.007 trillion or 14

times more!

• Similarly, in the days following the terrorist

attacks on the World Trade Center and the

Pentagon, the Fed rushed to flood the banks

with liquid funds, adding $40 billion in the 14-

day period between 9/5/01 and 9/19/01. Mr.

Bernanke’s recent trillion-dollar flood of

money is twenty five times larger.

After the Y2K and 9-11 crises had passed, the Fed

promptly reversed its money infusions and sopped up

the extra liquidity in the banking system. But this time,

Mr. Bernanke has done precisely the opposite: Since

he doubled the currency and reserves at the nation’s

banks with his 112-day money-printing frenzy in late

2008, he has thrown still more money into the pot.

With no past historical precedent, no testing, and no

clue regarding the likely financial fallout, Mr. Bernanke

has invented and deployed more weapons of mass

monetary expansion than all prior Fed chairmen

combined.

The list itself boggles the imagination: Term Discount

Window Program, Term Auction Facility, Primary

Dealer Credit Facility, Transitional Credit Extensions,

Term Securities Lending Facility, ABCP Money Market

Fund Liquidity Facility, Commercial Paper Funding

Facility, Money Market Investing Funding Facility,

Term Asset-Backed Securities Loan Facility, and Term

Securities Lending Facility Options Program.

None of these existed earlier. All are new experiments

devised in response to the debt crisis.

The single biggest new facility is the Fed’s purchases of

mortgage-backed securities (MBS). This massive

operation began on January 7 of this year with only

$10.2 billion. Now, just nine months later, the Fed has

bought up a cumulative total of $924.9 billion, the

largest money infusion by any central bank into any

single market sector of all time.

Mr. Bernanke would have you believe that he can

carefully control how the banks use all this free

money, with an eye toward preventing a sudden bout

of inflation.

In practice, however, he’s doing nothing of the sort.

If the bank lending were mostly to American

businesses, it might at least help rebuild the U.S.

economy. However, right now, the only big lending we

see is to finance a new speculative fever that has

swept the globe — the borrowing of cheap dollars to

buy high-yield investments.

The nation’s money supply is exploding. In August,

money in circulation and in checking accounts (M1)

expanded at the breakneck speed of 18.6 percent

compared to the year earlier. That was …

• Three times faster than the average M1

growth rate of the 1970s, which helped create

the worst inflation of our era;

• Over SIX times faster than the average M1

growth rate during the half century prior to

September 2008; and

• The single fastest M1 growth rate ever

recorded by the Federal Reserve.

The Consequences

This overabundance of high-powered money flooding

into the nation’s banking system and money supply

can have only one consequence: To cheapen the value

of each dollar you own.

The solvency concerns regarding major financial

institutions have now been replaced by looming

solvency threats to the U.S. government itself.

The debt crisis of 2007-2008 has been transformed

into the dollar crisis of 2009-2010.

Clearly, in this environment, following traditional

investment norms with conventional investment

vehicles could be dangerous; and evidently, an entirely

different approach to investing is now a must.

• Martin D. Weiss, Ph.D (Money & Markets)