The local equity market had a strong quarter, breaking out to new highs despite all the negative news headlines. Many investors forget that the FTSE/JSE All Share Index (ALSI) has been range bound for around three years and the average stock performed even worse given the large positive contribution of Naspers and SABMiller over that period.

As we have previously written, we have been finding increasing value in local equities over the past 18 months as valuations have come back to more attractive levels. This has been driven by investor pessimism towards domestic-orientated stocks given the poor political and economic backdrop.

There is substance to the pessimism as the poorly managed, poorly performing South African economy has finally caught up with corporate earnings after years of defying gravity. This has provided opportunities: if companies have reported down earnings for cyclical reasons, prices may overreact on the downside; if companies have expanded offshore and overpaid for acquisitions, they may have underperformed.

As a result, the Fund has a greater weighting towards domesticallyorientated stocks. However, it still maintains a significant weighting to stocks listed on the JSE that have large offshore operations, such as British American Tobacco and Naspers, in addition to the 25% the Fund can invest offshore. We don’t believe it is wise to invest solely on the basis of trying to predict what can be seen as an almost binary outcome in South African politics.

Remgro is a good example of a share that we are currently finding attractive. The share has underperformed as a result of its listed hospital subsidiary Mediclinic overpaying for Al Noor, a hospital group in Abu Dhabi (i.e. offshore expansion), and its exposure to the local economy through its stakes in companies such as FirstRand, Rand Merchant Insurance (RMI) and Unilever (i.e. cyclical earnings pressure).

We believe that Mediclinic is trading far closer to fair value following its significant underperformance. Many of the other companies in the Remgro portfolio, such as FirstRand, RMI, Distell and RCL foods, are listed. If we sum the market value of these listed subsidiaries and add our valuation for the unlisted companies, such as Unilever, we find that Remgro is trading at a historically high (18%) discount to its intrinsic value. In addition, we find the underlying holdings, FirstRand and RMI, attractive on a standalone basis.

From current levels, long-term investors in Remgro should benefit not only from growth in the intrinsic value of the underlying holdings, but also from a closing of the discount to its intrinsic value as pessimism subsides.

The Fund benefited from the strong absolute performance of Naspers during the quarter as a result of the significant increase in the share price of its Hong Kong-listed associate, Tencent. On the negative side, British American Tobacco detracted from performance after regulators in the US announced potential changes to regulations. Other than the continued active increase in exposure to domestic-focused stocks, there were no material changes over the quarter.

Commentary contributed by Duncan Artus

Investor sentiment towards emerging markets remains weak. This has left emerging markets at a valuation discount to developed markets. The MSCI Emerging Market Index trades at a discount of over 30% to the MSCI World Index - an index dominated by the US and other developed markets - on a price to earnings (PE) basis. Our offshore partner Orbis is taking advantage of this valuation disparity: 24% of the Allan Gray Balanced Fund’s foreign equities are listed in emerging markets.

A comparable trend is unfolding in South Africa. Domestic businesses exposed to the vagaries of local economic and political trends are trading some way off their highs or remain suppressed. This includes our construction (Aveng, Group Five), healthcare (Netcare, Life Healthcare) and industrial companies (Nampak, KAP), as well as our banks. Businesses exposed to Africa have fallen similarly out of favour (MTN, Nampak).

South African banks provide an interesting case study on the merits of investing during periods of poor prevailing sentiment. Our clients recently had the opportunity to invest a substantial sum of money in Barclays Group Africa (BGA) when Barclays PLC - the UK-domiciled parent company - decided to sell a large chunk of its shareholding in BGA. At the time of our investment, BGA’s dividend yield (7.8%) was marginally higher than its PE ratio (7.5x). This has only happened three times since 1987 and all these occasions were characterised by massive investor uncertainty: 1988 (South African state of emergency; political and economic isolation), 1994 (first democratic general election) and 2008 (the Global Financial Crisis). Importantly, on all three occasions, investors would have been well served to own the stock over the subsequent three years despite the uncertainty at the time.
Some of our biggest purchases over the quarter fall into this bucket of ‘unloved’ stocks: MTN, BGA, Netcare and Nedbank. We have also added to existing positions in Implats and Sasol - both of which are deeply unpopular mining stocks. We sold some of the more popular stocks like British American Tobacco, Capitec and Mondi to fund these purchases.

The net equity exposure of the Fund is up marginally on a quarter ago, which is indicative of the increased attractiveness of certain shares versus cash, bonds or commodities. While a higher equity exposure could introduce some more volatility (which should not unsettle a long-term investor), it is to some extent offset by a very conservative positioning in the fixed interest component of the portfolio with a duration of 2.3 years.

Commentary contributed by Simon Raubenheimer

People often stress the importance of asset allocation. We tested this theory using real-world data. Imagine an investor who has either 60% in shares and 40% in cash, or 40% in shares and 60% in cash. He can switch once a year, and he does so perfectly, every year: by magic he knows in advance which asset class will do best. In years like 1930 or 2008, when markets are down, he holds 60% cash, and in years like 2009 he has 60% in shares. In my view, one couldn’t hope to do better than this in real life: a 20% shift in equity exposure, done perfectly every year.

So, how far would our imaginary investor outperform a passive portfolio with a fixed equity exposure of 60%? In both the US and South Africa, over most time periods, by about 1% per year. Someone who can produce 2% equity alpha per year on a portfolio that is always 60% in shares would add more value.

We have done an analysis on our Balanced Fund, and we estimate that asset allocation has added somewhere between 0.60% and 0.75% alpha since inception. We can’t be more precise than this, because the Balanced Fund uses a peer benchmark, which has varying weights to each asset class. These don’t sound like big numbers, but they compare well with the 1% that our imaginary asset allocator has added over time. The vast majority of the Balanced Fund’s outperformance has come from stock selection.

The Fund’s performance over the past quarter was helped by overweight positions in KAP Industrial Holdings and British American Tobacco, and by underweight positions in BHP Billiton and Steinhoff. It was hindered by being overweight Sasol and Remgro, and by being underweight Richemont and Naspers. All this is relative to the FTSE/JSE All Share Index. We increased our exposure to Mr Price and MMI, and we reduced our exposure to Standard Bank and Nedbank. Strong returns from our offshore investment partner Orbis relative to international markets were mostly offset by a stronger rand, which means the portion of the Fund invested offshore was a drag for the quarter.

The Fund is a collection of undervalued assets that we believe will yield good real returns to investors over time. It is conservatively positioned and ready to take advantage of any opportunities that may arise.

Commentary contributed by Jacques Plaut.

The three major asset classes - equity, fixed interest and offshore - all contributed positively to the Fund’s 6.3% total return for the year. What is clear is that returns for most asset class were fairly modest, especially compared to the returns of the previous 5, 10 or even 15 years. The FTSE/JSE All Share Index (ALSI) returned 2.6% for the year, while the MSCI World Index rose 8.5% in US dollars but declined 3.8% when measured in rands. The standout for the year was the JSE All Bond Index, which returned 15.4%. The small moves in the headline indices mask substantial moves in the underlying investments. The Resources Index returned 34.2% while the Industrials Index had its first down year since 2008, falling 6.6%. The Orbis funds had a great year relative to international benchmarks - but this was offset to some extent by the stronger rand.

Despite South African equity markets being more-or-less flat over the past two years, we are still cautious. Valuations are down, but from a very high level compared to both historic metrics and what we consider to be fair value. We think the majority of companies are overvalued rather than undervalued. This informs the Fund’s 46% exposure to domestic equities and total equity exposure of 61%.

Like the overall market, the Fund had individual shares that contributed strongly to performance and others that were significant detractors. The good thing about the detractors is that our estimates of fair value have not changed; lower prices mean greater margins of safety and additional upside potential. We have reduced exposure to some of the winners, such as the banking stocks, as they approached fair value, and we have added to the underperforming positions. The increased exposure to the, now cheaper, laggards should put the Fund in a position to deliver good returns going forward.

An example of a share we added to is Sasol. The low oil price and cost overruns on Sasol’s very large Lake Charles Chemical Project (LCCP) in Louisiana have turned investors against the company. The LCCP cost escalations are disappointing and diminish the valuation, but not to the extent discounted by the market. Even though beneficial operation and operational cash flow from the LCCP will only begin in 2019, Sasol has a number of smaller projects ramping up over the next 12 months that should contribute meaningfully to cash flow. Additionally, in our view, an oil price of US$50 is low rather than high, which skews the risks in favour of Sasol investors. We don’t expect much of an oil price recovery, but a higher oil price is possible despite the negative rhetoric. As the very sharp price appreciation, against all expectations, of various industrial commodities (including copper, zinc, coal and iron ore) in 2016 demonstrated, forecasting commodity prices is very difficult. In our view, one should rather be a buyer when an industry is struggling and sentiment is poor (the oil industry currently), and a seller when the consensus is positive and an industry is booming.
The Fund is a collection of undervalued assets that we believe will yield good real returns to investors over time. It is conservatively positioned and ready to take advantage of any opportunities that may arise.

The largest net purchases over the past quarter were Naspers, Old Mutual, Investec and Sasol, while we reduced exposure to Sappi, Standard Bank, Nedbank and African Rainbow Minerals.

Commentary contributed by Andrew Lapping