Emerging market equity and currency markets had a very volatile quarter. Vulnerabilities, both economic and political, are being exposed as global financial conditions tighten. The MSCI Emerging Market Index is now 22% off its peak and the FTSE/JSE All Share Index fell 6% over the quarter when measured in US dollars.

This has impacted both local and the offshore equities in the Fund. Investors are currently focused on the risks as opposed to the upside in emerging markets - this is understandable. As contrarians, we are looking for opportunities where we believe intrinsic value has not been impaired to the same extent as the price has fallen. Investors in emerging markets have to balance the upside of above-average long-term potential growth and lower levels of competition with the risks of less developed and market-friendly government institutions and regulators.

Three shares have recently been affected by regulation, causing investors to question the value of some of their business units operating in emerging and frontier economies:

Naspers had a volatile quarter impacted by negative sentiment towards emerging markets and potential changes in regulation in China, which could affect Chinese technology company Tencent (Naspers holds 31% of the company). Tencent’s gaming business, which generates a significant portion of its profit, suffered from a delay in official approval to monetise new games. The government also issued statements implying that many Chinese, in particular youth, may be spending too much time gaming. While the process still needs to be completed, and indeed may even be positive for Tencent, we believe the implied valuation for Tencent when bought through Naspers is attractive. Naspers remains the Fund’s largest position.

MTN announced claims by the Nigerian government of wrongdoing involving the repatriation of cash from Nigeria as well as underpayment of tax. While MTN denies the allegations, and the amounts appear unbelievably large (approximately US$10bn), it is difficult to fight a government (especially one short of US dollars) which ultimately controls your licence to operate in their country. The value of the Nigerian business has long been a concern of ours, but with the change in price, we are taking a closer look.

Glencore’s share price has also fallen due to regulatory issues involving its copper operations in the Democratic Republic of Congo. In addition to having to negotiate with the local mining regulator, Glencore faces a potential fine from the US Department of Justice for dealing with a person on their sanctions list. Taking the above into account, we believe the share price has fallen more than the intrinsic value. We like the profile of Glencore’s commodity basket and while it does operate in riskier jurisdictions, the discount relative to the other major diversified miners is large. Glencore has been one of the Fund’s largest purchases.

Investors in emerging and frontier markets have been reminded 1) Of the associated risks that come with the upside and 2) That this is particularly the case in countries with unbalanced economies (think Turkey). Dislocations will invariably present opportunities to long-term investors who are willing to do the work. It is also a timely reminder that South Africa must get its house in order to reduce our vulnerability in a world with tighter financial conditions.

Over the quarter, the Fund lightened its position in Sasol and purchased Glencore and Naspers.

Commentary contributed by Duncan Artus

During the second quarter ‘Ramaphoria’ reversed with local bonds falling and many ‘South Africa Inc.’ companies (banks, insurers, retailers and industrial companies) selling down lower than at the start of the year. As an example, the FTSE/JSE General Retailers Index increased by 50% in US dollar terms from the start of December 2017 to late February 2018, only to end back to its starting point in June. The Balanced Fund gained during the quarter as only 30% of the Fund is exposed to purely South African risk assets (local bonds and purely domestic companies) and the offshore assets benefited from the rand weakening 16%.

As an investor you might think fund managers are good at anticipating such rapid changes in sentiment. Unfortunately, like most, we have no method of reliably predicting sudden changes in sentiment. The good news is that we have found that relentlessly focusing on whether the long-run prospects of assets are priced in by the market can also lead to satisfactory outcomes.

The Fund’s most significant buy during the quarter was British American Tobacco (BAT). The Fund’s holding in BAT peaked in November 2015 at 7.8% of the Fund, after which we decreased exposure with the share pricing in favourable tobacco economics at a high teens PE ratio. The current holding of 4.8% of the Fund is higher than it was at the start of the year (3.6%), but is still substantially below peak levels. Interestingly, the pound share price is flat since November 2015, despite the company growing its earnings by 36% as the stock market is pricing in a substantial probability of the tobacco industry being disrupted by products with reduced health risks, such as electronic cigarettes.

Being ignorant to disruption is a proven way to fail, but BAT has invested in a wide range of products including vapour, tobacco-heating and hybrid products that have gained traction across Europe and Japan, in many cases achieving higher market share than in their traditional products. BAT seems well positioned to potentially benefit from the trend to safer nicotine consumption, and is arguably more sustainable in the long run. The US market has seen competition rise from independent companies like JUUL, which has reached 4% market share in a short time. But all is not lost. BAT’s premium brands have continued to do well despite JUUL gaining significant traction and BAT’s reduced risk portfolio is still in the approval process (BAT’s acquisition of its US associate Reynolds closed in July last year). The Fund also purchased Remgro and Woolworths during the quarter. Remgro’s basket of local shares sold down and the holding company discount exceeded 20% during the quarter creating an attractive opportunity for long-term investors.

The Fund also added to its position in Woolworths as the share does not seem to price in the high-quality local food franchise at a 5.2% dividend yield and implies a substantial risk to their Australian subsidiary, David Jones.

We continue to monitor the extent to which long-run prospects are priced into assets and will adjust the portfolio accordingly.

Commentary contributed by Ruan Stander.

The first quarter proved to be a difficult one for absolute returns. The most significant detractors were the international investments and local equities. World markets fell 1% in dollars, the rand strengthened by 4% over the period and the FTSE/JSE All Share Index declined 6%. The positive contribution from fixed interest was insufficient to offset the equity declines.

The relatively modest market moves over the quarter belie the volatility many experienced during the period. Some investors were lulled into a false sense of security by the orderly uptrend of world markets from January 2016 to January 2018, a period over which the MSCI World Index rose 50%. The strong markets over the past two (in fact 10) years have made us increasingly nervous; we far prefer volatile and falling markets over calm and strongly rising ones. Don’t get me wrong, we don’t want our clients to lose money over any period, but the good thing about volatility and down markets is that they create opportunities for outsize returns. When markets fall value investors are able to buy companies that have been sold down to below their fair value - a very exciting prospect.

We are constantly searching for assets that will give our investors good real returns. The shares we bought in 2015 and 2016 performed pleasingly in 2017 and we were substantial net sellers of domestic equity in late 2017 and January 2018 as many domestically orientated companies reached and exceeded our estimate of their fair value. This was particularly true of the banks we bought during the very volatile Nene-gate period, when South Africa’s future looked very grim and investors priced shares accordingly. At the time, investors over-reacted on the downside by becoming excessively cautious. We are concerned that after the great news of Cyril Ramaphosa replacing Jacob Zuma and the positive changes at Eskom and government generally, investors are over-reacting by becoming too positive on South African assets. Investing is about comparing the price of an asset to its value. Value is subjective and inherently uncertain as it involves the future. Different investors use very different sets of assumptions to value assets. At the moment we think investors are using assumptions that may be overly positive and therefore they are overvaluing certain assets. If the future is not as rosy as these investors expect, the returns from the assets they value highly now will be disappointing. It is far better to invest in assets where expectations are very low, that way, when things turn out to be ''not that bad'' investors are surprised on the upside. We look for assets where expectations are low and our normal estimates exceed those priced in by the market.

The rand is trading at about fair value to the US dollar if one adjusts the historic rand/dollar exchange rate for both American and South African inflation. Looking at this data alone would indicate a neutral stance on the rand. We are a little more cautious than neutral for a few reasons. Despite very weak domestic demand, anaemic investment expenditure and favourable terms of trade at present, South Africa still has a current account deficit of 2.5% of GDP. The recent history of the rand (since 2002) has been somewhat distorted by the Chinese commodity boom, which has greatly assisted our exports.

We have used the opportunity provided by the current rand strength to increase the Fund’s international investments by 5% to 29.4%, in addition to the 2.3% invested in African bonds and equities. Given the generally high market valuations we have invested the additional 5% in hedged equity, corporate bonds and money market assets. We funded the 5% by selling South African shares and bonds.

Commentary contributed by Andrew Lapping

It has been an action-packed year on the market. Here are some things that stood out for us:

-Naspers, which is now 20% of the FTSE/JSE All Share Index (ALSI), started the year at R2 000 per share, traded all the way up to R4 100, and is currently R3 400. Only two of the top hundred companies have beaten Naspers: Kumba and Exxaro.
-Steinhoff started the year as a R300 billion company, and now has a smaller market cap than Italtile.
-Our government’s financial position continued to deteriorate, but sentiment towards local firms turned positive when Cyril Ramaphosa was elected as head of the ANC. Barclays went from R150 to nearly R200 in the four days following the national conference.
-The rand has strengthened by 10% against the US dollar since January 2017.
-The price of Bitcoin increased fourteen-fold.

We did not know who would win the ANC election. We do not have an edge in predicting this sort of thing, which is why we structure the portfolio for different outcomes. We also focus on buying undervalued shares, preferably shares under a cloud of negative sentiment and with lots of bad news priced in. This approach has worked well for us through numerous bubbles, crises, and upheavals. It is why we owned shares like Mr Price, Standard Bank, Foschini and Remgro - all of which benefitted from the change in sentiment after the ANC conference. We were substantial net sellers of equity in the fourth quarter given the price appreciation of some of our largest holdings. We reduced our British American Tobacco holding in November while we were substantial sellers of Standard Bank in the latter half of December. That said we did add to our Woolworths position and initiate a small position in Steinhoff. As of writing the Steinhoff purchase was a mistake and has detracted 0.4% of Fund.

There are a few things to be said:
1. We make many mistakes. Steinhoff was not the largest mistake in recent years. Not buying Kumba Iron Ore at R26 or Richemont at R80 were both way worse mistakes, to name just two.
2. There are different senses of the word ''mistake.'' We are not aware of any errors in our analysis, or process, only in how we weighed the upside versus the downside risks. These types of errors are always clear with the benefit of hindsight, never at the time!
3. The accounts of any business may be fraudulent. For some the probability of fraud is higher than for others. We do not take audited accounts at face value. We look for internal inconsistencies, pose questions to management, and evaluate the quality of the audit committee. We found plenty of cause for concern at Steinhoff. This did not lead us to blackball the share, but instead we put in place position limits and conservative valuation multiples. We only started investing when we thought the potential upside outweighed the risks.
4. For context, if you had owned a passive fund tracking the ALSI, your total loss would have been 2.4% for the year. This made Steinhoff the top contributor in 2017 to our performance relative to the market.
5. We don’t yet know the final outcome or magnitude of the fraud. It is possible that the share recovers some of its losses.

If we were only concerned about avoiding embarrassment, or if we tried to avoid all shares with downside risk, this would almost surely dent our long-term returns.

The Fund’s performance over the year was helped by positions in Standard Bank and Astral Foods, while it was hindered by positions in Sasol and Life Healthcare. Unfortunately, we did not find value in Richemont even when the share was below R90 in January 2017 and missed out on the share’s strong performance in 2017. Fortunately we could also not find value in Anglogold or Aspen, two large companies that underperformed. Strong returns from international markets, and outperformance by Orbis, contributed to the performance of the Fund in 2017.

Commentary contributed by Jacques Plaut