The FTSE/JSE All Share Index (ALSI) was down 4.6% for the quarter. The market has continued to be narrow, with a few big names outperforming, along with precious metal shares. The Fund has not owned, or been underweight, a number of these shares, which has contributed to our recent underperformance.

Despite a flattish market overall, a glance at a table of share price movements highlights that many local shares have been depressed for some time. Their performance reflects the mood of the country, given the local economic and political environment. This sombre mood has been exacerbated by some quite public strategic and governance mishaps at various companies.

Fortunately, history shows that there is not a strong correlation between economic growth and equity returns. What is more relevant for future returns is the price one pays for an asset today. We are reminded of a quote by investment writer, Jim Grant, who said: “For the investor as opposed to the statesman, macroeconomic growth places a distant third to price and value on the scale of financial virtues.” We aim to take advantage of this disparity in price movements.

That sounds logical, but it is understandably hard for clients to live through a grinding sideways market with no end in sight, and where income funds are outperforming balanced and equity funds. This experience differs from the shorter, sharp declines of 2008 and 2016, from which the market recovered relatively quickly to its previous highs.

We don’t believe that many of the assets the Fund owns are pricing in a significantly better future. Locally, real interest rates are already high, and many formerly safe shares have halved in price, if not more. In simple terms, we are closer to low than high.

These low expectations are slowly starting to reveal themselves. When Woolworths and British American Tobacco reported results in line with expectations, their share prices rallied strongly on the day. The well-known risks for each company had not changed, but the valuations had just got too low.

The investment team is writing more reports on companies due to share price declines than it has for some time. This is positive, as not only does it mean valuations are more attractive, but there is also a greater number of ideas competing for each rand of capital to be deployed.

Our colleagues at our offshore partner, Orbis, also believe they are finding good relative value when comparing their shares to those they don’t own.

The standout event of the quarter was the listing of international internet company, Prosus, which owns roughly 24% of Naspers’ internet and e-commerce assets, on the Euronext in Amsterdam (commentary on the listing is available via the News & Insights section on our website). Naspers is the biggest company in our market, yet continues to trade at a large discount to its underlying holdings. Time will tell whether the listing will help reduce this discount – and it may well just be the first step on a journey to do so.

During the quarter, the Fund bought Glencore and FirstRand and sold Prosus to buy Naspers.

Commentary contributed by Duncan Artus

The Balanced Fund returned -2.6% over the second quarter, underperforming its benchmark’s 0.4% return. Overweight positions in British American Tobacco, Sasol (discussed in the Allan Gray Equity Fund factsheet for this quarter) and Glencore accounted for the majority of the underperformance relative to the market. The 3% strengthening of the rand against the dollar also negatively impacted the Fund’s -1% offshore return.

The second quarter was good for investors that owned resource shares, with Anglo American and BHP Billiton gaining 4% as a result of an almost 40% spike in the iron ore price over this period. These two shares contributed to 0.7% of the ALSI’s performance. Unfortunately, the Fund was underweight these shares - on top of this, a significant proportion of our resource exposure underperformed. Investing in resource companies can be a wild ride for investors since almost all of the variables required to value a company are in flux: Commodity prices respond to short-term changes in supply and demand, natural disasters or labour commotions can disrupt mines, and company management needs to respond to all these factors by allocating capital. It does not help that the geology of a mine is hard to understand from the outside, and this can have a significant impact on unit costs.

Our approach to valuing resource companies is to focus on long-term expectations for commodity prices, normalised unit costs, as well as the skill of management in deploying the cash generated. This approach has led us to own multinational miner Glencore and pulp and paper producer Sappi, and avoid BHP Billiton and Anglo American. This is because a normal commodity price assumption leads to a more attractive free cash flow yield for Glencore and Sappi and at the margin, capital at these companies is being deployed sensibly.

Short-term changes in commodity prices have, however, gone in the opposite direction to our long-term expectations, with weaker coal/copper/paper prices hurting Glencore and Sappi, while a stronger iron ore price, as a result of the January tailings dam failure in Brazil and cyclones in Australia between September 2018 and May 2019, helped Anglo American and BHP Billiton. The iron ore price is up to US$118 per tonne relative to our normal estimate of US$55. Risks to an iron ore price from this level include increased supply (the return on a new iron ore mine is very attractive), capacity coming back in Brazil and Australia, and a decrease in demand from China (steel demand seems high compared to other countries, and iron ore is likely to be substituted by scrap steel over time). Glencore and Sappi appear more attractive in our view considering current valuations and that their commodity prices are lower than our long-term assumptions.

During the quarter, we purchased Glencore and sold Naspers.

Commentary contributed by Ruan Stander

The poor sentiment towards equity markets at the end of 2018 reversed sharply in the first quarter of 2019, with the FTSE/JSE All Share Index appreciating 8% and the MSCI World Index 12%. The 65% net share exposure held at the start of the quarter allowed the Fund to benefit from these equity market movements.

Regulation 28 of the Pension Funds Act limits the Balanced Fund’s share exposure to a maximum of 75%. The Fund’s share exposure indicates where we see the risk/return profile of equities currently: a moderately favourable balance. The relatively weak returns from JSE equities over the past four years have allowed many companies to grow into their valuations. The median price-toearnings (PE) multiple of the top 100 companies has fallen from 17.0 in 2015 to 13.6 today. This is a rough indication of an improved opportunity set and aligns with our bottom-up research where we are finding more companies trading at or below our estimates of fair value. Broadly, we think the JSE is trading at about fair value. Using history as a guide, these valuations suggest investors can expect returns over the next five years of about 4% above inflation - not a dripping roast, but a good opportunity for those with a long-term horizon. We look to add to the underlying market return through careful stock selection and alpha generation.

The year-to-date move in the JSE was a story of very distinct parts: The resources sector appreciated 18%, driven by Anglo American, BHP Billiton (BHP) and the platinum sector, while the weak economy and deteriorating sentiment towards South Africa caused the retail sector to fall 14%. In between, the banks registered marginal declines. We are currently focusing the bulk of our research efforts on the domestic cyclical sector. To date, we have not bought large positions, outside Woolworths, as the valuations are not yet exceptional given the risks. In a similar vein, the property sector has had a difficult 18 months, returning a negative 18% from its peak. Despite the lower valuations, we have not bought any large positions as the excesses of a 20-year bull market are not undone in just over a year.

Unfortunately, we held no Anglo American and only a small position in BHP, missing the stellar returns of the past year. Iron ore accounts for the bulk of these two companies’ earnings, a commodity we have been wrongly cautious about for some time. Brazilian miner Vale’s recent tailings dam failure has driven the iron ore price higher still, as it has been forced to cut production by approximately 40 million tonnes. We reassess our positions constantly but, based on our long-term commodity price assumptions, we don’t find value in Anglo or BHP. Glencore, a diversified mining company, is a top 10 holding for the Fund. However, given Glencore’s nil exposure to iron ore, it has been a relative underperformer in the mining sector.

Orbis has had a difficult start to 2019 with its funds generally lagging the sharp recovery in international markets. Half of the Allan Gray Balanced Fund’s international exposure (excluding Africa ex-SA) is invested in the Orbis Global Balanced Fund, while the remainder is in a mix of the Orbis Equity and Optimal Funds. The Orbis Funds are generally underweight the US equity market, which has detracted from the relative performance. The US market has driven global equity returns over the past 10 years and valuations are looking very stretched. Historically, if you invested in the US market at these valuations, you lost money over a five-year time horizon. This is confirmed by Orbis’ bottom-up research.

When managing the Allan Gray Balanced Fund, we continuously search for undervalued assets and strive to avoid overvalued assets. These are particularly exciting times as the nervousness around South Africa could grant us the opportunity to buy some very undervalued assets. We are working to assess these opportunities. The Fund’s largest purchases were MultiChoice and British American Tobacco, while the most significant sales in the quarter were Sasol and Nedbank.

Commentary contributed by Andrew Lapping

It was another eventful year on the market. The FTSE/JSE All Share Index (ALSI) was down 9%, making it one of the worst years ever. What made 2018 unique, though, is that nothing did well. Bonds and cash gave mediocre returns, and property did even worse than equities. Contrast this with 2008 (the worst year for stocks on record), when the ALSI was down 23%, but bonds gave you 17% and gold gave you 45%. The average return across the four major domestic asset classes - equities, bonds, cash, and property - has never been worse than in 2018, at least according to our records, which go back to 1976. Internationally, the picture is similar. No asset class delivered good returns in 2018. More than half the shares in the S&P500 have fallen 20%, or more, from their peak. Some other emerging markets have done much worse than South Africa: shares in Turkey are down 43%, and shares in Argentina are down 50% (both measured in US dollars). Here are some things that stood out for us in 2018:

-The rand weakened by 16% against the US dollar. Investors seem to have lost confidence in South Africa’s turnaround story. Eskom is proving difficult to fix, and public finances more broadly still look tenuous.
-Companies with lots of debt have been punished by the market. These include Aspen, Mediclinic, Intu Properties, MTN, AB InBev, and British American Tobacco (BAT) - the last being one of our top 10 holdings.
-The property sector had its worst year ever.
- Investors became increasingly jittery about accounting fraud. At various times during the year, Aspen, Resilient, Nepi Rockcastle, and Capitec were in focus. There has been little progress in the Steinhoff case, but the fraud does seem to have been worse than we feared.
-BAT, MTN, and Glencore all faced regulatory problems.
-Commodity producers have done well, especially Anglo American Platinum (Angloplats).
-The price of bitcoin is down 73%.

The return of the Allan Gray Balanced Fund was -3% for the year, roughly similar to the return of the average South African balanced fund. If we could have foreseen what markets would do in 2018, we would have had lower equity exposure, or put everything in Angloplats. But of course no-one knows in advance how markets will do. We are confident that having a sizeable proportion of your money in cheap shares is a good idea. We don’t know what the market will do in 2019, but we do know that the shares in the portfolio - Naspers, Sasol, BAT, Standard Bank, etc - are currently trading at attractive valuations, which is normally a good sign for long-term returns.

The performance of the Fund was helped by being underweight Steinhoff and by being overweight Sasol. Performance would have been better if we had owned less BAT, and more BHP and Anglo American. In aggregate, the domestic shares in the fund outperformed the ALSI. The weak rand boosted foreign returns, but these were offset by Orbis’ underperformance.

During the quarter we bought BAT and Glencore, and we sold Old Mutual and Anglo American.

Commentary contributed by Jacques Plaut