The Balanced Fund’s 15% price decline over the quarter was clearly disappointing; we strive for consistent real returns. The past quarter was an extremely unusual one, with global asset prices collapsing as economic turmoil resulting from COVID-19 swept across the world. March’s price movements have dragged down not just the short-term returns for South African assets, but also long-term returns. The five-year return for the FTSE/JSE All Share Index (ALSI) is now negative 0.1%; bonds have done better, but the 5.2% annual return of the JSE All Bond Index is equal to the inflation rate over five years.

These returns could lead people to draw very different conclusions. The first reaction could be to give up on equity investments and conclude that the best returns are to be had in money market funds. Alternatively, the conclusion may be that this is a great time to make equity and bond investments as the next five years are unlikely to be like the last. Historically, investors who arrived at the second conclusion have come out on top.

The most important driver of asset price returns is the price you pay. You are paying a great deal less today for South African assets than at any time in the past decade. These low prices should result in excellent returns over the next five years. In March 2015, the South African 10-year bond yielded 7.7%, compared to today’s 11.3%. Although the South African fiscal situation has deteriorated, and the current crisis means our government budget will be in a deep deficit in the near term, some things have improved: In 2015 the country was led by Jacob Zuma. Buying a government bond with an 11.3% yield offers a far greater margin of safety and return potential than buying one at 7.7%. We have been accumulating government bonds for the Fund and increasing the duration of the bond exposure as yields have sold off. The 11.3% available on medium-duration bonds compares to the 5.6% available in money market assets.

The Fund’s 41% South African share exposure is lower than December’s 47%. However, we actually bought 3% of Fund in equities over the quarter. The underperformance of equities relative to other assets caused the share exposure to fall. We think there is excellent value to be had in South African shares. The ALSI dividend yield is 4.9% and peaked at 5.6% earlier in March; this compares to the previous 25-year yield high of 5.4% in March 2009, which marked the equity low point during the global financial crisis (GFC). If Naspers - which (with Prosus) accounts for 23% of the ALSI and yields only 0.29% - is stripped out of the calculation, the market yields 6.3%. Historically, buying equities at these valuations resulted in excellent returns. Many companies will reduce or scrap their dividend pay-outs over the next year as the global recession bites, but the dividend yield is a strong indication of value.
The largest detractors from our performance over the past quarter were Sasol, Glencore and banking shares. We wrote about Sasol in a recent article on our website (see ''Coronavirus: Taking stock of the state of the markets''); here I will focus on Glencore and Nedbank, one of the banks we have been buying.

Glencore has been a consistent detractor since we started buying during the second half of 2018. Most recently, the share has fallen from R46 in February to R27 today; when measured in dollars, this decline is even sharper: US$3.00 to US$1.50. Demand for, and thus the prices of, many industrial commodities collapsed as the COVID-19 crisis gripped the world. For sure this shock has affected Glencore’s near-term prospects, with the copper price down 20% year to date and zinc down 18%. These prices may fall further as the situation develops. However, our estimates of long-term metal and coal prices, and therefore Glencore’s normal cash flows, are unchanged. We think Glencore should generate USc33 of cash flow per share through the cycle. On our forecasts, Glencore should reward investors with 25%+ dollar returns per year over a four-year investment horizon.

Banking shares have understandably borne the brunt of the recent sell-off. Banks are leveraged to the economic cycle and a severe downturn will impact them harshly: This is our base case. Nedbank trades on three times historic earnings and 0.4 times book value. During the GFC, Nedbank traded down to 0.9 times book value. The share is clearly priced for significant distress. Do we expect this recession will be worse than the GFC? Yes, substantially. However, we think the large South African banks will survive. Nedbank’s 10-year average price-to-book value is 1.5. If Nedbank just returns to book value, and that value is unchanged, the share will appreciate 150%.

South African assets have sharply underperformed global assets, despite global equities being very weak. We have taken this opportunity to repatriate funds from offshore to invest in South African assets. Additionally, we think the rand at R18/US$ is undervalued. While we have sold some offshore assets to rebalance the portfolio, the Orbis team is very excited about the assets we own offshore and expect strong returns from these investments.

The patience of even long-term investors is being tested by the poor South African equity and bond returns. The incredible uncertainty and negative sentiment around the global economic outlook generally, and the South African economy in particular, does not help. At times like these, retreating to the seeming-stability of cash is very tempting. Unfortunately, the comfort of cash does not protect wealth over long periods of time. When it is hardest to stick with your portfolio of assets, doing just that is most important for long-term growth. Over the quarter we bought government bonds, Nedbank and Standard Bank and sold British American Tobacco, Naspers and Netcare.

The Balanced Fund returned 6.7% for 2019, comprising 2.9% from domestic shares, 2.3% from foreign assets, 0.9% from domestic bonds and 0.6% from commodities. The Africa funds contributed 0% to the return for the year.

A braai over the weekend inevitably reminds us of the significant challenges our country faces – there is lots of negative news to talk about. An unemployment rate of 29%, combined with youth unemployment of 58%, means that most citizens are still not being included in the economy and cannot help the government to raise further tax revenue to address high and increasing debt levels (61% of GDP, currently). Our government bailout of Eskom alone will add R50bn to debt (1% of GDP) in 2020. Even an optimist would struggle to see a financial way out for the public monopoly as a result of poorly maintained infrastructure and new stations that may never operate economically as a result of significant design flaws.

The good news for investors is that asset prices compensate investors for risks, and various options are available to mitigate bad outcomes for the country. Government bonds may be seen as risky given the backdrop mentioned above, but the yield on 10-year government bonds at 9% is 4.1% higher than the average consumer inflation rate over the past five years. This has only been the case 23% of the time since 1974. Our stock market is also unusually cheap relative to inflation, with a dividend yield of 3.6%, only 1.3% below inflation. The average of the dividend yield on stocks and yield on 10-year bonds is 1.4% higher than inflation. This has only been true 3% of the time since 1974. What is also comforting is that subsequent five-year returns of stocks and bonds averaged 14% a year ahead of inflation when they were this cheap or cheaper, since pessimism on earnings growth does not always materialise and investors typically enjoy a re-rating on top of the above average yield when assets are this cheap.

Having said this, given the risks, one would be wise to look for opportunities that protect capital in a bad outcome for the country. Money market instruments carry low risk of default and capital loss in a scenario where inflation increases. These make up 3.3% of the Fund and yield 7.2%, currently. Bonds make up 9.5% of the Fund, yield 9.2% on average and are skewed towards corporates. Cheaply priced domestic shares that don’t depend on South Africa – including top 10 shares like Naspers, British American Tobacco and Glencore – are another option that we are fortunate to have. The average dividend yield of these three shares is 4.5% and there is a strong case to be made that this basket of companies will grow faster than the South African economy in most scenarios through a combination of secular growth (Naspers), organic price growth of strong brands (British American Tobacco) and strong commodity fundamentals combined with share buybacks at low prices (Glencore).

Owning domestic shares that trade at a meaningful discount to fair value helps to protect against a bad outcome as companies can pass on inflation to consumers. Top 10 shares like Standard Bank, Old Mutual, Investec and Woolworths trade at an average dividend yield of 5.3% and at a discount to our estimate of intrinsic value. In a scenario where the economy starts growing again, these shares would offer further upside. Finally, a diversified portfolio of global shares and fixed income securities selected by our offshore partner, Orbis, provides protection in a scenario where the rand weakens materially.

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

Commentary contributed by Ruan Stander 31 December 2019 Minimum