The global economy remains weak. The build-up of debt over a multi decade period culminated in the global financial crisis of 2008 and since that time the recovery has been lacklustre. This should have been expected as the aftermath of credit bubbles has been studied and well documented. This time is no different: debt levels need to be reduced and in so doing economic growth will suffer. Government spending can alleviate the pain on households or businesses by effecting a transfer of debt to the Government's balance sheet but as we are seeing in much of Europe this solution is no panacea. The best that can be hoped for in this environment is that policy makers get the right balance of debt reduction (and transfer), austerity and debt monetization to minimize the pain. The constraints of Euroland make it the most prone to a painful deleveraging while the flexibility of the US makes it the most likely to suffer the least pain. However, this is not written in stone and policy actions from this point remain important (and far from easy).

While in 2012 attention has been focused on the policy missteps of Euroland, 2013 has the potential to shape up as the year that US policy comes to the fore. With political partisanship running at extreme levels such that few policies get through both Congress and the White House monetary policy has been the only game in town. This may be exacerbated next year (depending on the outcome of the US election) as the US "fiscal cliff" approaches reality. Estimates for the size of the cliff vary between 4% and 5% of GDP. It is likely that some of this will be mitigated through extending some of the current tax reliefs (which will of course add to the US deficit) but some level of fiscal drag remains likely. With this backdrop, the Federal Reserve have certainly not disappointed in the verve with which they have tackled the issue with both zero interest rates as far as the eye can see and money printing in vast quantities. The latest intervention by the Fed was the widely anticipated QE under which the Fed will print up to $40bn per month to buy Mortgage Backed Securities and will continue this until the labour market improves substantially. Indeed if the labour market does not improve substantially over the coming months the Fed has committed itself to undertake more QE. It is clear the Fed has absolute confidence that QE works and it is simply a question of quantity: there is simply no doubt in the Chairman's mind even though we are now well into experimental territory. The theory is simple; QE should lower interest rates which will increase asset prices, which will increase consumption, which will increase employment. However, while QE has undoubtedly had an effect on asset prices the theoretical impact thereafter has been lacking. As Yogi Berra once said "In theory there is no difference between theory and practice. In practice there is."

Perhaps QE will prove more efficacious now that it is unlimited. While this could be the case in the short term, such monetary experiments in the past have often proved disastrous. We at Veritas are not macro economists and do not aim to predict the macro-economic environment in 5 years' time, however we should invest bearing in mind that a) equity markets have become an explicit instrument of policy b) The Fed are determined to prove that QE "works" and c) nobody knows today what the aftermath of so much money printing will be in the future. These factors need to be taken into account in any sensible investment strategy.

Despite all the alarming headlines about the Euroland crisis, slowing growth and huge deficits, equity markets have performed well so far this year, largely driven by cheap money and quantitative easing by policy makers. The broad MSCI World index is up 13.01% in the first 9 months in USD terms. With a concentrated, benchmark agnostic fund it should come as no surprise that the fund performance does not mirror the performance of a broad global index over a short time horizon. This is particularly the case during a period of money printing when it is usual for higher risk stocks to be the best performing. We continue to focus on the long run and remain acutely aware of the importance of capital preservation especially at times of heightened risks.

The first six months of 2012 have seen volatile markets with substantial rises and falls in countries, sectors and individual companies. However, the end result has been a modest rise in the global equity market (MSCI World) over the period despite substantial differences within that result. For example the US S&P500 is up 9.5% over the six months whereas the MSCI Europe (ex UK) was broadly flat for the period, gaining just 1.9% in US Dollar terms. Over a longer term perspective, global equity markets seem to be trading what perhaps can best be described as volatile, but sideways market with a total return since 1 January 2010 of 11.8%. Given the context of fair valuations, weak economic growth and policy intervention, this is perhaps not surprising. With a concentrated fund (34 positions at 30 June 2012) the performance of the strategy is unlikely to mirror an index performance.
The economic data emanating from all regions is weak. This is not surprising as we are still in the midst of a deleveraging cycle following the biggest credit boom of all time. This needs time to work itself through the system and during that (multi- year) period, high and sustainable economic growth will not be possible. If policy makers do circumvent this deleveraging through zero interest rates and other measures it will simply be sowing the seeds of the next (even larger) credit bubble and bust. It seems clear to most (outside central bankers) that a credit bubble cannot be solved by encouraging more borrowing and spending. In the meantime, equity markets are somewhat of a lottery - fundamentally they do not appear particularly attractive with values at around fair levels, economic growth on the wane, earnings growth likely to be lacklustre (at best) and asymmetric risks on the horizon (in particular the possible collapse of the Euro). However, in the short-term policy makers’ actions will dictate the direction of markets.

Forecasting the actions of policy makers is nigh on impossible and certainly impossible with any degree of consistency. At Veritas we do not aim to make such forecasts but instead take a longer term view using valuation as our guide as to when to invest in and when to sell individual high quality companies. We do understand that we do not invest in a vacuum and consequently we assess the environment in which we are investing, often describing our views in themes that help us in navigating the market context. In this regard, we are currently working on a new contextual theme of '2020 Rising Tide Industry Winners." With the current flip flopping nature of markets between risk on and risk off, this theme forces our focus away from the near term volatility of markets and out to 2020. Using the theme we are identifying specific industry, sector or sub-sector characteristics that will become increasingly important over the next eight years (the rising tide). We are then using this work to identify for further research and analysis those companies that have the requisite characteristics.
June 2012

Global equity markets enjoyed a strong first quarter in 2012. In fact, many individual markets posted their best first quarter in a decade or more. Evidencing the breadth of this strong performance, a broad global equity index such as the MSCI World returned 11.5% in the quarter. The difference from December could not be more marked. Investors are back in risk taking mood and this has been nowhere more evident than in the returns generated in equity markets.

What has led to such a volte face in sentiment by investors between December and March? There would seem to be two major "causes":
1. The actions of the ECB through its Long-Term Refinancing Operation (LTRO) in which the ECB offered unlimited quantities of cheap money for three years to Euro area banks (with the requisite "collateral"). This amounted to over €1,000,000,000,000 (1 trillion) in two tranches.
2. The modest improvement in economic data emanating from the US.

The LTRO has certainly had a beneficial impact by ensuring euro area banks had plentiful access to liquidity (thereby pushing any liquidity issues into the future), which consequently had an extremely positive impact on investor sentiment. However, given the subsequent rise in risk assets (especially equities) a note of caution is now warranted. While not taking the same form as the Quantitative Easing (QE) undertaken by the Federal Reserve in 2008/9 and 2010, the impact of such large scale money printing by the ECB has been in many ways akin to QE.

While it is difficult to assess what direct impact money printing in the form of either QE or the LTRO has on an underlying economy, the graph above exhibits what effect it has had on risk markets. This is not to dismiss money printing's usefulness - in late December there were rumours that European banks could not fund themselves and some of the peripheral European countries were unable to economically fund themselves. The LTRO has certainly helped both of these issues (at least temporarily). However, staving off the bankruptcy of some European banks and sovereign nations is not the same as creating solutions to the underlying problems that still persist. The understandable sigh of relief in equity markets has morphed into a misplaced optimism that the underlying problems facing a number of European countries and their respective banks have been solved. This is not the case as the patient still suffers from the disease despite the alleviation of the symptoms.

Our view is that the global economy is not out of the woods yet. Debt levels remain abnormally high and can only persist with equally abnormally low interest rates. In the event of sustained inflation, central banks would be faced with a difficult choice: Raise rates and create a recession or let inflation take hold. Furthermore, euro-land is facing dire problems, constrained by a monetary union that does not suit all its participants equally. This situation too is unsustainable. The US is in better shape, but is still in the emergency room with zero interest rates and fiscal deficits as far as the eye can see supporting the modest growth that is being generated. At the same time, the world's growth engine, China, is slowing down. Whether this slow down can be crafted into a "soft landing" remains to be seen.

Turning to the markets, based on the valuations of the companies that we analyse, equity markets seem modestly overvalued at 31 March. Even allowing for a more positive outturn than our conservative figures suggest, equity markets do not appear cheap. However, with the uncertainties that exist today (many of which have binary outcomes) perhaps equity markets should be demonstrably cheap to compensate?

Investment results:

After the volatility over the first three quarters of 2011, the fourth quarter also displayed considerable volatility in equity markets and currencies. Overall, the tone was positive and markets delivered strong positive Q4 returns. The Nedgroup Investments Global Equity Fund outpaced the market, building on our performance over the previous three quarters, to deliver a return of 1.1% for the full year. This can be compared positively with the MSCI World return for the year of -5.5% (USD, total return), but less favourably against G7 inflation at 2.8%. The depreciation of the Rand over the year resulted in the feeder fund producing a return of 20.5% for 2011.

Quarterly attribution:

The US dollar portfolio marginally underperformed the MSCI World Index in the last quarter, returning 6.5% versus 7.6%. Sectorially, stock selection in financials added to relative results. Stock selection in IT, consumer staples, telecoms and utilities was also positive. On a regional basis, the portfolio's underweight position to Japan and stock selection in North America benefited the portfolio.

The key point to remember is that the relative sector and geographical performance is driven by the 36 stocks currently held. The largest relative contributor to results was Varian Medical Systems. Varian Medical Systems had been unfairly punished by the market in Q3 as a result of slightly slower order growth. Consequently as orders were reported above expectation in Q4 the shares recovered their lost ground and performed well.

The largest detractor to results on a relative basis over the quarter was Capita. Continued concerns over the impact of austerity measures by the UK Government and the impact of these on Capita continued to weigh on the shares. Despite positive contract announcements, which bode well for 2012 growth, guidance for Q4 2011 growth was a little below market expectations.

Implications for the portfolio:

While the current economic malaise affecting developed economies has been beneficial for our dependable compounders, it is becoming increasingly difficult to find such companies at attractive valuations. The past two years uncertainty has led many investors to want the dependability offered by these companies and consequently valuations now reflect that. While we still own a number of these dependable compounders that we believe will deliver attractive returns over our investment horizon, there are few we would buy more of today. In fact, in the three months to the end of 2011, we sold our sizeable position in US pharmaceutical company Merck on valuation grounds following strong share price performance. As a consequence, we are now working to identify and analyse more economically sensitive companies that we consider to be industry leaders in their respective areas. As other investors have sought "defensive" companies over the past year (benefiting many of our holdings), some of the more cyclical areas have been ignored leading to some "quality" cyclicals now appearing to offer the prospect of attractive returns over our investment horizon. We are currently in the process of analysing these in more detail, but believe that holding some more economically sensitive positions would help hedge the portfolio in the event of a reflationary cycle taking hold. Given the possibility of this outcome, combined with the dangers of being too concentrated on "one side of the boat" we believe a more balanced portfolio at this juncture is appropriate and are working to this aim.