Coronation Resources comment - Sep 11 - Fund Manager Comment11 Nov 2011
The last quarter has indeed been a difficult one for the fund, adversely impacting both quarterly and rolling twelve-month performance. The fund returned -10.9% for the quarter against the benchmark- of -10.0%. For the year to September, the fund returned 3.4% against the benchmark return of 1.6%. Those who have followed the fund for some time are aware of the fact that we encourage investors to evaluate us over the long term, whether short-term performance is good or bad. We remain ahead of the benchmark over three, five and 10 years.
The greatest detractor from quarterly performance was our underweight position in gold equities. The gold weighting in the Resources Index is approximately 17.3% compared to 5.4% in the fund. Our overweight positions in Northam, Sappi, Pallinghurst Resources and ArcelorMittal also detracted from performance. Our underweight position in Anglo American and BHP Billiton contributed to performance, as did our overweight positions in Optimum Coal and Tongaat. Our offshore equity holdings detracted from performance despite the weakening rand, although this was partially offset by favourable contributions from our offshore commodity holdings.
During the quarter we took advantage of lower price levels to add to some of our existing holdings which have been indiscriminately soldoff. We also took profits in positions that have worked well for us. The events that unfolded during the third quarter of 2011, like in 2008, threatened to destabilise financial markets around the world. Ongoing uncertainty about the sovereign debt crisis in Europe was overshadowed during August by the bipartisan stand-off in the US regarding the lifting of the country's debt ceiling, culminating in the downgrading of US government debt to AA. In the meantime, anaemic economic growth and increasingly worrying numbers out of China scared the few remaining bulls out of equity markets by the end of the quarter. Whilst the US debt downgrade may have been the final trigger for the August equity sell-off, the solvency of the US government does not appear to be the primary concern of markets, as evidenced by the sharp fall in US Treasury yields following the rating change. Currencies became victims of large capital flows, and units like the South African rand and Brazilian real respectively lost 20% and 16% of their value against the US dollar over the quarter. Commodities also fell foul of this aggressive move to reduce risk in all portfolios, with copper down over 23%, platinum down nearly 12% and oil down over 5%. Predictably the gold price rose by more than 8% over the quarter. The fear expressed by global investors, retail and institutional alike, was almost tangible, leading to the VIX Index (a measure of market expectations of near-term volatility as expressed by S&P stock index option prices) surpassing levels achieved after the collapse of Lehman Brothers in 2008. In fact, the index was at 48.0 after the debt downgrade, compared to 31.7 after Lehmans. The index ended the quarter at 37.7, highlighting the fear that the situation in 2011 will worsen way beyond what was experienced in 2008. Whilst it is understandable that investors are fleeing risky assets during times like these, we disagree with the view that the current scenario is comparable to that of 2008. Corporate balance sheets and levels of profitability are significantly stronger than then, mainly as a result of decisive actions taken by strong management teams at the time of the 2008 crisis. Considerable deleveraging has already taken place in the financial sector, and recapitalisations have strengthened some players' balance sheets. More will be required as events unfold. In addition authorities are standing by to provide help in every conceivable way to reduce risk in the financial system. This does not mean that we can avoid the inevitable hangover in the form of significantly lower economic growth after the credit binge of the noughties, it just means, in our opinion, that perspective should be maintained to spot the opportunities during this indiscriminate sell-off of perceived risky assets.
The 'fear trade' or 'risk-off' environment resulted in a rising gold price and weakening rand. Gold equities were the clear beneficiary in this environment, with the FTSE/JSE Gold Index increasing by 19.5% during the quarter. Based on current spot gold prices we understand why the market has become excited about the near-term earnings prospects for gold equities. In our opinion, we don't believe current gold prices are sustainable neither do equity valuations for the gold majors present any margin of safety. Based on our assessment of normalised gold prices and exchange rates we believe the gold majors are trading at approximately 20x our assessment of normalised earnings, which we do not find attractive for businesses with such poor longer-term fundamentals and historical track record of shareholder wealth destruction. We do however have some gold exposure in the fund through our position in Pan African Resources, a small cap gold company. Pan African trades at 9x our assessment of normalised earnings compared to 20x for the gold majors on the same normalised gold price and currency assumptions. Pan African also trades on a dividend yield of 6%, whereas gold majors are generally trading at dividend yields below 2%. Our negative view on gold is very different to many of our competitors and market participants.
Some of the reasons we remain cautious despite favourable near-term prospects include:
-The current gold bull market is already more than a decade old with prices almost 8x higher than levels achieved in 2000 and almost 3x above the real historical average (1973-2011) of gold.
-We have no competitive advantage in forecasting the near-term gold price or exchange rate. Although we agree with many of the bullish arguments for gold, we believe these have to a large extent already been reflected in the spot price of gold. Many of my friends and family have in the last year either spoken to me about the gold price or told me about why gold is such a good investment. I always enjoy discussing the markets, however am concerned when people I know very well and who generally have no interest in or knowledge of financial markets can eloquently articulate the investment case for gold. Almost daily the media has some piece on gold and many people believe gold has become a one-way bet in the current environment. I have noticed many similarities to the discussions I heard in early 2008 on reasons why commodity prices could only go higher.
-Gold equities have historically been very poor investments and have generally failed to deliver a return on capital above the weighted average cost of capital. Some of the reasons for poor historic returns include poor capital allocation decisions and failing to benefit from the rising gold price due to declining grades, increasing costs and capital expenditure. The historical free cash flow conversion for the gold sector has been almost non-existent, which highlights the poor quality of historic accounting earnings.
-Some argue that gold equities have underperformed the gold price, therefore present a margin of safety. We do not believe that underperformance alone warrants an investment case. We are less fixated about price and more concerned about the value of the business, which is based on the present value of future cash flows. Longer term we are concerned that the prospects for future cash flows might not be as attractive as implied by current spot gold prices.
-Near-term ratings look very low compared to history, which might be attractive to some investors. We are however concerned about the sustainability of earnings implied by spot prices. We also believe historical ratings for gold stocks were clearly not reflective of business fundamentals and we could never justify why the market was prepared to value them at 20-30x earnings or 2-3x price-to-NAV. The closest comparison I can think of for illustrative purposes is the 2000 technology boom. Technology shares were trading at 100x earnings multiples, which with hindsight was clearly folly. As the bubble started bursting and they fell to 50x earnings they were no more expensive than they were at 100x earnings. Current best-in class technology shares in the US trade at 5-10x earnings, which illustrates the danger of relying on historical ratings. When valuing businesses we apply ratings to our assessment of normalised earnings based on the fundamentals of the business and assessment of quality of the business relative to other businesses in the market.
Globally we continue to face great uncertainty. You have entrusted us with your capital, which is a responsibility we do not take lightly. Based on our assessment of long-term valuations we are excited about the position of the fund and specific opportunities that have presented themselves within the resources sector. When building your portfolio, we strive to ignore the constant noise in the market and identify undervalued and mispriced companies based on long-term valuations. History has taught us that our ability to forecast the immediate future is limited. However, despite short-term market uncertainty, we will continue to strive to deliver superior returns relative to the benchmark over the long term.
Portfolio managers
Henk Groenewald and Duane Cable
Coronation Resources comment - Jun 11 - Fund Manager Comment18 Aug 2011
For the quarter, the Resources Index delivered a return of -5.7% as concerns on global and Chinese growth intensified. The other two major South African market sectors - financial and industrial shares - delivered positive returns. The developed world continued to experience an economic recovery, however, at a very pedestrian pace. The quarter-end also coincided with the conclusion of QE2, with a lot of uncertainty around the future impact of lower liquidity on economies and asset markets. While a default has so far been avoided in the European periphery, the debt crisis in Europe is still far from resolved and remains a major risk to investor sentiment.
The economic powerhouses of emerging markets and specifically China continue to outgrow the developed world. China's balance sheet looks very healthy and hence flexibility around monetary policy is much greater than their developed peers. Since October 2010, they have been using this flexibility to tighten policy to combat inflation and remove some of the liquidity that smoothed China through the financial crisis in 2009. The engineered slowdown weighed on commodity prices and our domestic resource shares. In this environment the fund returned -4.5% (after all fees). The fund is measured against the mean of its peer funds, which returned -4.9%. Since the start of the year, the fund has managed to stay in positive territory (+0.5%). The 12-month return of 26.7% is pleasing (helped by strong markets during the final four months of 2010) and ahead of the mean of our peers (24.5%). More importantly, the longer-term annualised returns over the three- and five-year periods are also ahead of our average competitor.
For the quarter, the major drivers of the fund's performance were holdings in more defensive companies like Mondi, Pan African Resources, AECI and Omnia. Anglo American, the fund's largest holding slightly outperformed the index. Sasol, however, lagged the index with a -8.3% return and its weighting as the second largest holding in the fund hurt our absolute performance. We remain convinced of the Sasol investment case and believe that investors can expect satisfactory long-term returns from current levels. While Sasol's GTL technology is still relatively immature, the market places no value on the potential and investors are effectively participating in any potential upside for free. While the economics of this technology are by no means certain, we believe the risk-return trade-off is in your favour.
During the quarter, we sold out of our Palladium ETF that has performed exceptionally well. We added natural gas and rhodium ETFs. Both commodities trade at below what we consider normal, or long-term, prices. We cannot predict when they will increase, but we believe the downside is limited from here and are happy to wait. Direct commodity exposure through ETFs, now make up 5% of the fund.
The emotional debate around the nationalisation of SA's mines is certainly increasing uncertainty in the sector. Global investors have taken note and many will have nothing to do with South African companies until the debate is concluded. We certainly hope sense will prevail - firstly nationalisation has almost always ended in terrible outcomes for countries that attempted this (for example Africa in the early 1970's) and secondly we do not believe nationalisation will in any way help address the issues (unemployment and income inequality) that has given rise to the debate.
Portfolio managers
Henk Groenewald and Duane Cable
Coronation Resources comment - Mar 11 - Fund Manager Comment13 May 2011
'At the core of analytical edge is an ability to systematically distinguish between fundamentals and expectations. Fundamentals are a well thought out distribution of outcomes and expectations of what is priced into an asset. A powerful metaphor is the racetrack. The fundamentals are how fast a given horse will run and the expectations are the odds on the tote board. As any serious handicapper knows, you make money only by finding a mispricing between the performance of the horse and the odds. There are no good or bad horses, just correctly or incorrectly priced ones.' Michael Mauboussin, Legg Mason
The fund returned 5.4% for the quarter against the benchmark return of 5.3%. For the year to March, the fund returned 21.8% against the benchmark's 16.7%.
The greatest contributors to quarterly performance were our overweight positions in Mondi, Gazprom and Sasol, as well as underweight positions in Impala Platinum and Evraz Highveld Steel and Vanadium. Our underweight position in Kumba Iron Ore and Harmony detracted from performance, as did our overweight position in Zimplats Holdings.
During the quarter, we took advantage of lower price levels to add to some of our existing holdings, primarily Anglo American, BHP Billiton, Implats and the Aluminium ETF. We have taken some profits in positions that have worked well for us, primarily Exxaro and Metorex. We had sold out of our position in Evraz early in the quarter as we believed that downside risks were not being appropriately priced by the market. The timing of our sale proved to be fortuitous and unit holders were not exposed to the 26% decline in the share price during March.
The past three months has been very interesting for global markets. We have experienced an earthquake and tsunami in Japan, continued political unrest in the Middle East and North Africa and Zimbabwean president, Robert Mugabe pushing ahead with the controversial Indigenisation and Economic Empowerment Act (The Act). The newsflow around Zimbabwe has been very negative for the share prices of Implats and Zimplats, both large holdings in the fund.
Zimplats is a world class asset and one of the lowest cost producers of platinum group metals (PGM) in the world. Its reserve base is unrivaled and it is very clear to us that had this asset been located in South Africa and not Zimbabwe, it would be trading at multiples of its current share price. The Act was originally gazetted on March 7, 2008 and signed into law on April 17, 2008. The Act provided for all companies operating in Zimbabwe to arrange for 51% of their shares or interests therein to be owned by indigenous Zimbabweans. Implats (which owns 87% of Zimplats) has made numerous concessions to government over the past few years, including the surrendering of land and investment in social development projects, in return for empowerment credits. The agreement was that these credits could be offset against the 51% requirement. The concessions and a potential equity empowerment deal have already been factored into our valuation. So what has changed over the last few weeks?
More recently new details specific to the mining sector were published, largely confirming the principles of the Act. Firstly, the timing for implementation has been significantly reduced. Secondly, no mention has been made of government honouring existing agreements made with companies to use empowerment credits to offset against the 51% requirement. Lastly, the value of shares to be disposed will be calculated based on a valuation agreed between government and the company, which potentially could be very subjective. This news was not favourably received by the market. Market participants feared that government would not honour existing agreements and that companies could potentially lose 51% of their assets for zero value or even speculated that they might lose 100% for zero value. Although one cannot dismiss these as possible scenarios, we would argue that based on a balance of probabilities, the odds are in favour of those investors who are prepared to take a longer-term view.
It is important to separate fundamentals from expectations. Zimplats has consistently been delivering excellent operational results in a very difficult operating environment. Even if we do not see a normalisation of the environment in Zimbabwe, and government just honour existing agreements with Zimplats and Impala, it is clear that based on the fundamentals of the asset, Zimplats will be the fastest horse in the race. It would be reasonable to expect the handicappers to reduce the odds of winning because of the increased political risk. At current prices we believe that the handicappers have reduced the odds too much, presenting an opportunity for long-term investors. Zimplats' share price has fallen to AUD 8.95 on the recent indigenisation news, implying a historic PE of c5.3 times, which represents a c82% discount to the c30 times historic PE the South African platinum sector is currently trading at. Zimplats is still currently ramping up production and the current annualised production of 361 466 4PGM ounces is still well below the medium term production target of 1 million 4PGM ounces. In our view the current earnings are well below normalised levels, so we are presented with a very low PE on very low earnings. We conservatively value Zimplats using a normalised production level of 800 000 4PGM ounces, so c20% below medium term targets and well below management's long-term stretch targets of 2 million 4PGM ounces. On a normalised basis we see significant value in this share and would argue that at the current share price the odds of the potential political outcome have been incorrectly priced.
Implats is exposed to Zimbabwe through its 87% holding of Zimplats and 50% holding of Mimosa in a joint venture with Aquarius Platinum. In our view, at current prices the market is ascribing zero value to Impala's Zimbabwe exposure, which implies that handicappers are expecting that 100% of its Zimbabwe assets as expropriated for zero value. Although this scenario is possible, we would argue that it is highly improbable. We view Implats as a low-risk exposure to the potential upside from a normalisation in Zimbabwe and we have used the current share price weakness to increase our holding.
Globally we continue to face great uncertainty. Based on our assessment of long-term valuations we are excited about the position of the fund and specific opportunities that have presented themselves within the resources sector. When building your portfolio, we strive to ignore the constant noise in the market and identify undervalued and mispriced companies based on long-term valuations. History has taught us that our ability to forecast the immediate future is limited. However, despite short-term market uncertainty, we will continue to strive to deliver superior returns relative to the benchmark over the long term.
Portfolio managers
Henk Groenewald and Duane Cable
Coronation Resources comment - Dec 10 - Fund Manager Comment17 Feb 2011
2010 was another good year for your fund. It returned 19.7%, relative to the resource sector (12.4%) and the average of our competitors (14.3%). In the last three months the fund returned 15.4%. Markets were generally volatile throughout the year but the last four months sustained an upward trend. Most commodities have nearly recovered to their 2008 levels and some (notably gold and copper) reached new all-time highs. This was one of the factors causing the significant strength in the rand and other commodity currencies.
As mentioned in our 2009 year-end commentary, the first decade of the noughties was an exceptional one for South African investors, especially for those invested in commodity shares. After another good year, the average annual compound return from the fund over the last five years was 18.8% and 24.6% over the last 10 years. These returns are flattered by the starting point - at the start of 2000 commodities and resources were at the bottom of a very protracted bear market, and has been in a nearly continuous bull market ever since (barring the 2008 interruption). Both earnings and the multiples applied to earnings (P/E ratios) has expanded over the period. We remind investors not to expect similar returns going forward.
Our share selection performed well over the year. The shares that contributed most to performance were Mondi, Pan African Resources, AECI and Exxaro. Not owning big underperformers (Amplats and Sappi) also helped. Detracting from our performance was holdings in Pallinghurst, Buildmax and Hulamin.
Our offshore holdings again acted as a drag on performance, with the rand strengthening by 11% against the dollar from R7.39 at the start of the year to R6.59 at the end. We remain convinced that the maximum offshore exposure is correct and should reward unit holders in the medium to longer term. This view is informed not only by our view on the rand, but also by the diversification benefits and the much larger universe of companies available to us to invest in.
The biggest risk to commodity prices remains a slowdown in Chinese investment into property and infrastructure. The possibility of a Western fiscal crisis also cannot be ruled out. While risks abound, current conditions remain favourable for commodity prices and a decent performance is still likely from current relatively fair valuations. Our position is aptly described by the French philosopher Voltaire: "Doubt is not a pleasant condition, but certainty is absurd."
In this environment, we continue to apply our investment process consistently. We will own the companies in our sector where we believe the return in most scenarios will be favourable to investors. We do not expect this process to deliver sector-beating returns in every year, but we do expect the fund to show good results over most periods of at least three years (and so should you).
Happy New Year!
Portfolio managers Henk Groenewald and Duane Cable