"When we long for life without difficulties, remind us that oaks grow strong in contrary winds and diamonds are made under pressure." - Peter Marshall

The third quarter of 2015 provided no respite for the carnage experienced in the resource sector this year. Glencore's rollercoaster ride and the VW debacle dominated headlines, although share price pressure was felt across the board. The fund returned -21.2% for the quarter against the benchmark return of -17.9%.

Over the last year, the fund has returned - 39.1% against the benchmark return of -37.1%. One now needs to go back close to ten years in order to have received a positive nominal return from the resource sector. Over the last quarter, the fund benefited from holdings in Mondi and platinum group metals (PGM) ETFs. The underweight position in BHP Billiton detracted, as did the overweight positions in Exxaro and Glencore.

During the quarter we reduced our exposure to Mondi. While we remain constructive on the Mondi investment case, it trades close to our assessment of intrinsic value. We added to our holdings in Northam Platinum and Glencore, where the gap between share prices and our intrinsic value have opened up. It has been a rollercoaster ride for Glencore. Starting the quarter at R49 per share, it dipped as low as R14 per share, before ending the quarter at R19 per share. At the time of writing, it was trading at R22. Glencore suffered due to concerns around the outlook for some of its key commodities (notably copper), the performance of its marketing division and the extent of its balance sheet gearing levels. As Glencore's earnings outlook weakened, its stretched balance sheet and debt covenants came into focus. Concerns around their ability to meet long-term obligations saw the share price come under tremendous pressure, taking on a life of its own. Glencore has taken a number of measures to strengthen its balance sheet and reassure the market, including a capital raising and asset sales. These actions, along with the fact that Glencore has no debt refinancing requirements before 2017, seem to have eased concerns. We consider the share price pressure overblown. Glencore trades at c4x our assessment of normal earnings and 0.4x book value. We have used the share price weakness to materially add to our Glencore holdings, such that it is now a top 5 position in the fund.

As a result of VW cheating emissions testing on its US diesel vehicles, there are question marks around diesel's long-term future. This has profound implications for platinum. Whereas a typical gasoline engine uses 90% palladium and 10% rhodium and almost no platinum, a typical diesel engine uses c60% platinum. One scenario could see platinum demand receiving a boost over the medium term as car makers increase PGM loadings to meet emissions legislation under real world driving conditions. Over the longer term however, the additional compliance cost worsens diesel economics and could see an acceleration in the shift towards gasoline and electric vehicles. Coupled with the brand damage to diesel, we may well see longer-term platinum demand come under pressure. We try to distinguish between what we know, what we expect and what we don't know. While we don't know how things will play out for diesel, we remain of the view that PGM producers need a materially higher basket price to remain economically viable. As a result, any pressure on the platinum price is likely to be offset by higher palladium and rhodium prices. So while it is difficult to build high conviction in any one of the PGM metals, an investment case for owning the basket of metals is easier to construct. The fund owns rhodium, palladium and platinum ETFs (in order of holding size). In addition to ETFs, we also own a basket of PGM stocks. Over 50% of the South African platinum sector is loss making at an operating level at current PGM prices. We own the stocks in order to benefit from the gearing effect that should occur if prices go up. We have focused our ownership on the lower cost companies, with healthy balance sheets, that are investing in their assets through-the-cycle. Industries rarely go bankrupt, even if companies within them do. After all, the world does still need PGM mine supply from South Africa. We believe the companies we own will be the last standing and should be poised to make good returns upon a recovery in the cycle.

There remains no greater clarity in the macroeconomic picture for key commodity consuming countries. Demand remains under pressure and this looks set to persist for a long time. However, as evidenced by supply cuts, project curtailments and capital raises, commodity prices remain too low on a through-the-cycle basis for producers. We don't know when they will recover. History suggests that when they do, earnings and share prices will follow. Given the pessimism being discounted in many resource company share prices, such a recovery could well be very fruitful.

We consider our primary responsibility to investors to be outperformance of the Resources Index benchmark. This is something we have achieved over a number of years and believe we can continue as long as we diligently apply our investment process and philosophy. We are also optimistic on the potential absolute returns available to investors in resources from current levels.

Portfolio managers
Henk Groenewald and Nicholas Stein

The poor performance of the resource sector continued into the second quarter of the year, leading to a 29% decline over the last 12 months. The only resource shares managing to deliver a positive return over this period were the paper producers Mondi and Sappi, while the returns for mining companies were dismal. Over the past year, the platinum mining index declined by 43%, gold mining by 29%, coal mining (Exxaro) by 35% and the diversified miners by 25%.

The poor performance of the equities was naturally linked to the poor performance of the commodities they sell. Over the past year, the price of iron ore declined by 37%, platinum by 28%, Brent crude oil by 45% and copper by a relatively modest 18%. The significant moves once again illustrate the volatility in the mining sector and often the very natural human tendency to underappreciate the potential range of outcomes. The mining sector today is a very bleak place. Over the last decade (despite the supercycle), resources have underperformed industrials, financials, international equity markets and even bonds. There is every indication that this state of affairs will continue for a very long time, with China slowing down and facing a potential credit crunch of its own as well as supply continuing to grow.

The reason why resource company share prices have fallen is because the environment for mining is terrible. The companies face not only low commodity prices, but also escalating labour tension and general regulatory uncertainty. A lot of what is ailing the companies are largely out of their control to remedy and does not look like it will be changing soon. We know that mining cycles can last a long time and that the preceding upcycle was very strong, which means the current decline could be equivalently bad.

It is easy to expect no change from current conditions or even a further worsening. The share prices of the mining companies, at multi-decade lows when measured against non-cyclical measures such as net asset or replacement values, seem to indicate that this is exactly what the market believes. We try to clearly distinguish between what we know, what we expect and what we don't (or can't) know. We also try and guard against the thinking error of merely extrapolating the recent past or having too much confidence in our forecast (although we still fall into this trap). What we do know is that mining companies around the world are struggling, cutting production, reducing cost and stopping projects. This would indicate to us that current commodity prices are low in general. What we don't know is how long the prices will stay low. We also know that in the past, when commodity prices and hence earnings expectations for miners increased, equities did well, sometimes exceptionally so. It would seem to us that if anything better than the negative scenario already reflected in the share prices play out, an investor could expect to do well out of mining companies in future. The fund's total return of negative 11% for the first six months of the year lagged the index's decline of 5%. The main reason for the lower-thanbenchmark returns were not owning enough BHP Billiton and our position in ArcelorMittal SA.

The fund has still performed better than the index over the last 12 months as well as over all other more meaningful periods.

Our major activity during the quarter was to reduce our exposure to Sasol, Glencore and Zimplats in favour of new positions in South32 and Centamin, as well as adding to our platinum position.

South32 was spun out of BHP Billiton and contains assets that were not considered good, or large enough, to be kept inside that group. This has left the company with a somewhat motley selection of assets, where most of the value sits in the aluminium value chain and manganese. South32's biggest advantages are its lack of debt and the maturity of its asset base which will ensure good cash flows even at currently depressed prices. The future value of the asset will depend on management's deployment of this cash, and we hope the new management team have learned from the mistakes of others. We expect the management team to stay true to their word of focusing on per share value and hence have built up a significant position in the company.

We consider our primary responsibility to investors to be outperformance of the Resources Index benchmark. This is something we have achieved over a number of years and believe we can continue as long as we diligently apply a rational investment process. We are also optimistic on the potential absolute returns available to investors in resources from current levels.

Portfolio managers
Henk Groenewald and Nicholas Stein

"Everyone has a plan...until they get punched in the mouth." - Mike Tyson

The resource sector remains on the ropes, receiving a barrage of blows from a weakening Chinese economy, supply growth from boom time investments coming on line, and regulatory uncertainty in South Africa, amongst others. The fund delivered a return of -6.3% for the first quarter of the year against the benchmark return of -0.2%. For the last year, the fund returned -17.7% against the benchmark return of -23%. Over this and longer-term periods, the fund continued to outperform its benchmark (FTSE/JSE Resources Index), although it feels like cold comfort given the poor absolute return!

Over the last quarter, the fund benefited from its holdings in paper stocks and Sasol. The underweight position in BHP Billiton detracted, as did the overweight position in platinum stocks.

During the quarter we reduced our exposure to paper stocks and physical PGMs given their strong relative performance and reduced margin of safety versus our assessment of intrinsic value. We added to our holdings in platinum shares and introduced Petmin and Merafe into the fund.

Merafe is globally one of the largest and lowest cost producers of ferrochrome, a key ingredient in stainless steel production. Merafe has invested well in excess of its current market capitalisation over the last decade in order to improve its cost position and grow production of low cost tons. As a result, no free cash flow has been generated over this period and the share has languished. Given that they are now at the end of this capex cycle, combined with the capital discipline brought on by their joint venture partner, Glencore, we expect free cash flow generation to improve meaningfully over the coming years. Key risks include a lack of geographic diversification (100% South African production base) and the fact that electricity is a large proportion of its cost base. In its favour, however, is its low cost position (and proprietary technology to protect this); stainless steel being a late cycle commodity poised to grow as China shifts from a more capital based economy to a more consumption based one; and valuation. Merafe trades at 0.65x book value, close to 0.3x replacement cost.

Our top holding in the fund remains Anglo American, with a 22% weighting. In contrast, the fund's weighting to the other key diversified player (BHP Billiton) is 4%. We continue to view Anglo American as a far more compelling investment than BHP Billiton, in spite of BHP Billiton's superb management team and higher proportion of tier 1 assets. This is predicated on our views that:
-the outlook for Anglo American's key commodities (diamonds and platinum) is far more favourable than BHP Billiton's (iron ore and oil);
-Anglo American's cost base has more fat than BHP Billiton's, giving Anglo American more scope to drive earnings relative to BHP as these costs are rationalised; and
-the valuation differential between the two companies is stark.

Looked at in pound terms (where one could argue the price of each share is set), Anglo American now trades at levels last seen at the bottom of the global financial crisis in 2009, while BHP Billiton remains 40% higher.

There remains much macro uncertainty, particularly around the Chinese economy, which continues to be the most important source of demand for almost all commodities. Steel demand, in particular, remains uncertain. Whereas a year ago, many commentators would have regarded peak Chinese steel demand as years away and materially higher, many are now questioning whether we have already seen the peak. If this is the case, iron ore could yet fall further and remain weak for many years. We remain underweight direct iron ore exposure.

Yet despite the negative news flow and uncertainty present, we remain constructive on the resource sector over the longer term. Although it will take time, limited investment in growth capex, coupled with dividends being prioritised, will ultimately curtail supply and bring commodity markets back into balance. Equity prices are already discounting much of the bad news, trading on historically low price-to-book ratios and low multiples on our assessment of mid-cycle earnings.

Portfolio managers
Henk Groenewald and Nicholas Stein

Of all those expensive and uncertain projects, however, which bring bankruptcy upon the greater part of the people who engage in them, there is none perhaps so perfectly ruinous than the search after new......mines. It is, perhaps, the most disadvantageous lottery in the world, or the one in which the gain of those who draw the prizes bears the least proportion to the loss of those who draw the blanks; for though the prizes are few, and the blanks many, the common price of a ticket is the whole fortune of a very rich man. Projects of mining, instead of replacing the capital employed in them.....commonly absorb both capital and profit.

Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations

This quote from the father of capitalism should resonate with anyone invested in the resource sector over the past number of years. At the end of 2014, we reflect back on the fourth calendar year of significant underperformance of the broader market by the resource sector.

The fund delivered a negative return of -5% for the year. Over both the year and longer-term periods, the fund has outperformed its benchmark (FTSE/JSE Resources Index). The poor performance this year was precipitated by the declines we saw in commodity prices, specifically the prices of iron ore and oil by over 45% each. Both commodities were relatively strong prior to their collapse and both contributed significantly to the sector's earnings.

Companies with the greatest exposure to iron ore (Kumba Iron Ore (-41%), Assore (-55%) and ARM (-34%)) fared particularly poorly. We have long held the view that iron ore prices were too high and successfully avoided most of these stocks. We initiated a position in ARM after the poor performance of its share price gave us an opportunity to buy at levels which we consider to be below fair value.

The global diversified miners showed relative resilience, with Anglo American (-2%) and Glencore (+1%) both outperforming BHP Billiton (-20%) that has exposure to both iron ore and oil. Again our positioning here was good, as our longstanding preference for Anglo delivered for a change.

The platinum sector continued to experience a tough time, with the sector declining by 31% over the year despite their basket improving slightly in rand terms over the period. The fund benefited from the significant holding in physical metals, although Impala and Lonmin detracted from performance. The gold sector performed better, as it normally does in times of stress, increasing by 14%. There was a significant divergence in performance amongst the gold companies, as companies with weaker balance sheets (Anglogold and DRD) were punished by the market. Goldfields and Sibanye were the two best performing shares in the resource sector, and not owning either detracted from performance. The fund also benefited from holdings in Sappi, Zimplats and Pallinghurst, while Exxaro and ArcelorMittal South Africa detracted.

We do not attempt to predict the future, nor can we promise that next year will be better; only that it will be different. Resources is a cyclical sector, and we believe the stage is set for better performance in the future, although patience might still be required. Most commodity prices are now below our estimates of normal and many higher-cost producers are loss making at current spot prices. In addition, we believe the companies represented in the fund own some of the best and lowest cost assets in the industry and they offer attractive long-term value at current prices.

Portfolio manager changes
Duane Cable has been the co-manager of this fund for the last 6 and half years and has made a significant contribution to its performance over this period. As head of SA equity, he will however be focusing on his other responsibilities within the Coronation team, with effect from 1 January 2015. From this date, the fund will be co-managed by Nicholas Stein, who joined the Coronation equity team in 2009. Nic has already contributed to the fund's performance through his analysis of some of the most challenging resource stocks and we look forward to his future contribution.