The positive performance by the resources sector continued in the third quarter. Over this period, the fund returned 16.1%, versus the benchmark return of 8.1%. Over one year, the fund has returned 46.0% against the benchmark return of 9.8%.

Over the last quarter, the fund benefited from overweight holdings in South32 and Exxaro, as well as from being underweight Sasol and the gold shares. An underweight holding in BHP Billiton detracted.

During the quarter, no new positions were entered into or exited. We did, however, add to the fund’s holdings in Mondi, Sasol, Exxaro and Merafe Resources. We reduced our exposure to South32 and Glencore on the back of their strong relative performance.

Anglo American continued its strong run. Strong price increases in some commodities (for example metallurgical and thermal coal, as well as manganese) and stable prices in others where declines may have been expected (for example iron ore) have improved the company’s free cash flow outlook. This has also resulted in fears over its balance sheet dissipating, and removes the urgency around asset sales (while increasing the likelihood of better sales proceeds if they do go ahead). The company also announced the appointment of Stephen Pearce as its new financial director. Pearce comes across from the Fortescue Metals Group and appears to have the skillset for what Anglo American needs right now. Glencore benefited along the same lines as Anglo American. It announced the sale of a portion of Ernest Henry Mining, its Australian gold, silver and copper mine.

Exxaro performed well over the quarter. It produced decent interim results, aided by good cost control and higher coal prices. Exxaro has done a good job of streamlining its portfolio and reducing its tail. By selling its Mayoko iron ore project in the Republic of Congo, it finally drew that sorry chapter to a close. A streamlined portfolio will also allow greater management focus on its crown jewel, the Grootegeluk coal asset in the Waterberg. This must rate as one of the best mining assets in South Africa, with low costs, a long lifespan and cash flow stability from its contract with Eskom.

We have been increasing the fund’s exposure to Mondi, which is now its second largest holding. Mondi’s economics are superior to those of the typical resources company. Mondi converts a high percentage of its earnings to free cash flow and earns economic returns on its capital employed. This is aided by one of the top management teams in the sector, with a strong track record of good capital allocation. Mondi’s balance sheet is strong and positions it well to favourably deploy surplus cash at some point in the future.
Finally, we bid farewell to Henk Groenewald. Henk has been managing or co-managing the Resources Fund since 2005, and has built up an encyclopaedic knowledge on the sector over those years. Thankfully, Henk has just moved a few steps away, taking up a new role within Coronation. As such, we are still able to benefit from his knowledge and experience.
Portfolio managers Henk Groenewald and Nicholas Stein as at 30 September 2016

What a change a quarter can make! Resources got off to a roaring start in the first three months of 2016. The fund returned 30% for the quarter against the benchmark return of 18%. Over the last year, the fund has returned -11% against the benchmark return of -25%.
Over the quarter, the fund benefited from overweight holdings in Exxaro, Glencore and Pan African Resources, as well as being underweight BHP Billiton. Low weightings in the gold majors detracted from performance. During the period we used the relative weakness in BHP Billiton and Mondi to increase our holdings, as well as relative strength to reduce our holdings in Northam Platinum and Exxaro.

The first quarter saw some spectacular moves in a number of resources shares. To pick a few: Kumba Iron Ore +118%, Amplats +109%, Anglo American and Anglogold both +78%, Exxaro +69% Glencore 65%, Pan African Resources +61% and Northam +57%. So why was the first quarter so kind to commodity stocks? We haven’t detected any material change in the macro environment: Demand for most resources remains muted, with little sign of life from China; supply responses have also been limited. Commodity prices have helped: In rand terms, iron ore +13%, gold +8%, platinum +4%, oil +2%, thermal coal +1%, copper -2%, but arguably not enough to justify the extent of share price moves. The truth is we don’t really know why share prices recovered to the extent that they had, nor do we know if the past quarter represented the bottom of the commodity cycle. Perhaps the old adage is applicable here: -Good things happen to cheap stocks. While the macro environment and timing of share price moves are always difficult to call, we believe that buying shares at big discounts to their intrinsic value will ultimately be rewarded.

Peak to trough, Kumba Iron Ore’s share price declined by 96%. After this quarter’s rally of 118%, it is still down 87% from its peak! Recent market conditions have been very good for Kumba: the price of iron ore in rands is up 13%; the lump premium has recovered; freight rates from South Africa to China remain near record lows; and the oil price (an important cost input) has been quite muted. Why doesn’t the fund own it? We are very bearish on the longer-term outlook for iron ore. After a decade of strong iron ore prices, there has been a strong supply response. This supply has come on (and is still coming on) predominantly from the low cost iron ore majors (BHP Billiton, Rio Tinto, Vale, and FMG). It is coming on at a time when demand from China (c.70% of seaborne demand) has stalled. As a result, there is a material surplus of iron ore, which we expect will persist for many years. What is harder to know is who the marginal iron ore producer is? It is conceivable that steel producers can make do with supply from the ‘big four’ producers. If that is the case, a producer like Kumba will be the marginal producer/break even for a long period of time. Even if supply from Kumba is needed, the company now finds itself towards the top end of the cost curve (partly due to more expansion by the low cost majors and partly due to cost containment issues as their stripping ratio has risen). As such, the margins Kumba will make in the future are likely to be materially lower than what it historically enjoyed. Given the wide range of outcomes, as well as the fact that a bearish scenario would still see a permanent destruction of shareholder capital even at current prices, we are comfortable not owning the stock. We prefer to own it via our shareholderings in Anglo American and Exxaro, where we don’t feel we are ''paying'' for it, and where we see it as optionality in the event that we are wrong on iron ore prices.

We remain big holders of Anglo American. In spite of its 78% rally this quarter, it is still down 79% from its peak. It trades on 5.5 times our assessment of normal earnings, a multiple we consider too low considering its suite of assets. We are encouraged by efforts to simplify the group, removing costs and focusing on the high-quality assets within the portfolio. When completed, Anglo American will be left with a portfolio of long lived, low cost assets in copper, diamonds and platinum. The market has placed a lot of focus on its debt levels and there appears to be a lot of pressure on them to do a rights issue to alleviate this. Our view is that, while debt levels are high, liquidity is not an issue in the short term. At spot prices, Anglo American is generating positive free cash flow. This, along with disposals of non-core assets, should allow them to address high debt levels appropriately over the medium term.

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

2015 was a horrendous year for investors in the resource sector. The resources index declined by 37% - its worst calendar year performance for at least the past 50 years. The sector has underperformed the All Share Index for the sixth consecutive year, also unprecedented during this era.

Commodity prices continued declining. Over the last 12 months gold fell 10%, copper 26%, platinum 28%, oil 38% and iron ore 39%. Commodity prices have generally trended down since 2011, but the pace accelerated in 2014 and 2015. Over the past two years, the price of iron ore and oil has fallen by two thirds and many commodity prices are more than 70% below their peaks.

The rand was one of the worst performing currencies in the world last year, weakening by almost 25%. Unfortunately, even this significant currency move was not enough to restore profitability in the South African mining sector as poor demand, cost pressures and declining prices weighed heavily on already struggling companies.

We are disappointed by the fund’s results in 2015; it lagged competitor funds significantly and had the worst calendar year since its inception. The fact that the fund has managed to outperform its benchmark over most periods is a small consolation. The main cause of the fund’s relatively poor performance was not having big enough positions in outperformers such as Sasol, BHP Billiton and Mondi, as well as owning too much platinum equities and the geared diversified miners, Anglo American and Glencore.

2015 proved to be the year in which commodity price declines and continually weaker prospects forced the market to take cognisance of balance sheets. Given the tough conditions, focus shifted to which companies will not survive to see the next cycle. Lonmin’s heavily discounted rights issue in December again highlighted the risk of dilution. Both Anglo American and Glencore have too much debt given current conditions and their share prices declined by more than 60% as the market punished companies at risk of rights issues. We believe both Glencore and Anglo American can survive the current downturn and own good assets that are worth significantly more than the debt on their respective balance sheets.

It is undeniably tough times in the mining industry and cyclical industries more generally. The slowdown in China and generally still robust supply growth has led to overcapacity in most heavy industries and sharply lower prices. While supply is starting to close, this adjustment will necessarily be slow and painful given the difficulty in closing mines. Eventually, the current lack of investment and demand growth will restore balance to commodity markets. We remind investors that the sector is cyclical. Most commodity prices are below those prices that are required to grow or even sustain current production, and an adjustment will eventually happen. The timing of this adjustment remains uncertain.

We remain committed to our investment philosophy and our primary goal of outperforming the resources index over meaningful periods.

Portfolio managers
Henk Groenewald and Nicholas Stein