The resources sector had a very strong third quarter. The fund returned 16%, while the benchmark returned 17.8%. The fund’s long-term track record remains compelling, performing well against both its peer group and the benchmark over most meaningful periods.

Over the last quarter, the fund benefited from an overweight holding in Exxaro and underweight positions in gold shares and Sasol. Overweight holdings in Pan African Resources and Impala, as well as an underweight holding in BHP Billiton detracted from performance.

During the quarter, we added to our holdings in Sasol and reestablished a position in Sappi after its share price retraced. We reduced our holdings in Exxaro and BHP Billiton and sold out of South 32.

Our thesis, when we bought South 32, was that spin-offs in the mining sector often benefit from increased management focus given that their assets become front and centre as opposed to ''also-rans.'' In addition, such businesses can benefit from leaner cost structures given that they are not forced to adopt rigid structures typical of larger diversified mining groups. South 32’s assets are attractive and are typically situated in the bottom half of their respective cost curves. Over the last year or so, these attributes have started to reflect in the company’s share price. More recently, we suspect a large portion of the share price strength can be attributed to the strong performance of the aluminium price. We don’t have high conviction around the sustainability of the aluminium price at these levels. In addition, South 32 recently experienced production hiccups. These may be temporary. The risk, however, is that they may become more frequent given the shorterlived nature of South 32’s assets. As such, we felt the margin of safety was not sufficient and we sold our holdings.

We re-established a position in Sappi. Sappi finds itself in a materially better place than five to ten years ago. At the time, Sappi was primarily a producer of graphic paper (a market in structural decline) and was saddled with high debt. Today, most of Sappi’s value comes from producing dissolving wood pulp, a product that is ultimately converted into synthetic clothing (a market growing nicely). They are also converting a number of paper mills to speciality paper mills. These markets are niche, high margin and have higher barriers to entry. Its balance sheet is also in better shape.

We have long been concerned by Sasol’s long-term track record in allocating capital. Their recent Lake Charles Chemicals Project (LCCP) has run materially over time and budget. Their balance sheet is also stretched. Why are we adding to our holdings? As Sasol moves towards the tail end of the LCCP project, risks of further delays and overruns are reduced. Sasol’s balance sheet is also close to the peak net debt point. As their balance sheet degears, and the LCCP project ramps up, the group’s free cash flow position, as well as its geographic diversification will improve.

An interesting theme that has been buoying commodity markets of late is China’s increasing focus on air pollution. The reasons are a likely mix of environmental (air pollution in key centres is notoriously poor) and economic (China has a prolific number of sub-scale miners using out-dated technologies producing commodities at losses). The Chinese government has clamped down and enforced production cuts in a number of commodities. These include coal, steel, iron ore and aluminium. This has had a series of knock-on effects. In some cases, China has had to increase imports, buoying prices. By reducing the number of small, sub-scale producers, they have increased consolidation and capacity utilisation for the rest of the industry. These players are now producing at better margins. This drives a desire to maximise production, which is achieved by using higher quality feedstocks (it also typically benefits pollution levels too), which has proved to be a boon for producers of such feedstocks. Iron ore lump premiums have shot up, benefiting Kumba Iron Ore and ARM/Assore. High grade Manganese is also trading well above low grade, benefiting ARM/Assore and South 32. The extent of this benefit is probably overstated at the moment and may well normalise lower in time.

We still see value in resource shares from current levels. That said, quarters as good as this one should be seen as the exception and not the rule!

Portfolio managers
Nicholas Stein as at 30 September 2017

The resources sector saw its gains from the first quarter reversed, taking its returns to -4.6% in the year to date. The Fund has returned 0.6% in the same period. Over the last year, the fund has returned 20.2% against the benchmark return of 1.9%.

Over the last quarter, the fund benefited from an overweight holding in South32 and underweight holdings in Anglo American and the gold shares. Underweight holdings in BHP Billiton and an overweight position in Merafe and platinum shares detracted.

During the quarter we added to our holdings in Anglo American, Merafe and Glencore. We trimmed our holdings in Sasol and Mondi. We sold out of Sappi. Sappi has performed strongly and now trades above our assessment of fair value.

News this quarter was dominated by the announcement of the third Mining Charter, which sent shockwaves through the SA mining sector. While a draft had been circulating since April 2016, the hope was that it would be toned down post consultation with the mining industry and other stakeholders. It appears as though virtually no consultation took place subsequent to this and the version published was no less onerous. The document is ambiguous and contains many burdensome provisions. For a sector struggling to attract fresh investment, this document will act as a further detractor, especially for those companies operating in multiple jurisdictions. Indeed, R50bn was wiped off the market capitalisation of the sector in the days post the announcement as investors voted with their feet.

As onerous as the document is, we think the reaction is overdone. Legal experts have been quick to pronounce many aspects of the charter as contrary to the provisions of the law. The Chamber of Mines has approached the courts to seek an injunction against the implementation of the charter. In addition, the chamber is seeking a declaratory order asking the courts to pronounce on the ‘once empowered’ principle. Our base case is that is that the charter in its current form will not stand up to legal scrutiny. This will necessitate a return to the negotiating table by both parties. We are hopeful a more balanced document will be the end result.

If one looks through our key holdings (Anglo American, Mondi, BHP Billiton, Sasol and Exxaro), only Exxaro is heavily exposed to South Africa. Exxaro has always been a black-controlled company. Following its new BEE deal, black ownership will remain material at greater than 30%. From a share perspective, the degearing witnessed as a result of more buoyant commodity prices over the last year has seen companies shift to the front foot. Glencore has attempted to purchase Bunge, an agricultural trading company focused on the Americas. Glencore has also been involved in a bidding war for Rio Tinto’s Coal & Allied Australian coal assets. These assets are contiguous to Glencore’s own Australian coal operations, so meaningful synergies are likely if the deal goes through.

South32 has acquired small holdings in two projects. This allows the group optionality to buy up stakes in these projects if the economics appear favourable.

We remain optimistic on the potential absolute returns available to investors in resources from current levels, although the path is rarely smooth.

Portfolio managers
Henk Groenewald and Nicholas Stein as at 30 June 2017

For the first quarter of 2017, commodities continued their upward march. The fund returned 9.5% over this period against the benchmark return of 2.7%. Over the last year, the fund has returned 37.8% against the benchmark return of 16.7%.

For the quarter, the fund benefited from overweight holdings in Exxaro and Northam, and underweight positions in BHP Billiton. Small positions in Omnia and Norilsk Nickel detracted. Over the last year, the fund benefited from overweight holdings in Exxaro, Merafe and South 32, and being underweight the gold stocks. Underweight holdings in BHP Billiton and Anglo American detracted from performance.
Portfolio changes over the last quarter include adding to our Sasol and BHP Billiton holdings on the back of relative share price weakness. We also reduced our holdings in Merafe (on the back of relative share price strength) and Petmin (now trading close to the price at which it is being bought out).

By end March all mining companies have reported either annual or interim results. In general, results were in line with, or better than, market expectations. Key take-outs include strong cash flow and deleveraging on the back of rallying commodity prices and cyclically low capital expenditure. While low capital expenditure levels can hold for a few more years, we view current levels as unsustainably low. If spend does not pick up, production levels will start to fall, impacting unit costs. In the interim, strong cash flow generation will test companies' capital allocation skills. For now, it seems like cash will be returned to shareholders. To date we have seen this in the form of dividends either being reinstated (Anglo American and Glencore) or raised (BHP Billiton), or through shares buybacks (South 32).

Glencore has been quite active on the portfolio front, selling some of its Zinc assets while buying out minorities in a few of its copper assets. Anglo American has not effected any M&A this quarter; however, they continue to look at options to dispose of its stakes in Kumba Iron Ore and South African thermal coal. The Agarwal family (70% owners of Vedanta) intends to take a 13% stake in Anglo American via a mandatory exchangeable bond. This effectively buys the family voting rights for the next few years. It is unclear whether they intend to be a passive shareholder, or if they want a seat at the table when the planned disposals (mentioned before) are being discussed. Exxaro is in the process of refinancing its BEE deal and will also be selling its Tronox stake. This decision follows Tronox's announcement to acquire Cristal, a transaction that will see Exxaro's stake in Tronox diluted.

All other newsworthy items have been eclipsed by President Jacob Zuma's decision in late March to reshuffle his cabinet. The announcement saw the capable minister of finance, Pravin Gordhan, and his deputy, Mcebisi Jonas,lose their jobs. It also precipitated the downgrade to junk status of South Africa's foreign currency rating by Standard & Poor's. Mining shares have responded positively to this downgrade: companies with predominantly South African-based operations saw the biggest gains (given their extreme operational gearing to a weaker rand), while those businesses with non- South African operations benefited to a lesser degree (they only benefit from translating results at a weaker rand but do not get the operational gearing). The longer-term impact on those companies with predominantly South African-based operations remains to be seen. A weaker local currency will ultimately lead to higher imported inflation, which will erode some of the revenue benefit. To the extent that government's attitude towards and policies affecting the miners become more interventionist/populist, this would erode confidence in the sector and hamper the ease of doing business. Arguably the miners have operated under these conditions for many years and have learned to adapt to changing conditions faster than other industries. We continue to believe the resources sector remains attractive, with meaningful upside in most of the stocks within the portfolio.

2016 was a great year for the resource sector and the fund, with the fund returned 64% against the benchmark return of 34%.

Over the year, key contributors to performance were overweight positions in Exxaro, Merafe Resources, South 32 and Glencore, as well as an underweight position in Sasol. Our small holding in Trencor detracted from performance, as did platinum group metals (PGM) ETFs.

Over the past quarter, we added to our holdings in Mondi, Sasol, Northam Platinum and Pan African Resources. We reduced our exposure to BHP Billiton, Merafe and Glencore on the back of good relative performance.

It is quite amazing what a difference a year makes. This time last year the resource sector was down 37% on the prior year. Anglo American and Glencore were particularly hard hit given their high levels of gearing. There were question marks around the solvency of both companies. Commodity prices were in free fall and Chinese demand had stagnated.

Fast forward one year. Anglo American and Glencore’s balance sheets are far healthier. Anglo American has even downplayed future asset sales and has walked away from possible sales of a number of assets. Commodity prices have rebounded strongly, led upwards by meaningful demand out of China. In fact, a number of commodity prices now look to be on the high side to us. This mainly holds true for steelmaking raw materials such as iron ore (up 77% over the year), coking coal (up 194%) and manganese (up 409%), where the price rises have been meteoric and unprecedented. Oil and the PGMs, however, still remain below what we consider mid-cycle prices.

Mid-cycle prices are probably the key determinant in our valuation models. How do we determine mid-cycle prices? We use four broad tools. Firstly, we have a look at what prices have averaged over decades in real terms. Prices tend to revert to mean, and big deviations from the mean warrant investors being circumspect. Secondly, we look a cost curves. How much does it cost the marginal producer to produce the last ton of a given commodity? (While producers often stomach losses in the hope that prices will recover, this cannot go on indefinitely). Thirdly, we look at long-term margins implied by whatever mid-cycle price we end up arriving at. We consider how that margin stacks up against history. Finally, we look at incentive pricing. If a producer is to build a new mine, for a given capital outlay, what sort of commodity price do they need to earn an economic return? Depending on the dynamics of a given market, we might place more stock in one measure over another. Price estimation is more art than science, so we never place undue reliance on a point estimate. Rather, we run scenarios using different prices to establish a range of outcomes to strengthen our conviction.

We still think the resource sector remains attractive, with meaningful upside in most of the stocks within the portfolio. Despite having bounced 40% off its lows, the resources sector is only back to where it was in November 2015 (and still 57% off the highs reached in 2007).