The past quarter was generally a quieter period for financial markets. Global equity indices steadily ground higher over the quarter, with the MSCI All Country World Index (ACWI) generating a 5.2% return and finishing the period almost at an all-time high. This meant that the index’s 12-month lagging return to end-September 2017 was an eye-watering 18.65%. The five, 10 and 15-year numbers are 10.2%, 3.9% and 9.1% (all annualised per annum) respectively.

Events on the political front continued to occupy the minds and attention of investors over the last quarter, both on the US domestic front as well as between the US and North Korea where the spat is growing increasingly intense. While most market commentators continue to believe that common sense will prevail and a mutually acceptable solution will be found, the increasingly personal tone of the insults thrown between two volatile and unpredictable political leaders has started impacting financial markets towards the end of the quarter. The tropical storms and the resultant devastation on the East Coast of North America, while tragic and upsetting, have not had any major effects on markets, except predictably on the insurance sector. We have no exposure to this sector.

The US dollar continued to weaken against most major currencies, slipping 3.4% against the euro for example. Emerging market currencies also strengthened significantly against the US dollar, with most of them now in positive territory against the dollar over the last twelve months. Towards the end of the quarter the dollar started showing signs of life against most currencies, but it is too early to signal a reversal of the bear trend.

Emerging markets continue to register superior returns relative to developed markets, outperforming by around 3% over the quarter and taking the outperformance since the beginning of 2017 to just over 10%. Over most longer time periods the developed markets have performed much better though. Europe marginally underperformed the US over the quarter, but the strong euro meant that in US dollar terms they showed better numbers. Since the beginning of the year, Europe has now outperformed the US by almost 10% in US dollar terms (most of the outperformance coming from a stronger currency), and has edged past the US over the last 12 months. Over the longer term, the US equity markets’ outperformance is still material.

Amongst the various sectors the range of performances over the quarter was tight. Technology was the outperformer, with healthcare, consumer staples and consumer discretionary being the underperformers. Energy performed in the middle of the pack despite a 20% increase in the oil price over the period. Over the last 12 months, technology stocks were the best performers, with industrials and financials not far behind. The energy sector underperformed technology by almost 22%, with consumer staples also a noteworthy laggard by 25%.

The fund marginally underperformed its benchmark over the quarter, but is materially ahead year to date, as well as over the 12 month and two-year periods. The fund is shortly coming up for its three-year anniversary, and while the first year of its existence proved to be a very tough initiation period, we are confident of deploying our consistent philosophy focusing on the longer term with success into the future. The two-year absolute performance number of 19.2% per annum is particularly gratifying against the benchmark number of 15.3% per annum.

The most notable contributor to performance over the past quarter was our position in Estácio, the second largest tertiary education operator in Brazil. After the proposed takeover by Kroton, the leading player in the space, was blocked by competition authorities, the stock sold off. During their most recent reporting period, the company produced very credible results, proving to the market that they would be able to effect much of the enhanced profitability measures that Kroton promised investors, even as a standalone company. The share price responded very positively, helped by some other positive news for the sector overall. We have reduced our position significantly, but remain positive about the longer-term prospects for the sector and for Estácio. Over the last 12 months all our holdings in the alternative asset managers also contributed meaningfully to performance, led by the proposed delisting of Fortress. We have written extensively about the motivation for these holdings, and continue to hold most of the positions, but in much smaller sizes.

The two positions that hurt performance the most over the three months were L Brands (which we featured in our March 2017 stock commentary) and Pershing Square Holdings, a portfolio of blue chip US companies trading at a significant discount and actively managed by Bill Ackman, a widely respected activist fund manager. We continued to add to both positions as we remain convinced of the long-term investment merits of both positions. Over the last year TripAdvisor was another disappointment, but in this case we sold out of our holding in light of another change in company strategy and continued (in our opinion) poor operational execution by management. Our holdings in the retail pharmacy networks in the US and the UK also disappointed, and while we are nervously watching Amazon’s intentions and ambitions in this space, we are still holders of these stocks.

One of the new names introduced into the portfolio over the last three months warrants additional commentary. The French media group Vivendi caught our eye when we started analysing its record label business, Universal Music Group (UMG). While the last two decades has been extremely tough for music owners as the methodology for selling music kept evolving in a digital age - consumption has continued to rise but monetisation has decreased substantially due to piracy, amongst other reasons - we have now seen a decided turn in fortunes for the industry over the last few years (see graph below). Subscription services are growing handsomely in the developed world, and we believe in time this industry will relive its former glory days. UMG is the largest of three significant global players and owns the most comprehensive music catalogue, which we believe is underappreciated within the wider Vivendi group. The group holds other media and communication assets like pay-TV, telephony and more recently advertising agencies, and is controlled by a successful, if somewhat controversial, French industrialist family led by Vincent Bolloré. Although we would have preferred to own the music assets directly, we think the unique corporate structure and controversial family control is what has given us the opportunity to buy the position at what we believe is an attractive entry price.

Portfolio managers
Louis Stassen and Neil Padoa as at 30 September 2017

Please note that the commentary is for the US dollar retail class of the fund. The feeder fund is 100% invested in the underlying US dollar fund. However, given small valuation, trading and translation differences for the two funds, investors should expect differences in returns in the short term. Over the long term, we aim to achieve the same outcome in US dollar terms for both funds.

After an encouraging start to 2017, global financial markets continued their strong form into the second quarter of the year, buoyed by stronger than anticipated economic news out of Europe. Whilst economic data out of the US have generally been disappointing this year, corporate profits continued to surprise on the upside, providing further stimulus to the strong momentum these markets have enjoyed over the last few quarters. Commodity prices have retreated somewhat during the second quarter, led by the oil price that disappointed despite some decisive action by OPEC to constrain supply. The gold price has also been weak.
From a political perspective, the last three months brought more uncertainty, as president Trump continued to surprise both his supporters and his political adversaries with some of his erratic actions. Much-touted healthcare reform stalled due to a lack of support from within the Republican Party, prompting a reassessment of the likelihood that his promised tax reform will be implemented in 2017. The tepid outcome of the UK election contributed to intensified uncertainty regarding the Brexit negotiations. Despite this, the pound actually strengthened over the three months.

The US dollar continued to weaken against other major currencies as investors re-evaluated the prospects for the greenback. The euro was almost 7% stronger against the US dollar, and has now strengthened by just under 10% since the end of 2016. Emerging market currencies were however weaker, in line with weaker commodity prices, although some of their equity markets continued to perform well.

The MSCI ACWI index returned just over 4% over the quarter, bringing the year-to-date return to 11.5% and the 12-month lagging return to an impressive 18.8%. Emerging markets outperformed their developed peers over all these time periods, with the 12-month emerging market performance just over 5% higher than that of the ACWI. Europe outperformed the US during the quarter as the economic news out of the region surprised on the upside. The stronger euro also contributed to the outperformance. Over the last 12 months, these markets have now produced very similar returns.

Towards the end of quarter, global equity markets witnessed some extreme sector rotation prompted by a sell-side broker report advising clients to take profits in the high-flying technology sector. This correction gained momentum as an unprecedented large fine was levied on Google/Alphabet by the European Competition Commission. Over any longer time period, technology stocks have however outperformed all other sectors by a large margin. Energy, materials and telecommunication stocks were the laggards over the last three months. Over the last 12 months, the energy and telecommunication sectors were significant underperformers, with consumer staples a surprisingly weak spot as well. We commented about this correction in a previous report. Besides technology, financial stocks did well over the last year, helped in the last quarter by a renewed focus on the benefits of deregulation in this sector in the US.

Your fund performed reasonably well over the quarter, slightly outperforming the benchmark by 0.05% after all fees and costs. Towards the end of the period, performance came under pressure when the technology sector sold off, but the year-to-date outperformance of 2.9% (net of all fees) is still very satisfactory. Our one-year performance is very strong at 28.91%.
The biggest contributors to fund performance over the quarter were the alternative asset managers, which continued to rerate as the prospects for stronger short-term profitability improved with the buoyant equity markets, as well as some positive news regarding further fund raisings. Over the last twelve months, this sector contributed about 70% of the fund’s outperformance, aided by the take-out offer for Fortress. This vindicated our long-held positive view on the sector, which even though it added volatility to the overall portfolio, more than compensated in terms of superior performance. Other notable winners over the quarter included L Brands (featured in the previous quarterly report, but who issued a very disappointing trading update after quarter-end), Yum China (a small position which we exited during the quarter), American Airlines and PayPal Holdings. The airline stocks also feature highly on the 12-month contribution list, as do JD.com and Charter Communications.
Detractors over the last months included Liberty Global (following an immaterial restatement of financials due to fraudulent misrepresentation), Schaeffler (poor trading update), Urban Outfitters (very poor newsflow from conventional US retailers), and Estacio (featured in previous commentary, its proposed merger with Kroton has been rejected by Brazilian competition authorities). Over the last 12 months, our biggest mistake was holding TripAdvisor, where despite strong secular growth in the sector, poor operational execution led to very disappointing profit guidance. We have exited this position during the quarter as we lost faith in management’s ability to effectively compete with both established players (like Priceline) as well as new entrants in the sector (like Trivago). Our exposure to retailers like Urban, L Brands and Walgreens/CVS Caremark also cost the fund relative performance over the last year.

We have continued to add to our exposure in some of the retailers under pressure, with L Brands now a top-five position. We also introduced another consumer finance company, Discover Financial Services, in addition to our exposure to Capital One. We see their low ratings as an attractive investment opportunity, especially as their strong capital positions give flexibility in terms of capital allocation, despite the recent CCAR setback for Capital One. We reduced our exposure to some of the consumer staple names, as they continued to rerate after their sell-off towards the end of 2016. We continue to rate these companies highly in terms of quality, but have become more concerned about valuation levels.

Given the increased uncertainty regarding the outcome of the Brexit negotiations, it came as no surprise that the UK property sector remained in the doldrums. We used this period of heightened uncertainty to add to our position in Intu Properties, making it a full position in the fund (among the top 20 holdings). Intu owns a high quality portfolio of dominant retail centres in the UK, and whilst we cannot predict which way the negotiations will settle, we do think that over time this portfolio will retain its quality and relevance to the UK consumer, even in a world of increased online retail penetration. The share is trading at a significant discount to estimated net asset value, highlighting a stock that is discounting the worst possible outcome in our assessment. It also pays out a healthy dividend, with the share maintaining a dividend yield of 5.3%.

Portfolio managers
Louis Stassen and Neil Padoa as at 30 June 2017

All in all, the first quarter of 2017 was another good one for global asset performance. Although weakness in the US dollar somewhat flattered returns, almost every asset class delivered a positive return, with the exception of certain commodities. Gold reversed its position as the worst-performing asset class of the fourth quarter of 2016 to end at the top of the performance tables in the first quarter of 2017, rising 8.4%. This reflects heightened geopolitical concerns in various regions of the world, as well as a slightly more sanguine approach to what US President Donald Trump can or may do over the next few years.
Global equities were amongst the global asset classes that did well, rising 6.9%, and thereby continuing its outperformance of bonds (as has been the case since the global low point in yields seen around the time of the Brexit vote). Within global equities, the best returns came from the global technology sector, which rose 12%. Energy was the only sector that did not deliver positive performance, falling 5% on the back of lower oil prices.

The fund returned 9.7 over the three-month period, handsomely outperforming its benchmark return of 6.9%. As we have often argued in the past, this short-term performance is purely incidental, given the vagaries of financial markets over shorter periods of time. Our 12-month lagging return of 21.0% has been materially above the index return of 15.0%. Given the challenging start for the fund shortly after launch, we worked hard at overcoming this deficit, and are pleased to report that this milestone has been achieved. Incidentally, our developed market carve-out has outperformed its benchmark by more than 3% p.a. since inception (gross), again confirming that our philosophy and process are generating the required results.

The highlight of our portfolio returns over the last quarter was Softbank's offer to acquire 100% of Fortress Investment Group (at the time a top five holding within the fund). The offer price represented a 60% premium to the undisturbed price, and while we think it still undervalues the stock by between 20% and 30%, we recognised that the majority of the equity is held by management, who were supportive of the transaction and intended to stay on as part of the larger group. As such, even though we were a material minority shareholder, we could not influence the transaction outcome, and hence liquidated the position to invest the proceeds in other promising opportunities. Fortress contributed just over 2% alpha over the quarter, and just less than 2.5% over the last year. Since inception of the fund, Fortress's contribution was a more modest 0.33%. We continue to believe that the alternative asset management sector offers interesting investment opportunities, and remain committed investors in stocks like Blackstone, Apollo, KKR and Carlyle.

Other notable contributors to positive performance over the last year include Apollo, Estácio/Kroton (featured in previous commentaries), Amazon, and Charter Communications. We had two material detractors in Limited Brands and Tripadvisor. (Our investment thesis for Limited Brands is featured at the end of this commentary.) In the case of Tripadvisor, it was again a reminder about the importance of management and their ability to execute strategy that ultimately will be the largest determinant of success. At the time of investing in Tripadvisor, we also invested in Priceline, the online travel agency that owns powerful platforms like Booking.com. While TripAdvisor and Priceline operate in the same sector, and therefore benefit from the same strong secular drivers, Priceline's focus on driving simplicity and customer value has allowed them to significantly outperform TripAdvisor over the last few quarters, thereby creating exceptional value for shareholders. TripAdvisor, on the other hand, has been trying to migrate its business model to include other services and changed value propositions for its customers, in the process losing focus and making some operational mistakes. We are watching them carefully to see if they can ultimately monetise the strong brand and content that they are known for.

As equity markets continued to scale new heights, we have become more concerned about valuation levels. It is clear that markets have been giving Mr Trump the benefit of the doubt regarding his ability to reflate the economy and kick-start growth in the US, and ultimately across other regions of the world. We take a more sanguine approach in that we do not want to be paying for promises, especially coming from a volatile and inexperienced US administration. As such, we have bought some put options in the fund as protection (to a very limited extent) against exogenous shocks. These options, while cheap relative to history, still cost around 5% to 6% per annum for 'at the money' protection. We also continued to look for value in the more defensively positioned sectors such as consumer staples (as covered in our December 2016 commentary). The world remains an uncertain place, and while we embrace taking risk when we believe the odds are tilted in our favour, we have become a little more circumspect in this regard.

Investment case for Limited Brands Limited Brands is the owner of powerful brands like Victoria's Secret and Bath & Body Works. When we initially bought the stock, the investment thesis focused on a continued opportunity in the US for Bath & Body Works and, what we regarded as an outsized opportunity for Victoria's Secret in China. Since then, the competitive landscape (for Victoria's Secret) has intensified in the US, and coupled with continued pressure on footfall in conventional retail malls, investors have essentially given up on the company in terms of its ability to compete in its home market. While short-term profits have been rebased downwards, we continued to add to our position, such that Limited Brands is now a top five position in the fund. We regard the brands as very powerful and relevant for future consumers, and still believe in the longer-term opportunity in China. In the meantime, we are comfortable paying a 14 to 15 price earnings multiple for the reduced profit base with continued strong cash generation. We expect our patience to be handsomely rewarded at some point in the future.

Please note that the commentary is for the US dollar retail class of the fund. The feeder fund is 100% invested in the underlying US dollar fund. However, given small valuation, trading and translation differences for the two funds, investors should expect differences in returns in the short term. Over the long term, we aim to achieve the same outcome in US dollar terms for both funds.

The event that overshadowed financial markets this past quarter (and for that matter, the entire 2016) was the election of Donald Trump as the 45th President of the United States. For a second time during the 12-month period opinion polls got the final result of a major election or referendum dead wrong. While commentators were united in expecting the worst for equity markets in the event of a shock result, the opposite happened. The market upheaval has been spectacular, and these newly established trends were continuing to play out at the time of writing.

For a short while on 9 November 2016 (the first day after the US presidential election) equity markets declined sharply, but then closed the day up 1.1% (S&P 500 Index). The S&P 500 is now up over 6% since the election date. However, the most volatility has been experienced within sectors. Trump’s promises and threats regarding taxes and global trade reverberated across the market with spectacular results. Financial shares (more specifically banks) stood out and outperformed strongly (with the sector being up 21% for the quarter). This rally was fuelled by the promises of higher economic growth, lower effective tax rates, and less regulation. Most cyclical shares rebounded, especially those that should benefit from the promised infrastructural investment programme and the ‘Made in the USA’ initiative. The energy sector benefited from both the anticipation that less regulation will facilitate volume growth and a renewed effort by the major oil producers to curtail production to prop up the oil price. The losers in this rotation exercise were healthcare (even though a Clinton election would arguably have been worse for the sector), consumer staples (also impacted by a sharp increase in long-term interest rates discussed below in more detail), and information technology (although this sector should benefit from the proposed capital repatriation relaxation).

Some of these themes significantly impacted other assets classes. The promise of stronger economic growth, lower tax rates (implying a higher budget deficit) and some hawkish comments in response to the actions of the US Federal Reserve led to a sharp adjustment in interest rate expectations. The US 10-year yield moved from 1.85% on election day to 2.05% two days later, and finished the year at 2.44% - a massive adjustment of 60 basis points in a very short space of time. Expectations for short rates also kicked up, albeit not as dramatically. As a result of these moves, the real estate sector sold off, becoming the second worst performing sector over the quarter after health care. The US dollar strengthened from over $1.10 to the euro to the current level of around $1.05, but emerging market currencies perversely strengthened on the prospect of better global economic growth. The gold price fell from $1 275 to a low of $1 130 as inflationary expectations rose and the US dollar strengthened, and most commodity prices (especially copper) increased.
All of this culminated in one of the most memorable quarters in financial markets in recent history. The global index (MSCI All Country World Index) returned 1.2% over the quarter and 7.9% for the last year. Within developed markets, the UK was a notable underperformer given the continued uncertainty prevailing after the Brexit vote. Over the course of 2016, US equities performed strongly, outperforming the global index by around 4%. Emerging equity markets underperformed during the final quarter of the year as Chinese stocks declined on Trump’s anti-China rhetoric, but still outperformed the global index by 4.5% over the year. Brazil and Russia were the two stand-out performers over the year, supported by both currency strength and a strong equity rerating.

The fund performed well against this volatile backdrop. Its quarterly return of 1.7% outperformed the benchmark by 0.5%. More importantly, the fund return of 11.6% exceeded the benchmark return by a very respectable 3.7% for the 12-month period. This was a gratifying outcome given the fund’s poor relative performance in 2015. We have now clawed back almost all of the initial underperformance since launch in November 2014. We remain committed to not only erase this deficit, but also justify our active approach to fund management by achieving positive alpha on the medium to longer term.

Another gratifying feature of our more recent returns is the higher hit ratio we achieved over the past quarter. This ratio of 1.57, which represents the fund’s winners relative to losers in terms of individual stock positions, is the highest since inception. While the ratio in itself does not guarantee good performance (it is far more important to avoid big losers and upsize your winners), it is indicative of an investment process that adds value in terms of tilting the odds of outperformance in our favour. As a matter of interest, this number is still below 1.0 since inception as initially a number of our emerging market positions cost us dearly.

For the quarter, most of our positions in the more cyclical shares and alternative asset managers contributed positively. KKR, Apollo, and Blackstone were all notable contributors, as were Tempur Sealy (featured in our September 2016 fund commentary), American Express, and the US airline positions. TripAdvisor continued to disappoint (after another poor set of results), while some of our technology positions like Amazon and Facebook suffered from the vicious sector rotation. The fact that the fund still outperformed, despite being materially underweight US banks, shows that the bulk of the rest of the portfolio was very supportive.

The stocks that made the biggest contribution to the fund’s strong performance were Kroton/Estacio (Brazilian education stocks currently merging and explained in an earlier quarterly review), Apollo Global Management (alternative asset manager that have bounced back strongly after a prolonged period of poor share price performance), NetEase (Chinese gaming company subsequently sold after a very strong share price rerating), Charter Communications (still a big position) and Urban Outfitters (subsequently sold out and recently re-introduced into the portfolio). Losers over the period include TripAdvisor (mentioned before), JD.com (Chinese e-commerce operator still building scale), LPL Financial (financial advisory business sold after disappointing operational and strategic results), and Pershing Square (Bill Ackman’s listed vehicle, discussed in previous review and still one of the fund’s biggest positions).

Investors that follow the portfolio closely, will notice that for the first time since inception, we have added meaningfully to the consumer staple sector. In recent years, consumer staple companies rerated and traded at a much higher premium to the market compared to the historical average. These companies were in demand not only for their defensive qualities amid a weaker world economy, but also as alternatives to government bonds (as they offered attractive dividend yields, low risk and the high probability of earnings growth). All of this changed when bond yields spiked after the Trump result, and these shares were shunned (and heavily sold) in favour of more cyclical shares that would benefit from many of the president-elect’s proposed policies. We added roughly 8% of the portfolio to a basket of these shares. The biggest buys include British American Tobacco (1.7%), Anheuser-Busch Inbev (1.4%), Unilever (1.2%), and Heineken (1.2%). Seeing that we expect the long bond yield in the US to continue rising over the next few years, we might get more opportunities to buy some of these highquality companies at attractive valuation levels, and we are standing ready to do so. However, we will always be conscious of valuation, wanting to pay a fair entry price, as this will be the key determinant in whether a holding will add value to the overall portfolio performance.

The global economy and markets enter 2017 on a considerably firmer footing than last year. However, markets have moved quickly to reprice assets that should benefit from this improved outlook, and as such we have become slightly more conservative in our portfolio positioning. The above holdings in the consumer staples have added to the reduced risk profile. We have also bought some put options to protect the fund against unforeseen hiccups, as the cost of these protection strategies remains attractive in our opinion.