The financial sector returned 5.1% for the quarter, lagging the JSE All Share Index return of 8.9%. Over the same period the fund returned 4.4%. Over longer periods, the fund performance remains respectable relative to both its benchmark and competitors, delivering per annum compound returns of 13.5% over five years (slightly behind the index), 11.8% over 10 years (roughly 1% ahead of the index) and 13.1% since inception.

Once again banks outperformed life insurers over the quarter. Over a 12- month period, the outperformance is now substantial with banks returning 13% compared to a return of 5.3% from the life insurers. The fund has been well positioned for this, consistently holding a heavier weighting in banks relative to the benchmark than insurers. Contributors to fund performance for the quarter were overweight positions in FirstRand, Standard Bank and Discovery and underweight positions in Barclays Africa Group (BGA) and property stock Hyprop. Detractors from performance included the fund’s holdings in Capital & Counties, MMI, Nedbank, Ethos Private Equity and Brait.

During the quarter, we increased the fund’s position in Nedbank, RMI and HCI and reduced its holding in BGA (sold to zero), Investec and Discovery (both of which remain significant investments in the fund). In addition, we switched some of the FirstRand exposure into its holding company RMH on a widening discount, and switched half of the fund’s shareholding in Capital & Counties into its peers Hammerson and Intu. These three UK property stocks have detracted from fund performance over the past 12 months, but together remain a substantial holding in the fund, at 8% - 9%. Why do we continue to hold them?

· Principally: valuation. A number of factors have impacted the ratings of all three stocks, but uncertainty around the eventual implications of Brexit and the potential for structural changes to the UK retail environment are probably the biggest. It is difficult to know with certainty how these will play out, but there appears to be a very healthy margin of safety in valuation. Intu, Hammerson and CapCo trade at substantial discounts to NAV (43%, 31% and 23% respectively) and the former two produce forward dividend yields of 6.4% and 5.0%. While the disclosed NAV rests on a number of assumptions regarding future events and may fluctuate somewhat over time, the attractive dividend yields afford one the opportunity to wait for the impact of a more stable environment to manifest.

· Within the sector, there are limited opportunities to diversify away from a very challenging domestic macro environment. Certain businesses, such as Old Mutual, Investec, Discovery and Brait provide some diversification in their mix, but it is only Reinet and the UK property stocks that allows one to detach fully from the drivers of the South African economy.

The third quarter is a busy time with most financial companies reporting results (predominantly interim results). The impact of the challenging domestic operating environment is unsurprisingly evident in these numbers. The banks reported low levels of asset growth, but the impact on earnings was partly offset by benign credit impairments, good cost control and strong results from the corporate and investment banking divisions, as well as the ‘rest of Africa’ businesses in the case of BGA and Standard Bank. The domestic life insurers experienced a challenging new business environment and received little help from equity and bond markets, reporting earnings that were broadly flat or down on prior comparable periods.

One of the exceptions to the subdued results tone is Discovery, a business in which the fund has consistently held a significant position (currently 6.3%). Reported earnings grew by only 8% in the period, but this masks a number of encouraging developments. Discovery has been extremely successful in disrupting traditional financial services industries by incentivising consumer behaviour to drive improvements in client wellbeing, as well as customer retention and profitability (what Discovery refers to as its Shared-Value model). Its established businesses in South Africa are strong operations with stable growth prospects, and its short-term insurance business has recently turned profitable.. In the UK, the company is starting to gain good traction in its Vitality Health insurance business, although the Vitality Life insurance business remains challenged by the low interest rate environment. Outside of these two markets, Discovery partners with large established insurers to leverage its intellectual property, either on a profit-share basis in most significant insurance markets, or in the case of China in a JV with Ping An Life, the country’s largest private insurer. These businesses are relatively immature, yet traction is growing strongly and losses are reducing. The opportunity in these markets is significant. By way of example: in the 12 months to June, the Ping An health insurance business increased membership five-fold to 3.7m lives (more than the total lives that the dominant SA health business has gathered in its 25 years of existence) with stable or improved operating metrics, and the Vitality Active Rewards programme was sold to 2.4m Ping An life clients. In addition to these emerging businesses, Discovery continues to invest in new initiatives - it will launch a bank and an umbrella funds business in South Africa as well as an investment business in the UK in 2018.

Discovery is a complex business to analyse - the nature of a growing longterm insurance business is such that it takes some time before earnings are backed by cash flow, and the company makes use of innovative funding structures. At face value, the share often looks expensive on both price to earnings and price to embedded value metrics. However, this ignores the fact that losses from the emerging businesses and investments into the new initiatives are fully expensed, and embedded values are only carried for the established SA and UK businesses. It is difficult to know which of its initiatives will be successful and which will not, but the opportunity for value creation over time by a highly energised and innovative management team that is strongly aligned to shareholders is significant. We remain happy shareholders of this business in the fund.

Portfolio managers
Neill Young and Godwill Chahwahwa as at 30 September 2017

The JSE’s financial index was flat for the quarter, and within that, banks returned 0.9% while the life sector (-1.8%) underperformed. The financial fund generated -0.8%, lagging the index for the quarter, and bringing the one-year return to 3.4% for the fund, compared to 2.6% for the index. Over more meaningful periods of three, five and ten years, the fund returned 3.8%, 13.7% and 11.0%, relative to index returns of 6.4%, 14.0% and 10.1%, respectively.
Contributors to performance for the quarter included holdings in Investec, PSG Konsult, Afrocentric Investment Corporation and Peregrine Holdings, as well as the fund’s underweight position in Growthpoint Properties. Holdings in Nedbank, MMI and Brait as well as underweight positions in Capitec and the property stock New Europe Property Investments detracted. We have spoken in the past about the importance of including smaller-cap financial stocks in the portfolio given the fund’s limited universe (as well as the limited investor interest in the sector) and the contribution from these stocks was again evident during the quarter. Nedbank, MMI and Brait came under pressure during the period, following weak results from Ecobank, an associate holding for Nedbank, as well as poor operational results from MMI and Brait. However, we remain confident in the underlying intrinsic value of these stocks despite the near-term challenges they face. Capitec remains a great business, well-positioned for growth in the market, but we believe the share is currently priced for perfection, leaving no margin of safety to justify a position in the fund.

The domestic political turmoil that characterised the first quarter of the year continued into the second quarter, with the fall-out from the axing of respected finance minister Pravin Gordhan followed by the downgrade of SA’s foreign credit rating to junk status by ratings agencies Fitch and S&P. We are now faced with a local economy where business confidence is collapsing and the growth outlook has rapidly deteriorated, leaving the currency looking vulnerable. This is an operating climate that will prove challenging for all financial companies. Banks will struggle to grow advances, transaction activity in the market will decline and loan collections are likely to deteriorate further. Life companies will in all likelihood face rising lapses and lower levels of new business volumes.

Importantly however, valuations for both banks and insurance companies have declined to reflect some of these concerns. The SA banks now trade between 7.5x and 10x forward price-earnings ratios, and on 5.8% to 7.5% dividend yields. Bank shares are offering upside of between 15% and 30% to our assessment of their intrinsic value. The picture for the life sector is not very different, with valuations offering between 20% and 50% upside to our fair value estimates. Near-term earnings will undoubtedly come under some pressure for both banks and insurers, but we remain comfortable with the through-the-cycle strength and resilience of the businesses we are invested in. Importantly, it is in the tough times that the higher-quality businesses typically outperform the poorer-quality ones, and hence our continued focus on investing in businesses with experienced management teams, robust operating models as well as strong and enduring brands.

Despite political uncertainty and the sovereign ratings downgrade, the rand strengthened by some 2.7% during the quarter and looks vulnerable at current levels, especially if we should see a further downgrade to junk status of SA’s local currency credit rating. As such, we have maintained a reasonable exposure to rand hedges within the portfolio, by investing in businesses that generate some of their earnings in developed market currencies, and whose valuations provide an adequate margin of safety. Examples of these include Investec, Old Mutual, Reinet, Capital and Counties, Hammerson and Intu Properties. We have written before about the opportunity we see in UK property names following the big sell-off in these stocks, as well as in the British pound, in the aftermath of the Brexit referendum. The result of the recent UK general election has raised the prospect of a ''softer'' Brexit, the implications of which are difficult to know, but which could potentially result in a more supportive operating environment for these businesses than under a hard Brexit scenario.

During the quarter, Barclays PLC sold down its holding in Barclays Africa Group (BGA) from 51% to 16% via an accelerated book build. In addition, BGA received £760m from Barclays PLC to replace systems and brands they previously accessed from Barclays as a subsidiary. The valuation of BGA came under significant pressure ahead of this sell-down. It was trading at very compelling levels and we participated in the book build, buying some BGA for the fund. The business still has some significant challenges to overcome as it transitions from the Barclays systems and brand in the rest of Africa, but we felt that there was sufficient margin of safety in the valuation to justify the position. Additional buys for the quarter included Afrocentric and Brait. We reduced or sold out of holdings in Remgro, Nedbank, RMI, Sanlam and Investec.

Times of uncertainty combined with the cyclical gyrations of the economy often provide great investment opportunities for the patient investor. We continue to focus on the valuations of businesses on a through-the-cycle basis and attempt to cut through today’s noise when building portfolios. This strategy has stood us in good stead in turbulent times in the past and we have no reason to believe that this time things should be any different.

Portfolio managers
Neill Young and Godwill Chahwahwa as at 30 June 2017

The first quarter of 2017 was characterised by a resurgence in political turmoil that impacted directly on financial sector returns. For the quarter, the sector was on track to deliver a 2% return. However, the dismissal of the finance minister and his deputy on the last day of March meant that financials ended the quarter with a negative 1.1% return. Against this backdrop, the fund delivered -1.2%. Over one year, the fund return is similarly negative (-1.4%) but ahead of the index return of -1.8%. Over the more meaningful periods of three, five and 10 years the fund has returned compound annual returns of 7.2%, 14.6% and 10.9% compared to index returns of 9.2%, 15.0% and 9.9% respectively.

Banks returned -6.3% for the quarter. This negative return is entirely attributable to the events of the last day of March. Life insurance companies fared slightly better in the sell-off, ending the quarter up 3.2%. Overall, financial sector returns were bolstered by positive contributions from property and non-life insurance stocks as well as investment trusts.

During the quarter our view on the South African macro outlook turned more positive. This was partly predicated on the low base of the year before. The benefit of currency strength and an end to the drought meant that the outlook for inflation had improved and an interest rate cut towards the end of the year seemed probable. In addition, sustained commodity price gains should have provided something of an underpin to economic growth. This would create a positive environment for domestic cyclical stocks, particularly banks. With this backdrop and despite their strong performance in 2016, bank valuations remained relatively undemanding. As a result, we maintained a healthy exposure to the three South African banks that we consider to be of high quality - FirstRand, Standard Bank and Nedbank, and built a small position in Barclays Africa Group. President Zuma's cabinet reshuffle and a subsequent credit rating downgrade by S&P sets us on a different path. You can refer back to the fund commentary of December 2015 following then finance minister Nhlanhla Nene's dismissal to infer the likely consequences - a swing to populism requiring expansionary fiscal policies, a weaker currency, higher inflation, higher borrowing costs and lower growth. The difference this time around is that any reversal of course seems extremely unlikely, and certainly nothing will change in the near term. Some of the damage has already been done, and it is difficult to know how much more will be inflicted before any change comes about, if it comes about at all.

While these events have been a great disappointment to many, they have not been entirely unanticipated. In constructing portfolios in this environment at Coronation, we have done our best to balance exposures in order to provide some protection in the event of this kind of scenario. Despite investing in a more constrained universe we have done the same in the Financial Fund. So while we have maintained an overweight exposure to South African banks, we have balanced this with a healthy exposure to businesses with earnings streams derived from outside South Africa, including UK property stocks, Reinet and Brait as well as Investec and Old Mutual, both of which have operations in developed markets. In total, these stocks comprise roughly a third of the portfolio. These holdings buffered returns somewhat over the period, and continue to do so.

Contributors to the fund's performance for the quarter were its overweight positions in Discovery and Nedbank along with underweight positions Barclays Africa Group, JSE Limited and Brait. Detractors included underweight positions in Sanlam, Capitec, PSG and property stock Growthpoint as well as an overweight position in FirstRand. During the quarter we bought Barclays Africa Group (based on compelling valuation and for reasons highlighted earlier), Peregrine, Brait, Remgro and Capital & Counties. We reduced or sold out of positions in Liberty Holdings, Investec, Rand Merchant Bank Holdings, Santam, and MMI.

The natural question is where to from here. At the time of writing, banks are down 10% from their close on Friday, 24 March, the last working day before former finance minister Gordhan was recalled from an overseas investor roadshow. Over the same period, the rand is 11% weaker. The fundamentals of domestic-facing businesses are unquestionably poorer than they were before these events. Banks are likely to be challenged by weaker advances growth, higher funding costs and increases in impairments. Life insurance companies will continue to face pressure on new business, disability claims and lapses on savings products in particular, and will probably be faced with weak equity market returns.

Valuations have discounted at least some of this. Banks trade on 12-month forward multiples of between 7.5 and 9.5 times earnings, with dividend yields in excess of 6%. They have strong management teams that have prepared as best they can for this kind of eventuality: the businesses are well capitalised and run with sufficient liquidity, and lending books are healthily provided. Unlike some of the life companies, these banks are most of the way through dealing with restructuring (Barclays Africa Group being the exception) and regulatory changes. In general terms, our preference for the higher-quality banking franchises remains. It is difficult to know how much lower the market will take the share prices of these businesses, but with valuation as the anchor it would seem the wrong time to be reducing exposure to them now. We continue to balance this with a healthy allocation to businesses with offshore earnings streams, the share prices of which have benefited from the rand's weakness in the wake of recent events.

The final quarter of 2016 delivered a positive 2.9% return for the financial sector, against which the fund returned 3.7%. Over one year, the fund returned 4.6%, lagging the index return of 5.4%. Over the more meaningful periods of 3, 5 and 10 years, the fund returned 9.5%, 17.4% and 12.0% against benchmark returns of 11.7%, 18.1% and 10.8% respectively. Disappointingly, the impact of a tough two years for the fund in terms of relative returns has pushed the 3 and 5-year performance numbers below the benchmark, something that is front of mind for us as we move into 2017.

For the fourth quarter of 2016, contributors to performance included the fund’s underweight position in an underperforming Brait SA, as well as overweight positions in Investec PLC, RMB Holdings, FirstRand and Nedbank, which all outperformed. The Brait share price declined a further 23% in the quarter on the back of softer UK retail conditions and a depreciating pound, which hurt its investments in New Look and Virgin Active. Brait was down 47% for the year and starting to offer some margin of safety relative to intrinsic value. Detractors from the quarterly performance included overweight holdings in Hammerson PLC, EPE Capital Partners and Old Mutual which underperformed, and the fact that the fund didn’t have exposure to Barclays Africa Group and Capitec, which outperformed. The potential for value destruction associated with the ongoing dis-investment by Barclays PLC from Barclays Africa Group has kept us from investing in the latter. Capitec continues to grow strongly and gain market share among core banking customers in SA, but we believe that this positive outlook is more than priced into what is a very demanding valuation.

The financial sector returned 5.4% for the year, with very divergent performances from the various sub-sectors. Domestic property was positive for the year, delivering 10.2% return. After selling off aggressively in the wake of Nenegate in December 2015, banks rebounded strongly in 2016, delivering a stellar 34%. The big four SA banks reported operating results to June which demonstrated resilience in a tough macro environment, supportive of the strong re-rating. The life insurance sector (-5%) had a poor year, as evidence of poor persistency and softer new business volumes emerged in their results. The sector subsequently de-rated from the higher valuations reached in 2015.

In past commentaries, we discussed our preference for banks over life companies, and this was a positive contributor to returns for the year. However, the fact that the fund does not hold domestic property, combined with a significant holding in stocks exposed to Brexit (discussed further below) detracted from returns. The fund is typically used as a building block for investors looking for direct exposure to financials and related stocks. As a result, it does not invest in domestic property. Should they wish, investors can gain direct access to domestic property by investing in a pure domestic property fund, also available as a building block.

Following the derating in the life sector, we are starting to see better value emerging in the life sector relative to banks. The fund has significant holdings in Old Mutual, Discovery, MMI and we have recently initiated smaller positions in Liberty and Sanlam. Of our large life holdings, Old Mutual and Discovery under-performed the sector in 2016, in part due to Brexit. Old Mutual was a particular disappointment given that the business is trading at a discount to the sum of its parts, with a new CEO who is incentivised to unlock this value. The first year of this strategy was plagued by higher costs and the departure of some senior managers, with the share de-rating as a result. We continue to see good long-term value in Old Mutual in spite of these early set-backs.

The surprise outcome of the British referendum to leave the EU had a negative impact on the fund. The British pound and UK stocks declined sharply in the aftermath of the vote, reflecting a weaker outlook for a Britain outside of the EU. Some of the companies listed in our market have direct exposure to the UK, and were not spared in this sell-off. Included on this list are Investec, Capital and Counties (Capco), Discovery and Old Mutual. We hold overweight positions in all of these companies, which detracted meaningfully from relative returns for the year.

Why then do we continue to hold these stocks? Clearly operating conditions are likely to become more challenging in the UK under a Brexit scenario, and the weakness in the pound, if sustained, means that the rand value of their UK subsidiaries has been impaired.

-We believe that the sell-off in these stocks exceeds the potential value reduction in the affected UK subsidiaries of these companies. As such, our assessment is that the intrinsic value of Investec, Old Mutual, Capco and Discovery exceeds current share prices.
-The sell-off in the pound has overshot what we believe to be a fair level for the currency. The pound should normalise over the long term.
-The finer detail around Brexit will still be negotiated.
-The strong run in domestic stocks (e.g. SA banks) means that the relative attractiveness of our holdings in UK-focused companies has increased. Discovery, Old Mutual, Investec and Capco now offer a wider margin of safety than the domestic banks for example.

Clearly, there is a lot of uncertainty around Brexit, but we often find that it is in these periods that stock prices diverge from their intrinsic values, presenting good opportunities for the long-term investor. In our September commentary we discussed in detail the opportunities in the UK property sector: our view remains largely unchanged.

In a limited universe of companies, we continue to see value in some of the smaller, less-researched financial stocks. Over the 2016 year, the fund benefited from holdings in Coronation Fund Managers, HCI, Santam, Sygnia, Sasfin, Zeder and Peregrine. This is an area we continue to focus on closely and has been an important differentiator for the fund over the long term.

Going into 2017, we reiterate our view that financial stocks in SA are faced with challenging economic conditions. Weak economic growth and pressure on employment and real wage growth are likely to have a negative impact on asset growth and impairments for banks and new business volumes, as well as persistency for insurers. We will continue to seek out opportunities where we believe valuations more than fully reflect these tougher prospects, while still providing the long-term investor with some adequate margin of safety.