Year-to-date in 2017, the fund has appreciated by 21.1% in rands and is 9.6% ahead of its benchmark. The fund’s equity exposure over the quarter averaged around 74% and in an environment of rising global equity markets, this positioning was a key part of the return. Emerging markets continued to outperform developed markets and emerging market exposure in the fund (around a quarter of total equity exposure during the quarter) was also therefore a positive contributor. Over the past five years, the fund has generated a return of 19.4% per annum and since inception 18 years ago, it has produced a return of 15.0% per annum.

The fund ended the quarter with 73.5% of its capital invested in equities, with 74% of the equity exposure being invested in developed market equities, 21% in emerging market equities and 5% in South African equities. The equity exposure was slightly down over the quarter, although we had already reduced this exposure earlier in the year. Global equities are clearly not as attractive as they were a few years ago, but we are still able to find good selected value in a number of global stocks. The fund’s equity exposure remains reasonably concentrated, with the largest positions being in technology (both global and Chinese internet businesses), the private equity investment managers, selected global car companies, selected global consumer companies, Brazil education and Russian food retail.
Our negative view on global bonds remains unchanged and we had no exposure to the asset class throughout the three-month period. Bond yields finally started to rise over the past few months, but they would still have to rise materially before we would become interested in the asset class. The fund has 5.7% invested in global property: we are still finding selected value in the UK, Germany and increasingly in the US, where we bought two new retail property stocks during the quarter. Lastly the fund has a physical gold position of 2.5%. The balance of the fund (18%) is invested in cash. As has been the case for a number of years now, the bulk of the fund (over 90%) is invested offshore, with very little being invested in South Africa (5% in total, with Naspers making up over half of this exposure).

The largest new buy during the quarter was a 3.2% position in Airbus. Airbus and Boeing are effectively a duopoly in the global aircraft manufacturing industry. Airbus earns around 55% of revenue from fast growing emerging markets (EM), and the share of its order book (future confirmed orders by airlines) from EM airlines is 60% and rising. While Airbus’s earnings have historically been erratic, its capital intensity high and its return on capital low, we believe there have been some material changes in the way Airbus is owned and managed that make the past history a poor guide to its earnings power going forward. The most important of these changes is the reduced influence of the European state shareholders that historically drove the strategic decisions of Airbus. The company was originally formed by European nations to provide an alternative to US dominance of the industry, so the level of interference by European governments has always been a big detractor to the investment case. Since 2012, however, the aggregate shareholding of the major European governments (France, Germany and Spain) that ran Airbus reduced to below 30% and the company has been professionally managed with limited outside influence. This change makes it far less likely that Airbus will embark on value destructive developments like the A380 Superjumbo.

Today Airbus has an offering in all core segments of the market - from narrow-body single aisle aircraft (the A320 series and its derivatives) through to the A380 Superjumbo. Crucially, they have the A350 which is ramping up production, which will compete with Boeing’s 777 and 787 and was the one big gap in their portfolio. Having a full range of offerings is important because many airlines prefer to operate only Boeing or Airbus to achieve economies of scale on their purchases, maintenance as well as pilots who are typically certified to fly only one of the two manufacturers. Despite the cyclicality of air travel demand in individual countries and regions, the overall demand has grown almost uninterrupted since the early 1970s (growth of 2x global GDP over the last 40 years) when mass market commercial travel first became affordable. This period has spanned several oil and geopolitical crises, as well as the dotcom bubble and Global Financial Crisis. In addition, 80% of the world’s population have still never flown on an airplane. Importantly, Airbus’s order book has a 10-year backlog - meaning that at current rates of production it would take 10 years to fulfil all their existing confirmed orders.

Airbus has historically earned low single-digit margins as for most of the last two decades Airbus was effectively state owned and lots of capital was spent developing products with limited commercial appeal, such as the A380. Under professional management we do not believe this mistake will be repeated. The quirks of accounting also means that in the early years of developing an aircraft there are significant losses that depress earnings (as has been the case over the past few years), while once a new model enters into mass production (as is the case now) the margin increases quickly as these losses fall away. A look across Airbus’s product portfolio shows all their major designs are well beyond the development phase and, in particular as the A350 production ramps up, operating margins can reach double digits within the next few years. Besides the ramp up of the A350, higher pricing on the new A320neo model (the new version of the existing smaller short-haul model) will also assist margins, as will the unwinding of FX hedges. As a reference point, Boeing already generates double-digit operating margins and are targeting mid-teen margins. Importantly, the next several years will also see lower R&D and capex (Airbus is coming out of a heavy investment cycle) and hence higher free cash flow generation (c. 80% free cash flow conversion) and return on invested capital (19% ROIC from around 10% today). While corporate governance has improved at Airbus over the past few years, there are still risks in this regard and this remains a cyclical business that will be negatively impacted by extreme global events as well as currency movements. We do however factor this into our valuation (using a lower multiple to value the business than would otherwise be the case) and we still get substantial upside to fair value for what is in effect a global oligopoly (Airbus and Boeing together have 90% market share) in a structurally growing category (global air travel) with very visible earnings and free cash flow growth over the next five years.

Portfolio managers
Neville Chester, Gavin Joubert, Karl Leinberger, Mark le Roux and Louis Stassen

For the first half of 2017, the fund appreciated by 9.6% in rand and was 6.0% ahead of its benchmark. The fund’s equity exposure over the quarter averaged around 75% and in an environment of rising global equity markets, this positioning was a key part of the return. Emerging markets continued to outperform developed markets and emerging market exposure in the fund (around a third of total equity exposure during the quarter) was also therefore a positive contributor. Over the past five years, the fund has generated a return of 18.5% per annum and since inception 18 years ago, it has produced a return of 14.6% per annum.

The fund ended the quarter with around 75% of its capital invested in equities, with 45% invested in developed market equities, 25% in emerging market equities and 5% in South African equities. The equity exposure was largely unchanged over the quarter, although we had already reduced this exposure earlier in the year. Global equities are clearly not as attractive as they were a few years ago, but we are still able to find good selected value in a number of global stocks. The fund’s equity exposure remains reasonably concentrated, with the largest positions being in technology (both global and Chinese internet businesses), the private equity investment managers, selected global car companies, selected global consumer companies, Brazil education and Russian food retail. Our negative view on global bonds remains unchanged and we had no exposure to the asset class throughout the three-month period. Bond yields finally started to rise over the past few months, but they would still have to rise materially before we would become interested in the asset class. The fund has 4% invested in global property (we are finding selected value in the UK and Germany), and it has a physical gold position of 2%.

As has been the case for a number of years now, the bulk of the fund (over 90%) is invested offshore, with very little being invested in South Africa (6% in total with Naspers making up over half of this exposure). Given the recent political developments in South Africa (the firing of the finance minister and his deputy, the downgrade to junk by S&P and Fitch, the continued political and economic uncertainty) and the resultant very uncertain future for the country, we remain comfortable with 90%+ of the fund’s assets being invested offshore. It is very unlikely that we will be increasing the fund’s South African exposure in the near future.

Potfolio managers
Neville Chester, Gavin Joubert, Karl Leinberger, Mark le Roux and Louis Stassen as at 30 June 2017

For the first quarter of 2017 the fund appreciated by 6.0% in ZAR (+8.2% in USD) and was 2.9% ahead of its benchmark. The fund's equity exposure over the quarter averaged around 75%, and in an environment of rising global equity markets the equity exposure played a key part in the fund's return. Emerging markets outperformed developed markets and therefore emerging market exposure in the fund (around one third of total equity exposure during the quarter) was also a positive contributor.

The fund ended the quarter with 73.2% of its capital invested in equities, of which 44% was invested in developed market equities, 23% in emerging market equities and 6% in South African equities. We reduced the fund's equity exposure during the quarter (from 81% at the end of December 2016 to the current 73%) as equity markets continued to appreciate, naturally making equities less attractive. The reduction in equity exposure was through a combination of reducing a few individual positions and through buying put options on the S&P 500 index.
We added to the fund's listed property exposure over the quarter by adding to existing positions in Intu Properties, Hammerson (both UK) and Vonovia (German residential) as well as buying a new position in Capital & Counties (UK). As a result, the fund now has 3.5% invested in property stocks. Twothirds of this property exposure is in the UK property stocks. While there is of course uncertainty ahead given Brexit, the valuations of these companies are very attractive in our view: both Intu and Hammerson trade at over a 20% discount to tangible book value and have dividend yields of over 4%.

Our negative view on global bonds remains unchanged and we had no exposure to the asset class throughout the three-month period. Bond yields finally started to rise over the past few months, but they would still have to rise materially before we become interested in the asset class. Lastly, the fund bought a new small position in gold (2% of fund in physical gold through an ETF). Gold has declined substantially over the past five years. This, coupled with the risks that currently exist worldwide, warrant a place for some gold exposure in a diversified portfolio.

As has been the case for a number of years, the bulk of the fund (94%) is invested offshore with very little being invested in South Africa (6% in total, with Naspers making up over half of this exposure). Given the recent political developments in South Africa (the firing of the finance minister and his deputy and the downgrade to junk by S&P and Fitch) and the resultant very uncertain future for the country, we remain comfortable with 95% of the fund's assets being invested offshore, and it is very unlikely that we will be increasing the fund's South African exposure in the near future.

The fund appreciated by 8.9% (in US dollars) in 2016, but declined by 3.5% (in rand terms) as a result of the local currency strengthening by 13% over the period. Since inception just less than 18 years ago, the fund has generated a return of 14.5% per annum (in rands) and 9.5% per annum (in US dollars).

The fund ended the quarter with around 80% of its capital invested in equities, of which 40% was invested in developed market equities, 35% in emerging market equities and 5% in South African equities. The fund has 2% invested in global property stocks (German residential and UK retail). Our negative view on global bonds remains unchanged and we had no exposure to the asset class throughout the three-month period. Bond yields finally started to rise over the past few months, but they would still have to rise materially before we become interested in the asset class.

Over the past few months we continued to add to Yum! Brands (owner of KFC, Pizza Hut and Taco Bell globally) and also added to Yum China after it was spun out of Yum! Brands. Following the split, the original Yum! Brands now consists of all operations globally (excluding China) and over 40% of earnings come from emerging markets: 20% alone comes from the royalty fee from the Chinese business. 100% of Yum China’s earnings come from the 7 300 units in China.

Yum! Brands owns three of the best global fast food brands, has defensive and stable earnings, generates large amounts of free cash flow and has very high returns on capital. This is particularly the case for the original Yum! Brands, where 93% of units are franchised (compared with the Chinese business where 80% of stores are company owned), resulting in even higher returns on capital (>100%) and free cash flow generation relative to earnings. The original Yum! Brands continues to refranchise units with a target of being 98% refranchised by 2018. This will raise the firm’s return on capital and lift its conversion of earnings into free cash flow even higher. In the case of Yum China we believe that there are still many years of growth left in China (due to low penetration of units and a fragmented quick service restaurant market) and, in addition to this, profitability is currently below normal in our view. We think both stocks are attractive and together these two positions now make up around 3% of the fund.

We also bought a new position in Nike, which has been a holding in the past. In our view, Nike is amongst the best businesses in the world. Its brand is iconic, it is the global leader in a structurally growing market and has high exposure to emerging markets (42% of profits), generates ROEs of 30% and converts around 90% of its earnings into free cash flow. Going forward, we believe the company can continue to grow its top-line in the high single digits and that it can also expand margins through continued purchasing and manufacturing efficiencies as well as due to an increase in the contribution of the higher margin retail and e-commerce divisions. Recently, Nike's share price has been under pressure due to slower short-term earnings growth, partly due to decent performance from rivals such as Adidas and Under Armour, and we used this opportunity to build a position.

As is often the case, there a number of developments in the world to worry about: The new US president-elect Donald Trump, Brexit, China in general, etc. We simply continue to do what we have always done: while being aware of the macro risks, we spend our time primarily doing detailed bottom-up research with the goal of finding attractive investment opportunities. In this regard, we continue to find good selected opportunities all over the globe.