Unlike other funds in the sector, which all passively track the FTSE/JSE top 40 index (Alsi 40), Coronation Top 20 (CT20) takes an active approach. Fund manager Gavin Joubert says the index is used merely as a benchmark.

This is seen in CT20's portfolio structure, which differs radically from the Alsi 40. For instance, exposure to resource shares, at 21%, is under half that of the Alsi 40. Joubert says most resource stocks are overvalued even if you factor in a weaker rand of, say, R8/US$.

CT20 is home to what many would call "big-bet" views. "If you are really confident on your view, three-quarters of the portfolio's holdings should be in the 9%-10% range," says Joubert.

Only 16 stocks are held at present, so confidence abounds. The top five alone represent 53% of exposure and the top 10 stocks account for 91%. At the pinnacle is a 10,8% exposure to Telkom, a share with a 1,7% weighting in the Alsi 40 at the moment.

Joubert says that even when Telkom gets a fixed-line competitor, it should generate free cash flow of about R14/share for a number of years. "This is truly free cash flow and, because there are few acquisition prospects, a large part of this cash could be returned to shareholders in the form of dividends and share buy-backs," he says.

Exposure to most other financial and industrial sectors is within tolerable limits. But the small number of stocks does not allow for a high degree of stock-picking error.

This may not appeal to advocates of risk diversification, but CT20's performance record can have few detractors. In its sector it has vindicated active management, its 83,3% three-year return trouncing its peer group's 49,6% average. CT20 has also achieved lower price volatility than the Alsi 40.

But there are limitations in a fund restricted to big-cap shares. CT20 has in the past been unable to take advantage of undervalued smaller-cap shares. Here value funds, unrestricted by market cap limitations, have a distinct advantage.

Financial Mail - 19 November 2004

The Top 20 Fund produced a return of 12.9% over the quarter. For the one year to end September 2004, the fund has appreciated by 43.9% compared to the 35.3% return of the ALSI 40, and over three years the Top 20 Fund has achieved an annualised return of 23% compared to the 16% of the ALSI 40.
The most significant contributor to the portfolio over the quarter was Absa; already a top 10 holding and over 5% of the total portfolio prior to the bid from Barclays. We started buying Absa early in 2003 based on our view that the South African banks were particularly cheap, trading on P:Es of 5 or 6 at the time. We couldn't identify a "catalyst" to re-rate the banks: a common argument at the time was that SA banks were over-owned by institutions, and therefore local institutions could not buy any more banking shares which would result in their drifting sideways for a long period of time as the only other potential buyer (foreigners) were not interested in SA banks. Our view is that valuation is the only "catalyst" that you need. In other words, if a stock is fundamentally undervalued, and by a significant margin, you need not waste an inordinate amount of time in trying to identify the event (or catalyst) that will cause that fundamental value to be realised. If the value is there, it will be realised over time. In the case of Absa, the fund's average purchase price was R 34.65 a share 18 months ago. The fund is likely to receive over R70 a share from the Barclays bid, which represents a return on investment of 100% in less than 18 months. So much for catalysts. And so much for foreigners not being interested in SA banks.
There were no new purchases in the fund over the quarter, rather the fund used the opportunity of weakness in certain to stocks to add to existing positions, including Telkom, Naspers, Impala Platinum, Sasol and Metropolitan. During the period, the Minister of Communications announced regulatory changes that could result in effective full deregulation of the SA Telecommunications market (i.e. several competitors), as opposed to the consensus market view that competition would be in the form of a single competitor, the SNO (Second Network Operator). As a result, Telkom's share price declined by 6% in one day and is some 10% below where it peaked a few months ago, and this at a time when most shares in the market are appreciating in price every day. In our view this provided another good buying opportunity in Telkom shares.
The first step in evaluating whether a particular event has changed the long-term intrinsic value of a company, is to quantify the impact of that change on a normalised earnings level. In the case of Telkom, there is still significant uncertainty as to the exact form that deregulation will take. Nonetheless, we had already assumed the existence of a strong competitor to Telkom in our forecasts (the SNO) and a resultant loss of market share. This market share loss is now likely to be higher than originally forecast, but the important point is that it is unlikely to be significantly higher.
In this regard, the SNO is now considerably weaker than what we had assumed, which means that we were too optimistic in our original forecasts regarding the market share that the SNO would obtain: some of this market share will instead be taken by new competitors, like Internet Solutions. Secondly, Telkom will still be a formidable competitor, no matter who the competition will be. In addition to this, telecommunications market deregulation globally provides historical case studies of what happens in the event of deregulation, and it is our view that the market is pricing in a worst case scenario for Telkom.
Given that Vodacom (which is largely unaffected by the proposed deregulation) contributes approximately one third of Telkom Group's Free Cash Flows, we believe that Free Cash Flow generated by Telkom as a group is unlikely to decline. In other words, even though the fixed-line Free Cash Flows may decline, the mobile operations Free Cash Flows are growing at 15-20% per annum, which means that at the Group level free cash flows will be at least constant.
This brings us to valuation. Telkom should generate around R14 per share in Free Cash Flow this year, and around R14 the year thereafter, and the year after that. This is truly "free cash", in other words, cash that is available to be returned to shareholders. Given that Vodacom is self-funding and that there are few acquisition opportunities available to Telkom, a large part of this cash could be returned to shareholders, in the form of dividends and share buy-backs. The current share price of Telkom is R75. If the entire R14 per annum is returned to shareholders, after just over five years, an investor would have received his original money back. And Telkom will still be around and worth something. Worth a lot in fact. This, to us, is an extremely compelling opportunity and we are comfortable with the fact that Telkom is the fund's biggest position at just over 10% of the fund.
Even though the SA equity market has enjoyed a great year in terms of performance (appreciating by around 30% over the past 12 months), we still view it as attractively valued, particularly when compared to the returns available from cash or bonds. We believe that the Top 20 Fund currently holds stakes in 17 of the most attractively valued large companies on the JSE, and that all of these stocks are still trading well below their fair values. The weighted average forward dividend yield of the portfolio is still above 4%. As a result, from a combination of dividend income and capital appreciation, we expect to achieve superior returns over the medium to long term.

The first half of 2004 has been characterised by the continual strengthening of the rand and volatile global markets, resulting in difficult JSE market conditions. Year to date, the ALSI40 has declined by 1.7% while the Coronation Top 20 Fund has appreciated by 5.19%. Over one year, the fund has generated a return of 33% and in doing so has outperformed the ALSI40 by around 10%. The main contributors to performance over the past year have been Telkom (+102%), Naspers (+77%) and SABMiller (+65%). With regard to SABMiller, we slightly reduced our position in the stock on the back of excellent full year results to March 2004 and the ensuing share price appreciation. In addition, we increased exposure to the resources sector, buying additional Impala Platinum and establishing small positions in BHP Billiton and Anglo American Platinum. Over the quarter, there was very little additional activity and the top 10 holdings remain largely unchanged.
Remgro, one of the fund's top holdings, released its results towards the end of June with the declaration of a special dividend of R2 per share in addition to the full year dividend of R2.85. This equates to the company paying an annual dividend of R4.85 per share, or put differently, a dividend yield of 6.5% at the current share price of R75. Furthermore, these dividends are tax-free in the hands of a shareholder. Remgro still has a significant cash pile and holds a portfolio of investments that pay out large amounts of cash. We therefore believe that going forward, Remgro has the ability to maintain this yield through a combination of dividends and share buy-backs. An investor in Remgro is therefore receiving a 6.5% tax-free return before any capital appreciation. This compares with a money market account which would provide an after-tax yield of around 4.2% with no opportunity for capital appreciation. We believe that all the investments held by Remgro, including British American Tobacco, FirstRand and Impala Platinum, are trading below their worth and as a result the Remgro Group is also trading below its fair value. Consequently, we anticipate capital gains in Remgro over and above this very attractive dividend yield. The Top 20 Fund reflects this view, with Remgro comprising 9.5% of the total portfolio.
The fund's two largest holdings, Telkom and Naspers, also reported excellent annual results over the quarter. Telkom generated R9 billion in free cash flow over the year, with Naspers reporting R1.1 billion in free cash flow. It is largely due to the free cash flows and the market's current low valuation of these free cash flows that we like these stocks so much. Their results confirmed our view that the intrinsic value of these two groups continues to grow, and as a result we are still very comfortable with the fund's large positions in these stocks.
The SA equity market is, in our view, still attractive with many companies offering dividend yields greater than the after-tax return from cash. In addition to this, these companies continue to grow their business value. We believe that the Top 20 Fund currently holds stakes in 17 of the most attractively valued large companies on the JSE, all of which are still trading well below their fair values. The weighted average forward dividend yield of the portfolio is 4.6%. As a result, from a combination of dividend income and capital appreciation, we expect to achieve superior returns over the medium to long term.

The fund is a good advertisement for the asset manager's active investment process because it is a concentrated bet on the team's favourite large-cap counters. The bets have paid off and the fund is the top performer in its sector over all but the three-month time periods. Fund manager Gavin Joubert upped the fund's financial exposure in January and slightly trimmed the weight of resources in the portfolio.

The Coronation Top 20 Fund had an excellent quarter, appreciating by 19.9%. For the year to 31 December 2003 the fund returned 20.3% which is 7.0% ahead of the ALSI 40's return of 13.0%. The greatest contributor to performance over the past quarter was Telkom, which was up by 60% and is now the fund's largest position. The fund bought Telkom on listing in March 2003, and subsequently increased the position significantly between June and September (highlighted in the September quarterly). Since listing, this share has appreciated by 150%, yet even after this price performance, the fund manager's continue to believe that the group is still attractively priced, trading on a one year forward Price/Free Cash Flow multiple of 5.5, and as such the fund manager's have retained the funds position. Several of the fund's other large holdings also produced strong performances namely Naspers, which appreciated by 47%, SABMiller and VenFin which both gained 24% as well as Remgro and the Banks (ABSA and Standard Bank) which were all up 22%.

Over the past quarter the fund manager's sold the fund's remaining holding in Dimension Data as the share price approached the fund manager's target price. The only new addition to the fund was a position in Bidvest, which continued to grow its intrinsic value while the share price continued to move sideways resulting in the opening up of an appropriate margin of safety. The fund manager's had started to buy Nampak in the third quarter and added to this position in the last few months of the year. Both Bidvest and Nampak are good businesses that are providing dividend yields above 5% and trading on single-digit P/E multiples. As mentioned in previous quarterlies, the fund manager's continue to find better value within industrials and financials than in resources and the fund manager's purchases for the fund reflect this view.

The biggest change to the portfolio over the period was the increase in the funds holding of Naspers. The fund manager's have been buying this share since the beginning of the year and continued to do so over the past few months. Naspers now comprises 7.5% of the total portfolio. The company is relatively complicated with several operating entities, but with thorough research the value within the group becomes apparent. The two largest underlying businesses within the group are DSTV (Multichoice) and Media24 (newspaper and magazine printing & publishing).

Both are great businesses with a monopoly or dominant position, pricing power and great free cash flow generation -all enviable qualities. DSTV holds a monopoly position in the South African Pay-TV market and several of the other African countries in which it operates. This position provides pricing power which in turn results in excellent margins. The SA market is maturing, but there is still significant growth potential in Africa, including Nigeria, Angola and the DRC. The strengthening rand also benefits this business as both the content and the satellite leases are US dollar denominated. All these factors mean that current earnings for the Pay-TV business are below normalised levels and the business is set to enjoy superior earnings and free cash flow growth rates over the next few years.

Media24 owns some of the most powerful media titles in South Africa, including Die Burger, You/Huisgenoot, Mens Health, Fair Lady and Drum. The business has been very successful in generating new titles, the latest of which is The Daily Sun which within 18 months of launch is now the largest daily newspaper in the country by volumes sold. Market share gains in both newspapers and magazines continue to be made in terms of advertising spend, and Media24 is also benefiting from the strong rand due to machinery, paper and ink costs being priced in US dollars. Once again these factors mean that the current earnings and free cash flows of this business are also below normalised levels and should show good growth over the next few years.

These two core Naspers assets are, in the fund manager's view, worth close to the current share price which is around R40. However, over and above this, Naspers holds stakes in several other valuable assets including MWeb, MNet Supersport, a Pay-TV business in Greece, a Pay-TV business in Thailand and an instant messaging business in China (which could be listed in Hong Kong within the next few months). It is the fund manager's view that the market is not ascribing much value, or an inappropriate value, to many of these assets. The fund manager's valuation of these assets result in our view that Naspers, at the current share price, is trading 30% -40% below its intrinsic value and as such still offers great value.

The fund manager's believe that the SA market is still attractive, particularly industrials and financials. Given the strong performance of the market over the past several months, new opportunities are not as frequent as six to nine months ago, but they do still arise. The risk remains to be the US market, in particular Nasdaq which is now approaching 'bubble' type valuations.

Nonetheless, given that the stocks held in the fund are still trading well below their fair values, the fund manager's expect to achieve good returns over the medium to long term.