The fund had a good third quarter, returning 9% compared to the benchmark return of 8.4%. The long-term track record remains compelling, with the fund meaningfully outperforming its benchmark over a 10 and 15-year period.

Our large holdings in Exxaro, Naspers, Anglo American and Mondi continue to perform strongly and have been the major contributors to the fund’s outperformance this quarter. The original investment cases for these specific holdings are playing out. They all remain top holdings as valuations are still supportive, but we have used share price strength to reduce the respective position sizes. We used proceeds from the sales mentioned above to increase our holding in British American Tobacco (BTI). The share has underperformed the market on a relative basis over the last year. In addition, the Food and Drug Administration’s (FDA) announcement of a new tobacco regulatory framework in the US caused further consternation and share price pressure. The US makes up approximately 40% of BTI’s earnings, but the FDA is an important regulator and a global standard setter. The new FDA framework will look at regulations to potentially reduce nicotine levels in combustible cigarettes to non-addictive levels. We think the regulatory process will take a long time and that there will be a phased approach to reducing nicotine levels. The body also announced their commitment to encouraging innovations in tobacco products that are less harmful and addictive. We think this will present an opportunity for the tobacco companies to grow next generation products (ecigarettes and tobacco heating products) that are less harmful for smokers. The global growth in these new products will result in a profound change in the tobacco industry, which has traditionally been accustomed to volume decline. BTI has put a lot of investment behind developing these new products and stands to benefit from this growth. At these levels, the share price reflects all the risks and none of the potential growth opportunities.

We have also increased our investment in Sasol. The company’s $11 billion Lake Charles Chemical project on the US Gulf Coast will be starting up in the next 18 months. As the capital spend on this project tapers off and the plant ramps up, Sasol will start to generate significant amounts of cash. This will support de-gearing of the balance sheet, which together with some normalisation of the oil price should produce decent earnings growth.

Domestically, we are seeing some good investment opportunities in defensive, high-quality businesses whose share prices have de-rated significantly. We have added to positions like Aspen, Netcare and Spar. These businesses are well managed, cash generative and should be fairly resilient in tough economic conditions. We have also initiated a position in Distell. This business owns good brands in cider, spirits and wine. We think the company can produce midteens earnings growth over the next three years from a combination of cost cutting, volume growth in South Africa and Africa and some select expansion investment. The business has also managed to attract former SAB management talent. We think the combination of powerful brands, experienced management and reasonable valuation is very attractive. While the global and macroeconomic headlines continue to be noisy, we concentrate on applying our long-term focus to help us identify solid investment opportunities. This patience and discipline is often rewarded and will continue to allow us to deliver good alpha for clients in the future.

Portfolio managers
Neville Chester and Pallavi Ambekar as at 30 September 2017

The fund returned -1.63% over the quarter, lagging its JSE Capped All Share Index benchmark, which returned -0.95%. Year-to-date performance remains solid, with the fund returning 4.00%, outperforming the benchmark by 1.71%. The fund’s longer-term track record remains compelling, with positive alpha over five years and longer.

Resource shares reversed their gains from the first quarter. Commodity prices came under some pressure and the announcement of the third Mining Charter added to the negative sentiment. 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 even more onerous. The document is ambiguous and contains many provisions in conflict with existing legislation and the constitution. For a sector struggling to attract fresh investment, this document will act as a further detractor, especially for those companies operating in multiple jurisdictions.

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. We believe the Charter in its current form will not stand up to legal scrutiny and this will necessitate a return to the negotiating table by both parties. While we are hopeful a more balanced document will be the end result, the direction of travel is concerning.

We added to our holdings in Anglo American, Sasol and Northam on the back of relative share price weakness. This was largely funded by the disposal of Mondi, which performed very strongly on the back of strong pricing in its key packaging markets.

Industrial shares had a reasonable quarter, driven largely by strong performances from rand-hedge shares. Naspers advanced 10% as its key associate, Tencent, reported strong results. Tencent remains an exciting proposition, with new opportunities such as cloud services and payments starting to emerge.

Aspen has an excellent long-term track record of earnings delivery, returns and cash flow. It is managed by two of the country’s most entrepreneurial managers in Stephen Saad (CEO) and Gus Attridge (deputy CEO). Together they own 16.2% of the company, which aligns their interests with that of shareholders. While Aspen operates in a highly regulated industry, this risk is mitigated by its extensive geographic footprint across Latam, Europe (East and West), South Africa, Africa and Australasia. We believe there is a significant opportunity to unlock value through bedding down the recent anti-coagulant and anaesthetic acquisitions, and simplifying (and thereby reducing costs) the current complex manufacturing process for these products. Management has a publicly-stated target of delivering R2.5 billion in operating income from these initiatives by 2019. This is material in the context of current group EBITDA of R9.2 billion. Aspen trades on a one-year forward PE multiple of 16.8x and on 12.9x our assessment of normal earnings. We believe the current negative sentiment towards healthcare stocks such as Aspen presents a compelling buying opportunity.

Like Aspen, Spar is another business with a formidable long-term track record. It is currently experiencing issues we regard as cyclical rather than structural. Spar’s recent results saw soft SA turnover and a contraction in margins. Its recent Swiss acquisition has also proved more difficult to bed down than initially thought. We believe the SA business volumes were hit by high food inflation and a soft economy. With food inflation moderating, we expect volumes to return, aiding a recovery in SA margins. Spar has also moved new management to Switzerland to aid the recovery of its business there. We expect this move will drive much-needed improvement.

Both Aspen and Spar positions have been funded by proceeds from our holding in Remgro, which we have reduced. Remgro has outperformed in a tough market and we regard Aspen and Spar as more compelling opportunities.

Financials had a muted quarter. We added to our holdings in Nedbank. Nedbank remains underrepresented in the retail market and has opportunities to grow its share and improve cross-selling. It has a strong corporate franchise and a low base in Ecobank, its African unit. Trading on 8x our assessment of normal earnings, Nedbank has a wide margin of safety. We live in uncertain times, both locally and globally. Domestically, growth is low and the consumer is facing unprecedented strain. Globally, growth is more robust, but geopolitics continue to cause much uncertainty. We remain constant in sticking to our long-term valuation philosophy and process to help us identify the right holdings for the fund. This patience and discipline will ultimately deliver long-term alpha for our clients.

Portfolio managers
Neville Chester and Pallavi Ambekar as at 30 June 2017

The fund has had a good quarter, delivering a return of 5.7% versus the benchmark performance of 3.3%. This is a continuation of the fund’s strong outperformance track record, with 6.9% alpha delivered over the last year and an annualised alpha of 2.3% net of fees delivered over the last ten years. In steep contrast to the beginning of 2016, we came into this year cautiously optimistic about the country’s prospects. Domestic counters certainly looked to have a brighter outlook and stood to benefit from falling inflation and low stable interest rates. While these macro variables remain largely unchanged, the recent announcement of the cabinet reshuffle has given us reason to pause and re-think this outlook. The political change in direction has once again put us in an environment of deep uncertainty. We have navigated these uncertain periods before by steadfastly focusing on the tenets of our long-term, valuation-driven investment philosophy.

Our exposure to resources continues to perform strongly. Exxaro, in particular, has re-rated on the back of improving coal and iron ore prices. The new management team have also taken a number of steps to improve the quality of the business. Capital allocation has focused on disposing of the loss-making Mayoko iron ore project in the Republic of Congo and turning around the performance at ECC, a relatively recent coal acquisition. Tronox, their pigment asset, announced strong results and the intention to acquire competitor Cristal. Meaningful synergies between the two businesses exist and the share price of Tronox reacted favourably.

Overall, the fund has roughly 20% exposure to the resource sector (excluding paper holdings). We have used relative strength to trim our position, but continue to have reasonable exposure as valuations remain attractive. We have used the proceeds to bolster holdings in Sasol and AB Inbev, both of which have underperformed significantly over the last year. Our rand hedge industrial shares, such as Naspers, British American Tobacco and Mondi (which have been long-term winners) have had a good start to the year, notwithstanding the rand strength. Mondi continues to deliver a steady earnings growth profile and good cash generation. The business has a well invested asset base situated low on the cost curve and stands to benefit from growth in consumer and industrial packaging and supportive kraftliner pricing. MTN continues to be a large position in the fund. The company’s recent results reflected the tough conditions over the past year. We think the share has priced in all the downside risk and none of the recovery potential. A new, experienced management team has been injected into the business and should be in a position to execute on this recovery potential.

Standard Bank and Nedbank make up the bulk of our domestic exposure. These have done well over the last year as the respective investment case splayed out. Domestic shares have rallied hard and we took the opportunity to exit our position in Foschini. This company has outperformed most of the retail peers in a tough local clothing market, through management actions which localised sourcing and introduced more core fashion lines in the business. The share price exceeded our fair value and we replaced the holding with a position in Remgro. Remgro's key investments are Mediclinic, First Rand and RMI. These are generally defensive investments, although Mediclinic has disappointed the market with poor trading updates from their recently acquired Al Noor business. Remgro is also sitting on some excess cash subsequent to its R10 billion rights issue last year. We think there is enough margin of safety in the Remgro share price at current levels. Top 20 is a concentrated portfolio, reflecting our highest conviction views. These views are based on sound long-term investment fundamentals and supported by robust valuations. While political events are deeply unsettling, we are unlikely to react hastily and prefer a more considered approach. We do expect the domestic situation to deteriorate further, so we are inclined to favour businesses operating outside of SA, and will require a greater margin of safety for buying purely domestic businesses. Times of stress often do present opportunities to the unemotive long-term investor, and we are carefully monitoring these potential opportunities. We think our rational process will continue to deliver meaningful outperformance for clients.

In a remarkable turn of events after a very tough 2015, the fund delivered an outstanding total return of 18.3% and alpha of 14.3% over its benchmark for the 12 months to end December 2016. Importantly, the fund’s key positions that delivered this outperformance were the same holdings that had driven the underperformance last year. While the outlook seemed grim at the beginning of 2016, the importance of taking a long-term view and focusing purely on valuation was once again confirmed by the turnaround in performance.
The fund’s resource holdings were far and away the largest contributors to outperformance during the year. Anglo American, a blue chip company which has been in existence for over a hundred years and which some commentators were claiming would go bust in 2016, delivered a phenomenal 183% return for the 12-month period. Exxaro, as we have explained many times before, is not that exposed to floating price contracts for its coal sales and should not have fallen like other resource companies, delivered a 103% return. Finally, Impala Platinum came through with a 70% return over the 12-month period. Like most market participants, we had no crystal ball with which to predict that 2016 would be the year in which commodity prices would stabilise and share prices would rally. What we did do differently to the market was to be prepared to invest when we felt that the long-term value of the businesses, as informed by our assessment of long-term commodity prices, were incredibly cheap - even though we could see no catalysts that would spark a re-rating. Catalysts, as we know from our many years in the market, are usually only seen with hindsight and never with foresight.

A counterpoint to this, however, is an investment where the catalyst is obvious, and yet we have not seen the share price respond. MTN has undergone a significant amount of change during 2016. Driven by the numerous problems suffered in 2015 due to lack of capable management of its regional operations, the MTN group has replaced and strengthened its senior management significantly. Virtually all of its major regions are being run by new CEOs with significant experience in the telecommunications industry. Its new group CEO, who joins the business from a senior position at a competitor company, will be in place by April 2017. Meanwhile, under the caretaker CEO of Puthuma Nhleko, MTN has successfully dealt with the major issues hanging over the group, mainly being the Nigerian fine and the repatriation of cash from Iran. With this all dealt with, it allows the new CEO to come into a clean streamlined group with a team of capable and energised managers to support him. We believe this is likely to spur a significant revival in the fortunes of the MTN, which remains the pre-eminent cellular provider across the Middle East and North Africa region.

We have started adding some new positions to the fund over the past quarter. After not owning Sasol for some time, we have started to build a position as we feel the company is now discounting most of the bad news around their spectacularly poor implementation of the Lake Charles Ethylene cracker plant. There remain risks attached to this project overrunning the new budget, but we feel that most of this is catered for in the current share price. The existing assets remain good cash generators and this will underpin the value of the overall group.

We have built up a decent position in Netcare, the SA and UK hospital group. Netcare trades at a significant discount to other hospital operators despite having an attractive portfolio of assets. The SA hospital base is equal to its local peers and the UK operations, after years of struggling due to onerous lease terms on its property portfolio, is now positioned to benefit from lower lease costs as well as greater participation in the provision of services into the NHS.

Finally, we have started to build a position in Spar, the SA fast-moving consumer goods business, which has successfully expanded into Ireland and more recently Switzerland through well-timed and attractively valued purchases of the Spar operations in those countries. While the rating looks high, we rate the low capital intensity business model and high-quality management team which has delivered consistently good results in a tough local environment.

2016 has been a year of surprises; from the opening month with the shakeup in the finance ministry in SA, to Brexit, followed by the loss by the ANC of the major metropoles, and finally the nomination of Donald Trump as president elect of the USA. It is therefore very pleasing for us that the fund delivered a strong absolute and relative return through this volatile period. Once again this justifies our approach of focusing on long-term fundamentals over short-term noise. 2017 holds the prospect of continued volatility and scope for surprises, culminating in the ANC elective conference in the month of December. We urge investors to remain calm and patient through what will likely be another interesting year as, ultimately, investing in equities is a long-term commitment.