It has been a good year so far for the fund, being up 14.17% over the first three quarters of 2016. On the other hand, the business climate in South Africa seems to be getting tougher by the day. We experience this from various angles: the ever lowering domestic GDP growth forecasts; the worse than expected company results (think Mr Price, Truworths and Invicta); and the general message from our interactions with management teams that conditions are tough.

But South Africans are resilient by nature, and within our economy there are pockets of growth as well as some very well managed companies that are able to extract growth despite the shape of the economy.

The dire state of the public education system in South Africa is providing a platform for growth in private education. This, coupled with some very astute management teams and shareholders willing to back them, has enabled the two listed players in this space to prosper. Until recently we were only shareholders in ADvTECH, but have since added Curro to the fund. A few years ago we lacked conviction in Curro achieving its huge growth plans. Each year that has passed, they have hit their lofty targets, and our conviction has increased. In addition, more opportunity has presented itself in recent years. This is largely due to the fact that our state universities are roughly three times oversubscribed at the beginning of each year (and in somewhat of a mess for the rest of the year!). Curro will now build private universities and we have no doubt that they will succeed in this endeavour.
Too often as investors we focus on a stock's price earnings ratio, and are reluctant to invest in companies with high price earnings ratios. It is equally (or even more) important to focus on the returns a business can make on invested capital, or return on equity (ROE). A business generating a 20% ROE will grow earnings by 20% if all retained earnings are re-invested in the business at the same returns. Over long periods of time, the return you make from investing in a share will trend towards its ROE, regardless of the price earnings ratio you pay. This is what Charlie Munger (Warren Buffet's longtime partner) was trying to tell us when he said:

'Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result.' So, while Curro trades on an eye-watering forward price earnings multiple of about 60 times, if the business continues to grow earnings near the rate that it has been doing, and re-investing its earnings in growing its business, investors should end up with 'one hell of a result'.

Our two largest additions to the fund during the quarter were positions in Curro and Ethos Capital. Ethos Capital is an investment vehicle set up to invest in a diversified portfolio of unlisted private equity type investments. Ethos Capital's investments will be sourced by Ethos Private Equity, the largest private equity firm in South Africa with an incredible track record (gross realised internal rate of return of 37.4% since inception some 30 years ago). We like the fact that through Ethos Capital we gain access to private equity returns which have been stellar for the past decade and more.

During the quarter we reduced our positions in both Omnia and ADvTECH to fund the additions mentioned above. Both shares remain top five positions in the fund.

Portfolio managers Alistair Lea and Siphamandla Shozi as at 30 September 2016

The fund has had a very pleasing start to 2016, returning 7.4% for the quarter. The one-year return to end March was 0.4%, reflecting the view we have communicated in prior commentaries that the current high level of the market (in general) would make meaningful returns difficult to come by. The forward PE of the fund is currently 12x, the highest level it has been since we began tracking this metric in 2006. However, it should also be noted that if all the shares held by the fund were to trade at our assessment of fair value, the fund would appreciate by 40%. This upside to fair value indicator is not far off the long-term average upside of 50%. What this tells us is that the fund is generally comprised of more quality stocks today (which the market rates at higher PE multiples) than in the past. This has been a deliberate and concerted strategy of the fund for the past few years, so much so that we now measure the ''quality rating'' of the fund, and think carefully whether any trading activity will compromise that.

The two biggest contributors to the fund’s performance in the past year have been the large holdings in Advtech and Iliad. Advtech has had a busy year: it resisted an advance by competitor Curro, made a few large acquisitions, concluded a rights issue to fund growth opportunities, and saw the retirement of its long standing CEO, Frank Thompson. We have been very active shareholders throughout this process, motivated by our view at the time that the company was not fully embracing the significant opportunities at its disposal. We are very encouraged by the fact that this has now changed, and the company is firmly on a path of growth. Despite the strong share price appreciation in the past year, the fund continues to hold a large position. There are not many companies in South Africa operating in a more attractive industry (private education) than Advtech.

Iliad was also a share the fund had held for some time, so it was satisfying to see our patience rewarded with a buyout of the company at our assessment of fair value, by Steinhoff. The business had operated in a tough environment for the past four years, which meant the share price was not reflective of its underlying value. The business is a good fit with Steinhoff’s building materials businesses and in an industry where scale is important, we think the business will prosper.

The two biggest detractors to the fund’s performance over the past year have been the holdings in Altron and Dawn. We have previously discussed Altron (in the third quarter of 2015), so will now comment in more detail on Dawn.

Dawn has been a very disappointing investment to date. The business has not performed well, partly due to the tough environment it has had to operate in, but also due to poor management and capital allocation. In the boom years of 2007 and 2008 the company made a series of acquisitions of businesses that have turned out to be of questionable quality, taking on significant debt in the process. When these businesses did not perform according to expectations, the company was forced to raise equity to repay bank debt. Interestingly, the company has now embarked on a process of selling down stakes in many of the businesses it bought back then - to focus on its core competency - trading and distribution. We support this strategy, and hope that management can execute well and emerge with a stronger business. To this end, we are encouraged by the recent appointment of Stephen Connely, the former CEO of Hudaco, to the Dawn board. Stephen was one of the most highly respected and skilled amongst the small cap CEOs, and we have no doubt that his experience will be of value to Dawn.

During the quarter we sold out of positions in Sygnia, Wilson Bayly and Royal Bafokeng Platinum. We invested in Sygnia on listing, and the fund did very well from the more than doubling of its share price. We think the business will be successful, but believe that the sharp share price move has taken it into overvalued territory.

Our selling of Wilson Bayly and Royal Bafokeng Platinum were both switches into companies in the same industries (Group Five and Impala Platinum), where the relative performance of our holdings justified a move into shares that had not performed nearly as well.

One of the fund’s largest buys during the past quarter was Zeder, the food and agricultural sector investment company. Its largest asset by far, making up some 70% of the value of the business, is Pioneer Foods. At some point during the quarter, Zeder was pricing in a R75 per share value for Pioneer, when Pioneer was trading around R130. Effectively, we were able to buy Pioneer (via Zeder) at an approximate 40% discount to what it was trading at. We happen to like Pioneer and its long-term prospects - it is a high quality, defensive business with some very strong food retail brands.

Portfolio managers
Alistair Lea and Siphamandla Shozi

The fund ended the year down 7.5%, in line with its benchmark, but below the median competitor fund. Although we have been expecting returns to moderate compared with the previous five years, we are nonetheless disappointed with the fund’s short-term performance. Over a three-year period, the fund has returned 8% p.a., in line with its benchmark.

Detractors over the past year included Altron, AECI, Northam Platinum and Royal Bafokeng Holdings. The major theme of the past year was the indiscriminate selling of resource shares. This was incited by falling commodity prices, which contributed to their poor performances for the year. The local Resources Index was down 37% compared with the All Share Index, which was up 5%. Within resources, platinum mining bore the brunt of the decline and was down 62% for the year. Our fund has just less than 8% exposure to mining resources and this has hurt performance.

With respect to our resource exposure, it is important to note that while we believe in the long-term value offered by these resource shares at the moment, we are also cognisant of the inherent risk due to volatile commodity prices. Hence, we believe that our current position reflects both opportunity and risk, and as such we have not been adding to our exposure. Since we have written extensively about platinum in our previous commentary, we would like to look at Exxaro, as a demonstration of how much value currently sits within resource shares.

The key operating asset within Exxaro is its coal business, which we feel is under-appreciated by the market. It also has stakes in Kumba Iron Ore and Tronox, both of which are listed and thus easy to account for in the valuation. Its primary mine, Grootegeluk, is low cost, long life and has a long-term fixed price offtake with Eskom. This should provide annuity-like returns for years to come and provide some insulation from the commodity price rout we are experiencing. One is buying the coal business at a discount and getting Kumba and Tronox for free, providing nice optionality. At the current price, Exxaro is trading at a multiple of 6x to our assessment of normal earnings, which we feel is very attractive. The largest holding in our fund, Advtech, was also the biggest contributor to performance over the past year, having risen 74% over this period. Other notable contributors include Tradehold, Sygnia and Iliad. Sygnia is a money manager that listed on the JSE during 2015. We took part in the capital raise and benefited handsomely as the share price subsequently more than doubled.

We continue to be cautious on the overall state of the domestic economy. As such, the bulk of the fund is invested in high-quality counters that should continue to generate reasonable returns even in a tough economic environment. It is in these times that our long-term focus allows us to pick deeply undervalued businesses that have been mispriced by the market, and which in time will contribute positively to subsequent performance of the fund.

Portfolio managers
Alistair Lea and Siphamandla Shozi