The fund continues to eke out modest gains in what is a very tough economy, posting a 4.5% return over the past year relative to a -6.1% return from our average competitor small cap fund. Even some of South Africa’s best businesses are finding the going tough. These would include the likes of Famous Brands, Spar and Distell, which for many years have earned a reputation for being superbly managed and highquality businesses. The market often punishes highly rated businesses when they deliver more modest growth in earnings than the norm, and this is usually a good time to add to positions in these counters, which is what we have been doing.

Over the past year, the two largest contributors to the fund’s performance have been its positions in Astrapak and Altron. This is gratifying, as prior to the last year or two, these two companies had performed miserably and were amongst the largest detractors to fund performance. There is a lesson in this. It is human nature to give up hope or lose faith in a company which has been a perennial disappointment. Often this happens close to the point where things are at their worst. In some cases, this may be justified; where cutting ones losses to recoup something is better than holding onto a company which fails and is liquidated. In the case of Altron, the huge decline in its share price resulted in an outside investor becoming interested in taking an active role (alongside their investment) in turning things around. Thankfully, we also recognised the value in Altron despite its woeful past performance, and continued to add to our position near the lows. While it hurt at the time, the share has more than doubled in the past year.

Astrapak was a similar story, where for many years the company produced dismal results and the share price followed suit. There were many times where we were tempted to sell out, but were held back by the huge discount at which the share traded to our assessment of fair value. Eventually our patience was rewarded and the business was acquired by an international packaging company at a level very close to what we thought the business was worth. In the past year, Astrapak was the biggest contributor to the fund’s performance.

We feel we are in a similar position today with our holding in Dawn. It is the biggest detractor to the fund’s performance over the past year, and has been a painful share to hold. The business has performed very poorly for many years and the future viability of the company has not been clear. However, selling out now would be a mistake in our opinion. In the past year we have supported a recapitalisation of the company and have been involved in introducing new management with a clear mandate to extract value for shareholders. The recently announced sale of their 50% stake in the Grohe Dawn Watertech joint venture will result in the company being in a position to repay all its debt, effectively de-risking the investment. There is still a way to go to fixing the business, but off these levels, we are hopeful that Dawn will contribute to the fund’s performance in years to come.

The two largest additions to the fund in the past quarter were Sygnia and PSG Konsult. Sygnia is a company we owned on listing and enjoyed the rapid rise in its share price on high expectations. We sold out as it overshot our assessment of fair value, but the share has since retraced to levels not far off its listing price - a level at which we are buyers. Sygnia is an owner-managed, entrepreneurial financial services business with lots of runway for growth. It also pays the bulk of its earnings as dividends. PSG Konsult, like Sygnia, is also building a business for the future, and should in our opinion be a much bigger business in five years’ time than it is today. While it looks expensive on current earnings, we think its earnings base will grow well ahead of the average South African company over the medium term. It also enjoys the support of its principal shareholder, the PSG group, who have a proven record of growing winning businesses.

Portfolio managers
Alistair Lea and Siphamandla Shozi as at 30 September 2017

After a good run of registering positive returns over a number of quarters, the fund returned -5.6% for the past three months, which is still ahead of benchmark which returned -9.5%. The fund has returned 8.9% (compared to its benchmark’s -1.7%), 3% p.a. (5%) and 10.3% p.a. (10.5%) over one, three and five years, respectively.

The past quarter has been difficult to navigate, especially for a fund like ours which invests only in shares outside the Top 40 index. At the start of the quarter, heightened political risk, triggered by a cabinet reshuffle and the replacement of SA’s finance minister, trumped everything else. This was followed by a weakening of the rand against major currencies and the loss of SA’s foreign currency investment grade rating from Standard & Poor’s. We see this as the beginning of a loss of confidence in government’s fiscal discipline amid an increased risk of a shift towards populist measures.

The weakening of the currency favoured the large diversified rand-hedge shares. These are invariably part of the Top 40 index which, as mentioned, falls outside our universe. However, through portfolio construction, we have tried to mitigate against this situation by having exposure to some shares in our universe that also benefit from currency weakness. These include shares like Brait, Northam and Exxaro.

The biggest contributors to performance over the past year were Astrapak and Pick n Pay. Astrapak probably reflects best our approach to long-term investing. It is a plastic manufacturer operating in various sectors including food and personal care amongst others. The group had two distinct segments: rigid and flexible packaging. Its rigid packaging division has good assets, it operates in an environment with high barriers to entry and long-term contracts, and generates decent returns. On the other hand, its flexible packaging unites operates in a highly competitive environment dominated by private players who are well funded.

Astrapak went through an acquisitive spree during the good times of the previous decade. When this started unravelling, its share price came under a lot of pressure. In its turnaround strategy, the group was going to shut down its under-performing flexible unit and retain only its profitable rigid businesses. During the long time it took to clean up the portfolio, the market lost sight of the real value of the rigid packaging businesses. Our long-term view allowed us to look beyond the turnaround to the value that would remain afterwards. Fortunately, as the turnaround gained steam, an offer was made by a foreign entity, RPC, to acquire the rigid assets from Astrapak at a very attractive price. This vindicated our long-standing belief about the value of those assets.

The largest detractors to performance over the past year were Dawn and Barloworld (which we don’t own, but has a large weighting in our benchmark). We have written extensively about Dawn in our previous commentaries. Barloworld is an equipment supplier to the mining industry, and also has a motor dealership business. Though it is a very well-managed group, its share price is trading at what we consider to be fair value, and as such we do not own it. Our two largest additions during the quarter were Spar, which we wrote about in our previous commentary, and Invicta. The fund’s two largest disposals were AECI and Dischem, a pharmaceutical retailer which listed recently. We took part in the capital raising. Since then the share price has gone up significantly above what we consider to be fair value, and as such we have sold all our holdings.

Portfolio managers
Alistair Lea and Siphamandla Shozi as at 30 June 2017

The fund had a very pleasing 2016, returning 19.3%. This trend has continued into the first quarter of 2017, with the fund returning 5.1%. Ironically, we have noticed that the fund is now attracting inflows, which we suspect is due to the good recent performance numbers. We would caution investors about such behaviour - buying into a fund on the back of good performance, and (usually) selling on the back of poor performance. As with equities, a decline in the share price will often present a buying opportunity and vice versa. The fund is trading at its all-time high weighted one-year forward price earnings multiple of around 13.5 times, yet we are experiencing the best inflows in many a year. In the aftermath of the global financial crisis, when the fund was priced at a multiple of just six times, we experienced outflows. While it is counterintuitive, the best time to invest is often at the point of maximum pessimism.

Despite the modest inflows we have had in the past six months or so, the fund is still very small (total assets at around R202 million). In many ways this is a distinct advantage. It means that we are able to be nimble - quickly building positions in shares we are buying and often being able to liquidate positions in a day or two. It also allows us to consider investing in less liquid shares without the fear that it might take months to build (or liquidate) a position.
Our strategy continues to focus on investing the bulk of the fund in good quality companies and avoiding troubled businesses. Past experience tells us that this is a better formula than a high-risk strategy of taking large positions in risky shares. We do hold some risky shares (e.g. Implats and Exxaro), but we weight the position size accordingly, normally at 2% of fund or less. We also very seldom take up shares in new listings, unless the valuation makes sense. New listings typically happen when the market conditions are right, and at a price that makes sense to a seller with significantly more information on the asset than what we have. As such, in our view, the vast majority of new listings happen at or above our assessment of fair value. New listings also tend to happen after a company has grown earnings healthily for a few years, meaning that the listing is priced on high earnings, as well as a full price earnings multiple. There are of course exceptions.

Our two largest additions to the fund during the quarter were Spar and RCL Foods. Spar is a fantastic business with a superb track record over many years. Every so often it presents investors with a brief opportunity to buy its shares at a reasonable price. For us, a forward price earnings multiple of under 15x for a business of this quality is a good opportunity to increase our exposure to Spar. RCL Foods has been a very disappointing share for many years. Ten years ago the share price was R16, the same level it is today. In that time the business has diversified away from being a pure chicken producer, to being a better quality company with food, logistics and chicken interests.

RCL Foods has also taken steps to reduce its exposure to the very competitive frozen chicken industry which struggles to compete with the huge amount of imports coming into the country. This, combined with the fact that the maize price (the main input cost of a chicken producer) has until recently come off very high levels, means that RCL Foods' chicken business earnings have been very low. The future however looks far more positive with maize prices having declined materially and potential future government support for the beleaguered chicken industry. As such, we believe normal earnings for RCL Foods to be about double the current level of earnings being reported. If we are right, this should turn out to be a good investment.

The fund's two largest disposals were The Foschini Group and Omnia. Both shares had performed well and had closed the gap to our assessment of their fair value. As such, lower portfolio weightings are appropriate. We do continue to like both businesses and still have positions in the fund, albeit smaller than before.

The fund has rebounded strongly over the past 12 months to end December, delivering a pleasing return of 19.3%. Over three and five-year periods, the fund returned 6.8% p.a. and 12.6% p.a. respectively. The past year’s performance was preceded by a fairly disappointing 12 months during where our exposure to resource shares had the most negative impact. It is therefore pleasing that holding on to these positions (resource shares) contributed handsomely in 2016.

For example, though the JSE/FTSE All Share Index (ALSI) was up 5% in 2015, the Resource Index (RESI20) was down 36%, within which the platinum sector (JPLAT) declined 62%. In 2016, an almost complete reversal occurred. Though the ALSI was still up 2.6%, the RESI20 gained 29%, within which the platinum sector advanced 56%. Furthermore, while the local currency weakened substantially in 2015, it regained a lot of these losses in 2016. This level of volatility has become the norm over the last few years; a period that was also marked by heightened local political instability, low economic growth and the resultant inability of the SA economy to create jobs.

The biggest contributors to performance in 2016 were Omnia Holdings, Exxaro Resources and Northam Platinum. Omnia has two reasonably sized businesses focused on fertiliser and mining explosives, and a small chemicals distribution business. The fertiliser business had felt the negative impact of the drought (a cyclical phenomenon) as farmers procured less fertiliser. However during this period, the business actually strengthened its long-term positioning. It gained significant market share by moving to new geographical areas to offset drought-related volume loss. So, although the business was facing cyclical adversity, it had actually increased its long-term value, thereby opening up a significant gap between its share price and intrinsic value. The mining explosives business had a similar experience in that as mining volumes and pricing came under pressure, it managed to procure more work, using its scale and squeezing the smaller weaker players out of the market. In the long run, this will prove positive as it will lead to market tightness when volumes return. Over the past few months, it became clearer to the market that conditions are improving in both sectors, and Omnia's share price has reacted positively.

The largest detractors to performance were Dawn, Trencor and Grand Parade Investments. Dawn has been a very poor performer for us. After selling a controlling stake in their manufacturing businesses to Grohe, a renowned international sanitary fittings manufacturing company, their joint venture underwent serious working capital funding constraints, which resulted in loss of both direct market share and volumes in their trading business. Recent results have been disappointing, recording operational losses with various asset impairments. On the positive side, old management has been replaced with Stephen Connelly, a former Hudaco MD, whom we rate very highly. If he stays in his current job, we believe the business has a decent prospect of turning around, although it will not be easy.

Our biggest positions in the fund are Advtech and Capevin Holdings. We will not reiterate the merits of Advtech as we have written in detail about our positive view on private education in SA before. Capevin Holdings is an investment holding company, whose sole investment is a 26% direct stake in Distell, an alcoholic beverage business. Distell is diversified across products (spirits, ciders and wines) and geographies (Europe, African continent, US, etc.). Its portfolio of ciders in SA has been out-growing the market by significant rates, with potential for more due to a low penetration rate. The company also has the opportunity to become a major mainstream alcohol producer in the rest of Africa, where growth rates are very attractive. Capevin trades at a significant discount to the look-through value of Distell, and as such, is our preferred entry into the stock (Distell).

Looking forward into 2017, we continue to be cautious on the overall state of the domestic economy. As such, the bulk of the fund is invested in highquality counters that should continue to generate reasonable returns even in a tough economic environment. It is in times like these that our long-term focus allows us to pick deeply undervalued businesses that have been mispriced by the market, and which will contribute positively to subsequent performance of the fund.