The tough investment climate in the mid and small cap space has continued, which is reflected in the fund return of 1.1% over the past year. Albeit a poor return, it places the fund in the top of its sector over the 1-year period. The fund’s five-year compound annual growth rate return of 1.6%, which is below inflation, also demonstrates how difficult it has been to produce decent returns in this environment. Only two funds in the mid/small cap space produced positive returns over this time period.

Over the past year, the largest contributors to the fund’s performance have been the holdings in Northam Platinum (Northam) and Metair.

The platinum-group metals (PGMs) basket price has finally increased in line with our forecasts, driven by the looming material deficits on the horizon after years of underinvestment in the industry, as well as robust demand as automotive manufacturers face increasingly stringent emissions standards, driving demand for PGMs in catalytic converters. This has resulted in the Northam share price more than doubling in the past year.

Metair has also been a strong performer in the past year, which does not surprise us. The company is a rarity in South Africa right now – it operates in a flourishing industry! The automotive manufacturing sector in this country is a real success story, with the government able to introduce policy measures aimed at incentivising Original equipment manufacturers (OEMs) to manufacture vehicles in South Africa. This has resulted in many of the large OEMs committing substantial capital to expanding their presence in South Africa, which is benefiting Metair’s automotive component businesses. In addition, Metair’s battery business is also performing well due to its ability to respond quickly to the technology changes occurring in this industry. Despite performing well in the past year, Metair still trades on an approximate one- year forward price to earnings (P/E) ratio of 6 times, which we think is way too low for a business that should be able to grow its earnings ahead of the market in the foreseeable future.

The biggest detractors to fund performance in the past year have been the holdings in Invicta and RMI Holdings.

Invicta has been a dismal share to own in the past few years. Not only has the company been the victim of a brutally tough economy but was also the recipient of a R750 million fine from the South African Revenue Service for a tax structure that resulted in Invicta paying a very low tax rate for the past seven or eight years. The deluge of bad news has caused the share price to decline significantly and is now priced at approximately half of book value and on about six times P/E on what we consider to be low earnings. These earnings are unlikely to recover in the current economic environment but should do in time as things improve.

RMI Holdings has also been weak in the past year, mainly due to the decline in the Discovery share price, a business of which they own some 30%. RMI is one of the best quality counters in our universe, with stakes in what we consider to be two of South Africa’s best businesses, Discovery and OUTsurance. As such, we have taken advantage of the weakness in RMI to increase our position size.

The largest additions to the fund in the quarter were the purchase of Reinet and Aspen. Both shares fell out of the Top 40 index in the quarter and therefore fell into our investable universe. Reinet is still dominated by its investment in British American Tobacco (BAT), which makes up some 70% of the value of Reinet. The combination of BAT on a single-digit multiple and the fact that Reinet trades at a historic high 38% discount to its underlying asset value, makes Reinet attractive in our view. In addition, our investable universe presents few opportunities for exposure to rand hedge global businesses, which we think add value to the fund from a diversification perspective.

It is hard to believe that Aspen has now fallen out the Top 40 Index. The market’s distaste for high levels of debt and companies that seem to not have growth prospects has meant that Aspen’s share price has fallen from over R400 in early 2015, to around R90 today. We think that the company is well on its way to getting its debt levels under control, and while there may not be much scope in the short term for strong earnings growth, we think that there is real opportunity for Aspen to drive more in-house manufacturing of product through its own facilities in the next two to five years. The company has invested significantly in these facilities and should be able to utilise them better in future, which should be accretive to earnings. On about a seven or eight times P/E, Aspen is attractive in our view.

The largest sales in the quarter was the sale of the positions in Pan African Resources (PAN) and Pioneer Foods. PAN, the gold miner, has been a strong performer for the fund and we sold as the share price neared our assessment of fair value. Pioneer Foods has been the target of a buyout offer by PepsiCo, and we sold out as the share moved towards the offer price. While the deal is likely to happen, there is still a small degree of risk until all conditions precedent are met. As such, we were prepared to sell out at a level slightly below the PepsiCo offer price.

The tough investment climate in the mid- and small-cap space has continued, with the fund down 9.7% over the past year. The fund’s five-year compound annual growth rate of 2.7% is below inflation and shows how difficult it has been to produce decent returns, bearing in mind that the fund was the second best performing fund in the mid- to small-cap space over this period. The Top 40 Index is up 6.1% over the past year, driven by the 42% improvement in the resource index.

The biggest decision we are faced with right now is whether to invest part of the fund in shares that have performed particularly poorly in the past few years and now offer significant upside to our estimate of fair value. As a general rule, we have avoided doing this as history has taught us that a business in distress often takes more time than one would expect to turn things around. Furthermore, the business climate in South Africa is not exactly providing any tailwinds to a recovery. However, in a few instances, the market reaction to a poor performing company is so severe that we can no longer ignore the mispricing of the asset. We are cautious in our approach in these instances and will typically manage risk by keeping position sizes modest, usually below 2% of fund. Omnia is a good example of the above, having fallen to a 10-year low. We discuss it in more detail below.

Over the past year, the largest contributors to the fund’s performance have been the holdings in Altron and Northam Platinum (Northam). Altron has been a very satisfying investment. Firstly, we bought our position close to where the share price bottomed and were then involved in facilitating the entry of Value Capital Partners (VCP) as shareholders. This was the catalyst for the recovery, which the fund is now benefiting from.

Likewise, our position in Northam was built at a time when platinum stocks were heavily out of favour. Our analysis showed that the platinum group metals (PGMs) would be in material deficits for many years to come, driven by weak supply following years of underinvestment in the industry, as well as robust demand as car manufacturers faced increasingly stringent emissions standards, driving demand for PGMs in catalytic converters.

The biggest detractors to fund performance over the past year has been the holding in AngloGold Ashanti and Implats. AngloGold has performed very well over the last 12 months, driven by a recovery in the gold price as well as increased company-specific optimism due to the appointment of a new CEO. We view the company as overvalued given that it trades on 15.5 times normal earnings. We feel there are significant operational hurdles to achieve these earnings, such as the extension of mine lives and ramping up the key Obuasi mine in Ghana.

Like with Northam, Implats has been a fantastic performer in the past year off a low base, driven by a strong improvement in the rand PGM price basket. Our view is that Implats is a lower-quality business than Northam, owning mines that are higher up on the cost curve. As such, we have preferred to take our PGM exposure via Northam.

The largest additions to the fund in the quarter were the purchases of Omnia and Wilson Bayly Holmes-Ovcon (WBHO). Omnia has been very weak over the past year or so, falling from around R150 per share at the end of the first quarter of 2018, to less than R50 today. To be fair, the business has not performed well and while a decline in the share price was justified, the extent to which it declined was not. When a business is under pressure and the share price falls rapidly, the entry point is always difficult to pick. At R60 per share, we think Omnia is significantly undervalued, and have started to build a position. The business will report a loss for its 2019 financial year, versus our assessment of normal earnings of above R10 per share.

WBHO has also been a poor performing share of late, driven mainly by the recent weak interim results which were heavily impacted by a large loss-making contract from its Australian civils business. This is not their first slip-up in Australia, and the market is now anxious that WBHO management may have lost their ‘midas’ touch - their long track record of managing risk and avoiding large contract mistakes. Our feeling is that WBHO remains the leading construction counter in South Africa and is the prime beneficiary of the demise of many of its competitors. On a normal PE of around 6 or 7 times, coupled with a very strong balance sheet, we think WBHO is attractive.

The fund’s largest sales in the quarter was the position in Adcorp and the trimming of the Spar position. Both counters have done well for the fund and Adcorp in particular no longer offers enough upside to justify a holding; especially considering the outlook for the employment market, and the industry in which it operates. Spar remains a large holding in the fund, but we trimmed the position size in order to raise funding for other ideas.