Three characteristics defined the quarter.

The first being the ongoing trend of domestic assets underperforming global assets, particularly in $ terms. In Q3, the MSCI World Index gained 1.4% (US$) whilst the MSCI SA Index fell 12.4%. The ALBI dropped 6.3% ($) in the third quarter whereas the FTSE World Gov. Bond Index gained 1.1%. In rand terms, the ALBI gained 0.7% and the MSCI SA Index declined 5.8%.

The second being the outperformance of precious metals and defensive equities. Gold and platinum had a phenomenal quarter – gaining 12% and 26% respectively. Beverages and Tobacco, both defensive investments, returned about 13% for Q3. As indicated above, this must be compared to the All Share Index’s quarter of -4.6%.

Finally, the strong relative returns on fixed income assets versus equities. Diminishing growth prospects globally has sustained bond returns relative to equities. This trend perpetuated into Q3. The ALBI produced a return of 0.7% in Q3, after gains of over 3% in Q1 and Q2, year-to-date the ALBI has risen 8.4%, significantly outperforming most major equity indices.
The Northstar SCI Managed Fund had an excellent relative performance against peers in Q3, this can be ascribed to sound stock selection and notable large exposures to outperforming asset classes, in particular, domestic fixed income and offshore assets. Stock selection was impactful with meaningful investments in beverage and tobacco stocks as well as very specific company outperformance from Wilson Bayly Holmes and Woolworths.
With large dislocations in asset valuations occurring across and within markets, the management team of the Northstar SCI Managed Fund have been making adjustments to the asset allocation of the fund. Most notable of these has been to reduce offshore exposure and importantly foreign equity levels based on lower potential returns. Lately, we have also added to SA equities as the local market has sold off and concomitantly, return expectations for domestic companies are now significantly improved off a lower base.

We appreciate that these changes face some risks in that SA could be on the receivingend of a Moody’s outlook change in November, but our modeling shows that much of this is already incorporated in the prices of domestic assets.

It's an interesting environment with tail events (both to the upside and downside) taking place in various areas of the market - this offers opportunity, but also results in extreme manager relative performance differences. There are effectively two camps of managers, those participating in the 'trend' or momentum area of the market, which means heavy resource exposure and then those less exposed to resources due to concerns around capital preservation. The unique market structure in South Africa (where 21% of the JSE All Share index is constituted by commodity exposure) lends itself to binary outcomes and tail events for market participants. What is also worth noting is that the center of the market - good businesses that are non-resource based has been in limbo.

South African equities have been a mixed bag in 2019, outperformance (albeit with extreme volatility) of commodity companies has dominated (resources are 21% higher year-to-date) the market while domestically focused companies have underperform both in terms of share price performance (the local financial index has gained 5% year-to-date and the industrial index is down 5.8%) and with respect to their earnings trajectory. Certain local stocks look cheap - although not many, there are a grouping of SA companies where free cash flow yields are elevated and ratings are no longer high, but earnings projections are dismal as underlying economic growth in the system is vacant. Contrast this to commodity businesses where ratings are high when applying normalized earnings but profitability levels are also elevated as spot prices for certain commodities have exceeded market expectations. It is also true that capacity is being well managed amongst the mining giants, helping to control supply in tight markets caused by supply disruptions.
The resource story and the level of bullishness by managers invested within that space becomes more questionable when the demand-side of the equation is thoroughly interrogated. Chinese investment spending growth peaked in 2003 and has been falling ever since, year-on-year growth is now under 8%, having been closer to 20% between 2003 and 2013. Air pollution regulations and Chinese interventions to stimulate the economy have certainly played a meaningful role in buoying commodities, but the extent of appreciation of share prices, driven by spikes in physical metal prices to levels significantly higher than the marginal cost of production, makes for vulnerability. We remain underweight commodities which is consistent with our quality at a reasonable price philosophy. This is hurting performance from an allocation perspective - we are not exposed to a sector of the market going parabolic, but we are redeeming ourselves by continued positive selection effects - our stock picking within the rest of the market is adding value.

With regards to fixed income exposure, we have enjoyed success in the fund by betting on South African fixed bonds as well as inflation-linkers, both having performed well in 2019 - the ALBI has gained 9.8% this year, second only to resources. We have subsequently de-risked our fixed income position by purchasing floating rate notes. Capturing yield at relatively low risk is attractive in this space. As far as property is concerned, the fund is underweight, we are concerned that the systemic risks in the economy, culminating in low distribution growth, has not been adequately captured in the valuations of property stocks. We continue to seek opportunities where this might not be the case.

The fund has been reducing equity exposure offshore as markets rally and valuations by our estimates look stretched. This continues to be our approach as we apply our buy list disciplines, only holding companies with reasonable upsides to intrinsic value and with a fair margin of safety. In conclusion, our overall asset allocation in the fund is one that reveals caution, as mentioned above, we have paired offshore equities and without visible earnings improvements in the domestic market, we are taking a slow and methodical approach to increasing domestic equity positions. We are also holding steady on the fund's gold position which has been in place for about a year.

The local equity market enjoyed a fourth consecutive month of positive returns in March 2019 after a particularly weak 2018, which saw the local bourse decline by 8.5%. During the first quarter of 2019 the JSE All Share Index gained +7.9% driven by a strong rally in SA Resources (+17.8%) and a rebound in SA Industrials (+7.4%). The large cap index returned +8.5% during the quarter while the small and mid-cap indices continued to underperform returning respectively -3.4% and 2.8%. Despite improving local returns, South African equities underperformed global emerging and developed markets by respectively 5.4% and 8.2% in USD terms. While global equity and credit markets enjoyed a strong rally in 2019 on the back of improved sentiment around US/China trade relations and a more dovish US Federal Reserve, South African specific issues weighed heavily on local returns. In this regard, Moody’s latest update notes that if continued low GDP growth rates persist during the medium-term and elevated debt levels are not curbed the sovereign would likely be downgraded to Junk status.

The Northstar SCI Managed Fund performed in line with its benchmark, the ASISA South Africa MA High Equity Peer average, retuning 5.8% during the quarter.

The fund’s local equity component performed well during the quarter despite a significant underweight position to SA resources. The fund benefitted from a strong performance in core positions such as British American Tobacco (Q1 2019: +30%), Anheuser-Busch (+27%), Reinet Investments (+13%) and an overall underweight position to SA retailers, who continued to experience losses as the state of the SA consumer has not seemed to show improvement. Whilst we admit local equity valuations are looking more supportive, particularly in the industrial space, we remain cautious as a result of an overall weak fundamental outlook for the sector. The fund continues to be overweight a number of stocks in the consumer goods and financial sectors, which we expect to outperform over the medium term.

The offshore equity component of the fund continued to perform well significantly outperforming the MSCI World Index on a gross basis due to strong hit rates (69%) and a win-loss ratio during the month in excess of 270%. The fund benefitted from the contribution of several stocks, of which worth noting are Danaher Corp (+28%), Moody’s (+29%), LVMH (+25%) and Philip Morris (+34%).

The fund’s fixed income component positively contributed to performance as a result of maintaining high average duration during quarter. Under current conditions, we estimate the front-end of the curve to be expensive (R208 & R2023) and longer dated bonds (R186, R2030, R213) to be undervalued, with a fair-value 1 year exit yield of 8.3% for the R186. The interest rate outlook is positive for fixed bonds, with inflation forecasts moderating more than expected and developed markets (lead by the US) taking on a dovish tone and indicating a neutral stance on the future direction of interest rates.

The inflation-linked bond weighting in the fund has been gradually increased over the past 12 months, with a bias for shorter dated maturities on real yields above 3%. Although 3% real yields are very attractive on an outright basis, their prospective nominal returns look muted relative to the returns from fixed bonds with the same maturity.

Up until recently, valuations on listed property stocks have looked unfavourable, given the deteriorating economic environment, weak consumer, declining business confidence, electricity disruptions, rising vacancies and over-supply. The result for companies, has been weaker top-line growth and reduced profitability as costs have increased and balance sheets leveraged in order to explore offshore growth opportunities. Despite this backdrop, valuations are looking more supportive, especially if economic conditions stabilise and improve.

The fund is currently well diversified, conservatively positioned and invested in high quality assets that we expected to perform well through the cycle.

The third quarter of 2018 has been another turbulent period for the local equity market with the JSE All-Share TR Index declining by 2.2%. Emerging equity markets have dramatically underperformed their developed counterparts as the impact of geopolitical tensions between the US and China and negative growth revisions in China and Europe were felt by global markets. In South Africa, while the SARB refrained from raising interest rates, the Rand rebounded by +3.7% in September as President Ramaphosa unveiled an economic plan aimed at reviving the economy. The JSE Industrial Index however declined in September by 7.7% recording its worst monthly performance since 2009 as stocks such as MTN (-18%), Aspen (-35%) and Blue Label (-50%) tumbled during the quarter. The selloff has been widespread with few areas of the market escaping bar the SA resource index which continues to be the exception returning +5.2% during the quarter and +21% year-todate.

In a difficult environment, the Northstar SCI Managed Fund performed admirably, returning +1.7% for the quarter versus +1.1% for its benchmark, the (ASISA) High Equity peer average.

With respect to domestic equity exposure, the fund avoided several hazards (Steinhoff, Resilient / Fortress, Aspen) whilst holding three of the top five best performing JSE stocks this year (Sasol, BHP Billiton and Mondi). Good stock picking compensated for the fund’s low weighting in the only performing area of the market, namely SA resources, which we acknowledge may continue to perform well over the short term, but broadly speaking we do not believe it to be a high quality industry. We see better opportunities in the SA industrial space, particularly in the out of favour mid-cap universe, which has drastically underperformed the market over the past 3 years. Confirming our view that stock picking can offset some of the concentration bias on the JSE, the fund enjoyed meaningful returns from several non-resource positions including Old Mutual (+14.5%), Super Group (+14%), Reinet Investments (+10.1%) and Bidcorp (+8%).

The Northstar SCI Managed fund’s offshore equity component continued to perform extremely well during the quarter with a particularly pleasing hit rate of 73% and a win-loss ratio of 244% against the MSCI World Index. Stock contribution was widespread over several sectors with the best attribution coming from global healthcare and information technology. Particularly pleasing were positive contributions from high conviction positions, namely Blackstone Group (+20%), Medtronic (+16%), Visa (+14%) and Thermofisher (+18%).

We expect global markets to remain volatile as geopolitical tensions simmer impacting trade agreements and the US maintains its interest rate hiking course. From a South African perspective, weak Q2 2018 GDP numbers are likely to be a low point of the cycle and in the absence of political shocks we expect the economic environment to gradually improve. The fund is currently well diversified, conservatively positioned and invested in high quality businesses that we expected to perform well through the cycle. We are finding good opportunities, both globally and domestically, which are now starting to offer compelling value.