The past quarter's events have reinforced our view that it is pointless to focus too much on what the peer group is doing - all too easily you end up doing things just because everyone else is doing them and not because it makes sense to do it. In fact, very often it makes a lot of sense not to do what others are doing. Numerous psychological studies have shown that the intelligence of a crowd of people reduces to, at most, the level of the least intelligent individual in the crowd.

Over the quarter, the crowd aggressively bought equities, pushing the All Share Index up by 20.3% - one of the best 10 quarterly returns over the past 25 years! This good run was lead by Sasol and Billiton. The equity portion of the fund remains weighted towards the industrial sector, where we find most value. We think that even at current market prices, the stocks in the portfolio are trading at around 80c on the rand. It will, however, do to bear in mind that there is no law that says that gap has to close this month, this quarter or this year. In fact, it could even happen that these same assets trade at less than 80c on the rand in future, before they eventually revert to fair value.

We also reduced the portfolio's equity exposure, as the price of equities rose. We are of the opinion that the prospective real return available from the equity market at current prices is very low - even if South Africa were to generate a sustainable 6% rate of real GDP growth, which we view as impossible.

The fund's top ten stocks remain largely the same - we have made only two significant changes over the past year. We added Richemont in January, and sold Nampak in June.

Bonds, like equities, also do not represent great value. We are of the opinion that there are quite large downside risks in the bond market, for which investors are not being compensated. Despite yields declining to long term lows in recent months, it is interesting to note that the equity market has performed better than the bond market over all periods over the past five years. How quickly things change - it was not too long ago that bonds were regarded as the asset class of choice, and a new type of bond fund was being launched on an almost weekly basis! Your fund continues, as it has done over the past two years, to hold only a very small position in bonds.

We see our job as custodian of your assets, not to guess unknowable things like the timing of future market moves, or which stocks investors will like most, or which company's earnings will be revised up by analysts. Rather, we see our job as making informed, rational investment decisions, based on fundamentals, which exploit discrepancies between price and value. Sometimes, these discrepancies take a long time to unwind, or it happens quite quickly and sometimes one has to sit through a long period of relatively poor performance to enjoy the fruits of one's labour. We think we are currently in such a period.

'Using sensible assumptions about the long term and ignoring the short term mood swings of the market leads to markedly better results.'
The cornerstone of RE:CM is the dedicated commitment to a single long-standing investment process. Valuation is a key point of departure within this process. Part of our competitive advantage lies in the fact that we value listed companies as a businessman would. This entails determining the intrinsic value of a business, and when the market price differs substantially from our estimate of intrinsic value, taking advantage of this.
Quality is implicit in our investment process, the foundation of which is our unique definition of a quality investment. The result is a portfolio quite different from most, with a strong bias towards high-quality companies that we consider to be under-valued.
We define risk as the loss of capital. We cannot appreciate the rationale behind investing our clients' capital in companies that we consider to be overvalued, just because they happen to be in an index.
Finally, being shareholders of reference is an ongoing goal of ours. Improving long-term corporate governance of companies is an important means of enhancing the value of equity investments. We constructively engage management where we feel we can add value, which is mainly in the area of capital allocation. We do not pretend we can add anything to managing the company itself.

'Using sensible assumptions about the long term and ignoring the short term mood swings of the market leads to markedly better results.'

The cornerstone of RE:CM is the dedicated commitment to a single long-standing investment process. Valuation is a key point of departure within this process. Part of our competitive advantage lies in the fact that we value listed companies as a businessman would. This entails determining the intrinsic value of a business, and when the market price differs substantially from our estimate of intrinsic value, taking advantage of this.
Quality is implicit in our investment process, the foundation of which is our unique definition of a quality investment. The result is a portfolio quite different from most, with a strong bias towards high-quality companies that we consider to be under-valued.
We define risk as the loss of capital. We cannot appreciate the rationale behind investing our clients' capital in companies that we consider to be overvalued, just because they happen to be in an index.
Finally, being shareholders of reference is an ongoing goal of ours. Improving long-term corporate governance of companies is an important means of enhancing the value of equity investments. We constructively engage management where we feel we can add value, which is mainly in the area of capital allocation. We do not pretend we can add anything to managing the company itself.

At RE:CM we prefer management not to be driven by short term goals but rather by what will add value to the business over the long term. Operations need to be built which will be successful over the next 20 or more years in the good and bad times. The notion that bigger is not necessarily better is well understood in some companies. Tigerbrands and AVI (both of which are held in our clients' portfolios) have unbundled divisions in their businesses namely Astral and Spar from Tigerbrands and Consol from AVI. This has given these "spin-off" businesses the opportunity to create value using their own rules and has allowed the parent company to focus on it's core business. Astral shareholders have been rewarded by an 8 bagger if they remained invested in their shares since listing in 2001.
Very often not doing an acquisition adds more value than doing acquisitions. In 1999 KPMG did a global research report (Unlocking shareholder value: the keys to success; Mergers and Acquisitions) where shareholder value was used as the benchmark to measure the success of mergers and acquisitions. The finding was "that only 17% of deals had added value to the combined company, 30% produced no discernable difference and as many as 53% actually destroyed value." What is interesting is that they further state that "less than half (45%) had carried a formal post-deal review." With odds like these against an acquisition working, investment bankers really have to be able to throw good parties.

The South African economy is strong with healthy consumer spending and low interest rates. Businesses have seen good cash generation and currently most domestic companies have very healthy balance sheets w ith excess cash. While a lot of this cash has been returned to shareholders, much of it is being hoarded as a war chest for acquisitions. We see this as a significant risk at this stage of the business cycle.
Cash holdings depress the return on equity (RoE), especially in the current environment of low interest rates.
Management has two options to enhance RoE under the (admittedly heroic) assumption that existing productive capacity needs no further capital investment to maintain and expand production levels. Either distribute the cash to shareholders or make acquisitions. Making distributions to shareholders is psychologically very challenging to management teams. Size of the business in itself is often management teams' obsession - justifying higher compensation and creating a sense of power that strokes egos. Disappointingly (but not surprisingly) management also strives for a larger market capitalization to form a bigger part of the index thus forcing index tracking fund managers to buy more shares, regardless of their intrinsic value. Essentially, this boils down to managing the share price, and is a classic example of the smart money taking advantage of the dumb money. In addition to all these pressures, you have shameless investment bankers continuous ly promoting the next fashionable acquisition, regardless of the fundamental underlying investment case. Unquestionably, investment bankers are the single biggest destroyer of shareholder value - but they do throw good parties!
At RE:CM we prefer management not to be driven by short term goals but rather by what will add value to the business over the long term. Operations need to be built, which will be successful over the next 20 or more years in the good and bad times. The notion that bigger is not necessarily better is well understood in some companies. Tigerbrands and AVI (both of which are held in our clients' portfolios), have unbundled divisions in their businesses namely Astral and Spar from Tigerbrands and Consol from AVI. This has given these "spin-off" businesses the opportunity to create value using their own rules and has allowed the parent company to focus on its core business. Astral shareholders have been rewarded by an 8-fold increase in share price since listing in 2001.

Run by Piet Viljoen at Re:CM, the fund has a bottom-up, "clean sheet" approach closer to Allan Gray than to the mainstream relativist funds in this category. It has been underperforming Re:CM's Core Managed fund because the latter recently took 12% of its assets offshore. It has taken a bet on Richemont, which is out of favour with the herd, as it likes the fat margins in the luxury goods business.

Financial Mail - 17 June 2005

"Using sensible assumptions about the long term and ignoring the shortterm
mood swings of the market leads to markedly better results."
The cornerstone of RE:CM is the dedicated commitment to a single longstanding investment process. Valuation is a key point of departure within this process. Part of our competitive advantage lies in the fact that we value listed companies as a businessman would. This entails determining the intrinsic value of a business, and when the market price differs substantially from our estimate of intrinsic value, taking advantage of this.
Quality is implicit in our investment process, the foundation of which is our unique definition of a quality investment. The result is a portfolio quite different from most, with a strong bias towards high-quality companies that we consider to be under valued.
We define risk as the loss of capital. We cannot appreciate the rationale behind investing our clients' capital in companies that we consider to be overvalued, just because they happen to be in an index.
Finally, being shareholders of reference is an ongoing goal of ours. Improving long-term corporate governance of companies is an important means of enhancing the value of equity investments. We constructively engage management where we feel we can add value, which is mainly in the area of capital allocation. We do not pretend we can add anything to managing the company itself.

The mid cap sector of the JSE currently offers significant opportunities as mid-cap earnings growth is much less volatile than other equity sectors. It grows at a consistently higher rate as these companies are highly focused, yet small and flexible enough to grasp new opportunities.
Large groups mainly grow through acquisitions, which dilute earnings; and many smaller companies drop by the wayside. Yet the market is currently paying more for large companies. The mid-caps have the lowest price: earnings ratings yet have superior earnings power, which we think is a huge opportunity.
Resources companies are now commanding higher prices, yet over the past ten years resource, financial and industrial stocks have shown similar earnings power.
The market says that resources companies have superior earnings ability but we doubt that's true - so why pay a higher price for a similar earnings level?
Highly specialised funds are currently in vogue, but balanced funds - offering a balanced exposure to local equities, bonds, cash, property and possibly offshore, depending on the mandate - have historically delivered good returns: In 10 years to end-December 2003, a lower-ranked balanced fund would have generated real returns of 5.4%. A highly ranked balanced fund would have generated 7.9%
Balanced funds already incorporate optimal asset allocation between different classes instead of "devolving decision making to the clients and making them pay for it, and they also reduced the food chain of fees.
Fads and sexiness often lead to tears in investments. The investor who makes the least mistakes is the one who wins in the end. A balanced fund offers a greater chance of making fewer mistakes.

At this time of year analysts are asked about the "outlook for the market". Very much like the moth that cannot resist the allure of the candle - and with similar end results - analysts fire up their crystal balls and proclaim to all who will listen, and those who won't, what their opinion is on the "outlook for the market".
Needless to say, we take a somewhat different approach in that we prefer to evaluate the existing pricing of assets and figuring out if this allows for inflation beating returns going forward. In addition, we take market conditions into account, some of which give strong clues as to expected returns. Such "market conditions" would include demand and supply considerations, consensus positioning and irrational actions by company management and/or our colleagues in the industry.
At present, we expect the broad equity market to deliver no more than pedestrian returns from current pricing levels. In fact, we think an equity index fund investor would be lucky to get 1% real returns over the next 10 years. This is not a forecast, but an expectation based on three simple facts of life:
1. The current P/E of the market is 15.1 - against a long-term (40 year) average of 11.4
2. The current dividend yield of the market is a paltry 2.7%
3. Long-term earnings growth (and, by implication, dividend growth) from the market has been only slightly above inflation.
The return from the market over the long-term consists of the starting dividend yield, plus annual earnings growth, plus (or minus) the effects of a re-rating of the PE ratio. With the above information, it can very easily be shown that returns over the next 10 years will be on the low side.
Within the market, there are (increasingly fewer) pockets of value. We think we have positioned the fund to take advantage of these situations, which should allow for somewhat better than market returns. The portfolio's top ten stocks are fully reflective of where we think the undervalued - and therefore, above average returns - lie.
Of course, the above analysis only obtains over the long run - in the short run anything can happen. We should bear in mind that the higher the short-term returns are, the lower they will be over the long term, from that point onwards. We think equity market returns will be lower over the next 10 years, as we have just experienced a very strong two-year period of historical returns. We would advise investors to exercise caution from here on forward.
In the bond market, we continue to believe that yields are too low to offer returns commensurate with the risk of owning rand denominated bonds. In our opinion the rand is marginally overvalued at present levels of around R6 to the US dollar.

We are always amazed at how consensus can change so quickly - without so much as a nod in the direction of it's own previously held views! Today we are in a period where investors worldwide are saying that SA is the place to be, while the US dollar is daily slipping to new lows against most currencies. Not so long ago, the rand was seen as the pariah of global currencies, now it is the Dollars' turn. One also reads of more and more global companies that want to exit from the New York Stock Exchange - apparently the costs of being listed in America outweigh the benefits. I remember the same argument being used in SA in the dark days of 2001/2002. With our recent spate of new listings, it is obvious that the consensus has changed its collective mind. As usual, the investment bankers are the only ones benefiting from this process of flitting between fashionable locations.
At RE:CM, when everything is coming up roses, we tend to dig a bit deeper; to try and uncover the fertiliser, so to speak. GDP growth, car sales, cement sales - all at multi-year highs, makes us wonder what can go wrong. Right now, we don't seem to be able to find too much!
Normally, the seeds of a potential asset price decline lie in the demand/supply equation. When either demand or supply rises too much, it is evidenced in that capital gets priced incorrectly. This is very important for investors to know, because over-priced capital leads to low returns, while under-priced capital leads to high returns. For years we argued that SA capital was under-priced, due to investors taking money offshore. The results of that mis-pricing are currently being experienced, with SA assets showing very high historical returns.
Naturally, the consensus has started to confuse these historical high returns with the prospect of future high returns. As the consensus gets even braver, there is the possibility that demand for assets might outstrip supply over the next year or so. This will lead to capital being mis-priced in the opposite direction of a few years ago - leading to low potential returns. In the meantime, investors will do well to enjoy the ride, for we don't see any imminent warning signs that stocks in general are hopelessly overpriced. How will we know when capital is being too richly priced? The investment bankers will tell us very clearly when they start offering us more and more stocks to choose from in new listings.