Investment Manager Commentary
Abax Investments

The Nedgroup Investments Opportunity Fund returned 2.4% for the month, taking the year-to-date return to 9.5%.

May 2016 saw the global market recalibrate toward the increased probability of a US Federal Reserve rate hike by September. The futures market now prices in a 60% probability of a hike by September from 40% a month ago. Several members of the FOMC, including Janet Yellen, have indicated that it would be appropriate to hike in the near term if current conditions persist.

The South African Reserve Bank decided to pause at the MPC meeting in May (interest rates were not increased), but signalled that continued further deterioration in the inflation outlook would necessitate interest rate hikes. The continued tension between the finance minister and the Hawks resurfaced through rumours indicating the potential arrest of the finance minister. This led to renewed rand and government bond weakness, which had a spill over effect on banks and the listed property market. The rand weakened from R14.23/USD at the start of the month to R15.71/USD by month end; a 10.4% deterioration against the US dollar. Listed property lost 3.5% while the All Bond Index lost 1.5% over the month. The South African equity market continued its rising trend of 2016 into May with the JSE SWIX rising by 1.3%. The Industrials sector delivered the best performance in May, posting a total return of +5.1%. Financials recorded a loss of 2.0% and Resources posted their first negative return since January with a loss of 3.8% as the strong US dollar put pressure on commodity prices.

The level of gross and effective equity exposure was increased in the weakness witnessed in early May but remains at modest levels. We have implemented various hedging strategies on approximately 6% of the fund¡¦s holdings to help protect us from some market downside should equity prices fall.

The sell-off in government bond markets allowed us to increase our bond positions at levels below our fair value estimates. During the month we again increased the fund¡¦s duration (from 0.8 to 1.25) by buying longer dated government bonds. In early June we locked in some of these gains as bonds rallied strongly on the ¡¥no downgrade¡¦ news. We also believe that in the short term the rand weakness may be overdone, and during the month we added to the hedges on some of our hard currency exposure, allowing us to retain our exposure to attractive offshore assets while at the same time protecting investors from some of the reversal should the rand strengthen from current levels.

The net effective exposure was 46% at 31 May 2016 (broadly unchanged from the previous month) and is a function of:
- Physical equity exposure (local 44%, offshore 8%);
- Plus option/future strategies (could increase or decrease net exposure ¡V currently decreasing effective equity exposure by 7%);
- Plus convertibles exposure (this is not the same as actual convertible holdings ¡V currently adding about 1% to effective equity exposure).

January was a relatively good month for the Nedgroup Investments Opportunity Fund, which was flat amidst falling equity markets. This was in contrast to December 2015 when the fund lost 3% of its value. We are working hard to take advantage of recent volatility and have been quite active recently.

The fund is positioned away from areas where we feel valuations are stretched, and focused rather on the areas of the market where reasonable value exists and income yields are attractive and have the potential to grow. Our equity exposure has increased. During the recent sell-off we primarily bought rand-hedge industrials that did not react (i.e. strengthen) along with the sell-off in the rand. These include Naspers, Steinhoff and newly listed Anheuser Busch; which all have high quality earnings streams with strong growth prospects. These businesses also provide some protection to the portfolio in the event that our domestic holdings are negatively impacted by higher interest rates. We also added to FirstRand and Growthpoint into severe weakness.

Within the equity component of the fund, we have a large allocation to financials, particularly to the banks, the largest holding of which is FirstRand - the highest quality bank in the sector. Banks are trading on single-digit forward PE multiples, with dividend yields in excess of 5% and expected earnings growth of 10% per annum. All South African banks and particularly FirstRand are well capitalised and have experience operating in an uncertain economic environment. We have stress-tested FirstRand against a repeat of 2008/9 bad-debt cycle (a 120% increase in bad debts from current levels), and although our expected return drops dramatically, it is still attractive (low double-digit expected returns).

We have added to listed property and now have a 9% allocation - mainly via a 5% holding in Growthpoint, a business of high quality properties (currently trading at 10% discount to NAV) that has low levels of gearing. Growthpoint currently yields 8% and has distributions that are likely to grow by 5% per annum, effectively providing a 13% p.a. expected return under the assumption of no re-rating. We also own 2% in the Schroders European Real Estate Fund, a new listing, which provides exposure to European offshore property.

With interest rates having sold off aggressively we see substantial value in government bonds. Bonds are now trading at yields close to 10%, which we have not seen since the financial crisis of 2008. We have a fairly large allocation to South African government bonds, a significant contributor to the overall portfolio duration of 1.7 years (during the month duration was as high 2.2 years, but we decreased into some bond strength).

We have 18% direct offshore exposure, with 8% in equities and 8% in offshore credit bonds. Our largest credit positions are in Eskom and Old Mutual, currently yielding 9.5% in dollars and 9% in pounds respectively. Our research suggests that both credits are sound.

We believe that the rand sell-off has been overdone. Although the fundamentals are weak, we feel the weakness may be too severe relative to the poor fundamentals. In fact, countries like Russia and Brazil, which have worse fundamentals than South Africa, have currencies that are not trading as 'cheap' as the rand. We have therefore implemented a derivative strategy that effectively protects a portion of the fund (basically the offshore credit allocation) from a rebound in the rand over the next 12 months. Effectively, that portion of the portfolio will benefit from any further rand weakness up until a level of R19.60/USD, but will be immunised against any strength beyond R15.50/USD. Our effective foreign currency exposure is 11%.

The net effective exposure at 31 January 2016 increased to 55% over the month and is a function of:

o Physical equity exposure (local 42%, offshore 8%);
o Plus option/future strategies (could increase or decrease net exposure - currently increasing effective equity exposure by 5%);
o Plus convertibles exposure (this is not the same as actual convertible holdings - currently increasing effective equity exposure by 0.3%).