Current context

At an index level (FTSE/JSE All Share Index), the JSE has gained 3.4% this year. However, all of this can be attributed to one share: Naspers (up 26%). Most shares on the JSE have declined in 2017. High levels of political uncertainty and weak economic conditions in South Africa have seen widespread selling of domestic equities, particularly by foreigners. South African banks are down 5%, the general retail sector is down 8% and the broad mid-cap sector is down 7%. Generally, confidence levels are very low and the sentiment around local equities is very poor. In contrast, global equity markets have generally enjoyed a strong year – South Africa is a stand-out underperformer.

Our perspective

The current market environment is a difficult one in which to make short-term investment decisions. This is an unpredictable time, and can result in portfolios being positioned around binary potential outcomes. We position our portfolios based on a consistent process that ensures inherent quality and sufficient margin of safety in all instruments we buy. We also avoid building binary portfolios that are skewed towards any particular outcome. Although this may result in short-term underperformance, we believe it increases the number of outcomes in which we will achieve the benchmarks set by our funds over the relevant time horizons.

Large parts of the South African market are currently deeply out of favour due to the political backdrop, recessionary conditions and aggressive foreign selling. As a result, we can buy quality companies at a widening margin of safety. We believe that this environment – where there are very diverse valuations on equity markets – is good for making long-term investment decisions.

The broad perception of the market is that risk is low when share prices are high, and have been rising. Contrary to this view, we think that risk is in fact lower when share prices are low (as is currently the case with out-of-favour domestic counters). We do not consider very expensive stocks that are deemed to be defensive as low-risk investment opportunities, and we expect muted long-term performance from such stocks. We believe the market is missing the fact that earnings are depressed for many South African companies, and we expect earnings to improve for most of our local investments despite the recessionary conditions. The combination of low earnings and low valuations supports strong long-term investment returns.

Portfolio positioning

We have taken full advantage of our offshore allocation (25%) to invest in high-conviction global ideas. While we anticipate superior returns from some of our domestic opportunities after the recent price declines, we continue to believe that our offshore holdings offer important diversification benefits as well as attractive long-term returns.

We think it is a good environment for long-term stock picking, and have a track record of generating good returns for our clients in tough times when sentiment is poor. Typically, we have enjoyed strong subsequent medium-term outperformance when fear is prevalent.

The investment environment and impact on portfolio positioning

The recent political events in South Africa had a tangible impact on the market climate. South Africa relies on foreign capital flows to fund its deficits, and with increasingly likely further downgrades of its sovereign debt looming, further volatility can be expected. While sentiment towards South African assets is very poor, the importance of the loss of independence of an institution like the Treasury is not something that should be underestimated.

We have seen a sharp decline in the rand in recent weeks and financial shares (especially banks) have been hit hard. Rand hedges have, on the other hand, enjoyed strong price appreciation.

Many commentators argued that the rand had been strong in early 2017, reaching levels of around 12.50 to the US dollar. It is worth noting the rand could only be viewed as strong when compared to the levels reached during the panic at the end of 2015. There is a case to be made that the rand remains undervalued on many measures and could strengthen materially in the event of more stable and predictable management of the economy. Similarly, because South African financial markets have been rocked by negative political developments for some time, it needs to be remembered that risk premiums have risen and a lot of the 'bad' news is reflected in asset prices.

We also need to acknowledge that we have a global backdrop that is supportive of strong returns from many South African assets, should the political situation stabilise. Commodity prices have recovered sharply over the past year and the drought in the north has been broken. The weak rand has underpinned strong improvements in the trade balance and the tourism sector has been booming. The global economy is also enjoying a period of synchronised growth, an environment that is usually very kind to emerging market GDP growth.

This is a time to remind yourself of the fund's investment objective. When sentiment is really poor, we tend to get opportunities to buy quality businesses at significant discounts to their intrinsic value. This goes a long way to achieving the investment objective but requires a long-term view.

The fund remains cautiously positioned with an almost full weight offshore.

We are, however, cognisant of the fact that the loss of independence of the Treasury will necessitate higher funding costs, which have negative effects on the intrinsic value of domestic securities.

Accordingly, we are applying more conservative assessments of intrinsic value to ensure that we only own stocks that are trading at attractive margins of safety.

- 2016 experienced a strong market rotation on global equity markets from defensives to cyclicals which rewarded our portfolio positioning.
- Even after underperforming in 2016, most of the popular large cap defensive equity names on the JSE remain expensive.
- We can find better opportunities for our clients: primarily higher quality cyclical businesses in SA and abroad.
- The stocks in our portfolios are still attractively priced, despite strong share price performance in 2016 in general.
- Our portfolios comprise a diversified selection of higher quality businesses trading at attractive prices and at a substantial discount to the broader market.
- We are confident that the holdings in the Fund will produce satisfactory long-term returns.

2016 in review

By the end of 2015, defensive bond-proxies and popular growth stocks had become very expensive. Hence, our clients owned none of the large cap rand hedge stocks that dominate the JSE indices. At the same time, economically-sensitive businesses with cyclical earnings streams found themselves deeply out of favour. We could find fantastic opportunities for our clients, particularly amongst higher quality cyclical businesses in South Africa and the US.

In our December 2015 commentary we concluded that: "sentiment is very poor in several areas of the market and it is possible to buy stocks at similar valuation levels to during the global financial crisis of 2008. These are circumstances in which we consider it appropriate to adopt a contrarian approach and invest in unloved cheap stocks on behalf of our clients. Investors should enjoy good long term returns from these stock price levels."
It is pleasing to report that many of these "unloved cheap" stocks delivered handsome returns for our investors during 2016. As a result, the Fund materially outperformed its benchmark over the year. The JSE (at an index level) was, however, weighed down by poor performance by expensive large cap rand hedges.

Portfolio positioning and outlook

The panic of 2015 and early 2016 provided the opportunity to buy good businesses at a wide discount to our assessment of intrinsic value. Cyclical companies were deeply out of favour with widest mispricings to be found in the Resource sector. Most commodity producers had very strong share price performance in 2016 and as a result, we reduced our exposure, selling out of Anglo American and BHP Billiton during the year after share prices exceeded our estimate of fair value. The Fund retains exposure to Glencore, where we continue to perceive an attractive discount to our value for the business.

We are long term investors, not traders, but given very strong share price appreciation in some of our holdings, portfolio activity was higher than normal in 2016. We sold Capitec during the year (in favour of PSG), reduced Imperial and Barloworld and took profit in US financials (JP Morgan, Capital One, Wells Fargo, Berkshire and Markel) and Microsoft.

The fears around the potential downgrade of SA sovereign debt saw attractive opportunities arise within interest rate sensitive SA financials and we were buyers of strong franchises like Firstrand, Old Mutual, Barclays and Nedbank at what we thought were very attractive prices for long term investors.
We have also added to Discovery throughout the year. We think the current share price materially understates the strength of the business model, addressable global market, sustainable growth rate and quality of the management team.

At the end of 2015 the Fund had 31.5% of its assets invested directly offshore. By the end of 2016 this had reduced to 22.2% as we could find better opportunities within the SA market in some of the stocks discussed above, especially given the extreme weakness of the rand against other currencies. Our offshore equity investments remain an important source of portfolio diversification and we have high conviction in the long term returns to be derived from our global equity positions, including Sainsbury, Brookfield and Cisco.
A feature of the bond bull market of recent years is that certain equities have competed for capital with developed market bonds and have become very expensive. These have included some of the popular higher quality rand hedges on the JSE like Naspers and British American Tobacco. As a result, investors are poorly compensated for the risk they are taking and are likely to experience poor long term returns. We constantly screen for opportunities to buy quality at a margin of safety but can currently find limited opportunities within the traditional JSE rand hedges and dual-listeds. We think we can find better long term investment ideas, some of which we have discussed above.

Our portfolios comprise a diversified selection of higher quality businesses trading at attractive prices and at a substantial discount to the broader market. We are confident that the holdings in the Fund will produce satisfactory long-term returns.