12 months to December 2017
In our commentary a year ago we said: “During 2016 it became evident that the tide of lower inflation, growth and interest rates was ending and starting to reverse. The election of Donald Trump as US president increased the probability of a reflating world dramatically and markets have started reacting to this.” While inflation has remained subdued, 2017 saw a gradual shift towards higher interest rates in the US as well as a number of other countries. We think this trend will continue in 2018 and beyond, which is very positive for global financials.

We focus on long-term winners
We outperform because our database highlights financial companies that are mispriced and grow shareholder value. Hence a supportive macro backdrop does play an enhancing role but our strength lies in the experience, constant company visits and database we’ve built up over the years. A glance at the top 20 contributors to performance over the past 15 years confirms this and shows that the same companies regularly appear, highlighting the focus on long-term winners as opposed to short-term turnarounds. The top contributors to performance in 2017 confirm this:

-TCS we’ve held for more than four years and it has generated a return exceeding 490% in the past three years. It is still in the early years of its evolvement as a financial services company in Russia, leaving considerable room to grow plus it remains undervalued.

-Similarly, IS Yatirim Menkul was purchased in June 2007 (its sister company TSKB was purchased in 2004). Toward the end of 2017 we started reducing our investment in the company but increased TSKB. Encore Capital’s management have been buying books of defaulting debtors from banks at good prices for many years and have built up considerable expertise in data management and debt collection to generate a high return on shareholder capital. The team have identified a number of similar companies with considerable potential in which we have built up positions which should benefit the fund for quite a few years.

-On the other hand the size of holdings in larger banks like Erste Group, Bank Negara Indonesia, Sberbank and Credicorp increase and decrease in the portfolio as their economies expand (and occasionally contract). The skill we have lies in our database and emotional strength to invest in these countries when other investors flee them (although we’ve learnt to wait with re-investing until we can see evidence of the economic turnaround). Towards the end of 2017 we increased the fund’s investment in similar situations in Brazil, Hungary and Austria.

We invest with a three to five year horizon and not every investment made will outperform in year one. The main detractor in 2017 was Panin Sekuritas – and we’ve spent a lot of time analysing (as we do annually with all our poor performers) why we did invest (or in this case remained invested after it had performed very well).

Besides Panin only the property and casualty insurers (XL, Renaissance and Validus) recorded negative returns in 2017. These were fairly small positions and important to note that they were outperformers in previous years. The market sold them down in the second half of 2017 due to the severe hurricanes and fires which will result in 2017 being a record year in terms of claims related payouts. These companies all have strong balance sheets and should re-rate sharply in 2018 as the pricing cycle improves again. We have gradually started adding to these holdings.

Looking forward
The evidence points to 2018 as being the year for financials. The growth, inflation and higher interest rate cycles that started turning in 2017 should continue, which bodes well for net interest margins and return on capital. The sector has sufficient capital, now has clean lending books and is operationally lean and mean. Most important: valuations generally remain attractive.

Our research and meetings with management confirm that the financial sector is well placed to generate strong shareholder value growth in 2018 and most probably for a few years. We believe the companies we are invested in are mispriced and should re-rate further making us optimistic that 2018 will be another good year for companies in the financial sector.

2017 again highlighted the team’s ability to find underappreciated companies in its circle of competence. This has allowed the fund to outperform for 14 years of the 18 years since we started it in 19992 outperforming the MSCI World index by a factor of 4x.

2From 1999 – 2004 the fund was managed under a different fund management company, but by the same fund manager.