Market overview

The quarter was dominated by heightened concerns around a contagion crisis in emerging markets which arose mid-way through the quarter. The Turkish Lira devalued dramatically as the Trump administration sought to impose sanctions in mid-August, following the detention of an American evangelical pastor. That caused a knock-on effect with similar sell-offs from the BRATS (Brazil, Russia, Argentina, Turkey and South Africa) currencies, as weak fundamentals were once again in the spotlight. In response to the capital flight and rapidly rising inflation, we saw some dramatic moves by central banks, with the Turkish central bank hiking rates by 6.25% to 24% and Argentina following suit, hiking rates by 15% to 60%.

Compounding the risk-off sentiment during the quarter was the ongoing tariff tit-for-tat between the Trump administration and China. Trump continues with the threat of 10% tariffs on $200 billion of Chinese imports, escalating to 25% next year. China is the biggest exporter to the US, while China is only the third largest destination for US goods – which would make China a net loser in a tariff war. This is not good news for the Chinese economy (and by implication other global economies), where exports have already been slowing prior to this tariff war accelerating.

Closer to home, the Rand also felt pain within the turbulent emerging market context, as the Ramaphoria rhetoric was firmly placed on the backburner and a slew of data points painted a dire economic reality. Following the dreadful downwardly revised -2.6% Q1 GDP growth1 , Q2 GDP growth continued its slide by contracting 0.7%, plunging the economy into a technical recession. The main ‘sector’ culprits in Q2 were agriculture (-29%), transport, storage and communications (-4.9%) and domestic trade (-1.9%). From an expenditure point of view, demand remains weak, with household expenditure down 1.3% in Q2 and inventories also saw a material reduction (-14.2%).

The real economy remains weak with retail sales under pressure, growing at around 1% year-on-year (y/y), while vehicle sales (a key indicator of consumer health) declined in August and September. Wage growth has slowed from over 8% y/y to 5% y/y this year, but the public sector wage agreement will help the second half of the year. Despite consumer confidence remaining somewhat buoyant, consumers have remained risk averse and this has led to an increase in savings at the expense of consumption. Money supply (with base money growth at less than 3% y/y) and credit growth remain subdued, which would suggest that economic growth should still remain below par. The overall picture is one of a very weak outlook on nominal GDP growth. Consensus views point to an improved second-half picture (off an admittedly low base) and we should manage real GDP growth of just above 1% y/y when the final 2018 numbers come in.

On the monetary policy front, the South African Reserve Bank once again has found itself between a rock and a hard place as they contend with anaemic domestic growth, a weak currency and rising inflation risks. At the latest meeting in September 2018, the Monetary Policy Committee decided to keep the repo rate unchanged, however, three of the seven members were in favour of a 25- basis point increase to 6.75%.

The continued plague of weak domestic fundamentals has manifested in a material divergence in performance across the size spectrum on the JSE. The vast divergence in performance of the larger Rand hedge businesses and the small and medium domestically-focused SA Inc. plays has remained stark over meaningful periods. Year to date (9 months to 30 September 2018), the Rand hedge-heavy large cap index (-3.2%) has outperformed mid- (-12.1%) and small (-7.8%) caps materially. Over two years (30 September 2016 to 30 September 2018), the divergence in performance among the Rand-hedge Top 40 large cap index (+15.5% total return) and more domestically-focused mid- (-4.7%) and small (-4.5%) cap indices is even more accentuated. Over the third quarter, the performance across the size spectrum was somewhat less pronounced with all three indices down 2% to 3%.

Portfolio Review

Morningstar data indicates that the SIM Small Cap Unit Trust generated a return of -4.3% in the third quarter of 2018 (three months ending 30 September 2018), underperforming the average peer return for the ASISA small and mid-cap fund category of -3.4%.

When taking into account total return (share price move and dividend received) and the size of each investment within the portfolio, a simplified attribution analysis highlights the following shares held within the SIM Small Cap Unit Trust that added the most to performance in the third quarter of 2018: Impala Platinum (generated a total return of 36% for the three months ending 30 September 2018), DisChem (+22%), African Rainbow Minerals (+25%), Exxaro (+20%) and Italtile (+11%).

The largest detractors for the quarter were Choppies (lost 72% of its value for the three months ending 30 September 2018), Blue Label Telecoms (-50%), Balwin (-30%) and Cartrack (-16%).

Risks and opportunities

Recent results reported in the mid- and small-cap space continue to be largely below par. Many companies, even those considered to be defensive, high-quality names, are feeling the bite of the harsh economic backdrop. With this backdrop of short-term underperformance, we however do see the structural reforms necessary to kickstart our flailing economy slowly being put into place. The new administration under President Cyril Ramaphosa has continued to make positive, albeit incremental, strides that bodes well for patient investors in the mid- and small-cap area of the market. We are aware though, that a meaningful positive impact on the ground in terms of business and consumer confidence is likely to be delayed and there are unlikely to be any quick fixes, particularly as we approach an important domestic election battle. From a valuation point of view, we find ourselves in a familiar situation this quarter. In many instances our high conviction ideas have continued to become cheaper over time, often without fundamental reason. In such circumstance of prolonged weakness, we must remain steadfast in our investment process and application of our pragmatic value philosophy. As always, we place our rigour and detailed research effort above short-term market volatility and believe that over time share prices will converge to their intrinsic value and patient investors will be rewarded handsomely