Market overview

Despite the overwhelming negative sentiment, the FTSE/JSE All Share Index (Alsi) had its best quarter this year, supported by the strong performance from the media and resource sectors. Both these sectors are benefiting from a weak rand and strong growth in offshore demand for their products. The performance of small and mid cap shares, which have a higher exposure to South Africa, continue to lag overall market performance and both sectors remain in negative territory for the year. In contrast, the FTSE/JSE Top 40 Index is up 15.3%.

South African companies have experienced some of the toughest times in recent history. Consumer and business confidence has taken a severe beating. Looking back over the past 20 years, when consumer and business confidence was this low it coincided with a global crisis such as the emerging market crisis in 2008, the IT bubble in 2002 and the Global Financial Crisis in 2008. It is different this time around - this predicament is completely self-inflicted. While the rest of the globe is experiencing an economic recovery, South Africa has struggled to achieve above 1% economic growth. In the hope of partially restoring business and consumer confidence and supported by an improving inflation outlook, the SA Reserve Bank cut interest rates by 25 basis points in July, but the lack of follow through in September and the heightened political uncertainty resulted in a fairly limited impact.

Unsurprisingly our conversations with company management teams over the past quarter highlight the frustrations of business leaders and the impact that the political uncertainty is having on investor confidence. Many projects that require long-term clarity have been postponed and some have been cancelled outright. No industry has escaped the negative ramifications of the Cabinet reshuffle and more companies than ever are looking for alternative avenues for growth outside of South Africa. In addition, companies have become focused on managing costs in an attempt to preserve margins. Unfortunately this has negatively impacted private sector job creation (mostly in the manufacturing and construction sectors) with over 80 000 jobs lost in the first six months of this year.

Despite the local headwinds, the South African equity market hit an alltime high during the quarter. The source of returns remains fairly narrow with only three sectors outperforming the Alsi. These are media (essentially Naspers), consumer goods (essentially Richemont) and resources (including forestry and paper). Of a total of 170 companies making up the large, mid and small cap indices on the JSE, just 40 outperformed with 130 companies failing to keep up with the overall market return. In other words, for every company that outperformed the Alsi, another three underperformed. When investment returns are so highly concentrated, it becomes difficult for active managers to keep up with the overall market returns, explaining why 90% of funds in the general equity category have underperformed the Alsi in 2017.

Performance
The portfolio returns lagged the overall market returns largely as a resultof our underweight position in Naspers and the underperformance of our investment in the Naspers core assets (through the listed stub instrument). In spite of the discount of Naspers widening to extreme levels, the investment case for the core assets continues to improve. There are various technical factors that we believe have contributed to the discount widening. One such factor is the continuing disinvestment by foreigners from South African equities. Since the discount of Naspers to its investment in Tencent turned negative in January 2016, we have seen a cumulative US$13 billion flow out of South African equities by foreigners. This is far greater than the US$6 billion outflow during the Global Financial Crisis.

Other stocks that detracted from performance during the quarter include our investments in Steinhoff and Group Five. Steinhoff came under the spotlight once again due to the resurfacing of an old dispute with a former joint venture (JV) partner. This case has been heard in Amsterdam and a favourable decision is expected in the next two months. Management has provided for partial settlement with the ex-JV partner and any negative outcome is not expected to have a material impact on the financials. We used recent weakness to add to our position.

Group Five has been the subject of significant shareholder activism. The board has been replaced and new management has been appointed in the various divisions. While the company remains extremely undervalued, it will take some time to restore profitability in the local construction business. The current share price attaches a negative value to the construction business and undervalues the concession business.

Our investment in Anglo American and Northam Platinum contributed positively to performance for the quarter.

Outlook
This is in many respects a perfect storm. As companies have struggled to grow the top line, they have had to compete harder than ever before to attract and retain customers. This has often meant that prices have remained under pressure resulting in lower margins. In this lies the opportunity. As investors we have always looked for mispricing opportunities, which tend to arise at the time of maximum pessimism. In order to find an advantage in the market, one needs to look for diversity breakdowns, which happen when participants imitate one another and make the same decisions based on the same signals from the market. Diversity breakdowns represent collective overreactions and underreactions to new information. We have seen this several times in the past and on each occasion have achieved significant returns by having the moral courage to act opposite to the crowd when our judgement has told us that we were right.
In a recent radio interview, Christo Wiese said: “In the last 50 years South Africa has been through tougher times than we are currently experiencing. There is no reason to believe that in this dark night, there won’t be dawn again. Things will be better again.” South Africa is currently at a crossroad and while the upcoming ANC elective conference in midDecember will be key, we are of the view that the South African domiciled businesses and the currency are already reflecting a bearish scenario. Many opportunities are emerging in the mid and small cap space and your portfolio currently has approximately 25% allocated to stocks outside the Top 40. The share prices of these companies have been under significant pressure this year and offer substantial upside for the investor. We also acknowledge our limitations in being able to predict the outcome of the ANC elective conference and its impact on the market in December. For this reason we maintain a diversified portfolio of holdings, both local and global, cyclical and defensive. While we remain of the view that SA Inc. remains grossly undervalued, the future performance of the portfolio is not only dependent on a recovery in South Africa. We have significant exposure to businesses that are listed in South Africa, but earn a significant portion of their profits outside of the country.

Market overview
The fourth quarter of 2016 was another weak quarter for South African equities, which finished the year with a total return of 2.6%, underperforming cash for the second year in a row. The low returns in 2016 were largely due to the impact of the stronger rand (12.6% appreciation in USD) on the dual-listed heavyweights such as British American Tobacco (-9% for the year), Richemont (-14% for the year), South African Breweries (-16% before it was delisted) and Naspers (+1% for the year). In contrast, mid and small-cap shares returned 27% and 21% respectively in 2016.

The disappointing returns in the fourth quarter were in spite of South Africa managing to avoid a credit downgrade by Standard & Poor’s (for now) and the positive impact that the Trump victory had on non-precious metal commodity stocks. Even if you had correctly predicted the Trump victory, global markets reacted differently to what most would have expected. Overall, however, the impact of the Trump victory was negative for emerging markets and South Africa was no exception.

Financials (+2.9%) outperformed industrials (-4.7%) and resources (- 1.2%). The best performing sectors in the fourth quarter were fixed-line telecoms (+25%), industrial metals (+19%), support services (+13%) and banks (+11%). The worst performing sectors included gold (-36%), platinum (-33%), media (-15%), healthcare (-13%) and tobacco (-11%).
Performance
Our continued focus on identifying mispriced opportunities and having the courage of our convictions to sometimes go against the crowd paid off for our clients in 2016. In spite of the market showing negative returns, our clients’ portfolios showed positive returns in the fourth quarter and significantly outperformed their respective benchmarks. Big contributors to these positive returns came from our investments in Barloworld (+42%), Altron (+42%), Anglo American (+13.8%), Investec (10.8%) and Hudaco (+11%).

Stocks which detracted from performance in the fourth quarter included our investments in Northam (-22%), Group Five (-11%), Reinet (-10%), Shoprite (-11%) and Steinhoff (-7%).

The benchmark-agnostic and diversified approach we take in allocating capital meant the portfolios were better able to withstand the several surprises and shocks during the year. In addition, the number of mispriced opportunities in the mid and small-cap space provided a source of differentiated returns compared to some of our peers. On a net basis our investments in smaller-cap companies contributed about 20% of the excess returns for the year.

The outperformance we achieved this year was based on a very conservative investment approach. Our portfolios did not have excessive concentration in any one sector or stock. In particular, our overall position in resources was not materially higher than the market and well below many of our competitors. However, the stocks which we were invested in like Anglo American (+182%) and Northam (+54%) performed substantially better than the Resources Index (+34.2%).

Outlook
There have only been three periods going back to 1960 when equities underperformed cash for more than two successive years. The last one was in the nineties when cash beat equities 60% of the time and equities actually underperformed cash for four consecutive years. In the years in which cash beat equities it was mostly (70% of the time) when returns from equities were negative. Looking back, the best time to invest in equities was in the year immediately after the year in which they underperformed cash. The average annual excess return from equities was 18% higher than cash in the year following equities’ underperformance. This is substantially ahead of the annual excess return from equities versus cash of 9.6% since 1960. Further supporting the case for equities is the current valuation. The FTSE/JSE All Share Index 12-month forward price-to-earnings ratio has de-rated from almost 16x a year ago to 13x today, making equities the cheapest they have been since 2013.

While valuations are more favourable than they have been for some time, there is no shortage of potential surprises on the horizon. The rating agencies remain concerned about the adverse consequences of persistently low GDP growth in South Africa. While growth is expected to recover in 2017, it still remains below the levels required to create jobs. On the positive side, food inflation is likely to have peaked, alleviating pressure on consumers and staving off any further interest rate increases.

On the political front, the focus will increasingly shift to the ANC succession dynamics ahead of the elective conference at the end of the year. While we are hopeful that the best outcome will be achieved for all South Africans, the road will be bumpy.

On the international front, the Trump trade has probably run ahead of fundamentals. Many of Trump’s promises such as immigration tightening, tariffs, border taxes and repealing Obamacare are negative for risk assets. The market seems only to have focused on the positives such as tax cuts, infrastructure spending and deregulation. Whether he can deliver or not remains to be seen.

With the US interest rate cycle on the up, we see challenging times ahead for stocks which have benefited from artificially depressed interest rates. This includes defensive companies such as healthcare and tobacco as well as gold, all of which have been overpriced for some time. We remain underweight expensive rand hedge and defensive stocks and although we are starting to see better prices than we have had in a while, we have been slow to commit new capital to some of these companies as the margin of safety is still not big enough.

We continue to see good opportunities amongst select mid and small-cap stocks. In addition, easing food inflation will be supportive of food producers and we own several of them (Tiger Brands, Clover and Rhodes Food Group). Finally, there are always a few significantly mispriced opportunities which are trading well below intrinsic value. While these may not be of the best quality, the market’s assessment of their prospects is far too negative. These would include the likes of Old Mutual, Altron, Stefanutti and Datatec, to mention a few. In conclusion, the outlook for 2017 on balance looks better than a year ago. Valuations are the most attractive since 2013 and the outlook for earnings growth is supportive of reasonable returns. The macro and political landscape, however, remains uncertain and may influence the improving fundamentals in the short term.