South African market overview

The FTSE/JSE All Share Index (ALSI) posted a total return of -2.2% vs. +4.5% for Q2 and -6% for Q1. South African resources and financials outperformed in Q3 with total returns of +5.2% and +2.8% respectively, while industrials were the drag on the index, shedding 7.8% over the quarter. Naspers, which was down 12.2%, was a big contributor to the fall in the index.

The best-performing sectors included technology (+10.4%), platinum (+25.5%) and non-life insurance (+16.6%). The worst performance came from pharmaceuticals (-31.8%), mobile telecoms (-12.8%) and media (- 12.3%).

Year to date resources remains the best-performing sector (+20.9%) relative to declines for both industrials (-11.8%) and financials (-6.8%).

South Africa entered a recession for the first time since the global financial crisis. In addition to the challenging macroeconomic background, the recent period has been characterised by a number of companyspecific calamities, which has resulted in their share prices experiencing sharp downward moves. MTN (down 18%) was hit by multiple regulatory financial claims in Nigeria, Aspen fell 34% after releasing disappointing results and Blue Label (down 49%) continues to be plagued by its Cell C acquisition.

The low growth environment has impacted confidence, resulting in returns from cash (7.3%) exceeding equities (6.7%) over the past three years. Year to date the MSCI South Africa Index is down 21% in US Dollars, significantly underperforming MSCI Emerging Markets, which were down just 7.4%. Second to Turkey, South Africa is one of the worst-performing emerging markets in 2018.

Performance

In spite of ongoing volatility, the portfolio continued to outperform its benchmark in the quarter due to good stock picking. Our large position in Old Mutual contributed positively (+14.5%) with the unbundling of Quilter Cheviot unlocking value for shareholders. We believe the counter remains very cheap and should see further uplift as Nedbank shares are still to be unbundled. The announcement by Investec to split its asset management company contributed positively to performance. In addition, we had very little exposure to both Aspen (-38%) and MTN (-18%), which added positively to relative performance.

Detractors from performance included Libstar (-27%), Shoprite (-12%) and Tiger Brands (-20%). While all three companies face short-term challenges due to the increased pressure on consumers and rising competitive activity, we remain positive on the long-term prospects for these companies and continue to selectively add to certain positions in the portfolio.

Outlook

The synchronised recovery in global activity faltered, with trade tensions and increasing political uncertainty in Europe. The US remains the brightspot globally with unemployment (at 3.7%) reaching its lowest level since 1969. Locally, corporate profit growth is growing at just 5.5% (i.e. no real growth). We are in the middle of a downturn in profit growth with no visible sign of a bottoming. The previous three downturns bottomed after corporate earnings had declined. Equity markets are, however, forward looking and will turn in anticipation of a recovery in earnings growth. Current consensus growth for FY19 for the ALSI is 18%, which includes over 25% growth for South African industrials. We view this as way too optimistic.

The price-earnings (P/E) (next 12 months) of the ALSI has fallen from 15.9x (its peak earlier this year) to 12.9x and is the lowest level in five years. This should provide some margin of safety against any further disappointments in profit growth.

So far, this year has been the worst year for equities since the global financial crisis in 2008. In this environment we continue to focus our efforts in uncovering companies that display a minimum of quality in the past financial performance and current financial position and which are trading below our assessment of intrinsic value. In times of increasing pessimism, our experience has proven that opportunities arise to buy great businesses at bargain prices.

With global interest rates moving firmly upwards, it will be the most expensive stocks (highest P/E) that are hit the hardest and as managers who seek out mispriced opportunities, this should play to our strengths.

South African market overview

After the euphoric end to the markets in 2017, the first quarter of 2018 was the worst quarter in over eight years. The biggest contributors to the 6% fall in the FTSE/JSE All Share Index were Naspers (-16%), British American Tobacco (-15%) and Reinet (-16%).

Continued strength in the currency also impacted the rand basket prices for both platinum and gold producers resulting in these sectors falling 21% and 13% respectively. The contagion from the Resilient group of real estate companies did not help the real estate indices, which underperformed the market. The strong momentum of SA Inc. stocks continued in the first quarter with strong performances from general retailers (+9%), automobiles and parts (+7%), construction and materials (+6%) and banks (+4.2%).

Performance

The fund materially outperformed its benchmark in the first quarter. Big contributors to the outperformance came from our investments in Hudaco (+16.5%), AECI (+15.5%), Anglo American (+10.5%) and Shoprite (+15%). Stocks which detracted from performance were Northam (-30%), Reinet (-16%) and Capital & Counties (-16%).

Outlook

We have seen a number of positive developments since the ANC elective conference in December 2017, which bodes well for improving consumer and investor confidence. This has supported Moody’s maintaining South Africa’s investment-grade rating (with a stable outlook). In addition, the 25 -basis-point cut in interest rates will help offset the negative impact of a higher VAT rate and higher petrol prices on consumers.

There is certainly light at the end of the tunnel; we are just not sure how long the tunnel is. Share prices have reacted sharply to a potential economic recovery and while GDP growth forecasts have been revised upwards we should not be naïve to the structural reform challenges required to get South Africa back on a sustainable, long-term growth path. There is much to look forward to when one looks at other countries such as India and Brazil, which recently went through positive regime changes. These countries experienced P/E multiple expansion which, together with a recovery in corporate profits, provided strong tailwinds for equity returns.

We are well positioned to benefit from an improving outlook with significant exposure to underpriced domestic cyclical and smaller-cap stocks. Because value does well in environments where growth is abundant, we think that the recovery in value currently represents the best contrarian trade in the market. This is supported by the extremely attractive discount at which value trades. The P/E discount of the MSCI South Africa Value Index versus the MSCI South Africa Growth Index is the widest it’s been in over 20 years.

Market overview

Without a doubt, 2017 was an eventful year full of surprises for South Africans. With elevated levels of government corruption, further cabinet reshuffles, a ballooning budget deficit, business and consumer confidence at extremely low levels, credit downgrades, ailing GDP growth, the Steinhoff debacle and finally, a ray of sunshine with the election of Cyril Ramaphosa as the next ANC president. Although there is a clear split in the top six candidates of the National Executive Committee (NEC), with half in the Ramaphosa camp and half in the Nkosazana Dlamini-Zuma camp, we are hopeful that Ramaphosa will be able to reduce government corruption and influence government policy in the right direction.

With all the challenges we faced in 2017, who would have guessed that the rand would have been the sixth best performing emerging market currency in the world, appreciating by 10.9% relative to the dollar (even though that 9.5%, was achieved in the fourth quarter). The reality is, as has been evidenced in the past, markets pre-empt bad news so the fear of credit downgrades, political challenges and the weak economy were priced into the rand a while ago.

From an equity market perspective, the FTSE/JSE Capped Shareholders Weighted All Share Index (Capped Swix) was up 16.5% for the year and 8.4% for the quarter. The FTSE/JSE Shareholders Weighted All Share Index (Swix) and the FTSE/JSE All Share Index (Alsi) were up 21.2% and 21% respectively for the year and 9.6% and 7.4% respectively for the quarter. Once again, Naspers had a massive impact on the overall markets return for the year with its share price up 71.8%. Excluding Naspers, the Swix and Alsi returns were 11.26% and 12.96% respectively.

The small and mid cap sectors lagged the overall returns of the market with small caps up 3% for the year and mid cap shares up 7.4%. This highlights the extent of the concentration of the market’s overall returns in large cap shares, driven by the Top 40 shares that were up 23.1% for the year. To further understand the concentration of returns in the market it is important to note that of the 176 stocks that make up the Alsi 41 stocks (i.e. 23%) outperformed the market. This means that 77% of the stocks on the JSE underperformed. A total of 59 stocks (34%) had negative returns in 2017. The median return of the 176 stocks was a meagre 1.35%.

From a sector perspective, the quarter was dominated by the performance of financials post the outcome of the ANC elective conference. A Ramaphosa win saw financials return 16% over the quarter, while resources and industrials lagged with returns of 4.9% and 4.7% respectively.

Global markets performed well with the MSCI World Index increasing by 24.6% (in US dollars). In US dollar terms, returns in markets excluding the US were generally flattered by the weaker dollar. When translated into rand terms returns were less flattering, negated by the rand that strengthened by 10.9% over the year.

Performance
The portfolio returns lagged the overall market as a result of our underweight position in Naspers and the underperformance of our investment in the Naspers core assets. The announcement by Steinhoff of the resignation of the CEO, Markus Jooste, together with the announcement that they had appointed PWC to perform an independent investigation into accounting irregularities took us and the market by surprise. We acted swiftly and immediately sold out of our investment. Our decision was based on the inability to assess the true value of the business on the basis of not being able to rely on the audited financial statements. We sold out at an average price of approximately 1880 cents per share. The valuation underpin, in our opinion, was the value of Steinhoff’s holding in PSG, KAP and Steinhoff Africa Retail (three listed investments that it owns). This closely equates to the exit price of our investment.

On a more positive note, Ramaphosa being elected was generally positive for many of the domestic SA stocks that we hold in the portfolio. For the quarter, Barclays Group Africa was up by 29.7%, Foschini was up 44.8%, and Standard Bank rose 24.2%, while Tiger Brands and Pick n Pay rose 21.9% and 21.2% respectively. Some of our small cap holdings like Adcorp and Italtile rose 20.6% and 12% respectively. Over the 12-month period ending December 2017, two of our core resources holdings performed well. Northam Platinum rose 29.7% and Anglo American was up 34.2%. Our best performing small cap holdings were Altron and Hudaco, up 34% and 31% respectively. Some of the global stocks in the portfolio also performed well in US dollar terms. Samsung and Oracle rose 55.9% and 22.6% respectively, although these returns were lower when translated into rand (given the strong rand over the period).

Outlook

A Ramaphosa victory was crucial, in our opinion, for South Africa. This is likely to result in a gradual improvement in both business and consumer confidence over time. We must, however, not expect a swift recovery. Much damage has been done to the economy due to the high levels of corruption and poor execution of economic policies that have weighed heavily on the growth outlook in South Africa in a period where the rest of the world has shown synchronised growth. The synchronised global recovery, however, will likely provide much needed support to the SA economy and together with a more stable rand and deft leadership from Ramaphosa, the domestic outlook for 2018 is likely to be more encouraging than 2017.

Commodity prices remain strong with copper prices up 30.5% in 2017, iron ore prices have been surprisingly strong given increased supply and while platinum prices are only up by 2.8% in 2017 ($ prices), the palladium price is up by 56%. The oil price has also been strong, rising by 12.5% in 2017. Commodity prices remain supportive of a more stable rand and we would expect our resource stocks to continue to see earnings upgrades as analysts factor in the higher commodity prices. This should be positive for our holdings in Anglo American, BHP Billiton, Northam Platinum and Sasol.

The many conversations that we had with management teams last year pointed to a “wait and see” approach to the outcome of the ANC elective conference. Corporate SA was reluctant to invest additional capital in an uncertain political environment. Although the ANC elective conference concluded with somewhat of a compromised NEC we believe the Ramaphosa win, and the fact that there is greater certainty now that the elective conference is behind us, will result in Corporate SA being more decisive in their capital allocation decisions. This, we believe will be more supportive of some of the small and mid cap shares that have lagged the overall markets returns over the last few years. This will be positive for our clients’ portfolios.

Should the rand remain stronger and more stable in 2018, we could expect some of the larger rand hedges to tread water and show more modest returns in 2018. However, this is a general statement and returns will clearly be determined by the underlying performance of the companies we own in the portfolio. We believe that the outlook for British American Tobacco, Reinet and Richemont remains positive and supports our holdings in these rand hedges. Overall, we believe that the portfolio is well positioned for 2018, especially in the environment that we have described above. We see significant value in domestic SA stocks, in particular in the small and mid cap sectors. The portfolio remains well diversified with broad exposure to small, mid and large cap shares as well as domestic SA and select rand hedges where we see long-term value.