Investment Manager Commentary
Denker Capital, a division of Sanlam Investment Management

In April/May South African financials were sold down aggressively – this is not surprising in light of the poor economic outlook we’ve been writing about and the political see-saw around Finance Minister Pravin Gordhan. Specifically, the insurers took a hit, Liberty being the worst (sold down 14% on disappointing results and its potential link to a pension fund closure investigation). However MMI (-5%) and Sanlam (-9%) were also sold down, partly reflecting selling by global funds fearing the coming sovereign debt downgrade. Banks held up better, FirstRand being sold down the most (-6%) versus Nedbank/Standard Bank/Investec only -2.7%.

The fund has a very small investment in Liberty and MMI, but its large investment in Sanlam and FirstRand dragged down performance. However, Sasfin (+5%) and JSE (+2%) and then the 20% investment in the Sanlam Global Financial Fund helped a lot. The global fund ended the month +2% in US dollars (+6% year-to-date) and the 9.4% decline in the rand also helped significantly.

The outcome described above is in line with our expectations voiced in the commentary of previous months: We expected global financials to re-rate and South African financials to de-rate, both on the back of their valuations (global very undervalued) and the changing economic situations (India, Indonesia, Georgia, Peru, Russia and even the US’s good/improving growth versus South Africa’s deterioration).

Now where do we see value?

Our research highlights, and our meetings with South African bank managements confirm that they have been building up reserves over the past few years and have also been very cautious in granting new loans. The probability therefore is high that they continue to generate between 15% - 17% return on capital (with FirstRand generating 22%) plus maintain (and possibly increase) their dividend payments. The expected further interest rate increases will be positive for net interest margins, I expect more so than the expected negative effect of increased bad debts. This and the price falls mean that, despite the gloomy environment, South African banks represent good value again and hence we will be looking to increase the fund’s investment in the bank sector.

The outlook for global financials is also improving due to the increasing probability that US interest rates will be increased. Should this happen the probability is high that US and global banks will re-rate over the next six to 12 months.

Hence, for the first time in quite a while we’re positive on the prospects of the Nedgroup Investments Financials Fund. I write this with a famous Warren Buffett quote in mind: "The most common cause of low prices is pessimism - sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer." - Warren Buffett, 1990 Berkshire Hathaway Chairman’s Letter

Global (and South African) markets sold off in January due to a combination of fears [the effect on Europe of the refugee problem, significantly lower oil prices and the risk of a (mild) recession in the USA] plus the sudden realisation that China's GDP growth slowdown can lead to a weakening of the yuan, putting further downward pressure on low global growth rates and deflation.

The SARB's raising interest rates by 50 bps lead to a sharp re-rating of the financial sector and especially banks on the last two days of January. The higher interest rates and the high probability of an austere budget pauses a dilemma for investors. The higher interest rates and (most probably) higher taxes and cutting of expenditure are very important steps to regain credibility and ward off a further downgrade of the country's sovereign debt. However, it will bring further pain to both the corporate and private sectors increasing the risk of a recession, social unrest and putting pressure on unemployment. At the same time the December 2015 rand weakness means pension funds will be forced to sell offshore investments and buy rands, which will cause the currency to strengthen for a while.

Needless to say that 2016 will be a difficult investment year but the big positive is that valuations are now at 20-year lows and dividend yields exceed 5%.

In the Nedgroup Investment Financials Fund, smaller caps that held up well in December got sold down: Transaction Capital, Sasfin, Capitec and PSG and then the insurers: Sanlam, Discovery and Old Mutual. Coronation bounced strongly (we did start adding a bit in December and also January). Banks are largely flat but Investec got sold down, presumably by offshore investors in line with global markets whilst FirstRand strongly outperformed (+5.6% in January), but most of that movement came on the last two days of the month.

During the month we increased the Fund's investment in FirstRand, Sanlam, Nedgroup and Coronation and reduced the investment in Discovery and MMI.