After a good July, the Nedgroup Investments Financials Fund continued with a good August, gaining 2%. For the past 12 months the JSE has gained 10.2% while the fund has gained 12.9% (gross of fees), making it one of the top funds (year-to-date) despite the negative environment.

The financial results reported by the banks and insurers in August (and July) confirmed most of what we’ve been writing about during the year. So, I thought it more appropriate to comment on why the fund has performed so well this year and for the past 10 years.

The lesson we’ve learnt over the years is that over time, but even more so in tough times, the quality of a business and its ability to compound shareholder capital is much more important than the accounting valuation. This sounds easier than it is. One needs a good database and loads of experience to be able to discern and test the quality of management teams.

For example, since 2003 Absa has underperformed the other banks, despite continuously being the cheapest on P/NAV and PE. Since December 2010 the share price of Capitec has gained 456% versus Absa’s 6% - this despite Capitec being much more expensive than Absa. To put that in context, since December 2010 FirstRand gained 184%, Coronation 275% and Sanlam 157% versus the JSE All Share Index’s 76%.

The true value of a business lies in its ability to grow shareholder value at a high rate, and with a high degree of certainty. As said before, forecasting this is not easy: we sold the fund’s last Capitec holding in April 2015 when we thought it was too expensive, and at this stage it seems we were wrong. However, as we sold down the Capitec position we did increase the fund’s holding in PSG.

We don’t know what lies ahead for South Africa or its financial sector in the next 24 months, let alone the next 10 years. We do know that if we continue to invest in managements running businesses that follow sound principles and allocate capital rationally over time, they will outperform their industry peers and (most probably) also most companies included in the JSE All Share Index.

The challenge for us as fund managers is: to keep monitoring managements’ behaviour to ensure they remain true to their DNA; to increase our investments when the share prices don’t reflect the potential returns (or decrease when the market becomes over confident); while diversi fying the portfolio enough to reduce the impact of mistakes we may make. The most important part is to make sure we value the quality of the business and management team correctly.

Denker Capital

2016 brought a number of extra-ordinary events with unexpected outcomes: the January/February China market collapse, impeachment of Brazil's president, Brexit, Trump's presidential victory, India's demonetisation, impeachment of South Korea's president….and the biggest surprise: South Africa avoiding a junk rating. For South African financials the two main events were the excessive fall in the rand in December 2015 which set the scene for an11% gain in 2016 against the dollar and Brexit, which saw the pound record a decline of 26% against the rand.

The fund continued its strong performance, outperforming both the Financials Index and the ALSI handsomely over all periods. The performers in 2016 were the banks, with the banks index gaining 26% which might seem surprising in the context of a struggling economy. However, expectations in December 2015 were very low (P/NAV of 1.4x) hence causing a re-rating when the banks surprised positively on their ROEs. Financials exposed to the British pound performed poorly - notably Brait (-47%), to which the fund had no exposure until after Brexit, Investec (-13%) and Old Mutual(-10%). The fund's investment in the Sanlam Global Financial Fund (managed by Denker Capital) performed well in comparison: +20.3% in US$ (+9% in rand). A number of factors weighed on the insurance sector which had a dismal year especially compared to the JSE (the share) and Coronation which gained 34% and 42% respectively (percentages quoted are total return including dividends received).The Nedgroup Investments Financials Fund's good performance was due to our focus on franchise quality (measured in the firms' ability to consistently grow shareholder value) but only at attractive valuations. Hence the low weight in insurers (22%) and 41% weight in banks in January 2016.

During the year we increased our investment in banks to 45% and reduced insurers further to 17% while we gradually increased PSG during the year from 1.6% to4.9%. A share that performed particularly well for the fund was Transaction Capital, but the holding was substantially reduced after its strong post results rally made it fairly expensive. Looking forward: Higher commodity prices will help South Africa's trade balance, but the 57% increase in the oil price during 2016 will put further pressure on the consumer and growth. Returns for 2017 will be shaped by many factors, however the most important factor (valuation) is at 'fair value' and hence one should not expect a re-rating of the market in 2017. Nevertheless, one always finds good investment opportunities, regardless of the environment or market.

We have identified quite a few mispriced opportunities both in South Africa and even more so globally for the Sanlam Global Financial Fund which should benefit from stronger US growth and higher US interest rates. Conclusion: The companies in the SA financial sector are well managed and generate an attractive return on capital. Based on this and the current valuation the probability is high that the financial sector will deliver satisfactory performance in 2017.