Allan Gray Equity comment - Sep 14 - Fund Manager Comment13 Nov 2014
We have written about the high valuation levels of the FTSE/JSE All Share Index (ALSI) for quite some time. Despite our circumspection, the ALSI has continued along its upward trajectory.
We define the intrinsic value of a company as the present value of unencumbered cash generated by the company over its lifetime. This is the free cash available to shareholders, over and above what is required by the company to sustain its operations.
Since a company's intrinsic value is determined over many years - indeed, decades - it is not a value that fluctuates wildly on a daily basis. With the market climbing as rapidly as it has, the market values (i.e. share prices) of many companies have risen beyond their intrinsic values.
This exposes investors to a risk that we are increasingly concerned about: one of permanently losing capital, should share prices revert back to (or below) their intrinsic values. This risk is proportionate to the gap between market and intrinsic values: the higher the market versus the intrinsic value, the greater the risk.
In the Equity Fund, our primary way of mitigating this risk is to stick to a disciplined valuation-based approach to investing. Valuation-based investing entails allocating capital to the shares that are trading at the most favourable valuations relative to their intrinsic values. Like a beauty contest, it is a relative game, since the Fund is currently restricted to shares that are listed on the JSE. In other words, in an expensive market we may have to settle for holding the least expensive shares.
An unambiguous measure of the cash generating capacity of a company is the history of cash dividends paid to shareholders over time. Sasol, Standard Bank and British American Tobacco (BAT) have managed to grow their dividends much faster than the average company over the past 33 years - by 5.8%, 6.6% and 12.3% in real terms respectively, compared to 1.8% for the ALSI overall; a clear demonstration of the strength of the companies' fundamentals. The 4% difference in growth rates between Sasol and the ALSI may not seem like much, but when compounded over 33 years it means that Sasol now pays out 3.5x more in dividends to shareholders (in real terms) than the ALSI. The difference of course is even more pronounced for Standard Bank and BAT.
Better still for investors, these shares can be bought at cheaper valuations than the market: the average dividend yields for the above three shares are just under 4%, versus the ALSI average of 2.7%. As a result: Sasol, Standard Bank and BAT make up 31.5% of the Equity Fund directly (and around 34.8% indirectly, if Reinet's exposure to BAT is included).
These are not glamorous growth stocks, but steady compounders that will hopefully stand us in good stead irrespective of market conditions.
Commentary contributed by Simon Raubenheimer
Allan Gray Equity comment - Jun 14 - Fund Manager Comment09 Jul 2014
The Fund's current active share- is 53%. The top 10 'heavyweight' stocks listed on the JSE are individually significant contributors to this active share. Let's consider eight of them in pairs.
We prefer British American Tobacco (BAT) to Richemont. BAT is trading on a lower multiple, despite it scoring better on metrics related to free cash flow, return on equity (ROE) and dividends, and despite the risk that Richemont's profits are close to a cyclical high. We prefer Sasol to BHP Billiton. We see more downside risk to iron ore prices than oil prices, as low-cost iron ore mines in Australia and Brazil are expanded. Sasol trades on a lower multiple of our estimate of normal profits, and it has significant scope to become more efficient.
We prefer Standard Bank to MTN. Standard Bank's ROE is low compared to its average over 40 years, and it will improve if its operations in Nigeria and Angola continue to grow into their cost bases. Falling tariffs and call termination rates impair MTN's potential to grow revenues, while necessitating continued high levels of capital spending to carry growing network traffic. We prefer SABMiller to Naspers. While Naspers' associate, Chinese online gaming and social media company Tencent, is growing strongly, one is already paying for many years of growth when you pay 59 times profits for Naspers. SABMiller may not be growing as fast as Tencent, but it has reasonable prospects for growing its profits as beer consumption expands in emerging markets, and as SABMiller obtains better prices for its beer and continues to grow its profit margins. SABMiller can be bought for 23 times profits, which is high compared to its history, but much lower than the multiple on Naspers.
These 'heavyweight' pairs currently contribute roughly half of the Fund's active share. Just as important as this contribution from the heavyweights, is the collective contribution from the Fund's exposure to smaller companies. Some of the Fund's small and mid-cap picks were discussed last quarter - since then we increased exposure to industrial company KAP, by buying about 10% of the company for our clients in a single transaction.
- Active share is calculated by summing the absolute values of the differences in weight between each share in a fund and the benchmark index, and then dividing the sum by two. It indicates the overall degree of difference between the fund and the index. Active share of 0% indicates that a fund contains only benchmark stocks in exactly the same proportion as the benchmark; its performance would therefore track the index. Active share of 100% represents a fund which is entirely invested in 'fledgling' stocks not included in the FTSE/JSE All Share Index. The measure was devised in 2006 by Martijn Cremers and Antti Petajisto at the Yale School of Management.
Allan Gray Equity comment - Mar 14 - Fund Manager Comment09 Apr 2014
We tend to focus on the Fund's big positions in this commentary. Our choice to hold large positions in British American Tobacco (rather than Richemont), Sasol (rather than BHP Billiton), Standard Bank (rather than MTN) and SABMiller (rather than Naspers) will be an important determinant of the Fund's future relative performance (alpha).
However, more than a quarter of the Fund is invested in small- and mid-cap shares. Any one of these shares could contribute materially to alpha if it appreciates significantly. Of course, their collective impact could be even larger. Each one of these small- or mid-cap shares has been selected by an individually accountable portfolio manager after the share has passed through our research process. These companies operate in a wide range of industries and are often attractive for idiosyncratic rather than thematic reasons. Some of the Fund's small-cap holdings include: Adcorp, Blue Label Telecoms, Clover, Comair, KAP, Net1 UEPS Technologies and Pan African Resources.
We believe that an increasing administrative and regulatory burden on employment services companies will counter-intuitively benefit Adcorp and further entrench its competitive advantage. Blue Label Telecoms is a dominant distributor of prepaid airtime and electricity in South Africa with the potential to expand into other products in SA, and with a reasonable shot at replicating its successful model in Mexico and India. Clover continues to drive efficiencies in its operations and will shortly be adding yoghurt to its product mix. Comair is entrenching its competitive advantage against its weak competitors by investing in more fuel-efficient aircraft and sophisticated IT, which helps the airline to maximise the revenue generated from each flight. KAP is a mini industrial conglomerate which should generate strongly growing free cash flow from supply chain and logistics solutions provider Unitrans, timber company PG Bison and PET (a component in plastic) manufacturer Hosaf. Net1 UEPS Technologies is successfully distributing over R9 billion per month to South Africa's 22 million social grant beneficiaries, but the awarding of the national tender to Net1 has been challenged in the courts.
This makes for considerable uncertainty and risk, but we believe the share is attractive on a balance of probabilities. Pan African Resources is showing that with disciplined capital allocation and cost control, South African gold mining companies can pay dividends.
Allan Gray Equity comment - Dec 13 - Fund Manager Comment13 Jan 2014
The FTSE/JSE All share Index (ALSI) produced a real return of 15.4% in 2013, above its long-term average, despite what we believe was an expensive starting point. Returns were driven by a few big shares, as opposed to a broad-based increase.
When evaluating this return, it is important to note that the ALSI is a very concentrated index; currently the largest 10 shares have a weighting of almost 60%. As a result, in pursuit of our goal to outperform the index, what we don't own can sometimes be as important as what we do own. In other words, a few decisions can have an outsized impact on our short-term relative performance when compared to less concentrated markets.
Five of the largest shares had contrasting fortunes, with the industrials - SABMiller, Richemont and Naspers - massively outperforming their two mining counterparts, BHP Billiton and Anglo American, and SAB trailing Richemont and Naspers.
Looking more broadly, resource shares have underperformed industrials to such an extent that they have surrendered almost all of the outperformance from the 1998 low when the commodity bull market began.
What makes this interesting, in our view, is that other than SAB, the fortunes of these big companies are all significantly tied to the evolution of the Chinese economy and the competitive dynamics within it.
Commodity prices (Anglos and Billiton), sales of luxury goods (Richemont) and internet/gaming penetration (Naspers via Tencent) have been buoyed by Chinese demand. While we focus on understanding the underlying economics of each company's business model, it is necessary to have some views on China.
Given our concerns over the sustainability of the commodity intensiveness of Chinese GDP growth, we have been underweight the diversified resource shares, which has been a positive contributor to relative performance. It would have been better to have had even less exposure over the last year.
On the flip side, our concerns about the sustainability of luxury good sales to Chinese consumers and increased competition in the internet sector for Tencent have proved to be unfounded so far. Being underweight these two shares has been a large detractor from relative performance to date.
SAB remains a large position in the portfolio with its ability to sustainably grow its earnings in dollars. While its Chinese operation has the largest beer market share in the country, it is still a small contributor to SAB's total profits, and it has great long-term potential.
Given current valuations we continue to be cautious about the level of expected real returns. But, as always, we concentrate on our investment process to produce returns above that of the market.