China has had, and continues to have, a significant impact on the fortunes of the South African stock market. China accounts for 19% of the world's population, approximately 15% of global economic activity and an even higher share of global growth. However, what has been important to South Africa over the last 15 years has been the commodity intensiveness of Chinese growth.

In 2014 China accounted for approximately 45% of the global consumption of copper, 51% of aluminium and 65% of seaborne iron ore. South Africa, which does not have a competitive manufacturing sector (see last quarter's Equity Fund factsheet), nor any new, large technology companies, was still able to earn valuable foreign exchange to pay for imports by exporting commodities at high prices and to enjoy all the associated indirect benefits for our economy.

It is hard to believe now but in 2008, boosted by Chinese demand-driven super profits, mining giants BHP Billiton and Anglo American alone had a weighting in excess of 20% of the FTSE/JSE All Share Index (ALSI). And it was not just the mining companies that benefited: Richemont sold luxury goods to the newly wealthy Chinese and our construction firms built and managed projects for expanding miners. Long-term clients will remember our concerns over the sustainability of that Chinese demand given the size of its investment and debt relative to its economy.

While our concerns over China were early, they are now more widely recognised, and manifested in the weakness in many of the mining shares and in the currencies of commodity-producing countries such as South Africa. Our equity returns look very different when viewed in US dollars. As China attempts to move from growth premised on investment to greater consumption of goods and services, it does so with a great amount of debt used to finance the boom. It is not clear whether South African companies will benefit to the same extent. While we have increased our weighting to selected mining companies, we have the potential tail risks associated with China front of mind as we do so.

Despite the large fall in commodity prices, China has retained its direct influence on our market through multinational media group Naspers, which, driven by its stake in the Chinese internet company Tencent, now accounts for a greater percentage of our market than BHP Billiton and Anglo American combined. Despite being a top 10 position in the Equity Fund, Naspers is our second-largest underweight relative to the ALSI. This feels more uncomfortable than the Fund's 0% position in BHP Billiton and Anglo American held in 2008 into the peak of the commodity super cycle.

Why is this so? Tencent is a far superior company to the mining giants, with the high return on capital inherent to platform businesses that achieve scale. Tencent has always traded on a high price-to-earnings multiple, justified by the growth in its intrinsic value. To highlight what a winner Naspers picked, and to their credit held onto, consider the following: Tencent has produced the highest compounded rate of return in the world of all companies with a market value greater than US$1bn in June 2004 (2743 companies qualified). Out of interest, Naspers and Apple are in the top 5.

We continue to spend considerable time debating Tencent and Naspers' business fundamentals and the sustainability of their profits in relation to the price being paid today. We doubt whether when we look back in a few years' time, the correct answer will seem as obvious as that of the mining shares in 2008. Nobody said investing is supposed to be easy.

There have been no material changes to the composition of the Fund during the quarter, other than the large positive move in SABMiller's share price in response to a potential offer by Belgian brewer Anheuser Busch Inbev (SABMiller is the Equity Fund's fourth largest holding). We have trimmed the position into the strength.

Commentary contributed by Duncan Artus

The last three decades have been tough for the South African manufacturing sector. Manufacturing's contribution to GDP has fallen from 24% to 13% and the number of people employed has fallen by 25% between the early 1980s and today.

South African manufacturers are facing a host of challenges, ranging from cost inflation in the form of administered prices, real wage increases, labour unrest and productivity issues, to infrastructure bottlenecks, policy uncertainty and weak global demand. These challenges have been compounded by falling trade barriers and depressed infrastructural spending.

The travails of South African manufacturing businesses are clearly echoed in the stock market. Companies exposed to the metals and engineering sectors have fared particularly badly: industrial group Argent, infrastructure business Aveng and steel manufacturer Arcelor Mittal have underperformed the FTSE/JSE All Share Index (ALSI) by between 80% and 95% since 2008. A number of listed businesses have disappeared altogether. Evraz Highveld Steel, South Africa's second-biggest steelmaker, applied for business rescue in April.

Many of the troubles SA manufacturers face will not be resolved anytime soon. It is clear, for example, that real electricity prices will remain higher than their historic averages for a long time. It would therefore be naïve to expect profits for manufacturing businesses to revert back to their long-run historic average.

When deciding on where to invest our clients' savings, we carefully evaluate each company on a case-by-case basis. There are several manufacturing businesses in the Fund's top 20 shares. British American Tobacco and SABMiller are, at heart, manufacturers. The strength of their brands, however, gives them the ability to pass cost increases on to their customers. Their distribution infrastructure makes it difficult for a new entrant to compete at scale and allows them to reinvest their retained earnings at high returns on capital. The same is true for pharmaceutical company Aspen. Integrated energy company Sasol, paper and pulp producer Sappi and packager Nampak do not have the same pricing power, but they are arguably better businesses than the average South African manufacturer.

Clearly the prospects for the above companies differ. However, we believe that in each case the share can be acquired at a reasonable valuation, in comparison to other over-valued alternatives listed on the JSE. Furthermore, the companies are globally diversified.

The most significant change in asset allocation this quarter is an increased exposure to offshore equities. Permission was given by unit holders to buy foreign assets up to 25% of the Fund and the new mandate came into effect on 1 March 2015. At the end of the second quarter, 7.2% of the Fund was invested in the Orbis Global Equity Fund, up from 2.1% at the end of the first quarter. This improves the diversification of the Fund and increases exposure to global stocks, which offer better value than many JSE-listed shares. The Fund's top 10 holdings at the end of the second quarter remain similar, but the order has changed slightly.

Since unit holders approved the new investment mandate, which came into effect on 1 March 2015, we have started to shift some of the Fund's equity exposure offshore. At the end of the first quarter, 2.1% of the Fund was invested in the Orbis Global Equity Fund, with a further 1.5% in US dollar cash, pending investment into Orbis. We will likely continue to steadily increase the offshore exposure if the valuation discrepancy between JSE-listed equities and the opportunities Orbis is identifying globally remains in place.

We are at a very interesting time in the market. The difference in price performance between the resource sector and financials and industrials is reaching extremes last seen in 1998, when the resource sector presented a great buying opportunity. The resource sector is down 26% over the past year and 17% over the past three years, while the Financial and Industrial Index has rallied 22% and 92% over the two periods.

The Allan Gray Equity Fund had 32% invested in resources in 1998 compared to the current 18% of South African shares, if Sasol is included. We are finding value in selected resource companies and are net buyers in the sector, but we do not yet see the value we saw in 1998. Why is this? Unfortunately, the relative underperformance of the resource sector is not only because of the vagaries of the stock market; resource companies have destroyed huge amounts of value through poor capital allocation over the past 10 years. This compares to many South African industrial companies, which have invested capital wisely and compounded their intrinsic value.

In the late nineties commodity prices had been in a 20-year bear market and investors saw little hope. At the time, resource companies were trading on low price-to-earnings multiples on low earnings, presenting an exceptional opportunity. Today there is still hope priced into many resource share prices and industrial commodity prices have only recently declined to what we consider normal after a period of extraordinarily high prices. From the oil price we know that prices can fall to well below our normal estimates in the short term, during which time investor sentiment can become distressed.

We prefer companies that have a proven track record of cash generation and capital allocation in the resource space, which is why we like Sasol. We are cautious about businesses with high iron ore exposure, as even though iron ore prices are now what we consider normal (the company share prices are still discounting prices that we think are above normal), they could become very depressed in the short term as Chinese demand slows and a wall of new supply hits the market over the next two years. Sentiment towards the resource sector is deteriorating. We are monitoring the sector very closely and will increase our exposure if the opportunity to buy undervalued businesses presents itself.

Commentary contributed by Andrew Lapping

When this Fund was launched on 1 October 1998 we believed that South African shares offered very attractive value, but we certainly did not expect the dawning of a 16-year golden era for the JSE. Since its inception, the Fund has returned 26.0% p.a. while the benchmark FTSE/JSE All Share Index (ALSI) has returned 18.5% p.a. Over the same period the Consumer Price Index (CPI) has inflated by 5.6% p.a. The cumulative ALSI return over the period was more than 10x the compounded CPI inflation rate! Moreover there have been relatively few tests of investors' resolve with the ALSI lagging CPI inflation by more than 10 percentage points in only two of the last 16 calendar years.

Real (inflation-adjusted) stock market returns over the previous 16 calendar years (1983-1998) were weaker and the ride was bumpier. Over that period, the ALSI yielded a lower total nominal return of 16.3% p.a., despite CPI inflation compounding at a much higher rate of 12.1% p.a. The ALSI underperformed CPI inflation by more than 10 percentage points in five out of those 16 years, making it even harder for easily-spooked investors to earn significant real returns.

The successful internationalisation of companies with South African roots has been a powerful driving force behind the high returns of the last 16 years. Naspers, SABMiller, Richemont, MTN and Aspen are prime examples. Many South African consumer-facing companies have benefited enormously from the growth in social welfare payments and the public sector wage bill. But these golden era winners will be hard-pressed to sustain their strong growth over the last 16 years for the next 16 years, and the current high valuation multiples on many of these recognised winners further reduces their future expected returns.
So how should we respond to a South African market that we expect to deliver lower future real returns? Should we simply try to increase the Fund's prospective returns by assuming more risk? Absolutely not - the criterion for bearing more risk is whether the prospective returns more than compensate for the risk, not an arbitrary absolute return target. Rather, we strive to maintain the discipline of selecting the relatively most attractively priced JSE listed shares, and combining them in a sensibly diversified portfolio.

A second response is to expand the Fund's investment universe so as to include more attractively priced shares. We have recently written to investors in the Fund asking them to vote on a number of proposed amendments to the Fund, including allowing the Fund to invest offshore to the extent permitted in the South African - Equity - General sector in which the Fund is classified. This limit is currently 25%. For more information please refer to the ballot letter, available on our website www.allangray.co.za or contact our Client Service Centre on 0860 000 654. Every investor in the Fund as at 21 November 2014 is entitled to vote. The deadline to submit votes is 6 February 2015.

Commentary contributed by Ian Liddle