The FTSE/JSE All Share Index (ALSI) returned a modest 6.7% per year for the past three years, against an inflation rate of 5.2% over the period. More recently, the ALSI is down 3.8% year to date. Fortunately in investing, the lower the historic market returns, the greater the potential for improved returns in future.

We have not found value in domestically orientated industrial stocks for many years, however the negative sentiment towards South Africa is finally beginning to reflect in share prices and value is beginning to emerge. The chance to buy undervalued companies is always exciting and we will look to take advantage of any opportunities.

MTN, a company which we have thought to be substantially overvalued for many years, finally fell below our fair value estimate in September. The price declined from just over R100 to a bottom of R70 in just a few days as investors became concerned about the Nigerian risks. The risks associated with doing business in Africa are pervasive but they became clear to investors when the Nigerian government asked MTN to repatriate US$8.1bn in dividends it had paid from 2007 to 2015. This presented a buying opportunity. Unfortunately it was only brief, as the share price quickly moved back towards our fair value estimate, eliminating the margin of safety.

Glencore was the Fund’s largest purchase during the quarter. Similar to MTN, regulatory issues surrounding their African operations, together with fears about slowing global growth, created a buying opportunity. We have carefully considered the Democratic Republic of Congo issues. The risks to metal demand caused by a Chinese or global slowdown are also very real. The question is whether these risks are discounted in the price. We believe they are and there is a sufficient margin of safety between our estimate of fair value and the share price for us to buy the share.

When valuing commodity companies we use an estimate of through-thecycle commodity prices to estimate normal earnings. The share prices of commodity companies often discount spot commodity prices, which can create opportunities when prices fall, as is the current case with the copper price.

Conversely, Sasol’s discount to fair value narrowed sharply as the share price rallied with the higher oil price and weaker rand. Sasol was our biggest sale in the quarter. We were also sellers of Old Mutual as its value became clearer to investors post the Quilter unbundling and recent results.

Commentary contributed by Andrew Lapping

The second quarter saw large moves in the prices of shares, bonds, and currencies. There was a sharp reversal in sentiment towards South Africa, as evidenced by:

1. The rand weakening by 16% against the US dollar. Only the Argentine peso and the Venezuelan bolivar had a worse quarter.
2. Domestic shares like retailers, banks, and telcos selling off heavily. Mr Price, for example, lost a quarter of its value. Barclays is back to where it traded last year.
3. The rate at which people are willing to lend money to the government has increased from 8% to 9%.

It seems that investors may have overreacted to the good news of the Cyril Ramaphosa presidency, and that sentiment was too positive in March. The magnitude of the problems we still face have been highlighted by a weak GDP number, weak trading by domestic companies, and service delivery protests.

The shares which did well in this environment were, unsurprisingly, rand hedges like BHP Billiton, Sasol, Mondi, and Richemont. Old Mutual split up on 26 June 2018. Owners of the business received shares in Quilter plc, a UK wealth manager, and Old Mutual Limited. The latter consists of the South African insurance business and a stake in Nedbank.

Old Mutual Limited will split again later this year, when most of the stake in Nedbank will be given to shareholders directly. The ‘managed separation’ was announced more than two years ago. Since then, Old Mutual has been a disappointing investment. Not because the share price has declined, but because the underlying businesses have performed worse than we had expected, and the process of splitting up has cost more than we thought it would. We continue to hold the position - Old Mutual Limited and Quilter combined are 4.7% of the Equity Fund - because we think the businesses are undervalued and that the new structure is more shareholder-friendly. Under this structure, it will be easier for shareholders to hold executives to account, and easier for the businesses to manage their regulatory capital requirements.

World markets had a mixed performance during the quarter. US stocks, led by technology companies, have been strong. Emerging market stocks have been weak. The foreign portion of the portfolio returned 12.4% in rands, underperforming the FTSE World Index’s rand return of 16.8%.

The Fund outperformed its peer benchmark by 3.3% over the quarter. The Fund increased its exposure to British American Tobacco and Remgro and reduced its exposure to South32 and Sasol.

Commentary contributed by Jacques Plaut

The market had a volatile quarter with positive sentiment towards South African equities continuing against a backdrop of volatile international markets. Investment strategies, such as risk parity and being short volatility, which few investors question in an up trending market, are now being tested. As we saw in February, these strategies can affect markets with little apparent change in fundamentals.

With the significant repricing of certain local equities that are geared to the local economy, such as banks and retailers, we reduced our exposure to these sectors. In our view, many domestic shares are pricing in a positive step change in the growth rate of sales and loans, which we are not yet certain will obviously materialise.

We have therefore increased our research effort on locally listed international businesses that have underperformed and offer better relative value than a year ago. An example is British American Tobacco (BAT), which is now trading under 14 times its expected earnings to December 2018. While BAT generates just under half its profits in the US, where the tobacco industry faces regulatory headwinds, we believe this is more than discounted in the current price.

We are also finding value in shares that have underperformed within domestic sectors that have rallied, such as Investec and Woolworths. Investec is trading at less than 11 times our estimate of earnings, which we don’t believe are high. In addition Investec earns around 65% of its profit from South Africa, so it should benefit from a better local economy.

Woolworths has significantly lagged the retail sector given market concerns over its Australian operations, where it overpaid when acquiring department store chain David Jones. The South African woman’s clothing division has also underperformed its peers recently. The dramatic change in sentiment towards Woolworths has resulted in the share trading at just over 15 times earnings that are not high, in our view. The jury remains out on the ability of management to turnaround David Jones, but the lower entry price provides some compensation for assuming the risk.

The biggest changes in the Fund over the quarter include the selling of shares in domestic consumer-facing sectors and an increase in shares with offshore operations, such as BAT.

Commentary contributed by Duncan Artus

For most of 2017, domestically orientated sectors fared poorly against the FTSE/ JSE All Share Index (ALSI). However, the last few weeks of the year saw a sharp and sudden reversal of this trend. Banks, insurers and retailers all rallied on the back of improving sentiment towards South Africa, and a stronger rand, to regain most, if not more, of all the prior year’s lost ground. The last six weeks of 2017 are a reminder of how quickly perceptions can change. Investors in out-of-favour sectors would have been well placed, at least in the short run. Naspers’ meteoric rise continued, with the stock up 70% for the year. It now constitutes 20% of the ALSI.

Over the course of 2017 the positioning of the Fund has tilted towards a domestic bias as we bought into the laggards. Two positions that have recently crept into the top 10 are Netcare and Life Healthcare.

The companies have a lot in common: Netcare and Life Healthcare are the largest and second-largest private hospital groups in South Africa. Both companies have underperformed the market substantially over the past year. Both companies generate the bulk of their profits in South Africa, a region both companies are actively trying to diversify away from with varying degrees of success.

The combination of a mature healthcare market, poor macroeconomic environment and intensified case management efforts by healthcare funders has resulted in a decline in profitability from South Africa. We believe this is temporary.

Given our dual burden of disease and a growing, ageing population, it is not unreasonable to expect case-load growth to resume at some stage. If the hospital operators do a good job on costs, profitability should follow. These are valuable earnings: medical spend is largely non-discretionary, barriers to entry are high, cash conversion is good and the operations are well capitalised.

The prognosis on their foreign operations is less clear. Life Healthcare’s Polish business has performed poorly. Their Indian joint venture might be valuable on paper, but it has hardly contributed to profits. Life Healthcare’s recent acquisition of UK-domiciled Alliance Medical Group did not come cheaply. The performance of this business is encouraging, but it is too early to pass a verdict. Netcare’s foray into the UK, through General Healthcare Group (GHG), has disappointed. GHG’s original structure was flawed and errors have compounded subsequently. On our estimates it is unlikely that capital allocated to the UK operations is recoverable. Fortunately for Netcare shareholders, the value of their South African operations exceeds the value of the company. It is important for the management team to ensure that this value is preserved.

The biggest disposals this quarter were British American Tobacco, Naspers and Standard Bank. The Fund’s offshore exposure is 22% with 2% comprising of pan- African (excluding SA) shares.

Commentary contributed by Simon Raubenheimer