The past year has been particularly disappointing as we strive to grow our clients’ wealth, while exceeding market returns. The recent poor performance was a result of only a few of our holdings contributing positively to performance, while a number of the shares in the portfolio performed poorly. These periods of underperformance are a normal part of our investment philosophy and have occurred before. During times like this, the important thing is to be consistent and consider each holding on its merits based on the underlying value, just as we always do. The recent underperformance makes us more excited about the future, as the single most important factor determining investment returns is the price you pay. We are now paying less for the assets in the portfolio than we were a year ago. This bodes well for future returns. Below I touch on a few of the significant detractors from performance.

Sasol has been the largest detractor by far. The share has contributed a negative 4.2% to the Fund over the past 12 months. Since we discussed Sasol in the June commentary the share has fallen 28%. The underlying profit drivers are basically unchanged and, if anything, the fundamentals for the oil market are looking slightly better. Unfortunately, the Sasol board announced the delay of the release of their annual financial results, first on 16 August and then again on 6 September. The reason given was the time required to complete an independent assessment of internal control weaknesses and therefore the annual audit process. This is clearly disappointing and reflects very poorly on the company but, to our mind, does not fundamentally change the company’s value. As we noted in June, we think the negative sentiment towards the oil industry, and Sasol in particular, is overdone, and we believe the valuation is very attractive. Interestingly, on a three-year view, Sasol is only a very marginal detractor, as we sold a third of our holding in the second half of 2018 and early 2019 at prices well above our cost.

Another significant detractor was British American Tobacco (BAT), which contributed a negative 0.6% to the Fund. Unlike Sasol, the underlying business has performed well, earnings grew 9% over the past year and ITC, the Indian associate whose market price equates to 16% of BAT’s share price, grew underlying earnings by 15%. However, market sentiment has turned decidedly negative towards tobacco companies and the price-to-earnings multiple has de-rated from 14 to 11.2, leading to a 16% price decline. We have used this opportunity to selectively add to our position. In fact, we have used the price weakness in a number of our holdings to add to our positions.

Similarly, mining company Glencore detracted 0.7%. We have steadily increased our holding over the past year as the price has fallen from R61 to R46. Our estimates of normal earnings and fair value are unchanged. We think the prices of the commodities Glencore produces (except nickel) are below normal and therefore cash flow is below normal. Despite this, Glencore can comfortably cover its 6.5% dividend yield. The share should reward investors for their patience.

We sold Impala over the past quarter, taking advantage of the 250% price rise over the past year, and invested the proceeds in Naspers and FirstRand.

Commentary contributed by Andrew Lapping

The Equity Fund had a poor quarter, returning -3.2% while the benchmark returned 0.1%. On the local front, the major detractors have been our overweight positions in British American Tobacco and Sasol.

Sasol is currently trading on eight times earnings. The long-term average is 10.5 times. A simple multiple re-rating from eight to 10.5 would give a return of 31%. Then in 2022, if all goes to plan, earnings should grow by 45% when its large project in the US (the Lake Charles Chemicals Project or LCCP) is fully up and running. This is not the whole story. Investors in Sasol have to carefully consider all of the following:

-Much depends on the oil price, which is difficult to forecast. On the supply side, US production has grown rapidly over the past few years, and the US is now the world’s largest producer. Demand growth has historically been very consistent but, in the long term, the impact of electric cars will be negative for oil.
-Sasol is a very large emitter of carbon dioxide and sulphur dioxide.
-The company has incurred a huge amount of debt in order to build their ethane cracker in the US. The balance sheet is currently stretched.
-Capital allocation has been poor historically. One barrel of oil currently trades for about R1 000. For the same price, you can buy 2.7 Sasol shares. This ratio was similar 20 years ago: In 1999, you could buy 2.7 Sasol shares for the price of one barrel of oil. One would have expected Sasol to become more valuable relative to oil, given the billions of rands that have been spent on expansion projects in the past 20 years.
-Management has lost a lot of credibility in recent years. Shareholders were short-changed in the company’s recent BEE deal. Costs have been disappointingly high. The ethane cracker has had multiple cost overruns.

These points seem (and are) alarming, but in fact, almost every company has a similar list. It is our job to worry about these things, to incorporate them into our valuations and, where we can, to encourage companies to pollute less and act in shareholders’ best interests. We do not sell shares on bad news or buy them on good news. Rather, we buy when we think we are getting a bargain for our clients. Sometimes, negative sentiment can create a good buying opportunity.

It is interesting to compare the valuation of Sasol with that of Anglo American Platinum or Amplats (which we don’t own). Everything has gone right for Amplats in recent years, and sentiment is extremely positive towards the company. Both companies have a similar market cap: around R220bn. Over the past 10 years, Amplats has made cumulative profits of R6.2bn. Sasol has made R210bn. One should see the issues at Sasol in the context of this very attractive valuation.

The foreign portion of the Fund also detracted from performance: It returned -0.2% in dollars, while the FTSE World Index returned 4%. Detractors here were biopharmaceutical company, AbbVie, and multinational tobacco company, Imperial Brands.

During the quarter, we increased our exposure to Glencore, and reduced our exposure to Richemont.

Commentary contributed by Jacques Plaut 30 June 2019 Minimum

The local equity market recovered strongly in the first quarter and is up 13% from its low in October. Indeed, two of the larger positions in the Fund, Naspers and British American Tobacco, are both up 41% from their recent lows.

As part of our aim to outperform, we are alert to special or unusual situations where investors may buy or sell shares for reasons not related to fundamentals, for example, when an unbundling takes place. Unbundlings often present the opportunity to buy shares at an attractive valuation during the initial period of trading. This is particularly likely to be the case if the business being unbundled is a small part of a much larger group.

A recent example is the unbundling of MultiChoice Group (MCG) by its parent company Naspers. In the unbundling, shareholders in Naspers received shares in MCG, which were then separately listed. A review of research showed that investors were carrying MCG at a value of less than 5% of their estimate of Naspers’s intrinsic value.

While MCG’s pay-TV operations are well known in South Africa, many offshore investors hold Naspers as a means to invest in Tencent, its giant Chinese associate, at a discount. The value of Naspers’s stake in Tencent dwarfs that of its pay-TV business. This led to many Naspers shareholders simply dumping the MCG shares they received in the first few days of trading. MCG was not crucial to their Naspers investment thesis and would be a tiny portion of their portfolios.

When an unbundling occurs, there are sometimes regulatory and technical reasons that result in certain shareholders being unable to accept the unbundled shares and receiving cash instead. This cash is generated by the company, in this case Naspers, selling the shares in the open market. This creates even further selling pressure. While we have always had a value for MCG as part of our overall Naspers valuation, we wrote a new detailed report on the business in anticipation of a potential opportunity. MCG also gave a lot more disclosure to the market on its financials and business which we could incorporate into our investment view. MCG consists of the dominant SA pay-TV operator (which we know as DSTV), its Rest of Africa operations, and a small technology business. MCG has consistently been a good cash generator for the Naspers group. It is a relatively mature business in SA facing new threats such as Netflix and potential adverse regulation. However, it is the Rest of Africa business that could provide upside if it can be turned around. In the last financial year, the Rest of Africa business lost over R4b.

On the day MCG was unbundled, it traded in a range of R93 - R114 and within the first week as low as R90.30. Based on our research, we believed this represented great value and were aggressive buyers for our funds. MCG has subsequently traded as high as R130 and closed the quarter at R121. We will stay on the lookout for similar opportunities in the future.

During the quarter, the Fund purchased MultiChoice and Woolworths and sold Impala and Sasol.

Commentary contributed by Duncan Artus

''In the short run, the market is a voting machine but in the long run it is a weighing machine.'' - Benjamin Graham

2018 was a disappointing year for South African equity investors, with the FTSE/ JSE All Share Index returning -9%. The good news is that based on our research the companies we hold in the Fund should generate healthy returns going forward under most scenarios. British American Tobacco (BAT) is a share that detracted significantly from returns during the year and therefore I thought it a good one to discuss.

BAT, in my opinion, is a good example of a company where the market’s ‘voting machine’ (valuing companies like a popularity contest) and ‘weighing machine’ (valuing companies on their actual worth) are in conflict. The voting machine part of the stock market is arguably trying to anticipate investors’ reactions to the next regulatory announcement from the US Food and Drug Administration (which wants to ban menthol cigarettes). What the voting machine ignores is the company’s long track record of compounding earnings for investors through various regulatory changes, as well as evidence that BAT’s investments into next-generation products are starting to bear fruit. BAT has grown its earnings by 12% p.a. since 2001, while paying out 63% of earnings in dividends and investing heavily to develop and distribute next-generation products that significantly reduce the health impact of smoking. A recent update from the company shows it is gaining traction in rolling out these products: BAT’s vaping volumes in the USA, the largest vaping market globally, grew about 40% in the second half of 2018.

Three scenarios could play out for BAT. Assuming BAT’s portfolio of nextgeneration products helps it to sustain its 17-year track record, an investor today would earn 20% p.a. (growth of 12% p.a. + dividend yield of 7.8%). One could argue that sentiment towards tobacco shares will remain subdued, but there is a scenario where the weighing machine takes over at some stage over the next four years. This would cause the share to price in its track record, resulting in a higher return (assuming a re-rating to a 5% dividend yield results in 32% p.a.). Under a bad scenario (the FDA succeeds in banning menthol and BAT doesn’t retain any menthol-smoking customers) regulatory intervention dampens growth. Under such a scenario the company may only grow earnings by inflation over the next four years. At the current price this still results in a good outcome with a total return of 14% p.a. (6% growth + 7.8% dividend yield). The weight one should place on the 14%, 20% or 32% p.a. scenarios is ultimately subjective, but these scenarios illustrate the impact of the ‘voting machine’ on BAT’s current share price and the opportunity that this offers to long-term investors. BAT, or any of the shares we own, could experience unforeseen events outside the scenarios considered. However, at a portfolio level I think now is a good time to be an Equity Fund investor. During the quarter we bought Richemont and Glencore and we sold Sasol and Old Mutual. Commentary contributed by Ruan Stander