Discovery celebrates 10-year anniversary on a high note

 

November 2017 marked the 10th year of Discovery Invest creating exceptional value for clients through our unique shared-value model. For the 10 years to end November, our flagship unit trust fund, the Discovery Balanced Fund returned a net 10.4% per annum and was ranked top in its category across three, five, seven and 10-year periods.

The Moderate Balanced Fund, which has a shorter track record, also delivered solid returns to investors adding a net 10.7% per annum over five years. This fund was ranked top quartile over both three and five years. We talked to Discovery Balanced Funds portfolio manager, Chris Freund of Investec Asset Management, about the year that was and the year that is to come.

2017 in retrospect

2017 was a decent year in terms of performance of the Discovery Balanced Fund range. In the second quartile, we missed a first quartile ranking by a very small margin. The Fund’s more balanced exposure to different macroeconomic risks provided support to delivering fairly consistent returns despite significant inflection points, sector rotations, currency fluctuations and increased political uncertainty - all market conditions which typically don't suite a more 'trending' investment style such as earnings revisions. The increased allocation to domestic bonds during the last quarter of 2017 added to returns from an asset allocation perspective.

The Fund remains 1st quartile over three and five years, outperforming the peer group by a significant margin. While a stronger rand impacted any offshore allocation, our active positions in our offshore exposure benefitted returns. Some of our key positions included a high allocation to global equities, with basically no bonds throughout the year and within equities we had a clear regional preference for European and Japanese equities where earnings expectations continue to improve and valuations remain attractive.

Towards the end of the year and December in particular, relative returns were negatively impacted mainly as a result of domestic stock selection. Gains from our exposure to retailers (Mr Price and Foschini) and banks (Standard Bank and FirstRand) were not enough to offset the negative performance from holdings in Steinhoff, STAR and Rand hedge counters such as Anheuser-Busch and Naspers.

Here is a short video from Chris Freund on his view

Source: Investec Asset Management

The South African equity market star performers

Despite a rough economic downturn and political uncertainty in 2017, the South African equity market turned in a good performance for the year. There were a few key stocks that contributed to the FTSE/JSE All Share Index ending 2017 21% higher than when the year started.

Naspers

This share showed strong gains (up 72%) and due to its market-weight, it contributed 10 of the ALSI's 21 percentage point gains in 2017. We had a substantial holding in the Discovery Balanced Fund (roughly 14% of SA equities). Our positive view on the share is driven by the strong positive earnings revisions on Tencent which we believe will continue to positively contribute to Naspers' share price gains going forward. We therefore maintain a decent allocation to the company. While valuations might look excessive on valuation methodologies such as P/E; on a sum-of-the-parts valuation methodology, the company continues to look attractive considering the significant discount ascribed to the 'rump' (non-Tencent) assets.

Kumba Iron Ore

In 2017, this was the best performing stock on the ALSI, up 159%. However, this is a fairly small company (only 0.2% weight in SWIX) and its contribution to the overall market was only 22bps. We did not hold the share. While the strong gains in iron ore prices drove the share higher, the bulk of the gains came from a re-rating. There was a much higher increase in price compared to the increase in earnings. This re-rating was in part driven by the fact that Kumba Iron Ore produces a higher quality of iron ore where we have seen a sharper increase in global demand and prices. That said, we believe the company’s valuation is high, especially when compared to other iron ore producers, such as Exxaro.

Exxaro

Despite being a fairly small company, Exxaro has been our preferred iron ore producer and we had an average exposure of around 0.7% of SA Equities (market weight of 0.3%) in the company. This positively contributed to returns, but not by a significant margin. The share was driven by strong gains from iron ore prices. Looking forward, we are less optimistic on iron ore prices considering the sharp gains we have already seen over the last two years and prefer exposure to more diversified miners such as Anglo American and Glencore where valuations are considered more attractive against rising earnings expectations.

Clicks

Clicks has been one of the strongest performers in the domestic retail space in 2017, gaining just over 60%. We have not held the share during the year as the valuation was not attractive and the earnings revisions profile did not meet our investment criteria. Our preferred holdings in the retail space were Foschini and Mr. Price - where valuations were more supportive and earnings expectations were coming off a low base. We increased our allocation to both these stocks during the last quarter of 2017. Both these holdings contributed positively to returns in 2017. Looking forward, we do not have any exposure to Clicks and continue to prefer exposure to the retail sector in mainly Mr. Price where the earnings outlook is strong due to significant operational improvements management has undertaken over the last 18 months.

Anglo American

Anglo American gained a healthy 35% in 2017, but all gains basically came in the second half of the year. We have gradually increased our exposure to the share during the course of 2017. Due to the strong gains from the company's underlying mix of commodities, we remain very confident that the share could continue to receive strong upward revisions in earnings expectations. This, coupled with very attractive valuations, underpin our positive outlook on the company. Anglo American is therefore one of our preferred resources holdings at present.

Richemont

After a number of years of disappointing share price performance, Richemont gained almost 26% in 2017. We were not significant holders of the share in 2016, but in January 2017, we believed that the market was too pessimistic on the earnings growth potential for the share and believed that growth expectations will be revised significantly higher. We actively added to our Richemont position in January 2017. This has been one of the key contributors to returns for the year. That said, we locked-in some profits during the last quarter of 2017 by reducing our position in Richemont in favour of domestic retailers such as Mr. Price and Foschini. This was because the share traded somewhat expensive. Over recent months, Richemont's share price pulled back. Recent sales updates from the company have been, in our view, positive and speak to more sustainability in recent improving sales (and earnings) trends. We have therefore added back some exposure to Richemont over recent days.

The Steinhoff and Capitec questions

Having looked at the top five stocks of 2017, a round-up of the year would be incomplete without a mention of Steinhoff - which took a drastic price drop following the resignation of the chief executive in early December on the back of rumours of accounting irregularities. At present it is impossible to make any definitive decision on Steinhoff considering that no information has been released in terms of the accounting irregularities. We therefore maintain the holding in Steinhoff. As a business, Investec Asset Management continues to actively engage from a governance and legal perspective on behalf of our clients. Investigations are ongoing, but disclosure of accounting irregularities has not been released as yet.

At the end of January, Viceroy Research issued a report on Capitec, which sent the bank's shares tumbling by 20% in just one day. However, at the time of writing this report, there were no confirmations that the Viceroy report was accurate. Our exposure to Capitec within the Balanced Funds portfolio is extremely minimal:

  • Discovery Moderate Balanced Fund - 0.07%
  • Discovery Cautious Balanced Fund - 0.15%

We will continue to monitor the situation and make adjustments to our portfolio if we deem it necessary.

The outlook for 2018

Looking forward, we believe that while equity markets and global growth are robust, it is too early to get defensive. We see equity markets moving back to the "traditional battle" of rising earnings versus tighter monetary policy, particularly in global markets. Locally, South African political leadership changes will likely take longer to resolve than some may expect so some caution is warranted. In the short-term, key upcoming events include the State of the Nation speech, the 2018 National Treasury budget and a potential downgrade from ratings agency, Moody’s. This means it is difficult to make any major "macro call" at this point.
We therefore maintain a more neutral positioning in terms of macro exposures from a sector perspective, rather taking stock specific risk. Within the Balanced Fund, some of our key positions include:

  • Resources (strong upwards earnings revisions): preferred holdings include Anglo American, Glencore and Sasol
  • Other global cyclicals (earnings expectations continue to benefit from strong global growth): Naspers (Tencent), Richemont, Mondi, Barloworld (more 50/50 in terms of geographical exposure)
  • SA Inc,: exposure through selective banks and specific retailers such as Foschini and, more specifically, Mr Price. We are very optimistic on the outlook for Standard Bank.

We remain constructive on the outlook for global growth and are pleased with the improvement in sentiment towards the outlook for the domestic political and economic environment. We therefore maintain a reasonable allocation to both domestic and offshore equities and prefer domestic bonds relative to cash.

Potential risks in 2018

Some of the key risks, in our view, would be:

  • Rising interest rates and the withdrawal of liquidity: This could start to negatively impact global equities. We are therefore closely watching interest rate expectations and market sentiment towards rising interest expectations.
  • Turn in global sentiment: At present, growth conditions are strong which is providing a strong underpin to equity earnings expectations. Any sign that economies are overheating could have a negative impact on equity expectations. We are therefore closely watching any sign of economic capacity constraints and rising inflation expectations.
  • Political (intra-party) transformation: On the domestic front, developments around this will be key. Risks remain in terms of our government's fiscal positioning as well as the looming Moody’s credit rating announcement.

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