It is interesting to note the surprise announcements made by several market ‘darlings’ over the course of the third quarter of 2016. Mr Price revealed negative unit sales growth and cautioned investors that its next reported profits are unlikely to exceed those of the previous year. Aspen’s recently reported earnings were impacted by currency volatility and a disappointing performance of its South African business. Steinhoff’s core business - excluding acquisitions - is growing slower than many expected. Mediclinic is struggling with the integration of its Middle East businesses. Richemont is experiencing a sharp slowdown in sales and expects profits to be down 45% when it next reports results. These are only a few examples.

In all instances the shares sold off quite sharply in absolute terms and also relative to the market. There have been one or two missteps - a supply chain issue here, a slow response to a competitor there - but share price weakness cannot be attributed exclusively to management. In some cases the companies did what they could in response to rapidly changing conditions.

The bigger problem was one of unreasonable expectations. The price-to-earnings (PE) multiples that these companies traded on were in the twenties and thirties. Profit margins in some cases rose to unsustainable levels. Lofty valuations provide little margin for error and a high degree of continued future success was priced in already.

Expectations for the future prospects of many of the Fund’s top holdings are far more modest. Sasol, Standard Bank and Nedbank trade on PEs of less than 10. Old Mutual and Investec’s PEs are in the low teens. The conglomerates - Reinet, Remgro and even Naspers - trade at discounts of between 15% and 30% to their sum-of-parts values. British American Tobacco’s current valuation relative to the FTSE/JSE All Share Index is lower than its average since listing on the JSE in 2008.

The outlook does not appear rosy for all the Fund’s holdings, with some facing meaningful challenges. Fortunately, a rosy outlook is no prerequisite for a good investment. The future merely has to be a little better than what is implied by share prices today.

Netcare, Naspers and Investec were the most significant additions to the Fund this quarter, funded by disposals of SABMiller and selected gold shares. The foreign portion of the Fund, invested in the Orbis Global Equity Fund, has increased from 10.8% at the end of the second quarter to 13.5% at end of the third quarter.

Commentary contributed by Simon Raubenheimer

The economic outlook deteriorated during the quarter, exacerbated by the British referendum. Although the market’s perception of near-term headwinds may be correct, it also creates opportunities for investors like us, who have long time horizons, to buy well-capitalised financial services companies on attractive multiples of sustainable free cash flow. The Equity Fund used this opportunity to buy a basket of financial services companies at what we believe are attractive prices.

During the quarter, the Fund also added to its position in Naspers, which now makes up 6% of the portfolio.

At 50 times core headline earnings, Naspers is not cheap on the face of it. However, our analysis reveals good value for money. Naspers can be considered as the sum of two major parts, the investment in Hong Kong listed Tencent, which has a market value of R2 500 per Naspers share, and all the remaining businesses, including Mail.ru, e-commerce ventures and pay TV. We think the remaining businesses are worth about R800 per share. If a holding company discount is not considered, the Naspers share price of R2 200 implies that investors are buying Tencent at a 44% discount to the listed valuation. This is approximately 19 times Tencent’s latest annualised quarterly non-GAAP earnings.

There are a number of reasons why 19x earnings is an attractive multiple for Tencent:

.. It has a dominant competitive position in online games and Chinese social media, a growing and highly profitable industry
.. The company is in a growth phase, with earnings growing at 40% to 50% per year
.. Tencent’s cash and associates can be conservatively valued at 20% of its market capitalisation and do not currently contribute to earnings
.. Various new growth initiatives show early promise (e.g. online video, payments and banking)
.. Free cash flow has historically exceeded earnings by about 10%

When considering the attractive implied price of Tencent one needs to remember that the holding company discount may persist for some time. Investor sentiment could remain negative towards the company and its current loss-making e-commerce ventures while some shareholders might prefer to own Tencent directly.

Additional risks relate to the fact that many internet business models are relatively new and hence the economics could change drastically as technology and innovation march ahead. Thus far, Tencent and Naspers have successfully navigated this space and have developed new products and revenue streams to offset those that have fallen out of favour with consumers.

The long-term capital allocation track record of Naspers gives us confidence that the underlying value should reflect in earnings and their share price in time. We are cognisant of the risks as well as the potential rewards when investing in Naspers and have sized the Fund’s position accordingly.

Commentary contributed by Ruan Stander

The Fund had a good quarter, beating the market by 1.7%. The performance was helped by overweight positions in the gold mining sector.

Traditionally, market commentators try to help their audience understand what is going on by identifying themes, such as 'China', 'The Fed', or 'US shale'. I will not veer from established practice: my theme for the first quarter of 2016 is 'volatility', or as I like to call it, 'opportunity'.
Of the top 100 companies on the JSE, the best performer was gold miner Harmony, up nearly 4 times in the three-month period. The worst performer was Oakbay Resources & Energy, which lost one-third of its value. The top 10 shares in this sample returned an average of 106%, and the worst 10 returned an average of -19%. It has been a long time since we have seen such a wide range.

Big moves like these provide us with buying and selling opportunities. For example, we were able to trim back our exposure to gold mining companies during the quarter, and increase our exposure to banks. We have also been sellers of SABMiller, British American Tobacco, and Anglo American, and buyers in the insurance sector.

Sasol is one of our top holdings, and also had some big moves during the quarter: from a low of R354 in January to a high of R497 in March. The company has been able to deliver good earnings numbers despite the weak oil price, because of cost control, a strong chemicals market, and because Sasol is helped by a weak rand.

We are bullish on the dollar price of oil, and think US$40 per barrel is not a sustainable level. The newspapers focus mostly on production in the US and the Middle East, but many smaller producers have cut back or completely stopped drilling for new oil. In Colombia, for example, there were 43 rigs drilling for oil in June 2014. There are now 7. Australia had 24, it now has 9. Across Europe, Asia, and Africa a similar story is playing out. And oil is not a commodity like iron ore or platinum that can be recycled: it gets used up. What's more, the typical oil well does not have a 40-year life like many iron ore mines. Conventional oil wells tend to decline at a rate of 5% or more per year. Sooner or later, the oil price will have to increase to a level that makes it economical for producers to explore for and invest in new production.

The year's 1.9% return for the FTSE/JSE All Share Index (ALSI), excluding dividends, masks substantial discrepancies in returns across the market. Brewer SABMiller and media giant Naspers, which each accounts for about 13% of the market, performed very strongly, appreciating 55% and 40% respectively. The broader market, excluding these two companies, fell approximately 10%, with certain sectors like resources falling 40% over the period.

Over the past few years we have cautioned that there was little absolute value in the market, with most companies being fully valued. This has begun to change, with the price weakness in certain market sectors. In particular we are finding good value in selected commodity and financial companies. Investors are expecting very little in the way of earnings growth from many of the financial companies, which is reflected in high dividend yields. Old Mutual yields 4.2% and Standard Bank 5.7%. If these two companies can grow their dividends in line with inflation over the long term, the dividends will provide good real returns; in fact, we believe these two businesses should be able to grow their dividends well in excess of inflation, providing excellent real returns for investors.

The Fund's investments in commodity businesses have detracted from returns over the past year, the only exceptions being Sibanye Gold and Aquarius Platinum. Mining companies are going through a very difficult time with most either paying no dividend or just about to cut their dividends to 0.

Chinese commodity demand growth slowed or declined in 2015 just as new supply was ramping up to meet expected demand growth. Commodity prices fell sharply proving that supply and demand do matter. Along with the falling commodity prices, sentiment towards commodity shares has turned extremely negative. There are many reasons to be negative - high levels of debt, poor management, suboptimal capital allocation and negative cash flow, to mention a few. In time the supply/demand balances will correct as lower prices do their work. A tighter pricing environment should dramatically change the cash flow and investor sentiment towards these businesses, yielding excellent returns for patient investors.

African Rainbow Minerals is an example of a mining business we find attractive. It has little debt, some very high-quality assets and is exposed to commodities that are experiencing a severe and unsustainable price downturn, such as manganese.

The Fund was a net buyer of financial stocks in the quarter, including FirstRand, Nedbank and MMI while the largest sales were in SABMiller and British American Tobacco.