PORTFOLIO COMMENTARY

The 3rd quarter of 2018 was a tough environment for the FTSE/JSE SWIX which lost -3.3%, while the Cadiz Equity Fund delivered a positive return of 0.7%. Over a rolling 3 year period, the Fund has provided a total annualised return of 8.8% while the FTSE/JSE SWIX has gained 5.6%. The rolling 3 year return demonstrates that our strategy of predominantly buying good businesses at attractive prices with capable management and low financial risk is delivering a good outcome for our clients versus the market.

The divergence of performance between developed markets and emerging markets this year is evident. MSCI EM equities sold off -7.5% compared to MSCI World equities gaining 5.9% (in dollars). Concerns around US-China trade war, US Fed rate hikes and the reversal of quantitative easing by central banks has caused investors to sell emerging markets. So far this month, October 2018, the US equity market has performed poorly and seems to be correcting - following emerging markets.

As equity markets fall, it provides us with excellent opportunities to add quality investments to the portfolio at highly attractive prices. This positions the fund for excellent long term returns. We encourage our clients to stay invested even though there is potential for increased volatility in the stock markets.

MTN was a large detractor from performance due to claims from the Nigerian central bank and Attorney General for alleged illegal repatriation of cash and tax underpayment respectively. From our review of the information, it seems that these claims are unfounded. The drop in MTN share price to R70 was so severe that the market has effectively priced the Nigerian operations at zero. This appears overly pessimistic and hence we still view MTN as an attractive investment.

Mediclinic also detracted from performance. The other hospital companies in SA reported weaker than expected results which added to the negative view on the sector. Nothing has come to light that has changed our investment case and we have used the lower price to increase our investment in this good business at more attractive prices.

Naspers continued to drift lower as the market was unimpressed by Tencent's quarter on quarter result and weaker Chinese Yuan due to the trade war. We don't believe that the quarter on quarter performance was definitive evidence of a major slowdown in the business growth prospects and hence are comfortable with our investment.

Woolworths continued to underperform. The financial results highlighted the tough economic environment that South Africa is in, while the turnaround in David Jones is not progressing as quickly as the market would like. The current share price assigns little value to David Jones and together with an improving SA business should deliver a good long term investment result.

Impala platinum has been trounced by the market over the last few years and had a decent recovery in the latest quarter making it the top contributor to performance. We exited Express Scripts as the share price moved close to the acquisition price on offer from Cigna. African Phoenix preference shares also recovered some underperformance as the possibility of the preference shares being bought back is on the cards. CVS Caremark, Discovery Communications and Starbucks all moved up nicely. All three of these businesses are good quality, with capable management and moderate financial risk at an attractive price and hence are still good long term investments.

PORTFOLIO POSITIONING

We trimmed our Sasol investment as the share price moved closer to our base case valuation on the back of the recovering oil price. We added to our investment in British American Tobacco on share price weakness.

We initiated a new position in Tiger Brands. Tiger Brands had initially been hit hard by the listeriosis crisis at the start of 2018 and the weak economic environment has caused short term expectations to be lowered with a resultant decline in the share price. The business has a very good long term track record but the previous management team made poor capital allocation decisions. New management are now in place who are focusing on stabilising and improving the core operations.

We invested in Famous Brands, as the share price has also declined to levels where we believe the long term returns are favourable. It is clear that Famous Brands made a mistake buying Gourmet Burger Kitchen in the UK. The core SA focused business is defensive and has a strong competitive position with excellent return on capital and hence is a compelling long term investment.

Absa has also been added to the fund as the share price declined significantly during the quarter. Absa is trading on a 7% dividend yield and even though the SA economic environment is tough with competition in the banking industry heating up, we believe that even if Absa delivers subpar earnings growth, the return prospects are favourable due to the depressed share price.

We invested in Peregrine holdings which is also a high return on capital business at a good price. The wealth management business is stable and still growing at a moderate pace, while the asset management business is differentiated and focused on hedge fund strategies which have good long term track records and have lower risk of commoditisation from ETFs.

In the international stock picks, we initiated a new position in Facebook which has a really powerful business model with a strong network effect and the ability to use the tremendous amount of data they have on their vast user base to more effectively aid advertisers in reaching customers. The share price declined more than 20% due to the market downgrading the near term growth expectations after managements 2nd quarter earnings comments. We believe that the near term growth pressures are overly discounted and hence expect a good long term outcome from this investment.

Our investment case review on Charter Communications highlighted that the attractiveness of the investment hinges on very aggressive tax structures and we were uncomfortable with the level of financial risk. This reduced our conviction level and hence we exited.

We used the proceeds and inflows to invest in Fairfax Financial Holdings and Franklin Resources. Both of these investments are held in the Cadiz Worldwide Flexible Fund and the additional capital available enabled us to invest in these businesses which have very good owner managers and excellent long term track records.

We remain focused on protecting and growing your capital by taking advantage of the markets short term overreaction to bad news by investing in predominantly good businesses at attractive prices with capable management and low financial risk.

The Cadiz Equity Fund fell to -7.4% over the first quarter compared to the FTSE/JSE SWIX which fell to - 6.8%. The fund generated solid returns over the quarter from Howden Africa, Netcare, Barclays Africa, Old Mutual and Grindrod. These gains were more than offset by negative results in some of our larger holdings, including Naspers, British American Tobacco, MTN, Sasol and Impala Platinum. Our underweight positions in Standard Bank, FirstRand, Anglo American and Shoprite were the main detractor from relative performance. The fund's offshore holdings, which have outperformed the MSCI World Index over the past two years, detracted from performance over the quarter falling 5.8% in US dollars and 10.4% in Rands.

During the quarter, we added to our holdings in Brait, Impala Platinum and British American Tobacco as prices fell to very attractive levels. Global brewer Anheuser-Busch InBev was the only new addition to the fund. These purchases were largely funded from the sale of Barclays Africa as it reached our fair value and cash resources. We also trimmed our holdings in Netcare and Woolworths.

British American Tobacco (BAT) is now the fund's largest position. Tobacco shares have underperformed since mid-2017, in part due to expectations of rising interest rates, ongoing tobacco litigation (mainly in Canada) and regulatory concerns. In addition, they are also investigating the impact of menthol in cigarettes on public health. Menthol cigarettes in the US account for roughly 20% of BAT's profits and one-third of the US cigarette market. These factors have weighed heavily on BAT's share price falling some 33%. Evidence seem to suggest that reduced nicotine levels in cigarettes has the opposite effect as it results in people smoking more to get their nicotine fix.

In the meantime, the market has priced the share at less than 13 times 2018 earnings with a healthy 5.4% dividend yield. BAT's most recent financial results indicate that the underlying fundamentals remain firmly in place with strong pricing power, market share gains and good progress in terms of their NGPs (Next Generation Products). In our view, the tobacco business model that has delivered 7% p.a. growth in earnings per share over the long-term, remains firmly in place. We remain confident that the short-term underperformance is temporary, and that over time we will achieve highly satisfactory returns as the market comes to appreciate the strong underlying fundamentals of the company.

Naspers is the fund's second largest position. The share price fell 16% over the quarter and roughly 25% from a peak of R4142. The shares trades at a 38% discount to its 31% stake in Tencent, implying a negative value for some valuable investments including Pay TV, Flipkart (Indian version of Amazon), OLX (largest online classifieds player in developing markets like Brazil) and Mail.ru (leading online platform in Russia). Naspers recently sold a 2% holding in Tencent at an effective 10% discount to the then spot price without any tax leakage. We believe the discount should begin to close when some of these other investments are either sold or go public. In the meantime, we get exposure to Tencent, one of the most competitively advantaged and fastest-growing company in the world, at a substantial discount to both its current market valuation and intrinsic value.

Sasol has underperformed the market by roughly 13% over the past three years as the share price has largely traded between R350 and R460 since falling from a peak of over R600 in mid-2014. The three key factors positively impacting Sasol's future profitability are rising oil prices, falling natural gas prices and a weaker rand to the US dollar. The rand has been flat (albeit highly volatile) over the past three years and is trading at roughly fair value on a PPP (purchasing power parity) basis to the US dollar. We would expect the rand to weaken over time in line with its inflation differential. There is no shortage of natural gas globally and prices look set to stay low relative to oil over the medium term. Sasol's Lake Charles Chemical Project (LCCP) is nearing completion and should start contributing to earnings from 2019 onwards. We see strong profit growth for Sasol over the next few years while the market continues to discount very low expectations.

We have been recent buyers of Mediclinic International which has contributed to our recent underperformance. It's hard to believe the market is an efficient discounting machine when it values Mediclinic at R70 billion today compared to R154 billion some 18 months ago. During this period it purchased Al Noor for roughly GBP1.4 billion in a reverse takeover and moved its primary listing to London. It purchased a minority stake in Spire Healthcare in the UK. The market appeared very excited about the future prospects and that reflected in the valuation.

Then things started to turn south. Profitability at Al Noor fell sharply following regulatory changes which negatively impacted capacity utilisation and patient mix. The operating environment in the UK become increasingly difficult for private healthcare groups. Proposed regulatory changes in Switzerland will likely have a negative impact on profitability. It's said that you can't have bad news and high share prices. The market seemed to agree with the share price falling as expectations were continually lowered. However, expectations are now so low that it appears to be attributing no value to Al Noor, while earnings remains relatively depressed. We believe the market pendulum has swung too far in the opposite direction. We now have the opportunity to buy good quality, globally diversified assets and an experienced management team at a very attractive price.

Woolworths is another share that has underperformed the market and significantly lagged its retail peers. The market seems concerned about the poor operational performance of its Australian operations, where it overpaid for David Jones, and the South African clothing division which has underperformed the local retail peers. Earnings are depressed and so are market expectations. We've been buyers of the share at attractive valuations of less than 14 times depressed earnings and a 5% dividend yield. We believe management have the experience to improve the operational performance, while the current valuation provides excellent compensation to assume this risk.

Inpex Corporation is Japan's largest oil and gas exploration and production company. Over the past several years the business has been investing in its Ichthys Project, a massive liquefied natural gas project off the coast of Australia. This project will start ramping up in 2018. Inpex also has one of the strongest balance sheets among its global peers with net debt to EBITDA of just 0.6 times. However the share price had not risen over the past four years, and trades at 0.8 times its tangible net asset value.

SoftBank Group is a Japanese multinational conglomerate run by founder Masayoshi Son who owns 25% of the company. Masayoshi Son is an owner-operator with an impressive long-term investment track record of some 44% annualised return over 20 years. SoftBank's largest and most successful investment is its 29.5% (originally 32.5%) stake in the Alibaba Group worth about $135 billion. Mr Son turned a $20 million investment in Alibaba in 2000 into $145 billion. SoftBank sold a small portion of their stake in Alibaba a few years ago raising $9.7 billion. We believe SoftBank has some highly valuable assets with long-term secular growth potential which the market is not giving it credit for as the implied value of many of these investment is negative.

The Cadiz Equity Fund is a robust, globally diversified portfolio of good quality companies at very attractive prices. We believe the market will over time come to appreciate the undervaluation of these assets and re-price them accordingly which should deliver highly satisfactory returns in the future. In the meantime, we will stay true to our investment philosophy and process, and remain patient until we reap the necessary rewards.