Rob Dower
Quarterly Commentary

2014 Q3 Comments from the Chief Operating Officer

My early career and training was as a mechanical engineer. Engineers deal with uncertainty in design by applying a 'safety factor' to their sums: if theoretical calculations show that a shaft needs to be 'X' mm in diameter to handle a required load without failing, the engineer will multiply 'X' by a safety factor to account for the uncertainties involved in the design process, such as the quality of the metal or the nature or type of load applied. Because the real world involves a lot of uncertainty, if engineers didn't use safety factors their designs would fail all the time. Since engineers often design things that will harm people if they fail unexpectedly, or at least cause a lot of inconvenience, safety factors often double the strength of a structure. Incidentally, the Eiffel Tower is designed with a safety factor of 4.5 times. As you probably know, it is an accidental example of long-termism, having been built as a temporary structure at the entrance to the Paris World's Fair in 1889.

The engineering safety factor has an analogy in investing. Portfolio managers and analysts have access to a lot of historical data from which they are normally able to form a theoretical view on what a company is worth. Because the companies they are valuing operate in the real world, this theoretical view has to be adjusted to take account of uncertainties. At Allan Gray we deal with these uncertainties in three ways. First we consider the impact of key uncertainties on the theoretical value in a sensitivity or scenario analysis. Second, just like engineers, we prefer to invest in a company's shares when they are priced sufficiently below our estimate of their value to provide a margin of safety. Thirdly, we recognise that we can have higher confidence in our estimates of intrinsic value in some companies than in others, and our internal peer review process and our portfolio managers incorporate this conviction level into setting appropriate portfolio weights and limits.

What makes investing different from engineering, is that investment managers can do an extremely good job for their clients - possibly even 5% per annum better than their benchmarks - if they can get just 60% of their decisions right. There are not many 'Eiffel Tower decisions' in investing, so if we waited to find investments that were priced at four times less than they were worth, we would hardly ever invest a cent and we would fail on your behalf. At the current high market valuations it is especially hard to find many shares priced to provide a significant margin of safety.

We do not expect to get things right all of the time. But this doesn't mean that we take it lightly when we get things wrong. Encouragingly, so far this year the impact of successful investment decisions has more than offset those that have gone against us, as is evident from the performance tables later in this magazine.

African Bank

We have had questions from some clients about the impact of the failure of African Bank on your portfolios. As with all investments we make on your behalf, we conducted in-depth qualitative and quantitative analysis on African Bank (ABIL) and vigorously debated the investment case internally before investing. While we identified risks, these concerns were widely known, and so it could be argued that they were fully discounted in ABIL's share price. It often proves profitable to buy shares when the risks and concerns are 'top of mind', as investors sell the shares at a low price which doesn't factor in the probability of circumstances improving for the company at some time in the future. In this instance, conditions deteriorated significantly more than we expected.

When we invested in ABIL's senior debt (which is essentially borrowed money that a company must pay back first if it goes out of business), we considered the probability of the bank being placed under curatorship and the senior debt suffering a 'haircut' as possible, but unlikely. At the time, ABIL's accounts showed a significant capital buffer (provided by shareholders and subordinated debt) to absorb losses on its lending book before the senior debt would be impacted. In August, surprise announcements by ABIL, and then the Reserve Bank, disclosed that the bank's book of loans was performing worse than previously indicated, and the unlikely transpired.

Although these investments went against us, the resulting losses in client portfolios were fortunately relatively small, as we limited our portfolio positions in recognition of the higher-than-normal risk of negative surprises. Nevertheless, our investments in ABIL shares and senior debt were proven to be poor and we sincerely regret and apologise for the impact of this on your portfolios.

What it means to be 'contrarian'

It is not easy being a contrarian investor. One has to look for opportunities where others fear to tread and see potential where others see underperformance, and yet also try to avoid situations like ABIL. We share this approach with Orbis and Allan Gray Australia, both of whom write about being contrarian in this issue of Quarterly Commentary. Seema Dala discusses how, in the face of growth, Orbis has worked hard to maintain a small team culture and to encourage contrarian thinking. This has contributed to the track record of the Orbis Global Equity Fund, which has delivered 5.5% outperformance to its clients, compared to its benchmark since inception.

Across the ocean and down under, LJ Collyer and JD de Lange illustrate how the Australian Equity Fund differs from its benchmark, noting that the small and mid-cap stocks it chooses give its portfolio an edge, and also offer South African investors diversification that is not only geographic. The Fund is invested in many sectors and companies that are unavailable (and often unknown), locally. Interested investors can access the Orbis and Allan Gray Australia funds via our offshore platform, which provides many diversification opportunities.

Uncertainty at home

Diversifying offshore is appealing in the face of political uncertainty and economic stagnation at home. In his piece this quarter, Sandy McGregor looks at our history to find some solutions to deal with the current lack of economic growth. In a harsh reality check he discusses how we cannot count on a recovery in commodity prices to save us this time. New ideas and actions soundly based on economic realities are required to generate the higher growth rate South Africa desperately needs.

I encourage you to remain committed to your long-term investment objectives. Thank you for your support.

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