Rob Dower
Quarterly Commentary

2014 Q4 Comments from the Chief Operating Officer

We were expecting 2014 to be a tough year for South Africa's economy and the JSE and, where our mandates allow, we invested cautiously in anticipation of this. After the longest wage strike in our history, severe constraints in energy and the fiscus and weaker-than-expected economic growth, we were somewhat surprised by the market's very sanguine reaction.

The JSE returned 10.9% including dividends and local bonds delivered 10.2% over the year, while rand cash deposits paid 5.7%. You will note from the performance tables in this edition that your equity portfolios ended the year between 2.7% and 5.3% ahead of the FTSE/JSE All Share Index. At the same time, after pleasing outperformance in 2013, 2014 was a disappointing year of relative performance for our offshore partner, Orbis. The combination of these factors and our cautious asset allocation meant that balanced mandate clients marginally underperformed the average manager while taking on less risk.

Once a week, I receive a friendly and interesting weather forecast from a UCT meteorologist. It includes a chart and a satellite photograph and an assertive prediction of what to expect around Cape Town for the next seven days.

Like the weather, the world's economy is a complex system. Economists put a lot of effort (if I may say, with less scientific support than meteorologists) into trying to predict supply and demand, their impact on prices and what will happen with unemployment or interest rates or growth in different countries and regions. These things all matter a lot to our welfare: as a simple example, it would be beneficial for farmers and consumers if we knew which crops would be most in demand from one year to the next.

Yet macroeconomic factors are very hard to predict accurately. Even if they could be accurately forecast, because of competition, their impact on the profits of companies is unpredictable and, under the leads and lags of markets, the secondary effect of this on the prices of shares and bonds even more so. This is why, although our company analysis often requires us to assume prices for commodities or exchange rates, each share investment in your portfolios is based on bottom-up analysis of that company's prospects and underlying value, which we compare to its share price. By starting with individual stocks, careful portfolio construction allows us an opportunity to mitigate the risk that the economic assumptions behind any individual investment may be wrong.

Oil price collapse

The oil price is just such a macro economic factor. In his contribution this quarter, Sandy McGregor discusses the interaction between the two developments which have led to the decline in the oil price: a technical revolution in the production of oil and the economic slowdown in emerging markets, especially in China.

Impact on our portfolios

Energy equity prices are reacting to the commodity weakness with a mixture of fear and panic, and the market is increasingly sensitive to short-term developments. Sasol, an oil producer, and currently one of the largest share holdings across the Allan Gray Equity, Balanced and Stable Funds, is no exception. The majority of the products that Sasol sells are priced off the prevailing oil price; Sasol's earnings are thus highly dependent on the rand-dollar exchange rate and the dollar price of oil, both of which can fluctuate substantially over the short term. We have anticipated a lower dollar oil price for some time, but oil prices are now below our estimate of a normal price over the long term. We think Sasol currently offers excellent value in the context of a fully valued JSE, and we have recently been adding to our position.

The Orbis Funds, in particular the Orbis Global Equity Fund, have a large exposure to shares that are highly sensitive to the price of oil. This includes both energy sector shares as well as shares in markets where oil exerts a significant influence (e.g. in Russia). All of these areas were out of favour when Orbis initially invested - and all have since continued to underperform. Opportunities to invest often arise amidst a backdrop of pessimism, fear or neglect. While we believe that we make rational assessments of intrinsic value based on the fundamentals, we know that we can't reliably predict when sentiment will improve. Worse yet, sentiment often continues to deteriorate for some time after we have established our position. Although building these positions quickly has been costly in terms of short-term relative performance, Orbis is now more excited about their future return potential. Graeme Forster from Orbis explains this in more detail.

Finding value

On the local front we continue to work hard to find value. This could be in the guise of an above-average company trading at an average price, or of a mediocre business selling cheaply, which can also prove to be a rewarding investment strategy. As Rory Kutisker-Jacobson discusses in his article, we believe construction companies fall into this latter camp. While these shares are not as cheap as they were at the turn of the century, they are comparatively unloved and currently appear to offer better value than the rest of the market.

Changes to the Equity Fund

When we launched the Allan Gray Equity Fund it was the first retail fund to have a performance fee; it is now the biggest equity fund in South Africa, having grown from good returns and thanks to your support over the years.

Richard Carter discusses the proposed changes to the Equity Fund's investment mandate, benchmark and fee.

If you were invested in the Fund on 21 November 2014 you would have received a ballot pack asking you to vote for or against them. We think all of the changes are in your interests and encourage you to exercise your right to vote. Please contact our Client Service Centre on 0860 000 654, or your financial adviser, if you have any questions about the changes or the process.

Foundation update

We end this issue on an inspiring note as we look at the progress the Allan Gray Orbis Foundation is making in fulfilling its vision, which is to create responsible entrepreneurs for the common good. People often ask how the Foundation goes about selecting individuals. In this piece Anthony Farr describes the 'five pillars' that the Foundation uses to measure entrepreneurial behaviour in potential Fellows.

I wish you everything of the best in 2015 and thank you for trusting us with your investments.

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