Bateleur Equity Prescient Fund—2018 3rd quarter report back to investors

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Bateleur Equity Prescient Fund – 2018 third quarter report back

The fund returned negative 0.6% for the third quarter of 2018 and negative 4.7% year to date,

compared to the JSE Shareholder weighted index’s (SWIX) return of negative 3.3% for the quarter and

negative 8.0% year to date.

Table 1 illustrates the quarterly and year to date performance of the fund relative to the SWIX. On a

year to date basis, the fund has achieved returns ahead of the benchmark.

Table 1 – Fund performance

Source: Bateleur

For the period under review, overweight positions were strong contributors to performance. Old

Mutual, Italtile and Discovery added a combined 105 basis points to relative performance while

detractors were limited.

The fund’s overweight exposure to Old Mutual performed well over the period, delivering a total return

of 14.5% relative to the market’s negative return. The managed seperation process is now largely

complete and on a stand-alone basis Old Mutual trades on an estimated 8.5 times forward earnings

multiple and a 6.3% dividend yield, attractive relative to peers and the broader market as per the

investment case discussed in the previous report back.

Italtile delivered excellent full year results against a tough macro backdrop, growing headline earnings

by 12.0%. Good working capital management, combined with a debt-free balance sheet provided the

scope for management to reduce the dividend cover, and in a positive surprise, declare a special

dividend of 30 cents per share. Italtile is attractively valued at a estimated 12.0 times forward earnings

multiple and will benefit from any upturn in the South African economy.

Discovery delivered impressive results growing normalised headline earnings by 16.0%. Discovery’s

established business performed well, increasing operating profit by 14.0%, while the emerging business

cluster turned profitable. These emerging businesses consist of Discovery Insure, Vitality Group and Ping

An Health. Discovery Insure is the fastest growing short term insurer in South Africa, Vitality Group is

building a global shared value insurance franchise and Ping An Health is the top performing specialist

health insurer in China. All of these business units are in the early stages of development and have large

earnings growth potential. Discovery is valued at a estimated 14.1 times forward earnings multiple with

little value attributed to these emerging business.

Aspen was the largest relative detractor (15 basis points) during the quarter after reporting weaker than

expected financial results. The manufacturing segment lost a key contract during the period and has

guided to experience ongoing challenges and input cost pressure in the next reporting period. As a result

Q1'18 Q2'18 Q3'18 YTD'18

JSE Shareholder weighted index (SWIX) -6.8% 2.1% -3.3% -8.0%

Bateleur Equity Prescient Fund -3.9% -0.1% -0.6% -4.7%

Relative performance 2.9% -2.2% 2.7% 3.3%

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of the aforementioned, 2019 earnings expectations for Aspen were reduced and the share price

declined to reflect the lower anticipated profitability and higher execution risk. The fund maintained a

marginal overweight position in Aspen.

Table 2 provides additional information regarding the top 10 contributors and detractors for the third

quarter.

Table 2 – Relative contributors and detractors Q3 2018

Source: Bateleur

Given the domestic market’s negative year to date return, we find it useful to evaluate periods with

similar characteristics and the subsequent performance of the JSE All Share Index (JSE ALSI) – Chart 1

below. Since 1996, we highlight 4 periods of broad based market weakness where approximately 60% or

more of JSE ALSI consituents provided negative returns - being 1998, 2000, 2008 and 2015. What

followed each of these periods was strong market returns of 70.8% in 1999, 32.6% in 2001, 32.1% in

2009 and 23.6% in 2016/17 combined. Year to date, in excess of 80% of the JSE ALSI constituents have

provided a negative return, the highest proportion since the global financial crisis of 2008 and the 2nd

highest occurrence since 1996. If history is anything to go by, the probability of improved future returns

are high.

Chart 1 – JSE ALSI constituent performance Chart 2 – JSE ALSI median P/E ratio

Source: Investec Securities ; Bateleur

Contributors (relative) Under/Overweight Q3'18 Detractors (relative) Under/Overweight Q3'18

Naspers underweight 0.6% Aspen overweight -0.2%

Old Mutual overweight 0.5% Capitec underweight -0.1%

Italtile overweight 0.3% Sanlam underweight -0.1%

Discovery overweight 0.3% Bid Corporation underweight -0.1%

Sasol overweight 0.2% Anglo Platinum underweight -0.1%

Mondi overweight 0.2% Exxaro Resources underweight -0.1%

Novus overweight 0.2% Impala Platinum underweight -0.1%

Reinet overweight 0.2% Nedbank Group Ltd underweight -0.1%

Adcock Ingram overweight 0.2% British American Tobacco overweight -0.1%

Santam overweight 0.1% Afrocentric overweight -0.1%

-40%

-20%

0%

20%

40%

60%

80%

100%

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

ALSI return % of market providing negative returns

13.7x

14.9x

12.9x

10x 12x 14x 16x

10 yearaverage

5 yearaverage

Today

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Chart 2 above calculates the current median P/E ratio of all JSE listed securities relative to the five and

ten year averages, highlighting that market valuations are low relative to long term averages.

Importantly, 31% of these companies are currently trading at a P/E ratio of below 10.0 times and the

median P/E ratio is 12.9 times, the lowest level in 5 years and below the 10 year average of 13.7 times.

Broad market weakness and low valuation multiples present opportunities for stock picking. One such

opportunity is Remgro; having not owned Remgro since inception of the fund, we discuss the

investment case in more detail.

Remgro, Market Capitalisation R101bln

Remgro is a diversified holding company with the majority of its investments in well managed listed

franchises such as FirstRand (FNB, WesBank, Ashburton), RMB Holdings, Rand Merchant Investment

Holdings (owner of Outsurance), Mediclinic (healthcare provider in South Africa, Middle East,

Switzerland and the United Kingdom) and Distell (producer of brands such as JC Le Roux, Nederburg,

Savanna and Hunters).

Remgro’s foundation goes back to the 1940s - founded as a tobacco, wine and spirits company and

listed on the JSE as Rembrandt in 1956. The business has a rich corporate history and has largely been in

its current form since the transformational unbundling of its interest in British American Tobacco (BAT)

during 2008.

From 2008 to 2015 (Chart 3) Remgro’s portfolio outperformed both the JSE ALSI and the Financial &

Industrial Index (FINDI). Recent performance has been disappointing due to the strategic and

operational underperformance of certain investee companies. In addition, Remgro’s portfolio is very

much representative of the South African economy and as such, has found it difficult to grow and add

value in a constrained economic environment. Notwithstanding these difficulties, shareholders received

a growing dividend payment (Chart 4) due to the benefits of a diversified portfolio and a conservative

balance sheet.

Chart 3 – Remgro share price Chart 4 – Remgro dividend history

Source: Bateleur ; Bloomberg

0

100

200

300

400

500

600

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Remgro JSE All Share Index Findi Index

Remgro CAGR 08-15 27.9%JSE All Share CAGR 08-15 19.9%FINDI CAGR 08-15 25.9%

Remgro CAGR 15-18 -10.7%JSE All Share CAGR 15-18 2.0%FINDI CAGR 15-18 -1.2%

0

100

200

300

400

500

600

700

800

900

1000

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Interim Final Special

BAT unbundling - November 2008

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A review of Remgro will not be complete without discussing the underlying investments – Table 3.

It is important to note that 76.1% of the intrinsic net asset value (INAV) is attributable to JSE listed

counters while the majority of the 23.9% unlisted investments is dominated by five assets – being the

Unilever Spreads business, broadband connectivity (CIV Holdings & Seacom), Air Products, Total SA and

a net cash position. The listed portfolio is well diversified across banking (31.6%), insurance (12.5%),

healthcare (16.7%) and food & beverage (14.1%) while the unlisted portfolio (25.1%) is largely made up

of domestic focussed business units within the industrial, telecoms and food & beverage industries.

Table 3 – Remgro INAV*

*As at 24/10/2018

Source: Bateleur; Company reports

Charts 5 and 6 below illustrate that the P/E multiples of listed investee companies Firstrand, RMI,

Mediclinic and Distell have contracted materially. These listed holdings have become attractively valued

relative to their long term valuation multiples. Mediclinic and Distell’s valuation decline is due to

adverse regulatory changes and disappointing internal execution while Firstrand, RMB and RMI have

derated due to lower expected earnings growth rates and a higher equity risk premium.

The business with the largest forecast risk is Mediclinic, comprising 16.7% of INAV. Mediclinic’s strategy

to geographically diversify the business has resulted in numerous acquisitions in Switzerland

(Hirshlanden), the Middle East (Al Noor) and the United Kingdom (Spire Healthcare). All three of these

acquisitions have encountered operational difficulties due to a change in their respective regulatory

environments. What is of additional concern is that South African regulators are potentially following a

similar path of increased scrutiny of healthcare costs. These concerns are now reflected in the 12 month

trailing P/E ratio of 12.0 times, a substantial derating from the peak of 30.0 times reached during 2013.

Listed INAV% Unlisted INAV %

Banking Industrial

RMH 21.4% Air Products 3.2%

Firstrand 10.2% Total SA 1.8%

Insurance Telecoms

RMI 12.5% CIV & Seacom 4.7%

Healthcare Net cash

Mediclinic 16.7% Cash 5.2%

Food & Beverage Food & Beverage

RCL Foods 8.2% Unilever spreads 5.3%

Distell 5.8%

Other listed 1.2% Other unlisted 3.5%

76.1% 23.8%

INAV per share (R) 228.89

Remgro share price (R) 178.33

Discount to INAV -22.1%

31.6%

16.7%14.1%

12.5%

25.1%

Healthcare

Food & beverage

Sector exposure

Banking Total unlisted & other

Insurance

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Chart 5 – 12 month trailing P/E Chart 6 – 12 month trailing P/E

Source: Bateleur ; Bloomberg

Within the unlisted portfolio Remgro recently agreed to sell their 25.75% stake in Unilever SA back to

Unilever PLC in exchange for full ownership of the spreads business (Rama, Stork & Flora brands) and

R4.9 billion in cash. We calculate that Remgro sold the business to Unilever PLC at 26.7 times historic

earnings while acquiring the spreads portfolio of brands at a 20.7 times historic earnings. The

transaction was effective 2 July 2018 and, in our view, a positive outcome.

The unlisted portfolio further includes a portfolio of broadband and connectivity assets, most notably

CIV Holdings trading as Dark Fibre Africa, the high-speed fibre-optic submarine cable operator Seacom

and last mile fibre-to-the-home installer Vumatel.

Other notable assets include fuel producer Total SA and industrial & specialised gas supplier &

distributor Air Products. In addition, the portfolio comprises numerous smaller unlisted investments that

are credible businesses. These businesses are largely South African focused and are well placed to

benefit from improvements in domestic economic activity.

It is not uncommon for investment holding companies to be valued at a discount to their underlying

holdings. In the case of Remgro, the current discount to INAV is 22.1%. Chart 8 illustrates Remgro’s long

term discount to INAV. While the 22.1% discount to INAV represents an attractive entry point, relative

to the average discount of 14.0% over the measuring period, it is important to note that the discount

has widened to as much as 35.0% in stressed situations - for example the global financial crisis of 2008.

Of greater interest to us is Chart 9, illustrating that the long term historic earnings multiple of Remgro

has reduced to an attractive level of 13.2 times.

5

7

9

11

13

15

17

19

21

23

2010 2011 2012 2013 2014 2015 2016 2017 2018

RMI Firstrand

5

10

15

20

25

30

35

2010 2011 2012 2013 2014 2015 2016 2017 2018

Mediclinic Distell

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Chart 8 – Remgro discount to NAV Chart 9 – Remgro 12 month trailing P/E

Source: Bateleur ; Bloomberg

Some market participants would argue that the discount is warranted based on an investors ability to

replicate 76.1% of the portfolio without the operational costs of the holding company structure. Our

view is that a discount of 22.1% is too large given the above average returns this portfolio has

historically delivered and the conservative carrying values for unlisted investments. In addition, Remgro

carries a CGT provision against its INAV which we view as prudent.

In summary, the investment case for Remgro is based on the current multi-year low earnings multiple in

conjunction with an above average discount to INAV. Furthermore, the underlying listed investments

have experienced material share price weakness and resultant valuation compression.

The unlisted portfolio is largely represented by four large investments that could all be listed in their

own right. The balance sheet is in a net cash position providing Remgro with the necessary flexibility to

withstand difficult trading conditions, financially support their underlying investee companies and

potentially engage in corporate action activities. The fund acquired a 3.4% position in Remgro.

Current fund positioning and portfolio changes

During the quarter we included new positions in Remgro, Tigerbrands, Woolworths and Supergroup

while adding to existing positions in Sasol and Billiton. Positions in AVI, Equites Property and Reunert

were sold. The detailed positioning of the fund can be found below in table 4. The sector classifications

used differ to the JSE’s grouping of companies and industries as to more accurately reflect the

fundamentals of the underlying businesses.

0%

5%

10%

15%

20%

25%

30%

35%

2008 2010 2012 2014 2016 2018

14.0%

5

10

15

20

25

30

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

22.1%

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Table 4 - SWIX Mandate current positioning *

*As at 24th October 2018

Source: Bateleur Capital

Conclusion

We expect market volatility to remain elevated as we approach the end of 2018. Nonetheless, we

remain confident in the fund’s ability to generate returns in excess of the benchmark applying the

Bateleur investment process.

Kind regards

Charl Gous Warren Riley James Easterbrook

Co-Fund Manager Co-Fund Manager Head: Distribution

Bateleur classification Over/(Underweight)

Telecoms & media -10.7%

Banks -0.5%

Insurance & other financial 4.7%

Retailers & food producers 0.0%

Property -5.3%

Resources -4.3%

Oil & gas 2.5%

Healthcare & pharma -0.1%

Industrial 7.8%

Dual l isted 2.6%

Construction -0.4% No exposure

Information technology -0.2% No exposure

Other 1.9%

Total -2.0%

Cash 2.0%

Overweight Remgro

Key holdings and relative positioning

Naspers underweight, MTN & VOD no exposure

Underweight sector, overweight BGA & FSR

Overweight sector, overweight OMU, QLT & RMI

Equalweight sector, overweight TBS, TFG and Italtile (off benchmark)

Underweight sector, overweight in Stor-age property & Atlantic Leaf

Underweight sector. No exposure to gold and platinum companies

Overweight Sasol

Overweight AIP. No hospital group exposure

Overweight SA facing industrials

Overweight BTI, RNI & MNP

Bateleur Capital (Pty) Ltd

Authorised financial services provider FSP no 18123 — SG109 Ground Floor, South WingGreat Westerford Building240 Main Road, Rondebosch7735 — T +27 (0)21 681 5060 F +27 86 649 1794—

bateleur capital 2018

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