Bateleur Flexible Prescient Fund—

2017 final report back to investors and 2018 outlook

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Bateleur Flexible Prescient Fund (“the fund”) – 2017 final report back to investors

The fund’s unit price (A1 class) appreciated 11.6% in 2017, ahead of benchmark (CPI inflation + 4%; or

8.6%). By comparison, the JSE All Share Index returned 21.0% including dividends reinvested, a basket of

government bonds (ALBI) gained 10.2%, while cash (STeFI) returned 6.9%. A disappointing performance

in December, where the fund declined 4.0%, detracted from an otherwise solid year.

December returns were negatively impacted by the sharp appreciation of the SA Rand against major

currencies (+10.4% vs. the US Dollar in the month) following Mr. Ramaphosa’s victory at the ANC

elective conference. The fund has a bias toward Rand hedge shares that has previously been well

documented.

In addition, the fund held a 2.2% weighting in Steinhoff, prior to the company announcement in

December that accounting irregularities had been discovered, and that CEO Marcus Jooste had resigned.

Following the announcement, on the same day, a risk management decision was taken and the fund’s

entire holding in Steinhoff was sold for a realised but contained loss.

A summary of the fund’s return by strategy for 2017 is shown in chart 1. Returns were positive across

both domestic and foreign equity holdings, domestic equity holdings delivered returns of 8.5% and

foreign equity holdings 3.0%. These returns were achieved with an average cash holding of 19.7% over

the twelve month period.

The fund’s long term track record remains intact, having returned a CAGR of 16.8% net of fees in the

seven and a half year period since inception (chart 2). By comparison, the JSE All Share Index returned a

CAGR of 14.9% (gross of fees) over the same period, benchmark (CPI+4%) returned 9.3%, ALBI 8.6% and

STeFI 5.7%.

Chart 1: Fund returns by strategy for 2017 Chart 2: Fund CAGR vs other asset classes since inception

Source: Bateleur Capital, Bloomberg

Global GDP growth of 3.7%* in 2017 was broad based and the highest in several years (chart 3). This

provided a favourable backdrop for corporate earnings, as evidenced in the 12.6%** EPS growth

registered by the S&P 500. Both developed and emerging equity markets performed well when

measured on a total return basis in US Dollars (chart 4). The S&P 500 returned 21.8% for the calendar

year and did not register a single negative month for the first time in its history.

*Source: IMF (WEO Update, January 2018), **Source: Bloomberg estimate

Attribution by strategy YTD %

Core long domestic holdings 8.5%

Core long foreign holdings 3.0%

Interest net of costs 0.1%

Total 11.6%

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Chart 3: 2017 GDP growth – select regions Chart 4: Global equity performance 2017 (in USD TR)

Source: Bloomberg, IMF World Economic Outlook January 2018, Bateleur

Looking ahead to 2018, the IMF is forecasting an increase in global GDP growth to 3.9% with leading

economic indicators pointing higher (chart 5). There is currently no shortage of optimism amongst

market participants. At the time of writing, the MSCI World Index is off to the strongest start in 25 years,

up 4.4%^ while the VIX index (a measure of perceived risk) is close to record lows (chart 6).

Chart 5: JP Morgan Global PMI index Chart 6: VIX Index close to record lows

Source: JP Morgan, Bloomberg, Bateleur

Under these favourable macro conditions, an element of caution is warranted! With growth accelerating

and unemployment in developed markets at multi-year lows, a further uptick in inflation is expected.

Consumer price inflation (CPI) has been on an upward trajectory for some time (chart 7), and with

quantitative easing (QE) no longer the ‘put option’ that it has been for several years, monetary

conditions are expected to further tighten. Consensus is for three interest rate increases in the US in

2018, which are generally not supportive for risk assets.

^Source: RMB Morgan Stanley

2017 global GDP growth; broad based and the highest in several years

Global upswing in economic activity gathering momentum

3 Valuations of global equity markets are also no longer attractive despite improving fundamentals for

corporate earnings. The S&P 500 is now well above its long term average P/E rating (chart 8), as are

most equity indices.

Chart 7: Global CPI inflation on the rise (%) Chart 8: S&P 500 P/E elevated relative to trend

Source: RMB Morgan Stanley

Looking domestically, the victory by Mr. Ramaphosa at the ANC elective conference in December 2017

could provide much needed impetus for the fortunes of the SA economy off a very depressed base.

Mr Ramaphosa is favourably viewed by the market as adopting a more constructive approach to the

business sector than his predecessor, and is expected to take a harder stance on corruption and

mismanagement in government departments and state owned entities (SOE’s).

Time will tell if major policy changes occur, however, in the short term there has been an immediate

increase in optimism, which will shortly reflect in the business and consumer confidence indices (charts

9 and 10).

Chart 9: SA business confidence Index Chart 10: SA consumer confidence Index

Source: Bloomberg

It will not require a lot from government to motivate the private sector to invest expansionary capital in

SA again – merely some policy certainty (for example a practical and workable mining charter). Capital

Improving business confidence will lead to increased investment Improving consumer confidence will lead to increased consumption

4 investment and infrastructure spend, are considered the most appropriate methods to kick-start

employment growth and future GDP growth.

Similarly, consumers have been reluctant to spend on discretionary items given their lack of confidence.

With inflation firmly in check and the potential for further interest rate cuts in 2018 now on the cards,

consumption expenditure should improve with a commensurate benefit to GDP growth.

Of course it is not all good news. SA still faces major long term structural challenges given high

unemployment and income inequality – while in the short term, areas of concern include the potential

for a Moody’s downgrade in March (now a reduced risk), a high budget deficit and the poor financial

health of the SOE’s most notably Eskom (notwithstanding a newly constituted Board). These issues were

all addressed in our last report back.

There was also an immediate sharp re-rating by the domestic constituents of the SA equity market in

December - that is already discounting a much improved economic outlook. Charts 11 and 12 clearly

highlight the sharp P/E multiple expansion of the SA retail and industrial indices during the last two

months.

Chart 11: SA Retail Index P/E multiple over time Chart 12: SA industrial Index P/E multiple over time

Source: RMB Morgan Stanley

Portfolio positioning

Equity valuations are above trend both globally and in SA, and investor return expectations need to be

tempered – especially with tighter monetary conditions prevailing. For these reasons, the fund carries a

high cash weighting of 21.9%.

The fund has increased its exposure to select companies in the industrial and financial sectors that

should benefit from any improvement in the SA economy and have not yet experienced a major re-

rating. Post these changes, the fund still retains an overall Rand hedge bias – though somewhat reduced

from the last quarter of 2017.

5 The Rand hedge bias is not premised on a top down view that the Rand is expected to weaken from

current levels. Rather, it is based on the attractive fundamental valuations of certain JSE listed

companies that generate a sizable portion of earnings internationally. Examples include Reinet and

Mondi amongst others.

Increased exposure to the industrial sector excludes larger capitalisation companies like Bidvest,

Imperial and Barloworld that have already benefited from emerging market portfolio flows and are no

longer attractively priced (chart 13). It would include mid-capitalisation companies such as Hudaco,

AECI, MPact and Altron where earnings are below trend and valuations are undemanding (chart 14).

Chart 13: Net foreign purchases of SA equities Chart 14: Select SA industrial co’s fwd. P/E’s*

Source: Bloomberg *Consensus 12 month forward P/E (times) based on Bloomberg estimates

With SA inflation comfortably in the targeted range, and the potential for interest rate cuts in 2018, the

fund has increased its exposure to select counters in the financial sector that should benefit from an

improvement in demand (either credit or savings). This has occurred via increased weightings in Old

Mutual, Rand Merchant Investment Holdings (‘RMI’) and Barclays Group Africa. These shares were

already core holdings in the fund.

Two specific share additions warrant further comment. After a pullback in the share price in the last

quarter of 2017, the fund has increased its weighting in domestic pharmaceutical company, Adcock

Ingram (“Adcock”). Over the past three years Adcock has executed well in streamlining its business (by

selling off non-core international operations), improving factory efficiencies and reinvigorating the

marketing and distribution function. This has resulted in a steady recovery in margins, good growth in

earnings and strong cash generation. The company has an ungeared balance sheet with R330m of net

cash, providing scope for selective bolt on acquisitions of branded consumer and over the counter

(‘OTC’) products. Adcock also benefits from a firmer Rand, as its major input costs are priced in US

Dollars.

Average daily flows into the JSE are running at record levels. Held by the fund

Not held by the fund

6 In our last report back, we highlighted the 35% discount that Reinet traded at relative to its underlying

NAV, providing an attractive entry point. Subsequently, the discount has further widened and reached

40% earlier this month. This is despite the company’s primary listing moving from Luxembourg to

Euronext as a means of improving share tradability. The fund continues to add to its Reinet weighting at

current levels – especially given our positive view on British American Tobacco which now comprises

112% of Reinet’s share price.

Chart 15: Current fund positioning

Source: Bateleur

We anticipate a challenging year ahead, but remain confident in achieving the fund’s investment

objectives.

Kevin Williams James Easterbrook

Fund Manager Head: Distribution

Strategy Exposure

JSE listed equities 64.1%

Direct offshore listed equities 14.0%

Total equity exposure 78.1%

Cash 21.9%

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