THE SINGLE MOST IMPORTANT DRIVER OF SHARE PRICES

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1 Quarter ONTRACK INSIGHT THE SINGLE MOST IMPORTANT DRIVER OF SHARE PRICES The endless noise emanating from daily news flow makes it difficult for many investors to remain focused on the issues that truly matter. With all this noise, it is easy to get confused about which factors actually determines stock market returns. Most fund managers will provide extremely convincing arguments that their approach is best, whether it is based on valuation, quality or growth. This begs the question: What is the single most important driver of share prices? In his must-read book on the South African investment landscape, The Effective Investor, seasoned investment professional Frank Busetti dissects the total returns received from the stock market as follows: Total Return = Dividend yield + Earnings growth + Change in P/E From a fundamental standpoint, these are the only three factors that determine returns. Importantly, Busetti went further by evaluating which factor contributed the most to the stock market s total returns from 1960 to The results can be seen in the following graph: Long term contribution to total returns by its three components *Contributions to the ALSI s compounded total returns ( ). Reproduced from The Effective Investor, Busetti, 2009

2 The first observation from this analysis is the stability of the contribution from dividend yield. Dividends provided a very narrow range of low positive returns, but their real value lies in their capacity to be reinvested back into the stock market. Busetti rightly states that dividends should not be ignored. However, the most striking observation is that the contribution from the growth in earnings is significantly higher than the contribution from the change in the Price/Earnings ratio (i.e. rerating). This is a surprising observation given the amount of time and resources analysts apply in determining the appropriate Price/Earnings ratio or valuation for a stock. OVER THE LONG TERM, THE MOST IMPORTANT DRIVER OF SHARE PRICES IS EARNINGS GROWTH The graph below of the history of the S&P 500 Index in the US gives further evidence of this fact. Price and earnings levels have moved together way back since 1870, while price movements around earnings (i.e. change in P/E) are secondary effects. This is probably what Warren Buffet meant when he stated that it is an inescapable fact is that that the value of an asset, whatever its character, cannot over the long-term grow faster than its earnings do. The S&P 500 Price and Earnings Source: The Effective Investor, Busetti,2009 2

3 CONCLUSION The non-stop programming that are forced onto financial news channels qualifies more as constant chatter than noteworthy news. This overload of information has rendered the task of separating substance from noise extremely difficult and the most successful investors of tomorrow, may well be the ones who focus their time and energy on the fundamental factors that truly matter. As proved in The Effective Investor, the single most important factor that investors should focus on is the probable level of a company s earnings over future periods i.e. its earnings growth rate from today onwards. By doing this, the investor smartly applies Pareto s 80/20 principle, concentrating most of his resources on the factor that has the biggest influence on his prospective returns. At True North Capital Management, we are indeed focused on factors that matter and therefore appreciate the importance of proven management, sector sentiments, strong balance sheets and sustainable earnings. We also realize that sticking to the fundamentals, may not always produce satisfying short term results - especially in the turmoil that we have witnessed over the past year - but that it does pay off in the long term. ECONOMIC DATA CPI: November ( 16) 6.60% PPI: November ( 16) 6.90% Unemployment (Q3 16) 27.10% Repo Rate 7.00% Prime rate 10.50% GDP (Q3 16) 0.20% q/q SOURCE: STATS SA, SARB STOCK OF THE MONTH OVERVIEW Steinhoff is an integrated retailer, positioned towards the value-conscious consumer. The company operates in furniture, household goods and general merchandise in the markets of Europe, UK, Australasia, USA and Africa. Steinhoff s share performed poorly in 2016 (-9.2% in rand terms), December provided a turn in fortunes as its price jumped 9.53% upon the release of robust financial results for its third quarter. In its results for the quarter ended 30 September, Steinhoff reported a year-on-year increase in revenue of 12.1%, while its operating profit also increased 12.37%.

4 This news was followed by the announcement of a proposed merger between Steinhoff and Shoprite (Africa s largest food retailer), thereby forming a new group called Retail Africa. The aim of this merger is to establish a diversified African retail business of significant scale and geographic reach. In terms of the proposed 2-step transaction, Steinhoff will receive Shoprite shares and exchange its retail businesses (incl. Pepkor, JP Group, Shoe City). Thereafter Steinhoff will issue shares in exchange for the Public Investment Corporation and Christo Wiese s (through Titan) interests in Shoprite. The expected revenue of Retail Africa will equate to roughly R200 billion for the year ending June and will approximately be twice the size of its close competitors like Spar Group and Pick n Pay. Shareholders will have to wait for further SENS announcements on the deal before a definite assessment can be made on the merits of this potentially ground-breaking merger. Little information is currently available, which may put pressure on Steinhoff s share price until more certainty is obtained. Nonetheless, Steinhoff is unquestionably a stock to keep an eye on in SOURCE: COMPANY WEBSITES, MONEYWEB, SHAREDATA FUND COMMENTARY FOR 2016 TRUE NORTH IP FLEXIBLE EQUITY FUND 2016 will go down as a poor year for True North IP Flexible Equity. The fund returned -7.9% compared to the +2.92% achieved by the JSE All Share Index. A number of our blue-chip holdings posted particularly poor returns during the year. Our underperformance was further exaggerated by our low exposure to resources shares, which have experienced an unexpected recovery. As the table below shows, there are some very significant companies that we are invested in that have performed poorly during 2016: Despite their disappointing returns, most of these companies remain best-in-class and should recover from their current oversold levels. This may already be evident as Steinhoff and Naspers are up 5.7% and 8.6% over the six weeks since the 1 st of December. Nonetheless, the True North investment team is in the process of a rigorous reassessment of the investment merits of all holdings in the portfolio. We aim to produce much better returns in 2017 and onwards. 5

5 TRUE NORTH IP ENHANCED PROPERTY FUND As with our equity fund, True North IP Enhanced Property Fund had a disappointing 2016 to say the least. The fund returned -9.42% compared to the +9.23% generated by the SA Listed Property Index. However, the True North IP Enhanced Property Fund is not strictly comparable to the SA Listed Property Index, as the fund is roughly 30% invested in the UK and European property markets all affected by Brexit and a weakening of the pound and euro which had a major negative impact on the fund s performance in The private property market in the UK has held up better since Brexit than what is suggested by the drop in the share prices of companies like Capital & Counties, Intu Properties and Capital & Regional. With the plunge in sentiment slowly but surely abating, we expect share prices to more closely follow company fundamentals going forward. Late in the year we invested in two smaller specialist local REITs namely Equites and Stor-age. These two companies operate in niche local property sectors (logistics and self-storage respectively) that are currently performing better than the more traditional office and retail sectors of the local property market. For more details on holdings and performances, please view the fact sheet s which can be downloaded from our website: Disclaimer: This document is for information purposes only and is not intended for the solicitation of new business. True North Capital Management shall not accept any liability or responsibility of whatsoever nature and however arising in respect of any claim, damage, loss or expense relating to or arising out of or in connection with the reliance by anyone on the contents of this document.