FUNDAMENTALS THE NEWS MAGAZINE OF OLD MUTUAL INVESTMENT GROUP WHAT YOU'LL FIND INSIDE MARCH 2017 NO SURPRISES. BUDGET IS BOND MARKET NEUTRAL

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1 FUNDAMENTALS THE NEWS MAGAZINE OF OLD MUTUAL INVESTMENT GROUP MARCH 2017 WHAT YOU'LL FIND INSIDE EMERGING MARKETS AND A MAN CALLED TRUMP SHARIEF PANSAREY & SIBONISO NXUMALO FLEDGLING CYCLICAL RECOVERY UNDER WAY, BUT POLITICS A RISK RIAN LE ROUX NO SURPRISES. BUDGET IS BOND MARKET NEUTRAL WIKUS FURSTENBERG BUSTING THE MYTHS IN MID- AND SMALL CAPS WARREN JERVIS

2 INSIDE THIS ISSUE GLOBAL GROWTH GAINS A FOOTHOLD TINYIKO NGWENYA 4 FLEDGLING CYCLICAL RECOVERY UNDER WAY, BUT POLITICS A RISK RIAN LE ROUX 6 NO SURPRISES. BUDGET IS BOND MARKET NEUTRAL WIKUS FURSTENBERG 8 THE WORLD S BEST PERFORMING EQUITY MARKET 11 DIVERSIFICATION IS THE ONE FREE LUNCH IN INVESTMENTS; USE IT. GRAHAM TUCKER 12 BUSTING THE MYTHS IN MID- AND SMALL CAPS WARREN JERVIS 14 EMERGING MARKETS AND A MAN CALLED TRUMP SHARIEF PANSAREY & SIBONISO NXUMALO 21 EXTREME ROTATION: THE PRICE OF INSTANT GRATIFICATION PETER BROOKE 24 FOR MORE INFORMATION JANINA SLAWSKI Director of Marketing and Distribution Tel: jslawski@oldmutualinvest.com WYNAND GOUWS Head: Marketing Tel: wgouws@oldmutualinvest.com 2

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4 GLOBAL GROWTH GAINS A FOOTHOLD TINYIKO NGWENYA OLD MUTUAL INVESTMENT GROUP ECONOMIST ABOUT THE AUTHOR Tinyiko is part of the Economic Research Unit. She is responsible for the analysis of macroeconomic data and key economic policy issues impacting financial markets. 4

5 GLOBAL ECONOMIC OVERVIEW AND OUTLOOK With the Dutch elections on 15 March 2017, local politics is taking centre stage in Europe. While Brexit and Trump s win have demonstrated that polls are not the best predictors of an election outcome, the latest Dutch polls do suggest that Geert Wilders farright Party for Freedom (PVV) is unlikely to gain enough seats to form a coalition government. The PVV is strongly anti-immigration and also in favour of the Netherlands leaving the European Union. A Wilders-led government would most likely cause another flare-up in concerns over a potential disintegration of the Eurozone and may also strengthen similar nationalist sentiments across the rest of the region. STRONG SIGNALS FOR US RATE HIKE Turning to the US, in President Trump s first address to Congress he again called for a strong fiscal boost for the US economy through sharply higher infrastructure investment and big tax cuts although he did not shed any light on the details or the timelines of his proposal. The uncertainty surrounding his ability to successfully implement his policies supports our view of a broadly flat US dollar through to A scenario where Trump implements decent, but not extreme, fiscal stimulus, and imposes only limited trade restrictions, would probably result in the US Federal Reserve (Fed) raising interest rates pretty much in line with market expectations. At the beginning of February, the futures market put the chance of a rate hike on 15 March at about one in three. By monthend, hawkish comments by Fed chair et Yellen and a few other committee members left the odds at more than two in three. This was the Fed s strongest signal yet that it is on the cusp of lifting rates again indicating that the pace of tightening is likely to accelerate from the only one 25 basis point hike in both 2015 and 2016 as it seeks to prevent the US economy from overheating. Despite stronger global growth and the prospect of rising US interest rates, the European Central Bank (ECB) is unlikely to change course from its sub-zero interest rate stand and its extensive bond-buying programme. The ECB first wants to see inflation, currently at 1.8%, durably stabilise at around their 2% target. While the recent rise in inflation appears to be mostly driven by the recovery in the oil price, core inflation, which strips out changes in food and fuel prices, is still only 0.9%. CHINA S HARD-LANDING FEARS FADE At the start of this year s National People s Congress, the Chinese government lowered its annual economic growth expectation to around 6.5% a downward revision from their target of 6.5% to 7% for The policy debate shifted from last year s concerns around their growing debt levels to government paying more attention to financial and economic risks, even if it results in slower overall economic growth. Government explicitly reiterated the need to rein in runaway house prices to prevent a property bubble and also set specific targets to reducing steel capacity. The Chinese government s willingness to accept a lower growth rate reduces some fears that we had earlier of a hard landing. The synchronised global growth recovery is becoming ever more convincing and even though it holds some policy roll-back risks, firmer global growth should be favourable for emerging markets, where former headwinds are abating. KEY TAKEOUTS: US INTEREST RATE HIKE LOOMS CHINA FOCUSES ON HOUSING RISKS GLOBAL GROWTH RECOVERY GATHERS MOMENTUM 5

6 FLEDGLING CYCLICAL RECOVERY UNDER WAY, BUT POLITICS A RISK RIAN LE ROUX OLD MUTUAL INVESTMENT GROUP CHIEF ECONOMIST ABOUT THE AUTHOR Rian is the head of the Economic Research Unit responsible for providing insight into and forecasts of how macroeconomic developments may impact financial markets. This research informs the boutiques top-down views. KEY TAKEOUTS: SPECULATION OVER STRONG RAND CONTINUES BETTER DATA AND GOOD RAINS LIFT GROWTH OUTLOOK AGRICULTURE HAS A STRONG MULTIPLIER EFFECT ON GDP 6

7 LOCAL ECONOMIC OVERVIEW AND OUTLOOK After ending 2016 at R13.69 to the US dollar, a sharp firming from the almost R17.00/US$ reached at the beginning of last year, the rand strengthened further during the opening months of 2017, dropping below R13/US$ early in March. The sustained strength of the rand continues to surprise analysts and commentators, given the depressed local business conditions, still large foreign financing requirement (needing some US$700 million of net capital inflows a month to finance), and the ongoing political noise and uncertainties in the run-up to the ruling ANC s elective conference later this year. While the actual sources of demand for the rand will only become clearer once the South African Reserve Bank (SARB) publishes detailed data on our foreign trade and capital accounts, speculation continues as to the underlying reasons for the rand s solid performance over the past year. TREASURY SENDS CLEAR MESSAGE TO RATINGS AGENCIES In last month s commentary, we highlighted a number of fundamental reasons that might be behind the rand s unexpected strength in recent months. The Budget Speech would likely have added to the positive sentiment, as the significant tightening of fiscal policy, through R28 billion of tax hikes, increases the confidence in fiscal consolidation over the next few years. Indeed, the Finance Minister s willingness to tighten fiscal policy, notably in the face of a soft economy and an already pressured consumer, sends a strong message about the intentions of National Treasury to rebuild the fiscal space and hopefully stabilise SA s foreign currency rating at investment grade. POSITIVE SIGNAL OF ECONOMIC RECOVERY Despite the tightening in fiscal policy, and while fourth quarter 2016 GDP will, in all likelihood, contract marginally, incoming data continues to send more positive signals about the economy. These include several months of successive increases in the leading indicators index (a reliable predictor of future growth trends), surveys of manufacturing conditions and vehicle sales. In addition, the good rains during the summer rainfall season have vastly improved agricultural conditions over broad swathes of the country, and the first estimate of this year s maize crop indicates a 14 million ton harvest, almost double last season s yield. As a result, our long-held view that GDP growth will rebound from 2016 s estimated 0.4% pace to little under 1.5% in 2017 remains unchanged. Indeed, with both mining and agriculture set to fare better this year, and hopefully the same for manufacturing, there is a possibility that growth could actually surprise moderately to the upside of our current forecast. While such growth is still way too slow, given the rapid growth in the labour force and already high unemployment, at least it seems as if the five-year long slowdown in the economy may have been arrested. A further bit of good news over the past month was that the foreign trade balance recorded the smallest uary deficit in five years. In fact, adjusting the data for seasonal fluctuations, the underlying data suggests that the trade balance actually recorded a sizeable surplus in uary. Current account deficit contraction is a key requirement for currency stability as a smaller deficit will lower SA s foreign financing requirement. This process, which has been under way at a gradual pace over the past few years, may speed up this year on account of higher commodity prices, stronger foreign demand for SA goods abroad and a potentially considerable improvement in the trade balance within agricultural goods. INFLATION STUBBORNLY ABOVE 6% On a more negative note, inflation remains outside the Reserve Bank target range, with uary s number easing only slightly to 6.6% from December s 6.8%. Still, despite inflation still being sticky and outside of the target range, we remain of the opinion that the combination of sharply lower grain prices, the stronger rand and the stable oil price will cause inflation to ease quickly over the next few months. Pulling all of this together, we believe that, as a result of a combination of tighter fiscal policy, a narrower current account deficit, a stable currency and declining inflation, the South African Reserve Bank will lower interest rates during the second half of On top of better exports, this will lend support to the economy through an eventual recovery in domestic demand too. Finally, after years of growth slowdown and disappointment, the economy may well be on the verge of recovery and possibly even upside surprises. This will require, though, not again being subjected to a political shock that will drain business, consumer and investor confidence anew. 7

8 NO SURPRISES. BUDGET IS BOND MARKET NEUTRAL WIKUS FURSTENBERG PORTFOLIO MANAGER AT FUTUREGROWTH ABOUT THE AUTHOR Wikus manages a range of institutional and retail fixed income portfolios at Futuregrowth Asset Management, which include income, core bond and flexible interest rate funds. He also heads up the Futuregrowth Interest Rate team. KEY TAKEOUTS: BONDS BUFFETED BY GLOBAL SENTIMENT SWINGS BUDGET: SOEs AND REVENUE SHORTFALL A CONCERN CONSUMER AND PRODUCER INFLATION STARTING TO SLOW 8

9 INTEREST RATE MARKET OVERVIEW AND OUTLOOK Based on daily closing yields, the intra-month trading range for the yield of the benchmark R186 RSA government bond (maturity 2026) turned out to be fairly wide, moving between 8.57% and 8.85%. Various factors served as the catalyst for this volatility. From a global perspective, sentiment ebbed and flowed between those investors strongly in favour of the so-called reflation trade and those of the opinion that markets are already priced for this trade. These sentiment swings were mainly reflected in US Treasury and US dollar movements, which, in turn, had a direct impact on the South African bond and currency markets. At home, persistent rumours about an imminent cabinet reshuffle and nervousness ahead of the delivery of the 2017/18 National Budget also contributed to volatility. Even so, the R186 bond yield still managed to close the month 3 basis points stronger at 8.79%. As a result, the All Bond Index managed to eke out a total return of 0.7% for the month. This was slightly higher than the cash return of 0.5%, while handsomely beating the 0.1% rendered by the official inflation-linked index (IGOV). Although inflationlinked bonds are still benefiting from recent high inflation data, investors are more focused on a much lower expected near-term inflation rate, which does not favour this asset class. As supply for inflation protection currently outstrips demand, upward pressure on real yields and thus a negative price movement is inevitable. REASONABLE BUDGET UNDER DIFFICULT CIRCUMSTANCES February is traditionally the month when a lot of emphasis is placed on the delivery of the National Budget to parliament. Since the budget deficit is mainly funded in the local bond market, it comes as no surprise that it always receives more than its fair share of attention from both local and foreign bond investors. Once again, the Minister of Finance, with the assistance of the highly regarded and competent team at National Treasury, managed to pull off a reasonably wellbalanced budget under difficult circumstances. All in all, no significant positive surprises were forthcoming, so we regard this budget, at best, as bond market neutral. That said, we remain concerned about the ability to turn around poor management at some state-owned enterprises, which has a direct impact on the size of the contingent liabilities at national level. We are also spooked by the sizeable tax revenue shortfall relative to the initial February 2016 and October 2016 budget estimates. Other data releases were mixed, with the rate of inflation at both consumer and producer levels starting to slow, while the latest external trade account showed a larger than expected deficit. None of these data releases had a significant impact on market sentiment, though. With the exception of the US, and more encouraging signs of some improvement in other G10 countries, the global growth recovery still remains fragile. This sets the scene for a modest rise in global inflation as well as monetary policy divergence. It also implies a steady tightening cycle for the few economies that are in a position to normalise monetary policy, especially the US. This should limit significant upside to global bond yields, especially following the recent bearish correction. On the negative side, the continued uncertainty about the global, and particularly the Chinese, growth outlook remains a risk especially for emerging market commodity producers with a weak external position in both absolute and relative terms, like South Africa. The anti-global trade tirade by the Trump administration is expected to add uncertainty to the mix. RATE CUTS UNLIKELY ANYTIME SOON Locally, the downward trend in inflation is imminent, supported mostly by significantly lower food price increases. While the South African Reserve Bank has now adopted a neutral bias, it is unlikely that they would consider interest rate cuts soon. The external trade imbalance is simply too big to allow for a lower real repo rate, while unpredictable currency swings continue to pose a risk to the more benign inflation outlook. Although the Minister of Finance is clearly determined to rectify the damage to fiscal policy credibility and, by implication, avoid a sovereign credit downgrade to non-investment grade status, the jury is still out on actual delivery. Therefore, the risk of a credit rating downgrade over the next 12 months still lingers. In the short term, local political uncertainty remains a nagging risk. Considering the above, we will continue to approach the market with caution. The emphasis therefore remains on capital preservation. This is expressed by the large underweight modified duration and 12+ year nominal bond positions. We have reduced our inflation-linked bond holding significantly in response to the more benign 12-month inflation outlook and have instead opted to create an overweight position in short- and mediumdated nominal bonds. The biggest risk to our cautious stance is US dollar weakness and consequent rand strength. 9

10 SOUTH AFRICAN INFLATION BREAK-EVEN CURVE (YIELD SPREAD BETWEEN NOMINAL AND INFLATION-LINKED BONDS WITH SIMILAR TERM TO MATURITY PROFILE) Market inflation expectations, as implied by the South African inflation break-even curve, are too high when compared to market consensus and our own inflation forecast. As a result, the yields offered by inflation-linked bonds are deemed too low (thus expensive) and should therefore not be considered as an off-benchmark investment choice in the near term. 8.0% 7.5% I2038 I2046 I2050 Break-even inflation 7.0% 6.5% 6.0% R197 I2025 R210 I2029 R202 I2033 R % 5.0% Term to Maturity Sources: Bloomberg, Futuregrowth 10

11 DID YOU KNOW? SOUTH AFRICA HAS BEEN THE WORLD'S BEST PERFORMING EQUITY MARKET SINCE % real return a year (after inflation) between 1900 and 2016 More than 2% above the world average of 5.1% of a year South Africa had its BEST YEAR in 1933 when it delivered a return of 102.9% in US dollar terms South Africa had its WORST YEAR in 1920 when the stock market lost 52.2% in US dollar terms The local bond market delivered a mere 1.8% a year in line with the world s average annual return, but well behind the front-runner Denmark s 3.3% (after-inflation returns from between 1900 and 2016). Looking at South Africa over the past 20 years, we see that our market has outperformed the S&P 500 Index in US dollars. This further reinforces what we all know: not to get drawn in by short-term volatility, but rather approach investing with a longterm goal in mind. BEST MARKETS SINCE 1900 Annualised real returns (% per year) SOUTH AFRICA OUTPERFORMS S&P 500 OVER 20 YEARS (USD) 31 uary February 2016 South Africa Australia United States New Zealand Equities Bonds FTSE/JSE All Share Index (total return) S&P 500 Index (total return) Sweden Canada United Kingdom 500 Finland Denmark WORLD 400 Netherlands Switzerland Ireland 300 Norway Japan Spain 200 Portugal Germany France 100 Belgium Italy Austria -5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6% 7% 8% Sources: Bloomberg, Credit Suisse Group AG, London Business School Source: FactSet Source: Unless otherwise stated, all data is sourced from Credit Suisse Global Investment Returns Yearbook 2017 Summary Edition Dimson, Marsh, Staunton 11

12 DIVERSIFICATION IS THE ONE FREE LUNCH IN INVESTMENTS; USE IT. GRAHAM TUCKER PORTFOLIO MANAGER ABOUT THE AUTHOR Graham is a portfolio manager at MacroSolutions and is responsible for their range of balanced funds. He is also a quantitative strategist, risk manager and a member of the asset allocation team. 12

13 After time in the market, diversification is the second most valuable tool you can use to manage risk as it reduces the impact that a single poorly performing asset has on your overall portfolio. Investors tend to have a low tolerance for pain, with the fear of losing money outweighing the greed for gains. This is especially true when it comes to investing in equities, due to their higher level of volatility. To better understand this volatility, we look at the drawdowns of equities and bonds in real terms (after inflation), which is a harsher light, as inflation normally softens the impact of a longterm bear market. DRAWDOWNS ARE PAINFUL AND COSTLY Market declines are measured by the amount of money lost from the peak and how long it takes to recover the losses. Both equities and bonds have exposed investors to painful periods of negative returns. CHART 5: DRAWDOWNS OF SA EQUITY December 1924 December 2016 THE WAY TO MANAGE THIS RISK IS THROUGH DIVERSIFICATION A simple 50% equity : 50% bond blend dramatically improves the drawdown profile. CHART 7: DRAWDOWNS 50% SA EQUITY : 50% SA BONDS December 1924 December % -10% -20% -30% -40% -50% -60% -70% WORST DRAWDOWN % -10% -20% -30% -63.2% EQUITIES -60.8% -45.2% 50:50 BONDS PORTFOLIO Great Depression -40% 1998 Asian crash -50% -60% -70% 0% -10% -20% -30% -40% -50% -60% -70% Post World War II crash CHART 6: DRAWDOWNS OF SA BONDS December 1924 December 2016 Over 50 years to breakeven 39 years crash 2008 Global Financial Crisis 15 years to get back to breakeven 63.5% lost in just 2.5 years Financial history clearly shows the truth in the old adage Don t put all your eggs in one basket. This article is an extract from the 2017 edition of Long-Term Perspectives a yearbook that scrutinises the performance and behaviour of select asset classes over the past 87 or more years. Visit our website for more information. 13

14 BUSTING THE MYTHS IN MID- AND SMALL CAPS WARREN JERVIS PORTFOLIO MANAGER ABOUT THE AUTHOR Warren is the portfolio manager of the Old Mutual Mid & Small-Cap Fund, as well as other client portfolios. He also manages the mid- and small cap components of Old Mutual Investment Group s institutional funds. KEY TAKEOUTS: MYTH-BUSTING THESE MISUNDERSTOOD SECTORS EXPERIENCE COUNTS WITH MID- AND SMALL CAPS OFFERING A PORTFOLIO TILT THAT ADDS RETURNS FOR LESS RISK 14

15 For more than two decades to December 2016, mid-cap companies have generated 2.66% and small caps 2.30% a year more than the Top 40 Index. This makes these two segments of the market hugely important contributors to the potential returns generated by pension funds and lifetime retirement savings, given the significant compounding effect of those superior returns over time. Mid- and small cap shares are also an excellent differentiated source of alpha for investors and therefore should comprise a permanent component of an investor s portfolio. In the South African market, the universe of potential investment opportunities is limited and therefore it makes sense to consider the full array of investment opportunities, especially when they have generated superior returns over time. In the Old Mutual Mid & Small-Cap Fund, we invest in quality companies, with excellent management striving to achieve superior compounding returns over time. MID-CAP, SMALL CAP AND TOP 40 INDICES SINCE 1996 Clearly, experience counts in a part of the market where successful stockpicking is the primary determinant of investment success. The understanding of the business models and key business drivers enables you to leverage your information advantage in an under-researched area of the market. To successfully invest in this sector, there are a number of midand small cap sector myths that you need to consider. MYTH 1: SECTOR RETURNS ARE EASILY EXPLAINED Over certain periods of time, different sectors have been the key drivers of the mid- and small cap performance. Two examples in the mid-cap sector have been property companies and the general retailers: Property company returns have been driven by mergers and acquisitions (R230bn of capital raised), the revaluation of assets and superior yields. Retailer returns were due to superior earnings growth and a strong rerating of the shares, largely driven by the closure of rating discounts to their global peers FTSE/JSE Africa Mid-Cap Index FTSE/JSE Africa Small Cap Index FTSE/JSE Africa Top 40 Index These sizable sectors can be excellent drivers of three to four years of outperformance, but it remains a relatively short-term phenomenon All asset classes still move, more or less, in line with the overall business cycle. In 2016, as an example, the Retail Index derated and its relative performance was poor Source: I-Net Graph, uary 2017 The mid- and small cap sectors consist of more than 120 stocks, roughly 60 stocks in each, that are very diverse in nature. Business models range from quarrying, poultry production, power generation, financial services and technology, to car sales and many others. Understanding their business models, management teams, competitive strengths and where they are in the business cycle enables better investment decision-making. Indices also change over time and many businesses either come to the market, restructure or are bought out. Consider some these names: Mvelaphanda, Gijima AST, JD Group, Curro, Alexander Forbes, Sibanye and Dis-Chem. All of them have had some impact on the constituents and weightings of the various indices. All indices change over time it is a given, and certain constituent changes can have a substantial short-term impact on any given index, but in the longer term these anomalies should normalise. Take the Gold Index in 2016 as an example. At the start of the year all of the major gold stocks (AngloGold, Sibanye and Gold Fields) were in the Mid-Cap Index. By the end of July 2016, 15

16 the Gold Index was up 168%, and shortly thereafter all three stocks were then included in the Top 40 Index. AngloGold moved back into the Top 40 Index just prior to the other two. Post July 2016, after being included in the Top 40 Index, the Gold Index was subsequently down over 58%. Constituent changes and extreme volatility clearly had an impact on the various indices. MINING INDEX VERSUS TOP 40 INDEX GOLD INDEX (J150) J150 ( ) Source: I-Net Graph, uary O N D J F M A M J J A S O N D J The mining sector has clearly impacted the Top 40 Index returns over time, but so has Naspers with a massive >600% performance over an eight-year period alone. Sizable constituents also play a huge role in the overall performance of indices. Source: I-Net Graph, uary 2017 There are also individual anomalies, such as AngloGold, which entered the Mid-Cap Index in November 2015 with a 4.5% weighting, and within three months had doubled in market cap and moved back into the Top 40 Index. Three months later it began to decline in line with Sibanye and Gold Fields. The other major sector that had a significant impact on the performance of the mid-caps last year was the mining sector in general, which strongly recovered off a very low base in Overall, however, the Mining Index was a major detractor from the Top 40 Index performance over the previous five years. If you look over the longer term, the Mining Index had two very strong periods of outperformance lasting more than five years each. The short, sharp corrections post these bull markets were also fairly brutal. Over a long period of time, 21 years, it is not simply a case of saying that the Mining Index hindered the overall Top 40 Index performance. Again, sectors can have a major impact over the short to medium term, but over the longer term they have much less influence. From an attribution point of view, we looked at the Old Mutual Mid & Small-Cap Fund against the Mid- and Small Cap Index dating back to 2004 (as far back as we could go with reliable data). The average resources weighting in the index was 13.0%, with the Property Index weighting at 14.8%. The unit trust had a long-term resources underweight position and this added alpha over the period. Resources as a whole has been a negative contributor to all the main indices, such as Top 40, Mid- and Small Caps. Interestingly, despite the higher 14.8% property weighting in the index and the unit trust s low exposure to the asset class, the performance foregone as a result of being underweight was far less than expected. Despite strong Property Index performance over the last 10 years, the portfolio exposure to performing industrial shares limited the damage of a property counter underweight. Regardless of what the sectoral drivers are in the short term, or what the various constituents of the index are, the fact remains that long-term assets should still be suitably exposed to the midand small cap area of the market. It is a sizable opportunity set of potential investment opportunities that should not be ignored. 16

17 MYTH 2: SUPERIOR ALPHA GENERATION IS IN THE TOP 40 STOCKS The average annual performances for the three sectors over 21 years are: Top 40 Mid-Cap Small Cap 15.78% 18.43% 18.08% RETURNS PER UNIT OF RISK Top 40 Mid-Cap Small Cap Std Deviation 23.3% 20.2% 22.4% Maximum 79.17% 47.53% 55.72% Minimum % % % Median 13.31% 21.39% 20.60% Return/Risk Unit 67.8% 91.2% 80.8% Source: Old Mutual Investment Group, uary 2017 Source: Old Mutual Investment Group, uary 2017 Mid-caps have outperformed the Top 40 by an average of 2.66% per annum and small caps have outperformed the Top 40 by an average of 2.30% per annum. The compounding effect of these superior annual returns is astounding. When looking at the compounding of superior returns over a longer time period, we did the following simple exercise. Investing R1 million into each of the three segments over 21 years would yield a 70.6% better result in the mid-cap sector (growing to R ), and a 50.3% better result in the small cap sector (R ) than the Top 40 sector (R ). This is a significant difference generated by better annual results compounding over a 21-year period. The young are encouraged to start saving early as the compounding effect, over long periods of time, of returns on their retirement savings is quite staggering. Adding exposure to the mid- and small cap sectors of the market would further enhance portfolio returns. MYTH 3: MID- AND SMALL CAPS ARE RISKY The level of return per unit of risk (as measured by the standard deviation) of small to mid-cap stocks versus the Top 40 Index has also been superior. Looking at the average return divided by the standard deviation gives return per unit of risk figures of 67.8% for the Top 40 Index, 91.2% for mid-caps and 80.8% for small caps. This is not a definitive risk answer, as the definition of risk is way more complex than that. However, it does help in understanding whether mid- and small cap shares are too risky for investors or not. One of the key parameters of risk management for me as a portfolio manager is the protection of clients capital. There are many types of risks out there and at all times a portfolio manager needs to consider an appropriate risk return tradeoff when making investment decisions. Avoiding many of the share calamities is a key component of mid- and small cap investing, and that is where the experience of the portfolio manager is vital. I am often told that mid- and small caps are risky regardless of what the return per unit of risk numbers say. So I decided to look at the unit trusts of the mid- and small cap peer group versus the general equity unit trusts in the same asset management house over the last five years. Quite simply, you have returns on one axis and standard deviation (risk) on the other axis. Although standard deviation is not a comprehensive risk measure, as mentioned, it is nevertheless appropriate for graphical purposes. STANDARD DEVIATION AND RETURNS OF MID- AND SMALL CAP VERSUS GENERAL EQUITY UNIT TRUSTS Annualised 5-Year Total Return (%) Risk/Return: 10 years ending 31 October 2016: Mid- & Small Cap and Core Equity Funds Mid- & Small Cap UT Peers Core and specialist equity funds SWIX Nedgroup Inv Rainmaker R Coronation Smaller Companies Nedgroup Inv Entrepreneur R SIM General Equity R Old Mutual Mid & Small-Cap R SIM Small Cap R Investec Equity R SWIX Old Mutual Investors R Momentum Small/Mid-Cap A Momentum Equity A Coronation Top 20 A Investec Emerging Companies R Risk (Annualised 5-Year Standard Deviation) Source: Morningstar Source: Morningstar 17

18 Of the six asset managers that were chosen, and assuming the same overall house view assumptions applied, there were five mid- and small cap unit trusts with lower risk profiles than the asset managers general equity funds. The only outstanding fund was a fund that was recently decimated by a large holding in African Bank during the assessment period. So over the last five years, the mid- and small cap funds have not been more risky than the general equity unit trusts in the same asset managers. MYTH 4: TOO ILLIQUID TO INVEST IN I hear too often from general equity portfolio managers that the sector is too illiquid for large asset managers. I agree. However, where does the management of liquidity risk fit into the overall investment process and what are the parameters being used to determine liquidity? Quite simply, liquidity is a function of the assets under management in which you are trying to invest. The more funds you manage, the harder it will be to participate in the small cap sector and a natural shift towards more mid-cap stocks will occur. In our mid- and small cap investment process, liquidity is the first starting point of the process and is a key risk to analyse. It is vital to understand how long it will take to move stock into and out of the portfolio, and what the overall equity holding will be in the company once the targeted portfolio weighting has been reached. Many stocks such as Bell, Basil Read, Hulamin, Caxton, Mustek and Rainbow are too illiquid to consider for a fund that has even assets under management of R2 billion. In our mid- and small cap universe, 24 stocks out of 123 stocks available are currently excluded based on liquidity issues. So slightly less than one-fifth of the universe is currently excluded, and this number of exclusions will slowly increase as assets are accumulated. Given liquidity concerns, actual practical experience still provides more insight than a detailed spreadsheet, and in the recent past we have also been able to transition over R3bn within a three-month period in the sector. So provided you have a quality portfolio of stocks that are appropriately priced, you will always find willing buyers or sellers in the market. However, trying to exit a 20% stake in a very poor business is not an easy task when things go wrong in the company. Liquidity is a constraint, but it is still not enough of a reason to completely exclude the sector purely on liquidity concerns. It is a vital part of the investment process and needs to be managed carefully. 18

19 SOLUTION: A MID-CAP AND SMALL CAP TILT IN THE PORTFOLIO Small and mid-cap shares offer an uncorrelated additional source of alpha within an overall portfolio and thus, as a large asset manager, it is appropriate to have some exposure to these companies. The extent of this portfolio tilt depends on the level of knowledge of these companies and the proportion of the portfolio that is able to be invested in equities in general. Mid- and small caps are never meant to be a substitute for Top 40 exposure. They should be considered as a portfolio tilt that adds additional returns for less risk. Consider a 100% Top 40 portfolio versus three portfolios with tilts of 10%, 20% and 30% respectively towards mid-caps only. Over 21 years, the additional 10% tilt to mid-caps would have yielded an additional 7.1% return; a 20% mid-cap tilt a 14.1% return, and the 30% mid-cap tilt would have yielded a 21.2% additional return. R100 initial investment OLD MUTUAL MID AND SMALL-CAP UNIT TRUST VERSUS THE PEER GROUP AVERAGE SINCE SEPTEMBER 2009 R300 R250 R200 R150 R100 R50 Aug-09 Dec-09 Cumulative Excess Value (RHS) Old Mutual Mid & Small-Cap Fund (ASISA) South African EQ Mid-/Small Cap Peer Group Average Apr-10 Aug-10 Dec-10 Apr-11 Aug-11 Dec-11 Apr-12 Aug-12 Dec-12 Apr-13 Aug-13 Dec-13 Apr-14 Aug-14 Dec-14 Apr-15 Aug-15 Dec-15 Apr-16 Aug-16 Dec-16 R80 R60 R40 R20 R0 - R20 Source: Old Mutual Investment Group (Pty) Ltd, uary 2017 Cumulative Excess Value (Rand) As a small and mid-cap manager, we strive to generate alpha for our clients and we believe we have a competitive advantage in the sector. We have achieved superior performance against the peer group average over 1-, 2-, 3-, 5- and 10-year periods. Given the superior risk-adjusted returns delivered by the midand small cap segments of the market, can you ignore the value they could potentially add to your retirement savings portfolio over time? We think not. Note: The performance quoted is for a lump sum investment and in respect of the Old Mutual Mid & Small-Cap Fund. The actual highest, average and lowest 12-month return figures since inception to 31 uary 2017 are 108.3% (highest), 17.1% (average) and -40.3% (lowest). The fund was launched on 30 April Performances are in ZAR and as at 31 uary

20 KEY TAKEOUTS: POLITICAL NOISE CAN CREATE GREAT OPPORTUNITIES DESIGNED IN CALIFORNIA. ASSEMBLED IN CHINA BUY INTO BUSINESSES THAT CAN WITHSTAND CRISES 20

21 SHARIEF PANSAREY INVESTMENT PROFESSIONAL SIBONISO NXUMALO BOUTIQUE HEAD EMERGING MARKETS AND A MAN CALLED TRUMP ABOUT THE AUTHORS Sharief is a senior equity analyst within the Global Emerging Markets boutique. He is responsible for listed resources and industrial companies globally as well as for broad market analysis. Siboniso is the joint boutique head of Global Emerging Markets. He is also one of the fund managers of the Old Mutual Global Emerging Market Fund. When Presidents Defy Economic Gravity, Gravity Usually Wins The Wall Street Journal headline on Donald Trump Globalisation has changed us into a company that searches the world, not just to sell or to source, but to find intellectual capital the world s best talents and greatest ideas. - Jack Welch (Former CEO of General Electronic) The life of an emerging market fund manager is nothing short of dramatic under normal circumstances. It s a world filled with political noise a constant stream of political drama that often gives both fund managers and clients something to worry about. Most of the queries, concerns and questions we receive have something to do with some political event that s just occurred. Over the past few years Brazil s president has been impeached, South Korea s prime minister is undergoing her own impeachment trial, the Turkish prime minister is seeking authoritarian powers after the failed coup attempt, South Africa s own government has been at war with itself and, well, then there is Russia, so you get the picture. All this political noise creates great investment opportunities for investors like us. We thrive in environments where markets discount great businesses to highly attractive prices for us due to perceived uncertainty. Especially when this uncertainty has nothing to do with the underlying fundamentals of the companies in which we invest was the year we were introduced to the concept of political risk in the developed world. First with Brexit, then with the man that s currently dominating water cooler conversation or, as the millennials would say, trending on Twitter President Donald Trump. A question we often get asked is: What effect will Donald Trump s "America first" policy have on emerging markets? Before we gaze into the crystal ball, in investing it often helps to look back in history. Trump s primary rhetoric has been directed against globalisation, with the ambition of bringing jobs back to America with a particularly keen interest on bringing back manufacturing jobs. Let us look back at the fascinating history of US manufacturing. Manufacturing as a percentage of GDP and manufacturing employment peaked in Therefore, manufacturing in the US and its employment has been in decline for 64 years. 21

22 US MANUFACTURING AS % GDP 34% 32% 30% 28% 26% 24% 22% 20% 18% 16% 14% 12% 10% Source: BCA Research US MANUFACTURING EMPLOYMENT AS % TOTAL EMPLOYMENT 40% 35% 30% 25% 20% 15% 10% Source: BCA Research President Trump is trying to reverse a 64-year trend in his first few weeks in office. Digressing a little, it s fascinating to note that global manufacturing as a percentage of GDP has also been in decline. Mexico s manufacturing peaked in 1987 at 27% and bottomed out at 16% in 2010 before rising to the current 18%. Even China, the world s leading manufacturer, has been in decline since So what is the issue here? The world has changed and President Trump seems to have failed to acknowledge this. The list alongside reflects the largest companies in the US in 1960 and at the present day. In1960, these were heavy industry companies in the auto, steel and oil industries. THE LARGEST 10 COMPANIES IN THE US (WHEN THE US WAS STILL A MANUFACTURING POWERHOUSE) TOP 10 LARGEST COMPANIES ON S&P 500 IN 1960 TOP 10 LARGEST COMPANIES ON S&P 500 IN General Motors 1. Apple Inc. 2. Exxon Mobil 2. Microsoft Corporation 3. Ford Motor 3. Exxon Mobil Corporation 4. General Electric 4. Amazon.com Inc. 5. U.S. Steel 5. Berkshire Hathaway Inc. 6. Mobile 6. Johnson & Johnson 7. Gulf Oil 7. Facebook Inc. 8. Texaco 8. JP Morgan Chase & Co 9. Chrysler 9. General Electric Co 10. Esmark 10. AT&T Inc. Source: S&P 500 as at 31 uary 2017 Sixty years on and the same S&P 500 Index is dominated by companies that manufacture very little. They are marketplaces, social networks and new-economy companies. You have to work very hard to find heavy industry companies that are thriving in the US these days or, for that matter, in the rest of the world. Now take time to refer back to the Wall Street Journal s headline on Trump. We suspect there could be some truth in this headline: When Presidents Defy Economic Gravity, Gravity Usually Wins 7 December 2016 Ultimately, our job is not to speculate on the economics of the murky world of politics. We are bottom-up fundamental investors and hence our expertise is in the detailed analysis and understanding of specific companies. Specific company examples always add context, therefore let us take a look at a few. CUTTING-EDGE MANUFACTURING Apple is the largest, fastest growing and one of the most loved companies in the world. President Trump has spoken extensively about Apple moving some of their production facilities back to the US. Globalisation has resulted in the global consumer gaining access to better quality products at lower prices. To be able to deliver these products efficiently, companies have developed 22

23 intricate and complex, yet highly efficient, global supply chains that have been engineered over decades to deliver quality at the best price. In the Old Mutual Emerging Market Fund, our clients money is invested in companies that participate in the Apple supply chain. It is thus very important for us to pay close attention to any activity related to Apple s supply chain. One such company is Taiwan Semiconductor (TSMC). TSMC is the largest independent semiconductor foundry in the world. One product they exclusively manufacture is the A10 chip, which effectively runs Apple s latest flagship phone (iphone 7). What s fascinating about this Taiwan-based company is that it employs around employees. Around of these employees have at least a master s degree or a PhD. A further have a bachelor s degree. TSMC s highly skilled staff produce chips that operate the products at the leading edge of human ingenuity and innovation. The idea of moving TSMC s capability to the US should prove to be a little more complicated than simply sending a tweet. Mind you, at the unemployment rate of 4.8%, the US is pretty much at full employment (with the unemployment rate of college graduates at 2.5%). President Trump s call for jobs in the US is thus peculiar. TSMC spends about US$10 billion annually on enhancing research & development and manufacturing capability. Can you imagine how much a US company would have to spend today to replicate this capability? On the back of Apple devices is a telling inscription: Designed by Apple in California. Assembled in China. Two sentences that abbreviate a very complex supply chain. Our analysts have travelled to Taiwan, China and Korea several times to visit the facilities of these companies. We ve spent many hours interrogating the management of over 30 companies in the mobile telecommunications arena. DOUBLE VISION Largan Precision, for example, is another one of the Taiwanese companies we ve spent extensive time with. They design and manufacture advanced camera modules for high-end phones. Their latest innovation is the dual camera as seen on the iphone 7 Plus. Apple dedicated a large segment of their product launch to profiling the advanced photographic abilities of this camera. Dual camera capability is an innovation originated in Taiwan, through significant R&D spend. A CASE IN POINT Catcher Technologies is another company in the Apple supply chain. They specialise in the manufacture of casings (basically the outside of an iphone). Walking around their factory is a fascinating experience as we had completely underestimated the complexity of making the covers for these high-end phones. To us, the casing was merely a commoditised product that could easily be replicated in China. There are only three approved casing manufacturers globally in the Apple supply chain, and this for good reason it s a highly complex process. Then finally, all these components are sent to Hon Hai for assembly. This is possibly the simplest part of the value chain that could be replicated in the US. However, we should bear in mind that it s assembled in China for economic reasons (very cheap labour). Last year the same Foxconn (a subsidiary of Hon Hai) replaced factory workers with robots. These are probably not the kind of jobs the US president is talking about. During times like this, we like to refer back to our investment philosophy. We seek to invest in quality companies in emerging markets, trading at attractive valuations with sound corporate governance. Our disciplined adherence to this philosophy has allowed us to generate pleasing returns on behalf of our clients and thus we will continue investing in accordance with our philosophy. We are unable to predict the future. Therefore we firmly believe in buying strong businesses (with proven sustainable competitive advantages), at attractive valuations and with sound corporate governance, as they tend to withstand crises and continue growing their earnings in the long run. Whether Trump adheres to his policies and what that means for emerging markets, is thus of far less importance to us than our assessment of the strength and competitive advantages of the companies we invest in. In short we believe that strong, quality businesses with attractive valuations "trumps" all other considerations. 23

24 EXTREME ROTATION: THE PRICE OF INSTANT GRATIFICATION PETER BROOKE HEAD OF MACROSOLUTIONS ABOUT THE AUTHOR Peter heads up MacroSolutions, our multi-asset class boutique. He is also the fund manager for Profile Edge28 Portfolio, Old Mutual Maximum Return Fund of Funds and Old Mutual Flexible Fund. KEY TAKEOUTS: 2016 SAW A LARGE DISPERSION IN RETURNS CHASING WINNERS IS A LOSING GAME CHOOSE A CONSISTENT PERFORMER, AND STICK WITH IT 24

25 South African equities had a challenging 2016, with the JSE returning just 2.6% for the year. However, this masked what was actually happening at a stock level, as there was a wide dispersion in returns. This dispersion was caused by a massive rotation as global investors moved away from growth-style investing to value-oriented shares and away from defensive to cyclical shares. This rotation was especially pronounced in SA, due to our market s high number of globally focused companies and the heavy weighting of cyclical resources share. This meant that in 2016 we saw large price moves, as previous winners were crushed and some resources shares skyrocketed (Glencore rose 124% and Kumba Iron Ore was up 286%). This rotation played into fund performance, as seen in the tables below. Using the South African multi-asset high equity category, where the balanced funds reside, we compared the ranking of the top 10 performing funds (based on three-year returns to the end of 2015) with the rankings one year later. Of those top performing funds, only two were in the top quartile at the end of In fact, the top fund at the end of 2015 came second last in the category in 2016 (102 out of 103 funds). Looking at the worst performing funds over the three years, the bottom fund was No. 1 in 2016, with half of all these bottomranked funds moving into the top 10 in 2016 and 70% being top quartile performers. TOP 10 BOTTOM 10 Morningstar rankings of all multi-asset high equity funds with a four-year track record. RANK 3 years to December 2015 RANK 2016 RANK 3 years to December 2015 RANK Sources: Morningstar, Old Mutual Investment Group 25

26 NAVIGATING THE EXTREME (and the not-so-extreme) There are many great lessons to learn from these extreme moves and the same rules would apply when the market is relatively stable: 1. Don t get distracted by the noise. These extreme market moves reinforce just how important it is to position your portfolio in advance moving to where the opportunities lie. Our investment philosophy (which blends top-down macroeconomic research with rigorous bottomup fundamental analysis) has resulted in a pragmatic approach to investing enabling us to make significant changes in our portfolios ahead of time. 2. Have a long-term view. We all know that, over time, the probability of negative returns significantly reduces. Our Long-Term Perspectives yearbook analyses 87 years of data and proves this point in multiple ways. Look out for the 2017 edition, which will be released in March. 3. Stick to your plan don t chase your tail. While the performance rankings tables on the previous page make a strong case for not chasing winners over the short term, the same is true over the longer term. The chart below shows what would have happened if, every year, you traded into the previous year s worst performing fund (blue line) and best performing fund (red line) based on three-year returns. When compared with remaining in one fund, the Old Mutual Balanced Fund, both these strategies are obvious losers. Choose a consistent performer that is managed according to a sound and proven investment philosophy. DON T CHASE YOUR TAIL Constructed portfolio based on three-year past performance calendar year rebalancing Old Mutual Balanced Fund R Selection based on best performer Selection based on worst performer Sources: Morningstar and Old Mutual Investment Group, 31 December Old Mutual Unit Trust Managers (RF) (Pty) Ltd (OMUT) is a registered manager in terms of the Collective Investment Schemes Control Act 45 of The fund fees and costs that we charge for managing your investment are accessible in the relevant fund s Minimum Disclosure Document (MDD) or Table of fees and charges, both available on our public website, or from our contact centre. The Net Asset Value (NAV) to Net Asset Value figures are used for the performance calculations. The performance quoted is for a lump sum investment and in respect of the Old Mutual Balanced Fund. The actual highest, average and lowest 12-month return figures since inception to 31 December 2016 are 45.5% (highest), 13.7% (average) and -23.2% (lowest). The fund was launched on 1 March Performances are in ZAR and as at 31 December 2016.

27 MARKET INDICATORS AS AT 28 FEBRUARY 2017 DY % P/E Ratio 1 Month %* 12 Months %* FTSE/JSE All Share Index FTSE/JSE Resources Index FTSE/JSE Industrial Index FTSE/JSE Financial Index FTSE/JSE SA Quoted Property Index ALBI BEASSA Bond Index STEFI Money Market Index MSCI World Index (R) MSCI World Index ($) *Total return index percentage change Economic Indicators Latest Data Previous Year Exchange Rates Rand/US$ February Rand/UK Pound February Rand/Euro February Rand/Aus$ February Commodity Prices Gold Price ($) February Gold Price (R) February Oil Price ($) February Interest Rates Prime Overdraft February % 10.3% 3-Month NCD Rate February % 7.0% R186 Long-bond Yield February % 9.4% Inflation CPI (y-o-y) uary % 6.2% Real Economy GDP Growth (y-o-y) September % 1.1% HCE Growth (y-o-y) (Household Consumption Expenditure) September % 1.6% GFCF Growth (y-o-y) (Gross Fixed Capital Formation) September % 3.4% Manufacturing Production (y-o-y) (seasonally adjusted) December % -0.3% Balance of Payments Trade Balance (cumulative 12-month) uary-17 $0.1 -$4.8 Current Account (% of GDP) September % -4.5% Forex Reserves (incl. gold) uary-17 $46.5 $47.5 Sources: JSE, Iris, I-Net DISCLAIMER: The content of this document does not constitute advice as defined in FAIS. The following entities are licensed Financial Services Providers (FSPs) within Old Mutual Investment Group (Pty) Ltd Holdings, approved by the Registrar of Financial Services Providers ( to provide advisory and/or intermediary services in terms of the Financial Advisory and Intermediary Services Act 37 of 2002 (FAIS). These entities are wholly owned subsidiaries of Old Mutual Investment Group Holdings (Pty) Ltd and are members of the Old Mutual Investment Group. Old Mutual Investment Group (Pty) Ltd (Reg No 1993/003023/07), FSP No 604. Old Mutual Alternative Investments (Pty) Ltd (Reg No 2013/113833/07), FSP No Futuregrowth Asset Management (Pty) Ltd (Futuregrowth) (Reg No 1996/18222/07), FSP No 520. The investment policies are market linked. Products are either policy based or unitised in collective investment schemes. Investors rights and obligations are set out in the relevant contracts. Market fluctuations and changes in rates of exchange or taxation may have an effect on the value, price or income of investments. Since the performance of financial markets fluctuates, an investor may not get back the full amount invested. Past performance is not necessarily a guide to future investment performance. Unit trusts are generally medium- to long-term investments. Unit trusts can engage in borrowing and scrip lending. Fund valuations take place on a daily basis at approximately 15h00 on a forward pricing basis. The fund s TER reflects the percentage of the average Net Asset Value of the portfolio that was incurred as charges, levies and fees related to the management of the portfolio. A schedule of fees is available from Old Mutual Unit Trusts Ltd, an approved Collective Investment Scheme in Securities. For more information please refer to the Fund s Minimum Disclosure Document (MDD), Personal trading by staff is restricted to ensure that there is no conflict of interest. All directors and those staff who are likely to have access to price-sensitive and unpublished information in relation to the Old Mutual Group are further restricted in their dealings in Old Mutual shares. All employees of Old Mutual Investment Group are remunerated with salaries and standard short-term and long-term incentives. No commission or incentives are paid by Old Mutual Investment Group to any person. All inter-group transactions are done on an arm s length basis. In respect of pooled, life wrapped products, the underlying assets are owned by Old Mutual Life Assurance Company (South Africa) Limited, who may elect to exercise any votes on these underlying assets independently of Old Mutual Investment Group. In respect of these products, no fees or charges will be deducted if the policy is terminated within the first 30 days. Returns on these products depend on the performance of the underlying assets. Old Mutual Investment Group has comprehensive crime and professional indemnity insurance, as part of the Old Mutual Group cover. For more detail, as well as for information on how to contact us and on how to access information, please visit Old Mutual Investment Group (Pty) Limited. Physical address: Mutualpark, Smuts Drive, Pinelands Telephone number:

28 By investing in Profile Edge28, I am confident that both my clients and I will have a retirement we can look forward to. Peter Brooke Boutique Head MacroSolutions INVEST WHERE THE FUND MANAGERS INVEST FCB JB/E At Old Mutual Investment Group, our fund managers invest their own money alongside yours. The Old Mutual Profile Edge28 Fund aims to maximise the growth opportunity available in the retirement fund investment environment, delivering growth that s outperformed inflation by 10.3% a year over the last 20 years*. Speak to an Old Mutual financial adviser or your broker about investing alongside our fund managers or call 0860 INVEST (468378). *As at 31 uary Source: Old Mutual Investment Group (Pty) Ltd. Old Mutual Investment Group (Pty) Limited (Reg No 1993/003023/07) (FSP 604) and each of its separately incorporated boutiques (jointly referred to as Old Mutual Investment Group) are licensed financial services providers, approved by the Registrar of Financial Services Providers ( to provide advisory and/or intermediary services in terms of the Financial Advisory and Intermediary Services Act 37, Investment portfolios are market-linked. Pooled products are either policy based, via a linked policy of insurance issued by Old Mutual Life Assurance Company of South Africa Ltd, which is a registered Long-Term Insurer, or unitised in collective investment schemes. Investors rights and obligations are set out in the relevant investor agreements and/or mandates. Market fluctuations and changes in exchange rates as well as taxation may have an effect on the value, price or income of investments and capital contributions. Since financial markets fluctuate, an investor may not recover the full amount invested. Past performance is not necessarily a guide to future investment performance. Old Mutual Investment Group has comprehensive crime and professional indemnity insurance which is part of the Old Mutual group cover.