2019 outlook the high road or the low road? A message from the world s richest investor

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1 Newsletter end December 2018 Authorised Financial Services Provider FSCA Licence No January 2019 Contact us: Another flaw in the human character is that everybody wants to build and nobody wants to do maintenance. ~ Kurt Vonnegut Alan McConnochie Avoid the crowd. Do your own thinking independently. Be the chess player, not the chess piece. ~ Ralph Charell alan@rcinv.co.za Di Haiden di@rcinv.co.za Mike Gresty mike@rcinv.co.za Visit our website: for back copies of the newsletter, background information, etc. RCI BCI Flexible Fund closed December at c, down 1.2% for the month. The JSE Allshare index delivered a positive total return of 4.25% in the month. The performance of the SA market in December was supported by mining shares (particularly Gold and Platinum), which we tend to avoid for risk reasons. The fund s offshore exposure was also a drag on performance, with the MSCI World index down 7.6% for the month of December. RCI BCI Worldwide Flex closed December at c, down 2.8% for the month. This compares with a negative USD return from the MSCI World index of 7.6% for the month. The fund was helped by the fact that the rand weakened by 3.7% vs. the US dollar. In addition, the decision to lower the equity exposure in the fund in favour of cash provided some protection. Inside: 2019 outlook the high road or the low road? A message from the world s richest investor You are welcome to pass this newsletter on to friends who may wish to learn more about investment. To be added to our , contact alan@rcinv.co.za Is the Panic over? - an article by Alan McConnochie A very sad but beautiful poem from someone who has emigrated

2 Newsletter - end December 2018 Page outlook the high road or the low road? A sharp sell-off in December added to what had already been an incredibly challenging year for equity investors, particularly in Emerging Markets. The table below shows how broad-based this pain was, with none of the major equity markets around the world managing to deliver a positive return. Global equity returns (US$) The challenges were not restricted to equities either. I have reproduced a chart we showed in our December newsletter in which Deutsche Bank produced an interesting long-term view. It tracks the performance of 70 asset classes in which one could invest. The chart shows the proportion of those that have delivered negative returns. At 90%, this is the highest proportion since 1901!

3 Newsletter - end December 2018 Page 3 When one reflects on why 2018 was such a disappointing year from an investment perspective, taking the US market the chart below shows that the valuation, expressed as the price investors were paying as a multiple of expected earnings, at the start of 2018 was demanding relative to its history. Yes, it was more expensive back around 2000, but this was due to the bubble that developed in technology shares at the time, when investors drove technology shares with non-existent earnings to stratospheric levels it ended badly. Source: JP Morgan While there was unease about equity market valuations at the start of 2018, there was general optimism about global prospects for the year ahead with the strongest growth since the global financial crisis. If one starts from the point that Mr. Market efficiently prices in expectations, in the short-term, it s how subsequent events unfold relative to that expectation that drives the market in the short term. Without being too scientific about it, the problem with 2018 was that virtually every subsequent market-moving event was negative relative to the pretty rosy outlook with which we started the year. Well, enough navel-gazing about 2018, what do we think about 2019? The binary implications of the tariff war between the US and China While the future is by its very nature uncertain, we think the era of Donald Trump, protectionism and populism in which we currently live feels like it is making the world much harder to predict. One particularly significant development the outcome of which we think is likely to have a binary impact on how markets perform this year is the tariff war between the US and China. What will be the outcome at the end of the 90-day truce that was agreed between the two leaders when they met in Argentina in late November? The market has warmly received comments from both sides that suggest progress in recent negotiations has been positive. However, we note the Financial Times, in its predictions for 2019 took a rather more pessimistic view: the US administration s criticisms of what it sees as China s habitual trade-distorting actions are deeper-seated than trade disputes with other countries, which were resolved. The US s demand that, to avoid more tariffs, China must begin dismantling its entire state-interventionist development model is not something it expects China to agree to. Its panel of forecasters therefore expects the US to resume increasing tariffs on imports from China post the 90-day ceasefire hardly a positive scenario for investors.

4 Newsletter - end December 2018 Page 4 On the other hand, potential economic fallout and financial market volatility from an escalating trade war would not be in the interests of either side. As the Trump administration enters the second half of this presidential term, attention starts to shift to the race for a second term, while for China, a deceleration in growth may expose vulnerabilities. Does this lead to concessions on both sides and a de-escalation in tensions? Removal of this risk could well provide the catalyst for a strong recovery in investment markets, particularly in Emerging Markets, which have so far suffered the most since trade tensions escalated. International equity markets After a year of negative returns, accompanied by positive earnings growth, markets are dramatically cheaper than they were this time last year. With valuation considered from the perspective of current price as a multiple of expected earnings in 12 months time, as the next chart shows, this has fallen sharply for both Developed Markets and Emerging Markets. The other point to note from this chart is how the valuation gap has opened between Developed Markets and Emerging Markets. Although Emerging Markets came in for a particularly punishing time in 2018 (see how many EM countries there are in the ranking of returns shown earlier), EM has in fact been out of favour for a number of years. Valuation: Forward P/E of EM and DM equities Source: Bloomberg

5 Newsletter - end December 2018 Page 5 The various equity valuation charts we have shown US market, DM and EM all present a similar story. They show that equities are pricing in a considerably more sombre economic outlook at this point. The sell-off late in the year occurred despite relatively strong economic data being reported, with investors focussed instead on risks of a sharper slowdown ahead. Current expectations for both corporate earnings growth (+7-8% for US companies) in 2019 and slower but still supportive global growth (3.7% according to the IMF) suggest to us that the market is currently pricing in a more pessimistic expectation. The concern at this point is that we do not think the failure of the US and China to reach an agreement that deescalates the trade war is currently the base case for most economic and company earnings forecasts. Thus, you might conclude that Mr. Market is further down the road to pricing in the Financial Times scenario than professional forecasters are right now. With markets no longer priced to perfection and sentiment already at a low ebb, risks out there are better priced in than they were. The charts below show what returns have been achieved from US equities from different valuation levels at the start. They reveal that the market adage of buy low, sell high has proved pretty reliable over time. Based on past market performance, the prospects of positive returns from this valuation level are good and become increasingly so with time. In fact, the chart on the right shows that, had one invested in the US market historically at its current valuation level of 14.4x expected earnings, there has only been one subsequent 5-year period in which the annual return turned out to be negative. Source: JP Morgan In summary then, valuations are looking a lot more attractive than they were and this is particularly so when one drills down to an individual company level. We continue to think, after a torrid few years, there are interesting opportunities in Emerging Markets. However, we think that, until there is clarity on the US/China trade dispute negotiations, it is sensible to avoid adding to stocks that are particularly sensitive to this outcome. Rather, we are selectively adding to high quality companies that have sold off in this broad-based correction but are set to benefit from secular themes over many years to come, e.g. Reckitt Benckiser. South African equities The table below shows the historic rand returns from various asset classes up to the end of One now has to go back 10 years to see any meaningful outperformance from equities. When one considers that Naspers, which today accounts for >20% of the Allshare index, and, despite a challenging 2018, has still delivered a compound annual return of 33% over the last 5 years, the performance of the balance of the SA market makes grim reading. The strategy of living in the sun but investing in the shade has proved to be the correct one.

6 Newsletter - end December 2018 Page 6 Compound annual return from various South African asset classes (Dec 2018) Economic Group 1 year 2 years 3 years 5 years 10 years All Share Index -8.5% 5.3% 4.4% 5.9% 12.7% Resources 17.9% 16.7% 22.3% 4.7% 6.3% Financials -17.7% 4.9% 5.1% 9.0% 15.0% Industrials -4.1% 0.6% -1.7% 5.1% 16.0% Listed Property -25.2% -6.4% -1.2% 5.6% 11.9% Bonds 7.7% 8.9% 11.1% 7.7% 7.7% Cash 7.3% 7.4% 7.4% 6.9% 6.7% Headline CPI (inflation) 5.2% 4.7% 5.4% 5.3% 5.4% Source: Bloomberg Forward P/E of the JSE Allshare Index Source: Bloomberg From a valuation perspective, the position for the SA market is very similar to that offshore. At the beginning of 2018, the South African market was trading at a multiple of 17x expected earnings. Thanks to the combination of earnings growth in and the negative performance, this has declined to 12.9x by year end. With reference to the chart above, this is the cheapest it has been in the last 7 years. While local investors are no doubt disillusioned after such underwhelming returns from equities over the last 5 years the SA equity market now owes investors some returns and, with valuations at more attractive levels, if the stars are aligned 2019 could be the year for payback. SA would be a beneficiary of any renewed investor interest in Emerging Markets generally, depending on the outcome of the elections and the urgency with which the country s new leadership begins to tackle the long list of challenges SA faces. These include (1) reform the leadership of state-owned institutions; (2) weeding out under-performers in cabinet; and (3) prosecution of those implicated in the enquiry into state capture historically

7 Newsletter - end December 2018 Page 7 If SA is proactive in addressing these issues, it could well appear an interesting self-help opportunity in the eyes of international investors. There is a large dispersion of possible outcomes depending on how the various geopolitical scenarios both locally and internationally unfold. However, a market-friendly outcome to the US/China trade negotiations and elections in SA could well see the SA market deliver returns in excess of 25% this year. The Rand As we have highlighted previously, the rand has historically proved to be among the most volatile currencies in the world. Unlike many other Emerging Market currencies, it is not pegged to one of the major developed market currencies and is relatively liquid. It has, in a sense, been a proxy of global risk sentiment, which has amplified the range within which it moves. As the chart below shows, although the long term weakening trend for the rand has been clear, it has diverged widely and for extended periods from our fundamental view of fair value. This model would put fair value for the rand at around ZAR/USD13.50 by the end of It therefore appears slightly on the cheap side at the moment. As a barometer of risk sentiment, where it moves in the short-term will likely be dictated by how closely events track the high road or low road scenarios: Source: Anchor Source: Anchor

8 Newsletter - end December 2018 Page 8 High road there is an agreement reached between China and the US that leads to a de-escalation in trade tensions, causing in turn renewed investor interest in Emerging Markets; some USD weakness as the slowing pace of growth reduces expectations for further US interest rates; a second referendum on Brexit sees the UK reverse course; an orderly election process in SA, followed by evidence that the new leadership is prepared to act on the popular mandate it has been given and implement much-needed reform. This risk on confluence of factors could well push the rand into firmer levels, as we saw in early Low road the Financial Times scenario plays out insofar as the US/China trade war is concerned; a disorderly no deal Brexit; an unexpected SA election outcome (an inconclusive ANC victory in which back-room dealing among powerful provincial leadership does not see Cyril Ramaphosa chosen as its candidate for President?). This singularly risk off confluence of factors would likely see the rand under pressure from here. In conclusion then, with markets no longer priced to perfection and sentiment already at a low ebb, risks out there are better priced in than they were. It would be unusual indeed if global events in 2019 turn out to be as singularly negative for markets as they were last year. This suggests good prospects for very respectable investment returns in the coming year. Whether these are realised, however, depends on how closely we track the high road scenario. We think the US/China trade negotiations will prove decisive in this regard. Until there is clarity on this, caution is warranted. A message from Warren Buffett- the world s richest investor During the Christmas break I (Alan) re-read the annual reports of Warren Buffet s Berkshire Hathaway company. He strongly suggests that investors should not sell their shares after a large fall in the stock market. This is nearly always a mistake. Buffet s timeless wisdom is normally worth following. Is the Panic over? By Alan McConnochie The following graph shows that the oversold indicator (the top chart) is at the -10% level which is the best buying chance since the 2008 crash. So, the question is: will the US economy tank, as it did in 2008, or will the indicators that show growth will prevail, persist? We favour the latter view but we must admit, the US economy continues to weaken. This is what makes markets interesting the fact that at turning points there are always two views absolute gloom or the seeds of renewal. Sure, there is a possibility that the market will fall further but the probability is that, unless the economy weakens substantially, we should be close to bottom. Buying at this point represents very little further risk. Of course, it may fall another 10% but with it having risen 2.5% in the past two weeks, we have likely seen the bottom now that the weird prices that prevail over the Christmas season are out of the way.

9 Newsletter - end December 2018 Page 9 We always find it constructive to examine the opposite view (i.e. what if we are wrong?). How much downside might there still be if the market collapses as in 2008 or 1929? If this unlikely scenario occurs (it should only happen about once in every 80 years, and as it happened just 10 years ago it is unlikely to recur in the short term), what does history tell us about how much deeper the correction might be? The following table reflects the current drop in the American S&P 500 index. The current fall is 14% percent. (It has improved from the 24 December by 2.7% from its bottom). We compare this to the three previous crashes and find that it is nothing out of the ordinary. Currently, the market is down 20% in dollars from its September peak (having risen 2.7% from 24 December 2018). Owing to the depreciation in the rand, the fall in rand is slightly less at 18%. In contrast, in 2008 it fell 52% in dollars and 33% in rand, whereas in 2000 it fell 47% (20% in rand) and in 1987 it dropped 30% in dollars (our graph does not go back far enough to show the fall in rand). All that counts in investment is how much will it have risen in three years time? The last three times, it rose 89%, 49% and 53%. respectively That excludes dividends. Similar returns at the beginning of 2021 should be more than satisfactory.

10 Newsletter - end December 2018 Page 10 A very sad but beautiful poem from someone who has emigrated I wanted to grow old in Africa With the sun warming my decrepit bones And my great grandchildren running through my grapevine The heat of the sun turning their skins bronze While they played in the sprinkler like I had done many summers ago Sweet potatoes dug up for a tea Mangoes and pawpaws ripening in the sun Cicadas in the trees Nyama in the pot Sitting on the veranda watching dusk creep up on me Cloaked in that velvet warm darkness. Respected for my wisdom Revered for my vision and experience And my son would offer me his arm and my daughter would come for advice And I would smile and tell them how it was when I was young And as the embers burn low In the grate of life I would willingly walk to the end of the path Look over the gate to the other side And know when I am gone My heart will be buried in the soil Deep in the land where I was born And I would be content to be married to elements that bring new life to the grass And when the wind blows among the kopjes my spirit will wander there once more. If we end where we begin Why am I so far away, trapped between two hemispheres as I walk and wander and toil away my years? The dark days are upon us again in the north Bringing with them who knows what Soon the cold will descend and my eyes will grow heavy from the strain of the gloom I will shiver and curse the grey in the sky As my neighbours shut their doors against it I will dream of the burning sun and remember the halcyon days of my youth Where the endless sky stretched forever It was my blue print for life My beginning, everything I knew. Sentimental am I Nostalgic for times passed And a land that exists no more It is true. For those cynics who call me foolish I tell you this You will only miss something once you no longer have it and no one can understand that pain in your heart, That longing, until they know what it means to be displaced So please leave me to my dreams To my memories But most of all to my wish. Yes, I wanted to grow old in Africa, but life had other horizons for me to pursue. Other things for me to do. Poem By Cyndi Barker

11 Newsletter - end December 2018 Page 11 RCI Unit Trusts Please contact Maggie on for any help on your unit trusts. RCI BCI Flexible Fund closed December at c, down 1.2% for the month. The JSE Allshare index delivered a positive total return of 4.25% in the month. The performance of the SA market in December was supported by mining shares (particularly Gold and Platinum), achieving a total return of 12.7% in the month. Owing to their risk, we do not investing much in mining shares. December was a particularly tough month for international equity markets, with the MSCI World index down 7.6% for the month. Although the international diversification has proved a successful strategy over time, this was not the case in December - with 32% of the fund invested offshore, this was also a drag on performance in the month. RCI BCI Worldwide Flex closed December at c, down 2.8% for the month. This compares with a negative USD return from the MSCI World index of 7.6% for the month. The fund was helped by the fact that the rand weakened by 3.7% vs. the US dollar. In addition, the decision to lower the equity exposure in the fund in favour of cash provided some protection. Finally, the decision to selectively increase stakes in EM equities provided support, with December being the second month in which Emerging Market outperformed Developed Market equities.

12 Newsletter - end December 2018 Page 12 Unit trust has flexibility happy to take small amounts The unit trust has the flexibility to buy and sell shares and to change weightings more frequently than in an individual portfolio. We are happy to take small amounts into the unit trust (from R1 000 per month or lump sums of R25 000). As you will not pay commission to any agents there is no cost to get in and out of our fund. On selling, the amount you receive back will depend on our performance. Collective Investment Schemes in Securities (Unit Trusts) are generally medium to long term investments. The value of participatory interests (units) may go down as well as up and past performance is not necessarily a guide to the future. Unit trusts are traded at ruling prices and can engage in borrowing and scrip lending. A schedule of fees and charges and maximum commissions is available on request from the company/scheme. Commission and incentives may be paid and if so, would be included in the overall costs. The portfolio is registered under the license of Boutique Collective Investments, a member of the Association for Savings & Investment SA. Forward pricing is used. More details are contained in a fact sheet that is available on request. To conclude So much for the Santa Claus rally investors might have hoped for after a few difficult months! For US investors at least, December served up the worst December return in any year since the Great Depression. That one may be feeling a sense of disillusionment at this stage is entirely understandable. However, as Alan has stressed in his recent articles, with the passage of time, these dips, emotionally jarring as they are in the moment, are barely discernible on the chart. Two final quotes to end off with from Mr. Buffett:

13 Newsletter - end December 2018 Page 13 Price is what you pay. Value is what you get. considerably better value has returned to equity markets. Of course, events in the short term could cause markets to fall further. But from current valuation levels, on a 3-5 year horizon, the probability that equities will not deliver a respectable inflation-beating return is very low. Forecasts may tell you a great deal about the forecaster, they tell you nothing about the future. It is just possible that the recent volatility in financial markets has been a timely reminder to the White House that markets hate uncertainty. The dispersion of possible outcomes for financial markets that stems from the outcome of US/China trade negotiations appears wide. That valuation and sentiment are at a much lower ebb than at the start of last year is a good place to start, but clarity in this issue could well dictate what sort of investment year 2019 turns out to be. Our aim remains to buy shares that we think can deliver a total return (capital growth plus dividends) of at least 15% (in rands) over the next 3 to 5 years. Pleasingly, better value means the universe of quality companies that could achieve this has improved. For now though, we are proceeding cautiously until the direction of US/China trade negotiations becomes clearer. We hope to be the best family office in the country! Best regards Di, Alan and Mike