ALPHAWEALTH PRIME SMALL & MID CAP FUND COMMENTARY FEBRUARY 2018 1 March 2018 AlphaWealth (Pty) Ltd. Reg. No.: 2004/026495. An authorised financial services provider - FSP Licence No. 13808. www.alphawealth.co.za
ALPHAWEALTH PRIME SMALL & MID CAP FUND UPDATE. 2 I DO NOT KNOW I am regularly asked by investors and potential investors a number of simple questions. These questions are easy to ask but I believe the investment industry does not adequately answer them (and, in many instances, some mislead people as part of the sales process). If you will indulge me, let me try and answer the most common of these questions here: Question: What will the Rand exchange rate do (against the USD/EUR/GBP)? Answer: I do not know. Reasoning: Historically, the Rand follows inflation and interest rate differentials between economies. Full stop. Everything else is noise. Although the shorter-term currency movements can be wild, in the long-term, the Rand has historically depreciated against the US Dollar (USD), Great British Pound (GBP), and Euro (EUR) by 6.16% pa, 4.81% pa, and 4.20% pa respectively. I.e. On average, the Rand has depreciated by 5.1% pa against hard currencies (actually, closer to c.5.5% if you take some pre-euro data into account). Interestingly, over the same periods, the average of the South African interest rate and inflation rate differentials against these hard currencies has been 5.7% (closer to c.5.5%, depending on a number of variables). I.e. In the long-term, assuming more or less the same interest rate and inflation rate differentials between economies, you can reasonably assume that the Rand will depreciate against hard currencies. Figure 1: Rand versus Hard Currencies USD/ZAR - CAGR 6.16% pa Depreciation GBP/ZAR - CAGR 4.81% pa Depreciation EUR/ZAR - CAGR 4.20% pa Depreciation 18 16 14 12 10 8 6 4 2 0 71 76 81 86 91 96 01 06 11 16 25 20 15 10 5 0 71 76 81 86 91 96 01 06 11 16 20 18 16 14 12 10 8 6 4 2 0 99 01 03 05 07 09 11 13 15 17 Sources: Bloomberg, AlphaWealth workings In other words, I do not know what the Rand will do tomorrow or this year or over the next couple of years, but in the long-term, it will almost certainly depreciate against the hard currencies.
ALPHAWEALTH PRIME SMALL & MID CAP FUND UPDATE. 3 Question: What will the equity market(s) do? Answer: I do not know. Reasoning: Equity markets are volatile but their underlying tracks a combination of GDP growth and, at the very least, inflation. Why inflation? Well, inflation is the price of goods and services rising. Goods and services make the revenues of businesses and equities are investments in these businesses. Thus, equities, at worst, track inflation and this serves as a good foundation for holding equities. Then add some normal GDP growth, returns to scale and the equity risk premium and you get a fair equity-base longterm return from the stock market. Figure 2: FTSE/JSE All Share Index History 70 000 +11.55% per annum since 1995, excluding dividends 60 000 50 000 40 000 30 000 20 000 10 000-95 97 99 01 03 05 07 09 11 13 15 17 Sources: Bloomberg, AlphaWealth workings Over the long-term, the FTSE/JSE All Share Index (ALSI) has generated a +11.55% pa growth rate (excluding dividends). This return period includes periods of negative return and periods of large and lumpy returns (see my comments later in this note about markets not having linear return profiles). This also includes booms and busts, and rising and falling interest rates. This includes everything, even the Credit Crisis as a black swan event. Yet, our market has gone up. Hence, I do not know what our market is going to do, but I can reasonably assume that in the long-term it will rise along with all other global equity markets. Everything else is noise.
ALPHAWEALTH PRIME SMALL & MID CAP FUND UPDATE. 4 Question: What return will the AlphaWealth Prime Small & Mid (AWSM) Fund generate? Answer: I do not know. Reasoning: Given that the JSE All Share Index (ALSI) has generated a basic price return of +11.55% pa and that the small & mid cap indices have outperformed the Top 40 Index over this same time period, I would logically expect the AWSM Fund to outperform the All Share Index and Top 40 Index over an equally long time period. Figure 2: FTSE/JSE All Share Index History versus Small & Mid Cap Indices 1 400 1 200 1 000 800 600 400 200-02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 ALSI Mid Cap Small Cap Sources: Bloomberg, AlphaWealth workings In other words, over the long-term, I would expect the AWSM Fund to achieve alpha over the 11.55% pa + dividend return of the ALSI. Given the alpha of c.7% pa* that our small and mid cap market generates over the long-term, I would expect that the AWSM Fund would at least track this. But, assuming that our quality-focussed methodology and its execution at least invests in slightly better companies than the average, I would hope that we would outperform this small and mid cap market. Thus, in the long-term, I would logically expect the AWSM Fund to generate at least c.18% y/y (perhaps closer to c.20% y/y). Obviously I would prefer much (much!) more, but these are foundation numbers for a long-term time horizon (10+ years). The AWSM Fund return will be lumpy with periods of large underperformance and periods of large outperformance, but on average in the long-term, this reasoning should prove fair and, thus, I strongly believe that the AWSM Fund remains an attractive investment proposition. The above are a few regular questions people ask me. Academic and statistical knowledge with a touch of logical and a heap of assumptions can help anyone answer these questions, but the reality is that the future is unknown. Hence, the only honest answer to these questions is that I do not know and neither does anyone else. And, the only hedge against the truth of prophetic ignorance is a degree of diversification. Everything else is noise. * Small & mid cap alpha calculated as CAGR price return excess over ALSI by average of FTSE/JSE Small Cap and Mid Cap indices since beginning of 2002 (Bloomberg)
ALPHAWEALTH PRIME SMALL & MID CAP FUND UPDATE. 5 NON-LINEAR STOCK MARKET RETURNS As noted above, in the long-term, equity stock markets rise. Given the hugely positive developments in South Africa, our domestic equities have risen and I fully expect them to keep rising. But, stock markets do not just go up in a linear fashion. In fact, stock market returns are deeply non-linear in nature and quite lumpy in practice. Despite January 2018 being a positive month and our domestic market s momentum, liquidity and growth coming back, global equities suffered a large and violent correction. The gravity of global beta is too strong and sucked our markets down with them. Hence, we have reported a small negative return of -1.7% for February 2018, though our performance remains positive for the year (outperforming all of the ALSI, Top 40 and our benchmark over this period). As South Africa continues to de-risk and positive sentiment translates into increased economic activity, we remain perfectly positioned to capture this upside. Thus, we expect this positive year-to-date performance to continue. There have been no material changes to the portfolio over this month, though we did deploy some cash into existing position as the market correction offered a great buying opportunity. This should prove very profitable as the year progresses. CONCLUSION & THANKS In conclusion, we have had a good start to 2018 and we consider the AWSM Fund to be well positioned for the long-term. We are playing in the sweet spot in SA Inc where trough valuations are meetings trough profits at near all-time low growth rates and, so far, all indications are pointing to the fact that there is plenty of upside from here as our beautiful country improves. As a reminder, the AWSM Fund strategy remains the following: Quality: Above all else, we try to find good quality, highly profitable, fast-growing, listed small cap businesses. Value: We invest in the cheapest of these, though limit our investments to different industries and/or geographies to maximize diversification (i.e. hedge against an unknown future). Concentration: Finally, we limit the number of stocks we hold to only the very best fifteen to twenty positions. In this way, we like to think that AWSM Fund holds a diverse, relatively lower-risk collection of only-the-best small cap investments out there and that it holds these investments in sufficient quantity to be really meaningful to us as investors. The rest is patience as we allow time to compound our capital. As a co-investor into our Fund with the majority of my liquid net worth, I have absolute conviction in what we are doing and I am confident in our Fund s future. Kind regards Keith McLachlan, CA (SA) Fund Manager of the AlphaWealth Prime Small & Mid Cap Fund
ALPHAWEALTH PRIME SMALL & MID CAP FUND UPDATE. 6 Disclaimer: Collective Investment Schemes in Securities are generally medium to long-term investments. Different classes of units apply to these portfolios and are subject to different fees and charges. A schedule of fees and charges and maximum commissions is available on request from the Company. Commission and incentives may be paid and if so, would be included in the overall costs. The price of a participatory interest is a marked-to-market value. Forward pricing is used. The purpose of the money market yield is to indicate to investors a compounded annual return for all money market portfolios on a comparable basis. The yield calculation is not used for income distribution purposes. A forward looking yield is used. This means that the last seven days yield (less the service charges, including VAT) is taken and is annualised for the next 12 month period, assuming the income returns are reinvested. Yields for money market funds are published daily. The value of participatory interests may go down as well as up. Past performance is not necessarily an indication of future performance. Performance numbers and graphs are sourced from Global Independent Administrators (Pty) Ltd are calculated on a NAV to NAV basis and do not take initial fees into account. The Company does not provide any guarantee either with respect to the capital or the return of the portfolio s. Income is re-invested on the re-investment date. Actual investment performance will differ based on the initial fees applicable, the actual investment da te and the date of reinvestment of income. Dealing prices are calculated on a net asset value and auditor s fees, bank charges and trustee fees are levied against the portfolios. The total return to the investor is made up of interest received and any gain or loss made on any particular instrument. This will have the effect of increasing or decreasing the daily yield but in case of abnormal losses it can have the effect of reducing the capital value of the portfolio. Excessive withdrawals from the portfolio may place the portfolio under liquidity pressures where a process of ring-fencing of withdrawal instructions and managed pay-outs over time may be followed. CIS are traded at ruling prices and can engage in borrowing and scrip lending. The manager may borrow up to 10% of the market value of the portfolio to bridge insufficient liquidity. Prime Collective Investment Schemes Management Company (RF) (Pty) Ltd is a registered Collective Investment Scheme Manager in terms of Section 5 of the Collective Investment Schemes Control Act and is a wholly owned subsidiary of Prime Financial Services (Pty) Ltd, a member of ASISA. 0105942100.