The SA equity market returned 12% in 2019, after being saved at the death by December’s 3.3% return. Still, this pales in comparison to the 28% return generated by the MSCI world index last year.

Disappointingly, the Allan Gray funds — including Orbis — didn’t take full advantage of strong offshore equity markets. Looking at the Balanced Fund, which returned 6.7% for the year, the underperformance came in two areas.

First, the fund’s domestic shares returned only 5.7%, underperforming the JSE all share index (Alsi) by 6.3%. Second, the offshore assets returned 8% compared to their benchmark’s 16% return. (The benchmark used is 60% of the FTSE world index, and 40% of the JPMorgan GBI global index.)

Looking only at the equity holdings, the four largest absolute detractors were Sasol, KAP Industrial, Glencore and Sappi.

We also missed out by not owning Anglo American, AngloGold Ashanti and Anglo American Platinum, and by having only a small holding in BHP.

Last year was unusual in that the large companies did particularly well while the remainder disappointed.

The four largest shares in the Alsi (Naspers, Richemont, Anglo American and BHP), which account for 40% of the market, returned on average 22%, while the remaining 154 stocks returned just 5.6%.

We own Naspers, but our caution on the super-profits from iron ore meant we avoided Anglo American and BHP and preferred Glencore, which underperformed BHP by 35% in 2019.

Avoiding losses is a key part of the Allan Gray philosophy, so we feel the detractors acutely.

We were keen Sasol sellers in the latter half of 2018 and the first half of 2019 when the share was above R400, but we had sold only 38% of our holding before the news emerged of additional cost overruns and delays at its Lake Charles project.

These delays, together with lower chemical prices, caused the share to fall to R300 by year-end from R425 in January 2019, even as the rand oil price rose 19% over the period. But at R300 we see good value in Sasol and have bought some shares below R270.

Despite recent underperformance, Allan Gray’s investment philosophy is unchanged

Based on our estimates of normal earnings, we also believe Sappi, Glencore and KAP present good investment opportunities.

Given the weak economy and sentiment towards SA, it was no surprise that the worst performers last year were domestically orientated companies. The general retailers index fell 18% while the financials index returned just 0.6%. But we are beginning to see value emerge in many of these companies, which bodes well for future returns.

Looking globally, all of last year’s 28% return from world markets was a result of a rerating, rather than earnings growth. The p:e multiple on the MSCI world index increased from 15.7 in January to 20.6 in December; this rerating is not sustainable.

It means that global asset valuations — both equity and fixed interest — look less appealing than those of SA assets.

While money market funds have done well in recent years, prospects for the next five years have swung in favour of equities. Three-month interest rates are now 6.5%, compared to the 7% dividend yield on Nedbank shares. Only once since 1988 — in 2003 — has Nedbank’s dividend yield exceeded the rate available on three-month deposits. Yes, the outlook for banking earnings growth is poor, and Nedbank will have more volatile returns, but the balance of probabilities surely favours an investment in Nedbank over a money market deposit for the next five years.

Despite this, we still have a 30% exposure to international assets through the Orbis funds, which we believe is essential for diversification.

Naturally the future can take many paths, some of which are extreme, and despite local assets being cheap, a 70% exposure in our asset allocation funds is a large position.

Furthermore, Orbis has taken care to seek out undervalued assets, so in buying Orbis funds we are not just buying large-capitalisation American US shares which dominate the international benchmarks. When it comes to the rand, after treading water for the past four years, we think that at R14/US$ by the end of 2019, the rand was slightly overvalued. A few of the drivers behind the stable local currency include global investors investing in our fixed-interest market, the recent surge in precious metal prices and the weak economy suppressing demand for imported goods.

Despite recent underperformance, Allan Gray’s investment philosophy is unchanged. Our founder, Allan Gray, who sadly died in November, developed our investment philosophy when the firm was founded in 1973 and it remains in place today: to seek out and invest in undervalued assets.

There have been periods when this philosophy has led to underperformance but, importantly, we stuck to it and our investments came through.

We think we are in a similar position today. We have underperformed over the past 18 months, but we believe we own undervalued assets and are excited about their prospects and future returns.

Lapping is chief investment officer at Allan Gray