A peek inside Allan Gray's sin bin with Duncan Artus

At a presentation this week, Allan Gray fund manager Duncan Artus spoke about the underlying holdings of the Allan Gray Equity Fund. Sin bin stocks SAB Miller and British American Tobacco rank first and third. But as usual, what the fund did not invest in is more telling than what it did invest in.

The Allan Gray Equity Fund is the largest general equity fund as measured by assets under management, as of September 30^th 2008, the fund was valued at just short of R15 billion.  

The Equity Fund weathered the financial turbulence better than most of its peer group in the general equity sector. The performance of the fund which had been lagging measured over 12 and 24 month periods, has recently leapfrogged in rankings. While the 12 month rolling performance, like all the other general equity funds is very much in negative territory at -19.10 (Nov 04^th), the ranking has improved to 3^rd out of 64 general equity funds.  

So how did the fund manage to steal a march on competitors?  According to Artus the main contributing factor was that the fund was underinvested in commodities, which Allan Gray fund managers considered to be over priced in the January to June period this year.

The other noteworthy 'gap' in the Allan Gray Equity Fund holdings were construction companies, particularly some of the newly listed companies. This was a curious omission, given that some competitor fund managers have banked on the ongoing construction boom due to predictable government spend. Moreover, more recently, some of the construction companies are reporting full order books.

But Artus is skeptical, pointing out that full order books are just that. 'Order books are as good as the paper they are written on, in the current environment, banks are becoming more conservative, maybe the price of money goes up, maybe the decision to build is reversed.,' he said.  He showed a graph showing cement sales between 1960 and the present, mapped alongside the real earnings per share of PPC cement. The graph shows the massive increase in cement demand from about 2001/2, which then falls off at the beginning of 2007. He says that some of the 'Second tier' construction companies that listed between Jan 07 and July 08 have reported 40 or 50% drops in expected earnings.

So now that resource stocks have fallen so dramatically, is he tempted to start buying?

'Not yet,' he says. He thinks that the while shares like BHP Billiton are approaching fair value range, there may well be further down side due to disappointing earnings. He lays a lot of store by historic records which indicate trends in sustainable levels of earnings. These charts clearly show that earnings peaked as measured against historic norms between June 2007 /08 and are still due to come down to historic trend lines.

At the end of June 2008, the fund's top ten holdings included SAB Miller, MTN Group, Remgro, Richemont Securities, Sasol, Anglogold Ashanti, Harmony , Sanlam and Sappi.

The current top ten stands at SAB Miller, MTN, British American Tobacco, Anglogold Ashanti, Sasol, Sanlam, Harmony, Standard Bank, Remgro and Richemont.

Artus said that Allan Gray had deliberately sought to invest in 'non-commodity hedge companies' that earned significant portions of their earnings outside of South Africa. He said that SAB Miller had served the fund well in that the price had fallen, but much less than the top holdings of competitors. SAB Miller will remain the top holding for the moment 'because it is a well run company, good and reliable earnings, a good defensive stock. People always drink beer,' he said.

He explained that the unbundling of Richmont gave the fund exposure to British American Tobacco, which he rates highly as a defensive stock: a good cash generator, high barriers to entry with good management.

With respect to his investments in luxury goods company Richemont, he conceded that earnings would probably fall due to the global economic downturn. But he countered this with the fact that statistics indicated that the percentage of income accruing to the top 0.1% of earners around the world was increasing dramatically, particularly in the United States. He said that a luxury goods business was difficult to create overnight, top brands such as watchmaker Vacheron Constantin were launched in 1755, Cartier was launched in 1847, Alfred Dunill was launched in 1893.

He described exposure to the luxury goods businesses by way of investing in Richemont as a 'poor man's hedge', a way of making money out the rich.

Commenting on the fund's exposure to Anglogold and Harmony he conceded that Allan Gray 'have yet to be proven right on gold shares' but pointed out that gold shares had lost less in value relative both to other commodity shares as well as to some industrial stocks.

He warned that the next few years equity markets were likely to move sideways and that it would be a stock picker's market.