Update on a perennial favourite: The Allan Gray Equity Fund

FUND FOCUS

Delphine Govender 

Allan Gray Equity Fund
Price:	R213.82
Inception:	01 Oct 1998
Domestic Equity General
Fund Size:	R 29,088.5m
Price Performance
12 months:	14.58%
24 months:	36.39%
More Details...

The Allan Gray Equity Fund attracts a lot of attention, not merely because it dominates the leader board in terms of assets under management in the equity sector with just over R15 billion. Liz Still asked the questions and Duncan Artus, one of the joint fund managers of the fund answered.

Q: Just for the record, please could you explain your investment philosophy?

Duncan Artus: Allan Gray's investment philosophy involves estimating the intrinsic value of a business as distinct from its share price which can diverge, sometimes substantially so, from intrinsic value. We take a long term view when determining this intrinsic value as if we were a businessman who has to purchase 100% of the business and is unable to exit by selling shares on the stock exchange. We then assess the potential return available from the share should the share price revert to our estimate of intrinsic value over a four year period.

We then compare that to the returns available from other shares and asset classes.   We spend a lot of time on estimating the sustainable level of profitability on which to place an appropriate rating. Allan Gray's ownership structure, incentivisation policies and investment process are equally as important as the philosophy in allowing us to take a long term view when trying to create wealth for our clients.

Q: What is the cash position of the Allan Gray Fund at present? What is the range of the cash component the fund has had, say over the last five years?

Duncan Artus: If an investor is investing in the equity fund, we assume they want to be fully exposed to equities. Where investors want Allan Gray to make the asset allocation decision on their behalf, we have asset allocation funds such as the Balanced Fund available. Given the nature of the unit trust vehicle we sometimes hold a cash buffer to handle flows. The cash position has ranged between zero and 3% of fund and has averaged 0.7%.

Q: Please could you explain the rationale of investing in your top ten companies.

The top 10 holdings of the fund have been defensive for some time given our long held belief that earnings for the average company are at very high levels, particularly in the resource sector. When these earnings revert to normal (as it appears is currently happening) judging individual shares solely on their historic PE is fraught with danger without having done considerable work on the level of profitability. The top 10 holdings have thus been characterised by high quality, stable defensive businesses and businesses whose earnings we believe are below normal. During the course of the year the makeup of the top 10 would have been influenced by the unbundling of British American Tobacco (BAT) out of Remgro and Richemont.

The fund has been underweight banks and general retailers in particular (the fund has held consumer shares such as Shoprite, Sun International and Spar). The fund added to banks half way through 2008 but has significantly lightened the position after their relative out performance. We believe that retailers (and to some extent banks) profitability continues to be well above our estimate of more normal levels. This is not compensated for by their current PE multiples. We believe that on a 2 to 3 year view many of our larger holdings will be on lower PE multiples as earnings (particularly domestically focused) come under downward pressure.

Q: The price of gold shares has moved up nicely over the last few weeks, your portfolio with significant holdings in Anglo Gold and Harmony would have benefited from this. Nevertheless, is it not a concern that the PE of Harmony  is 56.2 (according to Profile Media), while the estimated reserve life of the mine (Bloomberg and JP Morgan) is 27 years?

It is correct that the fund's gold position has contributed significantly to our recent performance. We value gold shares based on our estimate of a normal Rand gold price (which we acknowledge has a significant impact on the resultant valuation) and on each company's particular reserve, production and capex profile. We believe that both Harmony and Anglogold are attractive taking into account the above variables.

South African gold shares have underperformed the Rand gold price due to poor cost control, the extent of which we underestimated. In a period where governments will have to issue sovereign debt and create money at unprecedented levels, we believe that gold and gold shares will be attractive in a number of the possible scenarios that could unfold.

Q: Some competitor fund managers have given up on Sappi, saying that while they agree the share price is down, this is for a good reason, management are destroying shareholder value. Does the company fit with Allan Gray's investment philosophy in that the recovery of the share is dependant on recovery of demand in paper, a factor which is outside their control?

Duncan Artus: Sappi has been a disappointing performer for the fund over the recent past. We continue to believe that Sappi is attractive. It is often the case that a great business is not necessarily a great investment as this is already discounted by the price. Sappi is not a great business. Its historic earnings track record clearly illustrates this.  We simply believe the current price is attractive relative to our estimate of what a sustainable level of earnings is.

This is likely to be brought about by a supply response by producers in Europe. In virtually all businesses demand is outside of the control of management as current events in developed economies amply demonstrate. We acknowledge that our investment thesis has yet to work out and indeed there is a chance it won't. We do however believe that the odds are on the buyer's side. That most people have given up on Sappi is hopefully a sign that the expectations discounted into the current price are very low.

Q: Your top five holdings have double-digit PEs. Is this classic Allan Gray investment philosophy? 

Duncan Artus: It is a fact that our top five holdings have double digit PE's. Allan Gray is not simply a low PE investor. Indeed some of our best investments have been shares that appeared to be on high historic PE's. As mentioned above, we concentrate on sustainable earnings when valuing a business. To these earnings we place an appropriate rating given our judgement of the quality of the business.

We believe that looking out a few years that many of our larger holdings will be on lower forward PE's (assuming flat share prices) as their earnings make greater progress.  Clearly it would be great to have the opportunity, such as in 2002 -2003, to buy low earnings on low PE multiples. Unfortunately, in our view, this is currently not the case.

Q: What are the reasons that the Richmont have fallen so badly? We would have expected the company to have had a higher dividend yield?

Remember that Richemont 's 12 month return should take into account that shareholders received BAT and Reinet shares as part of the wider Rembrandt  group's restructuring. Nonetheless, Richemont, which is now the standalone luxury business has seen its share price come under pressure recently.

Richemont's earnings are clearly going to face significant short term headwinds. Despite this decline we believe the rating to be attractive for a business of above average quality and a debt free balance sheet.

Q: Your December 31st Total Expense Ratio for the Allan Gray Equity Fund is given as 2.14%. 0.33% of this is a performance fee. Please could you explain how your performance fee is calculated.  

The performance fee range varies from a minimum of 0% to a maximum of 3% plus VAT. The minimum/maximum fee is based on 15% under/outperformance of the All Share Index over a rolling two-year period. If performance is equal to the benchmark, then the fee will be 1.5% plus VAT. In other words the fund would have to outperform the All Share Index by 15% over a two year period to be at 3%.