Fund Commentary

Quarterly Fund review – September 2022

In this extract from our September 2022 Quarterly Commentary, Julian Morrison, CFA, our Investment Specialist, reviews the performance of the Allan Gray Australia Funds. Click here to read the full Quarterly Commentary.

Allan Gray Australia Equity Fund

The Australian sharemarket rose slightly during the September quarter, with the S&P/ASX 300 Accumulation Index up 0.5%. Strong gains earlier in the quarter were largely offset by a weaker September. The Allan Gray Australia Equity Fund Class A was down 1.6% this quarter, underperforming the benchmark.

The last month in particular saw a return to the caution and risk aversion shown earlier in the year. Looking back over 12 months, the Fund has meaningfully outperformed the benchmark over the last year in the face of overall market weakness and despite a weaker recent quarter. This is shown in Graph 1.

This provides a reminder of the difference in positioning of the Fund versus the benchmark. Today, we believe extreme difference in valuations remain across the sharemarket. Our approach is to position the Fund in our assessment of the most undervalued stocks versus long-term value. We believe this not only maximises the opportunity for long-term outperformance, but can also help mitigate the risk of permanent loss of capital, which stems from overpaying.

During the quarter, our positioning in the Materials sector was the largest detractor from relative performance, with Newcrest Mining the leading negative contributor, followed by Alumina. Both companies have competitive advantages in terms of long reserve life, and lower cost of production relative to competitors. Alumina faces some negative market sentiment with regard to surplus industry production currently, but their competitors have much higher cost of production and so face significant short-term losses, while Alumina is better placed in this regard. Rational curtailment of production by competitors would seem a likely outcome, and in due course Alumina could be a beneficiary of this. Alumina and Newcrest both have depressed share prices that are far below our assessment of fair value and we have added to both on weakness during the last quarter.

Overall exposure to the Financials sector also detracted from performance slightly during the quarter, with QBE and Virgin Money amongst the largest detractors. We added to these positions on weakness. Virgin Money faces some challenges – hence the depressed share price. But with the price reflecting around 0.5 times net tangible asset (NTA) value, the company is at a very material discount to other banks and factors in a significant margin of safety. By comparison, CBA and NAB trade on a price-to-NTA multiple of around 2 and 1.7 times respectively. We do not own either of these, having sold our last exposure to NAB entirely during the quarter. Elsewhere in financials, AMP bucked the trend and contributed very strongly to outperformance. We also had positive contribution from exposures to ANZ and Westpac.

Graph 1 | Equity Fund performance versus benchmark

Source: Allan Gray, Bloomberg, 30 September 2022.

In other areas, strong performance contribution also came from within the Real Estate sector, with property developer and landbank owner Peet Limited notably outperforming the market. We still view this company as underappreciated and retain our position there.

Officially categorised within the Healthcare sector, industrial and medical glove manufacturer Ansell Limited also contributed strongly to performance for the quarter. We have maintained our position in Ansell given attractive fundamental valuation and the stock remains within the Fund’s top ten holdings as at quarter end.

Lastly, our holdings in the Energy sector were mixed during the quarter, but overall contributed positively to relative performance. We have continued to trim these exposures at times of strength, re-allocating to some of the other ideas. Nevertheless, some of these companies remain significantly below fair value and so we remain overweight the sector and, in particular, Woodside Energy Group remains one of the largest holdings in the Fund.

We continue to observe market dislocation and will invest your Fund’s assets where we see the best long-term value. At this juncture in the cycle, as much as ever, the aim is to avoid investing in companies we see as overvalued and at risk of destroying capital. The gap between these categories remains large in our view and continues to present a great opportunity for long-term outperformance.

Allan Gray Australia Balanced Fund

The Allan Gray Australia Balanced Fund returned -1.5% for the quarter, underperforming its composite Benchmark which was flat for the quarter.

Share selection in global shares contributed positively to relative performance for the quarter, offsetting a roughly equal detraction from exposures to Australian shares. As at quarter end, the Fund remained overweight global shares and underweight Australian shares.

The Fund had about 66% in shares at quarter end. This is after accounting for about 8% of the global share exposure being reduced through the use of exchange-traded derivatives, which allows for some protection in those periods where market indices fall. This added positively to returns during the period, as global equity indices were overall weaker for the quarter.

At the end of the quarter, the Fund also held around 21% in fixed income securities and a 5% exposure to gold through an exchange-traded fund. The duration of the fixed income allocation has been allowed to rise slightly as interest rates have risen. However, duration remains significantly shorter in duration than the benchmark – at around three years versus seven years for the benchmark.

This means that the fixed income portion of the Fund remains more defensively positioned than the benchmark (in terms of both relative and absolute returns), in the event that interest rates rise. Longer-term interest rates did indeed rise further during the last quarter – more so in US government bonds than in Australian. Therefore, this positioning again contributed positively to relative performance of the fixed income component.

Currency exposure detracted from the Fund for the quarter, given our underweight exposure to the US during a period where most major currencies fell versus the US dollar.

As with the Equity Fund, we believe potential portfolio value relative to the market is significant and we continue to manage for risk with a long-term, valuation-driven perspective.

Allan Gray Australia Stable Fund

The Allan Gray Australia Stable Fund returned -0.5% for the quarter, underperforming its Reserve Bank of Australia cash rate benchmark, which returned 0.4% for the quarter.

The Fund has been reducing equity exposure for some time now and continued to do so during the last quarter. This has held the Fund in good stead during recent volatility. Nevertheless, the pronounced weakness of equities contributed to underperformance in the most recent quarter. We continue to manage exposures to what we believe is a prudent level and to hold allocations to what we see as the most attractively valued shares identified by our research.

In terms of assessing the Fund’s potential upside versus downside outcomes, there are various ways to do this. One simple method is to compare how the Fund has performed in rising sharemarkets versus falling markets. Since inception of the Stable Fund over 11 years ago, the S&P/ASX 300 Index has risen in 89 of 135 months, falling in the other 46 months. During the ‘up’ months, the broad sharemarket achieved average returns of 2.9%, while the Allan Gray Australia Stable Fund averaged 0.9%. On the other hand, during the ‘down’ months, the broad sharemarket averaged -3.5%. Meanwhile during those same down months, the Fund averaged -0.5%.

This means the Stable Fund has, since inception, participated in 33% of the sharemarket upside, with only 13% of the downside – as shown in Graph 2. We believe this asymmetric payoff is in keeping with our fundamental, contrarian approach and may be of significant benefit to investors seeking to outperform cash using an investment allocation of more moderate risk and return.

Graph 2 | Average return of the Stable Fund and the Index in up and down months

Source: Allan Gray, Bloomberg, 30 September 2022.

As at the end of September, the Fund had 25.8% invested in ASX-listed securities (of which around 24.8% was equities and about 1% selected hybrid securities). The remaining 74.2% is held in cash and money market investments. This can be seen in Graph 3, which shows our allocation between cash and ASX-listed securities over time.

The Stable Fund aims to add value from both our disciplined stock selection and from the decision on how much to allocate to ASX-listed securities versus cash. This provides the Fund with great flexibility to manage risk throughout the market cycle while still seeking to add long-term returns above cash. We believe the current environment provides the opportunity for this Fund to demonstrate its intended benefits. It offers a moderate risk/return profile, with the potential to outperform cash over the long term, while having the advantage of simplicity and ease of understanding.