Quarterly Fund review – December 2022

In this extract from our March 2023 Quarterly Commentary, Julian Morrison, CFA, 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 share market rose during the March quarter, albeit with some fluctuation, with the S&P/ASX 300 Accumulation Index finishing up 3.3%. Strong gains in January gave way to a weaker finish, as the index fell in both February and March. The Allan Gray Australia Equity Fund (Class A) was up 2.0% this quarter, underperforming the benchmark. It is worth noting that most of the underperformance came in the rising market of January. The Fund actually outperformed the benchmark from the end of January to the end of March, as shown in Graph 1.

Financials stocks were overall neutral for relative returns for the Fund for the quarter. Financials was the market’s weakest performing sector, so the Fund’s underweight position was beneficial. Looking at individual stocks, Virgin Money UK was the largest detractor for the Fund for the quarter. This came during a period of negative news and sentiment toward specific overseas financial companies.

Virgin Money trades at around 33% of net tangible assets, despite making high single digit returns on tangible equity. It is also well-capitalised. We believe Virgin is priced more moderately compared to other Australian-listed banks. We maintain the position and added to it on recent weakness.

Other Financials holdings include AMP, Westpac and ANZ, which were detractors for the quarter, and QBE which was a strong positive contributor for the quarter. The Fund added a new insurance company holding during the quarter in Insurance Australia Group (IAG). Potential risks for IAG include reliance on reinsurers, possible claims growth and cyclicality of commercial business. We believe the price reflects investor uncertainty, allowing investment at a reasonable valuation.

Lastly in Financials, Challenger was a detractor for the quarter. However, it has been a strong positive contributor to relative performance over the last one, three and five years, and as such we had significantly reduced the position on share price strength over that time, in late-2022 and early-2023. Consequently, the residual position is a relatively smaller weight in the Fund today.

GRAPH 1 | Equity Fund performance versus S&P/ASX 300 Accumulation Index benchmark

Source: Allan Gray, Bloomberg, 31 March 2023.

The Fund’s exposures in the Materials sector included both the second largest individual detractor for the quarter (Alumina) and the two largest positive contributors (Newcrest Mining and Sims). Notwithstanding some underperformance, the position in Alumina remains around 8% of the Fund which we believe is appropriate. The outperformance from Newcrest and Sims was quite significant and we have sold some of those holdings into that strength, though both remain substantial positions in the Fund. Also within Materials, Nufarm, Incitec Pivot and Fletcher Building all underperformed and we added to those positions on weakness (for a detailed recap on Fletcher Building, please see our September 2022 Quarterly Commentary). Taking all of these into account, our Materials positions contributed positively to relative performance for the quarter.

During the quarter the Fund added further to Ansell, which manufactures medical- and industrial-use gloves. While the stock underperformed during the quarter, our investment thesis remained largely unchanged, so the weaker share price presented an opportunity to increase this holding.

Other positions increased this quarter included Lendlease and Downer EDI. Lendlease is a globally integrated real estate business, while Downer builds, operates and maintains infrastructure and industrial assets in Australia and New Zealand. A summary of our investment thesis for Downer EDI is provided in the earlier section of this Q1 2023 Quarterly Commentary.

While it feels like the market has become more cautious in general recently, the broad share market (S&P/ASX 300 Price Index) is only around 6% below its all-time high. Moreover, even including that 6% drawdown, the broad market total return has been about 9% per annum over the last seven years and a heady 17% per annum over the last three years.

With this in mind, we believe investors should be wary of assuming broad market returns will be that ‘easy’ going forwards. Rather, paying attention to individual company fundamentals, and the price one pays for those, may well prove critical in the years ahead. Certainly, we will continue to apply such a focus in managing the Allan Gray Australia Funds, with the aim of growing our clients’ capital over the long term.

Allan Gray Australia Balanced Fund

The Allan Gray Australia Balanced Fund returned 3.3% for the quarter, underperforming its composite benchmark that was up 5.5%.

Stock selection in Australian shares detracted slightly from relative performance for the quarter, while selection within global shares added slightly. The largest individual detractors included Alumina where we have maintained our existing position, and Virgin Money UK where we added on weakness. Newcrest Mining and Sims were the largest positive contributors, and we reduced both on strength. As at quarter end, the Fund remained overweight global shares and underweight Australian shares.

The Fund had about 65% in shares at quarter end. This is after accounting for about 7% 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. During the March quarter, this hedging position detracted from relative returns as global share markets rose.

At quarter end, the Fund also held around 23% in fixed income securities. While these holdings contributed positively to absolute returns for the quarter, they detracted from returns relative to the benchmark. This was due to the Fund’s fixed income allocation remaining significantly shorter in duration than the benchmark – at three years versus around 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 interest rates rise. However, when interest rates fall (bond yields fell during the quarter), our shorter duration holdings rise less than the longer duration benchmark holdings. We are comfortable with this positioning and prefer to be more defensively positioned against negative absolute returns.

The roughly 5% exposure to gold through an exchange-traded fund contributed positively for the quarter.

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 2.0% for the quarter, outperforming its cash rate benchmark – which returned 0.8% for the quarter.

The Stable Fund delivered a positive return each month of the quarter, including February when the broad Australian S&P/ ASX 300 Accumulation Index fell 2.6%. This has further added to the Fund’s asymmetric return profile since inception (greater participation in equity market upside than downside, on average).

The Fund decreased equity exposure meaningfully during the quarter, from 27% of the Fund down to about 20% of the Fund at quarter end. Accordingly, the weight of the Fund allocated to cash and equivalents increased by about 7% during the quarter. This is held in cash, term deposits and government fixed interest securities with less than one year to maturity. Term deposits are currently held with NAB and Westpac, and the government bond is very short duration with maturity in April 2023. You can see the Fund’s asset allocation in Graph 2.

GRAPH 2 | Stable Fund asset allocation

Source: Allan Gray, 31 March 2023.

 

The allocation to ASX-listed securities versus cash and equivalents can vary over time, according to our assessed opportunity. Graph 3 shows our allocation to ASX-listed securities over time. Generally, when the market is high we find less value, so the opportunity set is narrower, and vice versa. We highlight this by overlaying the market (S&P/ASX 300 Price Index) on the graph.

The Stable Fund aims to add value from both our disciplined share selection, and from the decision on how much to allocate to securities versus cash. This provides the Stable 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 a great opportunity for the Stable Fund to demonstrate its intended benefits. It offers a moderate risk/return profile, with the potential to outperform cash with less risk than full exposure to the Australian share market, while having the advantage of simplicity and ease of understanding.

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.

GRAPH 3 | Stable Fund listed security weighting – allocation rises where we see value in listed securities

Source: Allan Gray, Bloomberg, 31 March 2023.

 

Julian Morrison holds a Bachelor of Arts (Honours – University of Sheffield) and the Chartered Financial Analyst designation.