Quarterly Fund review – December 2022

In this extract from our December 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 share market rose strongly during the December quarter, with the S&P/ASX 300 Accumulation Index up 9.1%. The quarterly number masks the fact that gains earlier in the quarter gave way to a weaker finish (the S&P/ASX 300 Accumulation Index was down 3.3% for the month of December). The Allan Gray Australia Equity Fund (Class A) was up 13.8% this quarter,  outperforming the benchmark. Graph 1 shows the Equity Fund’s performance over one month, three months and 12 months versus the benchmark.

 

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

Source: Allan Gray, Bloomberg, 31 December 2022.

If you invest in the same shares as the majority of investors at the same time, it is by definition almost impossible to outperform the market. As the following graphs demonstrate, the Equity Fund maintains a very different position to the index  weightings, and with good reason. Unfortunately, being positioned differently does not guarantee outperformance – only ‘different’ performance. Our conviction is based upon our fundamental research and today we believe extreme differences in valuation remain across the share market between shares that we assess as undervalued, and those that we assessed as overvalued.

Our approach is to position the Equity Fund in the most undervalued shares versus our assessment of long-term value. We believe this not only maximises the opportunity for long-term outperformance, but also best mitigates the risk of permanent loss of capital, which stems from overpaying.

Graph 2 shows the top ten holdings by weight in the Allan Gray Australia Equity Fund. It also compares the weights in those same shares against the benchmark.

GRAPH 2 | Equity Fund – top 10 holdings compared with the S&P/ASX 300 Accumulation Index weights

Source: Allan Gray, Morningstar

Graph 3 shows the top ten holdings by weight in the benchmark S&P/ASX 300 Index. It also compares the weights in those same shares for the Equity Fund.

GRAPH 3 | S&P/ASX 300 Index – top 10 holdings compared with Equity Fund weights

Source: Allan Gray, Morningstar

Looking at attribution for the last quarter, positioning in the Financials sector contributed strongly to outperformance. Amongst Financials holdings, Virgin Money UK was a large positive contributor, along with QBE, Challenger and AMP. We have trimmed some of these positions on recent strength. At the same time, most still look reasonable value versus the broader market and so remain meaningful positions in the Equity Fund. Amongst the Australian banks, we have positions in ANZ and Westpac, which have been slightly reduced during the last quarter.

Positioning in the Materials sector also contributed positively to relative performance during the last quarter – something of a turnaround from the recent past. Newcrest Mining and Alumina were major positive contributors during the quarter, having been the two leading detractors for most of 2022. We added to both positions earlier in the quarter before the more recent resurgence. We also added to scrap metal recycler Sims this quarter on share price weakness (for more on Sims, please see a detailed discussion in our December 2022 Quarterly Commentary).

Officially categorised within the Healthcare sector, industrial and medical glove manufacturer Ansell also contributed positively to relative performance for the quarter, outperforming both the  broader market and the Healthcare sector. We have maintained our position in Ansell and the share remains within the top ten holdings as at quarter end. Not owning some of the larger healthcare shares also contributed to relative performance as the overall Healthcare sector underperformed the broader market for the quarter.

Holdings in the Energy sector were overall positive during the quarter. We include Origin Energy in this for obvious reasons, though it officially sits within the Utilities sector. Origin’s share price benefited from a takeover offer during the quarter from Brookfield Asset Management and EIG. This deal is still in motion, though not yet certain, as at time of writing. Due diligence is to be completed (by mid-January). Looking at other energy-related companies, Woodside and Worley both contributed positively to relative performance for the quarter, while Santos underperformed.

Notable for the Energy sector during the quarter, the Australian Government imposed a price cap on the sale of gas. The cap is set at $12 per gigajoule for gas sold in domestic markets for the next 12 months. For the companies held in the Allan Gray portfolios, much of the gas sold in 2023 will take place at previously contracted prices. As such there should not be a major effect during this time, though a question mark remains over the potential extension of price capping beyond 2023. We will maintain discussions with our portfolio companies where relevant and maintain our independent, continuous assessment of valuations. For now, we have made a submission to government to share our thoughts on this matter.

The management teams of these companies have been vocal in highlighting the risks of excessive price capping – both quantum and duration – with regard to encouraging ongoing development of resources and thus certainty of supply. Indeed, it is possible for such policies to come with unintended consequences that may exacerbate energy pricing issues, rather than solving them.

Since the announcement, the share prices of these companies have been fairly steady, and do not seem to reflect any major concern. Given the strong positive contribution in recent times, we have continued to trim these exposures at times of strength (both during the last quarter and year), re-allocating to other ideas, and maintaining appropriate position sizing. Still, some of these companies remain significantly below fair value and so we remain overweight the sector and in particular Woodside remains one of the largest holdings in the Fund.

The most notable detractor from relative performance for the quarter was Lendlease. This Diversified Real Estate company has seen its share price meaningfully underperform the market as expectations have deteriorated for profitability over the next year. We believe the consensus view is excessively negative versus a longer term, normalised outcome. As such, we have added to this position during the last quarter.

We continue to invest the Equity Fund’s assets where we see the best long-term value. At this juncture in the cycle, as much as ever, the aim is also to avoid investing in companies we see as overvalued. The gap between these categories remains large in our view, and continues to present a great opportunity for long-term outperformance, as well as (less visible) prudent risk management.

Allan Gray Australia Balanced Fund

The Allan Gray Australia Balanced Fund returned 10.3% for the quarter, outperforming its composite Benchmark which was up 4.0% for the quarter.

Stock selection in global shares contributed positively to relative performance for the quarter, as did exposure to Australian shares. The largest individual contributors included oilfield services company Schlumberger which benefited from rising oil and gas prices, Newcrest Mining and Alumina (both mentioned in the above Equity Fund commentary). As at quarter end, the Fund remained overweight global shares and underweight Australian shares.

The Fund had about 64% in shares on average during the quarter. 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.

During the quarter, the Fund also held around 22% in fixed income securities. The relative contribution from fixed income was muted this quarter, with modest outperformance from the Australian component, and modest underperformance from global fixed income.

The duration of the fixed income allocation remains significantly shorter in duration than the benchmark – at three years versus about 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 further from here. Government bond yields were generally higher over the quarter, though relatively flatter when compared to the more aggressive rising of the last year.

Active currency positioning contributed  strongly, largely driven by the portfolio’s underweight exposure to the US dollar, which weakened relative to most other currencies during the quarter. The roughly 5% exposure to gold through an exchange-traded fund also 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 4.5% for the quarter, outperforming its cash rate benchmark – which returned 0.7% for the quarter.

The Stable Fund has outperformed the cash rate benchmark each month of the last quarter, including December, when the broad Australian S&P/ASX 300 Accumulation Index fell 3.3%. 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 increased equity exposure slightly during the last quarter. This was the combined result of active buying in some shares assessed as attractive at depressed prices, and positive market movement in others. We have trimmed some of those holdings where strong performance has brought them closer toward fair value.

As at the end of December, the Fund had 27.1% invested in ASX-listed securities. The remaining c.73% is held in cash and money market investments. This can be seen in  Graph 4, which shows our allocation between cash and ASX-listed securities over time.

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

Source: Allan Gray, Bloomberg, 31 December 2022

 

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