CONNECT WITH SELECT2016: Fourth Quarter Client Newsletter

2016 Fourth Quarter Client Newsletter

Think Efficient. Realise potential.

Busisa Jiya

More market volatility, but real opportunities for positive returns 3

Dawie Roodt

The price of free education 4

Callan Williamson

Decision-making amidst the noise 6

Lwazi Hlatshwayo

The unexpected benefits of behavioural economics 8

CONTENTS

At Efficient Select, we subscribe to a QUALITY Investment Philosophy; based on clearly defined fundamental factors. This investment philosophy seeks to identify investments with outstanding quality characteristics.

QUALITY investing focusses on capital preservation in volatile market conditions while providing a reasonable level of returns in rising markets. The emphasis we place on capital preservation ensures a positive compounding effect, resulting in consistent long-term returns.

DISCLAIMER: Although every effort has been made to ensure the accuracy of the content of this brochure, Efficient Select (Pty) Ltd accepts no liability in respect of any errors or omissions contained herein. The contents of this brochure cannot be construed as financial– or investment advise and does not confer any rights whatsoever, enforceable against Efficient Select (Pty) Ltd, its management, employees or agents. Efficient Select (Pty) Ltd retains the right to amend any information contained in this brochure at any time and without prior notice.

2016 Fourth Quarter Client Newsletter 2016 Fourth Quarter Client Newsletter

Following on from last quarter’s commentary, risk remains a key concern for

investors.

The financial markets have continued to be volatile as shocks such as Brexit, the fraud

charges brought against our Minister of Finance and comments made about South Africa

by the global ratings agencies have triggered spikes and corrections in valuations. For

local investors, the premium typically paid for risky assets has not paid off in the short

term. In addition, the volatility of the Rand has resulted in significant swings in returns

when investing internationally. It is therefore fair to say that, on a risk-adjusted basis, cash

has been king for most of 2016.

In the midst of this chaos, there has nevertheless been the opportunity to earn positive

returns. Efficient Select has remained defensively positioned, being underweight in

domestic equities and properties within its multi-asset unit trust funds, and overweight

in bonds and cash. As clients’ returns are expressed in Rand, we have also been cautious

about our global asset allocation. Our preference has been for high dividend-yielding

quality stocks within equities such as MTN.

Looking ahead, we believe that the markets will continue to be volatile as valuations of

risky assets and, more specifically, local equity remain materially above historic norms. It

is difficult to reliably predict how long this volatility will last for, and when valuations will

be attractive again. For the time being, as long as consumer inflation remains within the

3% to 6% range targeted by the South African Reserve Bank, we favour less risky assets

such as cash and bonds.

When it comes to equities, we believe the key performance driver will be growth in

company earnings. Upward earnings forecast revisions will be positive for share prices,

while downward revisions will be negative. We also believe the gap between the best

performing and worst performing stocks will remain wide, proving a challenge for fund

managers when trying to meet and beat benchmarks in the short term.

It will therefore be important to look beyond short-term performance and to invest with

long-term performance in mind. Based on market capitalisation, the South African equity

market continues to be driven by fewer and fewer large cap stocks, such as Naspers.

Investment periods of longer than three years therefore remain the focus for Efficient

Select.

During times of market volatility, investors typically search for absolute certainty. In

our suite of unit trust funds, the asset class that offers the most certainty at present is

interest-bearing money market and fixed-income funds. If investors have not recently

undergone a needs analysis or reviewed their risk tolerance, now would be a good time

to do that. If the outcome of such a review is that their long-term objectives have not

changed, it would be reasonable to maintain their current investment strategy.

The increasing popularity of multi-asset class funds during times of market turmoil is

expected, as investors focus on preserving purchasing power or, in other words, on beating

inflation net of all fees and taxes.

MORE MARKET VOLATILITY, BUT REAL

OPPORTUNITIES FOR POSITIVE

RETURNS

3

BUSISA JIYA

B Bus Sc (EconomicsHonours)Managing DirectorEfficient Select

Busisa Jiya is the ManagingDirector at Efficient Select. Hewas previously the ManagingDirector of ABSA AssetManagement (Pty) Limitedand ABSA Portfolio Managers(Pty) Limited (trading as ABSAAsset Management PrivateClients). He has more than20 years’ experience in thefinancial services industry.

2016 Fourth Quarter Client Newsletter 4

THE PRICE OF FREE

EDUCATION

The #FeesMustFall phenomenon appears to have lost some of its momentum, but the

underlying reasons for its existence are still very pertinent, so student protests may

therefore become more hostile.

As I see it, the call for ‘free’ education is mostly a symptom of something else. Essentially,

we live in a country in which unemployment and poverty rates are hugely elevated, and

matters are only getting worse. Further, although the population growth rate is dropping,

it still far outpaces economic growth, and falling average per-capita income is therefore

inevitable. To put it simply, kids are getting desperate.

There are actually a limited number of career options available for young people. The

most popular of these is a career in the civil service. This is because government pays

significantly more than the private sector, working conditions are generally acceptable,

perks are amazing, and there is hardly any pressure to be efficient or productive. Working

hours are also very attractive and there is the opportunity to earn additional income,

both through one’s official duties and by moonlighting. All of these factors make the civil

service the most preferred employer in the country.

There is, however, a problem with this. Capacity is limited. After a few years of aggressively

increasing our army of civil servants and granting unrealistic increases in remuneration,

the state’s finances have now been depleted to levels at which it simply cannot afford to

employ any more ineptocrats. Job-seekers now require even better contacts to land a civil

service job then they did in the past. An inferior matric certificate is no longer sufficient.

This leaves matrics with their second option, university. Sure, a university qualification is

a ticket to a good private sector job, but the fact of the matter is that our inferior public

schooling system leaves very few learners adequately prepared for university. Some

students also see university not only as a means of securing a good career, but as a career

of sorts on its own. Being a student offers a place to stay, food to eat and something to

do. In short, being a student keeps people occupied and, in many instances, they are being

paid to do this by the state’s student funding system.

But this system has also run its course. Requirements for funding have become more

stringent as previous - mostly unsuccessful - students default on paying back their student

loans. At the same time, universities are being swamped by more and more students that

see going to university as a career choice in itself.

We also need to bear in mind that university students are privileged. Very few school

leavers qualify to go to university and even fewer actually get there. For that reason,

free higher education is hugely regressive because, in essence, it involves subsidising the

privileged. Should we really wish to use education to uplift our society, better primary and

secondary education is a far better tool than free higher education for the privileged few.

That said, many students realise their ‘careers’ at university are coming to an end. It

is therefore conceivable that any disruption may be seen as an excuse to extend their

tenure. This means that the #FeesMustFall protests and calls for the ‘decolonisation’ of

the academy may just be an opportunity to force somebody to extend their stay.

The alternatives to this current status quo are grave. As I have mentioned, opportunities

in the civil service are becoming increasingly scarce and, if attempts to realise fee-free

tertiary education do not succeed, the only option for many young people is a life of

partial employment in minimum-wage jobs, unemployment, marginalisation, terrible living

conditions, poverty and crime, as is true for so many adult South Africans.

DAWIE ROODT Chief Economist Efficient Group

Dawie Roodt is an economist who specialises in fiscal and monetary policy. He brings invaluable exposure to the Group through his active presence in both the local and foreign media. He has been a member of the Tax Advisory Committee of the Afrikaanse Handelsinstituut and has represented Business SA at Nedlac. Dawie is an ambassador for Child Welfare (Bloemfontein), Childline (Free State) and the Adopt Moreletaspruit Forum.

2016 Fourth Quarter Client Newsletter 2016 Fourth Quarter Client Newsletter 5

THE PRICE OF FREE

EDUCATION(CONTINUED)

And perhaps this goes to the underlying issue. As a young person, there really are limited

options: employment in the civil service; a guaranteed job in the private sector if you

manage to obtain scarce skills; an extended ‘career’ as a student; a life of employment

uncertainty; unemployment and poverty; and, finally, crime.

Is free tertiary education the solution to this impasse? Personally, I don’t believe so.

Clearly, reliable economic growth would lead to more jobs being created in the private

sector. Clearly, better primary and secondary education would produce school leavers who

are well prepared to train for a wide range of different jobs or to become entrepreneurs.

Clearly, weak political leadership, inferior service delivery by the state and policy

uncertainties are all issues that contribute to the mess we are in.

In the Final analysis, #feesMustFall is just a symptom.

#FeesMustFall is just a symptom.

2016 Fourth Quarter Client Newsletter 6

In today’s global economy, low growth has become the new normal. This has exposed

a number of cracks within the socio-economic system and goes some way towards

explaining why there has been such a spate of socially and politically related incidents

across the world this year. Simply put, people are demanding change, and governments

are having to respond by adjusting their policies to meet these demands.

The result is a world dominated by newsworthy headlines, ranging from #FeesMustFall to

Brexit to Trump’s candidacy for the presidency of the United States. While this is a fruitful

environment for journalists, the same cannot be said for investors, who are having to

make investment decisions against a backdrop of low business confidence, poor consumer

sentiment, weak earnings and spikes in volatility. All of this has inevitably resulted in

subdued equity returns in the local market.

The purpose of this article is to give insight into how we, as asset managers, make local

equity-related investment decisions under these circumstances. More specifically we

address these decisions on a sector-by-sector basis.

Financials

On average, investments in the financial sector generate a return on capital that is in line

with the average for the overall market. These businesses make tiny profit margins but use

significant amounts of leverage to increase their returns. This, however, creates potential

for significant capital loss if the institution is unable to meet their debt obligations, so the

quality of management is critical.

The key negative currently facing the sector relates to whether the cost of debt will rise

further on the back of a ratings downgrade at the end of the year. Additionally, credit

advances are slowing as the consumer’s ability to service debt continues to diminish from

a rise in living costs. The environment is tough.

Despite this we maintain a positive view with regards to the financial sector, as we are

being compensated for uncertainty mentioned above in the form of attractive valuations.

We also attempt to offset market uncertainty by selecting companies that have their own

stock-specific growth stories which, we believe, makes them more immune to current

circumstances than many other companies. These include Discovery, Old Mutual and

FirstRand.

Retailers

The retail sector is one of the highest return-on-equity (ROE) sectors within our market

– as a result we naturally drawn to these companies. However, recent sales trends have

disappointed and have provided an accurate indication of the true financial state that

consumers find themselves in. This has inevitably brought some negative sentiment to

bear on to the sector. As a result, these companies have been sold off aggressively, to a

point at which valuations are now attractive.

It is our opinion that the structural trends of urbanisation coupled with the social capital

one derives from shopping as an entertainment form will prevail and offset the current

tough economic environment over the long-term. In this light, we see some opportunity

in buying these excellent businesses at today’s attractive valuations. More specifically our

convictions lie across Truworths, Mr Price and Holdsport.

General Miners

Mining stocks have experienced an incredible bounce-back since the start of the year

on the back of positive commodity price movement. It is precisely this sensitivity to

prices that saw these stocks fall so dramatically over the past five years. As a result, we

light-heartedly call these businesses ‘magic castles’; you close your eyes for a second

and a rusty shed magically turns into the prized castle. But be warned: market timing is

everything when it comes to this sector.

DECISION-MAKING AMIDST

THE NOISE

CALLAN WILLIAMSON, CFA

Equity AnalystEfficient Select

Callan Williamson joined theEfficient Select team in 2012after completing a BusinessScience degree in Finance atthe University of Cape Town. He has since progressed to Equity Analyst and is a CFA Charter Holder. He specialises in domestic equity and macroeconomics

2016 Fourth Quarter Client Newsletter 2016 Fourth Quarter Client Newsletter 7

DECISION-MAKING AMIDST

THE NOISE(CONTINUED)

Fundamentally, company balance sheets are improving as expansion plans have been

tailored to meet new, lower levels of demand, sales of ‘non-core’ assets and higher

commodity prices have all resulted in additional cash generated which has been used to

reduce debt.

The perfect time to buy into these businesses is when they are priced as ‘rusty sheds’ with

a good chance of turning into ‘prized castles’ as a result of a deficit in commodity supply.

At present, we are not far from the ‘rusty shed’ price, but we still see an oversupply across

commodity markets and therefore are not ticking all the boxes that would indicate an

overweight position. It is important to note; we are closer to this optimal scenario than we

have been since the Global Financial Crisis.

Telecommunications

This fast-paced and highly competitive sector is characterised by an insatiable demand

for its products and services, which remains true regardless of the current economic

environment. After all, do you know of anyone who is using their mobile phone less

because the economy is slowing? This constancy of consumption explains why the

telecommunications sector has displayed high profit margins and excellent returns on

capital over a very long period.

We have recently increased our conviction in MTN after the negative impacts of the

regulatory fine and poor operating performance within in the struggling Nigerian economy

saw its results deteriorate significantly. Our base case assumes the recently appointed

management team will go some way in towards rectifying the damage incurred under the

previous tenure – we have found management teams are more likely to improve focus and

execution after an extra-vivid experience than if the experience had not occurred.

Our longer-term view is based on the excellent underlying economics of the industry,

together with the company’s dominant market position across Africa. The scope of

mobile growth in Africa is also significant, and it is our opinion that consumers in other

African countries will demonstrate the same demand for MTN’s services that they have

demonstrated in South Africa. Current valuations imply the market disagrees with our

view that the company will return to its normal operating levels in the long term.

Conclusion

To conclude, we remain cautious when it comes to domestic equity given high valuation

levels, muted earnings growth and the uncertain macro environment in which local listed

companies operate. Our convictions are isolated to stock-specific stories, where we expect

current operating levels to return to normal in line with the companies’ long-term track

record of delivering above-average returns on capital.

2016 Fourth Quarter Client Newsletter 8

The psychology of price

One of the greatest ironies about human behaviour is that it is predictably irrational. More

specifically, when we hear the word ‘free’, it removes all mental barriers and fears when it

comes to the products and services we are exposed to on a daily basis.

This phenomenon can be illustrated by a specific example.

In a study conducted by a university professor, Dan Ariely, and a group of researchers,

customers at a supermarket checkout counter were offered a choice between purchasing a

Hershey Kisses chocolate for 1 cent ($0.01) or a Lindt Lindor chocolate truffle for 26 cents

($0.26). The majority of the participants, recognising that this was a good deal because the

price differential between the two options is usually far greater than 25 cents, chose Lindt.

However, when the price of both was reduced by 1 cent, making the Hershey Kisses free

and making the price of the Lindt Lindor option $0.25, the preference changed completely

and 90% of the participants chose the Kisses.

It is interesting to examine why this would have happened as the two choices remained

unchanged, as did the relative price between them. Logically, the preference should not

have changed. The answer, of course, is that we simply love the word ‘free’. It arouses

unjustified positive feelings in the brain and we end up responding irrationally. Naturally,

marketers have learnt to exploit these human irrationalities and misjudgements by using

them in everyday advertising.

Dan Ariely also describes an example of decoy pricing on a subscription offer that

appeared on Economist.com. The options presented were as follows:

1. Online access to all articles: $59

2. Print subscription: $125

3. Print and online access to all articles: $125

Ariely asked 100 of his students to select an option from these three. The result was that

84% of them chose option 3 and 16% chose option 1. None chose option 2. This begs the

question of why an option 2 would have been offered in the first place.

To test why this was done, he removed option 2 and presented only option 1 and option 3

to another group of 100 students. To his surprise, 68% of students chose option 1 and 32%

chose option 3, a remarkable change. It then becomes easy to see that option 2 was not

useless at all, but served the purpose of making it easier to make a choice.

Another interesting twist is to add what is called a default option, one in which marketers

inform consumers of what they will automatically receive if they don’t actively make

a choice. Defaults instil a false sense of ownership in consumers before they make a

purchase. In effect, when we are ‘given’ something, even by default, we value it more than

we would have done otherwise.

To illustrate this point, an Italian telecoms operator decided to try a different approach

when clients wanted to cancel their subscriptions and, in the process, actually managed to

increase its overall acceptance rate.

In the first effort, they incentivised their customers by informing them they would receive

100 free calls if they did not cancel their subscription. The offer was then rearticulated so

that the operator could say: “We have already credited your account with 100 free calls.

How could you use those?” Many customers did not want to give up free talk time they felt

they already owned and decided not to cancel their subscriptions.

THE UNEXPECTED BENEFITS OF

BEHAVIOURAL ECONOMICS

LWAZI HLATSHWAYO Junior Quants AnalystEfficient Select

Lwazi Hlatshwayo joined theEfficient Select team as a Junior Quants Analyst after completing a BSc degree in Physics at the University of the Western Cape

2016 Fourth Quarter Client Newsletter 2016 Fourth Quarter Client Newsletter 9

Within the context of investment and the markets, understanding the consumer

psyche and the irrationality of the human decision-making process is essential to our

understanding of how the markets are influenced. This, in turn, enables us to improve our

investment strategies.

References:

1. Dan Ariely, “The nuances of the FREE! Experiment”: http://danariely.com/2009/08/10/

the-nuances-of-the-free-experiment/ (Accessed: 24 October 2016).

2. Tim Baker, “Free is a Magic Number?”: http://www.thinkaboutpricing.com/uploads/75/

Free_is_a_magic_number-pdf.html (Accessed: 24 October 2016).

3. Piyanka Jain, “5 Behavioural Economics Principles Marketers Can’t Afford to Ignore”:

http://www.forbes.com/sites/piyankajain/2013/03/01/5-behavioral-economics-

principles-for-marketeers/#7d0c253e4f99 (Accessed: 21 October 2016)

4. Welch Ned, “A marketers guide to behavioural economics”: http://www.mckinsey.com/

business-functions/marketing-and-sales/our-insights/a-marketers-guide-to-behavioral-

economics (Accessed: 21 October 2016)

“One of the greatest ironies about human behaviour is that it is predictably irrational”

THE UNEXPECTED BENEFITS OF

BEHAVIOURAL ECONOMICS

(CONTINUED)

2016 Fourth Quarter Client Newsletter

Establishing and maintaining an unconventional approach, requires frequently appearing downright imprudent in the eyes of conventional wisdom”

- David Swensen

PRODUCT RANGE

Fixed Income Fund

Balanced Fund

Equity Fund

African Flexible Fund

Property Fund

Cautious Fund

Worldwide Flexible Fund

2016 Fourth Quarter Client Newsletter 2016 Fourth Quarter Client Newsletter

Efficient Select (Pty) Ltd is an authorised financial services provider, FSP 859 and a subsidiary of the Efficient Group Ltd.

Think Efficient. Realise potential.

Contact us:

9th Floor 22 Bree StreetCape Town8001South Africa

Tel: +27 (21) 410 6000 Fax: +27 (21) 410 8085

info@efselect.co.za

www.efselect.co.za Efficient Select @efselect

The icon in our logo symbolises the company’s ambition for growth and expansion,

both for our investors and for our company.

DISCLAIMER: Although every effort has been made to ensure the accuracy of the content of this brochure, Efficient Select (Pty) Ltd accepts no liability in respect of any errors or omissions contained herein. The contents of this brochure cannot be construed as financial advice and does not confer any rights whatsoever, enforceable against any party and does not replace any legal contract or policy which may be subject to terms and conditions. Efficient Select (Pty) Ltd retains the right to amend any information contained in this brochure at any time and without prior notice.