The Special Situations Fund - Our Thoughts James Sullivan - Coram Asset Management

“Central banks will not be able to control the markets’ behaviour for ever...”

Page 4

International Asset Allocation OverviewShaun McDade

“A Greek default no longer poses a systemic threat to the wider region’s monetary or banking system,...”

Page 7

The Value and Importance of Portfolio ReviewsGreg Easton

“Even Warren Buffett makes mistakes on occasion!“Page 12

SA Asset Allocation OverviewRoeloff Horne

Page 15

Meet the TeamBlair Campbell ACSI, Investment Officer

Page 19

Newsletter2015

AdvisoryServices

FundManagement

South Africa | Guernsey | Singapore | Isle of Man

July

www.mitonoptimal.com

Fund Management

Advisory Services

www.mitonoptimal.com

Contents

Asset AllocAtion insight7-11 International Asset Allocation

Overview15-18 South Africa Asset Allocation

Overview

4-6 The Special Situations Fund - Our Thoughts

12-14 The Value and Importanceof Portfolio Reviews

3 News Update

19 Meet the Team

MitonOptimal Group Introduction

IntroductionUnbelievably, another quarter has passed by and as the second half of 2015 rolls on, we ponder the low interest rate, low growth world we are living in. The three C’s, Central Banks, China and Commodities are all reacting to the challenges they face and behaving in interesting ways. The fiasco that was Greece appears to have died down in recent weeks, but I fear is far from over, whilst the opportunities that abound in technology and biotech march onwards.

In this latest newsletter we asked James Sullivan of Coram Asset Management, who co-manages our Special Situations Fund with Martin Gray, to comment on the themes in his fund and whether central banks can continue to control or drive markets forever? Interestingly, the fund is finding some potential opportunities, whilst still very cautious and positioned for further market weakness.

Shaun McDade has written his usual eloquent summary of our own International Asset Allocation views. Our long term structural asset allocation views of bullishness on global equity and exceedingly negative on global bonds and rising interest rates, continued to play out. Commodities have had a torrid time over the past twelve months and the somewhat surprising rise in the second quarter has quickly turned back into a rout. Andy Pfaff, our commodity expert, feels that we may be entering the capitulation phase soon! Roeloff also clearly articulates our South African domestic market and portfolio views.

Things have been busy at MitonOptimal, as usual, and of special mention was our inaugural road show in the Isle of Man. Shaun and I spoke about our investment process, strategic long term investment views and tactical asset allocation calls to a large audience, followed by numerous one on one meetings. Greg also organised a fantastic golf day at Castletown Golf Links, which include reasonably nice weather, which I understand is a rare event on the Island. Greg, who heads up our Isle of Man business, also writes about the importance of constant portfolio reviews and assessments in this issue.

Finally, we profile our other Kiwi with a Campbell surname, Blair Campbell, who is captain and star of the Guernsey Rugby team and an important member of our business. No surprise as who he would love to have dinner with? Oh, and our new website is to go live in August so please look out for that momentous occasion.

Advisory Services

FundManagement Scott campbell

Group Managing Director & Chief Investment Officer

New MitoNoptiMal Group website to be lauNched iN auGustWe are extremely pleased to announce that the long awaited new MitonOptimal Group website will be launched in August, after a lot work to ensure the new website meets the needs of our clients and all areas of our business, we feel comfortable in going live.

The new website encompasses the updated MitonOptimal brand and brings together all regions of the Group under one banner, whilst still supporting the individual regions and simplifying access to our information. We will notify everyone once the site is launched.

phil peNrose oN the road with iNterNatioNal advisor. During a recent International Advisor Far East road show, the first of which was held in Kuala Lumpur and then in Honk Kong last month, Phil Penrose was interviewed by International Advisor. As investors the world over seek to mitigate downside risk while simultaneously generating growth, Phil explains how investing in a carefully targeted blend of UK value and UK smaller company stocks provides an attractive solution.

Watch the interview now.

MitoNoptiMal ioM eveNt a roariNG success.The recent Isle of Man event, held in June (just after the Isle of Man TT races), was a roaring success, with over 50 intermediaries and institutional investors in attendance to hear talks from Shaun McDade (Head of International Portfolio Management and MD of MitonOptimal CI) and Scott Campbell (Group Managing Director and Chief Investment Officer).

The event was rounded-off with a golf competition at Castletown Golf Links and both were over-subscribed and, more importantly, enjoyed by all. We definitely hope to repeat it next year.

Mark MarGetts-sMithGroup Head of Marketing

International & South Africa

MitonOptimal Group News Update

3

MitonOptimal News Updates

MitonOptimal International Guest Article

4

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The Special Situations Fund - Our ThoughtsWe have, over the last few weeks or so, witnessed markets behaving in a manner that we have been expecting and waiting for – with a noticeable up-tick in volatility. It’s comforting to see the extreme heat come out of asset markets – albeit they have been rebounding just as quickly on various forms of political rhetoric leaks. Valuations are still pushing levels we deem expensive and unsustainable, whilst bonds, despite drifting back a little (the April low for German 10yr Bunds was 0.073%; today it stands at 0.83%) are still incredibly subdued. With the “risk-free rate” - a phrase, with bonds at sub 1%, is perhaps something of a juxtaposition - moving higher, it has left parts of the risk universe horribly exposed to weakness - and we’re witnessing that slowly put right. Bond yields had been manipulated too low and the equity markets are recognising that, without other markets being ridiculously expensive, they’re in danger of longer being the ‘least worst asset class’ whilst also acknowledging that central bank policy has not generated economic growth or inflation in line with forecasts. So is this an inflection point?

Central banks will not be able to control the markets’ behaviour for ever - that I’m pretty sure of - and in the absence of earnings growth and a significant pick-up in the health of the consumer, the chances of a mismatch are greatly increased. Worryingly so.

In August 2012 I wrote on record that: “Rates are likely to remain low for a considerable amount of time – perhaps even into the next decade...”. It was bit of a punchline to get attention, but I think it remains broadly valid. OK, so we may witness a tweak or two between now and 2020, but no more than that, and based on little more than lethargy perhaps.

The financial sector is positioned more robustly (but still a long way of being ‘fixed’, however) than it has been for some time, so we applaud the authorities for using our money to right that dynamic (putting aside the rather precarious situation surrounding some fringe European entities). Nevertheless, economic data remains fragile and we’re getting to a point where the government and central bank tool kit is empty. So we move now, perhaps, from relying on the authorities to support the markets, to asking the banks to take on the baton and support the consumer. M4 - a broad measure of notes and coins in circulation - has been negative or in decline for long periods since the financial crisis. For inflation and credit growth to reappear, therefore, we do really need the banks to increase the credit supply at a rate that is low enough to entice individuals and SMEs (the lifeblood of many economies) to borrow. At present, however, there is a huge gulf between supply and demand affordability. Having said that, loose lending practices are not something we wish to revisit anytime soon; so what is the right balance?

Many years ago, I recall questioning the justification for the upward direction of markets on many occasions, and my Chairman at the time would say “more buyers than sellers, dear boy.” – or words to that effect. With that in mind, I reproduce a chart I stumbled

across recently, courtesy of Bank of America Merrill Lynch. It’s a reasonably decent sample period, stretching back five years or so, and charts the cumulative flow of new money into the US equity market against the level of the S&P 500 Index. The development over the past few quarters is quite striking:

Clearly we have reached a point where investor flows into US equity markets are now negative (albeit the latest data point is a positive one), suggesting we’re close to (if not already at) a “risk-off” period. This would normally be expected to throw up some volatility to the downside, but in the age of buybacks and balance sheet wizardry, this time not so much. In April 2015, for example, S&P 500 constituent companies announced a record $141 billion of authorizations for share buybacks.

So to offset the outflow of money there has been a significant decreased the supply of shares – in theory it kind of makes sense, and I’m not adverse to buybacks per se. Indeed, I’d rather see considered buybacks taking place than cash squandered, as was the case in Japan all those years ago. It does not, however, bode well for the sustainability of earnings, as it highlights the absolute lack of significant capital investment which would usually be the “sunk costs” for the next earnings cycle. Buybacks also permit companies to be creative with their balance sheets in a manner that portrays value has been created, when in fact it hasn’t.

Buybacks only add real value if stock is being purchased below its intrinsic value (in addition to there being no better alternative use of the cash). It is debatable whether, at current market levels, there are any stocks trading below intrinsic value in the major indices, but I acknowledge that some stock-pickers would find room to disagree. There are also suggestions that interests are more aligned with senior management – not only long of stock, but also up to their eyes in options that are priced on stock market valuation rather than intrinsic value - and the investment banks that advise them. Indeed, no investment bank has made serious money by advising their clients to deploy a progressive dividend policy! I recall Terry Smith once commenting that a “herd mentality” has given rise to the buyback and “once someone does it, it becomes fashionable”. I whole heartedly agree with this. With corporate balance sheet cash stockpiles being what they are, I doubt there are any Board meetings in today’s environment where

AdvisoryServices

FundManagement

James sullivanInvestment Director & Senior Fund Manager

Coram Asset Management

a stock buyback isn’t on the agenda – no one wants to be left behind. Which is a certainly shame, as one could be forgiven for having a view that US corporates could seize this moment (strong Dollar, coupled with a high equity valuation) as an opportunity to pursue overseas M&A. But perhaps they’ve seen the future and aren’t too keen to back an economic recovery just yet.

The powers that be in Europe appear keen for Greece to remain where they are and serve their punishment, drawn out in public view. It is obvious to me that Greece needs to change course if it is ever going to move away from the depressionary cycle it is currently in and in this regard a significantly debased currency would go a long way to cure some of the economic woes. I’m not pretending I know how this can exactly be achieved or how much pain this causes short term, but it is worth noting that Iceland was in a world of pain in 2008, and is now (almost) a poster child for GDP growth. The Icelandic Krona (chart below) was collapsed in 2008 and now trades at close to half the value it did (against GBP), whilst the unemployment rate has fallen from more than 9% to around 4% today. It’s not out of the woods yet and the stock market remains incredibly subdued (down from a peak of 8,000 points to 1,100 today), but rightly so, as there was a price to pay by an index heavily skewed towards the financial sector.

There are some similarities in the relationship between Greece and Europe as there is (was) between Scotland and the rest of the UK. Westminster was keen for Scotland to stay part of the gang, as leaving and thriving would be rather unpalatable and embarrassing. If Greece were to make a go of things under its own steam, it would possibly lead the way for other Southern European economies to slowly drift away rather than be bullied by their creditors. The Euro is weaker as a result of Greece remaining a member, which in turn benefits Germany et al – so Greece is dressed up as the pantomime villain, but in many ways, they’ve been the best thing to happen to the German export industry in many years. Perhaps UK should welcome Greece into the United Kingdom?!

Despite our cautious stance, we do remain net long of equity markets (to varying degrees) within the Fund. However, today we

took the opportunity to take crystallise some profits and realign some of the underlying positions.

Focus: WoodFord Patient caPital trust

We supported the new Woodford IM vehicle within the Fund, but have now reduced our position by 50% as we locked in some very notable profits. Ahead of its inclusion into the FTSE 250 Index, the shares were trading rather erratically, as forced index buyers came in and we sold at an average price of close to 114p - a handsome profit on our 100p purchase in just a matter of weeks. The Trust now trades on a very significant premium to its NAV. We are not saying it cannot be sustained (but it seems unlikely), but we’d rather not have this significant premium risk in our portfolio, given our cautious outlook for markets.

Our portfolio remains positioned for broader market weakness, with a lot of emphasis on defensive assets such as zero dividend preference shares, short duration bond funds, and cash. It’s pretty dull stuff, but we suspect that “dull” is going to be a good investment theme over the coming weeks and months.

Our approach to investing has gently evolved over recent years, but we haven’t lost sight of the end game and what is expected of us. There is seldom a bad time to take profits, which is something we have done modestly over the past week. Now it’s our duty to ensure we rotate the proceeds wisely and at an opportune time. Cash is as good an investment at present as it’s been for quite some time (noting the low / negative levels of inflation) – but we hope it remains an interim measure. The optionality of cash in a falling market is an extremely powerful investment tool.

When valuations are more attractive, we wish to deploy more capital to work in areas such as Asia, and specifically the ASEAN region, in addition to revisiting UK (value) equity. Markets change constantly, of course, so our “watch list” evolves and themes come to the top and fall away again, depending on valuations and the economic picture. We are excited about the outlook for the Fund.

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MitonOptimal International Asset Allocation Oveview

7

The descent of the drama that is Greece’s debt crisis into near farce made for a nervous conclusion to the quarter for financial markets, as the Syriza-led government’s approach to negotiations with its creditors appeared to shift from plain old “bloody-mindedness” to a level of petulance beyond that displayed by even the most unruly, tantrum-throwing two-year-old. Not for the first time, the extension of proceedings beyond supposedly time-critical deadlines and, latterly, a series of unexpected plot twists added to the uncertainty and confusion over a possible (cringe) “Grexit” (horrible word!) among market participants. Broad government bond, credit and equity indices all posted losses for the period, with commodities the only mainstream asset class in green figures; volatility indicators, meanwhile, moved towards the top end of their recent ranges.

EquitiEs In contrast to recent quarters, movements in the broad market were relatively muted, with the MSCI World Index occupying a narrow (4%) trading range over the entire period when measured in USD terms. Somewhat surprisingly, this took place against the backdrop of decidedly mixed economic news flow that might ordinarily be expected to result in a far greater level of market volatility. In the US, the initial (+0.2%) print of Q1 GDP confirmed what was already known: that the combination of a strong Dollar, unusually cold weather and a dockworkers’ strike had curtailed activity by a meaningful degree. The full extent of this slowdown was not apparent, however, until the preliminary number was subsequently revised to -0.7% (!). On a more favourable note, whereas other statistical releases in the early part of the quarter also fell short of expectations, later figures pointed to a marked recovery in conditions, as indicators for employment construction / housing, manufacturing, and consumer activity all eclipsed consensus forecasts. Meanwhile, data emanating from the Eurozone pointed to a continued (albeit modest) recovery, with GDP growth of 0.3% and the region-wide Composite Purchasing Managers’ Index (PMI) hitting a four-year high of 54.1%. With Japanese numbers also surprising on the upside, thus rounding out a broadly positive picture in the developed world, there was further evidence of “growing pains” in China, as Q1 GDP growth hit its lowest rate (7.0%) for six years and trade numbers disappointed.

Rather like a mild toothache or the grumbling pain from a dodgy knee, Greece was a constant, if low-level, irritation for markets throughout the quarter. As a series of loan

repayment dates and deadlines for agreements came and went, the Greek government’s actions and tactics at the negotiating table assumed ever greater child-like levels of obstinacy and mischievousness, while their public pronouncements became increasingly defiant and even, at times, triumphal. Indeed, the casual observer would have been forgiven for thinking that, rather than working to a predetermined strategy, the dynamic duo of Tsipiras and Varoufakis were making up as they went along - so much so, in fact, that it might have been laughable, had the issue at hand not been so serious. Although met with varying degrees of consternation and bemusement among investors, this did not translate to big market swings, save for the fact that European equities exhibited a greater level of volatility (up and down) than those elsewhere.

On the subject of volatility, one of the period’s more notable features was the performance of China’s domestic stock markets. By way of example, despite suffering an intra-quarter peak to trough decline of more than 21.5% (!), the Shanghai A Share Index, still managed to record a gain of 14.04% (Fig. 1).

Needless to say, these movements displayed all the hallmarks of a good old market mania, à la late 1990s technology bubble. Huge volumes of margin trading? Tick. Day trading the new job of choice? Tick. “Widows and orphans” betting the farm with money they shouldn’t be “investing”? Tick. All of which, prompted the Beijing authorities, as is their wont, to announce a barrage of measures (including direct market intervention, a ban on

International Asset Allocation Overview

Index 2nd Quarter YTDMSCI World ($) -0.30% 1.52%

MSCI World (€) -3.92% 10.19%

MSCI World (£) -5.91% 0.55%

MSCI World (local ccy) -1.29% 3.01%

S&P 500 -0.23% 0.20%

FTSE UK All Share -2.54% 1.07%

FT Europe Ex-UK (€) -5.63% 11.29%

FT Europe Ex-UK ($) -2.09% 2.48%

Japan Topix 5.61% 15.84%

FT Pacific Ex-Japan (£) -8.71% -1.74%

MSCI Emerging Markets ($) -0.24% 1.67%

MSCI Emerging Markets (€) -3.85% 10.36%

MSCI Emerging Markets (£) -5.86% 0.69%

Fig 1: Shanghai A Share Index

large sale trades, and jail for short sellers!) in an effort to smooth out the markets’ excessive gyrations and keep the party going. On this basis, though this may (will?) all end in tears, reports of a fat lady doing vocal warm-up exercises appear to be a little premature……

As we have highlighted before, it is a measure of the extent to which conditions within the Eurozone have moved on from the dark days of 2010/11 that (notwithstanding some of the more hysterical media coverage) investors’ response to the very real threat of Greece’s exit has been so muted. Crucially, although clearly unsettling as far as sentiment is concerned (as well as devastating for the Greek populace), a default no longer poses a systemic threat to the wider region’s monetary or banking system, as was the case only as recently as four years ago. That said, the risks represented by a policy error on the part of the EU / ECB / IMF (such as those that, arguably, contributed to the current scenario) or for that matter the Greeks themselves, are very much alive. In that respect, the outcome of the impending (at the time of writing) “end game” has the potential for significant and far-reaching political ramifications that, in turn, could become economic factors in the future. Unfortunately, as demonstrated by the recent actions of Greece’s “leadership”, that outcome is impossible to predict with any level of confidence even at this very late stage of proceedings.

In terms of our strategic market view, the quarter’s economic and political events have done nothing to alter our preference for equities over the other mainstream asset classes. Given valuations that, within a historical context, can best be described as “not excessive”, a modestly negative performance from broad indices (ignoring the impact of currency movements) over the quarter has at least allowed for a marginal contraction in P/E ratings,

Fig 2: Global M&A (USD Bn Qtr)

as earnings have continued to advance at a respectable pace. Corporate activity also remains very supportive: M&A volumes - both in terms of deal numbers and their value - saw a significant increase in the past quarter (Fig 2), while the ongoing record trend in share buybacks (in combination with a paucity of IPOs) continues to remove stock from the market. Encouragingly, not only do meetings with, and reports from, our preferred equity managers suggest that the opportunity set within their various chosen areas of specialisation remains healthy (corroborated by improvements in benchmark-relative performances), the fact that many have been reducing their funds’ cash weightings indicates that they are backing those views through their actions.

Bonds A quarter that saw the largest rises in core sovereign yields since 2013’s infamous “taper tantrum” left bond indices in negative territory, measured over both three months and year to date, and in so doing re-ignited the debate as to whether this latest reversal signified a temporary or permanent change in market direction.

The period began quietly enough, as US and UK bonds tracked sideways for much of April, with very little volatility. In Europe, meanwhile, German Bunds extended their QE-fuelled rally, with the yield on the ten-year benchmark issue hitting a record intra-day low of just 0.05% towards the end of the month. Curiously, in a world where every single facet of markets’ behaviour is scrutinised at microscopic level and there is no shortage of views, opinions and forecasts from a multitude of media sources, the precise reasons for the dramatic reversal that followed have yet to be identified (or, at least, agreed upon among observers). Whatever the

trigger, the ensuing sell-off saw more than four months of market gains wiped out in a matter of a few days. After a brief and modest consolidation during May, yields headed higher again, with the 10-yr reference bond peaking at 1.06% before easing back to 0.76% for an increase of 48 basis points (bps) over the quarter (Fig. 3). Though the nominal yield increases seen in the equivalent Treasury (+0.43bps to 2.35%) and Gilt (+0.44bps to 2.02%) were similar to those seen in the Bund market, the overall impact was significantly reduced in index terms by virtue of their higher starting levels. Accordingly, whereas the Bloomberg / EFFAS German Government (>1yr) Bond index recorded a record (by some distance) quarterly loss of 4.52%, the corresponding US and UK figures were “only” 2.00% and 3.43% respectively.

Fig 3: 10-Yr German Bund Yield

As before, the extent to which both conditions in the Eurozone and confidence in its central bank have been transformed over the past four years and the degree to which Greece’s problems have been “ring-fenced” were clear for all to see in the performance of the region’s peripheral bond markets. Though they were not immune to the heightened sense of unease caused by the quarter’s events, the rise in (ten-year) yield spreads seen within the Italian (+51bps to +157bps versus Bunds), Spanish (+51bps to +154bps) and Portuguese (+53bps to +224bps) markets were neither significant within a historic context, nor cause for concern. Having said that, year to date movements and volatility in prices at the long end of the curve in these markets have been extreme, to say the least: for example, the buyer of a Portugal government bond with a 4.1% coupon and 2045 maturity has seen that investment climb from its 20th January issue price of €99.47 to a high

€142.20 on 16th March, before falling to €99.27 just three months later! (Fig 4) Who said bonds were boring?

Fig 4: PGB 4.1% 2015

Predictably, “risk-off” across markets also translated to higher credit spreads within the corporate bond space. These increases were, however, relatively modest, with the average AAA-rated issue just 8bps more expensive in relative terms, BBB yields some 25bps to 30bps wider vs “govvies” and high yield spreads up 33bps in Europe, but marginally lower (by 6bps) in the US. Emerging Market bonds, as measured by the JP Morgan EMB Index, also ended the period 18bps cheaper relative to Treasuries.

Having adopted a defensive approach within fixed income allocations at what, with hindsight, proved way too early a point in the interest rate cycle, both our portfolios and the managers that feature within them have fared relatively well in the recent market downturn. Whether the recent inflection point proves to be “the big one” that we and many others have been expecting remains to be seen; having been wrong for so long, we are certainly not prepared to call it. Indeed, with the consensus forecast on the timing of a US rate rise having been pushed out on the back of recent lukewarm data, there is plenty of scope for yet another shift in direction. Irrespective of markets’ future movement over the near term, we are, unsurprisingly, sticking to our guns, whilst at the same time continuing to seek out ways in which we can further improve the (already high) quality of our current bond fund selections. Importantly, though a rising yield environment represents a headwind, skilled and specialised managers are perfectly capable of continuing to generate positive returns from the fixed income space.

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International Asset Allocation Overview (Cont.)

AdvisoryServices

FundManagement shaun McdadE

Managing Director (Guernsey) and Head of Portfolio Management - International

currEnciEs Whether the 12-year high that the DXY spot index reached in March proves to be a high point for the Dollar is another matter for conjecture. Either way, the US currency trended lower over the quarter, losing 5.96% in Sterling terms and 3.77% versus the Euro to close down 8.85¢ and 4.05¢ respectively at $/£1.5730 and $/€1.1148, 2.88% lower in index terms.

Sterling was the strongest of the seventeen major currencies listed by Bloomberg over the period, rallying strongly on the foreign exchanges following a remarkable outright win for the Conservative party in May’s UK general election that confounded the expectations of pollsters, pundits and bookmakers alike. This, in combination with continued resilience in a range of economic indicators and events in the Eurozone, sent the Pound to an 8 ½ year high of €/£1.4305 against the single currency, before it settled back at €/£1.4110 at the quarter-end.

Alongside the small number of currencies that fell in US terms over the period (SA Rand -0.30%, Korean Won -0.52%, Japanese Yen -1.93% and Mexican Peso -3.02%), the New Zealand Dollar’s 9.44% decline stood out as by far and away the biggest move. This latest bout of weakness was a continuation of the decline that has seen the “Kiwi” lose 23% of its value in US Dollar terms over a little less than a year (Fig. 5). Having avoided the need, thanks to the robust performance of its economy, to cut interest rates or print money in the post financial crisis period, New Zealand has now begun to suffer from the effects that the resulting currency strength has had in terms of its international competitiveness.

Fig 5: NZD Spot vs USD

[Source for all chart data: Bloomberg - July 2015]

coMModitiEs Broad commodity benchmarks bucked the trend seen in those of other asset classes by posting gains over the period under review; the Reuters CRB and Bloomberg (formerly Dow Jones UBS) indices were up 7.23% and 4.66% respectively, measured in US Dollar terms. With energy contracts making up sizeable proportions (39% and 36%) of the indices in question, a 24.94% increase in the “front month” price for West Texas Intermediate, along with rises in US Natural Gas (+8.71%) and Gasoline (+14.11%) were a significant influence on their performance. Within other complexes, there were also sizeable gains in Lean Hogs (+24.14%), Cocoa (+19.18%), Wheat (+16.72%) and Corn (Maize, +8.45%), which were partially offset by declines in prices of Silver (-8.84%), Live Cattle (-8.62%), Orange Juice (-7.11%) and Nickel (-5.71%), amongst others.

Somewhat surprisingly, the rise in oil prices (Brent Crude was up 9.71%) occurred against the backdrop of OPEC’s ongoing efforts to regain the market share it has lost to US producers by maintaining supply at above the equilibrium level in an effort to render to “non-traditional” production methods (fracking, oil sands) uneconomic. While inventories in the US continue to grow, the combination of a much-reduced US rig count and evidence that global demand is increasing (in part due to strategic stockpiling in India and China - n.b. exports from the US are still not possible) sent prices higher during the early part of the quarter. In spite of this recent strength, our central thesis calls for energy prices to remain in the $60 - $80 range (for Brent; $50 - $70 for WTI) on a short- to medium-term view.

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MitonOptimal International Portfolio Management

12

The Value and Importance of Portfolio ReviewsSometimes the simplest plans are the hardest to achieve and maintain.

As investment professionals, it is easy to overcomplicate the investment decision-making process. Advisors are influenced by market noise, trends and contrarian views. These factors can impact the substance of clients’ portfolios and, left unchecked, can have distorting and destructive long term consequences.

Likewise, for fiduciary professionals, ensuring that assets and strategies stay aligned with a trust’s investment policy statement should be a straightforward process. However, a beneficial owner’s personal preferences, a good sales pitch from a product provider, or the search for yield can lead to decisions that shift the dynamics of a client portfolio away from the investment policy statement.

An increasingly important service that we, as asset allocation specialists, are providing for our investment and fiduciary partners is the provision of portfolio reviews, with the aim of realigning the portfolio asset allocation and, in some instances rebuilding the portfolio construction, to meet the investment objectives in accordance with the client’s risk profile.

Through this article, I want to introduce some of the key issues that we regularly see across portfolios and highlight the positive impact that conducting regular reviews can have from a compliance, performance and client relationship perspective.

Asset AllocAtion And Alignment to Risk PRofileThe first step we take is to assess the current asset allocation. This process includes both quantitative and qualitative analysis of the existing holdings and an evaluation of the risk level of each asset held and of the overall portfolio. Once we have a clear understanding of the portfolio, we review the risk profile of the underlying client and compare the current portfolio with a risk-rated asset allocation that matches the client profile. This stage of the review is critical, as it highlights two key areas of divergence from the client mandate.

The first area that we see with regularity is a mismatch of assets from a risk perspective; a common example is finding a high risk, illiquid fund in a low or moderate risk portfolio. Similarly, we often find that a particular asset has been mis-allocated: in a recent case, we found that an investment platform had categorised Structured Notes as Fixed Income assets (carrying a relatively low risk rating), whereas they should more appropriately have been classed as Derivative Instruments (carrying a significantly higher risk rating).

The second area covers the weighting given to assets classes within the portfolio, often with a bias towards one particular asset class. For example, we frequently see portfolios with over 80% exposure to equities that are inappropriate for all but the most adventurous investor. This lack of diversification often leaves the portfolio susceptible to increased volatility in adverse market conditions.

Risk And RetuRn

All investment professionals will, at some stage, have made poor investment decisions and errors in judgement, even Warren Buffett makes mistakes on occasion! - “An attentive investor, I’m embarrassed to report, would have sold Tesco shares earlier. I made a big mistake with this investment by dawdling.” [Source: Berkshire Hathaway Inc. 50th Annual Letter to Shareholders.]

The aim of a portfolio review is not to emphasise past mistakes, but to identify the current asset allocation risks and issues so that informed decisions may be made in the best interests of the client.

The complex relationship between risk and return is at the forefront of the many challenges to participants in the investment management industry; not all risks are bad and it is generally accepted that higher levels of risk are associated with potentially higher returns. There is, however, a pertinent difference between increasing risk levels through adjusting asset class weightings, making strategic or tactical investment decisions, and holding very high risk assets that promise to deliver high returns but have inherent flaws.

Unfortunately, the inclusion of higher risk assets can lead to capital loss, whether that’s through the suspension of a fund or a weak and incoherent investment strategy. Whilst conducting reviews, we have also noticed a recurring pattern: once one part of a portfolio fails, the natural inclination of an advisor or trustee is to try and recapture lost capital, invariably by taking riskier decisions that skew the asset allocation even further away from the risk profile of the client. It is also important to remember the fundamental fact that to recover a 20% loss you have to make a 25% gain!

RAising Red flAgs

One of our key roles, as asset allocators, is to identify potentially toxic assets so that they can be excluded from client portfolios. Our investment analyst team conducts extensive research into the nature and substance of assets through a screening and due diligence process.

MitonOptimal International Portfolio Management

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GreG eastonMember of the MitonOptimal (International) Investment

Management Committee, Managing Director of MitonOptimal, Isle of Man

Often, whereas an investment may look harmless on the surface, its fact sheet may show positive performance and the structure of the asset may meet all of the standard due diligence criteria, it is not until the proverbial bonnet has been lifted that a better understanding of the true risks can be analysed. A selection of the red flag issues we look for when identifying ‘bad’ risks are listed below:

■ Overly complex investment and ownership structures; ■ Multiple roles performed by related entities; ■ Upwards-only valuation models and no negative

performance; ■ Undefined ‘black box’ investment strategies; ■ No mark to market pricing (or acceptable independent

value); ■ Reliance on directors’ pricing of assets and potential

conflicts; ■ Exit penalties, long lock-up periods and prohibitive exit

clauses*; ■ Irregularities within offering documentation; ■ Discrepancies between stated and actual assets under

management; ■ Excessive leveraging or over exposure to higher risk

asset types; and ■ High levels of initial, ongoing and performance fees.

*One current theme that we are seeing, relating tofunds, is the ability of a fund or share class to prohibitredemptions but still allow subscriptions. This indicates ahigh likelihood that the fund may have significant liquidityissues. Whilst clearly counterproductive from a clientperspective, this feature of some higher risk funds is oftenburied within the offering documentation.

Any assets found to have inherently bad risks are red flagged and are highlighted within the portfolio review document along with a recommendation to address the position.

PoRtfolio dustBriefly, we also see a considerable number of portfolios that may have the same asset allocation since inception, sometimes going back decades. Often, this will be due to

an advisor or trustee inheriting a client relationship or book of clients. These ‘orphan client’ situations can be difficult for advisors and trustees to manage, particularly if they have minimal communication with the underlying client. In this instance, we are able to conduct enhanced forensic portfolio analysis and work with our partners to re-establish a suitable risk profile and asset allocation strategy.

minoR Adjustments oR the Reset ButtonOnce the portfolio review has been completed, we provide our partners with a full report along with our recommendations. On occasion, the current asset allocation may be meeting the needs of the client or require only minor adjustments; in such instances our partners know that they have met their regulatory obligations to review portfolios and can focus on growing client relationships and building their businesses.

In other instances, however - and these are the ones that we find are often most productive and useful - the conclusion of the portfolio review can serve as a turning point in a client relationship, whereby a process can be implemented to reset the asset allocation in line with client expectations or requirements.

So should one use a Portfolio Review Service? Whether you choose to work with MitonOptimal or your preferred asset allocation specialist, we would recommend implementing or refreshing your approach to reviewing client portfolios. The importance and value of conducting regular and thorough reviews is paramount.

In the next article on portfolio reviews, I will look at the fragility of asset classes and the potential impact of “black swan” events. I will explore some of the hidden asset allocation risks in more detail and look beyond performance as a measure of a healthy investment portfolio.

In the meantime, if we can be of assistance when it comes to protfolio reviews, please do not hesitate to contact me directly on +44(0)1624 610750 or your nearest MitonOptimal office.

MitonOptimal South Africa Asset Allocation Oveview

15

The reality is that the world is not in a high growth environment and neither is SA. That is why half the world are still doing quantitative easing (QE) or cutting rates, like the People’s Bank of China for instance. We are not in a high double-digit return environment that we might have had a couple of years back or in the 1990‘s. The global business cycle remains de-synchronised and fragmented an although these factors always present opportunity, investors should be happy with high single-digit or low double-digit returns.

Our SA Capital Market is highly correlated with global events and economic conditions and no SA Asset Class overview can be objective without first discussing global events.

Grexit concerns - a small issue in the Real WorldThere is too much stimulus in the world economy (China / India cutting rates, Japan and the ECB providing QE) to counter the negativity from Greece. In fact, Europe will need to keep interest rates at rock bottom, near zero, for at least another five years, maybe even longer, because of the high levels of debt amongst most governments. Aggressive European monetary stimulus - perhaps to continue big purchases of peripheral bonds - can put a hold on the US and the UK, to defer interest rate hikes in the near term.

At the time of writing, the ECB remains committed to containing the Greek situation, preventing harmful political and financial contagion into other parts of Europe. For now, we continue to believe the damage to the European real economy, from the Greek fallout, is not going to be sufficient to undermine the improving economic fundamentals in the rest of the Euro Zone this year. Purchasing Managers’ Indices (PMI) surveys signal continued expansion in both manufacturing and servicing sectors, whilst consumer confidence remains at high levels. But, we continue to monitor the situation very closely for any signs of contagion.

Corporate Earnings potential much more importantIn the SA equity market it is a stock pickers environment, where decent dividends and steady earnings growth can play a role to keep investors interested in keeping exposure to SA equities, despite the gloomy SA economic outlook. More than 60% of the JSE ALSI Top 40 stock earnings are derived from the global consumer. It is interesting that foreigners have bought more SA equities (R52bn year to date) than for the last few years.

The Return on Equity (ROE), inflation rates, currency moves against the US Dollar, local stock returns and USD stock returns have all meaningfully converged across countries the past 5 years. In addition, payout ratios have increased and return on equity have declined (see Fig 2:) across the SA and other countries, implying lower returns going forward.

Slower economic growth inevitably impacts negatively on corporate results. Much of the recent global stocks results were masked, in recent years, by significant cost savings and the containment of wage increases by companies. In the US, earnings have been boosted by low interest rates and extensive buy-back activity, enabling earnings growth to far exceed sales growth. Going forward these factors are all likely to be less of a positive for stocks that performed well during the past 5-6 years.

Fig 2: JSE Earnings Yield RHS (5%); JSE Dividend YieldLHS(3.1%)

[Source: Bloomberg & MitonOptimal - June, 2015]

Within most market conditions one will always find some value to purchase as long term investors. Forecasting future returns remain extremely challenging though and, we therefore believe that some exposure to unloved stocks or alpha equity managers who seek value in equity markets, are an appropriate part of our funds and portfolios.

One of these potential opportunities includes a thesis by fund managers that is predicated on the view that the

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South African Asset Allocation OverviewFor Domestic Funds and Portfolios

current commodity prices are unsustainably low (global commodity index at a 20 year low) and should revert to higher levels over time. Many businesses in this industry are trading at less than half the intrinsic value, as calculated by many of our underlying fund managers.

The question remains “Should we not wait for commodity prices to turn before exposing our portfolios to fund managers and/or ETFs that hold resource stocks or commodities?”.

We believe that our positive performance results over the past 5 to 6 years warrant limited (less than 10% of any growth portfolio) exposure to these assets. Markets pre-empt economic cycles rather than the other way around. It is when expectations are wrong that one has a material inefficiency to exploit. It is often the case that investor sentiment swings due to short-term events or news and to forecast behaviour remains challenging. We believe that, taking a long-term view, exposing our investors to a limited amount of value stocks and commodities will provide good investment returns in time.

Cry - Our Beloved CountrySouth African investors are increasingly negative about economic prospects in our beloved country. Why?

Load-Shedding has become a daily routine, influencing the BER consumer confidence number downwards, falling a massive 11 points, with:

■ Inflation bouncing back from 3.9% to 4.5%, ■ Petrol and diesel prices having nearly retraced their declines of last summer,

■ Higher electricity prices (+12%), ■ Municipal and e-tolling charges

all eating into consumer pockets.

CPI is expected to bounce another 2% in the next 9 months, almost eroding heavy wage settlements across the board - 8% nominal (Government and mining employees). Combine that with tightening credit conditions and business defensiveness in spending, hiring and commitment and we look like facing a real stagflation threat in S.A.

To make matters worse, our small, open economy has a large current account deficit - meaning that our national spending is significantly greater than our national income - which means that we need to borrow the difference. With the US Federal Reserve about to begin raising interest rates, funding will become harder to get.

This can lead to further Rand weakness and place further pressure on inflation, leading the Reserve Bank to

potentially raise local interest rates by at least 0.5% over the next 12 months. The potential of higher local interest rates does not bode well for local residential property considering already high household debt levels. (Fig 3:)

The average house price for April 2015 rose 5.0% YoY, slightly slower than the previous month’s revised 5.2% and continues the slowing trend of recent months. Fig 3: [Source: FNB - June, 2015]

We do see a number of positives for SA capital markets though. We expect:

■ Lower oil prices in the short term, due to global supply overload.

■ Lower global food prices and soft commodity prices will continue to decline as stable weather conditions currently keep a lid on prices. Both these ‘positive’ factors together can influence CPI by almost 30%.

■ The SA Middle Class to benefit from real wage growth and they will continue to spend - this is good for local corporate earnings potential.

■ The SA Rand to be undervalued and we believe that recent global events (Greece & China stock market correction) will put a hold on any meaningful developed market interest rate increase in the short term. Global rates may be low for a longer period than the market currently expects. We anticipate a more stable, but weakening Rand ( 2-4% p.a. weaker) relative to the US Dollar from here, unless unexpected global rate increases or financial risks derail our view.

Asset Class Returns - Year to DateThe past 6 months performance of capital markets were disappointing as risk asset classes start to price in higher valuations relative to history. The performance of asset classes were as follows (Year to 30 June 2015):

■ SA ALSI 40 Equity Index: 6.03% ■ SA All Bond Index: 1.09% ■ SA Inflation Linked Bond Index: 0.4% ■ SA Listed Property Index: 5.39% ■ MSCI World Equity Index: 7.68% ■ STEFI (Cash) 3.11%

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Roeloff HoRneDirector & Head of SA Portfolio Management

South Africa

AdvisoryServices

FundManagement

With the exception of SA Bonds, returns were broadly in line with our expectations.

Fig 4: {Source: Financial Express - 30 June, 2015}

ConclusionThe world is not in a high growth environment and neither is SA. Over the past year the IMF has downscaled potential for global economic growth .

Fig 5: [Source: IMF - 2015]

That is why half the world are still doing QE or cutting rates, like the People’s Bank of China for instance. This scenario still remains positive for global equities, as central banks makes an effort to enhance consumer spending, whilst global investors will continue to search for yield. These factors will attract flows to risk assets.

Although we expect a small interest rate increases locally, in the short term, we believe that local consumer spending will continue to support the corporate earnings of ‘SA incorporated stocks’. We therefore remain constructively exposed to SA risk asset classes (Equities, Fixed Rate & Inflation-Linked Bonds and Listed Property) and remain overweight Global Equities, relative to our strategic asset allocation benchmarks. We are using a phased approach to buy more local bonds, as they trade at more attractive levels relative to local equity earnings and dividend measures (i.e. Bond Yields vs. ALSI Earnings and Dividends) - especially when compared to global counterparts.

Our advice is to remain invested, but continue to remind investors about ongoing volatility in capital markets and more realistic single-digit returns for most asset classes in the short term, as equity markets are ‘priced to perfection’ and, at current elevated levels, are clearly more vulnerable to unexpected shocks than if valuations were markedly lower.

On each of all four of the times the JSE All Share Index corrected by more than 5% in the past 12 months, it paid to buy into weakness. That does not mean it will continue in this pattern, but it reflects the nervousness of participants at the advent of negative market events / news, but also reflect global investors realisation that global equities remain attractively priced relative to global cash and bonds. The current market trends remain positive and our local portfolios reflect limited, but growing exposure to unloved assets, such as resource stocks, SA bonds and commodities. We therefore currently advocate a buy and hold long-term investment approach.

MitonOptimal Group Meet the Team

Meet the Team

What is your job at MitonOptimal? Investment Officer.

What did you do before you joined MitonOptimal?Listings Analyst at the Channel Islands Stock Exchange.

What do you like about your job so far?My colleagues and the working environment.

What is your biggest interest outside of work?Watching, playing and training for rugby.

What do you do to relax?Socialise.

What would your best friend say is your best quality? Just being an all-round nice chap.

And your worst quality?‘Flakiness’.

What is your favourite holiday? Queenstown.

Your favourite meal?Homemade Lasagne.

We would like to introduce you to Blair Campbell ACSI - Investment Officer, who is a member of the Guernsey Investment Management team.

Your favourite colour? (All) Black.

Your favourite drink?Red wine (Chateau Musar)

If you could have dinner with anyone in the world, who would it be? Richie McCaw, Ricky Gervais and Homer Simpson.

Another job you considered doing but decided against?PE Teacher.

If you had all the money in the world, what would you do?Buy a professional sports team.

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Blair CampBell ACSIInvestment Officer - Guernsey

19

DisclaimerThis document has been issued by MitonOptimal South Africa

(Pty) Ltd with registration no 2005/032750/07, which is an

authorized Financial Services Provider (“the FSP”) with License

No. 28160. MitonOptimal South Africa (Pty) Ltd complies with all the

requirements of the Financial Advisory and Intermediary Services

(FAIS) Act (Act 37 Of 2002).

The content of this document is for information purposes only and

does not constitute an offer or invitation to any person. The opinions

contained in this document are subject to change and are not to

be interpreted as investment advice. You should consult an adviser

who will be able to provide appropriate advice that is based on your

specific needs and circumstances. MitonOptimal‘s prior written

consent must be obtained before the contents of this document

are communicated to any third party. The information and opinions

contained herein have been compiled or arrived at from sources

believed to be reliable and given in good faith but no representation

is made as to their accuracy, completeness or correctness.

MitonOptimal’s respective directors, officers, employees and

associates may have an interest in the products, services or

service providers referred to herein. The value of investments and

the income from them may vary and you may realise less than the

sum invested. Past performance is not necessarily a guide to future

performance and no guarantees are offered in respect of investment

returns and/or capital invested.

Tax assumptions may change and you should rely on your own tax

adviser when considering your personal circumstances. The funds

may have exposure to securities denominated in currencies other

than their functional currency; changes in exchange rates may have

an adverse impact upon the fund performance. The investment may

not be suitable for all recipients of this publication.

This newsletter is produced for the MitonOptimal Group of companies as an in-house publication. If you have any queries regarding our content please contact Mark Margetts-Smith (info@mitonoptimal-ci.com) in the first instance.

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Mark Margetts-sMithGroup Head of Marketing

International & South Africa

For further information contact us via the MitonOptimal Group Head Office

MitonOptimal Group - Great Westerford, Suite 202,South Wing, 2nd Floor,240 Main Road, Rondebosch, Cape Town, 7700, South Africa

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