Discovery Balanced Fund - Market background

Discovery Balanced Fund

Market background
After global stock markets sold off in October on fears of a resurgence in COVID-19-related lockdowns
in Europe and the USA, November turned out to be a record breaking month for markets on the back
of breakthrough vaccine announcements by Pfizer/BioNTech, Moderna and AstraZeneca/Oxford and a
market-pleasing outcome in the US presidential elections. Developed market equities (MSCI World
Index +12.8%) outperformed Emerging market peers (MSCI Emerging Markets Index +9.2%) which were
held back by China (CSI300 Index +3.9%) as the rotation into value and cyclicals benefitted the laggard
performers for the year. Global bonds (Bloomberg Barclays Global Aggregate Bond Index) ended the
month up 1.8%. All returns are quoted in or against US dollars.

On the local front, South African equities also had a strong month with the FTSE/JSE All Share Index
rising 10.5% as financials led performance (+17.1%) followed by resources (+10.9%), with industrials
lagging but still up a strong +8%. Within resources, the performance was offset by weakness in the gold
miners, which were the biggest losers for the month (-17.5%). Listed property (FTSE/JSE All Property
Index +18.4%) rebounded strongly and was the strongest sub-sector performer on the bourse, albeit
from a very low base as the sector is still down 42.4% for the year. Local bonds (FTSE/JSE All Bond Index
+3.3%) also benefitted from the risk-on sentiment with non-residents turning into net buyers for the
first month since January. The rand continued to strengthen versus the US dollar and the euro.

Performance review

For the month, the portfolio delivered positive absolute returns.

Key positive contributions:

    •       The allocation to general miners, Anglo American and BHP Group, performed well over the
            month.
    •       Absolute gains were further enhanced by our holdings in South African banks (Absa,
            FirstRand and Standard Bank), South African apparel retailers (The Foschini Group,
            Truworths and Mr Price Group) and financial services provider, Sanlam.
    •       Offshore equities delivered a solid performance over the month, with the European equities
            and US banks position being notable outperformers and contributors to absolute
            performance.

Key negative contributions:

    •       The stronger rand versus the US dollar the strong rand eroded returns from the offshore
            component of the portfolio.
    •       Given the risk-on market sentiment, our defensive exposure to the gold miners weighed on
            absolute performance, as did holdings in AVI and Pick n Pay pressured return over the
            month.

Portfolio activity

Within the local equity component, we continued to increase our holdings in select cyclical exposures at
the expense of more defensive exposures. We further trimmed our gold mining exposure to take
advantage of the attractive entry points in Impala Platinum and BHP Group, where the upside to
market consensus forecasts remains high given prevailing commodity prices and the free cash flow
yields are very supportive. We also took some profits by trimming our holding in British American
Tobacco and Prosus, while topping up our positions in Standard Bank Group, ABSA and The Foschini
Group as the earnings revisions profiles appear to be troughing and the valuation levels offered a good
entry point. In terms of offshore stocks, we took some profits on European equities in favour of cyclical
US and Japanese equities.

We also took profits on the offshore investment-grade bond position. We have sold down our exposure
to the high-quality basket of names we held, including paper from Apple, AT&T, and McDonald’s to
mention a few.

Outlook and strategy
The global economic environment outlook remains fluid given the current waves of COVID-19 infections
versus the vaccine rollout potential in 2021 and the lack of a US fiscal stimulus deal. To navigate
through this, we continue to have a balanced and diversified exposure across asset classes,
geographies, sectors and individual assets. In assessing the environment and making asset allocation

decisions, we continue to tilt the portfolio to those asset classes (and underlying assets) that score well
in terms of our compelling forces framework: fundamentals, valuations and market price behaviour.

The offshore allocation remains favourably disposed to equities, with exposure continuing to tilt more
towards cyclical companies where earnings have appeared to have troughed and valuations are
reasonable. Regionally, we continue to have a positive skew towards Asia. The China growth story – the
economic engine for the Asian region – remains more positive than the rest of the world. Chinese
markets continue to exhibit reasonable valuations, while earnings have substantial upside over the
medium term, in our view. China’s consumer industries have great growth potential given the low
penetration levels in many consumer sectors, while increasing household wealth is driving
consumption upgrades and industry leaders are seeing market growth, potential market share
expansion and higher margins over time. In Japan, with Yoshihide Suga now at the helm, there is
renewed focus on the reform agenda, and this could prove positive for growth. Japanese corporate
balance sheets are relatively healthy and provided support in managing through the COVID-19
pandemic and they are in a strong position to improve their profitability from these trough levels over
the medium term, coupled with attractive valuations. Both the Chinese and Japanese equity markets
also offer significant diversification benefits given their low correlations with the domestic equity
market, thus exhibiting attractive risk and return attributes from a portfolio construction perspective.

We have continued to reduce some exposure in the European region in favour of companies with a
more superior recovery and growth trajectory in other regions. Aside from these geographies, we also
have exposure high quality, attractively valued companies with improving operating performance that
are receiving increasing investor attention. This includes quality compounders with pricing power or
structural winners in healthcare and tech-related sectors. We believe these companies exhibit a long
runway for strong, sustainable earnings growth which should be key in a low inflation and interest rate
environment that the market appears to be underestimating.

Global bond yields, even after having risen off their lows, remain at low levels as we have witnessed
synchronised policy easing from central banks in the face of the COVID-19-related economic downturn.
Stimulus packages and policy measures to stave off a deep recession have been widespread and large,
along with the loosening of regulations to enable counter-cyclical responses from governments and
financial institutions. Most developed market government bonds have negative real yields and the front
end of the bond yield curve is likely to be anchored by easing biases from central banks, while the long
end could be affected by supply as countries will need to fund their fiscal stimulus packages. We
therefore prefer other asset class opportunities which exhibit better risk-return characteristics in our
view.

The local equity composition is well diversified, and we continue to tilt the portfolio towards select
cyclical exposures, while harvesting gains on the more defensive exposures. We still have some capital,
albeit less than previously, invested in global defensive companies (Naspers, Prosus, British American
Tobacco, Bid Corp, Anheuser-Busch InBev) where earnings expectations remain relatively robust, while
valuations are reasonable. These stocks also provide additional protection against any potential rand
weakness. This sits alongside a growing allocation to global cyclical stocks (diversified miners, PGM
miners, and luxury goods maker, Richemont) geared to the global economic cycle and exhibiting
favourable earnings revisions profiles. Most of the exposures in this bucket are benefitting from the

faster China recovery versus the rest of the world, as well as tight commodity markets in our view. We
also have a growing exposure to select local cyclical plays (FirstRand, Sanlam, Standard Bank Group,
The Foschini Group, Capitec Bank) with decent relative earnings revisions profiles, trading at
reasonable valuations and where we also have high conviction in terms of balance sheet quality. Our
exposure to local defensive businesses (MTN Group, AVI, Pick ‘n Pay Stores) is limited as earnings
revisions and valuations are still not as compelling in this space.

We have maintained the material allocation to local sovereign bonds and the asset class remains our
preferred play in the local fixed income spectrum. While the front end of the bond yield curve has been
anchored by significant interest rate cuts this year, we continue to see opportunities along the steep
curve, without understating the fact that our assessment of fair value (the appropriate yield to
compensate lenders for risk) is now substantially higher given the heightened credit risk. While
concerns around deteriorating fiscal metrics could keep a lid on capital gains, the buffer provided by
the income profile of local bonds provides a robust underpin to the asset class in our view. Additionally,
local bond valuations look attractive versus their own history (the current spread between the 2-year
and 10-year government bonds is extremely elevated in historical terms) as well as against emerging
market peers (the domestic 10-year government bond has one of the highest real yields versus its
counterparts, particularly those with a similar risk profile). We continue to be positive on the medium-
term total risk-adjusted return profile for domestic bonds.

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