FundManagement

Advisory Services

Performance Fees - What is a Fair Deal (For Clients)?

Prof. Evan Gilbert

The Quarter in Review (International Asset Allocation)

Joanne Baynham

Fixed Interest InvestingAlbert Botha

Domestic Asset Allocation OverviewRoeloff Horne

Practice Management - Building a Moat or Predicting the Future?

Rob Macdonald

Commodities vs. Consumer EquitiesArmin Diem

Nkandla: Short-Term Noise or Swing Factor in Voting Behaviour?

Helen Macdonald

Meet the TeamGabriël Botha

Newsletter Q12014

South Africa | Guernsey | Singapore | Isle of Man

MitonOptimal Group Index

3 IntroductionScott Campbell

4 The Quarter in ReviewJoanne Baynham

6 Fixed Interest InvestingAlbert Botha

8 Performance Fees - What’s a Fair Deal (For Clients)?Prof. Evan Gilbert

11 Domestic Asset Allocation OverviewRoeloff Horne

12 Commodities vs. Consumer EquitiesArmin Diem

14 Practice Management - Building a Moat or Predicting the Future?Rob Macdonald

16 Nkandla: Short-Term Noise or Swing Factor in voting Behaviour?Helen Macdonald

18 Meet the TeamGabriël Botha

19 Contact Us

Fund ManagementAdvisory Services ■ Domestic Funds ■ Offshore Funds ■ Co-branded Funds

■ Portfolio Management ■ Asset Consulting ■ DFM Model Portfolios ■ Full Service Para-Planning

www.mitonoptimal.com2

MitonOptimal Group Introduction

As we move into the second quarter of the year, relative calm and complacency is definitely reflected in global investment markets and the wealth management industry in general. MitonOptimal has made large strides across the Group, over recent years, to further build our expertise and capabilities in multi-asset management and discretionary fund management services for financial advisers and their clients, plus selected institutional clients. We believe that we are perfectly positioned to assist intermediaries in handling what lies beyond the currently calm and complacent investment world.

Global markets have consolidated on a great year in 2013, with a range-bound first quarter. Our core, long-term, asset allocation themes have not changed, but there is no doubt that we are slightly more cautious, from a short-term tactical perspective. The fragile, five currency volatility debate over Chinese growth in the year(s) ahead, plus political unease in the former USSR, gives us plenty to ponder in our morning meetings.

In this issue, Roeloff Horne digs deep into the new normal (Domestic Asset Allocation Overview - Page 11) whilst Joanne Baynham talks about global asset classes and what we can expect for the rest of the year. Prof Evan Gilbert tackles the delicate subject of performance fees and the balance between incentivisation and what’s fair to the client. Our South African high conviction equity manager, Armin Diem, looks at the pros and cons of domestic commodity stocks vs. consumer related counters. Our Chief Operating Officer, Rob Macdonald, looks at the concept of the optimal business strategy, in challenging times. Finally, our new guest columnist looks at South African politics and the “Nkandla” ramifications for the upcoming elections.

The MitonOptimal team continues to grow, with Gabriel Botha joining as a client portfolio manager in Cape Town during Feb, as we continue to invest in talented young people to assist out clients and ultimately drive the business forward in the years to come.

Thanks to all our intermediaries, clients and staff for a great start to the year and I’m sure the calm and complacent environment will continue forever, Yeah Right!

FundManagement

Asset Consulting 3

Scott campbellChief Investment Officer & Managing Director

of the MitonOptimal Group of Companies

www.mitonoptimal.com

The first quarter of the year, in terms of the equity markets, pretty much played out as we predicted at the end of 2013, with a lot of to-ing and fro-ing, but markets generally remaining range-bound over the quarter.

In fact U.S. equity investors saw the weakest first quarter in five years, as can been seen by the graph below.

S&P 500 Index Performance - Q1. % change

[Source: Bloomberg, Barclays]

Emerging market equities once again had a weak quarter, with the worries over China and large current account deficits leading to large outflows from this asset class. The outflows did slow down towards the end of the quarter, as investors began to question whether the valuation gap between developed markets and emerging markets had become excessive and that perhaps an awful lot of the bad news had been priced in. To cite one example: Brazilian equities gained 7% in the last week of the year and that was after Brazil was downgraded by S&P.

Poor returns were not the order of the day for the bond market, with the JP Morgan Global bond index ending the quarter with gains in excess of 2%, which, following on from last year’s negative returns was surprising indeed. More likely, it is because investors had become so bearish on this asset class, that we saw bonds rally, but we did note in our last commentary that yields had backed up last year and were offering a lot more value than they had for ages.

The star performer over the quarter was global property, with returns in excess of 3.5%. This was helped by the strengthening bond market, and also the growing realisation that property offered potentially good returns relative to equities, with decent and growing yields.

Equities During the quarter we reduced our equity positions to neutral (i.e. in terms of our long term strategic weightings to the asset class), as valuations are not attractive enough for us to be overweight equities within our portfolios, but nor are equities so parabolically expensive that we want to be underweight this asset class either. Investors are also incredibly complacent, believing equities are the only asset class in town and that there is no need for any protection. It is at times like this that we get nervous. Not only that, but companies continued to re-rate in 2013 and the early part of 2014, whilst at the same time expectations of earnings have been constantly downgraded. We remain underweight the U.S. within our portfolios, preferring the opportunities we are seeing in Europe and the UK. The S&P is on a forward PE multiple of 15.4X, far above the 10-year average of 13.8X. In terms of the cyclically adjusted PE multiple (CAPE), the S&P sits at 25.1 (52% above its average for the past century). Europe & the UK, on the other hand, are on far lower CAPE ratio and in our opinion offer far better value.

We have a small holding in emerging market equities and the bulk of this holding is in Asia, where we think a lot of companies have been wrongly sold, due to all emerging markets being painted with the same brush. Asia still has a strong savings culture, is highly productive and weaker commodity prices should assist in increasing company margins, given that they import a lot of these goods. Trades that we implemented during the quarter were out of our energy holdings, switching them into Legg Mason Japan’s fund, as we felt that the Japanese market had become oversold during the quarter. At the time that we purchased the fund, the market was down 14% and went on to end the quarter down about 7%.

MitonOptimal Group Quarter in Review

The Quarter in Review

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BondsThe near doubling of ten-year yields, in core sovereign bond markets during the latter part of last year, means that our outlook for fixed income is meaningfully more constructive than it was at this point in 2013. Despite having seen much of the over-valuation exorcised from these markets, as the result of investors’ reaction to the prospect (and subsequent reality) of the Federal Reserve’s (“Fed”) QE tapering, our choice of managers and relatively defensive positioning reflect the view that the bond space is still not exactly a “target-rich” environment.

The majority of our current holdings fall into two distinct categories, the first of which - strategic managers - makes up almost 40% of our MOO Fixed Interest Fund. Though differing in their approaches, all possess the flexibility, expertise and willingness to actively manage their portfolios’ duration (interest rate sensitivity) and its credit profile: attributes that we consider essential when investing in mainstream fixed income markets within the current climate.

Alongside these sit a number of credit-oriented managers, each of which invests within a particular sub-set of the market. This includes a manager concentrating on sovereign and corporate debt issued by the world’s creditor nations (a simple concept: lend only to borrowers that have the means to repay you), together with an Asian markets specialist. We also hold a fund focused on senior mortgage-backed securities.

In terms of portfolio activity, at a strategic level we have sold a position in a macro bond manager, which was selected specifically for its negative duration positioning in anticipation of the aforementioned market sell-off. Having seen this long-anticipated market correction, the rationale for the holding no longer applies.

More recently, changes to the Fund’s portfolio have reduced exposure to a manager specialising in short-dated corporate debt in favour of one pursuing a highly disciplined absolute return strategy in G7 sovereign bonds, interest rates and currencies.

PropertyGlobal commercial real estate still offers significant yield pick-up and absolute returns in both the physical and listed REIT markets. Following a big out-performance since the financial crisis, this has stablised in the past 12 months as investors come to grips with the effects of rising interest rates on the commercial property sector. As most properties have some form of gearing in their capital structures, higher mortgage costs will effect returns, as will higher yield expectations. However, these will be offset by the return of rental growth across most sectors and regions. For the first time in years, we see little valuation differences between Asia, Europe and the U.S., with South Africa one of the only markets where property yields do not offer yield pick-up over their respective 10 year government bonds.

One addition to our global portfolios towards the end of last year, which we are quite excited about, is the UK listed Tritax Big Box REIT. This

Joanne baynhamHead of International Portfolio

Management - South Africa

vehicle specializes in UK commercial sheds that focus on distribution for e-commerce and Internet shopping retailers. There is little infrastructure to support what is currently a small part of retail sales but growing quickly.

Alternative StrategiesAfter a difficult time during and since the financial crisis, many hedge funds, listed private equity and infrastructure have rebuilt their businesses and portfolios. Our core hedge fund holdings performed well, in absolute terms in 2013, and provide significant diversification, from a risk adjusted return perspective, to our high global equity exposure. Going forward, we see significantly more opportunities for long-short equity managers who can spot the good and bad companies or sectors to generate alpha. We recently decided to add to our core Nevsky long-short fund, to reflect this view.

Cullross, one of our hedge fund of funds managers with a global thematic style, had a particularly good 12 months, as did a number of our underlying managers in our Odyssey low correlation managed account platform.

CurrenciesWe continue to favour the Dollar against all major developed market currencies, particularly the Euro, the strength of which remains one of the biggest conundrums to us in currency markets. The U.S. will raise rates long before the Europeans do and furthermore growth in the U.S. is a lot stronger, which should favour the Dollar vs. the Euro. As for Sterling/Dollar cross, the broad pick-up in the UK housing market should support Sterling, but at current levels of 1.66, a lot of the good news of the UK growth recovery is pretty much in the price.

In terms of emerging market currencies, we have not changed our view that those countries that are running large current account deficits and are beholden to the fortunes of China will see renewed weakness, once this current bout of ‘’risk on’” is over. But those EM countries with surplus savings and current account surpluses should appreciate against the Dollar over time.

SummaryAs we look forward, to quarter two, complacency appears to be the order of the day as margin debt levels are at all time highs in the U.S. market, the Fed is continuing to taper and has even hinted at rate rises for 2015. Earnings are constantly been downgraded and we are beginning to see the start of the high flying stocks come off the boil.

Bond markets are more attractive then they have been in a while, but are still not offering fantastic value, but do offer some diversification should equity markets take a much needed breather.

Property and alternatives offer the best returns for the risk taken at this present juncture, one because of the yield pick-up relative to bonds and the other because we believe there is lot of mispricing of assets in markets, that alternatives who have the ability to go both long and short should be able to take advantage of.

Advisory Services

FundManagement

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Fixed Interest InvestingMitonOptimal Group

www.mitonoptimal.com

Not another rates article...

At the moment the market expects the Repo Rate to rise by at least another 2% over the next two years.

Stating that, in such a manner, grants a degree of certainty and credibility to a subject that is, in actual fact, greatly different. Market expectations, especially regarding interest rates, are quite fickle and varied - yet discussions tend to ignore these underlying realities. To a large extent this is necessary because, as much as they would like to believe otherwise, the person on the street is a layperson when it comes to certain types of specialized knowledge. Engineering, law and medicine are all great examples of this. In discussions with their clients, they simplify the problem – and the clients accept their understanding. Few people argue a diagnosis with their doctors!

Investments are another example of specialist knowledge - especially interest rate forecasting.

In the opening sentence of this article, the current market consensus regarding the future of interest rates was stated. Yet, the tone seems to imply that several senior people, from various institutions, sat down, had a lengthy discussion and then reached some form of agreement.

Fixed Interest Investing

The reality is VERY different though. When we try to analyse market expectations, we look at something called forward rate agreements (“FRAs”). These are contracts between two institutions, fixing the rate at some time in the future. Think of this in terms of fixing the next two years on your mortgage rate. If a bank offers you 5% you would jump at it, whilst you would most likly avoid anything above 10%.

By looking at the rate that these two institutions can agree on, we can get an idea of how professional investors view the future. If the asking rate is too low or too high, either of the two institutions will feel disadvantaged and the deal will fall through. Right now, there are thousands of funds and institutions looking to fix a borrowing rate or lend at a fixed rate – and there are thousands of these types of deals occurring every day. Where supply meets demand is where the rate is set. Thus the FRA rate in two years time is not really a consensus at all, but rather an average – and averages, as we know, can massively distort the underlying complexities of a situation.

For example: At Atlantic we believe that the repo rate may only be 1% higher in 2 years, while other investors believe rates may skyrocket by well over 3%. Chart 1 over the page shows the reality. The blue line is the history of the repo rate (and current consensus), while the gray lines denote the various opinions held by market participants.

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[Chart 1: Source: Atlantic Asset Management, Bloomberg]

This is one area where fixed income managers can earn their keep. If you believe that rates will rise less than expected, you can enter into a contract at the current market rates and, if rates then increase slowly, you generate excess returns. If you hold the converse opinion, you invest in instruments where the return rises with the interest rate and outperform that way. But the question may be asked, “Who are we at Atlantic Asset Management to question the wisdom of the mighty market?”

The point is, that historically market “consensus” has often been wrong. The reason is not because professional investors are stupid or incompetent, it is because economic circumstances change and views are adjusted accordingly. Most investors agreed that the Rand was too strong at the end of 2012, yet very few would have expected it to weaken from R8.50/$ to over R11/$ in little over 12 months (a 32% move). When events like this occur, our expectations and interest rate views have to adjust.

It is important to note that these reactions could still be based not just on changes to economic data, but also on fear and uncertainty - and it is in such cases that profits are to be made. Chart 2 shows the repo rate back to 2002, along with the 2-year market consensus at the end of every month.

albert botha Portfolio Manager & Analyst, Atlantic Asset Management

Advisory Services

FundManagement

[Chart 2: Source: Atlantic Asset Management, Bloomberg]

As you can see, the market gets it right as often as it gets it wrong. It under/overshoots the severity of the change; it gets the direction wrong and it misses the peak. In hindsight, 2009 to 2011, was a great time to fix rates, as market consensus was constantly calling the bottom - yet the reality was very different. And that is my final message: It is not easy; fund managers get calls wrong, which with hindsight, seem obvious. So stick to a fund manager that has shown a willingness to be flexible, along with the ability to adapt to the changes in circumstances. Doing so over the long-term can add incremental alpha, along with bringing peace of mind.

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www.mitonoptimal.com

MitonOptimal Group Performance Fees

Advisory Services

FundManagement

Performance Fees What’s a Fair Deal (For Clients)?

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Performance fees are payments made by investors to fund managers when their fund’s investment performance exceeds a hurdle rate. In other words, the investor only pays this fee when the performance of the fund justifies it. While this is apparently an attractive idea, there are some pitfalls which can easily turn them into an opportunity for investment managers to treat clients unfairly. It is extremely important for investors to understand these issues to make sure that the funds that they are invested in do not have performance fees structured in a way that is unfair to them.

What is attractive about performance fees?The most common justification for performance fees is that it is a mechanism that better aligns the interests of the investor and the manager. The argument goes that the more effort the manager puts in, the better the performance, so rewarding performance should incentivise additional effort. On the face of it this is a very attractive concept from an investor’s perspective – why pay for something when you do not get any value from it? From the fund manager’s viewpoint, the arrangement is also attractive as it allows them to earn additional fees when they are adding value to their clients.

What is potentially unattractive about them?Given the multiple factors that can impact on investment performance, there is doubt as to whether using performance as a proxy for skill is appropriate. Furthermore, the devil is in the detail of the specification of the performance fees.

1. Randomness and riskAt a conceptual level, it is important to recognise that randomness is present in any investment outcome. With all the effort (and skill) in the world, investment returns will always have some element of luck in them – either good or bad. Consequently, performance fees may be earned (or not) in part because of the presence of this randomness and not the skill of the manager.

While performance is what investors see, ultimately it should be the skill of the managers that should be rewarded, not its combination with the inherent randomness of the investment process. Unfortunately, this is not easily done in practice – although the choice of benchmark is key here.

2. The choice of benchmarkA performance fee is only paid when the manager’s performance exceeds the specified benchmark. The selection of this benchmark is thus crucial to the fairness of the performance fee arrangement.

An appropriate benchmark is one that matches the nature of the investment strategy. For example, using a cash benchmark is clearly inappropriate for equity mandates – equities are expected to earn a premium over time and thus thus performance fees can simply be earned by holding an index type portfolio. It is worrying how often this happens. A more subtle, but very similar, example is the use of a market capitalisation-weighted benchmark, such as the FTSE/JSE Top 40 index for a value style equity manager. There is much academic evidence that shows that value as an investment style earns a premium above market weighted indices. Managers using this style should therefore be assessed with reference to a value index, not a market capitalisation index.

A peer or sector average benchmark is often used as a benchmark for performance fees. This has several disadvantages from an investor’s perspective. Firstly, the returns reported are usually after fees, so this benchmark is easier to beat than an index-return benchmark. Secondly, unless the

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peer group or sector is very carefully chosen, there is a very real risk of funds with fundamentally different investment mandates being lumped together. Funds with a more aggressive mandate should outperform their more conservative peers – but why should this justify a performance fee? An appropriately designed index or style-based benchmark is more appropriate in most cases.

3. High-water marks - Making it a two-way bet The final problem with performance fees is that they are usually specified as a one-way bet for the managers. Managers earn fees when they outperform the benchmark, but do not ‘pay back’ these fees when they under perform. This arrangement is equivalent to giving managers a call option on the value of the portfolio: This option is worth a lot to managers and thus should be charged for. A lower (or even zero) base fee should be the norm if such a performance fee is present.

A far more appropriate method (from the investor’s perspective) is one that uses a “high water mark“ when calculating performance fees. The high water mark is the highest level of return earned by the benchmark over a rolling period and the performance fee is only chargeable if the fund manager outperforms the benchmark from the high water mark onwards. This means that if the investor suffers negative returns (i.e. is below the high-water mark) the manager cannot charge a performance fee. This method, to a large extent, makes it a fairer deal from a client’s perspective.

Managers generally don’t like high water mark-based performance fees, as they argue that they can add a lot of value when markets are moving down. That may be true, but something feels wrong about having the following conversation with a client: “we outperformed the benchmark by losing less money than it did, so you have to pay us a performance fee”.

4. Insist on clarity Given the potential for abuse of performance fees by investment managers, such fees are now very much in the spotlight of the regulator and under review. Until clarity from the regulator is provided, “caveat emptor” (buyer beware) should be the stance that investors take when making new investments. If a fund has a performance fee, investors should not simply assume that their and the manager’s interests are aligned. Investors should insist on getting a clear understanding of the performance fee arrangements of a fund they are investing into. And if the performance fee of that fund is not calculated on a high water basis, ideally with performance benchmarks being index- based, then the investor would be well advised to consider finding another investment.

prof evan GilbertHead of Asset Consulting

South Africa

Advisory Services

FundManagement

Performance Fees (Cont.)

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MitonOptimal South Africa Domestic Asset Allocation Overview

roeloff horneDirector & Head of SA Portfolio Management

Domestic Asset Allocation OverviewFor Domestic Funds and Portfolios

Advisory Services

FundManagement

We take into consideration both strategic and tactical decisions (overweight/neutral or underweight), within various asset classes, in each of our multi-asset funds, according to an optimized portfolio profile, per risk profile and investment horizon of each mandate. In that context, this overview deals with our views on

SA Equities (Marginally Underweight)

SA Bonds (Underweight)

SA Listed Property (Underweight)

SA Cash (Overweight)

Global Equities (Overweight)

Global Listed Property (Underweight)

Global Bonds (Overweight)

Global Cash (Overweight)

■ Main conviction, to be marginally underweight, is based on our market’s relative valuation to other emerging and developed markets and a superior earnings growth potential in these countries, as global consumer spending is recovering.

■ We reduced exposure to ‘SA incorporated’ stocks, such as small caps and consumer related stocks.

■ Within equity sectors, we are currently overweight Resources, underweight Industrials and neutral in Financials.

■ Resources had an earnings upgrade, based on a weaker Rand, and improved global growth prospects, which can influence commodity prices.

■ More than 60% of the Top 40 stocks generate offshore earnings, which isolates a large component of stocks away from the SA Consumer - who are experiencing higher inflation and administrative costs and the start of a rate hike cycle.

■ We are at the bottom of our interest rate cycle and the global normalisatoin of interest rate cycle has just started. This is a difficult environment for nominal fixed rate bonds. It does not mean one should totally avoid it as bonds can become mis-priced from time to time.

■ Within Bonds we favour floating rate notes as it inherently has no interest rate risk. ■ Although we are underweight fixed rate long bonds we used the opportunity to buy longer dated

bonds at higher yields just after the sell-off in January. ■ We were neutral inflation linked bonds up to 31 January, but a spike in the 10 year real yield from

1.7% to 2.2% due to the rate hike and a rerating of bond yields, inspired us to buy more to gain more exposure to this asset in seeking long term real yields for our funds.

■ Both trades offered us protection against a stronger rand in the past 6 weeks.

■ SA Equities trade at a premium to the MSCI Emerging Market Index and the MSCI World Index, therefore we seek maximum exposure to more attractive global stocks, with higher earnings growth potential due to a steady global consumer spending recovery.

■ We reduced our global equity exposure in the quarter, to take profit from a weak Rand. ■ We continue to favour developed market equities above emerging market equities, but for our

high risk investors, we plan to gain more exposure to Africa, China and other Emerging Market equities that are now trading at a 30% plus discount to developed market counterparts.

■ The underweight allocation is, as with bonds, also related to the normalisation of the interest rate cycle.

■ The other concern is the premium to NAV, that most large counters trade at and also the negative spread relative to the 10-year fixed rate bond. Global listed property counterparts trade with positive spreads and are more attractive.

■ As listed property rerates, we are considering adding exposure to this asset class, as it provides good long-term inflation protection, if you buy it at the right price, in more stable economic conditions.

■ Although we mainly use floating rate notes (which resets with interest rates) as our alternative to cash instruments, we use these short-term money instruments as a short-term tactical allocation, to preserve a large portion of investor’s capital as a counter position to our underweights in other asset classes.

■ As in our SA Bond portfolios, we favour US$ denominated floating rate notes and inflation linked bonds within this asset class. Being overweight global bonds in our SA portfolios, serves as a tactical allocation to mitigate risk and generate gains if any unexpected global event cause further Rand weakness.

■ We reduced our exposure to global listed property in light of tapering and the normalisation of bond yields in developed and emerging markets. The asset class remains correlated to bond yields in a period of consolidation.

■ Global listed property does not trade at a premium to global bond yields and is more attractive, relative to SA counterparts, as it trades much closer to NAV and can be a beneficiary of global inflation later in the cycle. We look to increase our exposure to this asset class as and when global economic growth improves and bond yields stabilise.

■ Global cash rates remain unattractive and we simply use US$ allocation as a a long-term risk management allocation against any unknown risk within global capital markets.

our short-term tactical calls; which may differ from our long-term strategic views. We believe this is prudent practice, in a world dominated by debt de-leveraging and political interference. We believe that ‘buy- and-hold’ and static asset allocation approaches carry risks, in an era of such extreme global volatility.

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www.mitonoptimal.com

MitonOptimal South Africa Making a Case

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The case for being overweight SA commodity equities and underweight SA consumer equities.

In August 2013 the MitonOptimal High Conviction Equity Fund made its first large allocation to commodity share acquisitions. We have accordingly over the past nine months, been positioned for an environment where commodity shares outperform consumer shares. In broad terms this has been correct year to date in 2014, with the resource index up 9% and consumer goods down by 0.5% and consumer services down by 2.5%. The last two weeks in March saw a big rally in consumer shares, with the likes of general retailers and food retailers rallying by 12%. Is this rally in consumer shares sustainable?

From a macro- economic perspective, we believe that South Africa has moved generally from a very consumer-friendly environment to a more difficult period for consumers and the companies that focus on consumers as their customers. This view starts with the global and South African backdrop, where the interest rate cycle has bottomed and short term interest rates are going up at different paces depending on which country you are looking at.

In South Africa’s case, interest rates are coming off a 50-year low. South African consumers are highly indebted and have used the last three years of low interest rates to increase their debt levels rather than paying off debt. In addition there has been a massive pull back in unsecured lending, where year-on- year growth is in single digits and falling off its highs of 25% a few years ago.

The South African Reserve Bank expects real retail sales to grow by only 2.2% in 2014: well off the 5% to 7% levels of two years ago. The basic cost of living increases are becoming increasingly difficult for the average consumer to bear, with petrol alone up 35% year-on-year, leaving less disposable income. The government has played its part in the massive consumer boom of the past 6 years by increasing civil servant employment and awarding above inflation salary increases. Now national debt has reached levels where restraint is required and spending must be reined in if the SA government wants to retain its investment grade credit rating.The valuations/ratings of consumer companies are very high in

absolute terms and relative to their history. This in a situation where their earnings growth is expected to slow very dramatically in some cases, or even decline in the case of the credit-driven apparel retailers or vehicle retailers. New vehicle sales are down by 5% year-on-year in the first quarter of 2014 and even the latest results from the likes of the usually dependable Shoprite showed EPS growth slowing to 8%.

On the other side of the equation we have commodity producers that have been in a relatively tough environment for a few years with Dollar commodity prices mostly in decline but their underlying producer costs, such as wages and electricity, going up at double-digit rates. This, together with a period of strong emerging market currencies due to the Fed’s quantitative easing (which has since reversed), has resulted in big declines in profitability. This has led to a proper reassessment of the way miners go about their business (after many CEOs were fired) and prompted big reductions in capital spending, massive cost cutting and closures of low margin mines. Together with a large adjustment in the value of emerging market currencies such as the Rand (down by 70% against the weak US Dollar over the past three years), this has led to a big turnaround in many of the miners’ earnings. Going forward, it is a continued focus on cost cutting and capital spending reductions that will drive free cash flows and the ability to pay out these cash flows to shareholders that should result in an improved rating of these companies. Obviously the role of iron ore will be critical in the earnings of all the three majors BHP Billiton, Anglos and Rio Tinto.

The massive underperformance of the resource sector, since both the peak of the market prior to the collapse of the global economy in 2008 and after the beginning of the recovery in 2009, suggests that there is more than this year’s year to date relative outperformance to follow. This forms the basis of our view, which at this juncture is based on a cyclical perspective rather than a secular perspective.

armin DiemFund Manager

South Africa

Advisory Services

FundManagement

Commodities Vs. Consumer Equities

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MitonOptimal Group Practice Management

www.mitonoptimal.com

Practice Management -Building a Moat or Predicting the Future?

The optimal business strategy for challenging times - building a moat or predicting the future?

As irrational as it is, predicting the future is something that humans try to do all the time. Whether it be the stock market, the weather, the election or the rugby score, there seems to be an insatiable human desire to try and predict the future. We do this as we hold onto the fantasy that we might “strike it rich” or avoid risks that may harm us.

For financial planners, predicting the future is something their clients probably secretly think they should be able to do. “Why am I not invested in that top performing fund?” is, I’m sure, a question most planners will have had to deal with at some point during their careers, and probably more than once! However, financial planners themselves would probably also like to be able to predict the future, not only for the benefit of their clients, but also to protect the future of their businesses.

This is of particular relevance, given the challenging times in which financial planning businesses find themselves. As the authors of a recent paper entitled the ‘Brave New World of Wealth Management’1 put it: “…most owners recognize that the business is becoming significantly more challenging. New clients are harder to find, operating costs – and employee compensation in particular – are increasing and regulators are becoming more hostile. Additionally, looming over all of these changes is a much greater, immutable force: old age. The founders of the industry’s participants, with an average age of 59, are reaching an age at which personal needs and objectives shift in preparation for retirement.” While this is a description of the wealth management industry in the US, it is just as apt for South Africa.

As the quote indicates, there are many challenges facing financial planners, but the most current one for many advisors seems to be the “hostile regulators”, with the obvious question: what are they going to do next?

Up to now, the Financial Services Board (FSB) has tended to look to the UK and Australia for regulatory regime guidance. The problem now is that seemingly similar regulatory reforms in the UK and Australia appear to be diverging in direction. The Australian FOFA reforms are backtracking under political pressure. Proposed changes such as, clients having to “opt-in” every two years, mandatory transparency of advisor charges

and a ban on volume payments are now falling off the reform wagon. In contrast, the UK RDR reforms appear as though they are being enforced with all the intent with which they were formulated. What then for South Africa?

It is probably safe to hazard a bet on South Africa ending up somewhere between the UK and Australia, but what that looks like we don’t know at this point in time. What we have seen already in South Africa is changes in line with the UK such as increased levels of business compliance, more onerous qualification requirements and greater fee transparency. But other changes, such as distinguishing between “Independent” and “Restricted” advice in the UK (and first mooted by Treasury in SA in a white paper in 2006) has still not eventuated.

We could spend time trying to predict further regulatory reform and the implications for advisor businesses, but given that we know we can’t predict the future, this would most likely be a futile exercise. This does not necessarily mean financial planners shouldn’t do anything to improve their chances of dealing with this uncertain future, however.

Unfortunately, research indicates that the majority of advisors in the country are following exactly this course of (in)action: according to Core Data Research, 54% of South African advisors are not making changes in anticipation of RDR-type reforms. The reasons for this are most likely to be varied, but having participated in a number of forums with financial planners over the past year, there is a very real chance that the reason for this is simply the perception that regulators are viewed as being “hostile” to financial advisors and thus are to be resisted.

Such unhappiness may seem justified, given that many financial planners have built up very successful businesses over many years with many very happy clients. Consequently they resist the need to change or be told what to do.

Another, more productive approach, we believe, could be to reframe the “hostile” lens through which regulatory change is seen. Warren Buffett says that ideally, he will invest in businesses that have a “moat” around them. By “moat” he means something that provides a business with a real competitive edge, ideally a barrier(s) to entry, which deters competition.

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Warren Ingram, a former Financial Planner of the Year, recently spoke to a forum of advisors about the fact that he sees regulation as the source for developing a moat for financial planning businesses. He encourages the regulator to “bring on” the regulation, as the more onerous the regulation, the bigger the moat gets around those financial planning businesses that are able to respond to it first and in a cost effective manner2. In the UK, requirements such as higher qualifications, a shift from commission-based to fee-based remuneration and the importance of having documented processes in a business have seen a significant fall-out of financial planners from the industry. Rich pickings remain for those who have been able to step up to the plate.

Given that financial planners have little or no influence over regulation, this reframing of regulation could be very necessary. In the same way that good advisors tell their clients not to worry about things over which they do not have any control (like the markets), advisors would do well to follow their own advice when it comes to regulation.

So when it comes to making decisions about the future of their businesses, a more productive strategy would be for advisors to bank on the fact that regulation is providing their business with a moat and to think about how they can benefit from this. The next challenge would be to create additional moats for their business. In particular, moats over which they have control, such as a unique value proposition, a profitable client base, an effective service promise and a distinctive brand. That way, trying to predict the future will remain the folly of competitors who, if South Africa follows trends in the UK in any material way, will, over time, cease to exist.

rob macDonalDChief Operating Officer

MitonOptimal South Africa

Advisory Services

FundManagement

References:

(1) Hurley, M. et al, “Brave New World of Wealth

Management: Opportunities, Competition, Demographics

and Growth Conundrums”, Fiduciary Network, April 2013.

(2) Ingram, W. Presentation to Fundhouse

Practice Management Programme, July 2013.

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www.mitonoptimal.com

MitonOptimal Group Background View

Nkandla - short-term noise or swing factor in voting behaviour? Much has been written about Nkandla in recent weeks and it will remain a political hot potato in the run up to the May 7th general election, as political parties, analysts and journalists alike place their particular spin on the Public Protector’s comprehensive report released in March 2014.

So far, the reaction from Luthuli House (ANC Headquarters) is one of delay, defensiveness and blame shifting, epitomized by the President refusing to respond to the report until the Special Investigations Unit (“SIU”) have tabled their findings on the matter. Conveniently for the President, this will only be at the end of May - after the election and the formation of a new Cabinet. More interesting to ponder however, is whether the Nkandla fallout will have an impact, not only on the national discourse, but also more significantly on the voting behaviour of the many South Africans who will make their mark at the ballot box come May 7th?

Voting Behaviour is a complex topic and not unlike investor behaviour, there are many factors which influence our final decision on election day. When making an investment decision, investors are often influenced by the short-term noise in the market, but in fact investors who make decisions based on medium to long-term factors are usually well-advised to do so. The current publicity around Nkandla represents short-term noise

in the voting market but will ANC voters be swayed by this noise or will they remain loyal to their well-established attachment to the party?

Voting behavior theory suggests that short-term factors, which are closer in time to the actual election, usually only play a role amongst those voters who show weak levels of party identification. These are factors such as the election campaign itself, issue opinions, media stimulus and the specific economic and political conditions at the time of the election.

Medium-term factors play much more of a significant role in voting behavior. These are factors such as group loyalty and value orientations, which help to determine the crucial element in voting behaviour: political party identification. This is a long term, affective, psychological identification with your preferred political party. It usually endures from election to election and is somewhat akin to brand loyalty in the commercial sense, where consumers are loyal to certain brands and resistant to trying new ones.

Longer term factors, like the economic structure of our society, its societal divisions and historical patterns are the context within which our voting decision is made, but are far removed from the actual tick on the ballot box.

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www.mitonoptimal.comAdvisory Services

FundManagement

helen macDonalDIndependent Political Analyst and Research Associate at

the Institute for Justice and Reconciliation, South Africa

Voting behaviour research in South Africa and indeed all the national election results, since 1994, testify to the fact that ANC voters have a strong sense of party identification. Their loyalty to the ANC is deeply entrenched and not easily swayed by short-term factors such as the publicizing of a corruption scandal, despite its proximity to the election and its magnitude. The only other political party in South Africa’s history to command such a loyal sense of party identification was the National Party and one could argue that without this bedrock of support, the party would not have been able to implement and successfully defend Apartheid for the many years that it did. The ANC was formed in 1912 and despite its banning and subsequent exile, has just over 100 years of party history and an indisputable legacy to its advantage, compared with the relatively new opposition parties such as the DA, COPE and UDM and very new EFF, Agang and NFP.

With regards to Nkandla, it is this identification with the party and loyalty to the ANC brand that will mitigate the short-term damage of the scandal. There are likely many ANC voters who will disapprove of Zuma’s record in office, but feel there is no credible alternative or no other political party with which they can closely identify. Party identification can change over time, but it is unlikely to change due to short-term factors and in the South African context would probably be reliant on a more general political party realignment, like the splintering of COSATU and the formation of a workers party to challenge the ANC in 2019 and beyond. This would provide a viable opposition platform for working class South Africans who cannot for historical and personal reasons identify with the DA or smaller parties like the EFF and COPE.

In an open letter to Zuma, published in the City Press newspaper (23 March 2014), former MK member, Marion Sparg, referred to her former comrades as being “heartbroken” by Nkandla and despite asking him to step down, goes on to say: “These comrades of whom I speak JZ, love the ANC and will vote for the ANC on May 7th, as I will.” Her words echo the sentiment that voter identification with the ANC is a deeply personal attachment and will not easily be shaken.

Loyalty to the ANC as party will more than likely override loyalty to the leader (Zuma) and most ANC voters are likely to view Nkandla as a ministerial/bad governance issue rather than a blight on the ANC’s brand come election day. Ironically, although the Zuma presidency has increasingly blurred the line between party and state, ANC spin-doctors will be at pains to separate it here, so the party is not too badly tainted by Nkandla.

Voters also have differing levels of exposure to information and the gravity of Nkandla will not register across all levels of society. Not all voters have equal access to information, through print or electronic media, and not all voters pay attention to or

are interested in news of a political nature. Thuli Madonsela’s report will be received differently (the evidence of this is already overwhelming) by different groups of voters, as we all filter information dependent on a range of factors such as our socio-political background and economic status.

Of course, Nkandla may well be a factor, influencing the voting decisions of those voters who have weak levels of party identification with the ANC. These voters are not bound by the glue of party loyalty and are more easily swayed. They are known as swing or floating voters, whose minds are not made up as the election campaigns get underway and are open to persuasion by opposition parties. In the most recent Ipsos/Sunday Times poll (March 2014), the ANC garners 66% of the vote amongst eligible voters and although this poll took place before Thuli Madonsela’s release of the Nkandla report, it points to the relatively small pool of voters up for grabs by the now increasingly congested opposition platform.

As a stand-alone issue, the release of the Nkandla report probably has limited influence, even on these voters, but when viewed together with Marikana and Guptagate it may give rise to sufficient disillusionment encouraging floating voters to question their loyalty to the ANC brand. Ronnie Kasrils, former defence minister and long serving ANC NEC member has intimated (Mail and Guardian 14 March 2014) that the ANC is no longer assured of his vote, but due to a lack of worthwhile political alternatives, he may consider spoiling his ballot rather than staying away from the polls. It will be interesting to see how levels of voter turnout in this election compare with previous elections, as this may be where we see the biggest impact of Nkandla. A sense of political apathy and lack of motivation to vote is a possible spin off.

Nkandla will come and go and probably not be the cause of a major upset on May 7th, due to the enduring nature of political party identification and attachment to the ANC and the lack of a viable alternative for loyal ANC voters. Political commentator, Eusebius McKaiser best sums it up in his latest book (Could I Vote DA?): “But identity is not just about history. Identity is about an enduring set of moral values and principles that guide my daily life choices. It is about the values that lie at the heart of my character. And I want a political party to be at least broadly compatible with my fundamental values and general political outlook.” For most ANC voters, their party still currently provides this sense of belonging, but looking ahead to 2019, the situation could be vastly different.

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MitonOptimal Group Meet the Team

Gabriël BothaClient Portfolio Manager, MitonOptimal South Africa

Meet the Team

What is your job at MitonOptimal? I’m employed as a client portfolio manager. (A very fancy name, not sure if I’m doing what that title says.) The main aim is to learn as much as possible and implement it!

What did you do before you joined MitonOptimal?I worked as a business consultant, for a private company. One year we did consulting work for Discovery, and the other for Old Mutual. It was a great learning curve!

What do you like about your job so far?I’m glad the words, “so far”, was used Ha-ha. I’ve been on admin training for most of my employment period, which is not one of my strengths. The most that I’ve enjoyed so far, was doing work that challenges me for example calculations for certain clients, recommendations on options for clients etc. Another very enjoyable aspect is to learn more in depth about the offerings we offer and the world of investments.

What is your biggest interest outside of work?I’m very active, so basically any physical activity or sporting events etc. Making time for friends and family is very important for me too but studies take up most of my time, so I’m really keen on finishing them!

What do you do to relax?Jogging, gym, reading, watching TV series , and something that couldn’t be said on the CV, but a good braai and drinks with mates relaxes me a lot!

What would your best friend say is your best quality? Dedication.

And your worst quality?Patience.

What is your favourite holiday? The longest one, is usually the best. Honestly I have no preference on any holidays.

Your favourite meal?After my food poisoning of last weekend, chicken and mushroom pies are off my list. So basically everything except that…and offal. Revolting smell!

We woul like to introduce you to the newest member of the MitonOptimal team, joining us in our Cape Town office.

Your favourite drink?Appeltiser, juice and water. These are the sober preferences. For the not so sober preferences it would be beer, whiskey and the odd brandy now and then. In Afrikaans, a vuil coke.

Your favourite colour? Blue.

If you could have dinner with anyone in the world, who would it be? I think the most influential people that I would like around one table would be, Malcolm Gladwell, Warren Buffet, Dr Wayne Dyer.

Another job you considered doing but decided against?I’m still young; life has not given me a situation like this yet.

If you had all the money in the world, what would you do?If I had all the money in the world, then this interview would not even have been printed, because you won’t work for free. Don’t think it would be that much fun.

Just enough money to give financial freedom to everyone around me and people who really need it. Sounds like a beauty pageant answer. In years to come this would, hopefully by the grace of God, be my real situation, maybe then you should ask me again.

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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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