THE CURIOUS CASE OF ANGLORECONNECT AMERICAN MAY 2015

This article discusses our thinking behind our holding in . It aims to provide context against the backdrop of an investment opportunity set. Our funds always consist of a diversified portfolio of opportunities and risks – please bear that in mind when evaluating our commentary about individual positions.

Once upon a time, there was a blue chip company called Anglo American. It was started by Ernest Oppenheimer in 1917 with the express intent to mine for in an area east of . The company was so successful at its mining endeavours that it started investing in other activities as well. By 1987, the Anglo American group controlled 60% of the total market capitalisation of the Johannesburg Stock Exchange through 80 listed companies. This was in its heyday when it had an interest in just about every sector of the South African economy, including banking, shipping, packaging and of course mining. No respectable portfolio could be found without a generous dollop of ‘Anglos’ as a core holding and investors came to rely on regular liberal dividends. Since 1994 exchange controls have been lifted gradually for South Africans and South African businesses. Anglos took the opportunity to divest of a number of businesses – especially those outside of its focussed group, leaving it with core assets that include industrial metals, and precious metals. Over time the geography of its assets moved far beyond South African shores. This period coincided with growing demand from China for all of Anglos’ products. The belief in the commodity supercycle led investors to drive the share price as high as R550 per share. At this stage, Anglos traded at a Price-to-Book ratio (P/B) of 4.2 times, having reported earnings of R39 a share in the previous financial year. In comparison, at the time the market traded at a P/B of 2.6.

But then things changed. The global financial crisis of 2008 meant that commodity prices fell precipitously and cashflow got tight for Anglos, culminating in a decision to suspend its dividend payment for the first time ever in 2009. This wreaked havoc with its reputation as a solid holding in any portfolio. Even though dividend payments were reinstated at their results announcement in June 2010, this reputational overhang persists. This negative perception, combined with escalating debt, low platinum prices, general negative sentiment towards growth in China and continued bad news on cost overruns at its largest iron ore project in South America – Minas Rios – has meant that the share price has never managed to claw its way back to the glory days before the global recession.

Chart 1: Price Performance of Anglo American vs the FTSE/JSE All Share Index Since 2009 (Based to 100) 300

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0 Mar 09 Mar 10 Mar 11 Mar 12 Mar 13 Mar 14 Mar 15 Allshare Anglos RECONNECT As a result, as of March 2015 Anglos makes up a mere 3.7% of the ALSI, having been overtaken by SAB, Billiton, Naspers, Richemont and MTN. This compares to June 2008 – just prior to the global financial crisis – when Anglos made up a whopping 17% of the popular index.

On the 2nd of March 2009, Anglos traded at a low of R138 when the ALSI also reached its low of around 18 000. Today, Anglos is still trading below the R200 mark while the ALSI has long since left it in its tracks, nearly tripling to its current level of around 52 000. Today Anglos is trading at a price-to-book value of less than 1 (0.88 as at 30 April 2015) while the market is trading at a value of 2.4 times.

Granted, the intrinsic value of Anglos has been revised downwards by most analysts at numerous points over the last seven years based on lower production volume assumptions, increases in capital expenditure and asset impairments at Minas Rio, and increased debt. However, considering the 65% decline in share price since the R550 peak level and the current decade low P/B of 0.9 on a much reduced book value, it seems that the market has concluded that these problems are here to stay. This despite Anglos shutting down several high cost operations and the inevitable normalisation of commodity prices. The bleak past performance is being extrapolated indefinitely into the future.

Despite Anglos’ numerous woes, it is not alone in this respect. Cyclical stocks are not exactly in vogue with investors around the world. An avalanche of bad news is priced into cyclicals, while a lot of good – no, great – news is already reflected in the share prices of the darling stocks such as Naspers and the like. In fact things better turn out pretty awesome in these stocks because investors have already paid for a whole lot of awesome! As with everything in life, the truth probably lies somewhere in the middle.

RECM’s investment philosophy doesn’t take into account the constituents of any index or the performance of those constituents against the index. Our estimated fair value for Anglos relies on a bottom-up valuation for each division, using normalised commodity prices, unit volumes and margins, all derived from long term data.

A quarter of Anglos’ intrinsic value comes from platinum, while diamonds, iron ore and manganese, copper and coal each contribute between 15% and 20%. This diverse commodity exposure allows for relatively stable profits due to cycle differences. For example, in 2007 platinum contributed 27% of earnings before interest and tax (EBIT), copper 30%, and iron ore and manganese 10%. In contrast, in 2012 platinum broke even (0% of EBIT), copper contributed 28% and iron ore and manganese contributed 48% of EBIT.

Our investment thesis relies primarily on a normalisation of the prices of all Anglos’ major commodities, an improvement in margins with high cost supply being shut down, and – on the side – a steady uptick in both volumes and prices.

Mark Cutifani, the not-so-new-anymore CEO, brought a wealth of experience from overseeing a cost- and capital-conscious environment at Anglogold. Evidence of his impact in 2014 included unit costs being flat or down for all their main commodities, renewed focus on better-performing assets, increased volumes and developments like Minas Rio being kept on track (thus far!). The Minas Rio mine development in particular is a key investment marker for Anglos. RECONNECT

The company announced in October 2014 that they shipped the first iron ore pellet feed from Minas Rio, on time and within the latest budget. The focus for the next 20 months is on a ramp-up to full capacity. Our fair value for the business is based on fairly conservative assumptions such as Minas Rio only achieving full capacity a year after target. Even so, the price is trading at substantially less than our estimate of fair value, representing an investment opportunity with a large margin of safety at these levels.

Anglo American PLC is currently a top 10 holding in the RECM Global Fund (4.9% of market value), the RECM Global Flexible Fund (6% of market value) and the Nedgroup Investments Managed Fund (5% of market value).

Contact René Klinger Miranda van Rensburg Western Cape, Eastern Cape, Gauteng Regarding Capital KwaZulu-Natal M +27 82 303 2594 Management (Pty) Ltd M.+27 82 784 1571 E. [email protected] T. +27 21 657 3466 PO Box 45040 E. [email protected] Claremont, 7735 Claudie Groenewald T. +27 21 657 3440 Western Cape, Southern Cape, www.recm.co.za Free State M.+27 82 054 9673 @RECM_Online T. +27 21 657 3490 E. [email protected]

Disclaimer Collective Investment Schemes in Securities are generally medium to long term investments. The value of participatory interests may go down as well as up and past performance is not necessarily a guide to the future. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. A schedule of fees and charges and maximum commissions is available from the company, RECM Collective Investments (Pty) Ltd (RECM). Commission and incentives may be paid and if so, would be included in the overall costs. These portfolios may be closed. RECM Collective Investments (Pty) Ltd, Company Registration Number: 2004/027540/07, is a member of the Association for Savings and Investment SA (ASISA). Trustees: The Standard Bank of SA Limited, PO Box 54, Cape Town, 8000.

Regarding Capital Management (Pty) Ltd is a licensed financial services provider (License number, 18834). The information provided herein is not advice and RECM and/or its associates do not give any warranty as to the accuracy or completeness of the information provided herein and disclaim all liability for any loss or expense, however caused, arising from any reliance upon this information.