The Hermes Managed Fund: An undiscovered gem

According to EFS Investment Solutions data, which currently tracks the performances of 99 Asset Allocation Prudential Funds, as of September 3rd 2010, the Hermes Managed Fund, managed by Arthur Karas, is the leading fund over five years with a rolling performance of 92.15%. It is extraordinary that despite this performance, this hidden gem is still relatively small with assets under management of R33.3 million.

EFS: We note that while the fund has fantastic 12 month and 5 year performances, the fund’s relative performance in the sector took a dip over the three year period. How do you protect the portfolio?

Arthur Karas: We use asset allocation as the primary risk diversification tool. We do not generally utilize derivatives to protect against potential downside in equities. We believe that on a net basis a consistently hedged portfolio will ultimately produce similar returns to those funds that remain completely exposed to the market. This is because the gains made by putting a ‘floor’ under the portfolio are paid for by selling the returns above the ‘cap’. Risk in the equity portion of the portfolio is managed through diversification and limiting exposure to highly geared or excessively valued investments.

EFS: Could you comment on management strategy of the fund over the period which now reflects performance over three years?

Arthur Karas: While our 5 year performance numbers are excellent, we took a cautious view of equity markets following the 2008 crisis, resulting in good nominal but lagging relative returns in 2009. We have subsequently lightened our exposure to defensive shares and built positions in companies with high expected returns. We are comfortable with performance that deviates from the benchmark for periods of time as we are confident that our investment process will deliver excellent returns over our return horizon of 3 to 5 years.

EFS: To your mind, what factors are responsible for the quality of return?

Arthur Karas: Our portfolios have consistently had a lower PE than that of the All Share Index, with a better prospective return. We believe that this is indicative of lower risk in our portfolios, as we aim to beat the returns of the index over time while holding a cheaper portfolio.

EFS: How much do you trade your portfolio?

Arthur Karas: Our investment horizon is 2 years and our portfolio turnover is driven by changes in expected returns. Typically we do not have high portfolio turnover. The fund’s recent portfolio turnover has been 33% over six months and 59% over 12 months.

EFS: What is your outlook for the equity and bond markets over the next two years?

Arthur Karas: The equity market looks attractive over our two year investment horizon. Strong earnings performance from the resource sector should bring valuations into cheap territory. We are cautious about bonds as we are of the opinion that US Government Bonds are in unsustainably expensive territory.

EFS: Please could you discuss three shares that are in your portfolio that you think will do well over the next two years or so?

Arthur Karas: Eqstra (EQS), a contract mining, fleet management and construction plant rental company.  The share is trading below book value and the recent rights issue has strengthened balance sheet. An overhang of excess inventory has been reduced and major new mining contracts have been secured. The company’s leasing business is still performing well and a substantial earnings turnaround has not been discounted in the current price.

Hulamin (HLM) is one of only six Global Aluminum Rolled Product manufacturers. The financial crisis has hit demand and margins for lower end product and 2009 results suffered accordingly. However, now Hulamin can grow production by 30% from its current infrastructure. Demand is strong for key products and 2010 should see a significant improvement in production and profits.

Metorex (MTX) has base metal, copper and cobalt mines in the Katanga province of the Democratic Republic of the Congo and in Zambia.  The main copper project in the DRC is steadily growing production. Financial risk is manageable following rights issue and some hedging of copper sales. There is good upside from additional growth projects.

EFS: Could you discuss three shares that you do not own and why?

Arthur Karas: It is our view that the rate of growth of cellular telephone company MTN (MTN) will slow, it will go ex-growth as the large SA and Nigerian markets are saturated and there are no other meaningful markets left to be exploited. The reduction in interconnect fees will hurt revenues. Data is a growth market that will require ongoing investment in capacity but at much lower margins.  

Media company Naspers (NPN) has some excellent businesses such as DSTV, but its valuation is very dependent on the investment in Tencent. Tencent is a Chinese gaming and instant messaging platform that has been growing very rapidly. Naspers has a number of other investments in the internet space and the disclosure around these is not very good. On a PE of 35 and expectations are elevated.

Retailer Shoprite (SHP) has a high PE that reflects its outstanding performance of the last few years. Furthermore, a low inflation rate tends to be bad for food retailers. Most of the retailers look on the expensive side to us. We prefer to invest in companies before the market recognizes their good attributes and performance.