Markets have continued to remain volatile and "flip flop" between optimism and pessimism. The third quarter experienced a fairly large dose of pessimism which had the effect of taking the return from global equities from being moderately positive at the half year stage (MSCI World up 5.3% at 30 June) to being quite markedly negative at 30 September with the MSCI World down 16.5% in the quarter taking the index down 11.8% for the year-to-date.

For the quarter, the portfolio declined 10.9% (in dollars), which was more than 5% better than the overall market. For the year to 30 September, the portfolio declined 5.1% (when measured in dollars) versus -11.8% for the MSCI. In rand, the portfolio was up 7% over the quarter and 13.7% year-to-date as performance was assisted by the severely weaker local currency over this period.

The extreme levels of volatility combined with another quarter of strong inflows, allowed us to allocated new money to ideas which offered the best price to value relationship at the time. Largest additions were to positions in MTN, Petrochina, CIA Saneamento of Brazil, SES, Google and Microsoft. We did not exit any positions over the quarter.

The portfolio currently has 6.5% in cash, down from 12% at the beginning of the quarter. This is due to the fact that the current (lower priced) market is offering more opportunities to meet our 15% return hurdle.

The largest relative contributor to results was Roche. Positive results from seven Phase III registration studies so far in 2011 have reassured investors that the Group can innovate and have led to upgrades to pipeline forecasts. The successful launch of new skin cancer medication Zelboraf, which has been developed rapidly with a companion diagnostic to assure efficacy, raises hopes that Roche's personalised healthcare strategy will benefit patients and reduce development costs. An analyst event highlighting the strength and growth prospects of the diagnostic division was also supportive.

The largest detractor to results on a relative basis over the quarter was UBS. UBS has been very weak, not helped by its Q2 results that were worse than expected in its investment bank, although wealth management continues to recover. As expected, it abandoned its demanding medium-term profit targets, although it has decided not to update these until its November investor day. UBS has also suffered from rogue-trading losses; it pre-announced that the group shall post an underlying loss in Q3 (although a headline profit), but that wealth management is still posting positive net inflows. Its valuation is very compelling for a business with higher than sector-average returns and its wealth management business is a scarce global franchise.

Despite the increasing level of intervention by policy makers, the underlying economic difficulties faced by the (still) highly indebted developed economies will continue to weigh upon the strength of the recovery. This makes our dependable compounders theme extremely pertinent as we seek to identify and own companies that can dependably grow their revenues, earnings, cash-flows and dividends every year even with a subdued economic backdrop. While no new names were added to the portfolio in the quarter, a number of positions were increased as markets declined and we had the opportunity to add to positions at attractive valuations - in particular Capita, Google, Varian Medical and PPR fit into this category.

Longer term perspective
The first six months of 2011 has seen equity markets range bound with the actions of policy makers encouraging advances in markets, but the statistical data on economic improvement largely countering these positive moves. Within this, our continued focus on "dependable compounders" has paid some dividends with the fortfolio tending to lag rapidly rising markets, but outperforming when markets stagnate or decline.

We have discussed our view as to the causes of the global financial crisis in previous letters. However, to summarise, the financial crisis was caused primarily by too much debt, particularly at the household level. This had been encouraged for many years by central bankers holding rates too low (the Greenspan put), by the introduction of innovative new financial products which separated the origination of credit from the credit risk itself, by the complicity of credit rating agencies in rating these new products and by banks who were more than happy to create and sell these products in one arm of their business while at the same time buying these products in another arm (for example Bear Sterns). This last point was most aptly illustrated by Citigroup's then CEO, Chuck Prince, when he said in July 2007 "when the music stops, in terms of liquidity things will be complicated. But as long as the music is playing you've got to get up and dance. We're still dancing." This vast amount of credit creation led to rising asset prices, and in particular, rising house prices. This further encouraged the animal spirits of homeowners and investors and led to an ever growing debt spiral. The more debt grew the greater the payback would be when it eventually arrived, which it finally did in the form of the global financial crisis.

The long-term solution to a debt crisis appears to be simple and would seem to require a de-leveraging phase, particularly at the household level. Indeed, in their book 'This Time is Different: Eight Centuries of Financial Folly' by Reinhart and Rogoff, theyindicated that after periods of exceptionally high credit growth, and therefore high debt levels, there was typically a prolonged period of de-leveraging during which economic growth was subdued. Furthermore, they indicated that in almost all cases, and certainly in all cases in recent history, private sector de-leveraging involved a debt swap from the private sector to the public sector and ultimately led to sovereign debt crises as a result of both the debt swap and the stimulatory measures taken by governments. It now seems clear that this time is not different and we are largely following the script as laid out by Reinhart and Rogoff: to date the recovery has been subdued with unemployment remaining high and wage growth being particularly anaemic; there has been a vast private to public debt swap; and, we are now witnessing sovereign debt crises. The major difference this time insofar as there is one, is simply the aggressiveness of the policy response: this will almost certainly have some unintended consequences and unpredictable outcomes.

Clearly the aim of the governments and central bankers has been to kick start a recovery through extremely stimulatory measures. Just taking the US, the measures to date include huge budget deficits amounting to over $4.0 trillion (including the stimulus package of 2009 and the budget deficit of 2011); zero interest rates for over two years; and, two rounds of quantitative easing (amounting to money printing of around $2 trillion). The sums involved are mind blowing. Indeed, the measures taken over the past few years have been unprecedented in their size and scope, and it is as yet unclear as to what unintended consequences these measures will unleash. How bad the recession would have been had these stimulatory measures not been undertaken we can only guess. What is clear is that all of these measures are unsustainable in the medium term. Furthermore, the measures seem to be working only as a palliative rather than as a solution and as yet we have not had any genuine attemptto address the underlying problems. There does not appear to be the political will to tackle these problems -this is exacerbated by short political terms of office and the consequent electoral cycle. Assessing the current situation, the recovery in underlying economies has been lacklustre. As noted above, unemployment remains high, wage growth remains low and economic growth -while we have seen an up-tick -remains muted relative to what would typically be expected during an economic recovery. This subdued recovery despite all the stimulatory measures that havebeen thrown at the problem highlights just how severe the global debt bubble had become. However, while the impact of the vast amount of stimulation has led to only a moderate economic recovery, it has had a substantial impact on asset markets. Zero interest rates have forced savers into riskier, higher yielding investments, and quantitative easing has had an explicitaim of pushing down treasury yields (in which it has failed) and pushing equity markets up (in which it has succeeded impressively).Taken together these have been extremely powerful forces. Through providing excessive liquidity to markets, and in particular, to equity markets, we now have a very artificial marketplace with moves being the result of stimulatory measures rather than being the result of strong and sustainable underlying earnings. Asset markets have become part of policy. This is a dangerousgame to be a part of and caution should be the investors' watchword.

As an aside, one of the likely consequences of policy actions is the threat of inflation becoming a growing problem over the next few years. As noted by Peter Bernholz, in his book 'Monetary Regimes and Inflation', "hyper-inflations are always caused by public budget deficits, which are largely financed by money creation. If inflation accelerates, these budget deficits tend toincrease (Tanzi's law)." This seems to be common sense. As the Federal Reserve prints dollars to finance the US budget deficit, the dollar itself will become worthless, as there is a greater stock of money chasing the same amount of goods and services. Commodities will increase in price in US dollars which will lead to higher costs for companies who in turn will trytopush up prices to compensate. However, it is not always easy to pass these higher prices on, as evidenced by Nike's recent profit warning. Therefore, it would seem that either we see inflation rising, or we will see margin compression at companies which require raw materials or commodities.

The current economic situation has been likened by many commentators to policy makers "kicking the can down the road" in an attempt to shift, rather than solve, our economic problems. This description has seemed appropriate because policy makers have used a range of novel techniques to make money freely available in order to attempt to stimulate a debt driven economic recovery that (they hope) becomes self-sustaining. Most commentators have concluded that the methods used will only provide a short-term solution and that the cost of these stimulatory packages will be substantial in the future. These costs are potentially many and varied ranging from a loss of confidence in policy makers and a lack of faith in paper currencies through to the possibility for high inflation.

Kicking the can down the road by encouraging the private sector to once again increase borrowings to finance more consumption is being most actively pursued by the US Federal Reserve, which has undertaken the most extreme policy manoeuvres to attempt to stimulate such a recovery. Actions undertaken to reignite "animal sprits" include maintaining interest rates at ultra low "emergency" levels and effectively printing huge amounts of money to purchase Treasury Bonds (aka Quantitative Easing).

However, it is becoming evident that while such policies can have an impact on asset markets, including bonds, equities and currencies, it is much more difficult to have a lasting and material impact on the economy as a whole. The implication of this is that recent policy has created the environment for asset price increases without any meaningful underlying improvement in the economy. It now appears that ever increasing amounts of stimulus from policy makers is having a smaller and smaller impact on economic growth, thereby questioning the usefulness of these policies, particularly given their potential longer term costs. The stimulatory measures may help in the short term by boosting asset prices, but meanwhile the long-term structural problems including unemployment and the high level of public and private debt remain unresolved. December 2010