Benjamin Graham in his seminal work on investing called "The Intelligent Investor", cautions that price fluctuations on the stock market serves long-term investors only to the extent that they should buy wisely when stock prices drop significantly and sell stocks only when prices rise above what is deemed to be fair value of the businesses they are invested in. Investors therefore gain nothing from worrying about the day to day fluctuations in stock prices.

September was a month of heightened price volatility for most asset classes as markets continue to grapple with an increased recession risk in developed economies and the impact that sovereign debt defaults can have on the global banking system. There is also clear evidence that Chinese monetary tightening is starting to have the desired impact on Chinese property prices and artificial investment demand in various parts of the Chinese economy. How this plays out is uncertain though and basing investment decisions on any extreme outcome in this regard is to say the least, unwise.

Our strategy has always been to buy companies where ratings are fair to cheap, and where growth prospects are reasonable based on sound industry dynamics. We have not applied too much attention in the past to whether the US and/or Europe is going into a recession, or any other macro factors. We intend staying our course of being micro, bottom-up managers rather than macro orientated as this simple strategy is what we believe in and it has served investors in the fund well over the last twelve years.

Your fund has held considerable levels of cash these past eighteen months as the opportunities for reasonable returns in the domestic market have been fairly limited. Even after the recent stock market correction, big parts of the domestic, financial and industrial universe are not offering significant value. We feel that off current levels, investors will continue to find it difficult to achieve returns significantly above inflation over the next few years.

The rand depreciated in excess of fifteen percent against the dollar during September and although it has aided the fund's performance, its fall is probably too much too soon. The PSG Balanced Fund, being almost at its full allowable offshore exposure, enjoyed strong tailwinds during this mini currency collapse, but we must warn that we would not be surprised to see the rand make a come-back and this will curtail fund gains in the short-term. Although rand weary, we will not reverse our current large offshore position as we believe that the companies that we are invested in offshore are undervalued and will outperform domestic stocks on a five to ten-year investment horizon.

Our ownership of bonds in the fund has been limited. Given the steepness of the yield curve and where we are in the interest rate cycle we remain cautious on bonds in general as an asset class. That said, there are some bond maturities that are starting to look more attractive now that yields have shifted higher, particularly when one compares these yields to cash.

Year to date the domestic market has produced low returns, in line with our views stated in these commentaries over the past few months.

In 2011, the All Share Index has produced a total return of a mere 0.5%, not one of the major constituent indices delivered double digit returns. A similar situation prevails for the other asset classes too, with the ALBI gaining 2.3%, cash 2.8%, Preference shares -0.3% and Inflation linkers a more respectable 5%.

Returns from Developed Markets in dollar terms on the other hand have been good this year and with the rand relatively flat against the greenback year to date, the perpetual strengthening bias which has eroded offshore returns for South Africans has started to dissipate this year. We started 2011 at 665c to the dollar and at the end of June the cross was 675c. In fact, a South African invested in the S&P in 2011 would so far have enjoyed returns of 7.5% in rand terms, clearly well above the 0.5% total return from the All Share Index. We see this as a noteworthy change and this is precisely what we have been waiting for within our funds and why we positioned our portfolios at their maximum allowable offshore exposures a long while back.

We continue to be underweight domestic equities as a result of few local companies being at price levels that are consistent with their intrinsic values. The same cannot be said for stocks abroad, although the market has rallied hard off its lows, stock specific opportunities abound and these are predominantly in the large company space. Companies with very long track records (exceeding a century), outstanding management teams and exceptionally resilient business models are being treated with a terminal mantle. Consequently, we have acquired world class businesses at bargain prices. We are fully exposed to these types of companies within our portfolios.

We do not see the PSG Balanced Fund's asset exposure changing aggressively in favour of domestic equities until the local market has retreated to a point where more companies reach price levels offering a decent margin of safety. Our bond exposure will also remain light in anticipation of rising domestic interest rates. We expect to continue to be fully exposed to offshore assets with a bias towards quality equities within developed markets

The unpredictability of human nature as well as Mother Nature converged in the first quarter of 2011 to cause severe disruption to the strong uptrend in global stock markets. These events of course cannot be predicted, and also cannot be factored into any valuation model, but what it does indeed illustrate is the high capital risk of ownership of overvalued stocks. Events such as those of the last few months could merely be the left-field catalyst for these permanent capital losses to occur.

Our allocation to domestic stocks over the last six to nine months has dwindled down to roughly 33% of the fund. This is not based on a general market view, but rather a function of available opportunities that meet our key investment criteria, of which a wide margin of safety is the most important. Fewer investment opportunities in stocks will almost always result in a bigger than normal cash holding and although it feels intuitively quite uncomfortable at the moment we believe it is the right decision for investors (including the fund managers) in the fund.

We certainly do not believe cash yields are attractively priced at the moment but we are happy to live with a 6% yield on 6 month cash instruments, for example, rather than not having the gunpowder dry when the opportunities in the stock market arises. There are a number of companies we would like to own over the foreseeable future, but only when the prices drop to levels where the acquisition price provide you with adequate returns relative to inflation and cash. The recent correction in many areas of the market did not reach that point yet.
Our offshore exposure has declined to roughly 21% over recent months relative to an allowed allocation of 25%. Although this may seem contrary to our advocating of increased offshore exposure it is fully explained by the reduction in our British American Tobacco position, which thus far has been included in the offshore component in line with regulatory requirements. Our objective is to increase the offshore exposure of the fund to the maximum weighting of 25%. Roughly 75% of the offshore assets in the fund are currently invested in stocks.

With another year behind us it is always interesting to reflect on what has worked and where we could have done things better. One lesson we learnt a long time ago is not to change things just for the sake of it. Lou Simpson, who Warren Buffet sees as his investment contemporary in the Berkshire Hathaway stable, once said in an interview that investors often spend too much time acting and too little time thinking.

The extent to which we share this view is reflected in our balanced fund portfolio. Of the nineteen companies we own in the fund currently, only three were not present at the end of 2009. The other seventeen positions we have mostly added to during the year, believing they offer reasonable returns in a market that otherwise offers limited opportunities domestically. We continue to actively look for new investment opportunities, but they are presently few and far between and when we do unearth them, they are often very illiquid.

Current economic conditions offer an ideal combination of supporting vectors for risky assets, as interest rates are low while economic activity is gaining traction, not only in developing countries, but also in parts of the developed world. Whilst this situation seems like a mouth watering opportunity for investors, one has to overlay these conditions with current stock valuations. In simplistic terms, valuations are currently high, while economic conditions are improving, contrasted with March 2009 when valuations were very attractive and economic conditions were poor. So, in 2009, ultimate fear prevailed which tends to be the ideal hunting ground for investment opportunities, whereas now, exuberance reigns supreme and we feel that it is wise to watch the show from a distance.

Over the past year we have increased the offshore equity exposure in the fund and at the time of writing, contained almost 16% in offshore stocks, with the total offshore exposure at 20%. The foreign stocks held are generally large, quality businesses that are trading at attractive valuations.

The portfolio continues to own a small portion of bonds (4.5%), of which half are inflation linkers, the balance being conventional ten-year government bonds. We will be increasing our exposure to inflation linked bonds in coming months as we view the probability of inflation becoming a headache in the near future as high. It is concerning that equity investors are very complacent about an inflation headwind and the potential impact on interest rates. Concomitantly, we view inflation linked bonds as an attractive hedge at current levels, albeit that we don't expect the returns to be mind blowing.

As always, we are hesitant to make predictions for 2011, particularly for an asset class like equities where a time frame exceeding 5 years is relevant and hence the chance of being wrong over 12 months is very high. What we do know is that markets are in general not cheap and added to this, there are headwinds building, these just add to levels of uncertainty when prognosticating. Clearly though, sovereign debt levels in the developed world are the most unpredictable challenge facing markets and their impact could be profound. But whilst these risks abound, it is important to understand that risks are ever present when investing and this does not deter us from our investment objectives for this fund:

1. Preserving capital for investors with at least a three year time horizon, and
2. Generating returns of 5% ahead of inflation on an annualized basis for investors with a time horizon exceeding three years.

This fund has been in existence for more than ten years and has handsomely outperformed these objectives for our investors.

In conclusion, JSE returns in the past two years have exceeded all reasonable expectations, including our own. Stocks are no longer cheap. Consequently, we are very comfortable to maintain higher than usual cash levels in the fund, with the aim of employing these when valuations reach palatable levels.