This is our ninth commentary of the year and so far, 2012 has proven to be a year that has far exceeded our return expectations across various asset classes and sectors. It has also been a year defined by strong momentum within specific market segments to the detriment of others.

We were tempted to head this piece something like this: ''if your portfolio produced outstanding returns in 2012, then be worried, be very worried'', but that is a conceited perspective and out of character with our style. It does, however, give insights into how concerned we are about areas of the SA stock market that we deem overvalued. That said, momentum markets are not uncommon and market participants exist that capitalize on these trends. We, however, are not one of those asset managers and choose to vigorously only invest in assets where the current share prices understate the value of the assets owned by companies.

Year to date, the three stand-out performance sectors on our market were health care (38.6%) consumer services (34.2%) and listed property - with the various sub-components of property producing mid 30% returns. The largest laggards were basic material (-3.1%) and oil and gas (-1.9%).

We have a wide range of assets held within our fund, but this year, we have actively been acquiring the very companies that constitute the laggard sectors whilst we have been exiting companies that have been star performers, those that have risen above their intrinsic values. These overvalued companies live in the out-performing sectors of the JSE this year!

To understand our logic, let's look at when retailers were last priced at their current P/E multiples. This dates back to between 1998 and 2001. 14 years ago, as our retail proxy, Shoprite, was rated on a P/E of approximately 30 - it went higher than that (45), but very briefly. Currently, Shoprite is rated on a multiple of 26. Between 1998 and 2003, Shoprite's P/E de-rated from its lofty P/E of 45 to less than 10 times - it reached its lowest multiple of a 9.8 times in 2003. I guess the obvious point we are making is that most businesses go through cycles of being enthusiastically valued by the market and then hopelessly undervalued. Retailers are no different. Shoprite's rating was not the only collapsing point from 1998, the share price halved over a 6 year period, from its high in 1998.

Against this, a company like Sasol, clearly not the current flavour of the month, presently trades on a lowly rating of 9x, a level last seen in 2008; that was the epicentre of a market crash. Before that, Sasol traded on a similar rating to the present in 2003. Sure, P/E ratings are too simplistic for resource rich counters and cyclicality in earnings distorts these simplistic type measures, but even on a dividend yield basis, Sasol at 4.7% (with a progressive policy) is 18% higher than its mean dividend level, which dates back to 1981. This looks compelling value to us!

These examples force us to return to the ethos of our investing policy, buy assets where the price does not reflect the true underlying value of the business. Conversely, avoid assets where the price overstates the true value. In a nutshell, we do not want to lose money for our investors - the first building block of our investment policy with respect to any money we manage.

We believe that the momentum areas of the JSE will in time, de-rate as they have done in the past and when this occurs, these will be the unwanted areas that will attract our intention. For now, however, we will be avoiding the sexy sectors and instead navigating this fund through waters where few want to travel, but where we see rich fishing grounds for the patient.

The failure of European leaders to find firm and enduring solutions for the European financial crisis, after yet another summit, is holding global stock markets hostage. Domestic stocks have given back most of their gains achieved during the first half of June.

Despite these global economic and political upheavals, domestic industrial stocks remain resiliently elevated and consequently, expensive. Our preference is to own high quality businesses over time, these we define as companies that deliver fairly stable cash profits over long time periods due to the competitive advantages that exist within their business models. These companies are unfortunately the most expensive area of the domestic stock market currently.

On the other end of the spectrum, cyclical companies which tend to deliver unpredictable cash flow streams, have suffered the most as a result of the financial crisis. Some of these companies are pricing in a permanent impairment of their businesses, which we believe to be an incorrect assessment by the market. Given our contrarian investment approach, we are now buyers of these companies.

The last time Mr Price traded at such a large premium to Sasol was in the mid-nineties. The gold line shows that Mr Price has never managed to sustain its outperformance once it reaches these extreme valuations. Something extraordinary therefore needs to happen for Mr Price to sustain its current premium relevant to Sasol.

One of the benefits of being a smaller fund manager is the ability to invest in companies that are off the radar screen for larger investment houses as the liquidity in some of these smaller companies does not allow for meaningful ownership positions.

We see significant benefits in owning sizable positions in smaller companies, if the risk of permanent capital loss is low enough. Investors often forget that the large companies available on the JSE today were relatively small companies years ago and given their competitive advantages and management talent, they have delivered strong profit growth, either organically or through acquisitions. Some have developed into global businesses, now delivering capital returns to shareholders all around the world.

Within our monthly commentaries, we thought it would be useful for our unit holders to receive information on certain of our stock positions - in so doing, to get a better understanding of where their capital is invested. A smaller company that we own a sizable position of is Kagiso Media. It adheres to all our investment criteria and we expect sound returns over our expected holding period, which we intend to be many years.

The majority of Kagiso's current earnings power is concentrated in its broadcasting assets, which contribute more than two thirds of group revenue and almost ninety percent of operating profits. This is derived from Kagiso Media's ownership of East Coast Radio (Natal) and Jakaranda 94.2 (Pretoria). The geographic reach and consumer demographics of these radio stations make them both sought after advertising mediums for corporate advertisers and combined they attract a meaningful portion of the radio add spend in South Africa.

Radio remains an important advertising medium in an emerging country like South Africa, although these moats or competitive advantages are never permanent. The one factor that we believe makes the high margin nature of Kagiso Media sustainable over the next few years is that there are no longer analogue frequencies in South Africa available - hence the incumbents in the industry are fairly well protected from new competition. Management believes that digital radio only poses some threat ten to fifteen years from now.

The broadcasting business is relatively capital light and therefore does not require significant reinvestment of retained profits to fund future growth. The business therefore generates copious amounts of cash and we are very comfortable with the sustainability of the dividend. We are currently receiving more than a 5% dividend yield on the initial purchase price.

Radio broadcasting is a very mature industry and changes in radio advertising revenues should more or less move in line with changes to Nominal GDP. We believe this is the main reason why management has been investing in other parts of the business with specific emphasis on information and content, hence the recent acquisition of Juta as replacement for LexisNexis. The risk of course is that these divisions have weaker competitive advantages than the core assets of Kagiso Media and could potentially dilute group margins and the return on capital in the long run. We will be monitoring this. Broadcasting remains, however, the central DNA of this business and management sees attractive growth opportunities in the African broadcasting landscape, most probably through acquisitions.

In the long run the capital return from most stocks on average should be more or less in line with nominal GDP growth, plus the dividend yield. That is, of course, assuming that stocks are bought at fair value. If not, returns measured over years, should be diluted by a de-rating in the value of the businesses, offsetting at least some of the capital returns.

We have no great insights into how Kagiso Media's stock price will perform over the next few months or years and it is not impossible that investor's receive negative capital returns over the short-term, in the event of a broad market sell-off. We are however not in the business of predicting stock prices and short-term price fluctuations do not bother us. Most importantly, we are comfortable that our purchase price for Kagiso Media does not reflect the full earnings power of the business and the total capital return from the stock should comfortably achieve our return-hurdles.

In short, we believe the total return to shareholders measured over the next few years should match the growth in profits plus the dividend yield, which is expected to be between 12% and 17%, not unattractive compared to a generally overvalued market.

2011 was characterized by exceptionally wild swings in stock prices returns from week-to-week and even day-to-day, but measured over the full year we went nowhere, slowly with a total return of 2.6% for the All Share Index on the JSE. Speculators that thrive on macro noise had a lot of news to chew on. Sentiment swung between extreme pessimism, centred on talks of a Eurozone break-up and Chinese growth deceleration, to extreme optimism that was typically fuelled by empty promises after each of the different Eurozone summits held during 2011. It was one of those years though where doing less generally ended up adding more value to portfolio returns.

After the sharp adjustment of the Rand to levels above 8 to the dollar, the urgency to convert rands to dollars has dissipated, and our focus is on the valuation of the assets that can still be acquired in dollars and euros. Because we can find attractively valued stocks in the US, Europe and the UK, we have maintained a maximum offshore exposure in our multi-asset funds.

Further deterioration in economic conditions abroad and increased risk aversion will result in continued rand depreciation. This will have negative ramifications for inflation, which is already breaching the upper band of the inflation target and is likely to sustain these elevated levels in the short to medium term. Accordingly, the risk to inflation remains to the upside.
While current indications are that interest rates will stay lower for longer than previously thought, we find bonds relatively unattractive. We are likely at the bottom of the rate cycle and there are risks to the upside on a medium term view. We do not view the spread above cash and inflation to be attractive enough to warrant large exposure to conventional government bonds.

We go into 2012 unexcited about the investment opportunities in the domestic stock market, but very optimistic about the opportunities available offshore, specifically in developed markets. The stocks we own offshore are all companies that have proven themselves over many decades as very strong franchises and with excellent dividend track records. Most of them are cheaper than their South African peers and are offering higher dividend yields.
The core of our SA-listed stock selection comprises companies that have strong moats or sustainable competitive advantages over their competitors. We tend to hold these businesses for very long periods of time and allow the management team to exploit this competitive advantage to our benefit by compounding the high returns they generate on capital. Typical characteristics of these companies are:

They generate high returns on each rand that is reinvested in the business. This reinvestment of profits entrenches the moat even further and long term shareholders benefit from the power of compounding.

1).These businesses tend to generate strong cash flow and if managed by shareholder-centric management will consistently pay out a portion of the cash as dividends.
2).The share prices of these businesses tend to be more stable than the average market, albeit not immune to economic downturns and bear markets.
3).The valuations are still reasonable and growth in profits should be reasonable.
Given the wide range of global economic scenarios that could potentially unfold (with none offering exciting growth potential), and the limited number of opportunities in the domestic market, we are sitting with sufficiently liquid portfolios to enable us to use any significant weakness in stock prices to add to new or existing positions of high quality businesses at more attractive prices.

We expect to bolster asset allocation-portfolio real returns through maintaining, and potentially increasing, exposure to inflation-linked bonds, and through maintaining exposure to companies with reasonable pricing power, or businesses with moats.