Howard Marks, a well known investor, has identified how investment fashions rarely repeat in exactly the same way, instead he points out that the underlying process is a recurring one. Let me relate what he describes:

o An idea is born when an undervalued asset is discovered
o Its undervaluation attracts attention, as do pioneering investors' early gains.
o The undervalued asset's popularity rises, attracting more and more adherents, even as 'undervalued' moves to become 'fully valued'
o It turns into a mania or "bubble," and price becomes immaterial
o Eventually, the last potential buyer is convinced and comes on board
o With no one else left to continue the trend, the bubble of overvaluation is ripe for the bursting
o When followers experience the first price declines, disillusionment sets in
o One-time devotees flee en masse, and the bubble results in a crash.

South Africa is showing signs of being somewhere between the last potential buyer and the bubble. This appears to be the case for the currency and certain industrial counters such as the retailers. I am not sure how Wal-Mart can justify the high price they are prepared to pay for Massmart (which is somewhere above twenty times earnings) but they are not alone. It looks like NTT of Japan also paid a high price for Didata. We are not sure what HSBC will pay for Nedbank but all these deals are carried out when the currency appears to be increasingly overvalued. I accept that we are living in a lower interest rate environment and Africa may have potential for growth but all of the above purchases don't make sense to us here on the 5th Floor of Mariendahl House, Aylett and Co.'s offices. These are classic examples of what we refer to as the institutional imperative. Their timing is poor and desperate but they just cannot help themselves.

The Gentleman of Omaha puts it quite nicely, "What the wise man does in the beginning, the fool does in the end." Our portfolio reflects our thinking: high cash exposure and increasing investment into foreign stocks. Investors should acquaint themselves with our mandate which allows us to increase our cash exposure to 25% of the portfolio and invest up to 20% offshore. We will not hesitate to use these important tools should we deem them necessary.
Our portfolio also reflects our lack of ideas. In the past 75% of our ideas were concentrated in just 15 counters. This has now dropped to 58%. This is not to say we are not working hard at hunting for new ideas but the market has taken many of the stocks on our "to buy" list to levels where the margin of safety is not high enough. Because of our size we do find some opportunities, such as Astrapak and RECM Calibre, but many of our winners are not being replaced at the same rate as the past. We are not calling the end of markets in the domestic arena. To the contrary the low interest rates and strong rand are extremely positive for the consumer. As a nation we do have this ability to surprise to the upside. But all this appears to be in current prices and our job is to find undervalued assets, not ones that are fairly valued. We need to be patient, ensure we do not suffer from the institutional imperative and be prepared for relative underperformance because of our high cash and foreign exposure. We need to make sure we do as the wise man does and not what the fool may do.

Walter Aylett

This June quarter end marks the funds' four year anniversary. In the spirit of this occasion I have written a letter which offers further insight into the events of the last four years, with the intention of giving you, the investor or potential investor, a deeper understanding of market events, the challenges which we have faced and how we achieved our out performance of the benchmark. The full letter will be posted on our website (www.aylett.co.za). I would be most pleased if you would read it. I have included in this communication the Prospects statement with which I concluded the letter.

Prospects
A major part of our focus is to make sure that we continue to look through the front windscreen, to maintain our discipline of investing within our circle of competence and that we do not deviate from an investment philosophy that works. It would be easy for us to get complacent on the back of these returns but as the Springboks recently discovered in Auckland, New Zealand, you are only as good as your last game.

South African shares look fairly valued and bargains are scarce. The currency, an important component of the growth in GDP, appears to have benefited from foreign inflows and hence is vulnerable to a change in sentiment. Foreigners own substantial stakes in local stocks. These investors can be fickle when sentiment turns. When the music stops they are quick to head for the doors. There are encouraging factors such as the positive momentum created by a successful World Cup and a declining interest rate environment. Furthermore, commodity shares are discounting high prices but as always these things are difficult to predict successfully. We have never tried to call macro economic factors. Investing in companies is what we are good at and our approach remains bottom up rather than top down. The portfolio is defensive and cash makes up about 14 percent of the portfolio if we view RECM/Calibre (RACP) as cash. RACP is a new addition to the fund and is a company which currently consists largely of cash. We have also introduced a small foreign component and this makes up about two percent of the fund with a view to enhancing our returns. Our team is busy and working hard to stay out of trouble. Hopefully we will find the next Delta or Cipla within the next year although; we will need some volatility to create these kinds of opportunities. In the meantime we must be patient and wait until the odds swing in our favour.

It seems poor Iceland cannot stop creating new problems for rest of the world. It was one of the first countries to experience the sub prime crisis and have serious consequences for savers not only in Iceland but also Europe. Currently one of its volcano's has erupted and produced so much dust that many of the airports in Europe had to shut down. Not even the events of 9/11 shut down the airports of the United Kingdom.

'Farming on the side of the volcano' describes well how we feel about the investment environment today. The soil near the volcano is fertile, crop yields are high and quality of the produce superb. From time to time the rain clouds hide the danger that lurks nearby as they sprinkle their soft rain on the lands. The farmers know of the threat that lies alongside them but the lands that are further afield produce less profit per hectare. Besides, they have been hearing for years about the impending eruptions that have never materialised. For a number of years we have been warning our investors about the imbalances in the investment environment.

The concerns about debt being transferred to the government's balance sheets are well documented. South Africa has benefitted from risk aversion and our markets have almost risen to the highs of 2008. The currency has reflected this renewed interest by foreign investors. China, in one year, managed to create 1, 4 trillion dollars of new debt, more than the total stock of bank credit in India! Talk of protectionism and trade barriers are on the rise. Commodity prices continue to rise on China's binge buying. When things normalise (and I don't know when), I expect at the margin money will flow out of South Africa and to the developed world. At present there is very little talk about China becoming a "Volcano", there does however exist an increasing chance for China to create the next problem for the world. How do they go "cold turkey", by slowing down their economy? I expect that if our concerns about China are met, South African stocks will suffer.

Many of our investors know that we are stock pickers, we tend to ignore the macro issues but we are more sensitive to the issues mentioned above. We are building in greater safety into our valuations and are taking a more cautious view on equities. We have also decided to hold more cash and take a defensive stance in our investment strategy. The type of risk we run is what I call "career risk", that is we tend to be underexposed to the market darlings and for a short period run the risk of underperforming the competitors. We have been here before and I suppose we may go through the same period of underperformance should the market continue to farm alongside the volcano. We have chosen the safer option and moved to further afield areas where the yields are lower but safer.

Our fund has had a brilliant period of outperformance, we do not expect to continue this outperformance in the short term as the market is fairly priced and opportunities are few and far between. Cash yields a paltry 7% and volatility has decreased which normally gives us a chance to purchase quality stocks at bargain prices. The eruption will come and we will have cash to invest when it does but in the meantime we must be patient and wait for Mr. Market to provide us with opportunity.

Our fund has experienced significant flows over the last few months. At Aylett & Co we are appreciative of the trust placed by our clients and their advisors and as always we will endeavor to deliver the long term returns that they expect. Our team (which has increased to eight strong) takes our job very seriously and also continues to invest alongside our investors.

As usual, should you need additional information please contact us or visit our website where a number of articles and presentations regarding how we feel about the markets and our views.

Two of the biggest contributions made to investment philosophy by Benjamin Graham (Warren Buffett's mentor) are the concepts of 'a margin of safety' and 'Mr. Market'. Generally, investing involves looking at a business operation and, if deemed attractive, purchasing it at a large enough discount to what you think it to be worth. Graham pointed out that the safest way to invest would be for one to incorporate a generous margin of safety into the valuation price of the underlying asset. Graham also suggested that one should view the market as an emotional partner called Mr. Market. He proposed that when Mr. Market was in a very good mood he would be prepared to pay a lot more for a share of a business and hence this was a good time to be selling the asset. Conversely, when Mr. Market was pessimistic and was prepared to sell shares for a lot lower than their true worth, Graham advocated buying these shares from this emotional partner. It is clear that when Mr. Market presents himself in this pessimistic manner normally the investor can purchase assets with a large margin of safety. When one looks at our current markets it appears that our partner is very optimistic, normally this is not a good time to be buying assets and certainly not in emerging markets. Secondly, the current valuation of stocks leaves little room for that all important margin of safety. We live at a time where we have extreme deficits, high unemployment and very low interest rates. National debt is expanding to levels unseen before against the background of little inflation. How will this end? We don't know, and trying to predict the future will only get us into trouble. Warren Buffet provided us with an additional rule to add to Graham's two principles. Instead of just looking for 'any' business at a discount, one should, in fact, look for a 'good business' at a bargain price. We at Aylett & Co will not hesitate to invest in good businesses at fair prices despite the fact that short term prospects for the economy look poor and pessimism abounds. 2010 will be an interesting time for investors and on behalf of our team at Aylett & Co we wish you prosperity in your investing.

Walter Aylett