The Aylett Equity Fund will change it's name to Aylett Equity Prescient Fund, effective from 31 October 2012

As we enter the second half of the year, monetary authorities around the globe are resorting to the third round of liquidity injections into the markets. The effect is to push interest rates to their lowest levels and to create renewed appetite for risky assets. Money appears to hold little value and investors would rather consume, or alternatively seek to invest in higher yielding assets such as emerging markets. Often the excess cash seems to end up on the balance sheets of companies and does not achieve the required effects. We are not experts on these matters but it does not feel like the central bankers are any different to the commercial bankers that are being lynched by their respective governments and media. Our conclusion remains the same. We don't know how it will play out and we will continue to stick to what we know: buying companies that will continue to operate successfully despite the prevailing economic environment. Furthermore, our expectations are low and when opportunities present themselves we will invest on our own terms. Experience has shown us that in these very volatile times, the market serves those who are prepared to take action when the rest of the market is "battening down the hatches".

Delta, a share we know quite well, was recently sold down to R5.25 from a price of about R7.40. The seller was a bank who decided to liquidate its holding, owing to a change in its policy on propriety trading. Once the bank sold out of its holding, the share recovered to R6.50. As a house, we purchased about ten per cent of what was sold at an average of R5.43 and only time will tell if it was a smart purchase. Similarly, in our Global Fund, we were afforded a chance to purchase Hellenic Bottling at reasonably low prices as the world pondered Greece's exit from the markets. At the time of compiling this commentary, the share was up 22% from where we purchased it. In these times of uncertainty, our goal is to continue to purchase businesses which will be able to fare well in any situation in which they may find themselves.

"History may not repeat itself, but it does rhyme a lot." - Mark Twain

It bothers us when we hear "experts" on local media who pronounce the future of stock markets, foreign exchange, interest and inflation rates. How do they know this? Our experience shows us that this is a very challenging thing to correctly predict and we have tried to unearth individuals that can genuinely accomplish this feat. Surely, if the "experts" did find themselves in possession of such valuable and potentially rewarding information, which they would have worked hard to garner, they would keep this information to themselves? Our conclusion is that they share this information with the public because they don't really know. Many also talk to their book. These modern priests of financial theory should stick to explaining the past and not attempt to persuade investors what to do with their savings. On the other hand, it suits us at Aylett & Co., as they often persuade Mr Market to enter one of his psychotic moods; this in turn provides us with excellent investment opportunities.

Our focus at Aylett is to try and avoid overpaying for assets. Our thinking is that if we don't lose permanent capital, the rest of our investment process will take care of the upside. Selecting good companies, coupled with an ability to ignore the soothsayers of market forces will, overtime, prove to be a winning strategy. So, what concerns us? Our concern is that investors in emerging markets and certain developed markets have not been punished enough. Buying during the dips hasn't been a bad strategy; in fact, just when you think that is it, some central banker/government comes to the rescue. Bad behaviour continues to be encouraged and common sense is ignored. The Volker Rule meeting such resistance in the USA, even from governors of the Fed, particularly Mr Lacker, is evidence of this mind-set.

Locally, I find the increases in unsecured lending to the unbanked quite remarkable: CEO's try to reassure us that we do not have a bubble and they inform us that this time, it is different. Why aren't they marketing products that encourage one to save? The Fund is a programme is a great example of this kind of initiative.

We have built up our cash reserves. Not much has changed in the world and this lull in the markets might be warning of a prevailing storm - we hope this is the case but until then, our cash reserves will continue to grow.

2011 was a good year for the Aylett Equity Fund in that it provided investors with a return of 7.5%. By way of contrast, the total return of the JSE All Share Index was 2.6%. The excess return that the fund generated came from the following main areas: underexposure to resource based stocks; increased exposure to offshore markets and higher cash balances resulting from the belief that local markets were fairly priced.

At the height of the motor industry, there were over 2000 car manufacturers in the USA - the impact that this would have on the US economy could not have been imagined. The industry's growth was remarkable as was its demand for fossil fuels. The dilemma for investors was the difficulty in picking the winners out of the crowd. As we know today there are only three car manufacturers left and all three would certainly have gone bankrupt without government assistance. Our task at Aylett & Co is to stay away from the losers and we do this by investing in companies where we really understand the economics of the company. To succeed at this, one needs to have a competence in analysing and understanding the industry in which these companies operate.

In South Africa there is not much choice for investors who try and follow the above approach. The solution to the lack of fruitful investment ideas is to either look offshore or to elect to invest in cash until opportunities present themselves - both of which we are very comfortable in doing. Many of the large fund managers do not follow this approach and instead choose to engage in the relative game which, in our opinion, quite often leads to poor returns.

Owing to this focus on trying to identify and avoid the losers there will be times when we will significantly underperform local markets. Local resource companies feel a bit like the USA car industry and it is very hard to pick the winners. Companies that rely on weak currencies, uncontrollable commodity prices and capital intensive projects with long payback periods do not make a sound investment case. This is not to say that we will never invest in these industries, but the investment would need to provide a very large margin of safety to make up for the lack of predictability of the revenue line.

Sasol, a company that produces fuel from coal, has some of the unpredictability of resource based companies but they process a commodity which we know is becoming scarce. Of all the commodity demand profiles, with specific reference to China, oil has the best fundamentals. Finally, a weaker Rand provides support for a company which does not have any real competition.
We do not know what the future holds, but it is clear that a lot of pessimism is priced into global markets. The rise in equity markets over the last two weeks has not surprised us and there is a good chance they will continue to do reasonably well this year. We wish our investors all the best for 2012 and please do not hesitate to contact us should you require additional information on the Fund.

"Panics do not destroy capital. They merely reveal the extent to which it has previously been destroyed by its betrayal into hopelessly unproductive works." (John Stuart Mills "Credit Cycles and the Origins of Commercial Panics", 1867)

One of our analysts recently attended a Bank Credit Analyst presentation on the global economy and provided feedback to us, which was music to our ears. The presenter, who had been on a global road show, suggested that in his entire career, he had never experienced so much pessimism expressed by investors.

All around in the media, in our visits to clients and companies and chatting to other fund managers, the world's future and how bad it is, is discussed at length. Some say that this time it is worse than 2008. My conclusion is always the same: I don't know! I don't mean to belittle those who attempt to worry about the future in general but my experience has been that worrying about the specific companies that we own is a much more profitable exercise and that when pessimism abounds, it creates wonderful buying opportunities. Clearly, if your time horizon is in the very near future you may want to concern yourself with the current situation but for us holding a five to ten year view, what happens in the next year is of less importance.

Unfortunately, pessimism has not hit the JSE very hard and has not created the buying opportunities we seek. On the other hand companies in the USA, such as the technology companies, are really cheap. To put it into perspective, I have counted five to seven companies that have an excess of 120 billion Dollars of cash on their balance sheets - the kind of cash Greece could certainly do with. Remember their debt is around 440 billion Euros.

Much of the pessimism expressed by ourselves in the early part of the year has materialised and we are now quite optimistic about the future. Our risk is getting lower as we move into the fourth year of washing out of excess capital and many markets have moved into bear market territory. I cannot say that the worst is over, but on balance there is a lot of bad news priced in. Cash, bonds, and emerging markets are not our desired investments whereas certain shares in the developed markets are looking very attractive. In my opinion, we may look back in the next few years and yearn for the days when we could buy companies (mainly in the USA) whose market cap was made up by almost 50% cash.

2011 was a good year for the Aylett Equity Fund in that it provided investors with a return of 7.5%. By way of contrast, the total return of the JSE All Share Index was 2.6%. The excess return that the fund generated came from the following main areas: underexposure to resource based stocks; increased exposure to offshore markets and higher cash balances resulting from the belief that local markets were fairly priced.

At the height of the motor industry, there were over 2000 car manufacturers in the USA - the impact that this would have on the US economy could not have been imagined. The industry's growth was remarkable as was its demand for fossil fuels. The dilemma for investors was the difficulty in picking the winners out of the crowd. As we know today there are only three car manufacturers left and all three would certainly have gone bankrupt without government assistance. Our task at Aylett & Co is to stay away from the losers and we do this by investing in companies where we really understand the economics of the company. To succeed at this, one needs to have a competence in analysing and understanding the industry in which these companies operate.

In South Africa there is not much choice for investors who try and follow the above approach. The solution to the lack of fruitful investment ideas is to either look offshore or to elect to invest in cash until opportunities present themselves - both of which we are very comfortable in doing. Many of the large fund managers do not follow this approach and instead choose to engage in the relative game, which, in our opinion, quite often leads to poor returns.

Owing to this focus on trying to identify and avoid the losers there will be times when we will significantly underperform local markets. Local resource companies feel a bit like the USA car industry and it is very hard to pick the winners. Companies that rely on weak currencies, uncontrollable commodity prices and capital-intensive projects with long payback periods do not make a sound investment case. This is not to say that we will never invest in these industries, but the investment would need to provide a very large margin of safety to make up for the lack of predictability of the revenue line.

Sasol, a company that produces fuel from coal, has some of the unpredictability of resource-based companies but they process a commodity, which we know is becoming scarce. Of all the commodity demand profiles, with specific reference to China, oil has the best fundamentals. Finally, a weaker Rand provides support for a company, which does not have any real competition.

We do not know what the future holds, but it is clear that a lot of pessimism is priced into global markets. The rise in equity markets over the last two weeks has not surprised us and there is a good chance they will continue to do reasonably well this year. We wish our investors all the best for 2012 and please do not hesitate to contact us should you require additional information on the Fund.