The recent quarter saw the risk taking switch firmly in the 'ON' position as money flowed into emerging equity and bond markets. The JSE All Share Index and local bonds benefitted handsomely from these flows, with a total return for the JSE of 13.3% and 8% for the bond index. The Fund performed pretty much in line with its benchmark achieving 10.2% for the quarter compared to 10.3% for the benchmark. Year-to-date, the fund is up 11.0% against the benchmark return of 9.3% - an excellent performance in volatile markets. The level and extent of this volatility has been surprising, and it certainly seems like the world has returned to reactionary mode where any new snippet of information, regardless of how inconsequential, results in a change of risk appetite and fund flows. Every week, month and quarter as non-farm payroll numbers, manufacturing indices or GDP returns are published globally, the market seems to spike or fall depending on whether or not these are better or worse than forecast. While this is frustrating to a long-term investor who appreciates that the value of businesses do not shift on a weekly basis, it is in fact advantageous, as it continually throws up pricing anomalies from which investors can benefit. Importantly one needs to be focussing on long-term valuations and performance and be prepared to stomach some short-term underperformance to achieve these benefits.

Within equities the fund has moved its positioning quite significantly into the resources space, with Anglo American now representing over 8% of the fund. This is a business which offers the patient investor significant volume growth as a number of key investments come into production over the next 3 years in the base and bulk metals space. Similarly we have increased our weighting in Impala Platinum, a company we know well and had sold out of during the 2008 commodity boom. The price had declined to the point where the market was no longer appropriately valuing the increase in production to come from its new shafts and expansion within its Zimbabwe operations. After applying our mind to the fair values for these businesses, assuming a normal level of platinum group prices, we felt the margin of safety was sufficient to buy a position in the fund. Our top holding, MTN, had an excellent quarter, returning in excess of 20%. This was another classic case of short-term thinking clouding what is an excellent, diversified business with access to great markets with high growth potential as well as strong cash generation. The recent announcement at the company's AGM regarding their planned significant increase in dividend payment over time was the catalyst that saw the share re-rate sharply.

The fund remains exposed to the SA banking sector. The recent interim results have by and large proven our investment thesis correct that the unwind of the excessive provisions made during the past rate cycle will come through. All indications are that the consumer is recovering, albeit slowly, and the overall level of provisioning in the bank will return to 'normal' levels. On this basis they are still trading on single digit forward PE multiples and offer good value relative to a more expensive domestic share market. Within bonds we have moved predominantly to floating rate instruments as we believe the next major move in interest rates will be up. In general, we are exposed to good quality credit to achieve an additional pick-up over the government yields. Preference shares, where we have long held a big position were reduced as a result of their strong re-rating this year. It still remains a reasonable position at 8% of the fund. We have also taken steps to reduce our overall property weighting as the asset class also significantly rerated as the market priced in the interest rate cuts. Our international portion remains at a full weighting and is predominantly invested in global equities which we still think offer compelling value on any long-term view.

Portfolio manager
Neville Chester

The past quarter was another strong period for markets, with equities in particular performing well. Credit also did well as spreads came in and domestic bond returns started to improve. The fund performed well, generating a return of 4.9% compared to its benchmark return of 4%. It is also pleasing to see that it beat the All Share Index return of 4.5% as well despite being less than 70% invested in equities. A number of strategies paid off in the quarter but I would highlight the return generated from our preference shares which I have highlighted many times as a glaring opportunity in our investment universe.

We have long held a significant portion of the fund's assets in preference shares. These became an overlooked asset class as investors became skittish about changes to STC (despite these changes being accommodated in the articles to the preference share issues) and short-term capital losses as the market sold off into a rising interest rate environment. Investors into the listed preference share market should never look at what the market price is but rather at the after tax yield these shares generate. For a number of years preference shares have offered a return which on a pre tax basis has been better than that of cash. Grossed up for the tax effect the yield has been almost double that of cash. If one had patience and the ability to correctly assess the underlying credit risk there was an opportunity for huge gains to be made, for relatively low risk. A lot of this return was generated in the last quarter as our preference share investments returned 7.6%. With a post tax yield greater than 7% they remain a compelling investment.

The equity portion of the fund performed well, with a number of our long-term investments delivering good performances. This was a mixture of cyclicals (especially the banking stocks) as well as some of the more defensive names like AVI, TigerBrands and Shoprite. We have been consistently reducing our overall SA equity exposure as the markets have continued to appreciate. This has been done either outright by selling or using the derivative market to buy put protection at certain levels. While not expensive we do believe that the local market is fairly valued.

Through this period of rand strength we have continued to maintain a full allocation to offshore assets. The majority of this exposure is held in equities, although we have a few smaller positions in good name credits offering relatively high yields. We believe that longer term this position will deliver superior returns to the domestic market.

In the fixed interest space we have built up a substantial portfolio of domestic credits, but focused mainly on inflationlinked bonds and floating rate instruments. Post the most recent rate cut we believe the greater risk now lies in higher inflation and ultimately a return to a rising rate environment. While this is not likely in the short term, one needs to be positioned for this eventuality well in advance.

Overall the fund remains well positioned for its objective of outperforming its benchmark and inflation over the longer term.

Portfolio manager
Neville Chester

The calendar year 2009 turned out to be a great year for the fund as it significantly outperformed the benchmark of 19% with a return of 25%. This was despite a slightly weaker final quarter where the fund 'only' returned 6.2% against the benchmark of 7.4%. This quarterly underperformance was driven by very strong SA equity markets, particularly commodities, and a strong rand which meant that our international holdings detracted from overall performance.

Looking back, 2009 was arguably an easier year to position the fund for, given the obvious cheapness of equity markets and the expensive level of bonds at the beginning of the year. Looking forward to 2010 it is far less obvious where the good value lies and which asset classes hold the best potential returns. SA equities have performed extremely well and in certain areas are looking very expensive. As a result the fund has been reducing its SA equity weighting. International equities do still offer relatively attractive returns and this position has not been reduced. Within the SA equities holdings we have favoured more defensive businesses with fairly high conviction earnings and strong cash flows. In the rush to re-risk portfolios a lot of the quality defensive business have been overlooked. The domestic economy is by no means on a strong footing and indicators such as credit growth and retail sales show that the consumer is still struggling to reduce his/her debt burden rather than spend, which is adding to the economy's woes. In this uncertain environment the more certain earnings delivery from defensive businesses, we believe, are worth paying a premium for. Where we can buy these businesses at a discount we think it is a great investment opportunity.

In the international equity space the fund has trimmed back some of its emerging market exposure after the phenomenal performance of these markets in 2009. This has been invested into the developed markets where valuations are more attractive. It still amazes us that in a world of 0% interest rates we can still find great quality businesses on dividend yields of 4% and 5%! With the reduced SA equity position the fund has had additional cash resources which we have started applying to additional listed preference shares. Preference shares are still offering better yields on a net basis than call rates. If you gross them up to a pre-tax basis they are offering a return in excess of twice what you could earn on call. We have also increased our bond weightings in the corporate space, locking in some very high credit spreads which will enable the fund to earn inflation-beating returns over the next five to seven years.

Given our longer-term outlook - the likelihood of rand weakness from this level - the fund continues to maintain its maximum offshore weighting, with the balance over equities being invested in high yielding corporate bonds.

To summarise, going forward it is a year where we are truly using all the elements of the flexible asset category that the fund is in to build a portfolio which will beat inflation and the benchmark for the foreseeable future.

Portfolio manager
Neville Chester