Ut veniat omnes ("Let them all come")
- ancient British naval slogan
The Fund returned 8.18% in the quarter, compared to 9.63% for the JSE-FTSE Industrial index. Over the 12 months to September the returns for the Fund and the index were 21.9% and 24.0% respectively. Compound annual returns for three years to September, in the same order, were 40.9% and 40.1%.
It is pleasing that the returns, after last quarter's negative number, are positive again. We are however disappointed that we must report another quarter of trailing the index; indeed while we manage for the long term it is never easy to endure a period of undershooting the benchmark. Against this backdrop, it is appropriate to confirm that our conviction in the investment views reflected in the Fund has not diminished. This conclusion was reached after much consideration of the altered state of the investment landscape, post the inflection point in markets during the events of May this year.
We referred to the mid-year sea-change in markets in our previous commentary. Re-pricing was then still underway, but predictably markets have settled down since. After the unusually high trading activity in the previous quarter, actions in the fund were limited to a few stock specific ideas. The key question is the degree to which economic prospects for companies have changed, and whether that change is correctly discounted in the price of the shares.
The shift to an economic scenario of increasing interest rates and hence reduced consumer spending surprised the markets with its speed and magnitude and resulted in a sell-off of shares geared to consumer spending. The negative surprise was aggravated by global issues. A reduction in emerging market risk appetite saw an end to the foreign portfolio flows which had buoyed our market early in the year. At the time of writing, the economic outlook remains uncertain, particularly with regard to the duration and extent of further interest rate increases. We stress-tested the individual investment cases for all our views. As a generalisation, it remains our sense that the best value is to be had in the consumer cyclical space. Although the earnings outlook for companies in this sector has undoubtedly worsened, valuation levels are compelling and discount a harsh economic outcome. We believe the secular improvement in economic prospects is sustainable, and will reassert itself as cyclical risks diminish.
During the quarter, we sold Delta Electrical and Super Group. These two seeds thus far failed to germinate. While their prospects have not changed much, the market turmoil offered companies with better earnings visibility, at similar or better ratings. Of the companies we sold in the previous quarter, we bought back Mvela Group at lower levels. Its prospects are much improved after the sale of its holding in Mvela Resources, and the valuation level is compelling. We also made use of the opportunity to establish a position in Imperial, where the 9x forward PE leaves much room for near-term earnings disappointment. On a similar thesis we instituted a position in JD Group, one of the stocks worst hit in the market sell-down. Lastly, we bought some shares in JSE Ltd. Although a financial stock and not strictly in our benchmark, we consider this an excellent long-term asset.
Our ten largest stocks make up 55% of the portfolio and are, by order of size: Naspers, Woolworths, Mr Price, Telkom, Richemont, Edcon, Famous Brands, Tiger Wheels, Mvela Group and AVI. Naspers enjoys strong annuity cash flows from its subscriber base; Woolworths' top-end positioning in food and its strong brand makes its earnings base defensive; Mr Price is a cash (as opposed to credit) retailer in affordable clothing and homeware; Telkom is a legislated monopoly; Richemont's diversification and brand ownership secures its earnings base. We could go on, but the point is to demonstrate the defensiveness in our key positions, underpinned in all instances by good valuations. Whatever the macro variables may serve up, we are ready. Let them all come.

Dirk Kotzé and Pallavi Ambekar
Portfolio Managers

The Fund returned -6.2% in the quarter, against the -5.34 % of the Industrial index. For the one-year to end June the Fund delivered 32% and the index 35%, and on a compound annual basis for three years to June, these numbers stood at 40.5% and 42%.
Our cautious comments last quarter were vindicated when the market suffered a serious setback mid-May, and the wave of emerging market optimism evaporated into a mist of uncertainty. It is often possible to identify abnormal levels of sentiment and valuation in markets. However, predicting how and when these will come to an end is a different matter entirely. Given our market concerns, we positioned the portfolio as defensively as possible and at the same time considered the possibility of the 'Goldilocks' period lasting some time still. It is for this reason that the Fund retained a significant exposure to 'cyclical' stocks, albeit those we believed to be undervalued. In the subsequent decline, all cyclical stocks were severely sold down, and our current holdings became even cheaper.
Times of market upheaval are good for stock pickers in that they provide entry or exit opportunities seldom seen in more stable markets. The rational reaction in a falling market is to sell those defensives that have 'done the job' and preserve capital, applying the cash to stocks that have become very attractive. We did exactly this, and our trading activity in the quarter was significantly above normal as a result. Stocks sold out of the portfolio in the period included Omnia, Group Five, Mvela Group, Trencor, Oceana, Tiger Brands, Johnnic Communications and Pick 'n Pay. New positions were established in Adcorp, Astral, Cashbuild, Massmart, Spar, MTN and HCI/Johnnic. In almost all instances the sales were not due to a negative re-evaluation of the prospects of the companies concerned, but rather to relative price moves. The same is largely true of the buys. We also used the market sell off as an opportunity to add to some of our core positions, and increased our holdings of Woolworths, Telkom, Edcon, Mittal, Richemont and Tiger Wheels.
Predictably, stocks with a rand hedge element were the biggest contributors to performance during the quarter, among them Mittal, Delta, AECI, Omnia, Tiger Wheels, Richemont and Oceana. The laggards were predominantly consumer cyclicals (and even defensives), notably Edcon, the newly acquired Massmart, Famous Brands, Woolworths, Tiger Brands and Mr Price.
The telecommunication sector now comprises 9.4% of the Fund in total. We have increased our Telkom position, buying at lower levels as the price declined substantially. During the quarter, Telkom traded at a price that implied that the fixed line business was trading on a 3 to 5 times normalised PE, a level that more than compensated for increased competition and regulatory risk. In addition, Telkom still owns 50% of Vodacom, a strongly growing, highly cash generative business that is the market leader in the South African mobile space.
After a long absence, MTN made an appearance in the Fund, mainly due to huge share price underperformance. Despite strong fundamentals, we historically considered the share to be expensive, as investors were caught up in the 'growth' story. The recent Investcom transaction will diversify MTN's portfolio of assets, but will put pressure on earnings for the next two years. However, we assess longer term growth in earnings and free cash flow to be very strong. In addition, operations in South Africa and Nigeria are currently generating substantial free cash flows and this should provide a stable underpin while other licences are still in their growth phase. At the current share price, the forward PE multiple no longer includes a premium for exceptional future growth.
We acknowledge that the world may have changed, and that we are moving into a weaker rand and higher interest rate environment, but it is by no means certain that the positive economic cycle in South Africa is fatally wounded. In fact, we believe that the consumer sector in particular has been oversold and now discounts a worse scenario than that which we view as the base case. In this sector we continue to see good value in Woolworths, Mr Price and Edcon. Our other large holdings are Naspers, Telkom, Remgro, Tiger Wheels, Mittal and AECI.
Dirk Kotzé & Pallavi Ambekar
Portfolio Managers

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they recover their senses slowly, and one by one." - Charles MacKay; Extraordinary Popular Delusions and the Madness of Crowds

The Coronation Industrial Fund returned 11.99% for the quarter, versus 12.85% for the benchmark. For the 12-months to March the returns of the fund and the benchmark respectively were 51.11% and 52.59%. For the three-year period to end March the annualised returns, in the same order, were 50.4% and 51.1%.

Two insights from these numbers are obvious. The first is that once again we have seen a "year's worth of returns" delivered in a quarter. As before, we caution investors not to think that 50% annual returns are normal, especially not after three years of such returns. The second ties in with the first. Once again the fund has underperformed the index. It is not managed with reference to the index as a benchmark; indeed given our concern with the valuation levels of many benchmark stocks we continue to ignore the benchmark with gay abandon. As discussed below, our stance from here is a cautious one, and capital preservation an ever greater consideration.

The last quarter of 2005 saw a significant acceleration in the purchase of SA equities by global emerging market investors. This trend intensified in the first quarter of 2006. SA equities, long the underweight in emerging market benchmark portfolios, saw unprecedented foreign buying: to the extent that the underweight position has been normalised to an onweight situation. At the same time, emerging market funds themselves enjoyed very strong inflows. To give an idea of the scale, the inflows into these funds in the first 11 weeks of 2006 were equal to those of the entire 2005. This placed SA equities in the "sweet spot" of being the favoured destination in an increasing stream of capital flows. This is what pushed the index to all-time highs.

It is not for us to comment on the acumen of our global industry colleagues. Their present actions confirm our past experience of their style: they like to use the shotgun rather than the rifle. Favoured themes among foreign investors have been fixed investment stocks, consumer plays and banks. The valuations of the usual suspects (those old favourites the foreign investors have traditionally liked) have sky rocketed. Observing these events with a touch of detached distaste, we note the undignified motions of a feeding frenzy. The memory of the IT boom (and bust) are fresh in our memory, as they should be in yours. The EM boom has all the signs of a similar, familiar trajectory: one described by Mr Isaac Newton. What goes up, must come down. The madness of crowds is with us yet again.

Nowhere is this madness illustrated more vividly than by the ridiculous prices currently being paid for construction stocks such as Murray & Roberts and Aveng. Like all companies, these have their right price; we have indeed held them from time to time. Knowing these companies as well as we do, we cannot but point out that construction is an industry with poor fundamentals. Contracting earnings are notably volatile, difficult to forecast and prone to subjective accounting recognition. The sector's earnings track record is chequered. Even global precedent offers little comfort. In Greece and Australia construction groups failed to increase their returns despite the Olympics.

Average global industry margins are around 1.5%, while our stocks now price in margins of 5% to 6%; and this forecast earnings base is valued at a premium to our market. Foreign shareholding in these companies, from a zero base, is now about a third of the equity, all on the well-flagged promise of massive construction spend.

The only new stock we acquired during the quarter was Mittal Steel. We believe that fundamentals in the global steel industry have improved to the extent that the mid-cycle steel price in coming cycles will be higher than in the past. This is largely due to a combination of supply-side consolidation (and hence production restraint) and continued demand from China, whose own production will not be as disruptive as initially feared. Much of construction is steel-intensive. We expect Mittal SA to be a better way to play the local fixed investment cycle than the construction stocks. Present negative news flow regarding competition issues provides an opportunity to establish a position in this counter at a single-digit PE on normal earnings, and with a possible minority offer in future, underpinning downside risk.

For the second quarter in a row we sold a stock we had bought only the quarter before; this time Afrox. We liked the investment for its defensive characteristics and bought it despite an already steamy rating. This became even steamier when, on the back of corporate activity relating to BOC, Afrox's parent company in Europe, the local subsidiary rerated yet further. The valuation now left no room for error, and we exited with a reasonable return.

The strong market run saw two other turnaround plays run ahead of fundamentals. One was Afgri. We sold in the belief that the margin of safety was getting too thin. The quarter also saw us give up on New Clicks, a stock we had doggedly held through thick and (especially) thin. The corporate turnaround here is indeed happening, if more slowly than we had hoped. The price at which we sold no longer adequately discounted the hard road that still lies ahead for this group.

It is tough in times like these when the shares one does not own, are pushed beyond their rational value by momentum factors. We do not intend to hold equities where we cannot justify the valuation to ourselves, even while momentum continues. This may cause some short-term underperformance. As stock pickers, we relish the opportunities that present themselves when theme investors move the market on a large scale. Overlooked equities in a market like this often offer much better long-term value. We reiterate our previous warnings: in a market that has doubled, we need to concern ourselves primarily with capital preservation. Given that prospective returns can surely not be as good as those of the recent past, our selection of defensive equities, each with an individually well motivated value proposition, makes us sleep well.

"All our sins come from sloth and impatience, and sloth comes from impatience," said Franz Kafka. With due modesty, sloth is not one of our failings. In what we see as an increasingly polarised market, we own reasonably priced investment ideas. We remain patient, confident that our views will prevail.

Dirk Kotzé & Pallavi Ambekar
Portfolio Managers

"Once more into the breach, dear friends, once more; Or close the wall up with our English dead! In peace there's nothing so becomes a man As modest stillness and humility: But when the blast of war blows in our ears, Then imitate the action of the tiger; Stiffen the sinews, summon up the blood, Disguise fair nature with hard-favour'd rage; Then lend the eye a terrible aspect." Henry V, Act 3, Scene 1

Clichés are what they are because they distil a truth other words do not capture. The holidays are over. Looking back, the returns of past periods fill us with a warm glow:
Over the quarter, the fund return was 7.3% versus 5.7% for the FTSE/JSE Industrial Index. For 12 months to December the fund returned 35.0%, and the index 35.5%. Over a three-year period, compound annual numbers were 39.9% and 35.5%.
It is in looking forward, though, that we need to stiffen the sinews and lend the eye a terrible aspect. We have been warning in recent commentaries that prospective returns are likely to be lower. By and large, we share the general optimism about the benign economic environment. We still believe that equities remain the best asset class by far. Yet our optimism is significantly tempered by valuation considerations. Increasingly we have to remind ourselves of the old truth that the only part of the return we as investors can control, is the entry price. When one looks at the rating of the market, it does not appear worrying. Of much greater concern to us is the high level of earnings in many companies. The present levels of profitability come against the backdrop of an unprecedented economic expansion, in terms of both magnitude and duration. Certainly the most critical investment variable at this point in the cycle is how high the present earnings of a company are, relative to what they will be in an average year.
This approach of 'normalised earnings' promises to keep us from being carried away by too much optimism about the present cycle and forces a focus on the long-term value of shares. While its rigorous application guarantees that we keep an adequate margin of safety and hence protect capital, it may cause us to exit stocks in the early phase of a valuation overshoot. This is a risk we must take.
Characteristically, our trading activity was subdued. We established new positions in two companies, Afrox and Omnia. The investment case for the two could not be more different. Afrox is an excellent company whose premium rating to the market could justifiably be even higher. As we move into an environment of overblown earnings, here is a company that will maintain its profitability come fat times or lean. Omnia is a well managed cyclical company presently facing very weak earnings, mostly as result of maize overproduction causing weakness in fertilizer sales. We believe its normal earnings level to be well above that presently being achieved. On the sales front, we grudgingly accepted the offer to minorities in Frontrange, and exited this investment. While we were disappointed that full value was not achieved, our hand was forced by major shareholders making the take-out a fait accompli.
During the quarter, good performers for the fund were VenFin, Mr Price and Remgro, while the tail end was brought up by Tiger Wheels, Delta Electrical and Super Group.
Needless to say, we were very pleased with the events at VenFin. Many is the time we had to resist ditching this boring value situation in favour of more sexy plays. This proves again that 'modest stillness and humility' are the allies of the longterm investor. May the word 'catalyst' be banished from the halls of Coronation forever!
We were also very pleased with the strong performance of Mr Price during the quarter. Often featured in our past commentaries, we have held a very large position in this counter for a long time, and seen it appreciate greatly. We still believe in substantial potential here, as the store chain expands and credit markets are accessed.
Lastly, it is with a touch of sadness that we see Karl Leinberger move on to other duties. His wise and dispassionate counsel is thankfully only a corridor away. This writer does look forward to fund commentaries without all the juicy bits edited out by Karl's dour pencil. Pallavi Ambekar joins the fund, seamlessly formalising a situation already existing in practice. Welcome to her. May she summon up the blood, and imitate the action of the tiger(ess).

Dirk Kotzé & Karl Leinberger
Portfolio Managers