The quarter to September was an unhappy one for the fund, returning -1.6%. As at the end of June, the 12- month return stood at 57.6%. Dropping off a strong quarter in the previous year and adding a weak one saw this drop to 39.4% as at the end of September. The three-year compound annual return now stands at 38.4%. Comparatively, the benchmark delivered 3.3%, 37.7% and 39.5% for the quarter, year and three years respectively.

We have been warning for some time that expectations were too high and that the market could experience a setback. That the setback happened was therefore no great revelation; the performance of the fund however was, especially in a relative sense. Tougher economic times are with us. The fund's exposure to consumer cyclicals is limited against this very eventuality. However, the performance did not reflect this conservative positioning. In looking for the explanation, three reasons are clear, the first being a sin of omission and the other two, of commission. Firstly, two biggest bets in the fund (zero telecom holding and low construction holding) proved costly. With industrials broadly under pressure, these were among the only sectors showing strong positive growth. Secondly, the large holdings in defensive plays such as food retail (Spar, Woolies), media (Naspers, Johncom), services (Bidvest) and hospitals (Netcare, Medi-Clinic) did not seem to do the fund much good. Lastly the new investments in two fallen angels (Imperial and Steinhoff) proved to be very premature, and like Icarus these angels continued a fiery downward trajectory well after purchase by the fund.

These timing issues feel painful in the short term, but would be much more concerning if they point to problems with valuation or process. Such is not the case. The fund remains well invested in equities that are soundly underpinned by fundamentals and more importantly, by a sufficient valuation margin of safety. The largest individual positions remain Naspers, Woolies, Spar and Bidvest. During the quarter the defensive component was further strengthened by a new position in Pick 'n Pay. This company will benefit greatly from rising food inflation but has lagged its peers, Spar and Shoprite greatly. It has an enduring franchise and despite management changes and strategic challenges, is offering value. Another 'defensive' bought in the quarter is Afgri. This group has a patchy track record, but has some good assets and will also be a major beneficiary of rising food inflation and improved agricultural conditions, all of this on a single-digit PE.

The recent market setback allowed a gingerly second bite at the construction cherry, with a small position in Aveng established and a larger 3% position in PPC, the latter a company whose high margins and strong cash flows enhance the margin of safety. The fund continues to struggle justifying the ratings on this sector and but for a flutter here and there, remains on the sidelines. One such flutter was Stefanutti and Bressan, a new listing in the sector. Having doubled since listing, it was sold just after quarter-end. Other indirect ways of playing the capital investment cycle include Mittal Steel, where a position was re-established in the quarter and York Timber, where a placement of new shares allowed an investment. This company may turn out to be a bit of a sleeper, but given its new-found integration into forestry assets its long-term prospects are excellent. Construction timber is going to become a very scarce resource.

Sales during the quarter were all small, and included Adcorp Holdings, a company whose fundamentals remain excellent but where shareholder value was unfortunately greatly diluted by a BEE deal; Iliad Africa, where a proposed private equity deal pushed the rating hard; Sovereign Foods which was switched into Afgri; Discovery Holdings, a non-benchmark stock against the backdrop of many cheap industrials; and HCI, in favour of increasing the more direct exposure to the gaming assets in Tsogo via Johnnic.

With relative performance under pressure the daily review of the fund reveals, encouragingly, that it is difficult to find things to sell, given that all holdings are offering value. This remains the acid test and signals hope going forward.

Dirk Kotzé
Portfolio Manager

During a volatile quarter, the fund managed to eke out a positive return of 5.3% vs 4.7% for the benchmark. For the 12 months ended June, the returns for the fund and benchmark respectively were 53.1% and 48.9% while compound annual figures for three years, in the same order, now stand at 45.4% and 43.0%.

The spectacular return of the last 12 months again underscores our caution going forward, as signalled clearly in our last few reports. Global events have since taken a turn for the worse. Long bond yields in developed countries have kicked up substantially, indicating that we may finally have reached the long-expected inflexion point of the global liquidity cycle. For the first time in a while, there is a more serious debate internationally about whether inflation will again become a force in global economies. Driven by high food and energy costs, the local inflation outlook has also worsened considerably and with it the interest rate outlook. On the back of this, banks and consumer cyclicals in particular have been hard hit in the last few weeks.

As always when markets pass a turning point, the initial price adjustment appears indiscriminate, equally affecting most stocks. For the stock picker, this is not the best news. While we feel happy with having beaten the index over three years, in all modesty the excess return does not appear to be commensurate with our efforts. Perhaps tougher times ahead will create a greater divergence between this portfolio and the index. The fund has been positioned defensively and is in good shape to face such tougher economic times.

The fund is managed with little regard for a benchmark or the holdings of competitors. It is however most instructive to review the holdings of other managers in the industrial space and compare these to our own. This reveals that various industrial funds have performed with remarkable similarity despite significant differences in positioning. This might be about to change. In discussing our recent trading, it may be helpful to focus on a few examples of where our thinking and positioning differ from others.

The fund holds no exposure to traditional credit retailers such as clothing and furniture companies. A high exposure to Woolies (50% food) has been maintained, while the position in Spar was beefed up. What other retail exposure there is, (Mr Price, Cashbuild, Verimark) is cash-based and has companyspecific attraction.

Along with the rest of Coronation, I believe that banks are a better way to maintain exposure to the cyclical consumer market. In an industrial fund, Mvela Group provides an attractive exposure to ABSA. The position here has been increased. Mvela also offers exposure to Life Healthcare. During the quarter, a position was established in Medi-Clinic. With the pre-existing Netcare position, the fund now has exposure to all three local healthcare groups. This sector has clear non-cyclical and defensive properties.

The sale of MTN during the previous quarter was followed up by that of Telkom in this one. Relative to peers, having no telecom exposure at all is a significant stance. My sense is that these companies are no longer attractively priced, and that the telecoms space is becoming increasingly competitive.

The last area of significant difference remains fixed investment. With the exception of (the purchase on listing, and subsequent sale of) Raubex, the valuations on construction companies remain too high.

Other defensive purchases during the quarter were Afrox, Mobile, and Johnnic Communications. A small position in Steinhoff was established: a paradoxical example of revising our view and joining the consensus! The stock had simply become too cheap, a fact unfortunately signalled by large director buying later on the same day we had started to buy it. SAB Miller was sold, as was Tiger Wheels; the latter sale closing a disappointing chapter and proving that investment return is often uncorrelated with research effort. The fund retains a big position in sister company Tiger Automotive.

Dirk Kotzé
Portfolio Manager

"A loon again"
- British Newspaper Headline, referring to Charles, Prince of Wales, between marriages

After a short 15-month period of shared responsibility between colleague Pallavi Ambekar and myself, your fund is again in a single pair of hands. My thanks to Pallavi, who goes on to other duties. Like the prince, I find myself alone, middle-aged and somewhat puzzled by the world around me. I fully hope that the similarity ends there. The most obvious meaning of 'loon' is a nutter. Personally I have always rather liked the alternative meaning (and I'm sure Prince Charles does too), that of a bird that can swim under water. Given the present state of the markets, one needs to be able to hold one's breath for a while at a time. Co-management does have its moments: the constant check and balance of persuading your colleague of what you want to do; the forced discipline of a well-articulated investment case; the patience of having your counterpart veto your idea (or vetoing hers) and waiting until the validity of assumptions are a bit clearer. This has worked well for us. On the other hand, after a three-year bull market, things are clearly moving into a phase of greater volatility. In a sideways but range-trading market the greater nimbleness of being able to act 'a loon' might well prove beneficial.

The quarter under review was divided into two parts: the portion before 26 February 2007 when markets continued their uptrend, and the portion thereafter when a renewed set of jitters around the yen carry trade, the US housing market and emerging markets generally upset the smooth upward progression. Off its highs as of end February, the fund produced a return of 8.2% in the quarter vs 7.1% for the FTSEJSE Industrial Index. For the 12 months ended March, the returns for the fund and index respectively were 36.3% and 34.7%. In the same order, compound annual returns for the three years to March were 43.5% and 41.4%.

With private equity transactions having become a feature of our market, the fund benefited by being able to exit Peermont, Edcon and Primedia at reasonable prices. Other shares sold included MTN, Hudaco, Mittal and AECI. In most of these cases the market sufficiently rewarded the effect of the rand's recent decline in earnings. Having sold these stocks, the fund is under exposed to rand weakness, and is actively looking for alternative rand hedge exposure. The position in JSE Ltd was also sold, having had a very good run. While we see further value here, it is no longer as compelling as some other options.

The fund continues to struggle with the valuations of construction-related stocks. During the quarter positions were established in Reunert and Iliad, playing different elements of the fixed investment boom. In both cases valuations are still reasonable. New positions were added in Value Group (regrettably just before an earnings disappointment), Amalgamated Appliances (after announcing the companychanging acquisition of Steinfurn) and AVI, an old favourite again offering compelling long-term value.

Shares that added to performance during the quarter were Primedia, Telkom, Distell, Hudaco and Famous Brands. Sovereign Foods, Tiger Wheels, Value Group and SAB Miller (after the loss of the Amstel contract) were detractors over the period. Of these, Tiger Wheels was by far the most disappointing. We correctly anticipated a split of the business between retail and manufacturing, and a recovery in the bulk of the offshore manufacturing business. The manufacturing recovery was premised on an improvement in macro industry conditions, one which did in fact play out as expected. Of great disappointment was a large loss sustained in a specific factory, due to a management issue. We continue to explore the limits of the term 'vasbyt' on this one.

As we have warned often in the past, our market is no longer inexpensive. There are however still ample value opportunities for the Fund to exploit. A sufficient margin of safety in the valuation of every stock is akin to the loon's ability to hold its breath under water. Even should the water become choppy, the canny bird should survive.

Dirk Kotzé
Portfolio Manager

"That's a great deal to make one word mean," Alice said in a thoughtful tone.

"When I make a word do a lot of work like that," said Humpty Dumpty, "I always pay it extra."

-From Alice in Wonderland by Lewis Carroll, as quoted in A.Word.A.Day.

We are pleased to report that the fund enjoyed an excellent quarter, both in an absolute and in a relative sense. So much so that it caught up all of its mid-year lag in terms of performance versus the peer group, and is back at the top end of the ranking tables. The fund was in fact listed as one of the top ten SA unit trusts on pure return for the five-year period to December 2006, with a compound annual return of 33%. This pleases us greatly, especially since we believe the returns were delivered without undue risk taking. To run through the figures in the customary way, the quarter's return was 24.3%, while the FTSE-JSE Industrial Index did 18.9%. For the calendar year to December 2006, the fund and index, respectively came in at 41.1% and 41.9%, while three-year compound figures up to the same date were, in the same order, 43.0% and 41.2%.

We focus on returns for a moment to enable us to make a couple of points. The first is to blow our own trumpet (just a tiny bit). The second is to state again that annual returns in the 30%'s and 40%'s are clearly not sustainable and no matter how positive the economic outlook might be, equities are now much more expensive than when some of our longer-serving clients joined us. At 44% annually, an investment trebles over three years. At 33% annually, it more than quadruples over five years. While it is wonderful when the magic of compounding works in one's favour, the opposite is also true. In the example above, the prospective earnings stream one bought three years ago at R1, now costs R3 to purchase; the one bought five years ago at R1 now costs R4.16. Sure, the expected cash flows from many companies have also increased, but have they trebled or quadrupled?

Let's leave the salutary warnings there. Thirdly, we'd like to refute the notion that a fund categorised in the much maligned "equity sector fund" category is suitable only for specialist investors or those with a high risk appetite. We see the industrial space as providing ample opportunity for diversification and risk management (admitting that we are talking of an equity portfolio), as the longer-term track record shows.

Our last point is to revisit our process just a bit. You will by now be used to our dis-inclination to trade much, and our preference for large chunky holdings of the stocks we like. Like Humpty Dumpty and his words, we make a stock do a lot of work, but when it does come through, 'it pays us back extra'. In the quarter, our large positions in Naspers, Peermont, Mr Price, Edcon and Woolworths all did well for us with returns (unbelievably) of between 30% and 40%. The laggard stocks in the quarter were Telkom, Famous Brands, Richemont and SABMiller. We continue to hold very large positions (5% - 10% of the portfolio) in Naspers, Woolworths, Telkom, Mr Price, Edcon, Remgro and Richemont.

During the quarter we sold some of the stocks we had bought during the mid-year sell-off of consumer cyclicals. These stocks had generally recovered to their normal valuation levels as fears of a consumer melt-down dissipated. Among them were Imperial, AVI, Massmart and JD Group. We also sold Astral, where we were correct in expecting prospects of rising food inflation to filter through to earnings forecasts.

Despite general valuation levels being fairly high, we still found investment value in a number of new buys. We bought the excellent quality businesses Hudaco, Adcorp (again) and Discovery Health, the latter not strictly in the industrial space but a company with very exciting long-term prospects. We also bought Netcare, largely for exposure to its newly acquired offshore assets; Tiger Brands, a quality company that has lagged the market; and Sovereign Foods, another beneficiary of food inflation.

A custom we neglected in the last few quarters is that of the feature stock. We return to this with a few comments on Mvela Group, now a long-time holding in the fund. This investment trust in the BEE space has lagged the market due to a hiatus in landing new deal flow, uncertainty about what it will do with its substantial cash pile, and leadership/succession issues. On our calculations it is however trading at more than a 1/3 discount to the stack-up value of its investment portfolio, the portfolio itself being made up of assets we mostly like very much: ABSA, Life Healthcare, cash, a service business and Group Five. Despite the risks, the margin of safety here is huge.

While the investment environment is as uncertain as always at the beginning of the year, we remain confident in finding a judicious mix between conservatism and capital preservation on the one hand, and daring and innovation on the other. Would it be to much to ask that it would be, after all we've already enjoyed, another good year?

Dirk Kotzé and Pallavi Ambekar
Portfolio Managers