The fund delivered 14.8% for the quarter versus the 16.3% of the FTSE/JSE Industrial Index. For the 12 months to September, the comparatives are 19.1% versus 15.4%, and compound annual figures for the three years to end- September stood at 12.2% versus 12.2%.

A year has passed since the bursting of the credit bubble and the beginning of the global financial crisis. Looking back, what could easily have been the worst possible year for investors in financial markets, has turned out all right. Markets have rebound strongly, business people are starting to talk about plans for 'the end of the recession' and risk appetite is back in town as evidenced in a wide range of measures ranging from emerging market bond spreads and equity flows to currency rates and volatility indices. So, it wasn't so bad after all. Yet another crisis has been successfully seen off and added to the list we know so well: '87 crash, LTCM, Tequila Crisis and Asian Crisis. Or is there something more to it?

We have been among those expecting a harsher outcome. Being a fully-invested equity mandate, your fund has performed well. This is due to all shares being so cheap 6 months ago that, to be honest, it did not really matter all that much what stock picks one had. Evaluate the performance a little more closely and it becomes clear that our gloomy worldview led us to pick a defensive set of stocks; typically those companies with diversified, global business models in staple-type industries. While these rebounded with the rest of the market, they lagged industrials overall in the last quarter or two. We would have been better served by embracing, at the bottom of the market, the very distressed cyclical sectors: among them construction, credit retail and consumer durables. Missing them would have been especially distressing if we now found ourselves believing that the world was a happy place. Thankfully, but somewhat regretfully, we don't think that. Two main concerns are keeping us snugly in the embrace of the defensive stocks we sought out back then - valuation differentials and the forecast risk to earnings.

We'll use an example or two to demonstrate these. Starting with valuation, consider British American Tobacco (BAT), a share we own, and Barloworld, one we don't. In a market where risk appetite is back, boring old BAT with its steady cash flows, hard currency earnings and low profile is seen as a little unsexy. Since unbundling from Richemont it has been a poor relative performer in rand terms. This global powerhouse, with best-in-class management, 60% of its revenues from still-growing emerging markets and, best of all, captive customers, can be had for a steal at 12.5x PE or a 13.3x free cash flow multiple. This represents a discount to the UK market. We think it will grow its earnings in sterling over the next four years or so (on average) at 11% per year, while returning cash in form of dividends and share buybacks. We have increased our holding into weakness and now hold some 10% of the fund in this counter. Now let's consider Barloworld. The share is up 60% from its 12-month low and has outperformed the market since then. While it is true that we missed this run, it currently trades on a forward PE of 11.7x, not cheap but admittedly reflecting an expectation that earnings will rebound strongly. Still, even factoring in strong earnings growth of 25% compound for the next few years, its rating to its 'normal' (or mid-cycle) earnings is only a very small (10%) discount to the financial and industrial market. For such a cyclical stock this is simply not cheap enough to leave a sufficient margin of safety for earnings disappointments. Which brings us to the second concern: earnings. We are not economists, but somehow we think it is too simple to assume that the vast liquidity pumped into the global system, the remaining debt burden on the real economy (as opposed to the speculative or financial economy) and the damage to consumers, jobs, trade and so on will all just be fixed in the normal course of business. Low interest rates globally mask the unpalatable fact that debt spreads and debt costs as a whole have increased. The world is tougher out there than it has been. And in particular we think there is significant risk to corporate earnings. The companies with the strongest business models are better options, even if one has to pay a bit more. For SA companies in particular, earnings risk is high and rising as long as the rand remains strong. It may sound counterintuitive to prefer rand-hedge shares (whose earnings by their nature will suffer under a strong rand) now, but companies such as MTN, Naspers, SABMiller and Bidvest are well diversified away from the rand and have the ability to 'perform their magic' in markets not so affected by the local dynamic. And we have a few geared rand plays in the bottom drawer, against the increasing likelihood (from here anyway) that the currency will blow out, as it often has in the past.

The MTN/Bharti talks appeared to be one of the factors supporting the rand. At the time of writing, the transaction has just been disbanded and the rand has depreciated slightly. We were not in favour of the proposed transaction as the indicative price range undervalued MTN and we were not in favour of being partly paid in Bharti shares - a company we consider to be fairly valued. The uncertainty surrounding the transaction has had a depressing effect on the MTN share price, and temporarily sterilised the market mechanism from weighing the company on its intrinsic value. In the short term, this adversely impacted performance. We continue to hold MTN for the attraction of its underlying fundamentals and not for any deal flow.

Thus, we continue to hope for the best, but are well placed to weather something worse than that. The fund remains centred in our high-conviction ideas, the first 45% being concentrated in 5 holdings, namely MTN, BAT, Naspers, SABMiller and Bidvest. The next 10 holdings, position sizes from just below 3% to just over 4%, takes concentration to well over 80%. Other than increasing BAT, there has not been much movement in the fund during this otherwise eventful period. At the small end (sub 2% positions) we added to Hulamin, Tongaat, Advtech and Remgro. While we do not feel brave, we are confident that this portfolio should do well whatever uncertainties the macro environment has in store.

Portfolio managers
Dirk Kotzé and Quinton Ivan

'To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.'
Sir John Templeton

At the time of writing the previous quarter's commentary, the market was enjoying a strong bounce. This bounce continued into the second quarter of the year, with the fund returning +15.8% compared to the 14% returned by the FTSE/JSE All Share Industrial Index. For the 12 months to June the fund and index returned +7.6% and -4.7% respectively, while the compound returns for three years now stand at 10% and 10.7%. The pleasing performance relative to the index continues, with the gap in three-year compound returns narrowing further. The fund continues to perform very well relative to peers and ranks first over a year and second over three years.

Although the recent rally in equity markets has calmed a few nerves, we continue to be of the opinion that the global economy remains challenged. In a world where everyone is talking about 'green shoots' of economic recovery we remain cautious. While we acknowledge that South Africa may not be facing the same kind of deflationary, deep recession apparent in many developed countries (thanks to our wellcapitalised banking system), we will not be entirely unaffected. The most direct impact has been on South Africa's export volumes which have stepped down in tandem with falling global demand. This has seen a number of sectors, most notably mining and manufacturing, slowing down. This, in turn, has had knock-on effects in the form of job losses and the curtailment of capital expenditure. The impact of the slowdown on the South African consumer has been amplified given last year's interest rate hikes and rising food prices. This, coupled with a tightening in bank's credit granting criteria, has resulted in a significant contraction in consumer spending.

The net result of our macro view is that we believe the South African rand will remain vulnerable. Declining exports and reduced capital flows (due to increased risk aversion) will result in difficulty funding the current account deficit. It is for this reason that approximately half of the fund remains invested in rand-hedge counters - such as MTN, Naspers, Richemont, SABMiller and Bidvest - that should benefit from a depreciating rand. We continue to be attracted to these globally diversified businesses with best-in-class business models, management and brands that entrench customer loyalty. In an environment where average companies battle to defend earnings, approximately a third of the fund is invested in domestic defensive counters such as Famous Brands, Aspen Pharmacare, Shoprite Holdings and the Spar Group. The latter are beneficiaries of rising food prices and have earnings prospects that are superior to the average industrial company, although one does not pay an excessive premium for this growth. At the time of writing this commentary, the Competition Commission has announced that it will probe the South African food retailers to investigate possible instances of anti-competitive practices. High food prices are an emotive issue and one that affects us all. While the investigation is welcome, we do not believe that food retailers are guilty of such practices. In fact, we believe that the South African food retail industry is highly competitive as their low operating margins attest. Consequently, we remain comfortable with our holding.

During the quarter, the fund sold out its holding in Aveng following an appreciation in the share price of some 40% from trough to peak. We previously highlighted that the pendulum for construction counters had swung from greed to fear, providing an investment opportunity. Following the recent run in construction counters, we no longer believe there is a sufficient margin of safety and resume our cautious stance on the construction sector given the risk of delays in capital expenditure as clients cancel or defer projects on the back of funding concerns.

The most significant new buys during the quarter were positions in British American Tobacco and Remgro. The return of global risk appetite during the quarter saw a massive sell-off in global defensive counters and British American Tobacco was not spared. This presented an opportunity to acquire this truly global blue chip at an 11x forward PE multiple and a forward dividend yield of 6.5% in sterling! This business is highly cash-generative with a stable earnings stream due to the inelastic nature of demand for its product. It is also extremely shareholder friendly and has, over time, returned large amounts of capital to shareholders in the form of dividends and buybacks (over _2.5 billion since 2005 in buybacks alone). British American Tobacco now comprises approximately 6% of the fund.

The fund also established a starter position of 1% in Remgro, with the intention to increase this over time. Remgro possesses one of the best track records of value creation for shareholders in our market and has a quality portfolio of assets (approximately 30% Firstrand and 9% Impala Platinum) that one is able to purchase at a 25% discount (net of CGT) to spot prices and at a 40% discount (net of CGT) to our assessment of fair value for the underlying investments. Furthermore, as a Remgro shareholder, one has exposure to quality unlisted investments such as Unilever South Africa as well as access to the deal-making prowess of the Rupert family.

In conclusion, we remain of the view that 2009 will be a tough year and although the end of the downturn may be in sight, it may be some time in arriving. Markets remain volatile and the time horizon of many investors has been truncated. Volatile markets often result in emotion trumping reason, thereby creating opportunities for the long-term investor who is able to be 'buy when others are despondently selling and to sell when others are avidly buying.'

Portfolio managers
Dirk Kotzé and Quinton Ivan

The fund returned -6.7% for the quarter, while the FTSE/JSE All Share Industrial Index lost 9.3%. For the 12 months to March the fund and index returned -13.9% and -18.7% respectively, while the compound returns for three years now stand at 2.6% and 4.1%. The pleasing performance relative to the index continues, with the gap in three-year compound returns narrowing further. We shall yet catch the index.

The global economy remains challenged. The crisis in financial markets received much publicity, with most of the coverage centred on how much capital has been lost, how the banking system might be saved and how long it will take to get back to normal. It is worth remembering that while markets are famously amorphous, ultimately the events in financial markets have their true effect in the real economy and in the everyday lives of ordinary people. We are increasingly seeing these second and third-round effects as experienced by our investee companies. Our sense is that conditions will be tough for some time. This makes us cautious and we see no reason to abandon the defensive posture of the fund. We have communicated this defensive stance often in the past. It is perhaps worthwhile to examine why some companies prove to be more defensive than others and what happens when there is a sudden large economic contraction, such as the present one.

In the real economy, volume demand is surprising on the downside. Those companies that were in expansionary mode find adjustment most difficult; they have to move from the front foot to the back foot. Cost bases are too high and have to be downsized. There is too much inventory in the system and many companies have to discount prices to get rid of excess stock. Discounting is causing price compression through entire industries. Faced with slower top-line (lower volume times lower price) the focus moves to what a company can do about its cost base. Is the cost base largely fixed (big problem) or is it partly variable (phew, we can adjust)? And how much debt do they have, can they service it, what is the interest cover and can they renew debt funding before it becomes due? These are the pertinent questions today. The price action in equity markets was largely indicative of who has been weighed to these measures and found wanting. Investors have to decide which share prices discount all these risks, and which don't.

In a tougher, lower growth world, with less available capital, cheap but nasty is simply not attractive enough. Weak companies can and do fail. Mistakes by average or weak management teams are more costly. Capital intensive business models require a higher discount. Re-rating is a vain and far-off hope in this environment, while solid earnings from defensive businesses are visible and support dividends in real cash. An interesting distinction in this market is between 'growth' and 'value' companies (a classification we most often find spurious and even dangerous). After a few years of steadily compounding earnings, the 'growth' company might prove to have been cheap relative to the 'value' company whose earnings recovery was much less certain. In other words, in the PE construct it is worth focusing on 'E', not on 'P'.

We think the earnings visibility remains best in those businesses we have preferred for some time: large, globally diversified, possessive of brands, annuity contracts or other ways to entrench customer loyalty, and with world-class business processes and systems.

During the quarter the fund sold out of small positions in Omnia, PPC, Seakay and Iliad. All these investments still had demonstrable upside but we took the view that they could not compete with the compelling value in some of the ideas detailed below. For the first time in many quarters, Massmart finds itself back in the fund. This is a group whose undeniable operational prowess is not often offered at a single digit PE, as is now the case. In a rare about-face, we also re-established a (small) position in Woolworths. While this investment has disappointed us greatly in the past, we believe it to be one of SA's great consumer franchises. Its earnings base is undoubtedly low. Despite reservations about operational execution, the margin of safety is big and we would rather own it than not.

The bulk of our firepower was spent increasing the weight behind our high conviction ideas. MTN now weighs in at 19% from 12% of the fund in the previous quarter. We have no qualms about this degree of concentration. Short-term concerns about weakness of the Nigerian naira created an opportunity in what is otherwise a high quality long-duration investment case. We believe mobile telephony to be as defensive as food; it is as much a means and enabler of economic activity as a discretionary expense (without which we cannot do anyway). MTN's subscriber growth continues to surprise. As long as growth remains strong, investors will have to 'buy' that growth with ever-increasing investment in network infrastructure (itself a feat in a world where access to finance is limiting peer spending). But the associated depreciation masks the true scale of the economic profit that is being accessed and once growth matures, cash flow release will be prodigious. A sophisticated valuation approach captures the full opportunity here, which the market will appreciate in time.

Naspers, Richemont, SAB and Bidvest remain the middle-order batsmen. Here nothing has changed and we continue to use periods of weakness to bolster our positions. The recent increase in the weighting of Aspen Pharmacare (discussed in the previous commentary) proved fortuitous. A potential corporate transaction may crystallise the value here faster than we expected but it is a stock that we are happy to hold for the long-term benefits of its globalising business model.

At the time of writing, the market was enjoying a strong bounce. We do not believe the road ahead will be smooth and hence a cool head is required to negotiate the bumps, both up and down. We do so by focusing on long-term valuations and by concentrating on high conviction ideas. The market still offers some high quality investments at extraordinary prices; there is no need to be too brave. This alone confirms that times of pessimism offer the best opportunity. Thinking about that, we're even having fun.

The financial crisis of 2008 will go down in history as one of the great crises of the modern era. Credit is the oxygen that feeds economic activity. With the credit crunch as far advanced as it is, there is no doubt that many countries will go into recession (the US, UK and Japan are already in recession). Even the emerging economies, thought by many to be immune to the woes of the developed world, will not escape unscathed. On a positive note, regulators and governments are united in their resolve to restore confidence in the financial system. Amid these challenging circumstances, the fund returned -3.94% for the quarter, compared to the FTSE/JSE Industrial Index return of -4.06%. For the calendar year, the return was -17.52% versus the index return of -16.08%. The 3-year compound returns now stand at 8.97% and 11.93% respectively. The underpeformance relative to the index over the year, while disappointing, masks some positives: the fund performed very well relative to peers and had a good second half, outperforming the index by 7.53%.

In previous commentary we highlighted that times of crisis provide allocators of capital an opportunity to acquire quality companies with strong franchises and good earnings prospects at attractive ratings. Although the market has recovered to some extent towards the end of December, we still believe that good value exists. The DNA of the fund remains intact, with large holdings in MTN, Naspers, Richemont, Bidvest and SAB Miller. The emerging market sell-off resulted in these liquid industrials being aggressively sold off to the extent that MTN, Richemont and Bidvest are now offered at around 8.5x forward PEs, whilst Naspers and SAB Miller trade on forward PEs of 11.5x. These ratings are undemanding for globally diversified businesses with best-in-class business models, management and execution. The depressed ratings of these counters are indicative of the market's focus on short-term risks rather than the risk/reward trade-off over the long term. Although trading conditions may be tough now, our work on the fundamentals of these companies gives us the conviction that an investment will be rewarding in the long term.

During the quarter, ArcelorMittal SA was re-introduced into the fund. Its share price fluctuation is a good indicator of current market volatility: we sold out of our position during May at an average price of R230 after which the share peaked at R265. The financial crisis resulted in the global steel market deteriorating rapidly driven by a sharp slowdown in the Chinese construction sector - the single biggest driver of demand. The waning demand was then followed by rapid reductions in both production and price by global steel producers, ultimately triggering a 76% decline in the ArcelorMittal SA share price from peak to trough. Notwithstanding the deteriorating environment, the investment case remains sound. ArcelorMittal SA trades on 6x PE using our assessment of the mid-cycle steel price, with R15 per share of net cash on the balance sheet. Our position of 5.9% of fund was acquired in three tranches, capitalising each time on price weakness. Since bottoming at R62.50, its share price has appreciated more than 50%.

During the quarter, we added to our holdings in MTN, Richemont and Eqstra Holdings, with MTN and Richemont now respectively comprising 12% and 7% of fund. We also added to our holding in Aspen Pharmacare on the back of price weakness, fuelled by concerns over regulatory issues and its ability to maintain margins on the back of rand weakness relative to the dollar. While these concerns are valid, they are short-term in nature. Aspen has an entrepreneurial management team and has succeeded in building a global business with a quality, defensive earnings stream. The recent deal with GlaxoSmithKline to sell Aspen products in emerging market countries (other than sub-Saharan Africa) will only contribute to earnings in two year's time. This deal has the potential to transform Aspen and at the current share price one is not paying for this 'optionality.'

A new addition to the fund during the quarter was Aveng. We also added to our existing position in Group Five. As we mentioned in earlier commentary, we were cautious of the premium ratings that construction counters attracted. This view was vindicated during the quarter with the tier one construction counters more than halving on the back of concerns that clients may not be able to fund future capital projects in the current financial markets. We had no special insights into when the correction would occur; our advantage lay solely in our investment philosophy - an uncompromising commitment to the long term. The pendulum for construction counters has swung from greed to fear and Aveng now trades on a 5.5x forward PE with approximately R5 per share in net cash on the balance sheet.

With great companies on offer at compelling prices, we looked hard at quality and sold out of Ideco Group and Mondi Holdings: 'lower quality' cyclicals which were used to fund more attractive opportunities. Finally, the last bit of Woolworths Holdings and Mr Price was sold to increase our existing weightings in Spar and Shoprite Holdings. The earnings stream of the latter are more defensive and visible in the current environment in which an already indebted consumer continues to be plagued by high inflation and interest rates.

Despite the bounce in markets towards the end of December, uncertainties remain. In a world of collapsing time horizons it is tough to hold a firm course and make the correct long-term decisions. It is essential that investment decisions are evaluated through the course of a full cycle. We have elected to do just that and set emotion aside and concentrate our bets where our conviction leads us. This makes us face the period ahead with surprising confidence.

Dirk Kotzé and Quinton Ivan
Portfolio Managers