For the year ended September, the fund return of 7.2% lagged the 7.8% of the FTSE/JSE Industrial Index, while over three years the fund was ahead of the index, at 18.2% versus 16.9%. Based on the strength of the sector relative to other asset classes, the fund was among the top performers of all equity unit trusts over this period. Financial markets are again going through a period of intense uncertainty. Investors battle to make sense of the European debt and currency crisis, the threat of recession looming in the US and other developed economies, as well as the spectre that under various (entirely possible) scenarios, some assets, asset classes and currencies could suffer large losses. Post the bursting of the internet bubble in 2000, the world has lurched from one crisis to another, but equities have always bounced back. This may lead to a sense that this crisis too, may be just another one of those minor inconveniences. The reality is that the disturbances of the last decade have been merely the opening fissures in a dyke behind which a muddy slimes dam of excessive debt has been accumulating for decades. Strong action can still avert the threat in an orderly way, but this will require a level of fortitude from global politicians which they have not yet found within themselves. While they stick fingers in the cracks, the world holds its breath. The mandate of an equity sector fund like this one implies full investment at all times. Hence despite the vagaries of the macro environment we concentrate on picking stocks from the investable universe that offer the best margin of safety relative to our valuation, and construct the portfolio weightings in order to offset different risk scenarios. Despite the uncertain environment outlined above, industrial shares have been the best performing of the SA equity market segments for the year to date. This is understandable when one looks at the stocks that make up the major index weightings. The defensiveness and global diversity of stocks like MTN, SABMiller and Naspers have often been extolled in this report. In uncertain times like these, such consistence is highly prized and achieves a premium rating. Whatever differences of opinion there may be on the path of world economies and markets from here, it is fairly clear that the world and South Africa will grow more slowly. Returns from all asset classes will be muted, probably for years to come, and in general it will be tougher to do business and capture earnings growth than in the past. These views continue to support the defensive stance outlined in previous reports, and our preference for quality businesses with a strong franchise value. In a tough macro environment, weak businesses will continue to struggle, and hence an extraordinary margin of safety is required to entice our interest. MTN, SABMiller, British American Tobacco and Naspers accordingly remain the biggest exposures of the fund. These companies have the ability to grow earnings strongly, even through tough times. During the last two quarters the position in Aspen was increased. Recent results were good. We consider the share, at around 11 times our assessment of normal earnings, an excellent proposition.

Bidvest has long been one of the bigger holdings in the fund. This position saw some excitement when various unsolicited offers were received by the company for its international food service business. The market was disappointed when the board of the company elected not to pursue the offers; more so when afterwards it was revealed that they had been of the order of R30 billion cash, equating to some 60% of the market capitalisation. In the aftermath, the share price retreated to much the same level as before the transaction. We were disappointed, too. Industry interest does confirm the value of these assets however, and our interest in holding them at a cheap rating is undiminished. Company management have various strategic options available at any time, and in this case argue that equal or bigger value to shareholders will eventuate from following a different route. We shall monitor with interest. Woolworths is an equally long-held position of the fund. Despite our general reticence to have too much exposure to retailers, we have been loath to trim this position in view of the internal dynamic in the company. Woolies has among the highest franchise value of any business in SA and is perfectly positioned in terms of aspirational appeal to emerging consumers. A victim of its own success, the cost base had become bloated over the years. New management signalled an intention to drive efficiencies and the first apparent delivery on this strategy is behind much of the 42% return that the share has delivered in the year to date. Our experience with similar situations in the past suggests that there may be much more to come, thus we continue to hold the position.

A comment this quarter would not be complete without reference to the depreciation in the rand, which seemed to pass a turning point after many months of being overvalued in our view. The timing of such turning points is impossible to forecast. The fund had been positioned for this long before, with about two thirds of the portfolio offering some degree of hedge to a depreciating rand. We continued to add to these exposures, particularly through making use of the attractive opportunities in the industrial materials sector. By the time of the rand decline, some 12.5% of the fund was held in names like Mondi, AECI, Omnia, Hulamin and Arcelor Mittal. A weaker local currency will bring some relief to the beleaguered local manufacturing sector, where our exposures remain small and targeted. Construction and capital goods sectors also remain depressed, and we are steadily building positions into an anticipated upswing. The industrial sector has held up quite well, but we consider that there are still many instances of long-term value on offer. Hence we remain confident in the likelihood of modestly positive returns going forward. The end of this quarter brings to an end Quinton Ivan's involvement in the management of the fund. He will concentrate on other assignments and will be sorely missed. Sarah-Jane Alexander joins as co-manager; her strong views are bound to make a big contribution to the internal debate.

Portfolio managers
Dirk Kotzé and Quinton Ivan

The fund delivered a return of 3.8% for the quarter versus 3.7% delivered by the FTSE/JSE Industrial Index. While the fund continues to lag over 12 months, it has outperformed its benchmark by 3.7% p.a. over a rolling 3-year period (20.3% versus 16.6% p.a.). The compound annual figures since inception stood at 18.5% for the fund compared to 14.2% for the benchmark. The fund is one of the top performing funds in its sector over all meaningful periods.

News surrounding the global economy has been mostly negative over the past quarter. The US housing market remains weak with house prices continuing to decline, while consumer spending also remains sluggish with household budgets under even more pressure now that inflation has edged higher. The disappointing economic performance has raised the possibility of another round of quantitative easing aimed at stimulating growth - a scenario that was not even mooted a quarter or two ago. Furthermore, the Eurozone continues to be plagued by sovereign debt concerns. At the time of writing, the Greek parliament voted in favour of a new austerity package. The revised package was a pre-requisite for the €12 billion aid payment by the EU and IMF without which Greece would have defaulted on its sovereign debt. While a default may have been avoided for now, it is merely a stay of execution. To date, the market has done a fair job of pricing in a default by a small country like Greece, but not for a significant sovereign like Spain, Italy or worse. The implication of this is that global interest rates are likely to remain lower for longer, supporting the pricing of risk assets as capital continues to scour the globe in search of yield.

Economic data in South Africa remains mixed - CPI data for May came in ahead of consensus at 4.6%, while PPI came in slightly below expectations. We remain bearish on the inflation outlook and expect CPI to breach the upper end of the South African Reserve Bank's 3% to 6% target band either later this year or early in 2012. This view is framed by rising food prices (notwithstanding rand strength), high wage settlements and continued pressure on administered prices all against the backdrop of an accommodative monetary policy. We continue to believe the local currency is overvalued and have approximately 54% of the fund invested in rand hedges such as MTN, SABMiller, British American Tobacco, Naspers and Bidvest.

SABMiller is one of the biggest positions in the fund. The share price recently came under pressure when the proposed bid for Foster's in Australia was announced. Corporate transactions often capture the headlines and can result in volatile share price reaction as arbitrageurs take positions and incumbent investors struggle to digest the new information. Such events can of course present opportunities for those with a long-term inclination. In this case, consensus opinion quickly decided that the company was overpaying, resulting in a sell-off of the stock. We too did our calculations and consider it a fair risk that some value might be destroyed by the proposed transaction. Management clearly believe differently, and our work suggests a possibility that their positive scenario may unfold. This has left us with a situation where the share price discounted bad news as a certainty, while leaving some chance, even a reasonable one, that the transaction might actually create value. As a result, we added to our holding.

Within industrials, we believe it will be a challenge for the average domestic company to defend its real earnings, a task made more difficult when interest rates are hiked from their three-decade low levels. Consequently, we own very little retailers (other than Woolworths and Mr Price) and remain defensively positioned with holdings in Famous Brands, Spar Group, Pick n Pay Stores and AVI. As highlighted in previous commentary, we continue to find value in selected small caps with many trading at around 6 times our assessment of normal earnings. Approximately 48% of the fund is now invested in shares outside the ALSI40. The fund currently offers 43% upside to our assessment of fair value for the underlying counters.

In conclusion, investor behaviour is likely to oscillate between high and low levels of risk appetite depending on the economic data of the day. In an environment fraught with uncertainty, assets are often mispriced which benefits the valuation-driven, patient investor. We seek to capitalise on these opportunities by setting emotion aside and investing for the long-term.

Portfolio managers
Dirk Kotzé and Quinton Ivan Client

The fund received various awards as best performer in its category for the three-year period to end December 2010. While this was gratifying, the performance relative to the FTSE/JSE Industrials index towards the end of that period started to trail, and this continued into the quarter under review. The return for the three months to end March was -2.7% versus -0.3% for the index. Over three years to end March, the fund delivered a compounded annual return of 15.8% against 14.1% delivered by the index. The portfolio is not managed against a benchmark and is constructed on a clean-slate basis. Thus periods of divergent performance are to be expected from time to time. The fund remains one of the top performing funds in its sector over all meaningful periods.

We wrote previously about our views on Trencor/Mobile, long a favourite holding in the fund. It was particularly pleasing to see the much-awaited unbundling of Mobile during the quarter, the pyramid company that held the controlling stake in Trencor. Our Mobile shares have thus become Trencor shares. Driven by strong underlying operational and share price performance of its offshore entity Textainer, Trencor's shares were strongly up in the quarter. Our small position in Arcelor Mittal also did particularly well. Despite the many uncertainties around its iron ore supply and BEE issues, we think the margin of safety is substantial and allows for all eventualities. Other positive contributions to performance during the quarter were Woolworths and AECI. On the downside, our construction-related exposure performed poorly, among them Group Five, Dawn and OLine. We believe the fixed capital cycle is now at or near the bottom, and there are encouraging signs that the upturn may already have started. Investors now accord steep discounts to these same companies which they rated highly in the heady days of the World Cup boom. Tongaat was also weak, on fears related to its Zimbabwean exposure. We have not changed our view on either the value underpin nor the long-term prospects for this business and retain our holding.

In a macro environment where uncertainties abound, few changes have been made to the composition of the fund, and our weighting in liquid global diversifieds and local defensives remains intact. MTN remains our largest holding. We are encouraged by the improving prospects of substantial cash returns to investors as this business enters a somewhat more mature phase. Aspen, having offered a buying opportunity, has come back into the portfolio. We are more comfortable owning this long-term success story, than not. Together with Adcock-Ingram, Netcare and Medi-Clinic, healthcare exposure now makes up a chunky part of the portfolio. We see these and other defensive positions (such as Advtech) as a necessary comfort in a tough macro environment that could be getting tougher. In particular, we see substantial challenges ahead for companies exposed to the heavier end of the local industrial economy. The currency is still too strong, both export and domestic demand remain weak, and cost pressures loom large: high wage settlements, rising energy costs and increased regulatory burdens all erode the competitiveness of local firms. It is now a virtual certainty that inflation will make a spectacular comeback. As interest rates rise in tandem, the undignified consumer goods feeding frenzy will finally be over.

A fund comment this quarter would not be complete without giving thought to the harrowing events in Japan, North Africa and the Middle East. The effects of these events on economies and markets might only be determinable well afterwards. This fact does not deter the market from swinging its pendulum between fear and greed, or between 'risk-on' and 'risk-off', with increasing force. It is worthwhile to affirm that our business remains the dispassionate valuation of financial assets, based on the average or typical cash flows expected from them for many years to come. Such projections are informed by company and industry fundamentals, and a study of how the underlying businesses or similar companies performed in previous cycles. The valuations are fairly stable and should not be overly affected by the news of the day. Trading activity, when it does happen, is initiated when market prices offer good or poor returns relative to these stable long-term fair values. This common-sense approach has served well and there is no intention to change it.

Though the environment may be tough, the market is not highly priced. The average forward PE of the portfolio is 11 times, not high considering that global multinationals weigh heavily in our basket. After a disappointing earnings reporting season, earnings bases are generally not as high as they were. Earnings recovery should gain traction as the currency weakens. Inflationary conditions also tend to be easy on corporate profitability. In our assessment, the weighted upside of the portfolio to what we deem to be fair value is above 40%. The many value opportunities that are available suggest that reasonable returns are still on offer in the industrial space. Thus we remain confident of protecting capital and adding alpha over time.

Portfolio managers
Dirk Kotzé and Quinton Ivan

The fund delivered a return of 7.81% for the quarter versus 7.79% delivered by the FTSE/JSE Industrial Index. For the 12 months to December, the comparatives are 29.45% and 27.39%, and compound annual figures since inception stood at 19.21% versus 14.45%. The fund is one of the top performing funds in its sector over all meaningful periods.

World equity markets rallied towards the end of the year with many US and European stocks trading close to their best levels prior to the collapse of Lehman Brothers in September 2008. Notwithstanding this rally, the global economic recovery remains fragile as reflected by weak housing data, high unemployment in the US and sovereign debt concerns in Europe. This has prompted the US Federal Reserve to announce a second round of quantitative easing by which the central bank will inject $600 billion into financial markets through the purchase of US treasuries.

The sheer quantum of the monetary and fiscal stimulus employed to support growth has moved the world economy into uncharted territory. We are possibly living through the greatest financial experiment the world has known: if the stimulus is withdrawn prematurely, the world economy risks slipping back into recession and if it is in place for too long, the effect will be higher inflation which will compromise future economic growth. This uncertainty has caused investor behaviour to oscillate between high and low levels of risk appetite as capital scours the globe for yield. This has driven the prices of emerging market equities higher and their bond yields lower.

The South African rand, like many other emerging market currencies, continues to strengthen on the back of significant capital inflows and traded at R6.60 to the dollar at the time of writing. It remains our view that the rand is overvalued and will have to weaken - the country is uncompetitive and is being deindustrialised at current levels. It is for this reason that approximately 56% of the fund is invested in rand-hedge counters that are attractively valued and globally diversified. One such example is SABMiller. It is the second largest global brewer and has a robust, balanced business portfolio that is diversified across geographies and currencies. It offers investors one of the highest exposures to fast-growing, emerging markets in the global consumer staples universe, operating in markets such as Latin America, Asia and Africa. It has a proven track record of brand building, cost excellence and earnings delivery. SABMiller is one of the highest quality investments available to the South African investor and offers good value at 13.6 times our assessment of normal earnings and we have added to our holding during the quarter.

We sold the bulk of our retail exposure by the end of the year with the exception of Spar, Woolworths and Mr Price. These businesses have been exceptional performers, with share prices up three to four times on average since the end of the interest rate hike cycle in June 2008. However, based on our assessment of mid-cycle earnings retailers no longer offer compelling value. We continue to find value in selected small caps with many trading at around 6 times our assessment of normal earnings. Approximately 42% of the fund is now invested in shares outside the ALSI40.

In conclusion, equity markets are no longer cheap - the fund currently offers 32% upside to our assessment of fair value for the underlying counters. Despite the bounce in markets during the last quarter of the year, uncertainties remain. While we have no special insights into the future, our proven philosophy of investing for the long term will ensure that our funds are positioned to handle the curve balls the market will inevitably throw our way.

Portfolio managers Dirk Kotzé and Quinton Ivan