In the late 90s, there was a highly rated US banks analyst called Tom Hanley who wrote a report entitled 'On our way to bank heaven' and I certainly feel like I could use that title for this report. It was another phenomenal quarter for the financial sector, with excellent results from the banks and topped off at the close by a potential offer for Absa from Barclays Bank in the UK. Our continued high weighting in the banks helped us again; especially our weighting in Absa and FirstRand, but the big difference for the fund this quarter was the pay-off from our large holdings in the life assurance sector. On the back of solid results from the life companies, and the clear indications by management of the intention to distribute excess capital, the life sector re-rated strongly reducing the discounts to embedded value that had built up over the past year. Thanks to these favourable moves the fund returned an outstanding 18.4% over the quarter, beating the financial index return of 15.3%
In dissecting the latest set of bank results from June 2004, what becomes evident is an enormous revival in the fortunes of the retail customer. Bad debt levels, particularly in the consumer segment, have reduced to some of the lowest levels in the past 15 years, despite a big up-tick in lending. Clearly winning the battle for market share, Standard Bank has dominated the retail space, growing its mortgage book and credit card book in particular. Despite this, Absa and FirstRand have managed a decent level of asset growth as well, with only Nedcor, due to its lack of significant retail footprint, lagging behind. Over and above credit growth and quality, the sheer volume of transactions processed by the banks has increased significantly due to an increase in the number of bank customers as well as more transactions per customer.
The sustainability of these benign conditions hinge off the interest rate outlook. If prime rates stay in a range below 13% I don't believe there will be a significant shock to the system and there is unlikely to be a major fall-out in the credit market. If they move higher, it would spell trouble for the banks from a credit quality point of view. The likelihood of this higher interest rate scenario, based on our current inflation view, is unlikely.
The entrance of Barclays into the SA banking system is another challenge altogether, but nett - nett I believe is positive overall for the sector. Barclays, by entering SA through the purchase of a large established bank has no reason to price aggressively at an economic loss in order to gain market share as it will immediately have a significant share of the market, meaning that pricing should continue to be done on a rational basis. In addition, this move will not have gone unnoticed by other major global banking players, and will certainly move other SA banks into the sights of potential acquirers.
During the quarter we added further to our stake in Alexander Forbes. This has started to pay off nicely as the company re-rated due to the de-gearing of its balance sheet. We also added slightly to our holding in Investec which produced a fairly strong trading update during the quarter. Now that the life insurance companies have rerated we will probably look for opportunities to reduce our exposure going forward.
Overall, the fund currently has a forward PE of 8.6 and a forward dividend yield of 4.5%. We believe this is an indication of the value still present in the financial sector, although the re-rating of the past quarter has reduced some of that upside. Given the benign environment and potential capital restructuring yet to occur in this sector, we believe there is still attractive levels of upside in the financial sector.

Coronation Financial Fund's 16% foreign holding was repatriated in April, at a rate of R6,80/US$. The money was brought back after the departure of Kokkie Kooyman to Sanlam.

Coronation no longer has offshore fund picking capacity and fund manager Neville Chester says he prefers to take his rand hedge exposure through locally listed companies. Since June quarter-end he has been increasing the holding in Investec and Alexander Forbes. He says the sales of the Israeli business shows a new focus on return on equity at Investec. Just before that he built up a 2,6% weighting in Liberty International.

But he also sold down the holding in Old Mutual when it traded above R12 in the June quarter and redeployed the funds into Liberty, Sanlam and Metropolitan. Chester likes Sanlam not only because of its high discount to embedded value but also because its net worth is underpinned by its holdings in Absa and Santam, both of which the fund holds in their own right. There is also some excess capital, which could be given to shareholders after the winding up of Gensec Bank.

Coronation remains African Life's largest shareholder after FirstRand but the Aflife weighting in the fund was also reduced earlier in the year when it was trading at R17. It is now trading at R12,40.

Coronation has lost its lead in the year to date, partly because of its high weighting in Alexander Forbes - though it has bounced back in recent weeks. It has underperformed Sage Financial Services, for example, as Coronation had sold its holding in African Bank Investments in the second quarter while Sage has kept a high weighting in the share which Chester believes "has gone from relatively expensive to unjustifiably expensive", in view of the risks in microlending.

The fund has the maximum permitted weightings in Standard Bank, FirstRand and Absa. Chester says Absa is a particularly sweet spot because of its large retail footprint, with consumer credit growth increasing and bad debt falling. Chester says that he will start looking at Nedcor again when the share price has fallen below R55.

The Financial Fund had an excellent second quarter. Our large weighting in domestic banks (42%) helped us deliver a strong return of 4%, beating the index return of 0.7%. Our higher weighting in life assurance companies was a drag on performance for the quarter, but we believe the value evident in these companies will come through over time. However, one life company in which we held a large stake did work in our favour namely, Capital Alliance. After trading at a large discount to embedded value for some time, the market capitulated post results and the share re-rated. We anticipate this will happen with the remainder of our life holdings.
Our decision to invest only in the local equity market paid off handsomely as the rand continued to strengthen. We repatriated most of our offshore money around R6.80 to the US dollar, and as a result have had no further drag on performance from the strengthening currency. When we deem it necessary, we will use our ability to invest in local companies with large offshore earnings bases to obtain international exposure.
During the period, we took advantage of the strength in Aplitec to exit this investment. The Aplitec share price had reached in excess of our fair value and we sold when liquidity was high. We also continued to reduce our weighting in Abil as it traded above our fair value. In addition, we took the opportunity to add to our Investec and Alexander Forbes weightings as both share prices experienced weakness pre-results. Since then, both have performed well and moreover add an element of growth outside of SA to the portfolio. We used the opportunity of strength in the Old Mutual price to reduce our exposure, and we increased our weightings in Sanlam and Liberty where the valuation and new business prospects respectively look more attractive.
Absa delivered a great set of results during the quarter, supporting the phenomenal run experienced by most of the banking groups over the last 12 months. The benign interest rate environment is proving to be a huge benefit to those banks with a large retail footprint as consumer spending has grown in leaps and bounds. In addition, the levels of insolvencies and bad debts have fallen to some of the lowest levels in 20 years. Barring any kind of large interest rate shock, which we cannot see based on current fundamentals, the retail banks should be able to continue to deliver strong real earnings growth off current levels. We remain fully exposed to those banks that stand to benefit from this environment.
Overall, the fund currently has a forward PE of 7.7 and a forward Dividend Yield of 5.2%. We believe this is an indication of the value still present in the financial sector and accordingly believe there is still substantial upside to the financial sector.

Neville Chester took over the fund from Kokkie Kooyman at the beginning of the year, after managing the domestic stock selection for more than two years. The international holdings, which Kooyman managed, will now be moved from developing to developed markets. Locally, there was a shift from banks into life offices: holdings in Liberty and Sanlam have been increased.

The Coronation Financial Fund had an outstanding final quarter, rounding off a great year which saw it take first place in its category across all time periods. More importantly however, returns in the three and five year periods are now comfortably in positive territory, despite the financial index still returning a negative 6% for the 3 year period.

For the quarter, the banking sector once again outperformed the life assurance sector by delivering a 20% return versus 10% -a trend which has continued throughout the year. At the beginning of 2003 the fund manager's identified that banks would provide the better returns, and positioned the portfolio so as to generate outperformance for the period. For the calendar year 2003, banks delivered a return of 18% while the life assurance sector was flat. This difference in returns was driven by the overall poor outlook for the life industry in 2003 due to low asset levels and a significant fall off in premium flows. The banks benefited from a benign interest rate environment as rates plummeted, and from a strong pick up in lending volumes.

Despite the run in financials in the final quarter the fund manager's are still optimistic on returns for 2004. The environment for banks continues to be good, with credit growth running at high levels and low interest rates boosting the overall credit quality of the portfolios. An improving equity environment will also assist in trading and private equity profits. The fund manager's are also more optimistic on the life assurance industry given the increase in value of the equity markets and the potential that this creates for demand for equity based savings products.

Outlook aside, valuations are still very compelling. Dividend yields in the banking sector are still averaging 4.5% and in the life assurance sector they are over 5%. The 10 year average of the bank sector's PE is 12x, while it is currently trading on a 7.4x PE to the end of 2004. The average discount to embedded value of the life assurance sector is currently 16% versus the five year average of a 4% premium (the history of embedded value disclosure does not extend beyond five years).

Last year the fund manager's big macro call was to be overweight banks and underweight large insurers. Going into 2004 the relative outlook between the two sectors is less clear, and the fund manager's believe a stronger focus on stock selection rather than sector selection will be the key to continuing outperformance.

At the end of the year Kokkie Kooyman announced his resignation and will no longer be responsible for managing the Coronation Financial Fund. For the past few years, Kokkie had been focusing most of his attention on the Coronation Global Financial Fund whilst Neville Chester and Neill Young have been managing the stock selection on the Coronation Financial Fund. Therefore the philosophy and style with which the Coronation Financial Fund has been managed over the past few years will not change.