The overall equity markets had another fantastic quarter (of the top 150 shares only 10 had negative returns for the quarter), however the financial sector did not do as well as the overall market as we saw a marked rotation out of financials into resource shares. This occurred despite the continued excellent outlook for financial companies.

The Coronation Financial Fund, while delivering a great absolute return of 11.4% for the quarter, underperformed the sector return of 13.1%. We obviously do not expect in the long-term business of investment to deliver index beating returns every quarter but as the managers of the fund we hate to underperform on any period so we spent some time examining why this occurred and will share some thoughts on how the fund is positioned to maintain its excellent long-term track record.

We have positioned the fund quite specifically overweight the banking sector. The fundamentals in this sector remain excellent with the latest batch of interim results confirming just how good the environment is. Standard Bank, FirstRand and, to a lesser extent, Nedbank showed strong asset growth, massive growth in non-interest revenue on the back of increased transacting activities and buoyant stock markets. All the while bad debts continue to sink to all time lows at each reporting period. Our largest bank holding, Standard Bank, did not perform well relative to its peers during this quarter. A large part of this can be attributed to the fact that it is widely held and would be the first source for funds when managers look to create liquidity to buy up other sectors. Management were also more conservative in their outlook for the rest of the year in their interim results review. This is a trait we value rather than discourage and we believe that Standard Bank's combination of a well diversified portfolio of businesses spanning multiple geographic regions offers outstanding value trading on a 9 forward PE.

We have had a fairly low weighting in the insurers with specific holdings playing on particular value situations. We remain sceptical about the success of the broader industry in the long term. The current shake up is revealing flaws in the business models of industry which cannot be papered over. A crucial industry like this will, of course, survive but certain players are more than likely to fall by the wayside as their lack of innovation or inability to adapt their costs to a new distribution paradigm weighs on their ability to sell new generation savings products.

Our largest holding in this sector, Metropolitan, is a specific play on a niche of the savings market which has continued to prosper during these turbulent times, one of the few life companies to have consistent positive cash flows the last few years. The share was a middling performer this quarter after a year of excellent outperformance. The latest results confirmed the turnaround in performance of this company with superb earnings growth from all divisions. With equity markets continuing to rise, and its positive impact on the fees charged by the life companies, there are bound to be good opportunities to pick up those companies, Liberty Life being a case in point where we believe it will be able to weather the storm.

This recent spike in equity markets and renewed activity in the equity markets has resulted in companies in the specialty finance sector delivering astonishing earnings growth. We have various smaller investments in this sector but remain wary of placing high valuation multiples on peak earnings generated by high equity prices. These can just as easily disappear resulting in huge expectation gaps between the prices of these shares and their sustainable earnings bases.

We continue to invest in good quality businesses where the underlying fundamentals are strong; ultimately the share prices move to reflect this. Valuations generally still look attractive especially as the earnings growth is delivered as expected. In the meantime we reap the dividends from these strongly cash generative businesses. Neville Chester & Neill Young Portfolio Managers

Former manager Kokkie Kooyman laid a strong foundation for Coronation Financial (CF) two years ago by moving from cash into equity. Neville Chester, his successor in early 2004, has not faltered, maintaining CF's position in the upper reaches of the top quartile. "The market has had a breather but I believe it still offers value," says Chester. He adds that the retreat in bank share prices offers a particularly good buying opportunity.

Financial Mail - 9 September 2005

The Coronation Financial Fund returned 4.7% for the second quarter of the year. Over a 12-month period, the fund has delivered a 51% return, which compares favourably with the index return of 48%. Similarly, over a three-year period, the fund has produced a compound annual return of 25% against an index return of 21%.
The banks outperformed for the quarter along with Remgro, which benefited from continued rand weakness. The life insurers delivered a negative return, giving back the gains made in the first quarter.
The top performer amongst the banks was Absa, driven by eventual finality on the price at which Barclays was to buy its majority stake. As we write this the deal has received High Court approval, and this will require the fund to sell 32% of its Absa shares. We believe that this is a fair price at which to dispose of a third of our holding given the benefits that will accrue to the remaining two thirds. On completion of the transaction, Barclays will hold 52.5% of Absa, below its stated intention of 56.5%. This should provide an underpin to the price as Barclays buys additional shares in the market. Nedbank was the underperforming bank for the quarter, and given our preference for the sector and that we are at our maximum limits on the other three of the big four banks, we have made use of periods of price weakness to increase our Nedbank holding to 1%. Banks now make up 50% of the value of the fund.
The quarter was a disappointing one for the life insurers. The well publicised rulings by the Pension Fund Adjudicator against the life companies weighed on share prices. This is an issue that we raised in our previous quarterly report, and one that in all likelihood will continue to receive more airtime, and negatively impact on new business for the remainder of the calendar year. The practice of penalising policyholders for unrecouped upfront costs is in effect an unequal sharing of risk between insurer, client and intermediary, and is clearly an unsustainable business practice. The life companies have for some time now been working to reduce their cost bases to provide a better value proposition to clients, and the actions of the adjudicator are likely to expedite this. The fund's largest insurance exposure is to Metropolitan which, given its market and business mix, is far less exposed to the issue than the other life companies - particularly Liberty and Old Mutual, to which the fund has relatively little exposure. Having said this, in our view the impact on insurance companies' embedded values is unlikely to exceed 5% in a worst case scenario, yet the sector has declined nearly 3% in a quarter in which the market has returned 7%, and this presents us with some opportunity.
Amongst the other financial shares, Alexander Forbes was a strong contributor. Financial results released during the quarter indicated that the company's difficulties are largely behind it despite the softening underwriting market, and the value in the share became more apparent. We have been of the view for some time now that the Discovery share price had run ahead of what was fair value, and our lack of exposure to the share weighed on performance. Towards the end of June the company put out a statement effectively confirming our view, and the share price has subsequently retraced closer to what we consider to be a reasonable valuation. We continue to favour banks over insurers - strong credit extension numbers, good credit quality and a positive outlook for the domestic economy will continue to drive earnings. Insurers are likely to continue to face short-term headwinds, but we intend to take advantage of periods of unwarranted pessimism.

After a very strong 2004 for financial stocks, the sector took a breather in the first quarter, delivering a marginally positive return of 1.1%. On a rolling 12-month period the fund has generated a total return of 51%, which compares well with the 45% from the FTSE/JSE Financials Index. For the rolling three-year period the fund has achieved a 27% p.a. return, which again compares favourably with 22% from the index.
The benign performance of the sector was driven partly by the weakening rand, which resulted in some switching into the resources sector of the market. At the end of 2004 the currency stood at R5.65 to the US dollar, a level which we felt was unsustainable given economic fundamentals. This prompted us to increase our exposure during the quarter to those stocks with some gearing to a weakening rand - i.e. Liberty International, Remgro and, to a lesser extent, Old Mutual.
The banks were the laggards during the first quarter of 2005, with a -1.6% return. This is despite both FirstRand and Standard Bank reporting good results during the quarter, and a very welcome increase in the dividend payout ratio from the latter. We made use of the weakness in the Standard Bank share price to increase our holding in the stock from 16% to 20% of the portfolio. Nedcor's results again highlighted that the internal issues that have dogged the bank since its merger with BoE have caused it to lag its competitors in an environment very conducive to banks. We have an insignificant holding in the stock, a position that has contributed to fund performance, and remain of the view that at current prices, Nedcor holds no special attraction over the other banks, yet still carries more risk. Absa's share price continues to be capped by the uncertainty surrounding the price at which Barclays will bid for a majority share of the bank. It would seem that regulatory approval is imminent, pending the compliance with certain conditions by Barclays. This we believe should go some way to unlocking the value inherent in the stock.
The insurers delivered a 3.6% return for the quarter, and we made use of the relative strength to take some profit on our insurance holdings with which to fund some of the positions mentioned above. The 2004 results reported in the quarter were a mixed bag - the strong equity markets boosted embedded values, but new business flows were mixed. Liberty and Metropolitan performed well, while Sanlam and the South African operations of Old Mutual struggled. Press coverage given to the rulings by the Pension Fund Adjudicator against some of the larger insurers' RA schemes will, in all likelihood, have some impact on the sales of savings product in the first half of the year. More important, however, is the issue of the potential impact on the valuations of the insurers - this is an area which still requires accurate quantification, although it should be noted that we do not expect the impact to be material. Our holdings in Metropolitan, with its R1 special dividend at the beginning of the period, and African Life, which moved up strongly on expectations of a buy-out, contributed nicely to the fund's performance during the quarter.
We continue to believe that there is value in the financial sector, especially amongst the banks which we favour over the insurers, and which trade on between 8.1x and 8.9x 12-month forward p/e multiples and a 4% dividend yield. The life assurance sector is now trading in line with our adjusted EV, and on a 4.5% dividend yield. The return of excess capital remains a key component of our investment case for the sector. The banks have the capacity to reduce their dividend covers further, Sanlam is likely to distribute at least a portion of the proceeds on the disposal of its stake in Absa, Metropolitan still sits on excess capital in our view, and Liberty has the potential to optimise its capital structure if and when it introduces debt onto its balance sheet.

The departure of Kokkie Kooyman from Coronation at the beginning of last year was a public relations blow for the shop, but it proved to do little harm to the performance of this fund.

In the short term, the decision to liquidate the fund's foreign holdings a year ago helped performance as the rand got stronger.

The environment has been sweet for financials, particularly banks, which make up 37%-50% of the assets of funds in the sector.

Coronation Financial Fund manager Neville Chester says that the lowest level of nominal interest rates since 1980 has resulted in strong growth in advances, high levels of transactional activity and unusually low levels of bad debt. He has taken the maximum exposure to both Standard Bank and Absa, which make up 28% of the fund. He has avoided Nedcor, which was the correct decision on a 12-month view, but he took a small, tactical position in February.

Chester says his one regret was not holding African Bank Investments, a share that helped Sage Financial Services overtake him over 12 months.

Another detractor in the short term has been the holding in Alexander Forbes, which accounted for more than 5% of the fund at the end of the year. Forbes was the only sizeable financial share to give a negative return last year. The position has been trimmed back.

Chester says Forbes has been hit by the downrating of insurance brokers after Eliot Spitzer's investigation of US brokers. But he says Forbes has limited exposure to the US and the risk of the share has reduced since Venfin converted the bond it issued to Forbes into a 25% equity stake.

Chester says the theme for insurers this year is unlocking capital. He has already benefited from Metropolitan's special dividend and he holds Santam in anticipation that it will follow.

Sanlam itself is also expected to return capital to shareholders after selling its Absa stake.

Chester says life offices will also benefit from stronger equity markets . The fund is a good vehicle to tilt a portfolio to the sector.

Financial Mail - 25 February 2005