The life insurers continued to be the drivers of performance within the financial sector for the quarter. The financial index returned 9.9%, comprised primarily of a 3.8% return from the banks and a 12.2% return from the life insurers. Interestingly, the life sector has outperformed the banks for each of the last 4 quarters - something that hasn't happened for at least the past 5 years. Over the same period the Coronation Financial Fund returned 6.2%. Over 1 year the fund has returned 19.3%, and over 3 years a compound annual return of 38.6%.
The reason for the fund's underperformance is an underweight exposure to companies with foreign earnings that benefit from the translation of these earnings at a weaker Rand. The fund does not own shares where our research does not indicate compelling value. It is for this reason we do not hold Investec, which has benefited from both rand weakness and strong equity markets during the quarter and which significantly outperformed the other banks. In a similar vein, we hold no Liberty International and have reduced our Remgro holding, and this has cost the fund performance as the rand has weakened.
Positive contributions to the fund's performance have come from the large holding in Discovery and our lack of exposure to African Bank, which stands out as the significant underperformer for the quarter. Our investment case for Discovery hinges on the fact that the strong franchise value and growth potential of the core South African businesses is not fully appreciated in the share's rating. This view has started to come through, aided by a sooner than expected maiden dividend from the company. In the case of African Bank, we viewed the share's rating as demanding relative to the larger banks given the competitive pressures the business will face with new entrants into its traditional market and the impact of the National Credit Act, which will take effect in June 2007. This has largely played itself out, with the share declining 21% in value in the quarter.
During August and September the big 4 banks and the insurers released interim results. Banks continue to show very respectable earnings growth driven by strong credit extension in the retail segment of the market. Corporate banking earnings have also shown growth on the back of strong markets and corporate activity, particularly BEE transactions. As was to be expected, bad debts have started to rise from abnormally low levels, and lending margins have seen some pressure as loan growth is increasingly funded in the wholesale market. The life insurers benefited from rising markets in the first half of the year and good growth in new business flows, particularly in non-life (primarily unit trust) flows. New business margins declined, reflecting the move by the life companies to improve the value proposition of their savings products. Results from the short term insurers reflected a sharp correction in underwriting margins from the peak levels of 2004 and 2005 to more normalised claims levels.
During the quarter we have increased our exposure to FirstRand, which we believe to be a high quality bank with an excellent management team trading on an undemanding rating. We have also switched our holding in Old Mutual into Sanlam. Old Mutual has performed very strongly due to Rand weakness, and despite the attractive fundamentals of the markets in which it now operates, we consider the rating to be full. In the case of Sanlam, we are starting to see some recovery in market share following management action, and the potential to unlock excess capital over time appears larger than we initially thought. During the quarter Sanlam announced that it was contemplating making an offer to the minority shareholders of Santam. Had the company been successful in achieving this at a reasonable premium to the then market price, our view was that the deal would have been value enhancing for Sanlam shareholders. The fact that the company walked away from the deal at a higher price is an encouraging indicator of strong discipline in capital management.
We continue to see value in the financial sector. The domestic life insurers trade on attractive dividend yields and discounts to embedded value, and still sit on excess capital which we expect to see returned in the near future. Bank valuations are attractive on p/e's of 9x to 9.5x and dividend yields of 4.5%. The sector should deliver good returns into the foreseeable future.

Neville Chester and Neill Young
Portfolio Managers

Against the backdrop of a -6% return for the financial index, the Coronation Financial Fund returned -9.7% for the quarter. For the past 12 month period the fund has returned 25%, and over 3 years a compound return of 37%.
In the previous quarterly commentary we cautioned that the strong positive returns earned in the past two years were unlikely to be repeated. However, the pullback in share prices in the current period has been severe, and in our view excessively so. An almost 20% decline in the value of the rand in a period of increased emerging market aversion resulted in heavy selling of financial shares as many investors switched into rand-leveraged resource stocks. In addition, a 50 basis point repo rate increase by the SARB in early June led to an almost indiscriminate sell off of interest-rate sensitive stocks in our market, in particular the banks. The result of this is that only 3 genuinely "investable" stocks in our universe delivered a positive return for the quarter, and all three of these have rand hedge characteristics. The defensiveness of the life insurers was evident during this period of weakness - the life insurance index was down 2% for the quarter, against a 12% decline by the banks.
Periods of excessive or irrational price weakness of course provide the opportunity to accumulate mis-priced assets. This we did during the quarter: We have increased our positions in FirstRand, Old Mutual (which has provided some buffer against the weaker rand) and some of the smaller cap financial companies where we see value. Discovery is a share we wrote about in the previous quarter's commentary, and we have continued to add to our holding as our investment case for the company remains unchanged.
Our largest investment for the quarter was into Liberty (via Liberty Holdings). This is a company that generates a superior return on its embedded value, attracts net positive policyholder cashflows (not all that common amongst SA life insurers) and has an exceptionally strong distribution model that generates strong new business growth, yet trades at a discount to EV, and at close to an historic low price to EV multiple. We sit at our maximum permissible direct holding of Liberty Group in the fund, and therefore have used the opportunity of price weakness in the holding company to increase the fund's exposure to the group.
The fund's purchases were funded primarily through sales of Remgro and Liberty International - stocks that had performed well in the period, although with the benefit of hindsight we should have held on to these shares longer given the extent of currency weakness experienced.
At current levels we view the banks as inexpensive, trading on PE ratios of between 9 and 10 times next year's earnings and dividend yields above 4%. The defensive characteristics of the life insurers have, we think, been under-appreciated by the market in the recent sell-off, and continue to offer attractive valuations.

Neville Chester & Neill Young
Portfolio Managers

The financial sector experienced another strong quarter at the start of 2006, with the index delivering a 14.5% return. Of its primary constituents, the life insurance sector once again outperformed the banks as these stocks continued to benefit from a rising market, and the excessive negativity previously built into life company valuations continued to work its way out following the agreement with National Treasury in December 2005.

During this period, the Coronation Financial Fund returned 11.62%. The fund has underperformed the index for the quarter, and while this does not sit easily with us, we remind investors that we manage this fund with the focus on superior long-term returns.

The big four banks and all of the insurers released 2005 financial results during the quarter. The results from the banks were again driven by strong growth in their retail businesses - both in advances and in non-interest revenue generated by consumer activity. Credit quality remains abnormally good with bad debt write-offs at all time lows. The impact of unprecedented levels of credit extension is starting to be seen on consumer balance sheets, and we expect to see a decline in credit quality to more normalised levels as a result. Corporate business amongst the banks showed a pick-up, driven largely by BEE activity and strong equity markets. The former we expect to continue, and together with infrastructure-related loan growth and private equity gains will drive continued growth in this market segment.

Life insurance company results were characterised by the positive impact of strong investment markets in 2005, a decline in new business profitability as a result of providing improved value for money products, and the return of excess capital from both Liberty Life and Metropolitan, with Sanlam undertaking to do the same within the next six months. The impact of the agreement with National Treasury we believe is largely in the base and we expect the year ahead to be characterised by reasonable growth in new business profitability. In addition, the opportunity for further optimisation of capital structures remains.
After having spent much of our time in the quarter wading through financial company annual results, we use this platform to voice our concern over certain financial reporting requirements applied in terms of International Financial Reporting Standards (IFRS). In our opinion, these standards do not always accurately represent the economic reality of a company's operations and financial position, particularly the treatment of own shares held to back policyholder liabilities. We would urge a rethink on their application so as to ensure that financial statements retain their usefulness for all stakeholders.

One of the main contributors to the underperformance is our large position in Discovery Holdings (8%) - a position we have continued to build during the period. Recent results revealed deepening losses in the US and poor profit growth in the local health administration business, and sentiment towards the stock is negative as a result. Although it may take some time before both of these issues are fully addressed, we view this as an excellent opportunity to buy a high quality business with genuinely good growth prospects (both in SA and the UK) at an attractive price.

Company valuations, particularly those of banks, have run hard, largely on the back of foreign interest in emerging markets and South Africa in particular. While the operational fundamentals for financial stocks remain sound, we caution investors that the exceptional returns of the past two years are unlikely to be repeated.

Neville Chester & Neill Young
Portfolio Managers

Coronation Financial has an enviable record and its manager, Neville Chester, intends maintaining it even at the expense of short-term performance. He says small-cap financials, in which a number of other funds in the sector are invested, have outperformed big caps of late but he is loath to buy what can be volatile and unmarketable small caps so late into the cycle. He adds: "I have to be confident that a share is a long-term hold."

Financial Mail - 24 March 2006

After a fairly quiet and looking to be disappointing last quarter, the financial sector really woke up in December. Enthusiasm for the sector had been dampened by concerns over the Pension Fund Adjudicator attacks on the life sector and the banks were out of favour due to expectations of rate hikes and the effect that this would have had on their earnings. However December brought about a change in heart at the South African Reserve Bank as the Governor signalled a change in thinking on where inflation was heading and as a result a rate hike seems no longer to be on the cards. In addition December also brought about a resolution to the ongoing crises in the life assurance industry, with the life sector as a grouping agreeing to minimum benefit pay outs where investment products are terminated early.
Both these events gave impetus to a late rally in December which saw the FTSE/JSE Financial Index up 10.1% for the month and giving the quarter a respectable return of 11.7%. Life assurers managed to outperform the banking sector for the quarter for the first time in a long time due to the improved sentiment as well as the very strong equity markets which should boost their earnings. The Coronation Financial Fund returned 11.4% for the quarter, in line with the overall index performance.
The sharp appreciation in banks in December was led by FirstRand/RMB which increased nearly 17% in the month! We went into December with a large position here but have now started trimming as we believe the appreciation to be overdone in the short term. Another stock we have been reducing is Sanlam. We have held a large stake in the business for a long time but now feel that there is more potential in other financial stocks.
On the purchasing side we topped up some more Liberty Life earlier in the quarter and have now also built up a sizeable position in the Discovery Group. Liberty presented their plans for the integration of the Capital Alliance group during November and this was well received by the market. At the margin we added to our positions in Absa, Standard Bank and Remgro when we felt there was value in the share price.
During the quarter an offer was made for our stake in VenFin by the Vodacom group. Due to the extremely attractive price offered we have accepted and this position will be liquidated early in 2006 and we will look to redeploy the cash as and when we find compelling investment opportunities.
The investment case for the financial sector remains one of strong earnings growth due to good market fundamentals. Bank asset growth continues unabated with no real credit risk on the horizon. The life sector, now that the regulatory issues are behind them, should stand to benefit handsomely from the great returns generated in the equity markets and a return to equity investments by the investing public. On this basis we remain optimistic about the potential return from financials over our investment horizon.

Neville Chester & Neill Young
Portfolio Managers