In another challenging quarter for financial shares, the fund returned -2.2%, against the index return of -1.6%. The consistent decline in share prices in the sector over the past five months has reduced the one year return on the fund to 25.9% and a compound per anum return over three years to 28.7%.

This was a quarter in which newsflow was probably the most negative for banks, with a further 50 basis point increase in domestic interest rates, the effects of the National Credit Act starting to become apparent, and the sub-prime crisis and its impact across a number of developed economies making headlines. Share prices have been volatile, but despite this the banks outperformed the life insurance sector for the period, effectively staying level while the life stocks retreated by 4.3%. This is probably a function of two things:

o As pointed out in our previous commentary, valuations were very attractive going in to the period - it would appear that much of the impact of domestic drivers had already been discounted into bank share prices
o SA banks have very little if any direct exposure to the sub-prime market, with only FirstRand and Investec carrying immaterial balance sheet positions ($2 million and £22 million respectively.) The crisis has however put pressure on the ability of banks around the world to access inexpensive short term funding, and local banks will be no exception.

The turmoil in the credit markets serves as a useful reminder of why banks continue to be rated globally as discount businesses. Northern Rock, a UK mortgage lender, was probably the most publicised casualty of the sub-prime crisis - it constituted the first run on a bank in that country in over a century. The irony is that its neardemise was not caused by lending to poor quality borrowers, but rather due to a number of banks on the other side of the Atlantic doing just this, which had the effect of extreme tightening in the short-term funding market on which the Northern Rock business model was so dependent. (US banks would repackage or securitise the high risk loans into units and sell these units off to investors. As the US sub-prime borrowers unsurprisingly defaulted on their mortgages, the market for all types of securitised paper simply dried up.)

Times of volatility often provide opportunity, and this was no exception. The Investec share price has been under severe pressure since concerns about the sub-prime market first began to surface. At about the same time, Investec spent £220 million buying Kensington, a UK lender into what is termed the non-conforming market - i.e. borrowers whose basic incomes may not qualify for large mortgages, but whose variable incomes (for example in the form of bonuses or commissions) would support a higher level of indebtedness.

As the Northern Rock crisis unfolded in the UK, it dragged down with it other banks that had exposure to the mortgage lending market, Investec included. The quality of this book is probably poorer than initially thought, and while the timing of the acquisition was clearly not optimal the nature of the investment is typical of the company's opportunistic style; one which has in the majority of cases created value for shareholders over the longer term. Kensington will contribute in the region of 5% to earnings, and the market appears to have overstated its significance to the group. Investec's market value has declined by over 30% (£1.5 billion) from its peak, and we consider this an attractive opportunity to build a position in an asset that includes businesses with high quality annuity earnings (private banking and asset management) where the high level of the more volatile earnings streams is now appropriately discounted in the share price.

Banks and insurers released their results to June during the period, all reporting strong earnings growth with the exception of Old Mutual and Mutual and Federal. As expected the growth in retail earnings in the banks slowed as the impact of 300 basis points of interest rate increases takes effect, and bad debts start to normalise. This was to a large extent compensated for good by growth in corporate and commercial banking, and we expect this trend to continue. The market is currently placing a 60% probability of a further 50 basis point rate hike, and we are increasingly concerned about the potential impact on the consumer and hence retail banking (and particularly vehicle and asset finance) if this were to happen.

The domestic life insurers reported solid embedded value returns in excess of 20% on an annualised basis, supported by higher equity markets and good growth in the value of new business. Encouragingly, new business flows were strong, aided by a recovery in retirement annuity sales and continued growth in risk products.

Notwithstanding our comments on the impact of another interest rate increase above, we continue to see the banks as being inexpensively priced given their attractive long-term earnings prospects and diversified earnings streams. Within the life insurance sector, we believe certain stocks continue to offer compelling value, and the fund is positioned accordingly.

Neill Young Portfolio Manager

For the second quarter of the year the fund returned -2.2%, slightly behind the financial index return of -1.7%. Over one year the fund has generated a 36.7% return, and over 3 years a compound annual return of 37.1%

The share prices of the banks came under pressure during the quarter, and as a group were down nearly 7%. Given that more than 50% of the fund is invested in banks, performance was negatively impacted. The poor performance of the sector appears to have been driven largely by two factors, namely:

- Poorer than expected macro-economic data which culminated in an interest rate hike in June, and concerns that a further, previously unexpected 50 basis point increase will materialise before the year is out.
- The implementation of the National Credit Act (NCA) in June, which anecdotally has led to a severe short-term slowdown in lending activities, particularly in the areas of mortgages and vehicle finance.

In our previous commentary we noted that the attractiveness of the banks was driven more by the opportunity in the corporate businesses, while the retail businesses were anticipated to normalise. Our view remains unchanged - while the developments noted above may well have a negative shortterm impact on retail lending activities, our outlook for medium-term earnings growth is unchanged, and we consider valuations even more attractive than we did three months ago.

The life insurance sector on the other hand experienced a strong quarter and was up nearly 7%. Followers of the fund will notice that for the first time, a significant position has been built in Old Mutual (10% of fund.) Old Mutual has been a notable underperformer of both the equity market and the financial sector since its listing in 1999 for a variety of reasons - expensive acquisitions and subsequent disposals of some of these, problems in Nedbank resulting in a recapitalisation, deteriorating fundamentals of the SA life business and more recently EV restatements in parts of the business. Investor sentiment towards the company remains negative. In our view this is an asset that contains some very attractive components which is now mis-priced.

The acquisition of the Skandia businesses 18 months ago fundamentally altered the make-up of the group, to one consisting of:

- some good quality growth assets (its UK and European life businesses and its US asset manager),
- some relatively mature assets (its SA and Nordic life businesses) and
- some assets that probably fit in somewhere in between (its US life business, as well as Nedbank and Mutual and Federal).

However, the entire group is currently being priced as exgrowth, at a 6% premium to our current estimate of stated embedded value. Looking at it slightly differently, if one assumes comparable market values for the non-life businesses in the group (or quoted values in the case of Nedbank and Mutual and Federal) the implied valuation of the life insurance businesses places no value on new business to be written in future. While there may be some uncertainty about the prospects for the SA life business, we believe the outlook for the UK and European life businesses, which wrote 40% of the group's new business in 2006, is very positive.

This investment may require some patience - restructuring and integration costs resulting from the Skandia acquisition will put pressure on earnings for 2007, and a review of the US life business could still produce some negative restatements. It is impossible to know when the market will look beyond these issues, but we believe that our investors will be well rewarded over the medium term. Overall we continue to view the financial sector as attractively valued, in particular the banks, now trading at forward p:e multiples of less than 10x.

Neill Young
Portfolio Manager

The fund generated a return of 9.4% for the first quarter of the calendar year, comfortably ahead of the return of the financial index of 7.3%. Over one year the fund has returned 26.3%, and over three years a compound annual return of 40.2%.

The quarter was once again a strong one for the banks, with the fund's three significant investments all gaining about 13%. After a volatile year for share prices, the 2006 financial results from the banks confirmed that the industry continues to grow strongly. Record levels of advances growth and improved margins boosted net interest income, while higher transaction volumes and strong equity markets supported non-interest revenues. Tighter monetary conditions have resulted in an increase in credit impairments, but these are well within expectations and still below what we would consider to be normalised levels. And while expenses growth was reasonably high, at least a portion of this can be attributed to investment in future growth. The past five years has marked a period of extremely rapid expansion in consumer credit, which has driven strong performances from retail banking operations. Encouragingly, the growth in consumption and the positive economic environment is now starting to translate into increased capacity utilisation, placing pressure on businesses to expand. As a result, growth in corporate advances has started to increase to levels similar to those of retail advances, a trend that is likely to continue. In future we expect the contributions from retail and corporate banking to be more evenly balanced than has been the case in the past.

The general financial sub-sector was also a strong performer for the quarter, and the holding in three of these stocks has contributed to the fund's outperformance. Brait, Coronation, and JSE are all businesses that benefit from higher equity market levels (albeit in slightly different ways). In times of sustained equity market strength, revenues tend to increase at a faster rate than costs, and good operational gearing is typically generated. While this appeared to have been largely ignored by the market in 2006, the shares have subsequently performed strongly.

Despite reporting good results (on the whole) for 2006 the life insurance sector delivered a poor return of 1% for the quarter. This is in no small part attributable to the arrival of a new regulatory headwind, this time in the form of governments proposed social security reform. A cornerstone of the proposals is the establishment of a national savings and risk scheme to which a minimum level of contribution by all employed people will be mandatory. The scheme is noble in intention, and is likely to go a long way to ensuring that low and middle income earners provide adequately for retirement.

However, the proposals are likely to result in funds being drawn away from the private sector, which for an equity investor in life insurance companies is not positive in the long run. This is an enormously complex overhaul of the retirement industry for which much of the detail still needs to be determined, and this will take some time. Government is working towards an implementation date of 2010, which to us seems unrealistically optimistic.

Given the scarcity of detail, it is difficult to quantify the impact of the proposals, or to determine which of the life insurers will be impacted most and which least by these reforms. In the shorter term there is unlikely to be a significant impact on the industry. It is the medium to longer term impact that concerns us, and as a result we have taken the decision to reduce the fund's holding in Liberty Group. Our investment in this business has for some time made up a large holding of the fund, and this was not a decision lightly taken. The move was motivated by the fact that, relative to the other life insurers, a greater portion of our assessment of the value of the company derives from the business's value of in-force (the present value of profit on business already written but to be recognised in future) and the value of new business yet to be written. It is these two components of the valuation that will be impacted by the reforms and which will remain under pressure for some time to come. While at the current share price, the investment opportunity would still seem reasonably compelling, the level of uncertainty and therefore risk has increased. It is for this reason that we can no longer justify the size of the position previously held.

We remain optimistic on the outlook for the financial sector as a whole. Banks have re-rated somewhat to a level where they trade on forward PE's of 11 to 11.5 and dividend yields of 3.5%-4%. Given our medium term earnings growth expectations for the sector, these valuations do not look excessive. Domestic insurers appear inexpensively priced and continue to trade at discounts to their embedded values, with the prospect of ongoing improvements to capital efficiency. However, until there is more clarity surrounding the social security reforms, regulatory uncertainty is likely to hang over the sector.

Neill Young
Portfolio Manager

The fund experienced a strong quarter, delivering a 20.3% return against a 14.8% return for the index. Over one year, the fund's return is 28.9% and over 3 years a compound annual return of 38.8%.

The quarter was characterised by a very strong performance from the banks. Of that sector's 28% return for the 2006 calendar year, 23.8% was generated in the last 3 months. Particularly strong performances came from FirstRand Group and ABSA, both of which are well represented in the portfolio. In our June quarterly we commented on the almost indiscriminate sell-off in the banks following the first rate increase in the current tightening cycle, and the opportunity that presented. December saw the fourth 50 basis point increase for the year. We view where we are now as being close to the peak of the cycle - with the possibility of one further increase. The fact that advances growth has remained strong during this period while credit impairment has behaved in line with expectations would appear to have driven a welcome re-rating of the sector. Despite this the overall valuations of the banking sector are not looking particularly stretched (on an average 10.4x forward p:e and 4% dividend yield). With the prospect of good growth in corporate lending and a continuing benign environment on the retail side we believe mid- to highteen earnings growth will be sustainable for the coming year.

The life insurers in contrast performed relatively poorly for the quarter with a 3.6% return. There was quite significant divergence of return within the sector, with Metropolitan and Discovery (again, well represented in the portfolio) performing strongly, and Sanlam (4% holding) and Old Mutual (no holding) performing poorly. Liberty remains a disappointing performer from our point of view. As noted in previous commentaries, we find this business attractively valued despite certain operational challenges that it is likely to face over the short to medium term. During the quarter, one of these obstacles was effectively removed: Liberty has proposed buying the 63% of the Stanlib asset management operations that it does not already own. The strategic rationale of the transaction is sound - life companies need to be indifferent between selling life-wrapped and non-life wrapped investment product (i.e. unit trusts), and to do this effectively they need to own 100% of their asset manager. What was of concern was the risk that Liberty would issue undervalued shares to pay for a business benefiting from the strongest bull run our market has seen in the last 25 years. In our view, the purchase price finally proposed is fair at an effective 0.8% of assets under management, and fewer shares will be issued than had been anticipated. The transaction results in the business being better positioned for the environment in which it operates, and immaterial EV per share dilution.

The strong run in financial stocks in the quarter means that for the third consecutive year the sector has delivered a total return in excess of 35%. This sort of move warrants some caution in forecasting future returns. However, we still see opportunities within the sector - particularly as we are close to the top of the interest rate cycle, the outlook for interest rate sensitive stocks should be positive over the next 12-month period. In the shorter term, one could see more volatility, which we will use to add to specific holdings where valuations are attractive and as a result have slightly more cash than usual in the portfolio at the quarter-end.

Neville Chester and Neill Young
Portfolio Managers