The Black Swan event "No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion." David Hume

The events of the month of the last quarter (and in particular September) in the global financial markets will shape financial history and probably carry as much significance as the crisis of 1929 following Russia's default and the demise of Long Term Capital Management. The credit crisis in the United States culminated in the lending markets freezing up, which coupled with the ever increasing mortgage related write downs led to the eventual demise of household names in the investment banking world. Lehman Brothers filed for bankruptcy, Merrill Lynch was acquired by Bank of America, and the US government rescued insurer AIG. As each institution failed, uncertainty over the sustainability of all others with any links rose, and confidence in the entire system evaporated. Banks ceased lending to each other for any extended period of time, and such was the crowding of short-term money that the yield on the one-month US treasury bill dropped to an intraday low of zero. In other words, investors were willing to place cash with the government and forego any nominal return for the certainty of security of capital. The crisis crossed the Atlantic to the European financial system, impacting institutions like the Dutch insurer Fortis and UK mortgage lender Bradford and Bingley. Indeed, such was the panic that it threatened the viability of the entire financial system and eventually prompted authorities in the United States to approve a $700 billion bail-out package to buy banks' bad loans in an attempt to shore up confidence and provide stability to the system. Are there more chapters to this drama? This remains to be seen - at the time of writing there are moves by European governments to guarantee depositors' funds and restore confidence to their financial markets. We expect more of this to happen in the coming days and weeks - the storm is not over just yet.

This is the backdrop against which we navigated the Financial Fund for this quarter, returning 12.0% against 11.9% for the index. Over one year the fund has returned -12.9% against the index return of -17.2%, and over 3-years an annualised 9.4%. Positive returns for the quarter against what appears to be a global financial meltdown would be counter intuitive. What these returns highlight is the relative strength of our domestic institutions within a troubled world and the fact that SA financial shares had been significantly oversold in the second quarter. We have in the past dedicated a meaningful part of our commentary to the fact that South African banks have very limited direct exposure to US sub-prime assets and to the developments emanating from the crisis. The operational issues that are currently impacting our banks are primarily domestic. They relate to rising impairments and a highly indebted consumer burdened by the 500 bp rise in interest rates over the last two years. One should not assume, however, that the impact of global developments on general levels of activity and access to funding will bypass our companies, nor that the equity market moves we have witnessed will not have an impact on profitability.

During the quarter, banks continued to outperform life companies, returning 25.5% versus -9.1% for the life companies. This bounce in the banks does not erase the fall earlier this year, leaving banks down 6.3% year-to-date. Banks remain attractive on p/e multiples ranging between 6x and 8x one year forward and based on our valuations are overweight domestic banks. We still expect bad debt impairments to peak and level off at some point in 2009/10 in an environment where advances growth remains muted. This means near-term earnings growth for banks will be uninspiring, but these businesses have retained sufficient franchise value to show real earnings growth beyond 2009. The fund's 9% holding in Absa contributed positively to relative performance in this quarter.

The life sector had a poor showing with Old Mutual (down 20% for the quarter), the worst performing stock in our universe. Early on in the period the fund sold out of Old Mutual and this was the largest positive contributor to performance relative to the index. We have always been wary of the risks inherent in the company's US life insurance business but felt that it made up a sufficiently small piece of the valuation to warrant the investment. The current climate has highlighted exactly how significant the risks in the business are, and has resulted in two large additional injections of capital with no clear indication of either an exit or turnaround. This, combined with what looks to us to be a very expensive acquisition of a Chinese asset management business and the desire to sell its under-managed short term insurer close to the bottom of the underwriting cycle, has raised serious concerns about the stewardship of investor capital. While it is inexpensive in absolute terms, and despite a CEO change, we think there are better opportunities out there. In the life sector, we have added to our holdings in Discovery, Liberty and Metropolitan given their attractive valuations and ability to weather the current tough consumer conditions.

Our relatively large holding in smaller cap financial stocks has served us well over the longer term. These businesses tend to have drivers that are less linked to domestic interest rates or global events and provide us access into attractive niche, often owner-managed businesses with room to grow. We continue to look for opportunities in this area to enhance investor returns. While banks have had a strong showing in the quarter, we continue to be positive about the opportunity that the current valuations present in the financial universe. The significance of events unfolding on the global arena should not be understated and are likely to change the shape of global financial markets going forward (increased regulation is one example.) Our market will not escape the impact of the negative sentiment of global investors in the short term, but this is likely to present opportunities for those willing to sit it out. Fundamentally, we remain confident in the financial strength of the fund's investments and their ability to weather what we believe amounts to a Black Swan event on global markets.

Neill Young and Godwill Chahwahwa
Portfolio Managers

Investors in the fund are probably as despairing reading quarterly commentaries lately as we are writing them. Financial sector share prices continue to decline; for the quarter to June the index return was -14.5%, making this the fifth consecutive quarter of negative returns. While global equity markets have been under pressure over the last six months, it is the financial stocks that have borne the brunt of this. Once again it is worth putting the deviation in returns on the JSE into context: year-todate resource shares are up 33% (driven by continued strength in commodity prices), industrial shares are down 9%, and the financial sector is down more than 25%. Against this backdrop, it may be some small consolation that the fund outperformed the index for the quarter, with a total return of -11.4%. Over one year, the fund has returned -24%, and over 3 years a compound annualised 9.1%. The fund's performance for the quarter was aided by two factors: o Its 3% holding in Liberty Holdings, the controlling shareholder of Liberty Group. Standard Bank, already a 59% shareholder in Liberty Holdings, in May offered to buy the shares it did not already hold at a 24% premium to the then market price, thereby eliminating the implied look-through discount to Liberty Group in the control structure. The fund will tender its shares into this offer. o A relatively large weighting in financial stocks whose fundamental drivers are less directly linked to the domestic interest rate cycle and equity markets. These include holdings in PSG (the only other financial stock to deliver a positive return in the quarter), Remgro, Brait and Discovery. We wrote in our previous commentary that we believed levels of profitability in domestic financial companies (with the exception of mark to market equity gains) were not abnormally high and that we were seeing the mechanics of a normal cycle at work. We continue to believe this to be the case, but it is probably fair to say that the cycle will be deeper and take longer to play itself out than we had previously believed. Since writing the March commentary we have seen two further 50 bps interest rate hikes, yet inflation remains stubbornly high. The Governor of the Reserve Bank has made it abundantly clear that fighting it remains his sole priority, and although we have seen signs suggesting that the medicine is starting to take effect, we would anticipate at least another 50 bps before the tightening cycle is complete. The indications are that the current downcycle is looking like it will be tougher than that of 10 years ago: debt servicing costs as a percentage of disposable income are now approaching the peaks last seen in 1998. The important difference being that 1998 was a short-lived period of extreme tightening followed by rapid easing, somewhat softening the blow, whereas this time around the hikes have been more gradual and will probably remain in place for some time before easing starts. At the risk of over-emphasizing the point, this is a normal (but reasonably severe) cycle, where earnings are not at an excessively high level. The cycle will turn at some point (that's what cycles do after all), yet it appears that share prices are factoring in some severe declines in profitability into perpetuity. We have written about price earnings ratios a lot in the past, so maybe it's worth having a look at another valuation metric: price to book value ratios. The chart below (courtesy of UBS) plots a 'snail trail' of the big 4 banks' P/BV ratios since 1995. These banks currently trade on average ratio of 1.35x historic book value, the lowest in the 13 year history (and interestingly significantly lower than the 1.9x multiple they traded on in 1998.) It is interesting to note how these multiples approached their lows in years of interest rate tightening (1998 and 2002) and how they re-rated strongly upwards thereafter. Based on UBS estimates of projected returns on equity over the next 12 months (now reduced and probably depressed given our comments in the previous paragraph) a fair P/BV multiple would be closer to 1.6x. Of course historic book values are susceptible to disappointments (due to large write-offs on their lending books) but bear in mind that a company would need to report a loss to reduce its book value, and this is a scenario we do not foresee at all. At worst, and despite our comments above, we believe bank earnings growth will be flat to slightly positive in the year ahead.

We continue to believe that financial shares offer compelling value. While it is difficult to say for how long this will be the case, we are firmly of the view that investors will in time look back on this period as an excellent opportunity to invest in the sector.

Neill Young and Godwill Chahwahwa
Portfolio Managers

The first quarter of 2008 was a challenging one for the manager of any financial sector fund. The index returned -12.8% for the period, the largest quarterly decline in 5 years, and the first time in the 10-year history of the fund that the index has registered four consecutive negative-return quarters. So widespread was the rout that only one share in the universe, Liberty International (a UK listed property stock and a top 5 holding in the fund) delivered a positive return, and this was due solely to rand weakness - in sterling it was down 9%. For the quarter the fund returned -13.5%, over one year -16.1% and over 3 years a compound annual return of 15.4%.

We concluded our previous quarterly commentary with an optimistic outlook; we felt there were sufficient grounds to anticipate better returns in 2008 than the 6% return that the fund achieved in 2007. Clearly with this sort of start to the year, that target becomes somewhat of a challenge. However, the reasoning behind our view remains unchanged - South African financial stocks are inexpensively rated and offer compelling value.

From our point of view, two principal drivers have been behind the de-rating experienced by South African financial shares over the last 12 months. The first is the impact of the slowdown in domestic economic growth - tighter monetary policy has resulted in higher bad debt write-offs by the banks and increases in lapse rates amongst the insurers. The full impact of the slowing will in truth probably only be seen during 2008. It is unlikely that we will see any reduction in domestic interest rates this year, and as a consequence advances growth will come under pressure and credit impairments will continue to rise amongst the banks. Trading profits and private equity realisations will in all likelihood reduce. Some of this should however be balanced by continued strength in corporate businesses for as long as the commodity cycle continues its strength, and the country's infrastructure build continues. Amongst the insurers, new business will be harder to come by and lapses will remain under pressure. However, from what we have seen from the financial results reported during the quarter and our subsequent discussions with company managements, this simply reflects a widely anticipated normalisation in these businesses. There were few surprises in the numbers reported, and there is very little that we have seen that suggests that there is any more to this than the mechanics of a normal cycle at work.

The second driver is largely sentiment driven - the spill over of what has been happening in the banks sector globally, as well as caution amongst foreign investors towards domestic shares following political developments late last year and the Eskom power crisis early this year. The shorter term impact of the subprime crisis is a tightening of global credit markets; something that will ease over time as confidence returns to markets. However, the level of profitability enjoyed by many developed market banks is unlikely to be seen again for many years. Regulation is likely to tighten, off-balance sheet vehicles are likely to come back on to the books, economic capital requirements are likely to increase, and as a result returns will decline.

While it would be naïve to assume that the South African financial sector is entirely immune to the impact of global developments, we believe that many of the factors impacting on developed market financial stocks have less relevance domestically. Funding growth will be challenging for our banks in the year ahead (making the capital raising by Standard Bank in the ICBC transaction last year all the more fortuitous) but it is highly improbable that we will experience a meaningful funding squeeze, and nothing like the one that led to Bear Stearns' demise. SA banks are not significantly exposed to sub-prime investments, have very few assets sitting off balance sheet, and are generally well capitalised. The impact of the domestic developments mentioned above may well be a slightly lower medium-term trajectory of economic growth. However, with the exception of earnings derived from mark-to-market equity gains, we do not consider profitability to be abnormally high and still anticipate acceptable medium term earnings growth from the sector as a whole.

Domestic financial stocks are being priced no differently to those of developed markets that are undergoing significant structural issues, have suffered severe write-offs, and where all indications are that profitability was abnormally high. We do not believe these factors to be relevant in any meaningful way to our market. After taking into account a slowing in growth, banks are trading on 12 month forward PEs of 6 to 8 times and dividend yields of 6%. Life companies trade on an average 20% discount to their embedded values, after producing EV returns in the high teens. In many cases small cap financial stocks have been indiscriminately dragged down along with the large caps, and we have added to certain of these during the quarter. While it is impossible to predict how long it will take the financial crisis to fully work its way through the system and for sentiment to recover, we consider these valuations to be compelling, and believe the prospect for superior return generation good.

Neill Young and Godwill Chahwahwa
Portfolio Managers

2007 proved to be a very poor year for financial stocks in both absolute and relative terms. While the overall market returned 19% for the year, this was primarily driven by resource stocks (29% return) and industrial shares (18% return), whereas the financial sector lagged significantly with a return of only 3%. Over this period the fund outperformed its benchmark with a return of 6.1%. Over 3 years the compound annual return now stands at 21.8%. For the fourth quarter of 2007 the fund delivered a positive return of 1.3% against the index return of -0.7%.

The disappointing performance of financial stocks in general over the past year can be ascribed largely to the tightening monetary conditions in the domestic economy. Since the middle of 2006 we have seen 8 interest rate hikes of 50 basis points each. Two of these came about in the final quarter of 2007, and both of these we consider to be unwarranted - insufficient time was allowed to see the full effect of interest rate hikes work through the system. In addition, inflation has more recently been driven largely by rising food and fuel prices and spending on these essential commodities is unlikely to decline materially as interest rates are raised. As a result, over the last quarter most sectors of the market with significant exposure to the consumer (retailers, motor vehicle distributorships etc) have performed poorly, and the bank sector has fared no better. In addition to deteriorating domestic conditions, global events in particular the sub-prime crisis, have impacted on financial stocks globally. South Africa has not escaped the fallout.

Despite the poor performance of the sector over the period, the fourth quarter included a significant development in the domestic banking industry: the approval by shareholders of the acquisition of 20% of Standard Bank by the Industrial and Commercial Bank of China (ICBC) for $5.5 billion. This represents the largest ever-single foreign direct investment into South Africa and its importance should not be understated. At 20%, Standard Bank has long made up the largest holding in the fund. Part of the investment case was driven by our positive view on management's internationalisation strategy into the rest of Africa and other emerging markets. The strength of this network has now been recognised by China's biggest bank. While ICBC has little or no presence in these markets, its clients are already active in them and will be increasingly so in the years to come. In countries in which ICBC clients transact and Standard Bank has a presence, ICBC will recommend Standard Bank as the preferred banking partner to those clients. The opportunities in both corporate and investment banking that will result from the growth in trade flows are significant. Standard Bank management, who we consider to be consistently conservative in their outlook, anticipate a $200 million increment to profit after tax in 2010 resulting from this transaction, a 10% uplift to our previous expectations. We continue to believe strongly in the attractiveness of Standard Bank as an investment and would be adding to our current holding in the current share price weakness were it not already so significant in the context of the portfolio.
Investors may be surprised to see nearly 5% of the fund invested in Ellerines, a furniture retailer. Early in the New Year, Ellerines will be acquired by African Bank by way of an issue of shares. For the reasons detailed below, we find the investment opportunity resulting from this transaction compelling, and buying Ellerines shares was simply a cheaper entry point into the combined business.

As a house Coronation has traditionally been wary of the furniture retail business model - for businesses that are essentially lenders, balance sheets were not optimally structured, and the margins earned in their lending and financial services businesses appeared unsustainably high to us. However, they do have significant experience in lending to the lower and middle-income markets, and through their store bases have attractive distribution infrastructures. There are a number of opportunities for African Bank in acquiring Ellerines:

o Capital synergies: appropriately gearing the combined balance sheet will allow more competitive lending rates in the furniture business and lead to a release of capital
o Cost synergies: two credit functions will combine into a single one, which should result in significant cost savings
o Distribution gains: 1,300 Ellerines branches add to the existing 600 branches of African Bank, and African Bank's 1.2 million customer base has minimal overlap with the 1.4 million Ellerines customers, giving African Bank a new avenue for growth

This is an investment that will require some patience - the current environment is challenging for both micro-lenders and furniture retailers, and business combinations invariably experience teething problems early on. However, we believe strongly in the long-term strategic rationale of the transaction, and consider the value opportunity compelling.

The continued weakness in bank share prices during the quarter has resulted in the shares now trading on what we consider to be attractive forward p/e multiples of between 7 and 8 times - large discounts to other emerging market banks, and although not quite at all time lows, multiples last seen in 2004. The full impact of the 2007 interest rate hikes will be felt in 2008, and we would consider there to be a reasonable likelihood of earnings disappointments being reported in the coming year. Notwithstanding this, we continue to believe the banks sector is undervalued. The life insurance sector also looks attractive from a valuation perspective, with a number shares trading at historically large discounts to their embedded values, and the benefits of a 19% domestic equity market return in 2007 largely being ignored in share prices. Looking to the year ahead, our market will not escape the impact of a slowing global economy, but we see sufficient opportunity within the sector to remain optimistic that the next 12 months will see a better return for the fund than the previous 12.

Neill Young and Godwill Chahwahwa
Portfolio Managers

This fund is a specialised investment that exclusively focuses on the financial services industry. The investment objective of the fund will be to gain steady, long-term capital growth by investing in both local and international listed companies with a significant portion of their current or potential earnings being derived from financial services.