The third quarter of 2009 saw a continuation of the rebound in domestic and global equity markets that began in the March. The SA financial sector participated in this, and delivered a return of 15.1% for the three months. Against this backdrop, the fund returned 17.7%, outperforming its benchmark by 260 bps.

The contribution to the outperformance came principally from the fund's relatively high weightings in businesses classified as General Financials, being Investec, Peregrine, Coronation, and to a lesser extent JSE. These are businesses that are relatively strongly geared to rising equity markets, and have rerated on the back of an improved outlook on their earnings prospects as a result of the rising equity markets we have experienced.

While we are generally pleased with the performance for the quarter, the one disappointment has been the performance of Liberty International (6.3% of the fund), particularly in September. Liberty International is a dual listed owner of UK prime retail property - mainly regional shopping centres. These are attractive assets in that the opportunities for new development of similar quality retail space are limited in the UK. But they are also cyclical assets, and with the sharp slowdown in retail spend over the last 12 months, the market had taken a very dim view on the valuation of the company. This resulted in mark downs to the NAV, bringing the business close to triggering debt covenants, and as a result a rights issue was launched in April. This rights issue was done at a significant discount to the post-rights issue NAV - an NAV which we felt was probably slightly understated given the high capitalization rates employed in the calculation.

In the lead up to this the fund held a small position in the share. We saw this as a good opportunity to increase our stake in a high quality asset at an attractive price that would also provide some protection in the event of rand weakness. We followed our rights, and subscribed for more, building the position to where it stands currently. In pence, the share has subsequently performed very strongly (it doubled in price in the six months from the middle of March to the middle of September). Some of the shine has been taken off this performance by the strength of the rand over the same period, and it is due to this rand strength that we have continued to hold the position in the fund. So it was with great disappointment that we were presented with another capital raising announcement late in September - this time not out of necessity to deal with debt covenants, but motivated by the desire to invest in new projects. The share has reacted negatively since the announcement. Although this time at a premium to NAV, the issuance signals to us (and we suspect to the market) management's readiness to raise new equity with little regard to the cost thereof. While we continue to believe that the share provides a good currency diversifier for the fund, we are reviewing the long term attractiveness of this investment.

There have been few changes to the fund over the quarter, other than an increase in the cash holding which has increased from 1% in June to 4.3 % at September. We would consider this to be a relatively high cash weighting, and is motivated by the fact that we find it more difficult to find shares in our investable universe priced with an adequate margin of safety. From its low in March, the fund is up 50% (excluding distributions). Some will point out that this is still nearly 20% below the previous peak in October 2007. But we believe that the 2006/2007 period should be considered a period of superprofit, particularly for South African banks, and unlikely to be repeated in the medium term. (Contrast for example Rand Merchant Banks' 2007 headline earnings of R3.9bn with the recently reported R1.5bn). The signs of increased regulation are already starting to appear internationally with the FSA proposing tighter liquidity requirements for banks in the UK. Despite not experiencing the same sort of excesses that drove the economic collapse of the last 12 months, domestic institutions are unlikely to entirely escape the regulatory consequences. Ultimately this will reduce returns.

The recent round of results announcements was generally a dismal one for both our banks and insurers. Although there has been little concrete evidence of it yet, we believe that from these lows the environment for these businesses will improve quite dramatically over the next 12 to 18 months. The market however tends to discount future information into share prices, and we feel that much of this improved outlook is currently priced in. While we do still see opportunity in certain stocks, our outlook from current levels is thus generally cautious.

Portfolio managers
Neill Young and Godwill Chahwahwa

The fund returned 10.35% for Q2 2009. Over the same period the index returned 12.25%. Relative to its benchmark, the fund was negatively impacted by the Old Mutual underweight and overweights in Discovery and Liberty Holdings. Our exposures to smaller cap financials were vindicated and Coronation, Peregrine and JSE Ltd came through with positive contributions to the fund. Over the longer term, covering periods of one, three and five years, the fund has returned 10.1%, 4.6% and 16.6% respectively, outperforming the index which returned 3.4%, 0.08% and 15.1% respectively over these periods.

Old Mutual was the biggest detractor to relative performance this quarter and it is therefore worth revisiting the investment case. We sold out of Old Mutual in the third quarter of 2008 on capital concerns and a lack of strategic leadership. This position served the fund well in up to the start of the current quarter. Old Mutual has subsequently been the best performing financial stock during the current quarter, driven largely by the recovery in corporate bond spreads in the US, which we believe the market may be reading to indicate that the problems in the US business have abated. We, however, are of a different view. We remain concerned that there is still some risk around rising default rates among corporates in the US which may still impact the group's capital position. While there is a possibility of the group internally funding all subsequent additional capital requirements that such defaults may give rise to, the risk of a dilutive capital raising cannot be ignored completely at this point. The business is not out of the woods yet and therefore, at current prices, we remain of the view that the risk-return profile of the stock is not in our favor. We are still presented with more attractive investment opportunities in our universe that do not carry as high a risk profile.

Discovery, we believe, is one of these attractive opportunities in which we were invested during the period, but was a detractor to performance for the quarter owing to negative sentiment around the potential impact of National Health Insurance (NHI) on their business model. The discussions in the local market around the implementation of NHI took centre stage during the quarter following the leak to the media of a draft NHI document from the government appointed task team. The contents of this draft effectively made no provision for participation in the proposed NHI by the private medical funding industry, clearly a negative for Discovery, an administrator of the country's largest open medical scheme. Has our fundamental view on the prospects of Discovery changed? No. The work we have done gives us comfort that while the implementation of an NHI of some form is very likely, the form that it will take will differ materially from the leaked draft. Politically, there may still be some more negative newsflow as the NHI process is debated, but we believe that in the long term, a solution will emerge that makes provision for effective utilization of resources both in the private and public sector. In such a scenario, a large administrator with scale should be a net beneficiary.

During the quarter we made some changes to the portfolio to take advantage of new opportunities that emerged. One of these was investing the fund into Nedbank. This is a stock that fell out of favour with investors following their enforced capital raising in 2004 and in the period since has managed to produce a decent operational recovery under CEO Tom Boardman. Following the underperformance of the stock, the valuation of the bank has now moved from attractive to compelling trading very close to net asset value versus the peer group which is trading between 1.4x and 1.5x net asset value. New management has taken the reigns at the bank, and we believe continuity has been achieved by the appointment of Mike Brown, from within the ranks of the bank.

Small cap financials rebounded nicely during the quarter and we benefited in the fund from our exposures to asset managers Coronation and Peregrine as well as investments in other small cap financials like JSE Ltd. Our strategy here will remain one where we seek out mispricings of sustainable, strong franchises in the small cap financials space especially during times when the sector is ignored by investors. This is an under researched space and therefore such opportunities do come about more often. Where our conviction level is high, we are happy to take a sizeable position in these stocks.

From the economic statistics that have flowed in recent times, there is no doubt that our economy is undergoing significant slowdown in many sectors and we expect businesses will be impacted by this. We expect that the bad debt ratios on the commercial side of banks' lending books will be impacted as a result. On the other hand, the medicine applied to the economy by the Reserve Bank via rapid interest rate cuts should start to take effect and improve consumer balance sheets with a commensurate improvement in defaults on bank consumer loans and lapses on life insurance products. Put together, we believe that while 2009 will remain tough for earnings for financial stocks, 2010 should provide a good platform for material rebound in earnings, especially for banking stocks whose earnings bases have been lowered by the large bad debt write-offs taken to date. We therefore remain overweight banks, selective in our life company exposures and keenly positioned in those small cap financials where compelling opportunity knocks.

Portfolio managers
Neill Young and Godwill Chahwahwa

The fund returned -5.8% for the first quarter of 2009. Over the same period the index returned -7.0%. Relative to its benchmark, the fund benefited from its holdings in the JSE, Liberty Life Holdings, Discovery and African Bank. During February the fund increased its exposure to Investec plc and Standard Bank, and this contributed to outperformance in the strong upward price moves in these shares in March. The notable detractors from performance were the fund's holdings in Eqstra, Peregrine and RMB Holdings. Over 3 and 5 years the fund has returned -2.1% and 15.4% respectively, outperforming the index over both periods.

The first two months of the quarter continued a brutal period for stocks globally and financial stocks in particular, with the FTSE/JSE Financial index down over 20% to its most recent trough in early March. The price movement subsequently has been remarkably strong - up about 20% - and has eased some of the pain for the quarter. This obviously raises questions as to whether we have seen the bottom. Calling peaks and troughs is not something that we try to do; we attempt to buy shares when we believe they are underpriced and negativity abounds and sell them when we believe the converse to be true. Having said that, there are a few points worth considering:

· From its peak in October 2007 to early March 2009, the value of the domestic financial sector has halved. Net asset values amongst the SA banks have all grown during this period and domestic insurers' embedded values have declined no more than 10%, despite the carnage in equity markets (we exclude Old Mutual from this analysis.)
· The market is a discounter (not always an efficient one) of future information. There is certainly more bad news to come from the world's economies; asset impairments, job losses and further economic contraction. But much of this news is being priced and at some point the market will look beyond this.
· Medicine is being applied. The inability of the global banking system to function properly is the greatest impediment to any sort of recovery. The programmes announced by the US Federal Reserve would appear to be a step in the right direction to restoring this functionality.

While each crisis has its own causes and characteristics, lessons can be learned from those that have gone before. When it comes to previous banking crises, the action taken in the Swedish crisis in 1992 is often pointed to as the most appropriate to restore balance sheet stability and confidence in the banking system. In this instance:

· Government provided a blanket guarantee on deposits.
· The banking system was fully recapitalized and systemically large banks were nationalized.
· A 'bad bank' was established into which delinquent assets were transferred, freeing up the remaining smaller 'good banks' to become viable private sector operators again.

In effect, these are the steps that the Fed has followed over the last few months. While we have not seen nationalization of large banks in the strict sense of the word, what we have seen is preference capital injections by the state. Mandatory stress-testing of balance sheets due for completion at the end of April should result in some clarity as to how much additional capital is required. The US government will ultimately end up owning a not insignificant stake in the US banking sector. The public-private investment program (PPIP) announced towards the end of March is an attempt to remove toxic assets from the banks' balance sheets. There is a still a lot of uncertainty as to exactly how all of this will play out. Equity holders are likely to be diluted as part of the recapitalization and there are question marks over whether banks will be willing to sell assets into the PPIP at market prices. But the basic elements to deal with the crisis would appear to be in place, in the US at least, and at some point the market will look past the work-through and begin to discount this.

How does this impact on the SA financial sector? We mentioned that in the US equity holders are likely to be diluted in the recapitalization process. The anticipation of this, as well as the uncertainty of further large scale write downs, has resulted in developed market banks trading at discounts to their NAVs. There is in effect no confidence that the NAVs will not decline. We would argue that the South African banking sector, while certainly operating in a challenging environment despite a slew of anticipated rate cuts, is a different case. Our banks are comparatively well capitalized, and although earnings have declined in 2008 and are likely to decline again in the year ahead, we believe it is extremely unlikely that the banks will make losses. In other words, recapitalization is highly unlikely, and NAVs are intact and will grow. While some of this is reflected in the fact that our banks now trade at an average 1.3x price to book (which we still believe to be below a fair multiple), there was a stage during the quarter when they traded at a discount to NAV. It is for this reason that the fund remained fully invested during the period, and Standard Bank, the best capitalized of the local banks with little developed market exposure, now constitutes one quarter of the fund.

Markets will likely remain volatile as we muddle through the steps to rid the global financial system of its blockages. We will probably re-test the lows of early March. It's a low conviction view, but we think we've seen the bottom, in the financials at least. Importantly, this doesn't necessarily imply a rapid recovery. We are unable to time these things - although some of the negativity has faded, there is still plenty of it out there. Despite the run in March, we still consider SA financial stocks to be attractively valued. The fund remains fully invested in those stocks that we consider most mispriced.

For reasons now well documented, 2008 will be remembered as one of the great bear markets in financial history. The fund was unable to achieve positive returns in a period in which the financials index returned -26.2. However, it managed to outperform the index with a return of -18.7%. The final quarter of 2008 saw the fund generating -5.4% versus -11.4% for the index. The outperformance can be attributed to an overweight banks position and an underweight Old Mutual position in the fund. The various holdings in small cap financials also had a positive effect on performance. Over the longer term, the fund has managed to generate positive returns and outperform the index, returning 18.2% versus 16.2% for the index over 5 years.

As we move into 2009, one can only pause to reflect on the significance of the year gone by in terms of shaping financial markets into the future. Many lessons will be drawn from the financial crisis that escalated during 2008 and the manner in which business is done globally will without doubt change. The impact of the crisis on the earnings of developed market banks was far more severe when compared to our own banks, indicating that the earnings base of these developed market banks had been significantly boosted by unsustainable profits, most of which are not likely to recur. As discussed in earlier commentary, South African banks were not significantly exposed to subprime assets and generally remain well capitalised. Despite this, our financial stocks were not spared in the sell-off and priced no differently to those of developed markets undergoing structural change. This, we believe, presents opportunities in our universe.

The banking index did better for the year at -10.4% than the life insurance index return of -46.9%. The life sector underperformance was mainly as a consequence of the large fall in Old Mutual's share price (down 64% for the year). The developments in global equity and credit markets exposed significant risks in Old Mutual's US life operations and reduced its attractiveness as an investment. We were therefore sellers of our holding earlier in the year. A change in CEO brings with it the potential for a good, hard look at the group. At its current price, we believe, there is value in the share assuming the US life exposure can be ringfenced, and no large additional capital injections are required. This is the key uncertainty, and given the attractive valuations of other financial stocks on offer in our market, we do not currently view the risk/return trade-off associated with Old Mutual sufficiently attractive to warrant holding the share in the portfolio. Liberty and Sanlam are companies that are owned by the fund, and the operational fundamentals of these businesses have fared well in a tough environment (e.g. new business numbers have been reasonably strong in a tough environment and lapses have not come in as high as we expected.) Our valuations of the domestic life companies also give us conviction that they are intrinsically undervalued, trading at discounts to embedded value of between 20% and 35%.

The banks showed earnings growth ranging from +10% to -10% which is acceptable for this point in the cycle. The major drivers were rising bad debt charges associated with the increasing stress on the consumer, brought about by the higher interest rates and high inflation. What is encouraging to see, though, is that within the banks' portfolios arrear levels for the shorter term assets (e.g. credit cards, vehicle finance and personal loans) are showing signs of flattening out and may even improve with the prospects of lower inflation and hence lower interest rates going forward. Home loan portfolios have, however, showed continued deterioration during the year and may take longer to cure and improve. All these are cyclical factors which will abate, and on our through-the-cycle valuations, banks trade at attractive price to book ratios at 1.5x and forward PE multiples of between 6.5x and 8.5x. We therefore believe the banks still offer value and continue to hold Standard Bank, FirstRand, Absa, Investec and African Bank in the fund.

The other financials arena is an area we believe the fund can continue to add value over time. Many of the businesses in this area tend to be entrepreneurially driven and focussed on niche areas of the financial services market. Many have sold off this year and now offer attractive valuations compared to their intrinsic worth. Currently we favour and hold positions in Peregrine Holdings, Coronation Fund Managers and JSE Limited. We believe asset managers may experience short-term earnings disappointments in tougher markets but have maintained franchise value and therefore retained both their funds under management and key managers. These businesses should improve their earnings base over time as asset levels grow from depressed levels and the potential for performance fee related revenues returns. The JSE is very cash generative and continues to grow trading volumes and still has a long way to go in terms of product innovation and additional sources of revenue when compared to developed market exchanges. We expect superior earnings growth over time, yet one is only paying a fair multiple on current profits.

What does 2009 have in store? We are cautiously optimistic about the outlook for financials. At the December MPC meeting, the SA Reserve Bank cut interest rates by 50 basis points in what we believe is the first of more rate cuts into 2009. The inflation outlook has improved and this too should improve the disposable incomes of South African consumers and have a positive effect on bad debt levels within banks as well as lowering lapse rates within insurers. Our caution is really a question over the extent to which the global slowdown will impact employment in South Africa. Already certain sectors (e.g. mining) have announced retrenchments and we expect more to come. The severity of the slowdown may also impact corporate defaults resulting in higher than expected impairment charges in the banks. We, however, remain confident in the financial strength and franchise value of the local financial institutions we are invested in and take comfort in the margin of safety afforded by the intrinsic values of all our holdings compared to their current prices.

Neill Young and Godwill Chahwahwa
Portfolio Managers