Following a negative second quarter, the financial sector staged a recovery in the third quarter with a return of 15.2%. The insurers (up 20%) again outperformed the banks (14.5%). As detailed in previous commentaries, the fund holds a high weighting in banks, and consequently underperformed the index for the quarter, returning 13.7%. The result of the past 2 quarters' relatively disappointing short-term performance means that over one year the fund has generated returns roughly in line with those of the index (24.1% versus 24.3%). Over what we would consider to be the more important longer term periods, the fund continues to meaningfully outperform the benchmark.

The high return of the insurance sector is almost entirely attributable to the performance of Old Mutual. During the quarter it announced a transaction (not yet concluded) to dispose of its troubled US life business, as well as the proposed acquisition by HSBC of a controlling stake in Nedbank, of which Old Mutual owns 54%. These transactions are significant, particularly the former. As discussed in previous commentaries, the US life business presented the share with significant downside risk, to the extent that at the peak of the credit crisis it had the potential to threaten the solvency of the entire group. Disposing of this business will significantly alter the risk profile of the group, and one can now increase conviction in an assessment of any potential downside in the share price. The Nedbank transaction too is significant. If concluded, the proceeds will be used to reduce offshore debt levels and allow the company to resume the payment of more meaningful dividends. Not owning the share has cost the fund performance in the current quarter, but despite the reduction in risk profile the fund remains uninvested in the share. Over the long term Old Mutual has been a very poor performer for a number of reasons, not least of which is overpaying for assets in its internationalization strategy.

This in our view extends to the Skandia business, for which Old Mutual paid £4 billion in 2006, and carries at £3.75 billion in its most recently disclosed embedded value. More than half of the profits of this business are earned by the UK Wealth Management unit, where we believe it will be extremely challenging to defend the current earnings base as regulatory reform and increased product commoditization start to erode margins. The share price has appreciated to a level close to that which we would consider to be fair value for the group. While the downside risk has been significantly reduced, we feel that the market has adequately priced the opportunity in the share and it therefore holds little attraction for us. Contributors to performance for the quarter came from the fund's holdings in Coronation, Nedbank (benefiting from the HSBC bid) as well as CapCo and CSC (previously together as Liberty International). Aside from not owning Old Mutual, detractors from performance were the fund's holdings in Metropolitan, Discovery and Standard Bank.

We have started to see the investment case for the fund's heavy weighting in banks play out - i.e. the unwind of bad debt provisions and the resulting reduction in the bad debt expense as the benefit of lower interest rates is felt in the pockets of consumers. It would be fair to say that in the June reporting season, the extent of this unwind has been somewhat disappointing from our point of view, with the possible exception of FirstRand. However, we believe that this is largely an opportunity deferred, and expect to see a more definitive unwind in the next 6 to 12 months.

Real wage increases and yet another interest rate cut in the quarter is undoubtedly good for those consumers still employed, and hence for the banks' retail businesses. However, we are increasingly concerned that corporates are able to afford these increases only by managing the entire wage bill, i.e. reducing the workforce. Consequently pressure on levels of employment combined with a stronger rand and its impact particularly on the manufacturing and mining sectors causes us to be slightly more cautious on the prospects for the domestic economy, and hence on some of the other important drivers of bank earnings, particularly loan growth.

Portfolio managers
Neill Young and Godwill Chahwahwa

After a strong start to the year, financials had a tough second quarter returning -7.8% for the overall Financial Index, with banks (-9.9%) underperforming life companies (-6.5%). The fund has a heavy weighting in banks and was therefore not spared from the sell-off, yet still managed to outperform the index with a return of -7.6%. Over more meaningful periods of one, three and five years, the fund remains ahead of its benchmark, yielding 28.3% versus 24.3%, 2.4% versus -2.2%, and 12.9% versus 11.1% respectively.

Going into the current year, we presented a bullish view on the SA banking sector. After the sell-off in banks during the past quarter, our view has not changed at all. The same investments we felt where cheap at the end of the previous quarter have become cheaper and we have therefore maintained the fund's large exposure to banks. It is important, however, to explore what we believe are the reasons for the sell-off in banks and financials as a whole.

During the quarter, investor concerns where escalated when it became clear that the Greek fiscal position was worse than the country had previously stated, and certainly worse than the market expected. The potential for default by Greece loomed and its implications for the Eurozone economy and the banking system as a whole would have been dire. Investor scrutiny moved to similarly weak economies in the Eurozone namely Portugal, Italy, Ireland and Spain (collectively dubbed the 'PIIGs'). The potential for contagion increased to a point where the ECB, IMF and Eurozone governments had to step in to provide funding lines to the government of Greece in exchange for fiscal reform. Against this background, banks sold off globally and our own banks, despite having no exposure to Greek debt, were not spared. Europe has shown some signs of stabilising and commenced the long process of resolving these issues, but our own banks have still not recovered and herein we see the opportunity. More recently, newsflow around heightened bank regulations and new bank taxes emanating from the US may be responsible for keeping investors out of the sector. We believe that if one cuts through the noise, it remains clear that all the positive drivers for South African banks in the form of unwind of bad debts and normalisation of credit margins remain intact and will drive earnings going forward. South African banks are well capitalised and we believe the local regulator will be very careful and not follow any regulations established in other markets should such regulations be detrimental or not relevant to our banking system. In our view, the fund's high bank weighting remains supported. The fund was invested in Liberty International, a property company with assets in the United Kingdom. We believe that this offers a great opportunity into what is a depressed, but attractive property market in addition to providing currency diversification for the fund. During the quarter, Liberty International was split into two businesses, namely Capital Shopping Centers, focusing on the UK retail shopping centre real estate market and Capital and Counties focusing on development opportunities in the London area. We continue to hold both assets and believe that the split will bring about greater focus on the part of the management teams on the opportunities in their respective markets. As the UK property market normalises, these investments should benefit both in terms of improved occupancies and lower capitalisation rates.

The environment for financial stocks in SA continues to improve. Interest rates are at low levels and consumers are taking time to deleverage personal balance sheets as their disposable incomes increase. This will come through in improved bad debt ratios for banks and lower lapse rates for life companies. Given the high levels of debt to disposable income, rising unemployment and weak global demand, we do not believe that advances growth for banks will be a meaningful driver to earnings in the near term. At the same time, there is reason to believe that while employment and global demand remains weak, rates will remain low for longer. In the medium term, as economic activity returns to more normalised levels demand for credit is likely to recover and risk appetite amongst lenders is likely to increase. We have therefore positioned the fund to benefit from this outlook.

Portfolio managers
Neill Young and Godwill Chahwahwa

Financial shares continued their strong gains in the first quarter of 2010. It is now just over a year since equity markets bottomed, and over this time the Financial Index has rebounded by over 80%. It is worth noting though that at the end of March the index was at the same level it was three years before. The fund returned a pleasing 11.7% for the quarter, ahead of the index return of 9.9%. Over 1, 3 and 5 years the fund has continued to outperform its benchmark with returns of 53.3% (51.3%), 4.4% (-0.1%) and 15.8% (14.1%) respectively.

The quarterly outperformance was due largely to the fund's significant exposure to banks (65% of fund) and a 7.5% holding in Metropolitan Holdings. The fund's holding in Liberty International detracted from performance. Very few changes were made to the portfolio during the quarter; share price appreciation and the relative valuation opportunity caused us to halve our holding in African Bank and invest the proceeds in Absa and FirstRand.

SA's big four banks reported full year earnings in the quarter, and it is clear that we are either very close to or at the top of the bad debt cycle. As we commented in our previous quarterly, as bad debt provisions unwind and loan growth starts to pick up again these businesses will demonstrate strong earnings growth. The potential extent of this growth is increasingly being recognized, and the banking sub-sector was one of the top performers in our market over the period.

Metropolitan Holdings was a last minute contributor to the fund's outperformance. At the end of March, the company announced its intention to merge with Momentum, the 100% held subsidiary of the First Rand group. We have long believed Metropolitan to be a decent quality business with strengths in the entry level insurance and closed scheme medical aid administration markets, but one which has been underappreciated and hence undervalued by the market. The group sits on a capital base in excess of its requirements, and opportunities for improved efficiencies exist within its cost base. It has no banking partner, nor a controlling shareholder, and we have consistently held the view that it would make an attractive acquisition target. A merger with Momentum should exploit many of these opportunities - there is limited overlap in the two businesses' target markets, but the combined operations should be able to achieve both cost and capital synergies. The merger is to be structured on an embedded value-for-embedded value exchange ratio, which we would consider to be fair given what we know of the quality of the two businesses. First Rand intends to unbundle its shareholding in the merged entity, so in addition to the direct holding in Metropolitan shares, the fund will benefit from its 10% holding in the bank.

The fund continues to hold a large weighting in bank shares, premised on the fact that despite their recent outperformance, these businesses have the potential to generate positive earnings surprises in the medium term. The SARB's surprise rate cut in March (taking the prime overdraft rate to its lowest level in nearly 20 years) increases the likelihood of this scenario playing out.

Portfolio managers
Neill Young and Godwill Chahwahwa

The final quarter of 2009 saw a rally in financials with the index rising a further 6.52% to bring the year's gains in financials to 28.03%. While the fund lagged the index for the quarter with a return of 5.69%, it continues to outperform the index over longer periods. Over one, three and five years, the fund returned 29.25%, 3.67% and 13.65% versus the index's return of 28.03%, -0.88% and 12.25% respectively.

During the quarter, the fund performance benefited from the large weightings in small capitalisation financials in the fund management space namely Coronation, Peregrine and Brait. Performance for the quarter and for the year was negatively impacted by the strong performance of Old Mutual, Sanlam and FirstRand; all stocks we were underweight versus the index. The fact that the fund has a zero position in Old Mutual warrants a mention. It is a stock that we sold during the third quarter of 2008 on concerns around capital adequacy and a lack of strategic leadership. At the time we felt that the deterioration in the bond portfolio of its US life business had the potential to trigger a large loss and a significant capital raising event. The share has since recovered to trade at similar levels to those at which we sold the fund's holding. This recovery has coincided with the recovery in corporate bond spreads in the US. The fund has not owned the share during this time and therefore did not participate in this recovery. This is because we have consistently felt that the potential for value destruction has outweighed the potential upside in a recovery in the corporate bond market. We are over the worst and the capital position looks healthier, but we remain of the opinion that the risk of rising corporate default rates remains and still has the potential to impact the capital position of the business. While there have been positive management changes and some refinement of the group strategy, the share price has risen commensurately. This does not offer us adequate margin of safety in light of these lingering risks.

Going into 2010, we remain very bullish about banking stocks and their ability to generate positive earnings surprises. We have therefore been increasing our overall bank exposure during the quarter. Over the last two years, bank earnings have been impacted by massive increases in bad debts as the South African consumer took strain from high levels of indebtedness and rising retrenchments. For example, in the first six months of 2009, banks wrote off a combined R19.6 billion in impairments compared to a total profit pool of R39 billion for the full 2008 calendar year. Any reduction in this bad debt charge will have a meaningful impact on earnings growth. We are already seeing early signs of an improvement in the bad debt picture across the banks, especially in their consumer portfolios as the effects of lower interest rates start to benefit individuals' cashflows. The strong rand and continued job losses may pose risks to this view, but we believe this is being discounted in the current valuations.

Small cap financials were big winners for the fund over the 2009 year. Asset managers like Peregrine, Coronation and Brait were among the top performing financial stocks. These shares are geared to equity markets and in this environment earnings benefit in two ways - increased base fees as a result of growth in funds under management as well as a recovery in performance fees. This year we have seen the benefit of rising funds under management coming through earnings and we believe these stocks will benefit from improved levels of performance fees in subsequent years. The shares have rerated strongly on this improved equity market outlook.

Our exposure to the life sector comes via our holdings in Discovery and Metropolitan Holdings. Discovery is a well run, innovative company which continues to grow into the local and selected offshore markets. During the quarter, they announced the launch of a joint venture with Chinese life insurer Ping An which will give them access to the Chinese healthcare market. Expansion into offshore markets has not yielded positive results for Discovery to date. We do however remain comfortable with our investment in Discovery as the investment in the venture remains relatively small versus the potential it can bring for the business in the long term.

Given the sharp recovery in financials in 2009 (+29.22%), it is clear that the easy money has already been made. The sell-off of 2008 was indiscriminate and left good quality stocks at very attractive valuations. A lot of these ratings have corrected in 2009 and 2010 will be a year in which strong earnings growth is needed if stocks are to show meaningful returns. We believe that the banks are poised to deliver this growth into 2010 and 2011 on the basis of an improving bad debt picture and have positioned the fund to benefit from this. Our general outlook however remains cautious given the tough economic picture that we face in South Africa - rising unemployment, a strong rand and rising electricity costs. Falling interest rates will eventually work and provide some relief to the indebted consumer and drive a recovery in economic activity.

Portfolio managers
Neill Young and Godwill Chahwahwa