For global equity markets, the third quarter of 2011 was the weakest since Q4 2008 - a quarter that followed the collapse of Lehman Brothers and marked the height of the global financial crisis. Fears of a return to global recession and a lack of concrete action to resolve the European sovereign debt crisis sent investors scurrying for the apparent safe haven of US treasuries. For the quarter the MSCI World Index was down 16.5% (in US dollars), of which 8.6% came in September alone. The impact of these events on our market was that foreign investors, after being net buyers of SA stocks and bonds earlier in the year, turned net sellers, driving the JSE down 5.8% and weakening the rand by 19.7% over the quarter.

The fund return for the quarter of -3.4% was slightly lower than that of the sector's -3.1%. Over one year and the more meaningful three and five-year periods the fund continues to outperform the benchmark with annualised returns of -0.6%, 12.6% and 9.4% compared to -1.3%, 9.3% and 5.2% respectively. It may be worth noting that the index includes an allocation of about 18% to property stocks. These shares have been outperformers over the long term as bond yields have declined. In the last 12 months for example, SA listed property returned 8.3%. With the exception of Capital Shopping Centres and Capital & Counties (previously combined in Liberty Properties), which have slightly different drivers and provide rand hedge qualities not easily found in the sector, we do not consider listed property as part of our mandate and hence do not invest in these stocks. We take the approach that investors in a financial fund specifically seek exposure to financial companies, and would invest directly in a property sector fund if this was where they wanted exposure. So given the lack of exposure to SA listed property, we would consider the fund's long-term performance to be good. In the context of a turbulent quarter, financial stocks fared particularly poorly: the MSCI World Bank Index for example was down 23.4% in US dollars. European banks in particular face very challenging circumstances. Significant sovereign debt exposures cast doubts on the adequacy of capital and the need to raise more, while a lack of willingness to lend to each other has placed pressure on funding costs. The result is that many of these banks trade on forward price to book multiples 0.4x to 0.6x. These sorts of ratings place an implicit cap on South African bank multiples - at face value a 1.4x book multiple does not suggest that our banks are comparatively cheap. While they face a subdued asset growth environment and decades-low interest rates put pressure on margins, they do not sit with exposure to European sovereigns on their balance sheets and their capital positions look very adequate. Some in fact have started to return excess capital to shareholders. We have written extensively in the past on the investment case for SA banks and our reasons for being overweight the sector. Some of these operational drivers have started to play out in the last 12 months, particularly the reduction in impairments. But any sort of rerating in these shares is unlikely until the risk attributed to investing in global banks is removed, and this could take some time. The SA bank sector returned -3.3% for the quarter, and the life insurance sector -3.8%. Year to date however, the banks index is down 3.1% while the life sector is up 3.3% - an indication of comparative fortunes of global financial shares.

Contributors to performance for the quarter were the fund's underweight position in Old Mutual, and overweights in Discovery and Liberty Holdings. Detractors were overweight positions in Investec and Standard Bank, and our lack of exposure to SA property stocks.

The global investment climate remains challenging. We believe that the portfolio is appropriately positioned, but emphasise that the difficulties faced by the global financial sector are likely to persist for some time. It is always difficult to know exactly when value will be realised, but we suspect that the fund's returns are likely to remain subdued in the short to medium term.

Portfolio managers
Neill Young and Godwill Chahwahwa

The fund had a good second quarter with a return of 1.7%, outperforming the FTSE/JSE Financial Index which returned 1.3%. While this performance goes some way to closing the gap with the index over the 12-month period, the fund's performance remains marginally behind the index (17.1% versus 17.3%). Over more meaningful periods of three and five years however, the fund remains ahead of the index with returns of 18.3% (index return: 14.7%) and 11.5% (index return: 7.9%) respectively.

In the past quarter, the banking sector declined 0.9% and continued to underperform both the life insurance and general financials sectors, which delivered 0.9% and 1.6% respectively. Given that our fund is fully invested in banks (in line with our positive investment case for the sector), this has detracted from performance in the quarter. Whenever our big positions move against us, we take time to revisit the investment case and where the case has not fundamentally changed, we view this as an even greater opportunity. In our investment case for banks, advances growth has emerged as a challenging area in spite of interest rates currently being at three-decade lows.

The current cycle has not seen the levels of mortgage lending one would expect given the low interest rates. Lower risk appetite, higher capital demands and higher consumer indebtedness all contributed to this low lending growth which has taken some shine off banks' near-term earnings. We however believe some very important longterm benefits will accrue from this slower loan growth. These benefits include: -Better lending margins. During the boom period of 2004 to 2008, banks sacrificed lending margins for market share, giving rise to the poor returns we saw in the sector over the last two years. This has changed and lending margins have widened to levels where current new business should earn the required return over the long term.
-Better lending criteria should lead to lower levels of write-off. The tightening of credit scoring within the banks means that even though they are writing low volumes of new business, one can expect a lower level of defaults on their new business over the longer term.

In a world where capital is scarce, responsible well-priced lending is the only way to preserve and strengthen franchise value. The core elements of our investment case for banks being a significant reduction in bad debt, improvement in net interest margins both from endowment benefit and re-pricing of lending margins and the release of surplus capital continue to play out. Our assessment of the sustainable earnings base for our banks therefore remains higher than current earnings in spite of the slower asset growth. In addition to the banks and life companies, we also look for opportunities in the small cap financials space where we see meaningful undervaluations. Typically, this area of our universe is under-researched and therefore can be a key differentiator for the fund. During the quarter, holdings in Coronation Fund Managers Limited, Zeder Investments as well as Capital & Counties contributed positively to the relative performance of the fund. Our positive view on asset managers has been vindicated as both Coronation and Peregrine outperformed, and we have reduced these positions as the shares approached our assessment of intrinsic value. We continue to seek opportunities like these to differentiate the fund.

The fund's life sector exposure remains concentrated around investments in Discovery Holdings and MMI Holdings where we see significant undervaluation arising from growth and restructuring opportunities respectively. More recently we have added Liberty Holdings to the fund. This business has started to implement necessary changes to its operating model and we believe early signs of an improvement are evident. Its fortunes are in part geared to investment markets and the share price has lagged those of businesses with similar drivers. We see limited risk of capital loss with acceptable return potential and an attractive 6% dividend yield. The domestic economy is recovering slowly, consumers remain wary of taking on long-term debt and corporate balance sheets are strong and cash flush. Low interest rates are allowing a healthy level of deleveraging for consumers - much needed after the previous strong lending cycle. The focus among financial sector businesses, especially the banks, has shifted from asset growth to delivering acceptable returns on equity and returning surplus capital to shareholders which should support and improve ratings. We believe our fund is well positioned to benefit from this.

Portfolio managers
Neill Young and Godwill Chahwahwa

The fund experienced a somewhat disappointing quarter and ended the three months down 0.8%, while the FTSE/JSE Financial index returned a positive 0.7%. The period was characterised by a reversal of the fortunes of the preceding one, with life insurers (6.4% return) outperforming the banks (1.1%) and the general financial sector (-4.9%). The fund's quarterly return has impacted negatively on the 1-year relative performance (6.4% compared to 6.9% for the benchmark). Over the longer periods of 3 and 5 years the fund continues to outperform its benchmark with annualised returns of 13.0% (index 8.4%) and 8.9% (index 6.3%) respectively.

While as fund managers we are cognisant of the benchmark against which we are evaluated, we do not manage the fund by starting with the index and 'tweaking' it to reflect our stock-picking views. Those stocks in which we have high conviction of long-term value will feature prominently in the portfolio (subject to regulatory limits), and those where we lack conviction will not feature at all. We make the assumption that you (the investor) wish to obtain maximum exposure to financial equities and at the same time mitigate the risk of capital loss. For this reason, the fund remains as close as possible to being fully invested at all times, but in a fully invested equity sector fund such as this there are limits to the ability one has to protect capital - i.e. the former is achievable, the latter not over short periods of time. Volatility in returns is something that is an inevitable consequence of being invested in a fund such as this. However, what we attempt to guard against is a permanent loss of capital, and this influences which stocks are absent from the portfolio.

Old Mutual is an example of a stock that is large in the index but that does not feature in the portfolio for reasons we have expressed in previous commentaries. Over the long term this has contributed meaningfully to the absolute performance of the fund (see chart below), but over shorter time periods can detract. The March quarter is an example of this: after posting an improved set of results and more stable financial position, Old Mutual has increased 15% in value, placing it amongst the top sector performers for the quarter. Naturally the fund has suffered in relative terms as a result. Old Mutual is not the only detractor from performance. The fund's two large holdings in small cap financial shares, Coronation and the JSE Limited, delivered negative returns. More significantly, as followers of the fund will know, we have a far more positive view on the long-term value on offer in the South African banks and are as close to being fully weighted in these stocks as we are able. The banks delivered a marginally positive return for the quarter, but Standard Bank, the fund's largest holding, was down 3.3%. Some of this was justified - the bank delivered disappointing results, is having to realign its international strategy, and has incurred significant restructuring costs in doing so. However, the core investment case for all banks, being a significant reduction in bad debts, an improvement in net interest margins, and the release of surplus capital was in part evident in the most recently published results and will continue to play out in the next 12 to 24 months. We continue to believe that banks' earnings are below normal, in all likelihood will overshoot normality over this time period, and we expect the shares to re-rate accordingly.

Our investable universe is a relatively small one, and for this reason we regularly revisit and test our investment views on all stocks both present in and absent from the portfolio, weighing up the return opportunity against the inherent risk of capital loss. Following the recent disclosure of full year financial results, we have done this once again and find no reason to substantially alter our view on the suitable composition of the portfolio. We continue to believe it is well positioned to deliver superior long-term growth, while at the same time mitigating the risk of a permanent loss of capital.

Portfolio managers
Neill Young and Godwill Chahwahwa

The fund closed the year with a strong 2.1% return for the quarter, ahead of the index decline of 10bps. The quarter was characterised by a flat performance from banks, a 5.8% decline in the life insurance sector and a 5.3% return from the general financial sector. The fund remains comfortably ahead of its benchmark over one, three and five years, with returns of 19.8% (index: 16.6%), 8.0% (index: 3.3%) and 11.5% (index: 7.4%) respectively.

The flat overall return delivered by the banking sector masks some very divergent performances between the big four banks. Nedbank was the worst performing bank for the quarter, returning -11.62%; mainly on the back of HSBC withdrawing their interest in acquiring a controlling stake in the bank. The ungraceful manner in which HSBC walked away from the potential transaction created uncertainty over what we believe is a well run, solid bank and precipitated the price decline. At current levels, Nedbank is looking attractive and we are happy holders of our stake.

The best performing bank was FirstRand, which returned 7.54% in a quarter characterised by corporate action for the group. The first transaction they undertook involved the merger between their life subsidiary Momentum and Metropolitan to form MMI Holdings, and subsequent unbundling of their holding in MMI to FirstRand shareholders. We are bullish about the opportunity offered by the new MMI and following this transaction, MMI is our largest life company holding in the fund. In December, FirstRand completed their group restructuring by selling their 49% stake in OUTsurance to RMH Holdings for what we believe is a fair price of R3.75 billion. This leaves FirstRand as a pure banking group, trading on what we believe is just under 9 times P/E to our assessment of sustainable, mid-cycle earnings. We believe this to be an attractive rating for great franchises like FNB, RMB and Wesbank.

The 5.8% decline in the life sector was driven mainly by the 15.47% fall in Old Mutual's share price. Old Mutual also suffered from HSBC's withdrawal from the Nedbank deal. We have no exposure to Old Mutual and as such, this was a large contributor to alpha for the quarter. Our concerns around the business have been clearly articulated in prior commentaries and the Nedbank deal would have gone some way towards mitigating some of these concerns, e.g. proceeds would have reduced debt at the centre and allowed for meaningful dividends going forward. At current levels, Old Mutual remains unattractive in our investment universe and our assessment of intrinsic value does not provide adequate margin of safety to fully compensate us for the risks in the business. We therefore remain comfortable with our underweight position going into 2011.

For 2010, our holdings in small cap financials like Coronation Fund Managers, JSE and Zeder served the fund well and we continue to see attractive opportunities in these stocks. Operating conditions for banks remain tough with a slow recovery in advances, further rate cuts impacting margins and general economic activity subdued. We however believe that the long-term opportunity still looks attractive. Bad debts have peaked and are improving, while interest rates currently at multi-decade lows will ultimately allow the consumer capacity to take on debt. Going into 2011, we therefore remain overweight banks as well as our favoured small cap financials, while we remain underweight life insurance within the fund.

Portfolio managers Neill Young and Godwill Chahwahwa Client