The fund continued to build on the gains of the first half of the year, returning 5.2% for the third quarter. This compares to an index return of 6.5%. While the fund's one-year return of 30.1% is respectable, it trails the benchmark index return of 36.5%. Over three years the fund has returned 17.1% p.a. (index 18.8%) and over five years 10.1% p.a. (index 8.1%) We are disappointed with the level of performance relative to the fund's benchmark. There are some technical reasons for the longer-term lag (see our June 2012 commentary), but in the recent quarter we scored some own-goals. Principal among these was our investment in Standard Bank. In contrast with the first six months of the year, the past quarter's performance of the banks (1.9%) diverged quite markedly from the life insurers (12.3%), but amongst the banks Standard Bank and ABSA stood out as the big disappointments. Standard Bank is the fund's largest single position. We have long been attracted to the business for the quality of the domestic franchise and the initiatives undertaken to expand into other emerging markets, anchored by a 25% shareholding by the Chinese bank ICBC. The company's strategy has evolved in recent years to focus exclusively on Africa, and has taken steps to divest of its exposure to Russia, Turkey and Argentina (currently in progress). At the same time, it has maintained a presence in London to facilitate the transactional capabilities of these businesses in global markets. Grouped together, the non-SA businesses have historically generated sub-standard returns, but to an extent this is to be expected as part of the build-out phase. In the first six months of the year the African operations demonstrated that they are starting to deliver on expectations (earnings grew by 84%), but this has been entirely negated by a R250 million loss in the London business. The loss is attributable to an increase in impairments, but more worryingly a large increase in costs to deal with more stringent regulatory compliance issues. The challenge for the bank is to reduce the London plc to a size that will still allow it to execute the Africa strategy effectively, while not burdening the group with prohibitive costs. This is unlikely to happen overnight, but we feel that the decline in the share price now discounts this negative development, and we have chosen to maintain our investment in the company. While the South African operations of Standard Bank, FirstRand and Nedbank all reported strong results in the period, ABSA stood out as the laggard. In our previous commentary we discussed how we had reduced the fund's exposure to ABSA given our concerns about the bank's lending strategy and adequacy of provisions. Their financial results confirmed this view. We believe there is a need for further strengthening of provisions, but as with Standard Bank, we believe the share price adequately discounts the challenges faced by the business, and the position is unchanged. Investec is the one bank that did perform during the quarter with a 10% return, and the fund's 10% exposure contributed positively to performance. The insurers (both life and short term) enjoyed a very strong quarter. The life companies all benefitted from an EV-relative rerating. During the quarter the fund's holding in MMI was increased, and this too was a contributor to performance. Both Santam and RMI (which holds stakes in Discovery, MMI and short-term insurer OUTsurance) performed strongly, in part due to strong underwriting results. The fund holds a position in RMI, but not Santam. Financial stocks have delivered strong returns this year, and it would be unrealistic to expect the trajectory to continue. The tragic events of Marikana, subsequent labour unrest and the recent downgrade of SA's credit rating by Moody's in our opinion all reflect the challenges currently faced by the country. In the short term, we worry that job losses will lead to increasing impairments, particularly amongst the unsecured lenders. Longer term, we suspect that these developments are to translate into a weaker rand, higher bond yields, and more nervous foreign portfolio investors. None of these are positive for equities, particularly banks. However, both SA banks and insurers remain well capitalised, trade on fair multiples and offer attractive dividend yields. We feel the fund is appropriately positioned for what we expect to be a more challenging period ahead.
Portfolio managers
Neill Young and Godwill Chahwahwa

Following a strong first quarter, financial stocks generated 4.6% in the second quarter compared to the fund return of 3%. This brings the year-to-date fund performance to 15.25% against the index return of 17.94%. Over 1, 3 and 5 years, the returns for the fund (and index) are 19.2% (24.1%), 21.5% (21.9%) and 8.4% (6.4%) respectively. While the absolute level of returns is acceptable, we remain cognisant of the fact that the medium-term performance has slipped below that of the index. It is worth bearing in mind that property stocks make up close to 20% of the index but the fund, as a pure play financial unit trust, does not invest in these companies (with the exception of the UK-based property stocks Capital Shopping Centres and Capital & Counties which provide much needed currency diversification). South African property stocks as a whole have performed very strongly over all periods in sympathy with declining bond yields, and the fund has not benefited from this move. (Investors should ensure we are reminded of this when property stocks underperform!) Our processes and philosophy remain consistent and we are confident that in time, our long-term ideas will benefit both our absolute and relative performance. The strong rally in financials in the first half of the year needs to be viewed in the context of a global environment that was very negative for financials in general and banks in particular towards the end of last year. Newsflow around the European debt crisis highlighted the potential for a significant recapitalisation of the European banking sector, while the new Basel III regulatory requirements added uncertainty to the capital and liquidity positions of many banking markets both in the developed and developing world. Against this backdrop, the SA banking industry emerged robust in terms of capital, offering a compelling earnings growth outlook and an undemanding valuation. This was the premise for our bullish outlook on SA banks last year, and we have been rewarded by the 18.8% rally we have seen so far in 2012. In a global context however, this has meant that our banks are now trading at big premiums relative to developed and emerging market banks, an acknowledgement of the current quality difference between the various markets. In a domestic financial fund however, we continue to see SA banks trading below their intrinsic value. In the final week of June, Absa issued a profit warning stating profits are anticipated to decline up to 10% and this precipitated a sell-off across the sector. This we believe presents investors with an opportunity. Our work suggests that the issues impacting Absa's earnings were company specific and have incorrectly tainted the sector as a whole. Earlier in the year we had significantly cut our ABSA position as a result of the concerns we had around their overall lending strategy as well as their level of provisions which we felt were too low. We have therefore taken the opportunity in the sell-off to increase our holdings in the other banks. This is one of those cases where we are happy to be buyers when the market is generally fearful. The domestic life sector also had a strong rally this quarter and year to date, registering returns of 4.8% and 19.1% respectively. Within this sector, the fund benefited from our positions in MMI Holdings and Discovery Holdings. We believe that these great quality investments still offer adequate margin of safety relative to their intrinsic value despite the strong run in share prices we have seen to date. We also continue to believe in the long-term prospects of both Capital & Counties and Capital Shopping Centres, both exposed to the property markets in the UK. Capital & Counties has continued to outperform as they secure their development approvals and enhance their NAV, while Capital Shopping Centres has been weighed down by the current tough UK consumer environment. Capital Shopping Centres own flagship UK retail properties which we see benefiting from any improvement or normalisation of the retail environment. Looking forward, we see the domestic economy continuing to slow in sympathy with the deleveraging story unfolding in Europe, one of SA's largest trading blocks. Inflation has been moderating with the latest expectations from the Reserve Bank Governor for inflation to remain within the target range into 2014. All this is supportive for an outlook where rates remain low for a long time, an environment which should be positive for a continuation of deleveraging by the SA consumer. Bad debts should therefore continue to moderate within the banks while lapse experience at the life companies is not expected to worsen. The rapid growth in unsecured lending into our market continues to be an area of concern for us. Practices like consolidations and term extension have the potential to mask any deterioration in credit experience in the near term with negative consequences over the long term. We feel that we have positioned the fund appropriately to mitigate against these risks as well as to be able to benefit from the valuation opportunities we see in our universe.

Portfolio managers
Neill Young and Godwill Chahwahwa

The first quarter of the year was a strong one for global equity markets, and financial stocks in particular. During the period the fund returned 11.9% against the index return of 12.8%. Over 1, 3 and 5 years the fund (and index) has produced 17.7% (20.2%), 24.3% (24.8%) and 7.3% (5.1%) in annualised returns. While quite acceptable in absolute terms, the disappointing trend in medium term relative returns has not escaped our attention. This is the first time that we can recall slipping below the three-year benchmark, albeit by a small margin. It may be worth noting that this has not prompted a dramatic rethink or altered approach. The way we go about analysing stocks and constructing portfolios hasn't changed - we perform detailed fundamental analysis, interact regularly with company managements, regulators, and competitors, and continually review, question and challenge our investment views. We continue to believe that the portfolio is appropriately positioned.

Encouraging macroeconomic data and optimism that the worst-case scenario being priced into many equity markets would not eventuate contributed to a strong global equity rally in the first quarter of 2012. Two rounds of LTRO (effectively the European equivalent of US quantitative easing) was a significant contributor to this. The injection of cash into the system restored some confidence in European banks, and this reflected in the share prices of financial stocks, pushing the MSCI financials 18.3% (in US dollar terms) during the quarter. SA listed financial stocks followed suit, with banks returning 15.6% and insurers 13.6% (in rand terms).

All of the large financial institutions with the exception of Investec reported results during the quarter. The banks continue to deliver in line with the expectations built into our investment case, and are clearly past the trough of the earnings cycle. Earnings growth exceeded 20%, driven by improved credit losses, moderate asset growth and some margin expansion as a result of asset repricing. The capital positions of all four big banks are strong, and the prospect of a return of excess as the impact of Basel III become clearer remains. As the interest rate cycle inevitably moves upwards these businesses should benefit from improved endowment earnings, and despite having declined notably, impairments have some further scope for improvement. Life insurance companies also reported results not dissimilar from expectations, although it was evident that the middle-lower end of the market is performing ahead of the upper-middle market amongst the traditional players. Excess capital and the prospect of its return, once regulatory uncertainty is resolved, is a consistent theme in this sector too.

The fund's holdings in Discovery, African Bank, Standard Bank and Nedbank contributed to quarterly performance. Offsetting this were underweight positions in Sanlam and Old Mutual, and overweight positions in MMI, Capital Shopping Centres and Capital & Counties (both of which suffered from a 3% strengthening in the rand against sterling). No significant changes were made to the portfolio during the quarter. Small reductions were made to the fund's holdings in FirstRand (price performance) and ABSA (some questions over their asset growth strategy and concerns about numerous senior management departures). These funds were deployed to increase exposure to Investec and Old Mutual, and establish a new position in Brait.

While the US is showing some signs of recovery and a 'slowing' in Chinese growth to 7% - 8% is now considered acceptable, much uncertainty still hangs over Europe. The consensus not too long ago suggested that the worst was behind us. Now there is more caution, with concerns focused on Spain as we write. A renewed hawkishness on Europe is likely to reflect in financial company share prices given that they are at the epicentre of this crisis. This in turn is likely to impact on the ratings of South African financial shares, although as we have highlighted before many of the drivers are quite distinct from those of the global stocks. We continue to see value in the portfolio's investments, with banks trading on forward p/e multiples of 10x, and 1.75x p/book with attractive earnings growth prospects, and insurers ranging between a 15% discount to EV to a par rating for Discovery.

Portfolio managers
Neill Young and Godwill Chahwahwa

Following a negative third quarter of 2011, financials rallied strongly into the fourth quarter of the year. The fund returned 7.1% for the quarter but fell short of the 8.7% generated by the FTSE/JSE Financial Index over the same period. Over one year the fund's return was a disappointing 4.3% when compared to the 7.4% generated by the index. The poor short-term performance has weighed on longer-term performance numbers. However, over three and five years, the fund remains ahead of the index, returning 17.3% (versus 17.0%) and 6.9% (versus 4.0%) respectively.

During 2011, financial markets were dominated by the European sovereign debt crisis, US debt ceiling woes and the threat of a global slowdown or 'double dip' arising on the back of problems in these markets. Policymakers were slow and inconsistent in their response to these challenges throughout the year, thereby creating increasing uncertainty and volatility in global markets. Developed market financial shares in general and bank shares in particular were negatively impacted amid increased regulatory risks and fears around the potential impact on capital of write-downs in debt issued by Greece and other periphery European nations. South African banks have no exposure to debt from these troubled European sovereigns and therefore proved to be much more defensive in this environment compared to both European and other emerging market banks In a global context therefore, SA banks have performed relatively well, but when compared to other domestic interest rate sensitive stocks, or against their own long-term metrics (see second chart below of long-term price-to-book multiple), it becomes clear the extent to which these banks have lagged their own intrinsic valuations, now trading close to their long-term lows in terms of price-to-book valuations. Only in 2003 and 2008 were South African banks cheaper than they are today on this metric.

The global uncertainty and negativity around banks in general provided a cap in terms of any potential rerating of South African banks even as other domestic interest rate sensitive stocks rerated. We are therefore now faced with an attractive situation where the banks remain on low ratings being applied to low earnings bases, which are still to benefit from further reductions in bad debt charges, improvement in interest margins both from endowment and asset repricing, the release of surplus capital as well as a recovery in lending given the current three-decade low interest rate environment.

The life sector outperformed banks in 2011 (20.8% return for life sector compared to 4.5% for banks) and therefore our underweight exposure to this sector detracted from performance for the year. While we benefited from significant holdings in Discovery and MMI Holdings, it was the very strong performance by Old Mutual (+36% for the year) that drove the performance of the sector. Over the long term the fund has benefited from holding very little if anything in Old Mutual, and our reasons for this have been well documented in previous commentaries. During the course of 2011, significant steps were taken to reduce the guarantee risk and some of the structural complexity inherent in the business. As a consequence we started to build a small position in the fund. In December the group agreed to sell its Nordic business for £2.1 billion. This equates to a 15% premium to the embedded value disclosed at June 2011 - a very good price considering where European life companies currently trade. This transaction took us by surprise, and was concluded at a value well in excess of our, and it would seem the markets' assessment of fair value for the asset. This resulted in a 16% increase in its share price in December, and being underweight detracted from the fund's relative performance.

We always seek opportunities to enhance returns by investing in smaller financials, which typically tend to be under-researched and therefore whose trading prices can deviate materially from intrinsic value. One of these opportunities came in the form of Capital & Counties which was one of the big contributors to performance this year. Capital & Counties is a landlord and property development company, spun out of Liberty International and focused mainly on Central London. The share returned 55% for the year, benefiting from a successful repositioning of Covent Garden, their largest property, as a retail destination as well as from progress made in securing planning approvals for their Earls Court development. Going forward, as their development pipeline is converted; we see scope for growth in NAV as well as further enhancement of the yield on their rental property portfolio and are therefore comfortable to remain investors in the share.

Looking forward into 2012, given the uncertain global economic outlook, we believe the South African economy will struggle to show meaningful recovery and should grow in the low single digit range. Inflation pressures are however building and we expect interest rates to start to rise during the second half of the year. We however believe that cognizance will be given to the vulnerability of both the domestic and global economy and therefore the quantum of rate increases is not likely to be large enough to derail economic recovery. In such an environment, credit default rates for banks and lapse rates for life companies should remain under control. While cautious about the macro-picture, we remain optimistic about the positioning of the fund into this year.

Portfolio managers
Neill Young and Godwill Chahwahwa