The financial sector returned 0.4% for the quarter. The fund underperformed the index over the same period with a return of -0.9%, taking its year-to-date return to 14.0%. Over the more meaningful periods of 3, 5 and 10 years, the fund continues to outperform the index, delivering annualised returns of 27.6% (index 27.1%), 20.7% (index 20.3%) and 18.6% (index 17.5%).

Positive contributors to performance for the quarter include holdings in Brait, Santam, Peregrine, RMI and Capitec. Sanlam, a share we do not own in the fund, once again performed strongly and detracted from performance. We continue to struggle to find value in Sanlam at current levels. The domestic property sector's strong performance also added to the fund's underperformance as we do not hold any of these shares in the fund. Holdings in HCI, African Bank and Nedbank underperformed over the period.

Banks and life insurers delivered similar returns for the quarter (-1.2%), offsetting the gains in the short-term insurers and real estate. The big four banks reported results to June 2014, and in all cases produced numbers that were in line with expectations given the current economic conditions. Of significance from a banking industry perspective, however, was the entry into curatorship of African Bank. After battling rising defaults over a period of 18 months, the bank signalled to the market its intention to embark on a second, significant capital raise within the space of a year. The announcement pointed to a significant deterioration in the quality of the debtors' book, which combined with poor trading in Ellerines, gave rise to further trading losses. This necessitated a recapitalisation of the business and the departure of the CEO and founder of the bank. The proposed rights issue, however, was not underwritten and no credible plan of action was put forward to stabilise the bank and return it to sustainable profitability. Ellerines was sent into business rescue and the South African Reserve Bank (SARB) stepped in and placed the bank under curatorship.

The curatorship process entails the creation of a "good bank" and "bad bank" structure with a consortium of banks committing to recapitalise the "good bank" and the SARB purchasing the "bad bank". Preference share and subordinated debt instruments have been written down to zero, while senior funders have suffered a 10% haircut. The fund held a 1.3%-position in the ordinary share equity of African Bank and the write-down of this investment impacted negatively on performance for the quarter. We were aware of the risks that investing in the company brought, but after extensive work felt that there was a reasonable prospect of a successful turnaround. In that scenario the potential return warranted an appropriately sized position in the fund. Clearly in this instance we got it wrong. This will happen from time to time in the construction of a portfolio (if we are doing our job correctly, less often than more). The greater mistake, though, would be to fail to take the learnings from this experience and apply them to investment decisions that we make in the future.

A direct consequence of this event was the subsequent downgrade of the other South African banks by Moody's. This course of action was not followed by peers such as Standard & Poor's (S&P). We are of the view that what happened to African Bank was largely company specific and as a result there should not be a direct read through to the industry as a whole. The big five banks remain resilient. Unsecured lending is a small part of their books, but importantly is well covered by prudent provisions. There is no doubt the failure of African Bank will continue to have ripple effects across the economy, but this does not alter our position on the remainder of our bank holdings in the fund. The fund continues to hold a position in Capitec.

Consistent with our views in past commentaries, our outlook on financial sector returns remains cautious, particularly compared to the returns achieved over the past 10 years. Current valuations are demanding across our market and we find ourselves in an environment where we will have to dig much deeper to find attractive, undervalued investments.

Portfolio managers
Neill Young and Godwill Chahwahwa Client

The financial sector continued its strong performance into the second quarter, returning 7.8% for the three months. Over the same period the fund outperformed the index with a return of 9.2%, taking the year-to-date return to 15%. Over the more meaningful periods of 3, 5 and 10 years, the fund continues to outperform the index, delivering annualised returns of 26.5% (25.6% for the index), 24.9% (23.6% for the index) and 20.7% (19.3% for the index). Banks outperformed life insurers during the quarter, an outcome for which the fund has been well positioned. In addition, the fund benefited from having no exposure to domestic property. More specifically, contributors to the fund's relative performance were its overweight positions in Zeder, Brait, Investec and Discovery. Detractors from performance were overweight positions in African Bank (although at less than 2% of fund) and Nedbank, as well as not having exposure to Sanlam (an excellent business that makes up a large component of the index, but where we find no margin of safety at its current share price).

Zeder is an investment holding company focused on food producing and agricultural assets. Its largest asset is an investment in Agri Voedsel, which in turn has as its sole asset a 30% economic interest in Pioneer Food Group, the listed food producer. Pioneer is a business that we know well, and is owned directly across our client portfolios. Zeder currently owns 48.5% of Agri Voedsel, but has made an offer to acquire the remaining shares it does not own. The company is proposing to issue new Zeder shares in exchange for the Agri Voedsel shares it wishes to acquire - a mechanism that we would consider to be value accretive to Zeder shareholders should the deal go ahead. Agri Voedsel currently trades overthe- counter, and there is uncertainty as to whether the FSB (as regulator) is willing to allow this to continue, which would leave the shareholders of Agri Voedsel holding an untradeable asset. We, and it would appear the market, consider the likelihood of the transaction going ahead as high given that Agri Voedsel are able to swap their shares into a listed, tradeable instrument in the form of Zeder shares, but at the same time maintain exposure to the same underlying asset. During the month of June, the share rose 25%, presumably in response to the proposed transaction. The share makes up a 4% position in the fund, and was the single largest contributor to outperformance during the quarter.

One may wonder why we devote so much attention to a small business such as Zeder, or indeed how a holding company for a food producer finds its way into a financial sector fund. Zeder falls under the Specialty Finance subsector, and therefore falls within the fund's benchmark. More importantly though, the relatively narrow and well researched large cap universe in which we have to operate (5 large banks and 5 large life insurance companies) means that we must often look outside of these narrow bounds to find mispriced assets that can deliver meaningful outperformance. It is for this reason that investors who have scrutinised the portfolio closely in the past will be familiar with investments such as Brait, HCI, Reinet, and of course Zeder. We continually look for stocks that may otherwise escape investor attention, and many of these have contributed positively to the fund's performance over the years.

We continue cautioning investors that the returns achieved over the last 10 years are unlikely to continue at these levels. We have been surprised by the strong performance of the sector in 2014 thus far. Our market has moved in sympathy with global equity markets (which continue to benefit from the availability of cheap money) and seems to have been immune to the longest strike on record as well as a sovereign credit rating downgrade, which has a spill over impact on the credit ratings of our banks. While we don't believe financial sector stocks as a whole are significantly overvalued, we are finding it increasingly challenging to identify mispriced assets.

Portfolio managers
Neill Young and Godwill Chahwahwa

The fourth quarter was very strong for financials with the fund returning 8.1% compared to 6.9% for the index. This brings the fund return for the year to 25.2% against 19.1% for the index. The fund has generated positive alpha over the more meaningful periods of 3, 5 and 10 years, delivering 21.1%, 22.4% and 20.3% versus 20.9%, 21.4% and 18.8% for the index respectively, while at the same time remaining within the top quartile among its competitor peer group.

The strong showing from general financials continued into the fourth quarter of 2013 with strong returns from Peregrine (up 29.8%), Sasfin (up 23%), Brait (22.7%), Coronation Fund Managers (up 20.2%) and Investec (18.6%). The fund benefited from ownership of all of these stocks with the exception of Coronation, which we do not hold. Despite the strong returns, we believe the shares we own continue to trade below our assessment of their intrinsic value and continue to command a place within the portfolio going forward.

The fund has a meaningful position in the banks, which again lagged the overall financial sector in the quarter (the big four in particular). All four banks presented results to June 2013 in the September quarter, and have subsequently provided trading updates. We find very little in these numbers that we believe could derail the long-term investment case, or impair our assessment of the intrinsic value of the banking franchises we own. The prospects of rates rising and having a negative impact on impairments in the short term may concern the market, but we feel that this should be more than offset by the benefits derived from positive endowment, i.e. interest earned on capital and free deposits.

The banks remain well capitalised to withstand any shocks with good prospects for growth, all of which does not appear fully discounted in the current ratings.

The life sector has continued to perform strongly during the quarter and as such the fund's underweight position in Old Mutual and Sanlam detracted from performance over this period. Valuations in the life sector remain demanding and therefore we have continued to favour holdings in Discovery (where we see attractive growth opportunities) and MMI (where we believe downside risks are limited). Both shares are therefore trading with some margin of safety to our assessment of their intrinsic value.

The unsecured lending market has seen a significant slowdown during the 2013 year with impairments rising and profitability margins normalising at lower levels. African Bank in particular suffered a meaningful rise in bad debts and had to recapitalise the business via a R5.5 billion rights issue to bolster capital. In the process, they took the opportunity to increase provisions and move to more conservative provisioning methodologies. While we still expect conditions to remain tough in the medium term, we believe that corrective action has been taken within the business. The share, however, continues to trade at very depressed levels relative to its long-term potential and we have therefore added African Bank to the portfolio.

Overall, 2013 has once again been a very strong year for financials, and after compounding returns at close to 20% per annum over 10 years, we continue to caution against expecting returns over the next 10 years to be as strong. Valuations and earnings bases today are much higher than they were a decade ago and the challenge to grow becomes increasingly more difficult. In view of this we have appropriately positioned the portfolio to weather what we believe to be a tougher outlook going forward.