The financial sector registered a negative return of -1.1% for the quarter.

This was driven principally by the sharp decline in the banking sector (-8.5%), offset to some extent by a strong rally in property (up 6.2%). As highlighted in past commentaries, the fund is overweight the banking sector and underweight domestic property. As a result, the sharp moves in these two subsectors resulted in the fund underperforming the benchmark for the quarter, delivering a return of -3.3%. Over more meaningful periods of 3, 5 and 10 years, the fund has returned 22.8% p.a., 19.1% p.a. and 16.2% p.a. respectively compared with the corresponding benchmark returns of 21.4% p.a., 19.3% p.a. and 15.3% p.a. While alpha remains positive over the 3 and 10 year periods, it has gone marginally negative over the 5-year period.

Our investment case for banks has been articulated in previous commentaries and remains unchanged. During the quarter, the big four banks reported results for the period ending June. These results showed acceptable earnings growth despite the increasingly challenging domestic economic environment. Judicious management of the debtors' books resulted in improving collections and stable bad debt ratios. While some pressure is emerging in specific sectors of the corporate advances books (e.g. mining), the banks have pre-emotively raised provisions to cushion themselves against potential losses, and are therefore well positioned to weather a slowdown. Capital ratios remain strong, well in excess of the Basel 3 requirements, resulting in dividend payments which grew either in line with or better than earnings growth. In our view, there was very little in these results to fundamentally challenge the investment case. We believe the long-term prospects of the banks remain sound, and valuations comparatively attractive in this market.

Turning to the international financial markets, of importance has been the increasing prospects of a rise in US interest rates as growth in that economy continues to take hold. As expectations for the first hike in the US increased, the rand weakened meaningfully along with other emerging market currencies as capital flows moved in anticipation of improving yields in the US. Against this backdrop, inflation expectations in South Africa rose, and with this the prospects for further interest rate hikes into an already slowing economy. We believe that SA banks may have come under pressure over the period as a consequence of this tougher economic outlook. The fortunes of the big four banks are closely tied to the domestic economy, so there is little doubt that growth in bank earnings will slow in the near term in response to this; however, there will be some offset and benefit to bank earnings as interest rates rise. We believe that the valuations at which the banks now trade more than adequately compensate for the slowing economic outlook and therefore provide the long-term investor with an attractive investment opportunity.

The life sector, despite also delivering a negative return, performed better than banks this quarter with a return of -2%. The fund's holding in Discovery contributed positively to performance over the quarter. The business continues to deliver strong earnings growth, but importantly has continued to innovate and enter new markets, which augurs well for sustained growth over the long term. The announcement of an entry into retail banking is their most recent initiative. Given the strength of the brand, we would expect Discovery to be a successful disruptor in this space. In a weakening rand environment, the fund also benefited from holdings in rand hedge stocks such as Reinet and Intu Properties, but missed out on the strong run in Brait after they made two significant acquisitions in the form of Virgin Active and New Look in the UK. While these are good acquisitions, we believe that Brait's current share price more than discounts the upside potential in these businesses, leaving the investor with no margin of safety when investing in the share at current prices.

After the strong returns delivered by the sector over the last ten years, we remain of the opinion that the next ten years will prove more modest. Within what we expect to be a slower growth environment, we continue seeking out those undervalued investment opportunities that have the potential to deliver outperformance for the fund.

Portfolio managers
Neill Young and Godwill Chahwahwa

The second quarter of the year marked a reversal of the strong gains the sector experienced over the preceding 12 months. In fact, this is the first negative quarter for financials since the second quarter of 2013. While the sector delivered a return of -2.3%, the fund ended the quarter more or less flat at -0.2%. Over one year, the fund has returned 18.9% against a sector return of 20.9%. Over the more meaningful periods of 3, 5 and 10 years, the fund has generated annualised returns of 26.4%, 23.0% and 17.9% respectively against the benchmark returns of 24.5%, 22.9% and 16.9%. Encouragingly, alpha is once again positive over all of these periods, albeit still marginally so over 5 years.

Banks outperformed life insurers over this quarter, returning -2.8% versus -5.9%. Over the last 12 months, banks have delivered a total return roughly 10% above that of the life companies. This is a scenario for which the fund has been positioned - we hold a larger weighting in banks, both in absolute terms and relative to the benchmark index. We continue to hold the view that banks are better placed to handle the economic environment that we now face. Life companies have been beneficiaries of a pretty consistent equity bull market over the last 6 years (that has supported their asset gathering businesses and grown their NAVs) and very low interest rates (that have kept lapses in check and lowered the discount rate used to value future profits). In a world in which the domestic equity market overall looks fairly fully valued and interest rates both globally and domestically are set to rise, we view the banks as being in a better position to weather the storm. Banks don't face the same direct exposure to equity markets, and with the proviso that interest rate rises are reasonably benign, the benefit of endowment on capital and "lazy" deposits should outweigh the negative impact of increasing bad debts. In addition, advances are well provided, and capital positions are generally comfortable. From a valuation point of view, banks' ratings are in our opinion defendable (one could argue attractive in this market), trading on forward price earnings ratios of 10 to 12x and fairly bankable dividend yields of 4 to 5%, while in contrast insurers in general trade on price to EV multiples at multi-year highs. Contributors to the fund's quarterly performance relative to its benchmark were the lack of exposure to Sanlam, as well as overweight positions in CapCo, Investec and HCI. The principal detractors were the lack of exposure to Brait and PSG, as well as overweight positions in Attacq and MMI. The fund attracted net inflows for the quarter, much of which was deployed in increasing exposure to banks, as well as to Old Mutual and Reinet. In addition, the fund disposed of its remaining stake in Capitec, and reduced some of its holding in RMI.

These are challenging times for equity investors. Equity markets have registered multi-year gains and certainly can't be thought of as cheap. At the time of writing, Greece has missed its June 30 deadline of a €1.5bn debt repayment to the IMF, and is set to hold a referendum on whether to accept austerity. Greece's future in the euro area remains uncertain and while the longer-term consequences of an exit may be relatively muted for the rest of Europe, the process is as yet untested and likely to be very negative from a sentiment and risk appetite point of view. In China growth is unquestionably slowing, as evidenced in weak commodity prices, declines in housing starts and slowing auto sales. At the same time, its equity market has seen frenzied activity, more than doubling between November and the middle of June and subsequently retreating by 20% in 2 weeks, to which the central bank has responded with further monetary easing. Growth in the US appears to be taking hold, and the biggest question now is exactly whether tightening will commence in September or December. A rise in US interest rates is likely to have an impact on rates around the globe, South Africa included. We've been banging this drum for a while now, but the margin of safety available in the SA financial sector is much reduced, and future returns are unlikely to replicate those of years gone by.

Portfolio managers Neill Young and Godwill Chahwahwa

The strong performance of the financial sector in 2014 continued into the first quarter of 2015, delivering a return of 11.2%. The fund lagged the sector for the quarter with a return of 9.5% (the drivers behind this we discuss in more detail below). Over the last 12 months the fund has returned 30.1% compared to the index return of 33.4%. Short-term relative returns tend to be very volatile, hence our continued focus on longer-term performance. Over 3,5 and 10 years the fund returned 27.7%, 21.1% and 18.4% respectively compared to index returns of 27.3%, 21.5% and 17.8%. Of concern to us is the fact that the five-year returns have now fallen marginally short of the index. We remain focused on returning to a position of long-term alpha across all significant periods.

For the quarter the life sector returned 14.9% compared to 12.6% delivered by the banks. Domestic property delivered the strongest return of 13.7%. The fund does not hold any domestic property, yet this subsector constitutes roughly 25% of the benchmark. This was an important contributor to the underperformance of the fund relative to the index for both the quarter and the 12-month period. With a few exceptions, we have concentrated our efforts in the fund at investing in financial stocks, excluding domestic property, in keeping with constructing the fund as a pure play financials building block. When considering fund performance relative to the benchmark, contributors for the quarter were overweight positions held in Capitec, Discovery and Standard Bank, while overweight positions in Nedbank, HCI and Investec detracted. Liberty Holdings performed exceptionally well during the period on the back of a strong set of results, and given that the fund does not hold the shares, this too detracted. During the quarter the fund experienced unusually strong net inflows, and cash was deployed into a number of existing holdings. We sold some Capitec shares into share price strength, but the fund retains a position in the company.

The fund's largest holding is in Standard Bank. After the recent reporting period for the banking sector, the attractiveness of the opportunity in this business became even more apparent to us. Over the last five years, Standard Bank has been through a process of refocusing their operations outside Africa by exiting non-core operations and redeploying the capital to their SA and African businesses. Stakes in Argentina, Russia and Turkey were sold and the most significant disposal, being the sale of the plc operations, was completed in January this year. Management time and effort, plus the surplus capital previously deployed in these businesses are now being put to work into the higher return businesses in SA and rest of Africa. This should drive ROEs higher over the long term. The rest of Africa is now starting to deliver strong earnings growth after a very long period of investing and building out the network. In their latest set of results, profits from Africa outside SA grew to just short of a third of group earnings, and grew faster than the SA operations. We believe that in time, this will serve to differentiate the group in the SA banking sector.

After the strong run we have seen in the market (outside of resources) and in the financial sector in particular, we believe that valuations are now looking stretched. It is proving much more challenging to find investment opportunities that offer adequate margin of safety. Stock selection remains an important differentiator for the fund and we continue to look for those stocks where downside risks are lower and business models remain robust and resilient in a challenging environment.

Portfolio managers
Neill Young and Godwill Chahwahwa

The final quarter of 2014 marked yet another strong period for financial stocks, with the sector returning 10.8%. This takes the total return for the year to 27.3%, confirming financials as the top performing sub-sector of our market for 2014. For the quarter the fund returned 9.8%, and for the year 25.1%. While these are admirable absolute returns, they lag those of the index. Over the more important periods of 3, 5 and 10 years the fund continues to generate outperformance with returns of 28.6% (27.9% for the index), 21.6% (21.2%) and 17.6% (16.7%).

Banks strongly outperformed insurers for both the quarter and the year, with returns of 15.8% and 32.1% for the respective periods. The fund has an overweight position in banks, and therefore this is a scenario for which it should be well positioned. However, returns within the banking subsector were widely dispersed - Capitec returned an incredible 40% for the 3 months following the demise of African Bank, while Investec returned only 4% - and our relative weightings in these stocks mean that the fund failed to fully benefit from the gains. In addition, the property sector generated comparatively strong returns for the quarter and more specifically for the year, and the fund has very little exposure to these stocks other than the UK-based Capco and Intu.

Contributors to performance for the quarter were the fund's overweight positions in Zeder, Capitec and Discovery as well as underweights in Sanlam (an excellent business but one to which the fund has no exposure given our view that it is very fully valued despite its quality) and Intu. Detractors from performance were overweight positions in Investec, Brait (both the ordinary and the preference shares) and HCI, as well as having no investment in Barclays Africa Group nor Coronation. It should be noted that over the longer 12-month period, the positions in Investec and Brait have contributed meaningfully to performance, while the lack of exposure to Sanlam has detracted.

HCI is a stock in which the fund started building a position over 5 years ago, and at 31 December represented 3.9% of the fund. Over the past 6 months, the share price has declined by 12%, which has resulted in it underperforming the financials index over a 5-year period. Given this, it is worth revisiting the investment case. HCI is an investment holding company 30% owned by the investment arm of SACTWU, the clothing and textiles workers union. It owns a number of assets spanning the transport, property, interactive gaming and clothing industries.

However, its two largest investments are a 47% holding in the listed hotels and gaming group Tsogo Sun, and a 72% economic interest in Sabido, which houses the free to air channel e-TV. Tsogo, although faced with a tough consumer environment, is an attractive business with a strong management team that generates good free cash through a cycle. At the current market price, in our view the stock is fairly valued. Sabido, housing the media assets, has been prominent in the news recently with the very public spat between the HCI founders Johnny Copelyn and Marcel Golding. The latter was the CEO of e-TV before his suspension and subsequent resignation, and some of the weakness in the HCI share price is presumably attributable to these events. e-TV offers the only free to air alternative to a rather underwhelming national broadcaster. In addition, it operates a 24 hour news channel distributed via satellite by Multichoice, and broadcasts in numerous countries across Africa. It is currently investing heavily in a free to consumer encrypted set top box rollout and the building of a content library in an effort to secure a greater share of the advertising revenue pie, and this is depressing earnings. This strategy does not come without risk - broadcasting regulation remains in a state of flux, and the business faces a formidable dominant competitor in the form of DStv. However, both HCI and its co-shareholder in the business, Remgro, have deep pockets and are committed to the strategy, and the business remains profitable and cash generative. In our assessment of HCI, at the current share price one is not paying for these media assets at all. HCI and its investment companies are run by a team of managers with great business acumen and deal-making abilities, and are aligned with shareholders. We find this an attractive investment case in a market that appears reasonably fully valued, and have continued to add to the position as the price has declined.

Globally, probably the most notable feature of the last quarter of 2014 was the precipitous decline in the oil price, plummeting from $95 to less than $60 in the space of 3 short months. This will keep inflation in check both globally and in South Africa, more than offsetting the impact of a weakening rand. Combined with weaker than expected growth in most economies other than the US, this means that interest rates are likely to stay lower for longer, globally and domestically. This takes the shine off the investment case for local banks somewhat. While lower rates may provide some benefit to impairments and possibly to advances growth, it pushes out the endowment benefit banks earn in a rising rate environment, which is more significant. We again caution investors not to expect returns to match the 20%+ compound returns achieved over the last 5 years.

Portfolio managers
Neill Young and Godwill Chahwahwa