The last quarter saw the spectacular reversion in the long commodities, short financials and industrials trade of the past two years. In a relatively short period there has been a wholesale sell-off in the commodity complex, reversing all the gains achieved and more. Given the size of commodities in the SA equity market, this has resulted in negative returns for the index as a whole. For the quarter, the fund's benchmark Top 40 index was down 23.3%. The fund, due to its strategic positioning, was down only 4.9%, delivering an incredible 18.4% alpha for the period.

This year has seen a significant increase in the volatility of equity returns. This seems to have accelerated even further in recent months. A combination of the credit crisis allied with a global slowdown and huge nervousness by all investors has seen daily share price moves in excess of 15% become commonplace. While this was once the preserve of small cap shares, it is now happening in megacap shares with market capitalisations in excess of R100 billion. Clearly fundamentals do not change sufficiently in one day to alter the value of a business by R15 billion. What we are seeing are the classic fear and greed trades driven by sentiment, as opposed to investing based on fundamentals.

By investing based on fundamentals and ignoring the shortterm noise, the fund has managed to avoid a lot of the market pitfalls, maintaining its strong long-term investment track record. Until recently we have recommended avoiding resource shares due to stretched valuations and high earnings bases. In this recent sell-off we have seen ratings plunge dramatically, but are still waiting for the lower commodity prices to feed through to the earnings bases. This is making stock selection more interesting as a number of these companies are starting to offer value.

We are being careful not to rush in just yet as the short-term global outlook for commodities is not great while the global deleveraging takes effect. That said, we are long-term investors and on a 5-year view we are certainly identifying and taking advantage of some good opportunities. One investment outside the commodity space is MTN. This share was fully priced as recently as 3 months ago driven by speculation over corporate action. This has now dissipated along with its premium rating. A business which the 'punters' were valuing at close to R300 billion in June is now valued at close to R200 billion. Thinking in enterprise value reflects exactly what we do: invest in businesses rather than share prices. At these levels we now think the share is trading below fair value and offers a nice diversification into growth opportunities outside of South Africa.

Globally, equity values are at the lowest levels we have seen in over 20 years and trending lower in the short term. We see this as an opportunity. Similarly, SA equity markets are feeling the same pressure and again we think the capital creation opportunities are immense. We cannot call markets in the short term, but on any kind of longer-term view we think that equities are cheap and based on our research we believe the portfolio, as currently constructed, will provide superior market beating returns into the future.

Neville Chester
Portfolio Manager

It was another difficult quarter for global equity markets, the SA equity market and the fund. The theme of global stagflation, combined with rising commodity prices continues, resulting in falling equity prices except the resource sector, though even here the returns have not matched the moves in commodity prices. The fund returned 1.4% for the quarter against the FTSE-JSE Top 40 index return of 5.3% We have entered a remarkable period in the equity markets. While we always warned that the returns earned for the past 4 years would not be repeated, the actual decline in SA industrial and financial stocks over the past 6 months has been extreme. It is an exciting time for investors to be able to get into the equity market and once again achieve stellar returns over a 5 year investment view (as achieved over the 5 years to the end of 2007). Glancing back to 2002 one can identify remarkable similarities within the economy: the sharp domestic equity decline after a strong rand sell-off and the concomitant rise in interest rates. At that time local financial and industrial shares were also reduced to 5 and 6 PE multiples and the lack of interest from foreign and local investors was at an all time high. Resource shares and rand hedges had outperformed strongly and there was little interest in the beaten down domestic sector. This was an environment which created the perfect base for the raging bull market enjoyed thereafter, with 30% plus returns for the market over the next few years. Buying opportunities are never clear cut in a market driven by sentiment. Obviously the outlook and economic expectations need to be cloudy or else the share prices would never fall to such attractive levels. The true long term investor needs to look through the short term gloom and identify truly good businesses which are trading on unrealistically low valuations. As we have said many times before, we don't buy in anticipation of 'catalysts'; this is a red herring because once a catalyst is known it is reflected in the price. Rather, we buy where we have confidence in the long term earnings power of a business and therefore confidence in its normalised valuation. Thereafter the passage of time always results in the true value being unlocked. Today the fund has built up big positions in great businesses with fantastic long term earnings track records at very attractive valuations. Big positions in Naspers, Richemont Remgro, Standard Bank and Tiger Brands are the core holdings of the fund. All are businesses which have survived many cycles comfortably before and have delivered strong earnings growth which provide the compound returns that create shareholder value. The core characteristics of these businesses are great cash flows, geographic and product diversification and shareholder friendly management. Broad market sell-offs, of the most recent kind, tend to bring down all companies regardless of quality. It creates the opportunities to get the really good businesses in this country at similar ratings to the average and poor quality businesses. This is an opportunity which does not come along every day and one that investors with a long term outlook should be embracing.

Neville Chester
Portfolio Manager

The first quarter of 2008 was marked by a similar performance in the local equity market to what we saw in the last month of 2007. The disconnect between local industrial and financial shares and the commodity producers was stretched even further. The All Share Index returned 2.9% against the fund's - 4% due to our lower weighting in resource shares and exposure to domestic stocks.

In building a portfolio from bottom up stock picking we also do a top down review to ensure that there are no unintended bets in the portfolio on a macro level. Based on our view that the rand was likely to weaken we had built up a number of rand hedge holdings, such as Richemont, Impala platinum, Exxaro, Sasol, Remgro, Naspers, Netcare, MTN and SAB. However, in January the Eskom failure to provide power to the mines both pushed up the prices of SA sourced commodities and triggered a massive sell-off in the rand. The net result being that the commodity shares in SA ran extremely hard and given our overall underweight position in commodities the relative performance of the fund was negatively impacted.

Focussing firstly on the localised element we believe that this is likely to be a short lived situation. Eskom and the mines have reached agreement on providing the necessary power and on how the mines can regain their previous productivity using less power. This will result in mines achieving close to their previous production levels. At the same time, to the extent that metals hold their higher prices, SA will be earning significantly more for its exports than three or six months ago. This will have a significant impact on the current account deficit as seen in 2002 post the previous currency crisis. Concurrently we have already seen imports fall rapidly due to the weaker rand and the impact this has on demand for expensive imported goods. Fundamentally the rand is oversold and will come back somewhat from its current levels.

Secondly, looking at the greater macro picture it is evident that commodities have become an alternative asset class to equities. The negative correlation between the S&P and commodities is very clear. There is a lot of 'hot' money which has moved into commodities, helping to sustain current high levels despite the fact that growth in the world is slowing rapidly. When risk aversion reduces and we see money beginning to flow back into equities (and US equities in particular) we will see a very rapid unwind of the speculative positions in commodities, which will see these prices retreat significantly. We have seen a couple of false starts on this front already and once again it seems that this may be in the process of happening. During this recent commodity boom the commodity companies' cost of production has sky-rocketed due to a number of cost pressures; any negative move on the top line is likely to be magnified significantly on the bottom line through margin compression. The net result is that we remain heavily skewed in our portfolio to industrial shares and those commodity shares that we do own have their own specific drivers. Platinum is almost entirely SA produced and hence its cost of SA production will set the price, which gives us confidence on its ability to maintain margins. In addition our holding of Impala gives us access to its Zimbabwe operations which we believe are significantly undervalued by the market. Exxaro is one of the main independent coal producers in SA, given the planned introduction of three new coal fired power stations over the next eight years they stand to benefit significantly from the increased off-take.

Our big holdings in Remgro and Richemont stem from undemanding valuations and the potential for a large discount unlock with the BAT unbundling (the timing of which has not yet been announced). Naspers, the media and internet business, continues to trade at a huge discount to its underlying business valuations. Stripping out its listed businesses and recent investments the core operating businesses are trading on an extremely low cash flow multiple.

Standard Bank, our biggest banking position, was reduced slightly during the period by the Chinese bank, ICBC, buying 10% of our holding at R136 a share. The share currently trades at R94 which is a significant discount to our estimation of fair value and gives very little credit for its unique African growth profile.

In selecting companies to own it is crucial to look at the margin of safety and to where the balance of the risks are skewed. We are very comfortable with the current portfolio given that most of the companies are pricing in most of the negative news and giving no credit for any potential upside. This is in contrast to a lot of the commodity shares which are priced for most of the good news and little room for disappointment.

Neville Chester
Portfolio Manager

The final quarter of 2007 was a difficult one for equity markets as the JSE sold off on global fears as well as concerns over a more difficult domestic market brought on by higher interest rates. The FTSE/JSE All Share Index fell by 3.0% while the more defensive positioning of the fund resulted in a smaller decline of 1.4% for the quarter. As noted in previous reviews, the returns generated by the market in 2007 have been driven by very few stocks, with the top 5 stocks generating 91% of the market's return for the year. This trend continued in the final quarter, further exposing valuation opportunities in the local market.

There were no major changes in the composition of the portfolio in terms of new positions; however modifications were made to existing holdings. We have been reducing our holding in Sasol due to the extremely strong run in the share, resulting in it moving past our estimation of fair value based on the long term normalised oil price. The performance of Sasol in 2007 was a classic case of how short-term thinking can ignore the long-term value to the detriment of investors. In the early part of 2007 the single-minded focus of the market on a potential windfall tax completely ignored the substantial business interests outside of South Africa as well as the potential additional revenue the company would be making were oil prices to remain above the long-term level in the so called 'windfall' price range. The weak price during this period enabled us to build up a substantial holding, which has appreciated remarkably once the concerns over the windfall tax dissipated. Now the market has moved to the other side of the fear/greed equation with a focus purely on the currently very high oil price, which is not sustainable in our opinion. As the oil price normalises we expect the Sasol price to once again revert close to its fair value and accordingly have been reducing our holding.

We have been adding to our holdings in businesses where currently the sentiment is quite negative and investors are ignoring the long-term fundamentals of these companies. Standard Bank, which recently completed a major transaction with ICBC the largest bank by market capitalisation in the world, is languishing below R100 despite the fact that ICBC will be paying R136 for 11% of shareholders' holdings. One can only wonder what happened to the vocal opponents to the deal who felt R136 undervalued the share; they seem to be ignoring a great opportunity to buy the share at a substantial discount to this price. It is however a great opportunity to invest in a business with an extensive growth profile in emerging markets at a cheap valuation.

We also added to our holdings in Tiger Brands and Richemont, a defensive branded consumer goods company and a rand hedge respectively. Both shares have been core holdings for some time but are currently looking particularly attractive.

The portfolio remains well structured and focused on excellent businesses with strong cash flow generating characteristics that should continue to outperform the market over a long-term investment horizon.

Neville Chester
Portfolio Manager

The fund's holdings will be very concentrated. It will at all times invest in between 10 and 20 large cap shares, with between 5% and 10% of the fund's total value invested in each share. Equity exposure will vary between 75% and 95% of the fund value. Shares will be selected largely in line with the house view, but no restrictions will be placed on the portfolio manager's discretion to deviate from the house view in the short-term. The fund will not be an index tilt-fund, as the decision will not be to over or underweight a share, but rather whether it should be included or excluded.