As signs of the nascent economic recovery abound, global equity markets continued their phenomenal run and the JSE was no exception. Risk appetite has returned with surprising vigour and the bystanders who moved to cash at the nadir of the market crash are being tempted back into equities and other risk assets. The Alsi40 returned 13.9% for the quarter, bringing year-to-date returns to 18.6% - a surprising outcome for many who went into 2009 forecasting the return of the Great Depression. Pleasingly, the fund also delivered 13.9% for the quarter, bringing the year-to-date total return to 24.9% - a figure that is 6.3% ahead of the benchmark after all costs.

Looking at where we stood a year ago and how markets have panned out, one is struck by how rapidly the perceptions of risk have changed. While most commentators were desperate for capital protection 12 months ago, we are now back to a phase of immense risk appetite. Riskier asset classes are back in vogue and market participants are focusing more on return than the risk element of the equation. In the fund we are starting to reduce our exposure to more risky and more cyclical businesses. The rally we have seen has priced a very benign outcome into many cyclical shares and the reality is that the SA and global economy still faces some severe headwinds.

As part of the global risk trade we have seen the rand strengthen significantly as cash has flowed back into SA. While this is positive for inflation, it is seriously prejudicing our industrial base, which is having to shoulder double-digit wage increases and astronomic electricity cost increases. If it remains at this level it will have negative consequences for the manufacturing industry which will depress the levels of GDP and economic activity - the end result being a tougher domestic environment for longer.

In this environment we believe it is more appropriate to hold well priced, defensive businesses over cyclical stocks which are pricing in a rapid and successful return to healthy economic conditions. There are a number of companies which have re-rated very strongly off their lows, yet are still to see any change in their profitability. While we always look far ahead into the future to value our investments, we believe the investment case is weak when that future profit has been reflected in the share price.

The one cyclical sector we do continue to have exposure to is the banking sector which we think is not fully pricing in the earnings opportunity in the medium term. Banks have suffered from the massive increase in levels of bad debts, driven by very high interest rates and a declining economy. They have now also been impacted by the reduction in margin brought about by the very rapid reduction in interest rates so far this year. Looking forward there is likely to be strong earnings growth, driven by a normalisation of the bad debt charge and interest margins. Even without significant asset growth the banking sector should easily be able to achieve solid double-digit earnings growth as bad debts recover and margins increase due to a much more stringent pricing environment. This is not reflected in current valuations and is what makes the sector still attractive as an investment.

Going into the final quarter of the year and reflecting on the past period which has been a remarkable time in the financial markets, two consistent themes come through. The first is that it is impossible to successfully time equity markets. The 'gurus' who managed to avoid a large part of the downswing by being invested in cash, missed out on the substantial and rewarding recovery. If you are a long-term investor, which we believe is the key criteria for investing in equities, one should never try to time the markets.

The second point is that the quality and strong cash generative businesses are the ones that deliver the most consistent returns through the cycle, and they are the businesses that benefit from an economic downturn as their weaker competitors disappear from the corporate landscape. If you can buy these businesses at the right price, they make for great investments regardless of the cycle.

Portfolio manager
Neville Chester

After three consecutive quarters of depression, we finally had a quarter with a more optimistic outlook; albeit off a low base. What the press rapidly took to calling 'green shoots' was merely a recognition of the fact that while the environment is definitely still tough, the rate of worsening is slowing and equity markets had been priced for a very dire outcome. This saw markets around the world rally quite sharply and risk appetite pick up appreciably. The fund had a great quarter, delivering a return of 14.6% - significantly outperforming the index return of 7.7%.

A concerted approach to increase some of the more cyclical shares at the beginning of the year paid off. As the level of appetite for risk started to rise, so did a number of these shares as the market once again recognised their fundamentals. A great example of this is Anglo American in which the fund now has a large top 10 holding. Last year's darling rapidly became this year's dropout as a stretched balance sheet and poor short-term outlook for platinum and diamonds resulted in Anglos having to skip its dividend. The share price fell to its lowest level in 10 years as investors focused on short-term concerns rather than the quality of the underlying assets. This enabled the fund to build up a good position at attractive levels. Subsequently, some balance sheet repair, improving risk appetite and an unsolicited offer from Xstrata has seen the price re-rate strongly; far sooner than we anticipated. This is the core to using a valuationbased approach in stock selection. While you can never time the market you do manage to ignore the short-term noise to make sound long-term investments.

Another example is MTN - also a darling of the market, soaring above R150 when the news first broke of a potential Bharti deal in May 2008. However, along with most other companies MTN fell in the period of risk aversion in the second half of that year. Prior to the Lehman collapse investors were hungry for exposure to fast growing markets like Nigeria and Iran, but when risk appetite turned, these exposures became viewed as negatives and MTN fell as low as R74 - half of its previous high. This enabled the fund to build a large position in a quality business at an attractive price. We now sit with the announcement this past quarter of another potential deal with Bharti that has caused investor sentiment to improve towards MTN, resulting in a re-rating that was also sooner than we had anticipated.

What these two examples illustrate is that our priority focus is the valuation of the businesses that we buy for our unit holders. While one can speculate about global trends and the direction of currencies, the only safe way to ensure that the fund generates sustainable long-term returns is to invest where valuation offers the investor a large margin of safety. Equity markets are volatile and indeed irrational in the short term, but in the long term rationality always prevails. This is why it is important to always be prepared to take the longterm view when investing in equities and equity-based funds.

Given the extreme volatility over the past year and the recent resurgence in risk appetite, we have found that a number of defensive businesses have de-rated and are offering attractive long-term returns. As a result, we have added to these as we have sold down some of the more cyclical shares bought late last year. Given the uncertain economic outlook and the favourable valuations, this is the preferred approach.

Portfolio manager
Neville Chester

The final quarter of 2008 was marked by panic selling globally as the fears of global recession were realised and owners of risky assets entered into a selling frenzy. Global equity markets were hard hit and SA fortunately less so, due to a better domestic economic outlook. However, resources were hit hard and the resource counters listed on the JSE suffered accordingly. We have, however, been very well positioned for this outcome. Despite the market and our benchmark being down 9.2% and 10% respectively, the fund managed a return of -2.7%, capping a year of phenomenal performance for the fund - achieving a return 13.7% ahead of the benchmark. This was predominantly due to our large underweight position in resources and overweight position in defensive shares, which we have reported on for a number of quarters. The rate at which the global commodity bulls have turned into commodity bears has been astounding. All the stories used to justify the continuous increase in world commodity prices (China/India growth, global power shortages, lack of new resource finds, etc.) seem to have disappeared and now a hundred reasons for why commodity prices will remain low are surfacing. Just as we never believed the former stories, we are sceptical about the latter too. As a result, we are now selectively adding to our resource holdings where valuations have priced in a worst case outcome. In the short term, markets are generally inefficient and create opportunities for investors to profit from these mispricings. The outlook for 2009 is certainly not clear currently. And we would be loathe to make any kind of short-term forecast given the huge battle taking place globally between what appears to be an unprecedented recession and, at the same time, an unprecedented combined assault by governments and central banks around the world using fiscal and monetary policy to stave it off. Given the extent to which interest rates have been cut and deficit spending is being ramped up, in the long term we definitely believe the stimulus packages will ultimately work. The time it will take to start working is unclear. What is clear is that when it does gain traction the levels of inflationary pressure will once again arise and the attractiveness of real assets will once again become more popular. As a result, the fund still has large positions in what are arguably more defensive equities but these are now being offset by higher exposures to the more cyclical companies, like the resource shares we have mentioned earlier. Our largest holding now is MTN, the EMEA mobile phone operator. It is both a reasonably defensive play due to the low levels of cyclicality in established phone call minutes of use, and also a growth story due to the low levels of penetration in most of its markets outside of South Africa. In the past six months there have been great buying opportunities and we have managed to build up a position at a price which offers little downside risk and great upside potential. Looking ahead for 2009, we remain confident that the balanced approach of increasing the cyclical element, yet not wholesale reducing the more defensive stock holdings, is the appropriate way of growing unit holders' capital into the new year.

Neville Chester
Portfolio Manager