This quarter, the Investec Commodity Fund underperformed its benchmark, the Resources Sector. It returned 8.6% against the index's 11.3% appreciation. The fund was underweight resources shares at the expense of cash and basic industrials, and hence underperformed as mining shares rallied sharply.

This performance occurred despite the rand strengthening by 7%, normally a strong headwind to mining shares' performance. This quarter, however, metal prices came to the companies' rescue and rose in excess of the currency. In US dollar (USD) terms, the gold price was 12% stronger, platinum was up 7.3%, copper rose by 9% and base metals prices (as represented by the Economist Metals Index), were 4% higher.

There is an established inverse correlation between the USD and commodity prices. There are fundamental reasons for this on both the demand and supply side. A weak USD means:
o Lower prices for commodities on trade-weighted basis. eg lower prices in Yen, Euros etc which has positive demand implications.
o Higher USD costs on the supply side - implying less supply. Recent examples of this have been manifold: supply cuts in South African and Australian coal in the face of currency strength, plus threatened mine closure/expansion deferrals in South African precious metals.

Metal prices are also being supported by the early phases of a global upswing. Continuing growth from China is key, as it now has a material impact on supply/demand. The USA appears set for growth and Japan may just have turned the corner. The prospect of synchronized global growth is not in our forecasts, although it remains a possibility.

We have included a stronger rand into our forecasts, the impact of which is negative for earnings and valuations. The local companies of Kumba, Anglovaal Mining and the Gold counters bear the full brunt of the rand's strength, mitigated by metals prices. Anglo has an estimated 35% of assets in South Africa and BHP-Billiton 15%. Accordingly, the rand impacts these companies to a lesser extent and the fund has a preference towards these counters at the expense of the more domestically focused single commodity operators.

Our previous sector concerns were based on strong operating currencies and sluggish global economic performance. However, we believe the negative currency trend has now been overemphasized, and that investors will begin to focus on the positive aspect of the historic relationship between a weak dollar trend and rising metal prices.

Historically, there has been a good correlation between a weakening USD and the global economy and metal prices. Mining shares have accordingly responded positively during these cycles, and at worst have performed in line with the market.

Investec launched a new B class (retail) on this fund on 1 October 2003.

This quarter, most commodity prices were stronger in US dollar terms. The gold price was 3% stronger, platinum was up 3.6%, and base metals prices (as represented by the Economist Metals Index), were 4% higher. Unfortunately, the rand proved a better performer: its 5% appreciation exceeded metal price gains.

Metal markets now seem pre-occupied with the onset of the seasonal third quarter slowdown, traditionally a sluggish period of demand. There is also the concern that some of the producers with idled capacity may take heart from a renewed sense of economic well being, and set in motion plans to reactivate. This sets up some very dangerous conditions for the miners. It causes a pinch on profitability, as weak commodity prices dent revenues while strong commodity currencies raise US dollar costs. We, therefore, maintain our underweight position in the sector and believe that the diversified miners have the most significant downside potential.

On valuation grounds, both Anglo and BHP Billiton are looking fully priced. The fund, however, continues to prefer Anglo for its mining-house exposure. Even with rand-related earnings downgrades, Anglo trades on a forward PE ratio of 12x compared to Billiton on 16x. Furthermore, Anglo is exposed to the strong diamond market (high margins and mostly non-SA earnings), and stable Euro based earnings from Forest Products and Industrial Minerals. Impala Platinum performed strongly this quarter and we still favour Impala Platinum, at the expense of Angloplats. Angloplats trades at a 50% higher p/e multiple than Implats, and we feel such a premium is excessive, given Implats's earnings growth profile, higher dividend yield and corporate action potential.

The gold price had another volatile quarter ending 3% higher. We believe that the gold price rally is still intact due to our view of continued weakness in global markets, a weakening dollar, and low/declining first-world interest rates. During the quarter, gold companies reported earnings on average 30% lower than the previous quarter's, as a consequence of the strong Rand as well as lower production, owing to working days lost over the Christmas break. GoldField's results were the least disappointing. The Mvela empowerment deal should also aid in removing SA regulatory discount and we thus increased our weighting in GoldFields during the quarter.

While a lower rand oil price has put Sasol's share price under pressure in the near term, our longer-term positive investment case, based on Sasol's undemanding valuation and growth prospects remains intact.

The next couple of months will see the market focus on reported results. The worst earnings are expected to come from the resource sector, where currency strength, domestic cost inflation and depressed volumes have already triggered some profit warnings (eg. Sappi). Share price weakness will present a buying opportunity to benefit from a cyclical recovery, the decrease in royalties and medium term currency movements.

The Investec Commodity Fund declined in line with its benchmark this quarter. Both fell by 16%. Resource shares suffered during the past three months, as the Rand continued its remarkable recovery. A strong Rand, while good for inflation and interest rates, is bad news for resource companies with large SA cost bases, as it narrows their margins, the revenue line falls as a consequence of lower rand commodity prices, and costs rise with inflation-linked wage increases.

Margins will also come under further pressure due to the new draft Money Bill, which will levy a revenue royalty on all turnover from commodities mined in SA. This proposed Bill has assigned higher royalty levels to higher margin sectors, for instance 8% for Diamonds versus 2% for Copper. We estimate the cost of this legislation to be in the region of R20-30bn to shareholders in the major listed resource counters, the bulk of which we anticipate has already been priced into the stocks.

The recent solid results from the diversified mining companies emphasized their defensive nature in the current market through their diversified portfolios. Strong precious metals prices have been beneficial for Anglo American, which reported excellent results, showing earnings per share up 10%. Earnings for BHP Billiton, on the other hand declined by 19% principally due to exchange rate translation losses. The fund thus continues to prefer Anglo for its mining-house exposure. Even with rand-related earnings downgrades, Anglo trades on a forward PE ratio of below 11x compared to Billiton on 14x. Furthermore, Anglo is exposed to the strong diamond market (high margins and mostly non-SA earnings), stable Euro based earnings from Forest Products and Industrial Minerals, and firm Coal markets.

We continue to believe that Anglo offers some value after being oversold on BEE issues. Impala Platinum performed very poorly this quarter as a number of factors conspired to reduce their expected earnings. Like most SA resource companies the strong rand and the proposed royalty resulted in downgrades. Furthermore, a loss of production due to a non-union-sanctioned strike and disruptions in Aquarius's supply of concentrate will result in less Platinum ounces being sold and thus even worse earnings.

One set of poor earnings, however, will have very little bearing on the long-term-valuation of the company which is now well in excess of the share price.

The gold price had another volatile quarter ending 5% lower. Last quarter we warned that gold shares were no longer cheap with no earnings growth to come. The market confirmed this view by punishing gold shares heavily. We now feel that pockets of value are forming with Harmony offering the most potential upside in the event of a gold price rally. Long liquidation by speculators has removed the selling over-hang and our view of continued weakness in global markets, a weakening dollar, and low / declining first-world interest rates, should all support the gold price. Still, we would be hesitant of building more than a trading position in the South African gold stocks ahead of what are likely to be dire March quarter results.

While a lower Rand oil price has put Sasol's share price under pressure in the near term, our longer-term positive investment case, based on Sasol's undemanding valuation and growth prospects remains intact. Sasol also has a strong cash-flow and, more importantly, has various opportunities to reinvest those cash-flows and generate a return in excess of their cost of capital. The share remains very cheap as it still discounts an oil-price below the long-term-average price.

We also continue to hold Sappi, which trades at undemanding ratings for this point in the cycle when we believe that earnings are troughing out as pulp prices increase. Continued consolidation in its industry, and the momentum that the sector typically enjoys at this stage in its cycle provides additional upside.

The Commodity Fund returned 1.8% this quarter, outperforming its benchmark - the Resources Sector - which declined by 6.7%.

Resource shares suffered during the past 3 months, as the rand continued its remarkable recovery. A strong rand, whilst good for inflation and interest rates, is bad news for resource companies with large SA cost bases, as it narrows their margins: the revenue line falls as a consequence of lower rand commodity prices, and costs rise with inflation-linked wage increases. The strong rand also masked a rally in the offshore mining houses whose sterling share prices appreciated in anticipation of a cyclical recovery in metal prices. The diversified miners have also benefited from the support offered by a rising oil price, a solid platinum price and more recently a soaring gold price.

Strong precious metals prices are beneficial for Anglo American but not for BHP Billiton. The fund thus continues to prefer Anglo for its mining-house exposure. Even with rand-related earnings downgrades, Anglo trades on a PE ratio of 11x compared to Billiton on 15x. Furthermore, Anglo is exposed to the strong diamond market (high margins and mostly non-SA earnings), stable Euro based earnings from Forest Products and Industrial Minerals, and firm Coal markets. Anglo has also recently increased its exposure to solid copper prices after its acquisition of Disputada, the Chilean copper producer.

In the platinum sector, we still favour Impala Platinum, at the expense of Angloplats. Angloplats trades at a 50% higher PE multiple than Implats, and we feel such a premium is excessive, given Implats's earnings growth profile, higher dividend yield, corporate action potential and pending increase in liquidity and index weighting once Gencor unbundles its stake. Angloplat's higher rating has, in the past, been ascribed to its vast mineral reserves; but its ability to mine those reserves is less certain now, given the new minerals development bill.

Towards the end of the quarter, the gold price broke through the key technical level of $328/oz and rallied strongly higher, taking SA gold shares with it. Harmony, being fully unhedged, and thus exposed to the spot gold price, participated in this rally. Unfortunately share price appreciation in the gold sector is now driven by multiple expansion and not earnings growth or value, and we are more cautious of the sector going forward.

Sappi reported their final results during the quarter, which were boosted by a decline in SG&A expenses. Sappi trades at undemanding ratings for this point in the cycle when we believe that earnings are troughing out. Continued consolidation in its industry, and the momentum that the sector typically enjoys at this stage in its cycle provides additional upside.

While a lower rand oil price has put Sasol's share price under pressure in the near term, our longer-term positive investment case, based on Sasol's undemanding valuation and growth prospects, remains intact. We, therefore, remain confident buyers of the sector on any material share price pullbacks.

Sasol also has very strong cash-flow and, more importantly, has various opportunities to reinvest those cash-flows and generate a return in excess of their cost of capital. The share remains very cheap as it still discounts an oil-price below the long-term-average price.

The sector's ability to maintain high margins and strong cash flows, even in the recent subdued economic and commodity climate, has improved investor perception of its inherent quality. The market's negative reaction to the leaked mining charter has left sector valuations at attractive levels, even on the assumption of a weak recovery in economies and base metal prices in 2003. We expect the two impending decisions affecting mining (the Money Bill and the Black Economic Empowerment scorecard) will not contain any material negative surprises.

We, therefore, remain confident buyers of the sector on any material share price pullbacks.