The Investec Commodity Fund appreciated by 2.4% this quarter, outperforming its benchmark, the JSE Resources Index which appreciated by 0.7%.
The quarter saw a divergence in the performance of commodity prices. The oil price fell by 15% as the hurricane season proved to be uneventful and political risks eased somewhat. Precious metals were dragged down along with the energy complex, reinforced by weak fabrication demand statistics from India, gold's biggest consumer. Gold fell by 1% and Platinum by 7%. The base metals fared better as supply specific issues (a strike at the world's largest copper mine, Escondida, and record low inventory levels), prevented prices from falling despite a deteriorating demand picture. The copper price rose by 1.3%. Steel proved to be the outperformer and rose by 30% due to global re-stocking Within resource equities, sub-sector performances mirrored the returns from their underlying commodities: The Oil sector fell by 7%; Gold fell by 14%, General Mining rose by 6%, and steel rose by 5%. The Platinum sector was the exception and rose by 2% despite falls in the Platinum price. The shares rose as the rand weakened and some of the by-product metals (Palladium, Nickel, Rhodium) remained at very high levels.

Key contributors and detractors of performance (for the quarter): Within the portfolio, the over-weight positions in Mittal, Kumba and Angloplats added to performance. Billiton, Sasol and Goldfields detracted from performance. Billiton and Sasol fell along with the oil price and on concerns of project delivery while Goldfields (and the Gold sector) followed the gold price down.

Sector Strategy and Outlook
Commodity prices have benefited from low inventories, many of which are at critical levels. However, a few fault-lines are beginning to appear. On the supply side we continue to see a host of new project announcements. On the demand side, the softer US housing market is of concern, and at some point we expect to see a slowdown in Chinese industrial production to more sustainable long-term levels. We continue to believe that speculative interests have made major investments in commodities and there are signs that these are beginning to unravel, as seen in the major losses incurred by the Amaranth hedge fund in natural gas, the US$12bn fund outflow from commodity investments last month, and the disappearance of the roll yield on commodity index products and energy futures. As yet it is too early to determine if this is merely a short-term correction in commodity markets or whether we have seen the peak. It is worth noting, however, that many commodity prices have come off appreciably in the last few weeks. We believe that we have probably now witnessed cycle highs for most commodities. However, prices have held up higher than we anticipated and as a result we have increased our average price forecasts for base metals and some precious metals for the remainder of 2006. We are likely to start 2007 at higher price levels than previously forecast, and so have also increased a number of our 2007 and 2008 forecasts. Another benefit on the earnings front for the SA miners is a weakening Rand. Given the strong precious metals bias of the SA mining board and equally the leverage to a weaker currency, it would be certainly premature to call the end of the commodity cycle for the SA miners, just yet.
Given the market's greater concern over risk and volatility, we like BHP Billiton for its bulk commodity exposure (iron-ore and coal are 36% of the portfolio), since prices for these commodities are contracted for the next six months and are therefore not subject to terminal market volatility. We are also keen on the growth profile of the group's petroleum business (21% of operating profit). BHP Billiton is not expensive, trading at 8x FY07 earnings, with very strong cash flow and likely more capital management to come. Encouraging for the prospects of precious metals equities has been a break in the inverse correlation between the rand/dollar exchange rate and the gold /platinum price. The Gold and Platinum prices are now rising in Rands as well as in dollars meaning that miners are finally seeing rising revenue lines and widening margins. The platinum stocks are highly cash generative, and discount a benign metal price environment. They therefore offer an opportunity to benefit from our forecast of continued rising metal prices. While we favour the sector in general, we believe AMS's relatively higher gearing to the metal prices will drive its outperformance. The gold sector has for some time discounted an earnings recovery. We are currently seeing that recovery play out, but believe stock selection is important, and reflect our preference in the higher quality stock, Gold- Fields, which offers a more stable cost outlook and discounts less gold price recovery.
The fund retained its large over-weight position in Mittal SA. Mittal SA has lagged other resource shares this year (and lagged its global steel peers), as potential government intervention on pricing policy weighed on sentiment. Encouragingly, global restocking has caused steel prices to rise after a poor 2005. Mittal SA is now offering excellent value as it trades on 7 times earnings with a 5% dividend yield. Unlike other steel shares, Mittal is effectively integrated as it buys its ore from Kumba on a cost plus basis and will remain insulated from the steep rise in its input prices.

The Investec Commodity Fund appreciated by 17% this quarter, outperforming its benchmark, the JSE Resources Index which appreciated by 21%. The first six months of the year saw unprecedented commodity price volatility, as investment interest pushed copper, for instance, from around 208c/lb at the start of the year to 399c/lb on 12th May before collapsing 24% to 304c/lb by 23rd June. The prices of many other commodities have been similarly volatile. The increased volatility is, we believe, a function of the market's varying concern over inflation and interest rates, and while commodities are likely to remain volatile, in many cases we believe that we have now seen cyclical peaks.

Within Resources, sub-sector performances were universally strong with the Mining-Houses, Platinum and Oil sub-sectors all notching up gains of 20% or higher. The Gold sub-sector lagged slightly and returned 14%. Paper was the exception and declined by 4% Key contributors and detractors of performance (for the quarter):

Within the portfolio, the over-weight position in BHP Billiton added to performance. BIL rallied on base metal price increases, high settlements for its iron-ore selling prices (+19%) and a stubbornly high oil price. The positive bets on Gold-Fields and Sasol also added alpha. Gold-Fields was again the pick of the gold shares in the current rising rand gold price environment, while Sasol shrugged off the spectre of a windfall tax to rally strongly with the weaker rand and stronger oil price. Sector Strategy and Outlook

The correction in commodity prices we saw from the May 11 peaks has resulted in the LME Index falling by more than 13%. This sell-off was precipitated by fears that higher global interest rates would result in lower commodity demand, leading to lower prices. However, nothing has changed in terms of fundamentals, which in our view remain strong for most commodities. Also, metal prices have not fallen that much (copper, nickel & zinc are still 10-20% higher now vs May 1).

We continue to see strong demand from key consumers (such as China) while the supply side continues to be hit by disruptions (It takes 3-5 years to develop a new mine and there is a 2 year waiting time for mining trucks alone!), with the added demand of continued re-stocking across most economies in 2006. We remain believers in the "super cycle" on a 5-10 year view, yet we don't believe the rally will be straight line, or that every year will be an "up year".

The market will likely still be vulnerable to corrections as investors dwell on concerns over rising global interest rates, China trying to slow its demand, and metal prices being over-hyped. Whilst we agree that traded metal prices seem unsustainable at current levels, we also believe that prices will remain substantially above long term averages for longer. This should result in continued earnings upgrades across the market for most stocks. We maintain our positive position towards the Resources sector on the basis that the market is pricing in a greater fall in earnings than our forecasts would suggest

Given the market's greater concern over risk and volatility, we like BHP Billiton for its bulk commodity exposure (iron-ore and coal are 36% of the portfolio), since prices for these commodities are now largely fixed for the next nine months and are therefore not subject to terminal market volatility. We are also keen on the growth profile of the group's petroleum business (21% of operating profit) and on the potential for further geopolitical price premiums in oil prices. BHP Billiton is not expensive, trading at 9x FY07 earnings, with very strong cashflow and likely more capital management to come.

Encouraging for the prospects of precious metals equities has been a break in the inverse correlation between the rand/dollar exchange rate and the gold /platinum price. The Gold and Platinum prices are now rising in Rands as well as in dollars meaning that miners are finally seeing rising revenue lines and widening margins. The platinum stocks are highly cash generative, and discount a benign metal price environment. They therefore offer an opportunity to benefit from our forecast of continued rising metal prices. While we favour the sector in general, we believe AMS's relatively higher gearing to the metal prices will drive its outperformance. The gold sector has for some time discounted an earnings recovery. We forecast that recovery will play out into 2007, but believe stock selection is important, and reflect our preference in the higher quality stocks, Gold- Fields and Anglogold, that offer a more stable cost outlook and discount less gold price recovery.

The fund retained its large over-weight position in Mittal SA. Mittal SA has lagged other resource shares this year (and lagged its global steel peers), as potential government intervention on pricing policy weighed on sentiment. Encouragingly, global restocking has caused steel prices to begin rising after a poor 2005. Mittal SA is now offering excellent value as it trades on 8 times earnings with a 4% dividend yield. Unlike other steel shares, Mittal is effectively integrated as it buys its ore from Kumba on a cost plus basis and will remain insulated from the steep rise in its input prices.

The Investec Commodity Fund appreciated by 10% this quarter, outperforming its benchmark, the Resources Index, which rose by 7%. For the full year 2005, the fund appreciated by 64%. This represented the best return of the resources unit trusts and consequently, in the environment of resource shares out-performing the JSE, the best performing fund amongst all SA unit trusts.

Resource shares outperformed the market as commodity markets posted their strongest bull market in two decades, experiencing their fourth consecutive year of double-digit returns and outperforming all major asset classes. Base metals were the best performer in 2005 (37%), followed by energy (25%) and precious metals (17%). Three broad factors drove this performance: above-trend demand growth in all commodity sectors; supply constraints in some markets (refined products, gold); and unprecedented flows across investor types.

We believe that we are in a long-term, structural bull trend for real commodity prices. The emergence of China as a consumer of approximately 25% of the world's commodities, coupled with a slower than required supply-side response to the increased demand, has caused this price cycle to be of sufficient strength to put an end to the trend of metals cycles declining in both length and magnitude. That being said, smaller cycles should still occur around the longer-term real uptrend in commodity prices going forward. The trough to peak rise of this cycle (November 2001 to-date) has been 137%. In 1995, the trough to peak gain was 82%, with a gain of 44% in the 1999 cycle. It therefore seems that we are closer to the peak of this smaller cycle than the trough, and that further gains in metal prices should be limited. Given the maturity of the cycle, the Commodity Fund prefers Anglo's more defensive commodity basket to Billiton's. Anglo is differentiated by its precious metals exposure which is less vulnerable to a supply-side response to the higher prices. On the other hand, Billiton is heavily exposed to 'peaky' steel making raw materials prices.

We believe that current over-capacity in a number of metal-intensive industries in China will slightly inhibit base metal demand in 2006 while precious metals demand through luxury-goods purchases should continue to gather momentum.

Global gold production has reached a plateau in contrast to the ongoing 3% - 5% pa production growth likely in the various base metals. Future expansion of platinum production rests almost entirely in the hands of South Africa. SA is the global platinum cost curve, so as things stand, if the world wants more platinum it will have to pay a price that provides miners adequate returns. As long as real US interest rates remain below zero, we believe that precious metals prices will be well supported as a store of value Also encouraging for the prospects of precious metals equities has been a break in the inverse correlation between the dollar and the gold price. In 2005 the gold price finally started rising in all currencies. Importantly this means that gold-miners are finally seeing rising selling prices for gold in their producer currencies and that their margins can widen. SA Gold Shares had been poor performers due to their deeper ageing ore-bodies, the strong Rand, and cost increases above inflation. This underperformance ended during 2005 as both the rand gold price and grades (grams of gold per ton of ore mined) began rising. The Commodity Fund backed up its precious metals preference, not only by its Anglo holding, but also by large positions in Impala Platinum, Gold Fields, Western Areas and Lonmin. Going forward, the fund has a large over-weight position in Mittal Steel. Mittal has lagged other resource shares during 2005 (along with its global steel peers), as the steel price fell and after sharp rises in iron-ore and coal input costs. Mittal is now offering excellent value as it trades on 5 times earnings with a 6% dividend yield. In addition local demand for steel products should remain buoyant in the low interest rate environment, and the counter is an attractive rand hedge and potential take-out target for its parent company

Last year, resource prices broke the shackles of a 25-year bear market and resource shares responded with a run that has driven the sector index 80% higher over the past 12 months.

Is it too late to join the resources run? Opinions on the bull trend's sustainability and the value offered by resource shares differ widely.

Investec Commodity Fund (ICF) manager Daniel Sacks sums up the case for the bulls: "We believe we are in a long-term, structural bull trend for real commodity prices." On resource share valuations, he says if the approach of basing these on spot prices is applied, "they look fine".

Underlying fundamentals, backed by China's continued demand for resources, are also solid. Supply constraints through limited new production and transport bottlenecks are also supportive of prices. But Sacks tempers his view, saying corrections in any bull trend are part of the game.

"Smaller cycles should still occur around the longer-term uptrend in prices," he says. After the rampant run that has boosted the Commodity Research Bureau resource price index 135% since its low in 2001, Sacks feels the current smaller cycle is now in a "mature" stage.

Sacks continues to favour Anglo American , to which ICF has a 21% exposure, over BHP Billiton (14%), as he has since mid-2005. This has made little difference to returns so far as both shares have registered almost identical gains over the past eight months.

But Sacks feels it could be a factor in the future, given BHP Billiton's greater reliance on steel-making raw materials and Anglo's higher exposure to gold and platinum.

BHP Billiton, he says, could be vulnerable to a rise in supply-triggered higher prices. This is less likely in precious metals as gold output is stagnant and expansion of platinum production rests mainly in SA's hands.

Perhaps the best indicator in favour of resources as an investment comes from China's director of statistics, Li Deshui . "Average GDP growth of 10% is sustainable for many years," he said after news last week that China's economy had grown 9,9% in 2005.

Financial Mail - 3 February 2006