The equity market turned in a solid return of 6.3% for the third quarter of 2006. Bonds returned a barely respectable 2.1%, while cash delivered 1.9%. The one-year return for equities is still an impressive36.1%. For the year to September, bonds and cash returned 5.0% and7.5%, respectively. We remain overweight equities in deference to the attractive valuation relative to bonds, although the recent sell-off in bonds has resulted in us moving our underweight duration position to match the benchmark. In addition, we have positioned the fund in a more neutral allocation towards bonds versus cash.
During September, the bond market was relatively volatile, with the curve ultimately steepening further. We believe that valuation in the bond market is finely balanced.
The economy is facing an interesting adjustment process, with the jury out on how painful this needs to be. The risks posed by the growing imbalance between rampant demand and struggling supply have been reflected in the widening current account deficit. The consensus forecast for 2007 is 5.25% (upon which our neutral fair value position is predicated). In our current strong demand environment, the upside risks to inflation merit a slightly cautious approach to current bond pricing.
On the equity side, the fund remains slightly underweight rand-hedges believing that the price paid per unit of rand-hedge is excessive and thus, when volatility stabilizes, we continue to believe that these particular rand-hedge shares should under perform the market. The portfolio currently remains underweight Resources, underweight Financials- due to our view on Insurance companies and Real Estate -and overweight Industrials, consists of 37 shares.
During the quarter, the fund bought AGI Industries, sold its entire holding in Shoprite, added to its holding in Richemont and reduced its holding in Standard Bank and Firstrand.
Consol, Bell Equipment, Bidvest, Richemont, Massmart, Johnnic and Alexander Forbes all contributed strongly to the fund's performance over the quarter. The underweight position to Gold Mining, Pharmaceuticals and Food & Drug Retailer also added to performance. The fund's underweight position to Construction, Healthcare and Real Estate were the strongest contributors to underperformance. Other specific weak performers included JD Group, Supergroup and Delta.

Equities restored some pride in June, with a quarterly return of 4.9%. The one-year return for equities is still an impressive 53.9%! Bonds experienced a sharply negative month, with a 3.6% decline for both the monthly and quarterly return. For the year to June, bonds and cash returned 3.9% and 7.4%, respectively. We remain overweight equities in deference to the attractive valuation relative to bonds, although the recent sell-off in bonds resulted in us moving our underweight duration position closer to the benchmark. In addition, we have recently increased our bond exposure away from cash.

The bond market has finally begun to respond to deteriorating fundamentals. The weakness seems to have been triggered by a sharp sell-off in the currency. We expect further weakness as yields adjust to a global trend of re-pricing risk. On the equity side, the currency took centre stage and hence all returns were affected by how much or how little a particular fund was exposed to rand hedges. The fund remains slightly underweight 'rand hedges' believing that the price paid per unit of rand hedge is excessive and thus, when volatility stabilizes, we continue to believe that these particular 'rand hedge' shares should underperform.

The portfolio's equity component remains underweight Resources, underweight Financials - due to our view on Insurance companies and Real Estate - and overweight Industrials. It consists of 39 shares and should enjoy a dividend stream of close to 20% more than that of the market (currently estimated at around 3% p.a.). The fund continued to buy Tiger Wheels, sold Reunert, switched Nedbank into Firstrand and Standard Bank and switched Truworths into Foschini. The following shares all had good relative returns; Implats (33%), Sasol (22%), Nampak (9%) and Oceana (6%).

The fund's underweight position to Gold Mining and overweight to Telecommunications were the largest detractors during the quarter. Ours is essentially a value-based approach to managing funds and hence investments will typically focus on stocks that are cheap on Price to Book, Price Earnings and Dividend Yield bases. Most of the performance in our (and other global) stock market(s) over the past 12 months came from stocks that would not fall into our universe: high beta, high Price Earnings, high Price to Book, low dividend yield and those shares, which have experienced upward earnings' revisions. Although volatility has risen substantially in the past month or so, one would hope that this would produce a more cautious approach to fund management and that the value cycle would re-emerge, tying in perfectly with our philosophy!

Equities dazzled again in March, taking the three-month return to13.3%. The one-year return reached 57.4%. Meanwhile, bonds have recently been struggling to match cash returns. For the first quarter of 2006, bonds and cash returned 1.51% and 1.69%, respectively. Were main relatively overweight equities in deference to the extremely unattractive bond valuation.
The bond market continues to be priced for a flawless world. As such, the market is vulnerable to any disappointment. Moreover, longer dated yields offer virtually no break-even cushion compared to cash. Were main cautious in a yield environment that precludes any nasty surprises.

The neutral interest rate in an economy needs to reflect underlying fundamentals. The level of the nominal bond yield should converge to the nominal economic growth rate. When the yield is below the growth rate, it acts as an implicit subsidy to growth. This situation can stimulate growth until the cost of borrowing is increased in one of two ways. Either relatively low interest rates stimulate higher consumption and investment, which results in inevitable excesses that lead to higher rates; or the economy draws down on its savings, which leads to higher rates being charged for scarcer funds.

In South Africa, a combination of these two responses is currently playing out. In addition, our consumption is placing enormous strain on the current account, which is at a deficit level not seen since 1983. Our investment, in the meantime, is being heavily subsidized by foreign capital inflows. And finally, our savings ratio has been eroded to 13% -the lowest level since 1984. Considering that the risks to this benign environment are not inconsiderable, we would consider it prudent for longer bonds to be pricing in not just the Reserve Bank's stated "tightening bias" to short term rates, but also some risks to the very flat path being priced in for future inflation.

On the equity side the fund added four new shares; Amap, Bell Equipment, Tiger Wheels and Astral, and sold its entire holding in African Bank.

The following shares all had good relative returns; Implats (33%),Reunert (34%), Lewis Group (34%) and Nedbank (30%). The fund's underweight position to Forestry & Paper and Construction were the largest detractors during the quarter.