The upward march continues, but the pace has slowed
Domestic equities managed to squeeze out a marginal gain during September after a very strong recovery since March this year. The index is now up 38% since the lows. We are cautious on the level of the market in general, and equity return expectations should be contained.

The All Share Index level, relative to the average earnings that was generated by the market over the last 10 years, is at 21.4 times. Although not at the highs of 36 times which applied in June 2007, we believe that at current levels, real returns will be lower than the average experienced by investors over the past few years.

We have previously written extensively on how cheap the markets were during the corrections which took place in November 2008, then valuations were outstandingly cheap. Unfortunately, even an expected earnings recovery which will deflate the market's P/E rating over the next twelve months does not make the JSE look that cheap in our view after the rally which has taken place. Consequently, we have moved from a position of high conviction on the stock market as a whole to a very selective or stock specific positioning.

Own the right assets at the right price and the returns will look after themselves
If we sound more cautious, the obvious question that should be asked is why the fund still has a 20% equity weighting. The answer is purely based on stock picking; we feel that given enough time, the shares held within the fund are expected to show superior returns relative to other asset classes and against inflation. We strongly argue against market timing and stated rather simplistically, we feel our companies are undervalued given their long term growth prospects and the value of their underlying assets and the returns that they can generate off these assets. The bulk of the companies in the fund are high and/or consistent dividend payers and more than 40% of these companies have management that are founding members or families as substantial shareholders in the business. We favour this type of alignment. These holdings will be trimmed back to zero if the long term Earnings Yields of these businesses, the dividend yields and expected returns decline to unattractively low levels relative to a long term sustainable bond yield.

Essential, but short-term supporting factors for bonds
As we mentioned in the past, we are looking to accumulate inflation linked bonds as inflation continues its downward trend. The short term risks to inflation are clearly to the downside, driven primarily by the currency appreciation. Given the increased focus by the Reserve Bank on the output gap in the economy, and the diminishing short term inflationary pressures, there are real downward risks to interest rates in the short term. This is likely to result in conventional bonds outperforming inflation-linked bonds. This we do not perceive to be a long-term scenario and we are cautious on bonds for the following reasons. The currency strength that we have experienced in recent months has helped to put a cap on conventional bond yields, despite a 30 basis point rise since middle-August, and has masked the building fiscal pressures in the broader economy. These pressures normally act as catalysts for a more aggressive upward adjustment in bond yields.

Given the shortfall in government revenue, there is an increased risk of the Budget Deficit reaching 8% of Gross Domestic Product in the near term, but these risks have been largely ignored by the bond market as a result of the declining inflationary pressures. The FRA's (market for forward rate agreements) are now pricing in a 74% chance of the first interest rate hike during the next 9 months. Whilst this might end up being a too pessimistic scenario and rates will probably only rise later, it does explain our concerns that at some point rates will reverse and protection is higher in shorter maturity instruments. In summary, equities remain our preferred asset class even though most of the easy returns have already been extracted.

Neels van Schaik

2009 continues to play-out as a fascinating year for all the asset classes.

Whilst in the first quarter this year, equities were decimated by the ongoing financial crisis which started in 2008, the second quarter was one where stocks bounced and equities have now topped the return tables for the quarter.

After losing 4.2% in rand terms in 2009 Q1, equities gained 8.6% in quarter two, well ahead of bonds with a 0.3% gain and cash with 2.3%. Bonds have performed poorly in 2009, losing 5.1% in quarter one and as mentioned above, have only just eked-out a positive return in quarter two. SA government debt has, however, performed really well in the past few years, 2008 being no exception with the ALBI returning 17%. A combination of disinflationary forces globally, a steadily improving South African Government fiscal position and elevated commodity prices supporting the rand all conspired positively for this market. A rather different scenario could be surfacing presently though.

In the last budget, Government indicated that its debt funding requirements this year from the local market would equate to approximately R131bn, but finance minister, Pravin Gordon, has indicated recently that revenue shortfalls of about R60bn as a result of the economic crisis are likely. Consequently, extra borrowing from Government within the local market to cover the shortfall is required. The size of the shortfall is unexpected and hence the new stock being placed may well be negative for bonds. Added to this, considering the size of South Africa's current account deficit to GDP and although it is expected to reduce over the year ahead, it remains dangerously high at 5.8%, making the rand vulnerable at current levels. This too could prove gilt unfriendly. The R157, South Africa's most well watched long-dated bond, spiked last year in July on the onset of the financial crisis and due to the inflationary forces working their way through the domestic economy, the yield reached 10.86% at the time. Yields rapidly declined to 7.1% by mid December. With the market becoming increasingly aware of revenue short-falls however, yields have subsequently moved to 8.69%. As rates track higher and it looks as if they are most likely going to sneak over 9%, we may well initiate our first accumulation process in quite a while.

Local equities, in rand terms, have gained 4.1% in 2009, second to cash which has returned 5.1%. In 2007, the JSE fell 23.2%, cash gained 11.7% and bonds produced the above-mentioned return of 17%. Performances from the major equity indices from January 2009 were not too dissimilar; Resources returned 4.4%, Industrials 3.5% and Financials 4.4%. SA listed property has been the only negative returning major sector year-to-date, losing 2.3%. The real action took place in sub-sectors, with the likes of Pharmaceuticals (47%), Software and Computer Services (23.2%) and Platinum and Precious metals (20%) being stand-out top performers and Forestry and Paper (-31.1%); Automobile and Parts (-30.2%) and Industrial Engineering (- 22.3%) being the worst underperformers.

In May, the PSG Alphen Optimal Income Fund was 19% exposed to equities, at the upper end of its 0% to 20% equity exposure band. This was, however, actively reduced in the early part of June to 14% based on our view that from the late October 2008 lows, the JSE had enjoyed a meaningful rally and the market was no longer as convincingly attractive relative to other asset classes. That said, on a stock picking basis, we continue to find stocks that we believe will outperform cash given a five year view. In summary on equities though, we chose to position more defensively during the month, most notably reducing exposure to cyclical stocks. This has worked well!

The portfolio continues to be positioned predominantly in cash, equities and preference shares with a miniscule holding of 1% in property. Presently, the fund has no exposure to government bonds.

We remain cautious on bonds and property but will be buyers if these asset classes remain under pressure and continue to de-rate as is the case at present. Equity exposure will be based, as always, on stock picking but our preference will be for defensive companies with strong and sustainable earnings bases. Many of these companies have been de-rated during the latest cyclical rally.

While equities delivered a very strong performance during March, it remains to be seen whether the rally has any legs. The question we constantly face these days from clients is whether the market has bottomed and how long the rally will last? We do not know the answer to either of these questions. Being expected to manage money by making monthly market predictions is a failed strategy, untenable and one we do not ascribe to, albeit that many clients seem obsessed with this approach.

As we have highlighted in many reports in the past, the companies we invest in are constantly monitored to assess whether they justify their current share prices based on their earnings power, return on capital and ability to convert profits into cash. This is based on individual company analysis as against market predictions, two completely distinct approaches. Our investment thesis is that fundamentals drive share prices in the long run, but we realize and appreciate that during bear markets, sound company fundamentals are discarded by the market. Whilst this is the case, it in no way detracts from the quantifiable results achieved by stock pickers over the long-term and does not deter us from sticking to our approach. The fact is that patient long-term investors inevitably outperform speculators as market timing is a low odds investment approach and whilst fundamentals do require time to shape company profits; these inevitably are reflected in share prices and thus in returns.

The PSG Alphen Optimal Income Fund is currently close to its mandated equity limit of 20%. Given equity valuations, we feel that stocks will outperform cash over the next five years. Sentiment towards risky assets has also turned more positive in recent weeks with various economic indicators pointing to a potential recovery in economic activity towards the turn of 2009.

This may indeed be the case, but our point of departure is rather to ask what long term economic scenario is being priced into the share prices of the companies which we own at present and to gauge whether this is a realistic outcome. We believe that in many instances the market is pricing in a too bearish outcome for certain listed companies given the next five years. With respect to the following few months, we think anything is possible and to see the market even test it's Oct/Nov 2008 lows would not surprise us.

Government bond markets, both domestically and offshore have experienced significant tailwinds due to a flight to quality and as a result of deflationary impulses moving through the world's economy, we feel that some of these tailwinds could begin to subside as we enter the eye of the "creditstorm". The likely impact of massive money supply creation, albeit that it has yet to filter into the real economy, should at some point lead to slightly higher inflation, but presently asset price deflation and excess manufacturing capacity is preventing inflation. We believe that bonds have priced in the deflation but not accounted for any possible inflation. Consequently, our view is that bonds are not offering significant value at current levels and we expect to earn more competitive returns from other asset classes, in particular equities. The fund has no current exposure to domestic bonds.

With 12 month cash yields having declined to around 7% it is clear that cash has become an unattractive asset class relative to the potential returns available from domestic equities and offshore assets. Simply put, for the risk being taken at current prices, growth assets are offering significantly better return prospects and in many instances, sustainable higher after-tax income yields than cash. The fund is therefore maintaining its underweight position in cash.

Neels van Schaik

The fact that the All Share Index has seen one of the worst calendar year performances ever, with a return (including dividends) of -23% is by now old news. Commodities, which were the star performers up to mid 2008 ended the year as one of the worst performing market segments. This does not imply decent returns from the rest of the market however with the Industrial and Financial sectors having both lost 26% of their values.

We are mindful of two error-filled strategies that many investors might be tempted into following in 2009. The first is obsessively trying to predict when a global economic recovery will unfold and to make the assumption that markets will patiently wait for proper recovery signs before rallying. The second is basing investment decisions on the behavior of other investors - a herd following technique. The first strategy fails because market gains normally precede economic improvements, thus waiting for the recovery translates into lost returns. The second fails as attempting to time equity entry and exit points is impossible and leads to volatile and inconsistent returns. A much more likely winning strategy will be purchasing cheap assets and bravely maintaining exposure throughout volatile times until the economic environment normalizes and true asset values are again realized.

In response to the globe's economic woes, central banks around the world are doing everything in their power to avoid a deepening crisis and prevent a debt-driven deflationary spiral. In 2008, very aggressive interest rate easing in the US's Federal Funds Rate saw rates decline from 5.25% at the end of 2007 to 0.25% as at the end of 2008. Bond markets responded accordingly and investors in three month US treasury bills currently earn a mere 0.02% and on two year paper only 0.8%. As Bennet Sedacca of Atlantic Advisers puts it, the Federal Reserve Bank is punishing savers and prudent investors by manipulating interest rates to zero, meaning the returns investors currently earn on safe investments are so low that they are forced to buy higher yielding, but more risky assets.

The irony is that the Fed is promoting spending to save an immediate calamity but this is occurring in a country where the savings rates are desperately low and need to rise. A further problem is the existing high US debt levels and whether US consumers have any interest or capacity to take on new debt and spend their way to a sustainable economic recovery. In the meantime, economic hope rests on the fiscal stimulus packages of the US government. Once again, however, this should not be seen as an offsetting factor to the impact of the consumer's wealth implosion but is rather a new, but not sustainable source of consumption. Around $13 trillion of US household wealth has been lost since September 2008 as result of the collapse in US equities and the continuing decline in US house prices.

Emerging Markets have not been left unscathed by the chaos that clouds the global economy at the moment, but growth rates are likely to hold up better than those of industrialized countries. With South Africa being a commodity producing country, falling commodity prices will hurt exports, but the value of imports are also tailing-off due to slowing domestic consumption and the collapsing oil price. This should bode well for our current account deficit as oil accounts for approximately 20% of imports and South Africa's terms of trade are also improving. Under these conditions, the SARB has scope for further interest rates declines in 2009, and we feel that an economic recovery will likely be seen from 2010 onwards as the rate cuts in 2009 start flowing through to the real economy. As can be seen in the price action of interest rate sensitive and consumer orientated companies on the JSE, these stocks have already in advance been discounting interest rate changes and improving prospects.

Much the same argument applies to the domestic bond market and in fact, bonds have already delivered one of the best six month performances ever. This occurred during the second half of 2008 with a 25.3% return. The bond rally occurred despite a significant depreciation of the rand against all our trading partners. At Alphen, like many South African managers, we have been reluctant to buy bonds given the fact that yields were never really attractive relative to cash yields or attractive relative to domestic orientated company earnings yields. Our preference has been domestic cyclicals and these have performed superbly too. The latest domestic bond rally has in fact increased our bond caution as these instruments, as mentioned above, have rallied in sympathy with US bonds and we view US bond yields as absurdly low and longer-term look potentially bubble-like. In summary, we view the odds of losing money on bonds at current yields high enough to consider avoiding this investment class altogether.

As mentioned in our previous fund fact sheets, we started increasing our equity exposure within all our funds throughout the deepening crisis in the second half of 2008. Given what happened to equity returns since initiating this process, the argument could well have been made that we were too early on our equity purchases. However, we continued to lift exposure right into the depths of the market falls and since the lowest point in markets, a rally in excess of 25% has occurred. This has been beneficial for the fund's returns and the predisposition within the fund to domestic stocks has been rewarding. Although in hindsight our initial purchases might have been a touch premature, we feel that our reasoning at the time was sound.

With respect to the companies we chose to invest in within the PSG Alphen Optimal Income Fund, the following characteristics amongst others are sought:

1. Cyclical companies with sound business models, but where margins and profits have already experienced severe pressure during preceding years and where share prices and ratings have responded similarly.
2. Businesses with leadership positions in the products or services that they bring to the market. These companies must have the ability to protect and even grow market share positions over time.
3. Companies with adequate free cash flow able to maintain dividend payments without negatively affecting the capital structure of the business.
4. Companies that are trading below their Net Tangible Asset Values (NTAV), but with the ability to generate returns on their invested capital that are superior to their cost of capital and with the ability to grow their (NTAV)
5. Companies with sustainable earnings yields that are much higher than cash yields. This is a good indication of an investor's 'margin of safety'. If cash yields 8% for example and a company trades on an earnings yield of 20%, the company's profits can fall by 50% but total remaining profits will still yield more than cash.

Looking out at the year ahead, we believe that pending interest rate cuts will prove very favourable for equity returns, but sentiment will oscillate wildly between extreme optimism and pessimism over coming months. News-flow with regards to unemployment, the steepness and longevity of the economic downswing and the uncertain outlook for company profits will all make equity markets jittery and volatile. Domestically, political changes could undermine investor confidence too. However, we perceive all these factors as transitory as against the long-term nature of asset ownership and particularly equity ownership. Our view is that at current valuations and given the benefit of time, the marginal safety within equities is actually relatively high. Against this, cash-type investment returns will decline steeply off the high base set in 2008 and we do not currently believe that investors aggressively placed in cash will be well rewarded in the immediate future.

Thus overall, we are cautiously optimistic for the year ahead believing that equities are our favourite asset class but we view returns as occurring within a volatile environment.

Neels van Schaik