The third quarter of 2007 saw fear creeping into the market. The fall-out from the US sub-prime housing woes saw credit markets freeze; risky assets sell-off and volatility increase markedly. Central Banks around the world moved swiftly to inject liquidity into the system and equity markets have managed to rally strongly after being pacified by the Fed's decision to cut rates. The Fed's bold move has been led by ever-weakening US economic data that is pointing to a sharp housing-induced slowdown and the possibility of recession in the US cannot be ruled out.

Rate cuts have had the effect of weakening the US dollar and with the rest of the world, particularly emerging markets still growing strongly, commodity prices have surged in recent weeks. This has been most evident in precious metals with the gold price making new 20-year highs in excess of $700 per ounce. The result has been very sharp increases in the share prices of the Resource counters with shares like BHP Billiton and Impala Platinum up by more than 40% from their mid-August lows.

At the same time as commodity counters have been surging, stocks focused on the domestic economy have been weak. Domestic stocks have been weighed down by rising interest rates, foreign selling and sector rotation in favour of Resources.

The JSE has shrugged off the sluggish performance by domestic stocks to register new all time highs at the time of writing, though it is noticeable that with the move upwards being driven by a handful of heavyweight commodity counters, market breadth has deteriorated significantly.

Fund Performance

The fund's performance had been satisfactory up until the half year, largely keeping track with the JSE despite having a significantly lower risk profile than the index. It significantly outperformed the JSE in the July/August correction due to its relatively defensive positioning. We viewed the opportunity of the sell-off to increase our exposure to selected Resource counters (BHP Billiton and Impala in particular) although we remained underweight the sector.

Being underweight resulted in a marked underperformance in September that was exacerbated by a decision to cut our exposure to the aforementioned high-flying counters that we previously owned. This exposure was rotated into increasingly attractive domestics.

Fund Positioning

We are of the opinion that the divergence in performance between the Resources and the domestics has been extreme. The medium-term outlook for commodity prices and commodity share earnings is unclear with the conflicting forces of a weaker dollar (positive), a slowing global economy (negative) and high levels of speculation (positive in the short-term, but ultimately negative). The mining shares could prove to be expensive should commodity prices roll over. It is worth noting that the dividend yield on a share like Anglo American is at an eleven year low, though to some extent shareholders are compensated in the form of share buybacks.

We think that the current and expected levels of investment spending in the South African economy bodes well for the long-term earnings growth prospects of many domestic companies. In addition, the boom in commodity prices is likely to continue to provide support to the rand and underpin the economy. Given the poor price performance by the domestic stocks for the reasons mentioned above and the healthy medium- to long-term prospects, many of these shares have moved into attractive territory.

Though, they are susceptible to higher interest rates and a weaker rand we are of the opinion that this is more than factored into the share price. Generally, we now prefer the risk-return characteristics of the quality domestic counters, which also provide investors with superior earnings visibility in the years ahead.

Given our belief that the current bull market is reasonably mature, we have a strong preference for shares that offer value characteristics. Here, we have spent a great deal of effort in identifying stocks that offer some form of margin in safety. The types of characteristics we are looking for in stocks that provide a margin of safety are:
At or above market earnings growth over the next three years, where this is not discounted in the price. Examples: Standard Bank, Woolworths, Super Group. An attractive valuation level, particularly as represented by a high and growing dividend yield or a discount to net asset value. Examples: Nampak, Mvela Group, Reunert. A corporate action underpin with the potential for further value to be unlocked. Examples: Johncom, Telkom. The fund has owned no retailers since the end of 2006, with the exception of Shoprite when the private equity bid provided a very attractive entry earlier in the year, and had been light on banks for some time. Recently, our investment team has classified Standard Bank and Woolworths as high conviction buys - the first we have had in a while. Accordingly, each of these shares constituted in excess of 8% of the fund as at month-end.

We expect Standard Bank to grow its earnings ahead of the market over the next three years, despite a slow down in retail advance growth, and yet it has been trading at about a 30% discount to the market which we feel is unwarranted when you consider its broad exposure to domestic economic growth, investment spending and an exciting and growing emerging market portfolio.

We have been aggressively buying Woolworths in recent weeks. In the short-term, sales growth will be impacted by higher interest rates and the new Credit Act. However, with the share trading under R18, this is more than factored into the share price, and we expect continued strong earnings growth (ahead of the market over the next three years). Furthermore, earnings will be supported by a catch-up in usury rates and the food division will be underpinned by further expansion and food inflation. At these levels Woolworths would be on an estimated forward dividend yield of in excess of 5% (twelve months out), the most attractive yield since 1998!

The fund's portfolio is on an estimated twelve-month forward price-to-earnings (PE) ratio of 10.8 versus 13.3 for the JSE as a whole, and a forward dividend yield of 3.6% versus 3.1%. Still, we expect the bulk of the portfolio to deliver earnings growth ahead of the market over the next three years. We feel comfortable with the current portfolio composition at this stage of the bull market. We picked the stocks that we consider to offer the most attractive risk-return characteristics as things stand, and expect this portfolio to provide very attractive real returns on a three-year basis. It is not a happy time to be a value investor, yet every way we look at it, a strong bias for value is the only way we would be prepared to approach the equity market at present.

First, the good news, the fund is once again the best performing General Equity Fund over five years as at the end of June. Unfortunately, the one year performance story is not as pretty as the long-term track record and the fund finds itself 53rd out of 57 funds. We are not usually inclined to dwell on short-term performance, but in this case the relative one year showing is ordinary enough to warrant comment.

We remain very comfortable that our process is generating good stock picks but, unfortunately, in the second half of last year we allowed ourselves to be too defensively positioned which came back to bite us in the relative rankings. The good news is that we have learnt from our mistakes. We will continue to position the fund defensively and avail ourselves of tactical opportunities to reduce the fund's beta when we consider it appropriate, but we will endeavour not to repeat the major tactical error of 2006 which was to take directional (or asset allocation) bets on the market.

We are therefore satisfied with the returns that the fund has delivered in 2007 on the back of solid stock picking. We have largely kept pace with the All Share Index which is pleasing considering our unwillingness to overload the fund with risk and our preference for value over momentum. For some time the fund has been running at much lower levels of volatility and risk than the broader market, given our belief that the bull market is reasonably extended.

We have found ourselves long, but underweight the heavyweight miners Anglo American and BHP Billiton (BHP) that have been the cornerstones of JSE performance in 2007, particularly in the second quarter - BHP is up over 50% in the first six months of 2007. We like these businesses long-term but are not prepared to allocate 25% of the portfolio to two stocks in order to align ourselves with the ALSI benchmark weighting at this late stage of the commodity cycle.

Recently, the diversified miners have shot the lights out on the back of further good news on the commodity price front as well as rumours on the corporate action front. Though we are underweight Resources, BHP and Impala Platinum are our preferred commodity counters on account of their solid production growth profiles.

Up until earlier this year most stocks were in well established bull trends, and to a large degree relative performance had been driven by relative earnings growth. Further, global equity markets have been characterized by a distinct lack of volatility. We do suspect we may be approaching a crossroads where the earnings (and price performances) of the various sectors begins diverging. We think that the playing field is likely to move in favour of stock pickers and active managers and we are relishing the opportunity to take advantage of the increase in volatility that we expect.

Many of the domestic counters have to contend with top of the cycle earnings slowdowns that are largely not reflected in the price. Inflation is surprising on the upside and, given our contention that the rand is on the strong side, the tightening cycle may have legs.

Accordingly, we are underweight the domestics, although we quite like the banks at current levels on a lower-risk medium-term domestic play. Our preferences are Standard Bank and Firstrand. We continue to own SA media counters that dominate their areas, though the value that we perceived in Johncom and Primedia has largely been unlocked.

We prefer stocks that are earlier in the earnings growth cycle or have bad news in the price. In this regard we remain long of Afrox and have been acquiring AGI. We bought Steinhoff into weakness and have been buyers of Old Mutual.

Historically we have performed well in an environment of higher volatility and one where careful stock selection differentiates managers. We think we will be well placed given our expectations for choppier markets that offer good stock picking opportunities in the months ahead.

The first quarter of 2007 has seen a continuation of the bullish sentiment on the JSE. The All Share was up 10% on the quarter, no mean feat considering that the end of February correction wiped out all the gains for the year. In other words, the market put on 10% in less than a month from the lows of 5 March - no wonder we call this a bull market.

We would point out that the characteristics of the JSE at present are unlikely to be representative of an environment in which we would expect to cover ourselves with glory. We are unapologetically conviction managers. When conviction is high, and the rewards are high relative to the risks, we take relatively large stakes and are much more focused on the pay-off of a position relative to the capital risk. Where conviction levels are low, as they are at the moment, we happily adopt a focus on value and give attention to preservation of capital. Remember, our objective is to outperform the benchmark over the market cycle, as opposed to every quarter (which is impossible).

It is worth noting that while recent relative performance has been mediocre and the current state of the market is not exactly to our liking, being in a high-beta high-momentum mood, it needs to be seen in the context of our longer term achievements and strategies. According to Standard & Poor's Fund Services, the fund is the best performing general equity fund over five years to end March 2007 (out of 38 funds) and is ranked second out of 51 funds over five years if you combine the general equity, value and growth unit trust sectors (as we believe one should). The fund has produced a compounded annual return of 37% over five years and 49% over three years. We believe this bears out our ability to produce excess returns in different types of markets on a long-term sustainable basis.

We capped the fund size at R1 billion to ensure that we will be in a position to avail ourselves of juicy opportunities that arise in the equity market, rather than constrain ourselves to large caps, and are convinced that we will uncover such opportunities in the fullness of time as we have done in the past.

Investors will notice active management of the net equity position of the fund during the first three months of 2007. We started the year struggling to find stock ideas and were happy to sit in relatively high cash levels. This stood us in pretty good stead during the end-Feb early-March mini-correction. When it became clear that markets were happy to shrug off their woes and march higher, allied to the fact that our process generated some buying ideas, we put most of the cash to work. Recent purchases and core holdings come from outside of the hyped emerging market stories and while it can be argued that we sold our retailers, construction plays, telecoms stocks and banks too early, particularly in the context of the private equity underpin, we prefer to sell early when our price targets are breached.

The fund has taken on a distinctly value bias and we have focused a lot of attention on seeking out opportunities where we perceive downside to be fairly limited, preferably combined with the optionality of upside pay-off.

2006 ended up being another monumental year for South African equities - the JSE All Share returned in excess of 41 %. Against this, the fund returned 37.7% lagging the benchmark largely on account of our cautious stance during the latter stages of the year, which saw the fund sitting on relatively high levels of cash and a migration of the Alphen stock picks to more defensive selections with a value bias. The strong surge in equities over the second half of 2006 was driven by stronger than expected stock earnings and heightened global appetite for risk which spilled over to the local stock market.

The fund's recent under-performance of its benchmark needs to be seen in the context of the phenomenal bull run of the past three and a half years. From the lows of April 2003, the fund has produced an average compounded annual return of 50.4% (Micropal), placing it first in the General Equity unit trust sector, versus the 43.3% (I-Net) of the JSE All Share Index. The fund's excess return over this period was built upon effective allocation of cash to the sectors and shares that we believed offered the best return on a risk-reward basis. Over this period this has seen the fund relatively aggressively exposed to domestic shares (initially) and then resource shares (more recently). We took the opportunity of stocking up on the domestic shares after their May/June 2006 sell-off, but having trimmed our exposures in November have been surprised by the extent of the surge into the year end.

For some time our investment process has been failing to generate high conviction buys, with few shares offering an attractive enough return or margin of safety for our liking. This does not mean that we are bearish on the South African economy or that we cannot find stocks with good growth prospects, it just means that we deem the good news (and more) to be largely in the price. Sure, investors taking a five year view can afford to weather the inevitable corrections, but we consider that the risk of capital loss over the short and medium term has increased substantially. With the preservation of our client's capital in mind we consider it appropriate to be inclined to de-risk the portfolio in the current circumstances.

The dividend yield (2%) and the PE (17.8) of the Top 40 are at levels last seen in early 2000. Headwinds that need to be overcome by the market in 2007 include: higher local interest rates (with risk lying to the upside); higher levels of earnings risk; likely margin pressure; and a downturn in the commodity cycle amidst a slowing global economy.

At year end the fund's net market exposure was 78%, with cash levels relatively high at 13% and a further 9% hedged via ALSI futures. Within equities, Resources and Financials are underweight and Industrials overweight. We are very cautious on commodity prices over the start of 2007, though the rand may mitigate some of the damage. Within Resources our largest holdings were Sasol, BHP Billiton and Impala Platinum. Both Sasol and BHP would be vulnerable to further falls in commodity prices, though our analysis indicates that this is largely in the price. Remembering that we like raw materials over the long term, we anticipate viewing a material correction in the sector as a buying opportunity. We continue to like the long term fundamentals for precious metals, though the platinum stocks are likely to need to consolidate the gains of the past two years. We remain long term gold bulls, but find ourselves cautious of the gold stocks while the rand gold price goes through a consolidation phase and our exposure is less than 2%.

On the domestic front, we have several economic themes that we like including, construction and infrastructure spending, media, gaming and financial services. In most cases, the profit outlook for the companies that we analyse remains positive, but we are of the view that the shares are pricing in very strong growth and leave little room for the inevitable earnings slowdown. Accordingly, our stock selection within financials and industrials is largely focused on special situations where stocks are not priced for perfection. Some of the stocks we like that fit this profile are Tongaat, Primedia and Steinhoff.

If the market continues surging, the fund is unlikely to keep pace. We remain on the look out for value opportunities and the chance to employ the cash holdings.