The SARB's slow reaction to the May/June fall in the rand and the continuing increase of South Africa's negative trade balance resulted in a 7.7% depreciation of the rand against the US$ in September.

This compares to a 3.1% fall in the Turkish lira (Turkey's Central Bank raised interest rates by 4.25% during June/July) and a 1.2% Indonesian rupiah and Brazilian real decline. (For interest sake, the moves since 1 Jan 2006 have been: rand -23.6% and lira -10.7% while the rupiah and the real strengthened by 5.7% and 7.9% respectively.) The excessive fall in the rand reflects the sudden increase in political uncertainty about South Africa, whether it will continue to follow investor-friendly and responsible growthoriented policies or whether the socialists/populists are gaining ground. The above is very important in making investment decisions regarding the future. Should South Africa indeed move away from investor-friendly growth policies, we face higher interest rates and a lower growth rate. Hence the period up to the presidential election will be volatile as the rhetoric from Cosatu and the ANC Youth League could drive/keep foreign investors away.

What to do? A weak rand is not necessarily bad for banks, but historically a weak rand has a high correlation with periods of relative underperformance. This makes sense: a weak currency implies the country is experiencing net outflows of capital, which must lead to higher interest rates, reduced economic activity and structurally higher bad-debt levels. So investors will vacillate between the benefits of the World Cup infrastructural spend and escalating political drama in the background. In the short term, the fall in the rand will spur growth in export-oriented companies, but the inflationary impact must result in higher interest rates, thus dampening consumer spending.

This brings us back to the banks and life insurers. Valuations are not bad, but the quantum of 2007 earnings growth will depend on how much more interest rates will be raised. We draw comfort from the fact that an investment in Standard Bank has generated a compound return exceeding 28% since 1982 - a period which included extreme currency and interest rate volatility. When valuations are attractive, investors must ignore the short-term negativity and focus on the longer term.

25% exposure to the SIM Global Financial Fund - now 15% The fund has had a 25% exposure to the global financial markets. However, unit trust regulations state that the category in which the fund is registered limits offshore exposure to 15%.

Hence we had to use the rand weakness to reduce this exposure to 15%. This is clearly not in the best interest of investors but was forced upon us by regulations. The Sanlam Global Financial Fund performed well in US$ (+4.5% during September and +10% since 1 January). As per the above, we are not positive on SA financials in the short term, whereas we are positive about global financials

The rand declined by a further 6% against the dollar during June (to 7.12), bringing the decline since 1 January to 13% against the dollar and 21% against the euro (the dollar weakened by 7% against the euro during this period). Comparing this to movements in other currencies is instructive:

The Turkish lira was flat during June and has declined by 17% against the dollar since 1 January, while the Brazilian real gained 6% in June (against the dollar) and is up 7% since 1 January.

It is noticeable that the rand has been one of the weakest currencies this year, and currencies with large trade deficits (i.e. imports > exports) (also Hungary, New Zealand etc.) also declined the most. Emerging-market currencies with strong fundamentals and specifically trade deficits actually appreciated against the dollar.

These currency moves and the market falls reflect the increased risk aversion brought about by the continued rise in interest rates in the US (and also many other countries).
Markets have finally shifted their attention to inflation and are now worried about a) how high interest rates might go, and b) how the higher interest rates will affect the country growth rates and hence earnings forecasts of companies.

Especially banks (along with life insurers and retailers) are negatively affected in this scenario. Higher interest rates remove disposable income from consumers and increase the risk of bad debts.

It is no surprise then that with the exception of Nedcor, banks declined during this period.
Life insurers fell as well, with only Old Mutual being positive (due to its offshore exposure). Santam (a large holding in our funds) was down the most after management warned about the tough environment.

Unfortunately the uncertainty regarding higher interest rates (and their effect on consumer spending and growth) will be with us for a few months yet. Specifically in South Africa we could still face 2 - 3 further interest rate hikes.

It is unlikely that financials will outperform in this environment. However, prices have come down and valuations are attractive again. Dividend yields are between 4.5% and 5.5% and most financials will still show earnings growth exceeding 15%.

The long-term investor should find the next 3 months fertile investment ground as prices react further to the unfolding environment. 25% exposure to the SIM Global Financial Fund:

The Global Fund declined in line with other emerging markets but the impact was mitigated by the falling rand. Investors in some of the smaller emerging-market banks overreacted in their scramble to exit emerging markets. This pushed some prices down by more than 20%, creating excellent future investment

The high gold and platinum prices and global interest in emerging markets continue to keep the rand, and in turn our financial sector, strong. A strong rand makes it impossible for the SARB to hike interest rates, meaning that the good times continue to roll. Payback time will come - but it keeps being postponed.

In the meantime investors are benefiting handsomely.

A few shares performed really well (dividend payouts included) during the quarter: Nedbank (+30%), and Absa, Metropolitan, Liberty, Old Mutual, Investec and Liberty International all exceeding 15%.

Among these, Nedbank and Investec appear to be overly expensive but the prices are kept high by the limited supply of shares and, in Investec’s case, a very good and supportive environment.

Worst performers were Sanlam and Santam (11% and 15%).

The month and quarter to March were a portfolio manager’s nightmare. While delivering good returns for investors, we underperformed the Financial Index (a much cheaper option for investors). This was largely due to the unexpected good performance of Nedcor and Investec (very expensive), Old Mutual (Aviva’s bid for Prudential caused all UK listed insurers to rerate), Liberty (held up well despite the resignations of Myles Ruck and Ian Kirk) and Liberty International, which jumped on the back of the March UK budget that made investing in UK REITs more attractive.

After a month in which the three top-performing stocks were those to which the fund had zero exposure, one feels like saying to clients: "I’m sure you would do better by investing in an index fund".

Hopefully underlying valuations will reassert themselves next month.

25% exposure to the SIM Global Financial Fund

The global fund did well (13.0%) in US$, but this was not good enough compared to the returns of South African financials. At some stage these dynamics will change, but it is difficult to forecast when. We remain convinced about the long-term benefits of the strategy of having a large exposure to non-South African financials. While it is causing the fund to underperform relative to other financial funds (and the SA Financial Index), the absolute returns are very satisfactory and one has the peace of mind of not being solely dependent on one market in one country for performance.

It seems as if international investors have rediscovered South Africa, especially during December. Our large financial shares were significantly rerated: FirstRand +16%; Sanlam +14%; Sasfin +13%; Santam, Metlife and Abil +12%, the "laggard" being Liberty with +5%. The last quarter of 2005 was also a good quarter for financials, with Venfin gaining +43%; Abil +21%; Sanlam +18% and Liberty +17%.

Looking back at the year, we feel vindicated by our continued calls in 2004 and early this year that financials were very undervalued: Venfin +93% (corporate action), Investec +60%, FirstRand +53%, Remgro +43%, etc. We held the wrong small caps in our fund (Sasfin +44%). The four best performers in the financial sector showed that small cap fund managers had a great year: PSG +140%, Peregrine +120%, Capitec +112% and Brait +100%.

With hindsight our investment mistake was not to invest in the above small cap stocks. Our investment stance, however, is to invest in undervalued (financial) companies with predictable, sustainable earnings. Hence we selected Sasfin and Santam but not PSG, Peregrine and Brait, where the earnings are very inconsistent and dependent on the investment climate of the JSE (which can swing at a moment's notice).

That does NOT excuse us from not holding Abil (African Bank), especially as we have known management and the company for many, many years and have always held it as one of our largest investments. African Bank has a team that is very focused and incredibly professional in what they do. In addition, they continually pay out the surplus cash generated to investors via dividends. Yet we sold our holdings during 2004 when we thought they were too expensive - a bad mistake by a professional fund manager who should have known better.

For the first time since 1998 financial shares are marginally overvalued. However, the dividend yields and earnings growth prospects are still such that these shares should outperform cash, bonds and resources shares.

Investors must however realise that most of the rerating has taken place. Standard Bank and FirstRand are back at P/NAVs exceeding 3x. From here on share price gains can only be driven by earnings growth (+/- 15% per annum) and there is a risk of a derating if there is a sudden change in the global investment climate (an oil shock, unexpected higher interest rates or something else that derails the current optimistic outlook on global growth).

Over the past 25 years South African banks have proven their ability to consistently grow their NAV and pay a dividend that grows every year. The economic environment for South Africa is now better than at any stage since the early 1960s (resource prices were still under pressure in the mid-1990s and our inflation and interest rates were still higher). Hence, one can't find fault with the current investment environment. Long-term investors won't be disappointed. But in the short term investors will have to temper their expectations.

25% investment in the SIM Global Financial Fund
This fund performed very well in US$ (+38% taking its annual compound growth rate in US$ to 47% over the past 3 years and 25% over the past 5 years). The advantage of this fund is that it "plays in a very large park" with literally the world as its oyster. Hence we are very positive about this investment as it will enhance our returns when the South African market goes ex-growth or derates.