They say a week is a long time in politics. The past quarter and indeed the past few weeks have seemed like an eternity in the financial markets. In our recent commentaries we have consistently said that we expected financial markets to be volatile, but little did we know just how volatile they would be.

The credit fiasco, which started with an oversupply of liquidity in global markets and led, among other things, to the US sub-prime debacle, has now begun to affect all segments of the global economy. The recently announced US bail-out package is evidence of just how bad things have become. At this stage we can't see a quick resolution of the financial crisis and expect the recovery to be long and slow.

The kind of risk aversion that is part of the current crisis means that many investment fundamentals are being ignored. This leads to good opportunities to buy good companies at cheap prices. However, we are very aware that even highly regarded companies have succumbed in this environment.

Our financial companies (87% of the fund) have been relatively unscathed due to a combination of factors, not least of which are exchange controls which limited exposure to foreign assets. However, we also believe that management and the regulators have also been conservative in terms of having adequate capital and not being too overzealous about putting that capital at risk.

Most of the third quarter was quite promising for the fund and despite a sharp decline in financial shares in September we were able to reverse some of the losses from earlier in the year. Among the biggest detractors were our investment in OML and our exposure to the Sanlam Global Financial Fund. OML has suffered as a result of ongoing problems in its US life business. This was compounded by developed-market investors' aversion to all financial shares. We continue to believe that OML is oversold and that it offers good value.

Similarly we remain very comfortable with the fund's exposure to the Sanlam Global Financial Fund. This fund has a broad spread of investments in financial companies across both developed and developing markets and provides the fund with valuable diversification from an otherwise limited local investment universe.

In this environment, predicting the future is even more hazardous than it normally is. However, while we expect fundamentals for SA financials to continue to moderate well into next year, we still believe they offer good value for the long-term investor. Who would have thought that, given all that has transpired, bank shares would outperform the ALSI for the year to date? Although nothing is certain in these uncertain times, our financial companies remain well capitalised and most have limited exposure to foreign assets and funding. We continue to believe they offer an attractive investment opportunity in the long-term.

In our previous review we indicated that we expected markets to remain volatile for the next 12 to 18 months. This has indeed characterised the investment environment in the last quarter and financials in particular have not been spared. The US sub-prime contagion continues to have widespread ramifications that defy those experts who have repeatedly claimed that the worst was over. We remain of the view that markets will remain volatile for at least the next12 months.

Over the last quarter, the SA Financial Index was down 16%, which was in line with a decline of 14% for global financials but worse than emerging-market financials, which declined by only 9%. The biggest declines occurred in June when global inflation fears surged on the back of increasing food and oil prices.

The Financial Fund could not escape the contagion and declined by just over 13% over the period. This was despite our efforts to invest in those shares offering best fundamental value or which we perceived to be more defensive in nature. Banks declined by 16% and life insurance companies fared even worse and were down almost 17%. The latter decline was largely due to OML announcing a further negative surprise in its US life business on the back of the global credit crisis.

In short, there has literally been no place to hide within financials, both locally and abroad. While we often focus on the SA fundamentals as depicted in the media, it is telling that issues such as tight credit markets, food and transport inflation as well as falling house prices are afflicting many markets around the world. We are not alone in the challenges the economy faces but, unlike some of the other markets, our banks and life companies remain well capitalized and there is no evidence to suggest this will change as we make our way through the current difficult cycle. In terms of our local financial sector investment universe, only four shares actually gained in value over the period, namely Blue Financial, Liberty Holding (on the back of the Standard Bank offer), Clientele and PSG Group. None of the large life companies or banks could do better than -13%.

The sell-off has been indiscriminate. Unfortunately the medium-term outlook remains challenging as the SA consumer battles the twin perils of high inflation and increasing interest rates. This will impact credit quality and the sales of financial products over the next 18 to 24 months. Corporate SA is also starting to feel the effects of lower consumer demand.

It is in times like these that we remain focused on our pragmatic value approach in the realisation that we cannot time the market. As an equity-only fund (we can only hold limited amounts of cash) we will continue to invest in those shares that in our opinion offer long-term value on normalised valuation metrics. After the battering the financial shares have taken we are even more convinced that there are very good value opportunities, but we are equally aware that it may take some time for that value to emerge.

Sanlam Financial Fund changed its name to SIM Financial Fund on 1 August 2008.

Financial services companies remained under pressure in the first quarter as expected. The full implications of the financial crisis stemming from the US sub-prime debacle are still unknown and this uncertainty is leading to extreme volatility in prices as markets react quite violently to different news flows. We are of the opinion that this situation is likely to continue for the next 12 to 18 months.

Some argue that this is only a liquidity issue, but our view is that the liquidity problems stem from a fear of defaults, which points to the underlying issue being a solvency matter which is much more serious. The drastic action by the US Federal Reserve in reducing interest rates and effectively bailing out Bear Stearns is, in our opinion, indicative of serious potential systemic risk.

While local financial services companies in general are relatively unaffected, some have been directly impacted. Old Mutual has direct exposure to the US credit markets through its US life business, while Investec has exposure both in the US and the UK. FirstRand lost R1.3 billion as liquidity dramatically affected its offshore equities trading business.

In addition to the difficult global environment, local conditions also deteriorated as it became more evident that the consumer was facing increasing pressure on disposable income. The middle-market consumer seems to have been most severely impacted as a result of the cumulative 400 bps increase in interest rates and much higher than expected food and transport inflation. As second-round inflationary risks increase there is a strong likelihood that interest rates could be increased still further despite signs of slowing private credit extension.
The Financial Fund could not escape this negative environment and lost 12.6% of value in the first quarter despite a concerted effort to retain higher cash levels and to invest in shares with more defensive qualities, such as the life insurers.

Specifically our positions in Sanlam, Old Mutual and Sasfin were among the biggest detractions from performance. Old Mutual was particularly negatively impacted by the global financial crisis despite sound operational performance. Our bets in ABSA, Metropolitan and Liberty International were among the better performers. It is interesting to note that Liberty International was only one of three shares in our investment universe (and the only large liquid share) to appreciate in price over the quarter.

Although we believe it is important to communicate about the fund on a quarterly basis we would caution about measuring performance over such a short term. While we do not underestimate the seriousness of the current financial crisis, nor the constrained prospects for the SA economy in the short to medium term, we remain confident about the financial health of most financial shares in our investment universe. We expect the environment for financial shares to start improving towards the end of the year and believe that these shares offer a great opportunity for long-term value investors.

The last quarter of 2007 proved the most eventful of the year. The market has a tendency to underestimate how far the pendulum swings and sentiment towards interest-sensitive stocks like the banks was a good example of this.

With some thinking the worst of the sub- prime crisis was behind us, it became clear that we would have to live with the consequences for some time to come. Even those investment banks that should have known better appeared uncertain of their own exposure. This did not instil confidence in investors and bankers alike, which took its toll on equity and credit markets.

On the domestic front it also became obvious that while there were some signs of retail credit extension slowing down, the rate of growth was still high. Unfortunately the SARB has very limited tools with which to fight inflation and continued to use interest rates to combat inflation primarily driven by food and energy prices, which are not much influenced by interest rates.

Although we were well aware of the risks of further sub-prime contagion as well as a longer-than-expected interest rate up-cycle, we were of the opinion that bank share prices had already more than compensated for this towards the end of September. We subsequently started to rebalance the fund away from our foreign exposure towards local banks. We were able to benefit from the rebound in prices through middle October and the second wind derived from the announced sale of 20% of SBK to a major Chinese bank.

However, we felt the exuberance reflected in the very strong price movement was overdone and started lightening our banks position only a month after increasing it. Once the initial excitement abated and the realities of higher interest rates, slowing retail sales, the impact of the National Credit Act and an overburdened consumer started to take their toll, the banks retraced all of the gains made.

Looking back over the year it may come as a surprise that some financial stocks did outperform the market. Most of these were smaller-cap financials, but Santam, Sanlam and African Bank all did better than the JSE index. Some of the best performers in 2006 were the laggards in 2007, namely Investec and Liberty International, and the life sector did better than the banks for the second year in row.

According to our records, with a return of 12.5% the fund outperformed the Satrix financial index by almost 10% over the year and the JSE by almost 6%, proving that even in a difficult macro-environment for financial stocks a focused, actively managed fund can deliver outperformance.

We expect 2008 to be an even more challenging year but remain confident that the banks' diversified revenue streams, the life sector's restructuring efforts and valuations will underpin share prices that do not reflect the underlying value of these shares.