Sector Market Review

The financial sector remained volatile during the third quarter. Initially the market rallied on positive earnings expectations for the June results season, only to be disappointed by performance that was below expectations from many financial services companies, including three of the large banks. Outlook statements were generally cautious and investors may also have been concerned about a slowdown in business after the exuberance of the World Cup.

Fortunately in September corporate activity came to the rescue as Old Mutual announced HSBC was considering purchasing a controlling interest in Nedbank. This news probably ignited renewed foreign investor interest in South African financials and also boosted the Old Mutual and Nedbank share prices.

Life and smaller financial services company results were as much of a mixed bag as the banks, with the market rewarding those companies that delivered better results, such as FirstRand and Discovery.

Fund Developments
We did not trade aggressively through the quarter. We added to our holdings in FirstRand, Investec and Metropolitan and sold down some of our Sasfin stake on the back of expectations that they will find it hard to generate adequate returns on their excessive capital base in the medium term. We also took profits in some of our offshore investments before the rand strengthened.

Our holdings in Old Mutual, Nedbank and PSG were very good contributors to the fund's performance. Standard Bank, Liberty and Metropolitan were the main drags on performance.

Outlook
While bank earnings are likely to recover as a result of lower bad debt charges, the possibility of even further rate cuts on the back of a benign inflation outlook would constrain that recovery. It will take time for credit repricing to positively affect the back book of the banks, given expected slow credit growth.

Demand for new financial products is likely to remain tepid but overall the consumer's financial position should stabilise on the back of lower inflation and higher wage increases. This is likely to favour the life companies more than the banks in the short term by improving lapse rates.

The markets have improved since June and if these levels are maintained the life companies will benefit, together with some of the smaller financial services companies, which have business models linked to asset values.

Given pressure at the top line, we expect companies to concentrate on cost cutting to offset lower revenue growth. Overall South African financial services companies remain well capitalised, are still profitable and will benefit in the medium- to longer-term as the economy improves.

Market review
The strong first quarter performance of the financial sector was not sustained through to June. The net result was that the financial sector finished the second quarter pretty much where it started 2010. In contrast to the generally steady gains made by the equity market through March, the subsequent decline has been characterised by nervousness and thus significant volatility.

Both positive and negative news flowed during the quarter, with concerns about sovereign debt and potentially restrictive new financial regulations weighing on the sector. Up until the end of the quarter, however, there was enough evidence to suggest that the global economy had seen the worst and had entered a period of slow but steady growth. However, more recent indications are that global growth is slowing and a double-dip scenario has become more likely.

Local macroeconomic developments echoed the patchy global outlook. Car sales continued to recover off a low base and house prices began to show signs of growth after their first nominal decline in more than 20 years. This was offset by sluggish credit growth and worrisome unemployment data. Trading updates from the companies suggested earnings expectations might be a bit too optimistic.

Although the insurance sub-sector was the best performer during the second quarter, the general financial shares have still been the place to be year to date.

What SIM did
During the quarter we increased our weight in banks on valuation grounds. In hindsight this seems to have been a bit premature but we believe the position will contribute positively in the medium term. We have also slightly reduced our exposure to foreign financials on the back of recent relative outperformance.

What added to - and detracted from - performance
Although the fund delivered a negative return for the quarter, performance remained positive year to date, primarily as a result of our exposure to some of the smaller general financial services companies, such as Coronation, Capitec and PSG. The Fund's exposure to Santam also added to performance.

SIM strategy
The recent market weakness has increased the gap between market prices and our estimates of intrinsic value of many of the financial sector shares. So whilst the macro outlook remains somewhat opaque, the margin for error has contracted given the widening spread between our valuation and current share prices. South African financial companies have escaped the worst of the global excesses and, while asset growth may be sluggish for longer than originally anticipated, the unwinding of the bad debt cycle, as well as the stabilisation of the consumer should provide a platform for earnings growth in the medium term. Companies are well capitalised, costs are being tightly managed and margins should improve on better pricing of better quality business. All these factors should provide a solid underpin for good quality financial shares.

Market Review

Financial shares continued their strong run in the first quarter of 2010, with banks and particularly the general financials posting strong gains. Most of this performance came through in March after most of the large financial companies released their 2009 results.

Although credit demand remained extremely sluggish, the market seems to have taken heart from indications that economic woes are slowing and that bad debt levels have peaked and should improve going forward. This would lead to strong earnings momentum for the banks. Life company valuations also improved on the back of improved equity markets and reasonable operational performance. However, the best performing subsector was the general financials, which includes Investec and African Bank.

What added to- and detracted from - performance

The fund had good absolute performance in the first quarter, performing in line with the Financial Index. We did lighten our offshore exposure during the quarter but still retained a weighting of approximately 7.5% in offshore financials. This detracted from our relative performance, primarily due to the rand's strength. Although we prefer ABSA in the fund, all four of the large banks performed in line with each other so it was our relative underweight this sub-sector that detracted from fund performance during the quarter.

Our Old Mutual holding detracted from performance as it did not sustain 2009's strong performance. We believe the company is in a vastly better financial position than in 2009 and that management understand what they need to do to extract the obvious value in the group. We increased our weighting in Metropolitan where the valuation gap was subsequently unlocked on the announced merger with Momentum.

We missed the rally in African Bank's share price. We think the market is expecting too much of a turnaround in Ellerines. But this underperformance was largely offset by our increased position in Investec.

Outlook

The market's exuberance continues to surprise us. Job losses will not be recovered easily and the consumer still has to deleverage. Weak credit demand and lending appetite is evident in the recent surprise interest rate cut. Despite this, lower bad debts will support bank earnings and lower interest rates should stimulate some credit demand towards the second half of the year. Meanwhile, higher equity markets should support life company valuations while operational performance in the sector should also benefit from a probable peak in policy lapse rates in the first half of 2009.

Non-SA banks look more attractive on valuation grounds than domestic financials. But the environment remains fragile, with sovereign debt issues in Europe and impending new regulation dampening sentiment. While it is folly to predict the rand's moves, we think the recent strength is overdone. This, together with attractive relative valuations in the banking sector, should support our continued investment of part of the fund in offshore financials.

Market Review
Stock markets and financial stocks in particular continued to be impacted by the global financial crisis well into the 1st Quarter of 2009. However by early March it appeared that US financials were showing signs of earnings recovery. This, together with massive monetary stimulus packages and the authorities' determination to prevent any further major financial company failures were the catalyst for an extended market rally for the remainder of 2009. The market seemed so relieved that the worst was over that it almost completely ignored continuous weak fundamental data. In SA the situation was no different. Massive job loses, an over-leveraged consumer, weak demand and declining earnings did not stop SA financials from posting very strong price gains from their lows in early March.

Fund Developments
The fund has delivered good absolute performance in 2009 as a result of the strong rally in financial shares in general. It also enjoyed good relative performance as a result of the investments we made in 2008. The most successful of these are our exposure to Old Mutual and the SIM Global Fund. Both of these significantly outperformed the financial index last year. Performance during 2009 also benefited from the exposure to the smaller financial shares that we built up during 2008. Detractors from performance were our underweight in Sanlam, which has been the best performing domestic large life company, and in Nedbank, the best performing domestic large bank. We also cut our position in the SIM Global Fund too early in the year, which resulted in a lost opportunity. We weren't convinced about the sustainability of the rally so we probably also had too much cash during the course of the year. It was more difficult to differentiate fundamental value in 2009 and as a result we did not trade as much as in 2008 as a rising tide seemed to lift all ships.

Outlook
The exuberance of the market continues to surprise us. Job losses will not easily be recovered, the consumer still has to readjust and the recent Christmas season may have been the last hoorah for many. We think 2009 will come to be characterised by weak demand for financial services. Globally, we can expect the authorities to start withdrawing the stimulus packages, which pose their own risks in terms of the quantum involved and the timing. Yet despite these very real challenges, the market appears to be looking forward to a recovery well into the future. Earnings will recover off a low base but real growth in advances and premiums will probably remain elusive. We are struggling to find significant value in financials in the current market and stock selection remains very difficult. As a result, we continue to avoid taking extreme positions and invest in line with our fundamental value philosophy.