Sector Review
Much of the quarter was spent grappling with the peripheral sovereign debt issues in Europe, as politicians and the private sector battled to find common ground. Second quarter European bank earnings were also softer than expected. UBS reported a 49% decline in earnings largely due to the underperformance of its investment bank and trading arms. Its cost-to-income ratio came in at 86% - the highest in the industry. It announced a 5% jobs cut. Credit Suisse, Nomura, Deutsche, Morgan Stanley and Goldman's also announced job cuts during the period as investment banking and trading activity just did not materialise.

Perhaps one of the biggest concerns for global banks is the changing regulatory environment. Many commentators have voiced concerns over the hoarding of capital by banks given the uncertainty around the capital and liquidity requirements for Basel 3. This is one of the reasons banks are reluctant to grow advances on assets that carry a high risk weighting, which might be one of the constraints for growth. Our local market was equally volatile in response to the above events. The broader market, as represented by the SWIX, ended the period down 5.3%. The Financial Index outperformed the broader market, falling 4% versus more than 5% in quarter three. Year to date, the broader market is down 6%, while the financial index has lost 4.4%.

The developed world consumer remains under pressure, as do advances growth, with any apparent earnings growth from the large developed world banks' retail and corporate divisions resulting from lower bad debt write offs. The SA consumer remains over indebted and the little growth we have seen in retail advances has been in the unsecured credit market benefiting primarily the new age banks: Capitec and African Bank. In general, our banking sector is experiencing a recovery in retail bad debts while waiting for the return of commercial and market activity.

Our market and the financial sector in particular has not escaped the prevailing negative sentiment towards financial shares as the sector absorbed the uncertainty around the regulation of financial services companies, in particular with regard to capital requirements.

Fund developments
The fund had a weak third quarter, underperforming the Financial Index as our banks, Old Mutual and Investec positions underperformed materially. Local insurers outperformed and we have less exposure to the sector. Year to date, however, the fund has outperformed the Financial Index and broader market. We continued to cut our position in the insurance sector, in particular in Liberty Holdings and Santam, which have performed exceptionally well. We also sold our holding in Coronation, which has exceeded our intrinsic value. We remain significant holders of counters that are exposed to events unfolding in the Euro zone region, (Old Mutual and Investec) as well as local banks as these counters offer value in our view. Outlook With the implementation of Basel III in 2013 we would expect the regulatory rhetoric to continue to weigh on the sector in the near term. Locally, activity in the financial sector might remain subdued term. Locally, activity in the financial sector might remain subdued for a while.

We reiterate our view that the value in the financial sector lies in the areas of greater uncertainty, with the local banks, Investec and Old Mutual offering the best value in our view. But we are aware that we will need to be patient as there is no obvious catalyst to realising this value in the short term, and we firmly believe these sectors will deliver good returns for the fund in the medium term.

Sector Review
The developed world consumer remains under pressure as does advances growth, with any apparent earnings growth from the large developed world banks' retail and corporate divisions stemming from lower bad debt write offs. The South African consumer remains over indebted and the little growth we have seen in retail advances has been in the unsecured credit market, primarily benefiting the new age banks: Capitec and African Bank. In general, our banking sector is experiencing a recovery in retail bad debts, while waiting for a revival in commercial and market activity.

Our stock market, and the financial sector in particular, has not escaped the prevailing negative sentiment towards financial shares and the sector is still in the process of absorbing the uncertainty around the regulation of financial services companies, in particular with regard to capital requirements.

As a result, the South African financial sector essentially moved sideways in the second quarter, declining around 0.33%, with the broader market down around 0.5%. Year to date the financials are down a similar percentage. A strong performance from the insurers was offset by a poor showing from the banks. The latest quarter was, however, a disappointing one for the life insurers on the whole. Old Mutual came under pressure during the quarter as the Greek debt situation dominated concerns in the pan-European region. So while the local life companies recovered most of the decline experienced in the first quarter, this was not enough to offset Old Mutual's decline.

Financial services had a good quarter as Investec put in a robust recovery, albeit off a depressed base, and Coronation continued to climb higher on the back of strong results. Banks gave away the marginal outperformance experienced in the first quarter to end lower year to date. Weak sentiment continues to weigh on the sector as regulatory uncertainty coupled with an over indebted consumer and lacklustre advances growth persist.

Fund developments
The Fund had a weaker second quarter, performing largely in line with the Financial Index as our Old Mutual and bank holdings underperformed and our larger holding in Investec was insufficient to offset this decline. Investec, despite all the negative news in the quarter, bounced back strongly having carried just too much bad news in its price in our view. Year to date the fund has outperformed the Financial Index and the broader market. With the recent outperformance of local life companies, we see little value in this space and have been reducing our weight here in favour of the banks that are showing some value. Coronation and Santam have performed well and appear to be fully valued in our view and we have also been reducing our positions here in favour of the banks. We did comment in the prior quarter that we had trimmed our holdings in counters that had more significant pan-European exposure to reduce some of the risk in the portfolio, but pointed out that we are still significantly exposed to the region as we believe these counters offer good value.

Outlook
It seems the debt issues plaguing the Euro zone will not go away in a hurry. Mervyn King stated recently that he believed this crisis was one of solvency and not liquidity and could not be solved by continuing to lend to countries that simply could not service their debt. While this strategy buys time, it does not solve the problem. If the route is to be via austerity measures, there is a tough reality looming. With the implementation of Basel III in 2013, we would expect the regulatory rhetoric to continue to weigh on the sector in the near term.

Locally, activity in the financial sector might remain subdued for a while. The consumer is still over indebted and we are not creating jobs. Inflation seems to be under control for now but upward revisions from the Reserve Bank and local economists due to rising input prices points to some uncertainty on this front. Rising inflation will put pressure on real income growth. With corporate South Africa sitting on excess capacity, we expect the investment cycle to remain fairly subdued in the short term. This, coupled with the state of the consumer and a lacklustre property market, is likely to continue to suppress advances growth for some time.

We believe the value in the financial sector lies in the areas of greater uncertainty, with the local banks, Investec and OldMutual, offering the best value in our view. We are aware that we will need to be patient because there is no obvious catalyst to realise this value in the short term but we are firmly of the view that these sectors will deliver good returns for the fund in the medium term.

Sector Review
Financial shares continued to show no clear direction during the first quarter of the year, heading steadily into the red before a late rally in the bank shares saw the sector end flat for the quarter. A recurring theme we have been commenting on is the uncertainty about what is happening in the global economy. This uncertainty seems to be magnifying investors' reaction to news flow. And there certainly has been a lot of news flow, ranging from weatherrelated disasters to ongoing sovereign debt issues and political turmoil. While South Africa will be impacted to varying extents by these and other factors, most of the domestic financial shares have limited exposure to offshore operations. Due to the relative underperformance of virtually every one of their foreign operations, these now comprise an even a smaller portion of the value of these shares. So while our financial companies continue to spend an inordinate amount of time and capital on their foreign operations, they are not likely to be the real driver of medium-term performance unless the rand weakens substantially. As often happens, the unloved shares of the previous quarter can become the stars of the next - and that is what happened to the Old Mutual and Nedbank shares, which dramatically outperformed their peer group during the first three months of the year. The market's love affair with Standard Bank seems to be under serious threat, with the counter lagging the rest of the big four banks during the quarter.

Fund Developments
The fund had an excellent quarter. As mentioned in the previous commentary, we were comfortable with the portfolio and did not think any radical action was necessary. Our positions in Old Mutual and Nedbank came through making up for the underperformance during the previous quarter.

While we retained our conviction bets through the quarter, we have decided to change one aspect of the financial fund.We have continued to reduce the exposure to foreign financials because of the complexity of the current environment, with governments owning large pieces of banks and insurers; the uncertainty of their capital bases and the advent of ever more regulation, makes it difficult to have conviction across so many jurisdictions. In future we will be focussing the fund on South African financials.

Outlook
The investment environment continues to be challenging. Despite the lowest interest rates in several decades, borrowers are still recovering from the overindulgence arising from the previously low interest rates cycle and the asset bubble that was a result of that.

While economists and the government are happy to focus on core inflation, the consumer is bombarded with increases in food prices, transport and electricity cost, as well as rates and taxes. Corporates have excess capacity and are not keen to borrow until they know any uptick in demand is sustainable.

So while the consumer is in better shape than 18 months ago, loan growth is likely to be muted for a while. Financial companies will have to concentrate on efficiencies to boost earnings until the top line recovers later on. By continuing to invest in financial shares that offer the best value, we should be able to maintain the fund's very good long term track record relative to its JSE Financial Index benchmark.

Market Review
Financial share prices continued to be volatile in the fourth quarter of 2010, with the index receding more than 5% before recovering in December. The biggest news was HSBC's decision to walk away from a Nedbank deal without really saying why. This had a negative impact on Nedbank's share price on concerns that HSBC saw something in their due diligence that scared them. Time will tell but we believe these concerns are unfounded. The knock on impact on Nedbank's parent Old Mutual (OML) was even more pronounced and this, together with their failure to complete the sale of their US life business by year end, meant OML was the worst performing financial share of the quarter.

Other important news was Standard Bank's decision to cut costs quite radically and change their offshore strategy to become more Afro-centric. This admission that revenue growth was not going to match spiralling costs led to significant earnings downgrades and consequent share price weakness in what many consider the blue chip financial share in SA.

The excellent share price performance of some of the smaller financial shares such as Coronation, Santam, African Bank and Brait was not enough to outweigh the underperformance of the larger shares mentioned above resulting in a decline in the Financial Index for the quarter.

What added to - and detracted from - performance
The fund did not have the best of quarters. Over-exposure to the three large shares mentioned above and an underweight in many of the better performing smaller shares meant we underperformed the index during the quarter although not for the full calendar year. Not only were we underweight these shares but we also sold them too early, which, although inherently a by product of our pragmatic value philosophy, contributed to the Fund's short-term underperformance. Despite the poor relative performance in the quarter we remain convinced that value investing leads to superior performance over the longer term. We believe the Fund is well placed for the year ahead and will not be making any radical changes to the portfolio at the start of 2011.

SIM strategy
As we expected, 2010 proved a challenging one for the financial sector. No one yet seems sure what is going to happen to the global economic recovery post the financial crisis. However, it does seem that investors are currently giving the recovery the benefit of the doubt and shares appear to be discounting a lot of good news to come. Whilst SA financials don't offer significant upside to our valuations, the companies remain financially sound and dividend yields are very competitive when compared with current cash rates. In 2011 we will focus on maintaining the fund's very good long term track record relative to the Financial Index.