A key change over the last quarter has been the moderation in global growth expectations, driven by a slowing developed world. The key questions now are how deep the developed world slowdown is likely to be and what fallout if any can be expected in the emerging economies. It could be argued that the commodity cycle currently lies at an inflection point.
We do, however, see some relative value within commodities. Among the commodities we have a preference for precious metals, paper and coal. Least preferred are the base metals, ferrous (iron ore and steel) and oil, all, which are trading at large premiums to their long-term values. Extensive analysis has been conducted on observed commodity price movements, and our fundamental analysis reveals that the spot prices of bellwether commodities like oil and copper are unjustified. Therefore our overweight Amplats, Anglogold, Harmony and Sappi and our zero weight in Sasol.

Turning to the Financial and Industrial sectors, we indicated in our previous quarterly report the risks attached to rising inflation and the short-term risks to interest rates. Nothing has changed. We also highlighted that we have underweighted the more cyclical, interest rate sensitive retailers (both furniture and clothing). This has proved to be correct in the short term. We are of the opinion that the inflation risks will peak in the first or second quarter of next year and then gradually decline within the targeted range set by the SARB. Interest rates are likely to peak within this period (with the potential for another 50 bps hike).

We see value in the banks. Short-term sentiment, however, is not favouring a re-rating of the banks. Although the risks have increased (in terms of a slowing retail environment and increased bad debt risk) the high levels of economic and corporate activity in SA, together with a continued improvement in the employment rate will continue to support banks returns at reasonable levels (even though the rate of growth is likely to moderate). We continue to believe that the Gross Fixed Capital Formation (GFCF) sector of the economy will grow well above trend in the medium term (at least for the next three years) supported by high levels of infrastructural spend. We have been aggressively positioned to benefit from this. The problem now, however, is identifying how to continue profiting from this growth. Many of the share prices are already reflecting the positive growth outlook, yet it is still early in the growth cycle.

As a pragmatic value manager, we will be focussed on avoiding sectors that we believe are overvalued and that pose a serious risk to the preservation of capital.

The JSE ALL Share Index has continued to show exceptional returns with a year to date rise of 14%. Share prices in general have re-rated significantly and it is becoming more difficult to identify true value in the market, especially with valuations and earnings more than doubling over the past four years. Returns are expected to moderate from current levels.

Although we remain positive on the GDP growth outlook for SA over the next few years (with compound real growth of 4.5% forecast over the next three years), there have been real signs of a slowdown in consumer spending. We do, however, believe that the interest rate and inflation risks are short-term risks and these should abate towards the end of the year. Notwithstanding this, we believe that the cyclical credit retailers remain at risk and we have very little exposure to them.

The banks have also been under pressure on the back of the rising interest rates, potential risks attached to the introduction of the National Credit Act (NCA) and the general slowdown in the consumer spending. We feel that this has been overdone. The banks are benefiting from the corporate growth that is currently accelerating and, in our opinion, activity levels will remain high on the corporate front for the foreseeable future. We see the current weakness as an opportunity to increase our exposure to the banks.

Gross Fixed Capital Formation (GFCF) spending is currently at its highest levels since the 1970's. As a percentage of GDP, this has accelerated past the 20% level and is approaching the 25% level experienced in the 1970's. We continue to believe that we will see further upgrades in earnings and growth expectations in this segment of the economy. However, much of this growth is being priced into certain shares that operate in this sector. We will revisit our shareholdings and exposures accordingly.

On the global front, global growth ex the US and Japan has surprised on the upside (in particular China). This has supported commodity prices in general. It remains our view, however, that although the demand for commodities will be supported by a benign global growth environment, commodity prices are trading well above long-term sustainable levels. Notwithstanding this, we do see some value in the precious metals stocks.

Finally, given our views that the markets in general are trading at or above fair value, investors should consider increasing their exposure to defensive assets. One for the proverbial "bottom drawer" that we know well is Remgro (REM). To remind investors of the track record of returns, adding back dividends, Remgro generated an annual compound return of 28.2% versus the FINDI of 17.8% over the past 40 years.

The JSE has started the year on a high note with the ALL Share Index rising another 9.4% in the first quarter. The resources sector has led the charge with the RESI20 index rising 13.6% in this quarter. Although we still remain generally very positive on the local fundamentals of the SA economy it is important to acknowledge that the earnings base of SA Inc has increased substantially over the past decade (it has quadrupled). Over the past three years alone it has doubled! The earnings base is high and it is likely to become more difficult to grow off this base.

In addition to this, the price to earnings ratio of the All Share has almost doubled to 15.5 times since April 2003. As a pragmatic value investor it is becoming more difficult to identify absolute value in the market. There are now a limited number of companies that are trading at a discount to intrinsic value and hence the important margin of safety required when making investment decisions is becoming less evident. We could argue that it is now becoming more of a relative investment return environment than an absolute return environment. In summary, investors should take a more cautious outlook with respect to return expectations. We could argue that this is now becoming more evident for all asset classes, not just equities.

In a market that has generally been a one way bet over the past few years, investors have generally been able to make money by being invested in just about any listed company. With the return environment potentially moderating, we feel that stock picking is becoming more important in our overall equity positioning. Successful stock selection is therefore going to be increasingly more significant in order to generate incremental alpha.One share that we still believe is likely to unlock further value for shareholders' is Barloworld. The board, together with the management team have been under pressure to restructure the business into a more focused, better run business.

We believe that after the unbundling of PPC, the sale (or listing) of the coatings division and the sale of non core businesses such as the Scientific business and Freightliner, Barloworld will be left with a more focused Caterpillar, logistics and motor business (including Avis) with strong growth prospects over the next few years. We also believe that the SA Banks are trading below their intrinsic value. Although the retail banking returns are likely to moderate, we remain positive on the growth in the corporate environment and overall returns are likely to remain high. Valuations are still reasonable.

In conclusion, although we remain very positive on the underlying growth of SA Inc, we believe that valuations are now pricing in much of the expected future growth. Although it is impossible to predict the timing of any potential turnaround in the market, we can highlight, according to our investment philosophy, that there is a limited number of shares offering value. Investors therefore need to moderate return expectations from current levels.

A big feature driving the strong equity markets has been the strong fundamentals underpinning the SA economy. The outlook for economic growth remains robust, led by continued strong fixed investment growth from the private sector and increased investment momentum from parastatals and the public sector in general. It is our view that the SARB is unlikely to increase rates further from current levels, although the risks have increased over the past few months especially due to the higher than expected current account and trade deficits. Overall, we expect another strong year of 4% real GDP growth in 2007, following last year's 5% growth. We also expect a fairly stable rand, albeit at slightly weaker levels than we see currently. This is likely to support the outlook for the financial and industrial sectors.

Many of the views that we have held with high conviction paid off handsomely this year. Our positive views on Barloworld, Remgro, Anglo, Richemont and MTN benefited the portfolio, while our negative views on Billiton and Sasol also had a positive impact on overall equity performance.

Overall, asset prices have re-rated substantially to reflect the more stable economic growth outlook. The All Share index is trading on a PE ratio of 16.9 times, while the FINDI (Financial and Industrial sector) is currently trading on a historical PE multiple of 16.4 times. These are almost double the ratings that the indices traded on in April 2003. We feel that investors should expect a more moderate outlook for equities in 2007 with returns driven mainly by earnings growth and dividends rather than any further re-rating.

In particular, we remain concerned that commodity prices are trading generally well above their long term average levels in real terms. Although they have started to moderate, we feel that further moderation is likely. Our portfolio is positioned in such a way to get the maximum benefit should this view hold.