The recent volatility in local and global markets has been induced to a large extent by the US sub-prime issue. This has led to uncertainty in global financial markets as liquidity has tightened and central banks have had to intervene in order to calm markets. However, the reaction of global markets to the US Federal Reserve's 50 basis point cut in the Fed funds rate has been interesting. In previous cycles, this would have been a clear signal that risks to the US growth outlook are to the downside. Markets would react cautiously, commodity prices would soften somewhat and the general outlook for growth would moderate. The old adage of "it is different this time round" suddenly springs to mind. Hwoever, in the past we have learnt (sometimes the hard way) that there is and always will be a cycle - the US is likely to see slower growth, at the margin, and this is likely to impact other developed economies, although the developing world's growth rate is likely to remain sound.

Since the start of the decade the world has seen three cycles in industrial output, with a noticeable underlying upward trend. It is evident that each successive trough has been higher than the previous one, and each trough has been positive. In other words, in this decade demand has rebased upwards compared to the previous two decades. 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.

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 of which are trading at large premiums to their long-term values.

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 pointed out that we have avoided the more cyclical, interest-rate-sensitive retailers (both furniture and clothing). This has proved to be correct in the short term. We continue to believe that the risks remain in the short term; however, we are of the opinion that the inflation risks will peak in the first or second quarter of next year and then gradually decline to within the targeted range set by the SARB. Interest rates are likely to peak within this period. The outlook for sustained growth in domestic GDP is sound and this will support the general outlook for SA Inc.

We see value in 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. We also see some value in the more defensive food retailers, telecommunications, areas within the health-care sector and technology. We continue to believe that the gross fixed capital formation (GFCF) sector of the economy will grow well above trend in the medium term. We have been reasonably well positioned to benefit from this.

As a pragmatic value manager, we will be focused 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 the year-to-date return at 13.7%. As indicated in my previous quarterly report, asset prices in general have rerated 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.

Although we remain positive on the GDP growth outlook for SA over the next few years (4.5% compound real growth over the next three years), there have been real signs of a slowdown in consumer spending. This, understandably, is on the back of the recent increases in interest rates, the huge increase in credit extension (household debt to disposable income is now at 75.9%) and the consumers- debt-service cost increasing to 10%. With inflation remaining stubbornly high in the short term, the risk is clearly that we may see a further rise in interest rates (especially if food inflation and oil prices remain high). 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 related to the introduction of the National Credit Act (NCA), and the general slowdown in consumer spending. We feel that this has been overdone. The banks are also exposed to 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 banks.

Gross fixed capital formation (GFCF) spending is currently at its highest levels since the 1970s. As a percentage of GDP this has accelerated past the 20% level and is approaching the 25% level that was experienced in the 1970s. 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.

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). Remgro generated an annual compound return of 28.2% versus the 17.8% of the FINDI over the past 40 years.

In conclusion, although we still see pockets of relative value with certain companies offering the potential to generate double-digit returns over the next 12 months, the market in general is trading at or above intrinsic value and returns are expected to moderate from current levels.

The JSE started the year on a high note, with the ALL Share Index rising by another 9.4% in the first quarter. The resources sector has led the charge, with the RESI20 Index rising by 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 have a more cautious outlook with regard to return expectations 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, has 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 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 believe a limited number of shares are offering value. Investors therefore need to moderate return expectations from current levels.

The third quarter proved to be a strong quarter for equities, with the All Share Index rising by 11.4% in the fourth quarter and by 37.7% for the full year (excluding dividends). Overall, the total return for the All Share Index (including dividends) was 41% in 2006, this coming on top of a return of 45% in 2005. The first three quarters of the year were all about resources; however, with commodity prices in general coming under pressure in the final quarter and the industrial sector gaining significantly, there was little to choose from between the two sectors for the full year. The Resources Index returned 41% for the year, while the Industrial Index returned 39% and Financials lagged slightly, returning 31% (all of the above excluding dividends).

A major feature driving the strong equity markets has been the strong economic fundamentals underpinning the SA economy. The outlook for economic growth remains robust, underpinned by a favourable outlook for gross fixed capital formation led by continued strong growth from the private sector and increased momentum from parastatals and the public sector in general. Although consumer spend is expected to remain sound on the back of strong household balance sheets, we do expect the rate of growth in spend to moderate due to higher debt service costs, lower real wage growth, moderation in expected social grants and tax relief. 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 deficit. That said, although we are of the opinion that inflation is likely to exceed the upper end of the inflation target band in the first quarter of 2007, we believe that this will be temporary and inflation will moderate to below 5% in the second half of 2007. 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 are seeing currently). This is likely to support the outlook for the financial and industrial sector.

We do, however, remain concerned about the fact that commodity prices are generally trading well above their long-term average levels (in real terms). Although they have started to moderate, we believe that further moderation is likely. We remain wary of commodity shares in general. Many of the high-conviction stocks that we had in the portfolio, i.e. Barloworld, Remgro, Sappi, Richemont and MTN, paid off handsomely this year.

Overall, although we feel that the outlook for economic growth in SA is good, asset prices have re-rated substantially to reflect a more favourable 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. This is almost double the ratings at which the indices traded in April 2003. We are of the opinion 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. We still believe that the outlook for SA is more conducive to better returns being generated from the FINDI sector versus resources.