In the first quarter of this year I ended the report with a comment that value remains in the eye of the beholder. Different interpretations of returns allow active managers to earn their keep. Value, generally, takes time to unwind. Sometimes irrational behaviour takes years to unwind (e.g. the technology bubble) and other times (especially with cyclical sectors, i.e. commodities) the correction is swift and nasty.

For the past few quarters we have:

o stated that equity market returns need to moderate. We have spoken of the "lollapalooza" (abnormal) events that have taken place over the last few years.
o spoken, at length, of the extent of the commodity cycle and the risk attached to a normalisation of returns, especially when more than 50% of commodity consumption takes place within the developed economies. We have spoke of the misconception that commodity shares suddenly seemed to be a "safe haven" or hedge against higher inflation and a weaker dollar - this would've been a first!
o believed that the FINDI shares offered greater relative value (versus resources) notwithstanding the risk of moderation in our local FINDI shares as well. For this reason, while the FTSE All Share Index had a 45% weighting in resource shares, we had a significantly lower weighting in this sector.o also mentioned that we will continue the search for value. We will continue our search for shares that are trading below their intrinsic value (based on what we believe are normalised and realistic assumptions).
o In the last quarterly report we spoke of the risk that, with developed economies moving into a recession, it is likely that emerging markets will also be under pressure - there is nowhere to hide in a bear market.

Our view still holds and it is uncanny how dramatically the world has changed within the space of three months. In the six months ended June 2008, the resources sector had outperformed the FINDI by 56.6%. Within three months this changed and at the time of writing the FINDI has now outperformed the RESI by a remarkable 12.6% for the year to date.

We are a fundamental, value-based asset manager. We pride ourselves on doing our own original research on companies through our pool of 15 fundamental analysts. We believe in making long term normalised assumptions when valuing companies. This allows us to avoid the short-term "noise" that is inherent in our industry. The day-to-day noise drives irrational behaviour. May we remind ourselves again, commodity shares are cyclical. Economics drives returns. Excess prices and margins are eventually eroded and some form of reversion to the mean takes place. The credit crises, the corporate failures and the bail-out packages have been well documented. I won't repeat what you've already read. What we need to highlight, though, is that when credit becomes scarce, small, medium and large companies are unable to raise sufficient capital to fund their working capital and capital expenditure needs. This puts the brakes on growth and leads to a focus on cost cutting, which means retrenchments, unemployment, slower consumption expenditure and ultimately a recession - but I think this is being priced into the market. Value managers need to see these types of corrections as great opportunities to buy good companies at bargain prices - if we're not considering buying into this weakness now, when will we ever consider buying good companies at good prices? Even some commodity shares are starting to look attractive!

In these uncertain times, we've seen relative value in the likes of Remgro, Pick 'n Pay and Shoprite. These are defensive companies with strong franchises, fantastic business economics and a strong ability to continue paying good dividends. We very recently acquired a shareholding in Telkom. This was premised on our belief that there is exceptional value in Vodacom (Telkom owns 50%of the business) and one was effectively getting the fixed-line business almost for free. We have retained our position in the banks (in particular Standard Bank and Nedcor) as we see value in the sector. We do expect a moderation in the returns of the banks (Return on Equity) as the local economy moderates; however, the valuations are already discounting this to a certain extent. We have reduced our exposure to construction shares. For the first time in a few years, we're starting to see more realistic valuations in some resource shares. We have retained a position in gold (Anglogold). This should prove to be defensive in these uncertain times. However, should we see better value in other companies, we will use our shareholding in ANG to finance other investment opportunities.

The outlook remains tough. The strong growth in corporate profits both locally and internationally is moderating as we speak. Share prices are following this trend (downwards). But, with the ALSI down almost 36% from its peak, valuations are looking more palatable (historical dividend yields are approaching 5% and price-earnings multiples for the ALSI are back in single digits).

The conclusion of my report in the first quarter read: "The first quarter of 2008 was tough". Short-term risks prevail (we will manage these appropriately) and we expect equity returns to be volatile and more subdued in 2008. However, we are pragmatic value investors and believe our clients' interests will be best served by continuing to search for shares trading below their intrinsic value. We try to avoid overvalued shares - the tricky part is that value is in the eye of the beholder. Nothing has changed - in fact, the second quarter of 2008 has proved to be tougher than the first both locally and globally. We can unequivocally state that we're in a bear market!

I've spoken at length of the likely moderation in asset prices after the excesses of the past few years. We've seen this before - it is yet another cycle. Inflation is surprising on the upside, interest rates are being hiked at a rate of knots, the oil price is at unprecedented levels and our current account is becoming a constraint that is posing risks to the currency. This is the unwinding of the excesses referred to above. It is likely to take some time to correct and in the process asset prices (equities, bonds and property prices) will moderate. I have little doubt that the pendulum will swing, once again, to the other side and the overreaction of the market on the downside (as it was on the upside) will create great value investment opportunities for the patient investor. It is happening as I'm writing this report. Alas, it is not only South Africa that is going through this period of moderation. Developed economies (in particular the US) are heading for recession. The consumer globally is reeling from high levels of debt, stubborn inflation, and a high oil price. House prices (generally the largest single asset of individuals) are falling sharply - consumers are reining in spend. It is the consumer that drove the US economy to these high levels over the past decade and it is likely to be the consumer that will drive the correction. Credit in general is being repriced and is becoming scarce. In addition, companies are de-leveraging at a rapid pace (leverage is great in the good times, but nasty in bad times). Europe and the UK are showing precarious signs of moderation as well. Japan is also in a state of moderation. Will the emerging economies follow? I would venture to bet that it will be difficult for emerging markets (generally) to escape the vagaries grille of a global slowdown. Time will tell.

Let's move away from all the pessimism now and focus on opportunities that are emerging and will emerge over the coming months. Dividend yields are moving back to the 5% (plus) levels and a number of opportunities are emerging. Shares are moving closer to net asset value (with some trading at discounts to tangible NAV). Although we expect the return on equity (ROE) for many shares to drop to lower levels, the "normalised" levels of many of the shares justify higher values than the current share prices. Barloworld is now trading at 1.3 times book value, with ROEs trending higher and expected to be over 16% within 12 months. The dividend yield is now over 5%. Although we expect the Iberian business Finanz auto to moderate as construction activity in Spain moderates and the local motor division's profits to drop as the vehicle cycle rolls over, this is likely to be offset by robust growth in the Caterpillar business locally and in Siberia, as well as a stable performance from the Logistics business. Avis is likely to show modest growth. The food retailers (Shoprite and Pick 'n Pay) are likely to perform well in a higher food inflation environment, although volume growth will slow. They remain fairly defensive in this environment. MTN remains in a high-growth phase. Although its share price is now better, reflecting the improved growth prospects, we remain confident about our investment in the group. Old Mutual (although it seems to be getting cheaper by the day) is now starting to offer compelling value. On our forecasts, it is trading at close to a 40% discount on its embedded value, although this is volatile and is leveraged to the market. However, it is now offering close to a 6% potential dividend yield notwithstanding its challenges in the US life business and the uncertainty in global markets. At some stage one needs to consider the potential of unlocking long-term value.

At face value, it seems as if the cyclical retailers (clothing retailers and furniture retailers) are cheap. Although we feel that with the recent underperformance of the sector signs of value are appearing, we firmly believe the consumer is going into a prolonged recession. The large debt burden, coupled with higher food and oil prices and the duration of this recent interest rate hiking cycle, is going to leave the consumer with a prolonged hangover. We believe the earnings base of the cyclical retailers is too high and will drop sharply in the coming months. These shares are likely to offer more compelling value over this period. As we've indicated previously, the banks are showing signs of value. In the short term, they will suffer from rising bad debts as the retail cycle corrects. House prices are falling and vehicles are being re-possessed at an alarming rate. To some extent infrastructure spend and a (hopefully) stable corporate environment will support banks' profits. We do, however, expect ROEs to fall and normalise, although this is partly reflected in the current share prices. The "catalyst" for banks rerating is likely to be a more stable inflation and interest rate environment. A sign of a peak in interest rates is normally one of the important catalysts for the share prices - we're not there yet.

In conclusion, the cycle always prevails and at this time investors need to brace themselves for a normalisation of the past excesses. But, as surely as night follows day, the investment opportunities of tomorrow will be created as asset prices correct. As pragmatic value investors we're excited about these future opportunities.

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

Our previous quarterly report spoke at length about our view of a moderation in local and global equity returns. We spoke of "lollapallooza" events, a term that Charlie Munger (Wesco Chairman and Berkshire Hathaway director) often uses. These are events that occur when a number of factors work together to achieve abnormal results. Until recently times were good, and a moderation of equity returns off this base is realistic and should be expected. Locally, the sharp depreciation in the ZAR on the back of an uncertain political environment, the Eskom disruptions, upside inflation surprises, a lower GDP growth outlook and a "skittish" foreign investor, all contributed to a derating in the local FINDI sector. Moreover, this coincided with a significantly weaker growth outlook for the global developed economy, providing a nasty cocktail for equity returns (mainly local financial and industrial shares). However, notwithstanding the weaker global growth outlook commodities have held up. Ironically, investors seem to feel that the generally cyclical commodity shares are a safe haven (or hedge) against higher inflation and a weaker US$. It would certainly be a first if commodities have now become a safe haven against slower growth in developed markets! To be fair, the growth outlook for developing economies in general - and China and India in particular - remains sound. Although growth is likely to moderate in developing economies, internal growth in many of these countries (outside of exports) is expected to remain fairly robust. However, we should not lose sight of the fact that some 50% of global commodity consumption still takes place in the developed economies of the world - and those economies face some serious headwinds.

The outperformance of resources relative to the FINDI has resulted in the first quarter being extremely tough for us. While we expect the FINDI earnings growth to moderate, we believe that commodities (and commodity shares) are at very high levels generally and pose greater downside risks to investors when the earnings eventually moderate. However, the timing of this expected moderation is uncertain and will depend on a sustained commodity supply response that has, until now, been lacking. The impact of this has been that pure economics (high demand, low supply) has led to a natural rerating of commodity prices. The tight supply situation is likely to persist in the short term, but all the large commodity companies have significant capital expenditure plans to capitalise on the high commodity prices. Economics will eventually prevail as high returns moderate when supply comes on stream.

So what does a pragmatic value investor like SIM do in the current environment? We look for value of course! What shares/sectors are trading below their intrinsic value on a normalised basis (after normalising earnings and cash flows)? Although the cyclical retailers (clothing and furniture) look like compelling value, we're still avoiding these sectors in the short term as we expect the earnings base to come under severe pressure - the consumer is likely to go into recession.

Banks' returns (return on equity) are expected to moderate from current levels and the retail portion of banks' earnings is expected to come under pressure as the consumer pressures intensify and bad debts continue creeping upwards. This is likely to be offset by a more buoyant corporate demand environment; in particular those segments of the economy aligned to infrastructure spend. We do, however, see value in the banks as share prices and ratings have been (unfairly) tainted by the global credit crises. In the short term they could remain in a "value trap", but we expect the catalyst eventually to be definitive signs of a moderation in the interest rate cycle - though this may only be evident later in the year or early 2009. The construction sector (Gross Fixed Capital Formation) is expected to continue experiencing the benefits of increased private, public and state-owned enterprise spending. Earnings certainty is high in this sector, and valuations are now starting to reflect the optimistic outlook. There are other areas within the FINDI where we see value and which should be defensive in these challenging times. These include the likes of Remgro and the food retailers (e.g. Shoprite). The growth outlook for MTN remains robust.

Although we're generally negative on the resources sector (from a valuation perspective), we do see more value in certain areas (precious metals) and the likes of Mondi (now trading close to its net tangible asset value) - a bit contrarian, but that is our style when we are convinced that value will be unlocked.

The first quarter of 2008 was tough. Short-term risks prevail (we will manage these appropriately) and we expect equity returns to be volatile and more subdued in 2008. However, we are pragmatic value investors and believe that our clients' interests will best be served by continuing to search for shares that are trading below their intrinsic value. We try to avoid overvalued shares - the tricky part is that value is in the eye of the beholder.

Let's reflect on the year that was. 2007 was all about the following key events:

o China's continued growth
o Emerging economies generally outperforming developed economies
o The oil price steadily approaching $100
o The threat of inflation (on the back of both high oil prices and food prices)
o And, finally, the well-publicised sub-prime credit crisis and the threat that it poses to global growth (in particular the US).

So what does the year ahead hold? I think it is fair to assume that 2008 is likely to be a more challenging year in terms of expected returns from equities globally and locally, especially after we've witnessed what the esteemed Charlie Munger would term "lollapalooza" effects over the past few years. This term refers to a number of factors that work together to achieve abnormal results such as the confluence of forces that has driven exceptional real returns, i.e. low interest and inflation rates, strong GDP growth and the effects this has had on the exceptional earnings growth that domestic South Africa has enjoyed. Indeed, as I've mentioned in past quarterly reports, it is going to be more and more challenging to grow off this base.

Last year, although we felt that the market in general was trading above its intrinsic value, there were a number of shares that had the potential to generate double-digit returns. We believe it is difficult to predict returns for markets generally. We're much better at evaluating companies and determining whether the companies that we're invested in offer good medium- to long-term return prospects. Our pragmatic value investment philosophy simply means that we focus on acquiring more than what we're paying for. We remain focused on our investment style and philosophy and believe that by avoiding overvalued assets we will generate long-term wealth for our clients.

Your investment in the Sanlam General Equity Fund generated a return of 21% last year (2% ahead of the JSE All Share Index). We were correct last year to be cautious on interest rates and inflation given the pressures that were evident within the economy. We took a cautious view on the more cyclical consumer retailers and this paid off. We were also more positive on companies exposed to the gross fixed capital formation cycle - this too was correct (although the old adage of "you can never have too much of a good thing" springs to mind). However, we have been premature with our view of a slowdown in the commodity cycle (or rather, our view of a more rapid supply response has not yet materialised). We did, however, point to the risks of a global developed-economy slowdown and expressed the view that the commodity cycle, generally, was at an "inflection point". We will see how this plays itself out in the current year. We have been building a position in the banks on the back of the value that we see emerging within the sector. However, sentiment is against the banks in the short term. The likely catalyst for a rerating will be a peak in the interest rate cycle.

We reiterate the view that investors should have more moderate return expectations, especially after the "lollapalooza" returns that we've enjoyed over the past few years. The consumer is only starting to feel the negative effects of a tighter interest rate environment. The profit warnings are likely to come soon. The focus on infrastructure spend will continue this year and will be evident in the earnings reported by the companies exposed to this. With global growth moderating, commodity prices should too. We remain of the view that this will be reflected in selective resources share prices. This may provide investment opportunities in time to come.

Overall, it is going to become more difficult to generate real returns off this base. Good stock picking will, however, hopefully protect our investors' returns.