Market Review
After 2008's dramatic fall in the market, we felt equities offered compelling value as we moved into the new year and thus increased our equity exposure. That said, even we were surprised to see how quickly the upside to intrinsic value was realised. For the year to date the All Share has gained 18,6% and was 13,9% ahead for the third quarter alone. The Small Cap Index is up 20,4% for the year and 15,2% for the quarter, and the Mid-cap Index is up 28,6% for the year and 17,5% for the quarter. These are exceptional returns in tough times, albeit off a low base.

SIM strategy
We were well positioned for this recovery and thus our stock picks added value. The following stocks contributed substantially to performance this quarter: Imperial, Barloworld, Woolworths, Nedbank, Pick n Pay and Old Mutual. A good example is our view on Old Mutual. Contrarian investors often identify their great investment opportunities during periods of maximum pessimism when "the market" is running for cover. However, stocks that offer in excess of 100% upside potential, as we believed Old Mutual did in March this year, do come with risks. It is our job to assess those risks and determine whether the upside potential justifies the risks and whether they are manageable. We did consider the risks to the Old Mutual US life business manageable and felt the upside potential justified taking on these risks. It has since proved to be a good investment for us.

What we did
We began to reduce our exposure to Imperial after the share price's recent strength. However, we still believe there is some upside to its fair intrinsic value. The management team managed the business very well through this cycle. They sold off non-core assets and reduced balance sheet risk by paying down their debt. The earnings have already rebased to below what we consider to be normalised levels and we expect an improved outlook to lift the share off its current depressed levels. We cut our position in Implats because it is has now surpassed our intrinsic value and we see better value elsewhere. We began to reduce our position in Shoprite because, although it is a great business and has performed exceptionally well, margins are now above levels we feel are sustainable and the share price is close to our intrinsic value. We used the proceeds of these sales to fund purchases in Barloworld, Vodacom, SA Breweries and British American Tobacco. Vodacom is starting to offer attractive upside to its fair intrinsic value. Although it is moving into a mature growth phase, we believe the market is too pessimistic. It has very strong business economics and a sound management team. We also added slightly to our position in British American Tobacco on the back of an attractive valuation (10 times price-earnings ratio and a 6% dividend yield).

Outlook
Judging from our bottom-up assessment of the long-term intrinsic value of the market (refer to the above chart), it is now trading at close to fair value. We can still justify some 8% upside to the fair intrinsic value in the financial and industrial sector. While we increased our exposure to select resource shares during the course of this year (Anglo in particular), after the recent sector rerating the resources sector is now offering only about 5% upside to our assessment of its fair intrinsic value. However, unlike June last year when we believed resource shares in aggregate were 80% overvalued, sector valuations have converged. Although globally there are signs of a recovery, with US industrial production data bottoming and now growing month on month, China continuing on its long-term growth path and other parts of Asia, in particular Japan, also showing improvements in their industrial production growth rates, there are still worrying signs. In particular, US employment numbers remain weak, with the unemployment rate now at 10%. A full recovery in the US economy would be constrained without the support of consumer spending and this may be compromised if unemployment remains high, debt is repaid and the more fortunate citizens start rebuilding savings. The recent recovery in asset prices may well have been due to the liquidity injected into global economies by governments and thus used by companies to deleverage and shore up balance sheets rather than to invest in projects that improve general economic productivity.

Market Review
The expected normalisation of SA's real earnings base is currently under way, with some of our banks guiding earnings declines of 20% to 30%. The resources shares are also likely to see substantial declines in earnings and cash flows after the massive downward correction in commodity prices. Earnings in the retail and manufacturing sectors are also in decline and this will definitely feed through to our local industrial shares. However, we need to separate short-term economic impacts on profits and long-term valuations. After all, two years of cash flows are a small proportion of the net present value of a business. For this reason, the market is willing to "look through" many of the short-term challenges. In our first-quarter commentary, we indicated that the market was implying at least a 21% decline in earnings and that much of the negative news was already "priced in" to the market. Since then, the All Share Index has rerated by 8%, the INDI25 has risen by 13.4%, the FINI15is up 12.6% and the RESI20 is 2.6% higher.

What SIM did
Over the past year, we reduced our underweight in resources significantly based on our bottom-up assessment of where the value is in our investible universe. In particular, we added to Anglo. With the significant drop in the Anglo share price, we now believe it is trading below its intrinsic value. From a valuation perspective, it was trading at four times its net asset value in May 2008 (on peak-of-cycle commodity prices), while it is currently trading on a 1.5 times price to net asset value on more normalised commodity prices. We have started reducing our position in Anglogold, which has paid off handsomely over the last few months, and we're using the proceeds to finance better value opportunities. Within financials, we have retained our overweight position in the banks. We expect bad debts to get worse in the short term. This is likely to result in banks' return on equity dropping sharply in the short term. We have already started to see some recovery in the bank share prices. Our overweight position in Old Mutual has also started to pay off. The share price has more than doubled since March 2009. Within industrials, we cut our shareholding in Telkom after the unbundling of Vodacom. We also reduced our position in Dimension Data. We used the proceeds of these sales to increase our shareholding in Barloworld, Liberty International, Liberty Holdings and Nampak. All four shares are trading well below their intrinsic value, with earnings below normalised levels.

SIM strategy
According to our measure of the intrinsic value of the various sectors on the JSE, which we determine through a bottom-up consolidation of our analysts' valuation of each share, resources are trading at about a 10% discount to our assessment of longer-term intrinsic value compared with our May 2008 measure, which showed that the sector was trading at a 70% premium to fair value. This measure shows the INDI25 Index (the top 25 industrial shares) is trading at a 15% discount to its long-term intrinsic value, while the FINI15 Index (the top 15 financial shares) is trading at about a 20% discount. We thus still see slightly more value in the financial and industrial shares relative to the resources, although the valuation difference has narrowed since May 2008. Given our assessment of the sectors based on our bottom-up views, we remain overweight the FINDI and slightly underweight resources. We expect economic pressures to intensify in the short term. However, much of this is already reflected in many share prices and we would rather focus on the market's long-term value and exploit short-term emotional reactions.

Market Review
It has been another volatile quarter. The All Share index (price only) fell by 5.3% over the first quarter of 2009. The market has, however, recovered in March with the All Share index rising 10.3%. From a sector perspective, the Resources index (Resi20) is up by 0.7%, the Financial (FINI15) index is down 9.7%, while the Industrial (INDI25) index is down 10.2% for the quarter. We need to prepare ourselves for further volatility in the markets in these uncertain times. We, however, are less concerned about the short-term movements in the market and more focused on long-term intrinsic value. With this in mind, let's understand the current value of the market. Referring to the table below, the historic price to earnings (PE) ratio of the market is close to 8 times (note: this will differ from the INet PE ratio as the table reflects a sample of shares under our coverage). The historic return on equity (ROE) for the market is 21% and has been declining. There is a high probability that, in the short term, earnings will "normalize" at lower levels than they are currently (refer to the chart below depicting growth in corporate profits and the return on capital employed for the Financial and Industrial Index). Hence, the historic PE ratio is not necessarily a good indicator of current value as the "E" in the PE ratio is likely to drop and thus the PE ratio is higher than we think. However, using a simple dividend discount model, I'm able to "back out" what the current market price is implying the ROE is likely to be. The market is currently implying that ROE's will drop from the current 21% to approximately 16.7%. This implies a further 20.5% drop in earnings. It is likely that earnings will drop further, but we feel that this is now priced into the market. That doesn't mean that the market will not drop further, it simply means that a lot of negative news has already been discounted in share prices. Another valuation metric that is relevant to us is the price to net asset value (P/ NAV). This is currently at 1.67 times for the market - well below its long-term average.

SIM strategy
We're first and foremost a bottom-up, research driven investment company so I'm always loath to generalise at the sector level. However, in our opinion the valuation differences between financials, industrials and resources have narrowed. At the beginning of last year, we had a strong view that the financial and industrial shares were much cheaper than resources. This has been the case for a while. However, with the large correction in many of the resource shares, it is now less obvious. We have reduced our underweight in resources. We see value in Anglo. The share price has dropped from R550 to R150. We have been increasing our exposure to Anglo. We also believe that Mondi is extremely cheap - although the fundamentals of the paper and packaging cycle will remain negative while we're in this global recession. As a low cost producer, however, we believe the company will weather the storm. We still have an investment in Anglogold. This has done well for us recently, however, we see less value in it at current levels and hence we have been selling the share to finance other interesting opportunities. Within financials, we prefer the banks to the local life assurers from a valuation perspective. We do, however, acknowledge the downside risks to earnings in the short term. We see value in Old Mutual though and have increased our exposure. But we remain cautious due to the risks inherent in the US life business. For this reason, we will limit our overall exposure. Within Industrials, we remain overweight the food retailers (Shoprite and Pick 'n Pay). Both are defensive businesses that are still offering value. We also see value in the diversified industrials (in particular Imperial and Bidvest). Imperial still faces many risks in the short term but, in line with our philosophy, we believe that earnings are well below normalized levels and the current valuation does not reflect a fair value for the business. We do, however, acknowledge the short term risks.

Risks and opportunities
We can highlight a number of risks (but I will limit it to a few): o The earnings base in SA remains high and is likely to drop and normalize, o The global financial system is still in a precarious state. We need to encourage the banks to lend money. At the moment, the global banking system has frozen. Companies require liquidity to grow. Without this, the global recession is likely to intensify, o Growth is under strain and we could well move into a recession. Unemployment also remains a big threat, o The SA elections are coming up soon. The change in leadership poses risks. There are, however, opportunities: o We have, unlike the rest of the world, tremendous scope to reduce interest rates in order to stimulate a recovery in growth. Let's hope that we use the opportunity wisely, o Inflation is likely to drop back within the inflation targeting band, o We are not faced with the "toxic asset" risks that the rest of the world is trying to overcome, although we will not escape entirely, o Equity valuations are now more reasonable and are offering long-term opportunities. In summary, it is easy to be sucked into the negativity of a global recession. It would be naïve to think that times will not be tough and we are likely to face many challenges and uncertainties in the short term. However, markets are driven by fear and greed. Just as they were driven by greed only a year ago, they're now being driven by fear. In this lies our next big investment opportunity.

Market Review
Are we not glad 2008 has passed? What a year! The FTSE JSE All Share Index (price only) fell by 25.7% last year, with the total return a negative 23.2%. In US dollar terms, however, the All Share Index fell by 45.4%. Without playing down the significance of the correction we have seen in the local market, it certainly has not been as severe as some of the corrections we've seen in the local market in the past and is also far less than some of the declines other emerging markets, like Russia, experienced last year.
From a sector performance perspective, it has also been an extraordinary period. It was truly a tale of two halves. Between January and June 2008, the resources sector outperformed the FINDI by a staggering 57%. Between July and the end of December, the resources sector underperformed the FINDI by 43%. For the year, it lagged the FINDI by 10%. For the quarter, industrials lost 13.5%, financials 11.4% and resources were off 12.9%.

SIM strategy
For some time we have believed that the financial and industrial (FINDI) shares offered greater relative value compared with resources, notwithstanding the risk of moderation in our local FINDI shares as well. We have 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 discussed 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!
During the latter half of last year, our view paid off and we have continued, and will continue, the search for value, namely for shares that are trading below their intrinsic value (based on what we believe are normalised and realistic assumptions).
Ultimately, it was difficult to add much absolute value in 2008. When markets collapse there are few places to hide. It was a year for being defensively positioned. Shares that did add value to the portfolio included Shoprite (up 23.1%), Remgro (up 9.7%) and Naspers (up 2.6%).
With the likelihood of interest rates dropping substantially over the next few months, we believe there may be support for some of the interest-rate-sensitive companies and sectors, such as the banks and companies like Imperial.
Within the financial sector we remain overweight banks and underweight the life insurers. Within industrials, we're overweight the food retailers. We have a big position in Shoprite. This paid off handsomely for us in 2008 and we believe this holding will continue to perform reasonably well in 2009. We also increased our weighting in Pick 'n Pay. This also paid off for us in the last quarter of 2008. It is now trading closer to our fair intrinsic value. We also increased our holdings in Woolies and JD Group. Fortunately we cut our exposure to the construction shares before the correction and we're currently re-evaluating our exposure to the sector. Although we remained underweight in resources, we increased our weighting in the sector as the share prices corrected downwards in 2008. We increased our exposure to Billiton, Sasol and the platinum shares.

Risks and opportunities
Our earnings base remains very high in SA (in real terms) and is likely to correct. The SA industrial sector return on equity (ROE) is currently at almost 30% and is well above its long-term average of 19% since 1961. However, without forecasting, we can calculate what the current industrial share prices are implying the return on equity of the industrial sector should be - and this is 19%, the longterm average. For the All Share Index, the market is implying ROEs of 17.5%. From this, we can conclude the share prices are already discounting a fall in returns and a likely drop in earnings from this high base. Our view is that the SA and global markets are now offering value. If there is further downside, we would see this as a good opportunity to increase our exposure to equities. However, one cautionary market indicator is the Graham & Dodd PE ratio, which calculates the price-earnings ratio based on the current price and five- or seven-year average earnings. This effectively smoothes the earnings base and hopefully better reflects the earnings cycle.
On this basis, the All Share Graham & Dodd PE ratio is currently 16.2 times (in line with its 47-year average of 16.3 times) - and thus suggests that the market is closer to "fair value". Although there remains much uncertainty regarding the current state of the global market and the growth outlook, the correction in share prices is reflecting much of the uncertainty. We believe a more stable base has been set for better future returns.