Richemont and Naspers have contributed substantially to South African equity market returns over the last 12 months. By virtue of their substantial The biggest active change in the Fund over the past quarter was the purchase of additional Standard Bank shares, now a 7% position in the Fund. Standard Bank is not outrageously cheap in absolute terms, trading at 1.7 times tangible book value and 11.5 times forward earnings, but in the context of a generally overvalued South African equity market we think it is very attractive for a few reasons. The earnings' base for this 11.5 price to earnings (PE) multiple is not high, unlike many other South African companies. In real terms, earnings are still 9% below the peak achieved in 2008, despite retentions of R16 per share. Off this base there are various factors that lead to a positive outlook for earnings' growth. In South Africa, management did well to take mortgage market share following the global financial crisis by putting good, profitable business on its books while the other banks were still cautious. The bank will also benefit from improved interest margins if the interest rate cycle turns (declining interest rates have been a substantial headwind over the past few years). Internationally the group has simplified its business and is focusing on areas where it has a competitive advantage, namely Africa, and not the very competitive space of emerging markets in general. It is the African business that sets Standard Bank apart. The bank has been investing in its Africa Strategy for 20 years and this has finally become significant. Investors don't tend to care when a small part of a business is growing rapidly, but suddenly when 19% of the profits come from Africa and the division grows 27% year on year, the market takes note. What sets Standard Bank apart is the significant presence and actual branch network across a range of African countries. In many cases Standard Bank is the only highly rated, international bank with a branch network, rather than just a representative office, making it the go-to choice for multinationals looking to expand. The business from international customers adds to the solid domestic businesses in these growing markets.

Many people perceive stock market returns and economic performance to be closely correlated. Our interpretation of the very long-term data is that the link is tenuous at best. There are more important factors, such as the level of competition. For example, a stagnant economy like South Africa's may not attract much new investment, which allows the incumbents to continue earning high returns on capital. A rapidly growing economy like China's may attract substantial investment, which increases competition and depresses returns on capital. In South Africa the link between our economy and our FTSE/JSE All Share Index (ALSI) is made even more tenuous by the inclusion in the index of large multinational companies, which have grown substantially from their humble South African roots. The top 5 industrial shares, which carry a combined weight of just under one-third of the ALSI, are SABMiller, Richemont, MTN, Naspers and British American Tobacco. South African operations contribute a minority of the profits and value in these companies today. These five shares have been massive winners over the last decade. Their share price appreciation (before even considering dividends) has been spectacular: SABMiller has moved from US$7 to US$49; MTN from US$2 to US$19; Naspers from US$3 to US$74; BAT from US$11 to US$51; Richemont too has been a big winner (after adjusting for its unbundling of BAT). South African investors should be extremely grateful to the management teams of these companies for the value they have created. The ALSI's heavy weighting to these winners conceals the dismal returns on a number of shares which are much more dependent on South African operations. There has been considerable selling pressure on Anglo American, our gold and platinum mines, construction firms, some unsecured lenders, furniture retailers and even some clothing retailers this year. This may be a leading indicator of the many challenges which lie ahead for the South African economy. We are concerned about the imbalances and vulnerabilities in the South African economy (simply speaking, we South Africans are, and have been, living beyond our means). Fortunately, our job is not to make economic forecasts, but to allocate capital to a portfolio of JSElisted shares offering the best long-term value. We have been buying some of the underperforming domestic companies, but we are mindful that the quality of their businesses is generally inferior to that of the multinationals, such as BAT and SABMiller, which remain top 3 positions in the Fund

Most South African mining stocks extended their underperformance into Q1 of 2013. The severity of the sell-off indicates the extent to which the market has lost/is losing confidence in South African mining companies' capacity to pay future dividends to shareholders to justify their share prices. The knee-jerk response of a self-described 'contrarian' investor is to buy the oversold mining stocks on the simple thesis that the news can't be this bad forever. But there is a risk that the poor fundamentals may persist for a long time - or at least for longer than many investors can stomach. This risk is exacerbated by what we perceive, up to now, to have been complacency and a reluctance to change amongst many leaders in mining companies, unions and government. Managers of mining companies generally rate their own performance as good, but this is at odds with their share prices. For example, the managers of one large mining company recently scored more than 100% on their own internal performance measure, but 0% on a total shareholder return measure used to calculate their long-term incentives. Union leaders seem content to see their membership base dwindle as real wage increases and disruptive strikes force the closure of marginal shafts. Regulators appear to be aiming to extract as much as they can from the mining sector, which contrasts with their support for other less labour-intensive industries. There is little sign of enthusiasm for implementing reforms to our labour regulations to make South Africa more competitive. There are some glimmers of hope. The penny seems to have dropped with the mine managers that shareholders are more interested in sustainable free cash flows and dividends than in fanciful production growth targets. Some managers also appear to be stiffening their resolve to deal firmly and fairly with illegal strikes and indiscipline. National Treasury is keenly aware of the very important role still played by the mining sector in our economy. The dilemma is that when one carefully studies the performance of mining companies over the last 10 to 15 years, a disturbing picture emerges for many (but not all) companies: an increase in share count, increased debt levels, stay-in-business capital expenditure masquerading as 'growth' capital expenditure, disappointing production and cost performance and surprisingly low generation of free cash for the payment of dividends to shareholders. These poor fundamentals have persisted for so long, that it could be argued that they are 'normal' for the industry. It is very hard to predict whether conditions will change for the better over the next decade; there is a significant probability that they will not. Therefore, the Fund continues to hold substantial positions in high-quality globally diversified companies such as British American Tobacco and SABMiller. The Fund's 8% exposure to South African gold and platinum miners (including indirectly via Anglo American) reflects our assessment of the current risk-reward balance in these stocks.

The Fund returned 17.6% for the 2012 calendar year compared with the CPI inflation rate of 5.6%. The bull market in South African shares has rumbled on: the FTSE/JSE All Share Index (ALSI) topped 40 000 points on the first trading day of 2013. For more commentary on the overall market, please refer to the December 2012 fund factsheets for the Allan Gray Balanced and Stable Funds. The Fund's returns lagged the benchmark ALSI in 2012. A significant portion of this relative underperformance is explained by the drag from the Fund's conservative cash position in rising markets and by its two top holdings, Sasol and British American Tobacco. Despite being one of the Fund's biggest positions, Sasol did not contribute to the Fund's absolute returns as the dividends received from the share were marginally outweighed by the depreciation of the share price. British American Tobacco performed better with an annual total return of 16.4%, but this was not enough to beat the benchmark return of 26.7%. After re-evaluating the investment case for these two companies, we added to the Fund's positions in both over the second half of 2012. Sasol is priced at just less than nine times historic profits and yields 4.8%. This compares favourably with the P/E of 15 times and dividend yield of 2.8% on the basket of companies that comprise the ALSI. Sasol has a longer reserve life than most traditional oil companies and many South African mines. In Qatar, it has proved itself as a world leading operator of the technology to convert natural gas into liquid fuels. Why is the share priced so cheaply versus the ALSI? The dollar oil price is certainly high compared to its history, but then the rand is arguably also too strong versus the dollar on an inflation-adjusted basis, meaning that the current rand oil price may be closer to its 'normal' level than the dollar oil price. Sasol (like many other South African companies) has been struggling to control cost inflation, but there are some encouraging signs that production stability is returning to its plants. The market's biggest concern now is arguably the potentially huge capital expenditure if the company decides to invest in opportunities in America stemming from the shale gas revolution. We continue to stress to company representatives the importance of sound capital allocation, which will generate appropriate returns in a wide range of possible scenarios. British American Tobacco is priced at 15 times its estimated profits for 2012. We find it very attractive to buy a business of the quality of BAT on close to a market multiple. Please refer to Quarterly Commentary 2, 2012 for an explanation of why we find the economics of the tobacco industry so attractive. While there are clearly risks arising from aggressive (and not necessarily rational) regulatory actions in some countries, it is important to consider the positives such as the company's flexibility to respond to regulatory changes, its exposure to growing emerging markets and the remaining potential from the company's long-term cost saving programme.