The difficult start to 2013 for emerging markets has continued into the second quarter. So far this year, emerging markets have returned a negative 9.4% compared to developed markets, which are up 8.8% (both in US dollars). This 20% performance differential between emerging and developed markets is one of the most pronounced in the last decade and, in our view, provides us with many opportunities as bottom-up, longterm focused stock pickers. In spite of the tough market conditions, the fund has performed very well, with a 16.1% return (in rands) for 2013 compared to the benchmark return of 6.5% (in rands). Since inception the fund has outperformed the benchmark MSCI Emerging Markets Index (expressed in rands) by a very pleasing 5.9% per annum, which is as good a start we could have asked for given the volatility in global markets since launch. There are several reasons behind these market moves and the street protests in countries like Brazil and Turkey have certainly contributed to the negative sentiment. We believe that the structural reforms undertaken in most of the larger economies amongst emerging markets over the last 15 years mean that we are unlikely to see a return to a 1997-style scenario, where turmoil in the financial markets in Asia had a significant impact on the affected countries' real economies. If anything, some of the protests are testament to the success of these countries in lifting millions of people out of poverty and into the middle classes. Previously, the bulk of the population were too busy eking out an existence on the peripheries; now they are demanding more responsive, less corrupt governments as their countries become firmly middle income. One of the worst affected markets in 2013 has been Brazil, with the broad Bovespa Index down 22% in local currency terms and down 28% in US dollar terms. The primary culprit has been the country's resource sector, epitomised by Petrobras (oil) and Vale (iron ore), who have sold off heavily as commodity prices decline and the macroeconomic outlook in Brazil and China becomes more unclear. As long-term investors, we typically look at these situations as opportunities to purchase businesses that have deviated significantly from our assessment of fair value, yet we have refrained thus far from purchasing any commodity exposure in Brazil or elsewhere. Vale, as an example, has declined 40% this year and looks very cheap at face value on one-year forward consensus price multiples of 6 - 7 times earnings. These forecasts, however, are based on current iron ore prices of $120 to $130 holding into the future. In our view, sustainable iron ore prices are significantly below current levels as we believe that China's historical consumption of iron ore is not sustainable. If you value Vale using an iron ore price of $90, not only are revenues 25% lower but the effect on profits will be multiplied as margins decline. The net result is that what appeared cheap at 7 times earnings can very quickly move to 20 times earnings with only a 25% decline in the price realised for iron ore. In our view there is therefore significant downside potential in Vale over and above the decline already realised. Instead of a foray into commodities where the risk/reward trade-off is just not attractive enough yet, we have increased our Brazilian exposure by adding to existing counters in which we have greater conviction as these have sold off along with the general market. We have spoken previously about the long-term appeal of the fashion retailers, whose total installed store base and collective profits are smaller than their South African counterparts, despite catering to a market four times larger in population and with significantly higher social mobility. Earlier this year we were reducing our exposure to Marisa, Lojas Renner and Hering as they continued to appreciate toward our fair value. In recent weeks they have declined by as much as, and sometimes more than, the general market and we have increased our stake in all of them as a result. Short-term economic difficulties will definitely have an impact on what these companies are worth; however, the actual effect is a fraction of the 30% decline in their share prices, in our view. The ability to look at businesses on a five-year time horizon is a crucial aspect of our investment philosophy and we believe it is a significant competitive advantage relative to a market that often prices businesses off the next quarter or year's earnings. Our investment philosophy is well illustrated by developments in one of the largest fund holdings, Anhanguera Educacional (4.2% of fund). It is the country's largest private university group and, after years of acquiring smaller operators to consolidate the market, it has spent the last 18 months concentrating on integrating its acquisitions and generating free cash. Although we have been invested in the company for most of the last four years, we owned very little in the latter half of 2011 when Brazil last experienced a sell-off. As a result of Anhanguera's reliance on acquisitions and fears over collection of fees from students, the company's share price more than halved in the space of two months. Very little new information had become available on the company, but short-term fears led to widespread panic amongst investors. Back then we were able to build a substantial position in the company at below R$6 a share and today it trades at double this level. Not much has changed in the investment case of Anhanguera, it has simply delivered on its promise to concentrate on maturing the existing business and generating cash in the process. In our view, margins are well below what is achievable long term and the share still offers significant upside. In addition, Anhanguera is likely to merge with Kroton, which is a previous fund holding and, in our opinion, has the industry's best management team. The combined entity will be several times larger than the nearest competitor in terms of total sites and student enrolment and should be able to deliver higher profitability than either company on a standalone basis. Due to the fragmented nature of the industry and the small overlap in geographic location of their campuses the deal is unlikely to run into insurmountable antitrust issues. China is another country that has sold off heavily this year and to which the fund has a large exposure, albeit all in consumer facing companies. The local Shanghai stock exchange reached lows last seen in early 2009 - the bottom of equity markets during the aftermath of the global financial crisis. Several of our Chinese holdings have come under pressure as a result and we have also been adding selectively to these stocks. Daphne is a good example of a magnified reaction to a poor short-term profit outlook. As the Chinese economy has 'slowed' to a 6% growth rate, Daphne has experienced slowing revenue trends and pressure on margins. In the short term there is a negative impact on profits but management are taking concrete steps to address this. In order to improve sales performance they are focusing on improving the customer experience, shutting/shifting unprofitable stores and dropping brands that have no traction with customers. On the cost side there are moves to improve productivity, make better use of promotions and streamline inventory. In our view, these collective efforts should allow margins to increase from their current below-normal level. From a valuation perspective, the reduced profitability over the next year or two has a moderate negative impact on Daphne's long-term fair value compared to the actual market reaction of -47% . The current share price reflects these current low levels of sales growth and profitability continuing into perpetuity. In the first six months of 2013 the team has undertaken eight research trips to visit management and assess operations of businesses we own or would like to own in the future (valuation permitting). The most recent was to Russia where we met with 14 companies, including all our current Russian holdings - Magnit, X5 Retail, Sberbank, Mail.Ru, Yandex and Globaltrans. On the whole we came back with our conviction in all of these confirmed. We spent the most time with X5, for now the largest food retailer in Russia by revenue (likely to be overtaken by Magnit this year). The company has struggled to integrate its various acquisitions over the years and high management turnover has exacerbated the problem. We met the new CFO and toured several supermarkets and discount stores to assess how their operations compare to competitors and to see how their efforts to refurbish their stores and improve the customer experience are going. X5 is also investing heavily in its inventory management and supply chain systems, which is an area where it has historically been very weak. The success of these efforts will only be known over the medium term and, while it is still early days, our initial assessment is that the company is taking the right steps to restoring the business to a sustainable footing. There is also a noticeable shift in the culture of the business toward one focused on results, with store managers now assessed and rewarded quarterly (as opposed to annually) on key operating metrics to ensure that any problems are picked up and dealt with early instead of only once a year. Our view on the long-term prospects for a large number of emerging market stocks is very positive and the relative attractiveness of many emerging market stocks has increased as a result of the recent underperformance. This is evidenced by the decline in our holdings of emerging market focused, but developed market listed stocks. Whereas earlier this year, we were close to our 25% limit, today the fund has 21% in these stocks and if emerging markets continue to decline we are likely to head even lower.
Portfolio managers
Gavin Joubert and Suhail Suleman

After a positive calendar 2012, this year has turned out to be relatively tough for emerging markets with the market as a whole down 1.6% year to date in US Dollars (as measured by the MSCI Emerging Markets Index). The weakness in the rand, however, has seen offshore investments perform strongly in most cases. The fund has appreciated by 12.7% over the quarter, resulting in 4.5%. While it is satisfying to have done better than the market over this period, measurement of performance over such a short time horizon is meaningless in our view. We believe that one should look at performance in terms of years, not months, and in fact ideally over periods of 5 years or more. In this regard the fund is now into its sixth year since launch in December 2007. It has returned 10.3% per year since launch compared to its benchmark's 5.0%. This alpha compounded since inception would have resulted in an additional 38% return, after all fees, for investors with holdings in the fund from its launch. We are still managing to find good value in a large number of emerging market stocks: the upside to fair value for the portfolio (on a weighted average basis) is currently 41% (against an average of 50% over the past 3 years). Today there is however an increasingly high level of disparity that exists in valuations within emerging markets. While the market is well below its peaks of 2007, 2008 and 2010, many of the blue-chip consumer businesses that are commonplace in a number of emerging market investment portfolios are at all-time highs. These companies have market leading positions in their home countries and operate in industries with very compelling economics. Examples include Hindustan Unilever (household products in India), ITC (tobacco in India), Walmart de Mexico (multiformat retail in Mexico and Central America), Femsa (beer, Coca- Cola bottling and supermarket retailer in Latin America with a focus on Mexico) and BIM (hard discount in Turkey). Each business has continued to grow earnings and generate cash through the economic cycle, and the market has rewarded them by consistently placing high multiples (25 - 30) on one-year forward earnings. Although we would love to own all of these companies, we will only do so when valuations offer sufficient margin of safety; and in most cases even perfect execution by management for the next several years would not justify paying such multiples in our view. It is quite possible that Hindustan Unilever, ITC, Walmart de Mexico, Femsa and BIM will continue to grow earnings by 15 - 20% p.a. year in and year out, in which case their share prices may well just continue to appreciate. However, we believe this is already being priced in by the market, and any slight deviation from this expectation is likely to result in the 'double whammy' effect of reduced earnings expectations and a lower multiple. These odds are just not attractive to us - the best business in the world can still be a poor investment if one pays the wrong price upfront. Instead, we own a mixture of (mainly consumer) businesses that we believe offer better long-term upside, but whose short-term outlook is either poor (X5 Retail, Arcos Dorados) or whose profits are currently depressed, making their near-term multiples look deceptively expensive (Naspers and Tsingtao Brewery). Our other large holdings include companies that, in our view, offer cheaper exposure to the emerging market consumer but trade at low multiples based on market perception of the poor earning power of their industry as a whole instead of looking at company specific performance. Examples of such holdings in our fund include the Chinese car companies, Great Wall Motors and Brilliance China Automotive. We also own a number more highly rated stocks, where the business is doing well operationally and where the share price has been appreciating, but where we believe the market is still underestimating the long-term prospects for the business. An example of this would be Magnit, the second largest food retailer in Russia. While the very high quality emerging market consumer companies are richly valued, many of the commodity (materials and energy), and some of the banking stocks, look (superficially in our view) cheap on short-term valuation metrics. We have a strong preference for good businesses (many of which happen to be consumer companies) but we continue to look at commodities and banks, because even though they are clearly below average industries, we believe they are industries that we know and understand well. Given that they represent such a large part of the South African market, we have over the past two decades built an extensive knowledge base of these industries. There are also a large number of investable stocks in emerging markets in these two industries (including a large number listed in South Africa, which our South African team already covers in detail and as such requires no incremental work from the emerging markets team). These two facts (industries that we understand and that have a large investable universe in emerging markets) mean that it is worth continuing to cover stocks in these sectors. In addition to this, although we have a strong preference for higher quality assets, valuation overrides everything and at times commodities and banks can be extremely attractively valued (commodity valuations in 1999 being a classic example). The choice between the best business in emerging markets (but that trades on 30x forward earnings and 20% above our fair value) and a commodity company (that trades on 8x depressed earnings with 50% upside to our fair value) is an easy investment decision for us: we would far rather own the commodity company in this specific situation. Today however, the valuations of commodity companies are generally not attractive enough, particularly when considering the risks. While there is upside of 30% or more to fair value in the case of a few of the commodity companies we look at (others have significant downside), the portfolio is built on the basis of risk-adjusted expected return, and not just expected return. In other words, the level of risks generally and in particular the conviction we have in our long-term earnings forecasts (and hence our fair values, which are driven by the next 5 years' of earnings on average) are key factors that we evaluate when deciding to own a share at all, and also in determining the position size. In this regard, we believe the risks are to the downside in terms of long-term earnings streams (and hence fair values) for most commodity companies. On a risk-adjusted basis, commodity stocks are just not attractive enough yet. State intervention in commodity companies also appears to be increasing (in many countries, including Brazil and South Africa), which has also increased our levels of caution. Furthermore, in a number of cases we believe that current commodity prices are well above long-term normalised levels. A good example of this would be iron ore, where the spot price is $140 but in our view (based on supply and demand modelling) the correct long-term normalised iron ore price is closer to $85. When we value the Brazilian iron ore producer Vale, we use a normalised iron ore price of $85, not the current spot price of $140. On short-term valuation metrics, some would argue that Vale looks cheap (8x 2013 consensus earnings) but in our view the company is in fact expensive (25x normalised earnings using an $85 iron ore price). The fact is that Vale's current earnings are based on the prevailing iron ore price, which in our view is unsustainable and 8x earnings is an illusion. In a similar vein, the Chinese banks look 'cheap' on shorter-term valuation metrics (6 - 7x 2013 consensus earnings), but due to effective forced State lending, we are just not sure of the magnitude of bad debts in the system and as such can get little conviction in the long-term earnings streams of these businesses. In the first quarter of this year we already undertook five research trips (to China, India and Turkey and twice to Brazil) during which we met with over 100 companies. We also met with the unlisted competitors of some of our holdings, toured a few of the private university campuses in Brazil and undertook a review of all the major food retailers in Turkey. This last example was particularly insightful as the market opportunity for food retail in Turkey is immense and there are three listed firms that aim to take advantage of it. The most well known of these is BIM, mentioned earlier and possibly the best run food retailer in emerging markets, with the other two being Migros (a listed supermarket chain) and Bizim (a cash and carry operator). Turkey has over 200 000 points of sale for food and groceries, but less than 10% of these are formal retail. By revenue the formal market only represents 40% compared to more than 70% in most of Western Europe. It is likely that over the next ten years the share of formal retail will grow materially, and within formal retail the market will consolidate from its current fragmented nature - small regional supermarket chains, for example, are likely to be absorbed by national banners. We have spent substantial time analysing what this means for the earnings potential of the listed retailers, but have refrained from investing as the valuations were simply too steep to offer the required margin of safety. This analysis is not complete, however, without trying to understand what makes a customer choose BIM over its competitors in the discount segment (A101, Sok and Dia), or Migros over other national supermarket chains (Carrefour and Tesco are both in Turkey) and Bizim over other cash and carry operators (Metro and Tespo). To enhance our understanding, we met with management at several of these competitors and conducted extensive site visits to multiple stores of each of these operators over a two-day period. A number of insights picked up were very useful. For example, there are marked differences between the discount stores in terms of location, ambience, staff numbers, fresh produce and the proportion of private label merchandise. We have incorporated the results of our research into our valuations and will be ready to invest at the appropriate time and price.

Portfolio managers
Gavin Joubert and Suhail Suleman

The fund had a good year both absolute and relative terms, appreciating by 30.7% in ZAR; and in doing so outperformed the MSCI Emerging Markets Index by 7.3% for the year. Four of the fund's top ten holdings appreciated by around 50% or more in US dollars, and naturally this was a key driver of returns. Great Wall Motors appreciated by 119% (contributing 4.2% of return), Magnit appreciated by 89% (contributing 2.5% of return), Anhanguera appreciated by 56% (contributing 2.4% of return) and Naspers appreciated by 47% (contributing 2.3% of return). Importantly, the magnitude of our losers was limited with only two stocks detracting more than 1% each from performance: Arcos Dorados and Lianhua Supermarket. We continue to believe that both stocks are substantially undervalued. In the case of Arcos Dorados (the franchise holder of the rights to McDonald's for the whole of Latin America and the bigger position of the two), we have had a number of conference calls with the company's three key executives (CEO, CFO and COO) over the past few months and remain convinced that while there are shorter-term headwinds, the long-term prospects for the company are excellent. Most investors (and short sellers) continue to be fixated on the poorer shorterterm earnings outlook (next 1 year), which has resulted in a significant decline in its share price, presenting an opportunity for investors like us who have a longer-term investment horizon (3-5 years). The fund's largest new purchase over the past quarter was Baidu, the leading internet search engine in China (in effect the Google of China) with market share of around 75%. Recently Baidu has gone from being a market darling to being very much out of favour due to slower growth rates and increasing competition, notably from a new entrant (Qihoo). As a result, Baidu's share price has declined to a point where we think it offers an attractive investment opportunity (from a level of over $150 to below $100). Although internet advertising has already taken market share from TV and newspaper advertising (see chart below), we believe the amount spent on internet advertising in China will continue to increase significantly over the next several years. Internet penetration in China (at around 40% of the population) is well below that of more developed Asian countries (Korea, Taiwan and Hong Kong), all of which are in the 70% - 80% range. As internet users increase, the incentive for corporates to advertise on the internet increases. In addition, there is currently a mismatch between where Chinese individuals spend their leisure time (largely on the internet as opposed to watching TV) and where adspend is directed (still predominantly on TV). Advertising spend as a percentage of GDP in China is still low and we believe that this, combined with a growing economy and the above-mentioned factors, will result in growing the pie (internet advertising) over the next several years. In terms of Baidu's share of this growing pie, while Qihoo (and others) are no doubt a threat, it is typically very difficult to dislodge the no.1 dominant search engine. One of the key reasons is because the more users a particular search engine has, the better its search algorithms can be refined, which in turn results in better search outcomes - ultimately a key driver of usage. We therefore believe that Baidu has a very strong defendable position, but acknowledge that technology risk exists and account for this in our earnings models (assuming Qihoo take 10% market share), our valuation (valuing Baidu on a sensible multiple that acknowledges the technology risk) and lastly position size (3% of fund). At a share price of $100, Baidu trades on around 15x the next 1 year of earnings, which we believe is very attractive given Baidu's prospects. YUM! Brands (owner of KFC, Pizza Hut and Taco Bell) has been a holding in the fund for a large part of its track record since launch. In our view, this is one of the best businesses in the world. It owns very strong brands (KFC in particular), has an asset light, high return business model (most of the business is franchised), a largely defensive and predictable earnings stream, great free cash flow generation, high quality management, an excellent financial track record (EPS growth of 13.4% p.a. compounded over the past 10 years) and many years of growth ahead due to low penetration of KFC/Pizza Hut/Taco Bell outlets in emerging markets. In China today YUM! Brands (YUM) has around 5 000 outlets and the country already contributes 45% of group profits. The company believes that the Chinese market could ultimately accommodate 20 000 outlets. So YUM is only 25% into their roll-out programme in China (5 000 outlets today versus an end goal of 20 000 outlets). While the high contribution to earnings from China is partly due to Chinese stores being company-owned (as opposed to the bulk of YUM's network which is franchised), the reality remains that China is likely to contribute over 60% of group profits at some point in the not too distant future. Today other emerging markets (excluding China) contribute a further 13% of profits, meaning that 58% of profits already come from emerging markets. This contribution will continue to increase sharply in the years ahead. Towards the end of the year YUM's share price declined by 10% in a single day because same store sales in China for the quarter were - 4% as opposed to the 'expectation' of +1%. Because of one quarter's sales figures collective market participants concluded that the business was worth 10% less than what it was the day before. If one ever needed evidence of how ridiculously short-term focused markets have become, this is it! We held the view that YUM was worth around $100 before the 1-day 10% share price decline from $74 to $67. After the release of this quarterly figure, our assessment of what YUM is worth remains around $100: we value businesses based on their long-term earnings streams, not on one quarter's sales or earnings. Subsequent to the release of these sales figures it emerged that two suppliers to KFC in China had been using antibiotics to promote the growth of their chickens, causing a further decline in the share price. While this is without doubt negative news, we believe that YUM will deal with this issue (as it did with similar incidents in 2005 and 2007) and that there will not be a long-term negative impact. YUM has a 25-year history of building an incredibly successful business in China (its first KFC China outlet opened on Tiananmen Square, Beijing in 1987, two years before the infamous uprising at that location), there is still a long way to go in terms of roll-out of KFC and Pizza Hut outlets and the product is aspirational and loved in the country. While we cannot predict the timing thereof, we believe same store sales will undoubtedly continue to increase again at some point, and the long-term prospects for KFC China as well as the rest of YUM's operations around the world remain excellent. We therefore saw this negative news as an opportunity to increase our holding from 2.5% to 3.5% of fund, making YUM! Brands a top 10 holding.

Portfolio managers
Gavin Joubert and Suhail Suleman

The fund changed sectors from Global--Equity--Unclassified to Global--Multi Asset--Flexible on 23 Jan 2013.