International
Although global economic conditions remain seriously distressed, equity markets were broadly higher in September with MSCI world index rising by over 2.5% and the SA index increasing by 1.2%. A confluence of positive monetary developments in the US, Europe, China and Japan rallied investor sentiment despite a number of weaker economic releases. Earnings expectations, too, are still declining globally. In the US, the second quarter GDP was revised down from an already tepid 1.7% to 1.3% and current activity suggests that the third quarter will be no better. In recent months, industrial production and construction activity have fallen sharply and the labour market remains in the doldrums. The housing market, however, appears to have turned up and is impacting positively on sentiment and consumer spending. Ben Bernanke's low interest rate policy is boosting confidence among consumers, but is not flowing through to the industrial sector as fears about how the fiscal cliff will be resolved are weighing negatively. Moody's indicated that unless the fiscal cliff is resolved appropriately, a downgrade of US debt in 2013 is likely. Elsewhere in the world, economic conditions continue to deteriorate. The buoyant mood in Europe following the ECB's actions appears over optimistic. The seriously challenging problems of too much sovereign and bank debt, excessive fiscal deficits and sharply lower growth all endanger the success of the austerity programs. The economic outlook remains dire: the flash PMI tumbled to a new low of 45.9 in September. In Japan, GDP growth was revised down from 1.0% to 0.7% and exports have slumped significantly. China's seemingly impressive reflationary moves in infrastructure spending are only likely to impact positively in the medium term and the 2012 growth forecast of 7.4% is unlikely to be revised upwards. The global economic outlook is for low interest rates, below trend economic growth and weak equity and bond returns.

South Africa
The tense situation triggered by the Marikana shootings, and the resultant significant increase in wages at Lonmin, has escalated into a seemingly uncontrollable 'me too' syndrome among employees across the mining industry. Accompanied by violent demonstrations it has developed a dangerous momentum along an ugly path of self-destruction. Moody's downgraded South Africa's government bond rating on September 27, citing a deterioration in South Africa's sovereign creditworthiness. This will have an impact on the rand which, in any event, appears vulnerable as the current account deficit in the second quarter jumped to 6.4% of GDP (almost double the 2011 deficit of 3.3%). The financing of this deficit is heavily dependent on portfolio flows from offshore, predominantly into our bond market which has seen a record inflow of R76.5bn in the first 9 months. This is significantly higher than the previous best annual inflow of R44bn and is largely due to the inclusion of several local bonds in the World Government Bond Index from 1 October. Even a cessation of these inflows would impact negatively on the rand, let alone a political or labour unrest driven outflow.

International
Global equity markets ended in positive territory in June, but the bounce was not enough to recover losses incurred earlier in the quarter resulting in a quarterly decline of 6% in the world index. The late surge in June was thanks to the decision taken at the latest European summit to allow Spanish banks to be directly recapitalised from European bailout funds, removing the pressure on Spain itself. However, despite the current burst of euphoria, severe headwinds remain. The European recession is deepening and global growth rates continue to grind lower as the lagged effects of the European recession impact relentlessly on its trading partners. Earnings forecasts are being downgraded over a broad front (US Q2 forecasts are now -1.1%) and central banks have limited scope left to assist meaningfully. Clearly the global economy remains in a fragile and unstable condition. In the short term the widespread decline in inflation offers some relief which should help slow the further deterioration in world economies. However, the underlying problem - of excessive debt and a lack of growth - persists and is still not being addressed with the resolve that it requires.

South Africa
SA's current account deficit widened in the first quarter to 4.9% of GDP as exports declined as a result of softer growth in our key trading partners and large falls in mining production due to industrial action and Section 54 stoppages. Investment growth is also weakening as sliding global growth is curbing the appetite for new investment.

Portfolio
The Rand's recovery during June hurt the fund's offshore component, while heavyweight gold shares, Anglogold and Gold Fields, both fell 8%. This was far more severe than the marginal decline of less than 2% in the Rand gold price. These negatives were offset again by some excellent share price gains during the month amongst the fund's small cap industrials; notably Mix Telematics (+43% on the back of excellent results), Jasco (+20%) and Interwaste (+30%). The fund's mining small caps were mixed. Pallinghurst, ahead of its large rights issue fell sharply as did Sentula which now trades at a 57% discount to its already heavily written down NAV. However these were offset by gains in Village (+14% on the back of the special dividend declaration) and Metmar (+16% including the dividend paid during June). While some share price moves were dramatic, portfolio activity was limited. The fund remains overweight in areas where we see the best value; namely heavyweight Rand hedge stocks (Reinet, golds and other resource stocks) and also in small cap miners and industrials. There is a corresponding underweight in large and mid cap domestic financials and industrials.

Many readers of this commentary will be aware that the fund's largest holding, Reinet, is very much a proxy for BAT, the multinational cigarette business and the largest company (by market value) listed on the JSE. As its stake in BAT represents 85% of Reinet's net asset value, one might be forgiven for thinking that the price of Reinet would track that of BAT fairly closely. Over long periods this may well be the case, but over the past 12 months, BAT shares have gained 41% while Reinet is only 20% higher. If one adds in the effect of the BAT dividend, BAT's total return amounts to 46% - no less than 26% ahead of Reinet. Why should this be? Likely reasons include: BAT pays generous dividends while Reinet retains the full BAT dividend it receives and pays no dividend itself. Investors are unhappy with the performance fees charged by the Reinet management company. Reinet has made several small acquisitions, the merits of which still have to be proven. The net result of Reinet's massive under performance against BAT is that Reinet's discount to net asset value has widened significantly and now stands at around 30%! Of course Reinet would be vulnerable to a stronger Rand or a decline in BAT's share price. However, at the current price of 1,395c, one is getting a holding in BAT worth 1,675c per Reinet share and a portfolio of other businesses valued at close to 300c giving a total of 1,975c. Investors are effectively saying that not only are Johann Rupert and his team taking extortionate performance fees, but also that they are likely to destroy value over time through a series of ill judged investment decisions. We believe this to be an unlikely outcome and accordingly consider Reinet to be very attractively priced at current levels. Another notable feature of the fund is the overweight holding in gold shares, a position which has hurt performance for the year to date. The Rand gold price has actually gained 1% since 31 December 2011, but over the same three month period there has been a 14% slump in the JSE Gold Index. Gold shares are distinctly unloved and after years of excessive cost increases, labour problems and in some cases, poor management decisions, we can understand why most investors prefer to buy the metal itself, usually in the form of an ETF. However, we believe that the gold bull market is intact and that the shares offer considerable upside from current depressed levels.

Market Comment

World markets held their own in December despite ongoing problems in the US, Europe and China. In the US, dysfunctional politics nearly derailed the extension of the Bush tax cuts; in Europe, widespread 'negative watch' ratings were imposed on 15 member countries; and in China, property bubble concerns increased sharply. These negative developments were offset by slightly better US data, some progress at the latest European summit, and a sharp fall in Chinese inflation. But caution remains the watchword globally.

Against a myriad of uncertainties the global forward PE ratio is only 11 - a level only once reached in the last 25 years, during the severe recession of 2008. This modest rating against a backdrop of low interest rates should continue to underpin equities until interest rates start rising and corporate profitability declining.

Portfolio Comment

The fund ended the year on a positive note and ultimately achieved an 8.6 % total return as against 2.6% for the all share index.

Gold shares led by Anglogold (-11%) and Gold Fields (-9%) retreated sharply in December. As both these counters feature in the top ten holdings this was clearly negative. However, against that, selected Rand hedges such as Hulamin and Trencor performed very strongly and offset the drag of the gold shares and a slightly firmer Rand. We trimmed our holdings of these two companies into strength and used the proceeds to add to selected small cap mining stocks, which we believe have reached oversold levels.

As indicated in the table on the right, the fund is effectively 80% invested in the equity market after allowing for the effect of derivatives, which have been used to hedge market exposure. While we believe that the market as a whole offers only moderate value, we are convinced that there are many opportunities outside of the well-known names and it is this area that we will continue to seek out value. Companies with good management (ideally who think like owners and have a large personal investment in the business), strong balance sheets and a good business model will be targeted. Many of these are likely to be Rand hedges, where the potential turnaround in earnings on the back of a weaker Rand, is not yet reflected in the share price.

The fund had an excellent month gaining 4.3% against a 3.6% decline in the All Share index. This was partly due to translation gains on the offshore assets, as the Rand slumped from 6.99 to 8.05 against the dollar.

However, other important contributors to the strong showing were:

- a rally in gold shares in which the fund has an overweight position;

- very good results from what is now the fund's largest holding, Afrocentric (HEPS up 70%). This saw the shares gain 27% in September - readers are referred to our March fact sheet in which we featured this company;

- avoiding poorly performing financial and industrial large caps.

While September was a tough month for the market and the first few days of October have been worse, it is gratifying that some of our long held views are starting to be fulfilled. Namely that:

- the Rand was overvalued in the 6.60 to 7.30 range against the dollar;

- China's seemingly unstoppable growth was unsustainable;

- a setback in the price of industrial metals was long overdue. Copper fell by 14% in September and we would be surprised if the price of iron ore does not fall by a similar amount in the weeks and months ahead, notwithstanding the sanguine views of most mining and commodity analysts.