Market review
The third quarter was dominated by the subprime housing crisis in the United States, widespread credit concerns and the growth prospects of the US economy. The general reluctance of banks to lend to each other was not confined to the US, and global banks saw a severe squeeze in liquidity. A full-blown implosion of the US credit market was narrowly averted when the US Federal Reserve (the Fed) first cut the rate at which it lends to commercial banks and later the benchmark federal funds rate, from 5.25% to 4.75%.

Amid the turmoil, global equity markets ended the quarter well in positive territory to reach record highs; bouncing off their intra quarter (August) lows. The MSCI World Index gained 2.5% in US dollar terms over the quarter. The MSCI Emerging Market Index extended its positive performance (up 14.5% in US dollars) over the quarter, mainly on the back of a very strong performance out of Asia (up 19%).

Domestically, we witnessed a modest slowdown in growth and evidence of somewhat weaker consumer spending, particularly evident in the motor vehicle retail sector. Rising inflation, mostly on the back of sharply higher food prices, and a pick-up in inflation expectations were met by a further interest rate hike in August.

Global events reflected in the SA market, causing bonds and the currency to weaken and equities to sell off as risk appetite waned and uncertainty with regard to the global outlook grew. However, the bears seemed to lose the battle yet again as US Federal Reserve governor, Ben Bernanke, provided some monetary relief.

Equities recovered strongly from their August lows, gaining 6.7% over the quarter. The local market was led higher by resources (up 13.5%) and industrials (up 3.3%). Financials, which were caught up in global credit concerns were down 1.6% over the quarter. Bond and property yields pushed lower and the currency gained strongly against a falling dollar. Over the quarter the All Bond Index was 3.4% higher, listed property rose by 9.5% and cash (as measured by the STeFI) earned a return of 2.3%.

Fund performance
The third quarter displayed a significant degree of volatility. Markets initially fell in sympathy with US housing market problems, and then recovered strongly when the US Federal Reserve provided monetary relief. The cut in the federal funds rate and the discount rate provided markets with much needed recession insurance.

Your investment performed very well during the height of the volatile August month, but delivered more muted performance for the full quarter, particularly against the strong performance of risky assets. The foreign equity portfolio component of the Investec Opportunity Fund had a strong quarter. This was largely due to a great performance from China Mobile, which re-rated significantly during the quarter. The fund has not invested in global bank shares in any significant way, which added hugely to performance, as these shares were particularly hurt by the global credit squeeze.

Over the quarter the Investec Opportunity Fund gained 2.2%. One year and longer historic returns continue to be strong, and ahead of benchmark. For the year to September the fund earned a return of 23.4%. This is an excellent return, particularly when considered relative to the risk assumed.

Portfolio activity
Fund activity has been remarkably low, largely as we have chosen not to chase resource and construction shares, as we believe their valuations are stretched. Commodity prices, particularly base metals, are near their all time highs and have huge downside risk. Copper margins are close to 70% for the major producers including Anglo and Billiton, and have never been this high. The Investec Opportunity Fund does not have any exposure to these areas.

South Africa has a substantial infrastructure backlog. However, we would like to point out that the current margins analysts are using for 2010 earnings are four times historical averages, based on planned revenues of over R90bn at the peak spend. We continue to believe that investors are pricing in a long cycle already and are ignoring project risk. Our view is that the undiscounted opportunity lies in holding shares in companies, which will benefit from the multiplier effect of the infrastructure boom. Banks will assist with the financing of many of these ventures and consumer related activities will receive a boost from the ensuing job creation benefits that will flow. Banks with single digit P/E multiples offer great value for the next three to five years, particularly as the shares have massively underperformed their intrinsic value.

Market outlook and portfolio positioning
In our view investors are buying bonds too soon relative to cash, given the inflationary pressures and currency risks that are evident at these levels. The poor macro picture is priced into banks, but is not reflected in bond yields and listed property shares.

Local equity weightings continue to be below 60%, with lots of cash in the fund. Cash still looks attractive. We purchased 12-month negotiable certificates of deposits (NCDs) bearing interest at 10.9% in the quarter. Cash continues to be the one asset class that everyone needs, but nobody wants, particularly in an overleveraged world.

Market review
Against a backdrop of steady global expansion and some inflationary concerns, monetary policy risk remains to the upside. Global bond markets sold off aggressively during the quarter, reflecting rising demand for capital and higher real yields. The European Central Bank's tightening bias pushed the euro to reach a series of record highs against the yen while at the same time climbing to two-year highs against the US dollar. The rand strengthened against major currencies over the quarter, in line with both commodity and emerging market currencies. Commodities remain generally well supported. The two main drivers of global inflation, oil and food continue to push higher. Metal prices were moderately weaker but remain well supported by supply constraints and robust growth.

The domestic inflation outlook has deteriorated over the quarter. Rising yields globally and domestic inflation concerns resulted in the local government debt curve increasing sharply. Over the quarter the benchmark R153 and R157 peaked at 9.15% and 8.58% respectively. The All Bond Index lost 1.7% over the three months ended June. We expect CPIX inflation to remain firmly above the targeted inflation band until year-end. This is likely to force the South African Reserve Bank (SARB) to tighten rates further. However, early signs of some moderation of consumption led growth, coupled with a potentially negative impact of the recently implemented National Credit Act are likely to moderate the SARB's stance on the extent of further tightening. Rising bond yields and deteriorating inflation expectations put pressure on domestic listed property. The sector was up marginally over the quarter (0.3%) but remains firmly in the black year to date at 16.1%.

After a strong first quarter, domestic equity market returns moderated slightly over the past three months. The FTSE/JSE Index gained 4.3% since the end of March. The market was driven higher by general mining (up 12.5%), oil and gas (up 9.9%), construction (up 9.9%) and life insurance (up 6.9%). Interest rate sensitive counters, in particular banks were down 6.9% and retailers lost 6.7%. This reminded investors of a similar occurrence last year, when diminishing global risk appetite coupled with higher domestic borrowing costs, caused a massive sell-off in domestic oriented sectors.

We remain positive, yet cautious, on our equity outlook over the next few quarters. Increasing volatility and fluctuations in sentiment should not deflect from a global and domestic backdrop that remains supportive of continued earnings growth and above average equity ratings.

Fund performance
The second quarter saw a slight deceleration in the overall rate of performance of your investment, although still positive and ahead of cash. The Investec Opportunity Fund returned 3.2% over the quarter. The performance for the six months still exceeds the benchmark returns. Over this period the Investec Opportunity Fund gained 9%. As equity returns start to flatten off and CPIX continues to rise, we expect returns over the next 12-18 months to moderate.

Portfolio activity
The biggest transactions on the fund have been the purchases of Steinhoff and Impala Platinum, and the sales of Absa. Overall, we have slightly reduced the equity weightings. The share price of Steinhoff has actually declined this year, although the business has increased in value.

We purchased more Impala after a near term disappointing trading update, which is more due to the timing of metal sales than operational issues. The business still has strong growth momentum into 2008, and the valuation still appears too low to us.

We have taken profits and sold all the Absa shares out of the portfolio. The results are probably more aggressively stated than the peer group and we are concerned about negative surprises. We continue to favour the prospects for the other major banks, given attractive valuations and substantially poorer credit conditions already priced into the market valuations.

Market outlook and portfolio positioning
We anticipate a gradual slowing in the overall earnings growth outlook as commodity prices peak and lose upward momentum. Furthermore, we expect ratings of equity prices to earnings to reduce as higher short and long term interest rates lower the prices that markets will assign to the earnings.

As cash rates continue to rise, we would find increased opportunity in money with terms up to a year. We are actively investing in these areas. Overall equity weightings have moved down to 58%, but nevertheless negative equity returns are not expected.

We have also reduced exposure to listed property where the market is expecting strong growth in the retail sector, which is not supported by trends in the prices of credit retailers. We would expect yields to rise to approximate the current yields on bonds.

Bonds yields have risen sharply over the quarter, and the underperformance of bonds over cash is becoming more evident. We will start to look for opportunities here, but are not in a hurry to add weight yet.

The defensive portfolio of offshore equities has continued to increase in value, although the big undervaluation has been partially reduced by rising global bond yields. Cyclical share like Samsung and China Mobile have added strongly over the quarter.

Market review
Goldilocks economics held sway among investors in the opening days of the new year. However by the end of February it seemed quite plausible that the US housing market might go into crisis mode. All the major data releases disappointed the markets. Almost overnight, everyone heard about the appalling abuses of the subprime lending market. Global equity markets did not take kindly to the deterioration in the macroeconomic backdrop. By mid March most markets were 5% to 10% down from their earlier highs but by month end, equity markets had bounced back. The MSCI World Index gained 1.9% (in US dollar terms) over the month and 2.6% over the quarter. The JSE saw heightened volatility in March. Local equities declined very sharply but as global risk aversion eased, stocks bounced back strongly. By month end the JSE had broken convincingly through its earlier February highs. The FTSE/JSE All Share Index returned 6.4% in March. This rally raised the first quarter return to 10.4% and the 12 month return to 37.6%. For the quarter, resources were up 15.2%, financials 6.5% and industrials 5.6%. The bond market had a difficult month, losing 0.4%, which trimmed the quarterly return to a meagre 1.6%. In the run up to the national budget, bonds priced in so much good news that they became vulnerable to any signs that the rate cycle might not have reached its peak. Credit and trade data suggested that the imbalances in the SA economy might be unusually tenacious. This was enough to convince investors that the monetary authorities might have to keep their finger on the interest rate trigger for a while longer. The rand weakened by 4.1% against the US dollar and 4.6% against the euro over the quarter.

Fund performance The Investec Opportunity Fund posted a return of 5.8% over the quarter. We have been surprised by the strength in commodity prices and the resultant widespread surge in resource share prices during the first quarter. Fortunately, a reasonable exposure to platinum has contributed strongly to performance. However, more defensive shares like Remgro, SAB and Tiger Brands, which form part of your portfolio have typically been quite lacklustre this year. In fact this is somewhat of a global phenomenon. We have a large exposure to shares whose performance is less tied to overall economic growth. The relative flat performance thus far bodes well for stronger performance later this year, particularly as the intrinsic value of these companies rises.

Portfolio activity
We raised your exposure to Sasol, following steep recent and longer term share price underperformance. This has highlighted inherent absolute value emerging in the share. At present the market is placing a low long-run valuation on the cash flows of the business in anticipation of sharply lower oil prices. The markets seem to believe that oil prices will decouple from broader commodity price indices, or that production volumes will remain under pressure for some time. We are more sanguine on volumes and prices

Market outlook
The resource weightings seem to have bottomed in the portfolio, but we are not in a rush to increase our exposure. As value re-emerges we will add further weight. We continue to be concerned about high levels of speculation in several spot commodity markets. We think that quality industrial companies are underpriced by the market and you have a large exposure to Tiger Brands, Remgro, Afrox and MTN to name a few in the industrial space. The chart shows how three key holdings have lagged relative to the strength of Anglos and Billiton The equity weighting has crept up slightly, but we retain our overall conservative stance, with an SA equity weighting of more than 59%, complemented by an offshore equity weighting of more than 8%. The current equity bull market is shaping up to be one of the best in South Africa's history. The 1961-1969 bull market ended on 25 times earnings in tears with massive retail participation in the market. The bull market of 1976-1986 was long in duration, but very volatile with three years out of ten where cash outperformed equities and where we had a steep loss of value. This was also a fantastic commodity price driven bull market. It ended on 15 times earnings. If the current bull market follows the average pattern of the previous two bull markets it would be due for a correction soon, 80% of the gains have already been made. One year money looks attractive at close to a guaranteed 10% return, particularly with domestic inflation risks squarely on the upside. We continue to think that cash will offer competitive returns for 2007, even if equities provide double digit returns. Bonds still lack value, and the underperformance relative to cash is starting to become visible. We remain uninterested in essentially an expensive asset class, which is buoyed by a perceived issuance shortage. Property continues to carry a growth premium, and we expect more equity-like performance from this asset class, similar to what we saw in the 1980s.

2006 certainly will go down as a banner year for SA financial markets.This year we have seen
I. Continued new highs in South Africa's export commodity prices, particularly base metals and platinum, fuelled by a super cycle that we have not been seen in close to 30 years.
II. A record economic expansion in the SA economy, now the longest consecutive growth period since the second world war
III. Continued low interest rates, even though rates have risen 2% from the bottom
IV. Continued volatility in the exchange rate, with the usual 20% swing in the currency.
V. Another record performance for the JSE, with the index rising for a fourth consecutive year.

Before considering the prospects for markets it is important to note that market performance over the last year culminated in the best balance in the markets as an allocator of capital that we have seen in over a decade. We have interest from traditional managers, both locally and internationally, we have interest from alternative managers, hedge funds and private equity, and we have new companies coming to the market raising capital for new growth opportunities. Three years ago equity capital was considered too expensive (i.e. equities too cheap), but now companies are using their shares to buy other companies, like MTN and Naspers.

The presence of all these players in the markets makes for greater efficiency, but also for less visible opportunities for exceptional forward looking returns. Most shares now trade close or at fair values, meaning implying that in order to generate better returns from companies with lazy balance sheets, different financial structures are required, typically through more gearing. The converse is that lower absolute levels of future returns need to be accepted by investors. More gearing means more risk, as there is no free lunch in the markets.

The year was a good year for investors in the fund, with achieved returns again comfortably exceeding the benchmark hurdle rates, although with inflation rising from the recent lows, and fair equity valuations, expensive bond valuations and moderate interest rates we think the gap between these future returns and future inflation rates will narrow sharply.

Traditional thinking on the cyclicality of emerging markets and commodity prices will be challenged in 2007 as US economic growth (and subsequent global growth) tapers off. We believe it prudent to consider negative implications of such a scenario under the assumption that "Chindia" will not be able to drive global economic growth and reflect this caution in the overall portfolio strategy. We continue to have limited exposure to highly cyclical businesses, both credit retailers and commodity shares. Under the premise of continued non-discretionary consumer demand, food producers and retailers will benefit from higher food inflation, hence Pick 'n Pay, Astral Foods and Tiger Brands will do well. Higher short term interest rates will benefit the banks profits, and although the share prices picked up strongly towards the end of the year, we still see some upside.

The markets have seen their usual year-end buoyancy, but with rising interest rates firmly entrenched we continue to believe that cash, the oft forgotten asset class in a bull market, will provide a competitive return into 2007. Aggressive equity weightings appear imprudent, but low bond yields offer very little as an alternative, and property stocks are discounting continued strong distribution growth.

(Offshore cash weightings and exposure to the global Absolute Income Fund continue to complement the domestic equity allocations, and we will look to maximize this exposure going forward)