As we have indicated in previous months, the FTSE/JSE All Share Index currently offers much lower future return prospects than it did three years ago. The Fund is essentially fully invested in shares in pursuit of its aim of earning a higher total rate of return than that of the FTSE/JSE All Share Index. As such, it is unlikely to be immune to the increased volatility that inevitably comes from higher equity prices and should investors wish to trim back their exposure to South African shares, our other unit trusts offer opportunities to lower share exposure and invest offshore. Nonetheless, we remain confident of our ability to outperform the benchmark index and through our proprietary fundamental research continue to find investments that should generate attractive long-term returns for our investors. Many of these counters are high quality businesses whose earnings are expected to grow faster than the market and which can be acquired at attractive valuations.

Investors in the Allan Gray Equity Fund should be cognisant of the Fund's aim, which is described above. This means that the Fund can still achieve its objectives if South African share prices and the value of the Fund fall, as long as the Fund falls by less than the All Share Index. We remain confident of our ability to outperform the All Share Index over the long-term. But the All Share Index is now within 5% of its all-time high, and offers much lower future return prospects than it did 3 years ago. The Fund remains fully invested in South African shares in pursuit of its aim. Should investors wish to trim back their exposure to South African shares, our other unit trusts offer opportunities to lower share exposure and invest offshore.

It is unlikely you would select Allan Gray Equity on the basis of its current rankings. In the very short term, a number of the fund's top holdings, such as the banks and Sanlam, have been hit by the increase in interest rates, and it has not held some of the more robust rand hedges, such as BHP Billiton.

Over three years it is still carrying the returns for a disappointing 2004. Portfolio manager Stephen Mildenhall says he sold out of cyclical industrial shares such as Edgars and Foschini too early. But experience shows that periods of average performance do not last long at this shop.

As its competitors rush to buy the big resource shares, Allan Gray has been trimming back. It has halved its holding in Sasol and trimmed back Anglo. Mildenhall says it would have helped if he had held BHP Billiton but right now the prospects for shares with rand costs and dollar incomes, such as the platinum shares and Harmony, are more attractive.

The overall resource exposure is falling and funds have been redeployed into stable industrial shares with high-quality cash flows, such as MTN and Remgro, which were already in the fund. New positions were established in Richemont, SABMiller and Barloworld.

Mildenhall avoided the life companies until about 12 months ago, when he started to accumulate Sanlam. He says Sanlam cannot quite be described as a turnaround but it has better management which is doing a good job, both in operations and in capital management, though this has not yet been acknowledged by the market.

He has also been nibbling at Liberty but avoided Old Mutual, which he says is too heavily geared to vulnerable international equity markets.

Other than Old Mutual, he says there is little to choose between financial shares. In contrast, stable industrial shares are underpriced relative to their cyclical counterparts and the specialist precious metal counters are underpriced against the diversifieds.

Though the fund focuses on quality shares, there are a few weaker counters which have turnaround potential, notably Sappi, in which the holding was recently doubled, and Nampak.

Financial Mail - 30June2006

Original investors in the Fund have seen their investment grow by more than 13 times since the inception of the Fund 7.5 years ago. This extraordinary return can be attributed to two factors:
1. The general return from our stock market; and
2. The outperformance (alpha) generated by Allan Gray.
While our outperformance has added considerable value to the Fund, the general rise in share prices in South Africa has also been a significant contributor. If our original investors had invested in the All Share Index (ALSI) back in October 1998 instead of our Fund, they would still have grown their capital by 5 times. The returns of the ALSI have been driven primarily by a closing of the valuation gap between South African shares and shares listed elsewhere in the world. This gap has closed and South African shares now trade on much more comparable multiples to their global peers. This leaves little margin of safety in South African shares, particularly when one considers that the earnings of the All Share Index are above trend-line, the profitability of many South African consumer-focused companies is at an all-time high, and the Rand is very strong. We thus urge our investors to temper their return expectations, although we believe that our stock-picking skills should continue to generate superior performance over the benchmark over long periods of time.

Strong returns for the fund continued in December, bringing the Fund's 12-month return to 50.0%, versus the 12-month return for the Fund's benchmark, the FTSE/JSE All Share Index of 47.3%. Over the period the fund benefited from its overweight positions in South African focused resource shares (including gold and platinum shares). While the valuation gap between these shares and the rest of the market has narrowed we continue to find these shares more attractive than the broader market. In addition, the fund has increased its exposure to selected financial shares. Given the substantial rise in the South African equity market in the last three years, return expectations from this point need to be tempered.

The fund was one of the worst performers in 2004 but it had a strong recovery last year. It went against the herd with its overweight positions in gold and platinum shares. And it was the first major asset manager to reduce its exposure to retailers significantly. Positions in Standard Bank, Remgro and Sanlam were increased significantly while Sasol, Anglo and Nedbank were trimmed back.

Financial Mail - 20 January 2006