The 3rd quarter was characterised by a sudden cooling in the rampant commodity market and a dramatic sell off in the Rand. While the slowdown in the commodity market has always been our view, and is reflected as much in the portfolio, the Rand weakness, which has occurred independent of other currencies, has in our view been excessive and resulted in the continued outperformance of a number of currency geared resource shares as well as the dual listed shares. There has however also been some measure of bounce back in the domestic equity sector as the 'wheels off' scenario which was priced in during May/June has started to normalise as market participants have realised that the underlying economy remains strong.
The equity fund which has continued to be positioned for the down cycle in commodities, struggled in the quarter due to the weaker Rand (which declined some 15%) during the quarter. It was gratifying to see some of our domestic positions start to pay off as well as portfolio stalwarts such as Remgro and Richemont come through nicely. The equity fund returned 5.14% for the quarter compared to the benchmark of 6.40%. This did still vindicate our view of favouring equities despite the volatility of the previous quarter.
There has without a doubt been much concern expressed over the outlook for the SA economy as we have moved into this rising interest rate environment. Clearly the tightening bias at the SARB has been focused on reigning in the rampant consumer spend evidenced over the past few quarters. The strategy is not however to bring the economy to a screeching halt but merely to slow the excesses and by doing so to relieve the pressure on the current account.
In this scenario we believe the prices of domestic equities looks particularly attractive. By valuing businesses on realistic assumptions (not the boom times of the past few years) it is evident to us that there is significant upside in the domestic equity market. Why is this so? We believe overly pessimistic assumptions of the impact of the tightening cycle, coupled with very short term earnings outlook has created an environment were investors have exited rapidly from these shares. Limited liquidity as well as some negative news flow (SARB 'talking the market down', initial draconian proposals on Chinese imports etc) impacted on the price movements further. As a long term investor we characterise a lot of this as 'noise' which can easily distract momentum investors. At Coronation we try to look through the short term distractions and identify what businesses are worth through a cycle. Regulation will come and go. Interest rates will rise and fall, predicting these are difficult, predicting what businesses will earn over time is far more practical.
The net result is a portfolio of strong cash generative businesses which we believe are either well positioned to continue with strong growth in earnings, or are currently being viewed so negatively as to discount the worst possible outcome over the next few years. This creates a margin of safety which provides for great upside and the ability to ride through any short term cyclical volatility. The overall forward PE of the fund is 1.4 and the forward dividend yield 4.3%, great indicators of the attractive valuations.

Neville Chester
Portfolio Manager

This quarter marks the tenth anniversary of the launch of the Coronation Equity Fund (formerly the Coronation High Growth Fund). The fund has enjoyed a phenomenally successful ten years, delivering an annualised return of 19.5% to investors and ranked second out of all funds over this period.
If there is one certainty in investing, it is that equity markets are volatile, and that equity markets in emerging markets are even more so. In a volatile environment it is very difficult to consistently call the short term direction of different equity classes. Thus what is crucial is to be able to take long term views based on solid convictions and this can only be achieved by bottom up stock picking. Forecasting interest rates, currencies and all the attendant macro factors is extremely difficult, they don't call economics the 'dismal science' for nothing!
The fund is run on the principles of bottom up stock picking, where we choose the best stocks from the Coronation houseview and back them fully with large positions to achieve maximum returns over the longer term for our investors. By nature, this approach may result in short-term underperformance, such as the fund is experiencing now. Our strongly held view that it is virtually impossible to accurately forecast the gold price, coupled with our aversion to investing in shares priced at 2 or 3 times net present value and on PE multiples which are headed for the stratosphere, has meant that the fund had very little exposure to Gold shares this year. This has detracted from performance as the increasingly hot and excited speculators continue to pour money into physical gold and the available gold miners.
As Warren Buffet sagely pointed out in his most recent AGM: '..in metals and oil there's been a terrific [price] move. It's like most trends: At the beginning, it's driven by fundamentals, then speculation takes over. As the old saying goes, what the wise man does in the beginning, fools do in the end. With any asset class that has a big move, first the fundamentals attract speculation, then the speculation becomes dominant.' and as Charlie Munger would say 'I have nothing to add to that!'
For the quarter the equity market returned 4.9%, driven by very strong returns from resource shares. The rapidly depreciating rand more than offset the commodity weakness of late May and early June, which has subsequently been retraced. The hike in interest rates by the Reserve Bank appeared to shock the market, causing investors to start dumping interest rate sensitive stocks with little appreciation of what the longer term impact would be. This was repeated even more vehemently when the current account deficit for the first quarter was announced and was ahead of expectations. The net result was a severe de-rating of domestic industrial stocks and a sharp re-rating of resource counters which was extremely punishing to stock-pickers who had not been playing 'macro' themes.
The Fund managed a total return of -3.6 % for the quarter due to its bias towards domestic companies, which were predominantly negative over the period, and non-resource based rand hedges. We remain extremely comfortable with these companies and in fact used the weakness to add to some of the bank and credit retail holdings as panicked sellers offloaded at low levels. As the market normalised in the last few days of June this seemed to have been the most appropriate action.
At quarter end the top 10 holdings were trading on an average forward PE of 10.7 and on a dividend yield of 3.6%, both metrics indicating good value. Investors need to be aware that we have moved into a period of high volatility. Foreign investors are feeling more risk averse and could have a significant influence on short term price moves, as well as local investors attempting to time the market. In the short term equity prices could go anywhere but in the long term we are very comfortable with the return potential of equities in general, and our fund specifically.

Neville Chester & Charles de Kock
Portfolio Managers

A strategy that manager Charles de Kock calls defensive failed to protect Coronation Equity (CE) during the market's five-week slump that ended in mid-June. CE's price dived 15,6%, slightly more than the general equity sector's average 5,2%. CE has also failed to impress during the market recovery, its price up 12,7% (to August 29) against a 14,5% average sector gain. Much hangs on CE's top 10 holdings which make up 53% of its portfolio.

Financial Mail - 08September2006

Coronation Equity (CE) has hit one of those patches where not much seems to go right for it. Since the end of the first quarter of 2006 in particular, an aversion to resource shares and some poorly performing stock picks have combined to depress CE's 12-month ranking from fourth in June 2005 to a dismal 40th.

Shrugging off the lacklustre showing, Charles de Kock, who manages CE with Neville Chester, says CE's portfolio has been structured defensively with the aim of achieving a lower average beta - in essence, lower volatility than the overall market.

Having a lower beta worked against CE during the run in resource shares between March and mid-May. Again De Kock is unfazed: "We were not prepared to be heavily exposed to a sector in near bubble territory."

A low exposure to resource shares is certainly comforting now, but less comforting has been the showing of some of CE's key stock picks. This is especially true in a fund where views are backed by hefty exposures: CE's top 10 shares make up 57% of the portfolio and the top 15 shares 72%.

One notable top-10 weak spot has been Telkom, which has experienced a 22% slump in price since March. Though a quarter of the holding was sold near peak levels, De Kock concedes "it was not enough". But he feels that given Telkom's 50% holding in Vodacom, its fundamentals remain sound.

CE's third-largest holding, SABMiller, (6,6% exposure) has also failed to impress, its price rise of 17% over the past 12 months being barely half the financial & industrial index's rise. "It has been disappointing," says De Kock.

Overall, CE's low beta profile has offered little defence against what De Kock rightly terms "an indiscriminate sell-off". But he remains positive that this will eventually work in its favour.

De Kock says the market sell-off has left valuations less stretched and has created some "fantastic" long-term value situations, including CE's top holding, Standard Bank. Hopefully this will help free CE of its recent performance jinx and, combined with its low cash policy, allow it to emerge as a leader in a market recovery.

Financial Mail - 16June2006

Equity markets continued their relentless surge upwards and onwards in 2006, with foreign interest reaching new highs. Anecdotes abound about the volume of new foreign money pouring into local equities, as well as about how naïve some of this money is (an apocryphal story is doing its rounds about a foreign investor sitting down with the CEO of a local listed company and telling him "I am a large shareholder in your business, can you give me an overview of what you do ...").

The All Share Index surged by 12.5% driven mainly by continued interest in resources, although industrials and financials have also had a decent return. The Coronation Equity Fund returned 12.1% which is a great absolute return but has disappointed in the short term relative to some of its peers.

In order to shed some light on this we would like to illustrate the differences in some of the holdings in the fund and what has been driving the index. A company like Harmony has increased in price by 18% over the last quarter (on the back of an equally stellar performance in the previous quarter). Harmony mines gold predominantly in South Africa and, as one would expect, given the recent rises in the gold price, has been the focus of a lot of attention. Imagine yourself as a buyer of the entire business, in order to buy Harmony you would have to pay R37 billion. For this large amount of money you get a business which has not made a profit for the last eight quarters, despite the raging gold bull market. Nine months ago their debt was downgraded due to concerns over whether or not they would be able to repay it. We do not own any Harmony at the current price

Then you get a company like SABMiller. This is a business with a global footprint which has operations in developed and emerging markets around the globe. It has, through organic growth and astute acquisitions combined with superb management, grown to become one of the global leaders in the brewing industry. It has consistently generated profits year after year, most recently with increasing levels of profitability. Its earnings have grown compound by 12% over the past five years and, at the same time, it has returned cash not required for growth by means of dividends to shareholders. Its emerging market businesses all have growth profiles generally superior to that of developed markets, and despite this it trades at a discount to its global peers. This is a great business which we like and we own. It has underperformed the market significantly in the last quarter, but that in the long-term world of investing is irrelevant. It is a great asset trading at a reasonable price.

The Coronation Equity Fund continues to own excellent businesses with strong earnings potential and cash generative characteristics. We are confident that this will continue to generate superior performance in the medium to long term for all unit holders.

Neville Chester & Charles de Kock
Portfolio Managers

The final quarter of the calendar year had plenty of surprises for investors. After a sudden fall off in October the market was spurred on by some corporate activity in November with the Vodacom acquisition and then produced an absolute cracker in December, initially led by resources and then local stocks as the rand strengthened. Overall for the quarter the All Share Index (ALSI) returned 7.7% with the Coronation Equity Fund delivering a similar return of 7.4% despite our large underweight position in the resource sector.
This has been another exceptional year for the SA equity market. A combination of a benign local market with strong underlying consumer demand, allied to a raging bull market in commodities resulted in an exceptional return of 47% for the year for the ALSI (with resources as a sector returning 71%!). These kinds of returns are truly exceptional and one would be foolish to expect them to be repeated at similar levels. We do however remain reasonably bullish on SA equities due to the strong potential earnings growth for the period ahead.
Towards the end of 2005 markets were getting cautious given the bearish stance of the South African Reserve Bank and the expectation for interest rate hikes in early December or by latest February seemed to be weighing heavily on the investor mindset. However the spate of benign inflation data and the rampant strong rand has put paid to any interest rate hike fears and given the current trajectory of the rand I imagine most economists are now pencilling in interest rate cuts for 2006!
The equity fund remains fully invested and positioned to favour the local economy with large weightings in domestic financial and industrial stocks. While being underweight resources in 2005 clearly detracted from what would have otherwise been a truly phenomenal performance, the strength in the resource share prices has just made our argument for being underweight these shares even stronger as they look even more expensive.
We tend to favour companies with very strong brands and entrenched market positions with good cash flows and shareholder friendly management. Our top holdings such as Standard Bank, Remgro, Naspers and SABMiller reflect these virtues.
To conclude we believe the favourable domestic economic outlook should provide the impetus for strong earnings growth for domestic companies which will result in good returns for local equities over our investment horizon.

Neville Chester & Charles de Kock
Portfolio Managers