The fund delivered reasonable outperformance of peers in a volatile quarter for markets, driven by good stock selection. Comments from the US Federal Reserve hinting at a possible deceleration of stimulus, concerns around a Chinese slowdown and the weak South African economy were key themes during the quarter. It is still early, but there are signs that a market environment, for which we have been positioned for over a year, is finally coming to pass, with valuations driving this view. US economic activity appears to be improving, but remains significantly below potential. The Eurozone faces significant challenges as it grapples with debt in its periphery and an increasingly negative demographic burden as its population ages. China's growth prospects remain high, but are decelerating as the new leadership undertakes necessary structural reforms and reins in excessive credit extension. The South African economy remains weak and vulnerable. Lacklustre manufacturing, slowing household spending and a struggling mining sector, all contributed to a weak 0.9% GDP growth rate in the first quarter. In addition, the large 'twin deficits', high and rising inflation, falling commodity prices and a credit-driven consumption boom, which is now showing signs of unwinding, are all contributing to a fragile economic outlook. With the exception of Japan, global markets performed poorly in June as news of the Fed's stimulus tapering saw a re-pricing across risky asset classes and bond markets. Yet, despite the sharp sell-off in June, most developed equity markets performed well over the quarter. The US market (S&P 500 Index) ended the quarter up 2.4%, the Japanese market was a strong performer, with the Nikkei 225 Index gaining 10.3%, however the UK market (FTSE 100 Index) fell 3.1% as did the MSCI Emerging Markets Index, which was down 9.1% (in US dollar terms). The local equity market hit a new high in May, but then fell sharply during June to end the quarter down 0.2%. In line with the previous quarter's trend, Industrials (up 6.9%) outperformed the broader market, driven by rand-hedge stocks which were boosted by the depreciating currency. The positive trend in domestic industrials has again been fuelled by foreign buying, with equity inflows totalling R19.7 billion over the quarter, up from R3 billion in the previous quarter. Financials (down 1.6%) and Resources (down 11.8%) once again lagged. Resources continue to underperform as the prospect of lower stimulus and concerns around Chinese demand contributed to pressure on commodity prices. Most commodities relevant to South African miners fell in US dollar terms. Iron ore was down 15%, copper lost 11.1%, platinum fell 14.9% and gold was down 22.8%. The oil price (Brent Crude) ended the quarter 7.4% lower. The rand had another difficult quarter, weakening 6.5% against the US dollar and 7.9% against the Euro. Inflation eased to 5.6% at its most recent reading for May. However, inflation is expected to breach the 3% - 6% target band in the second half of this year due to fuel price increases and the lagged impact of the weaker rand. The Kagiso Equity Alpha Fund outperformed the average fund in the South African Equity General sector over the quarter. This outperformance was driven by strong stock-selection as many of our highest conviction positions were rewarded. The fund is number four in the Domestic General Equity sector since its inception in April 2004 - a testament to the value of our investment philosophy and process over the long term. Strong performers for the fund over the quarter were MTN (up 13.9%), Naspers (up 27.4%), Sasol (up 5.9%) and AECI (up 12.2%), while our exposure to Standard Bank (down 5.8%), Lonmin (down 6.2%) and Anglo American (down 19.8%) detracted from performance. Looking ahead, while the unwinding of stimulus will be a slow process, the reality is that any slowing (and ultimately reduction) represents a significant change in the flow of liquidity to markets. This will have implications for several asset classes and we will continue to avoid those assets that have benefited disproportionately from quantitative easing over the last few years. We maintain our view that SA consumer-focused industrials are overpriced and will continue to avoid this sector. We believe that there is significant scope for capital loss as several drivers of the consumer sector (currency, interest rates, employment, wage growth and access to credit) have all turned negative. It is important to highlight that the SA resource sector's significant underperformance coincides with substantial foreign selling of local resource shares. While this represents a clear opportunity as the sector is attractively priced, it also highlights the potential downside risk to SA industrials if foreigners were to start selling. The fund continues to be positioned in our best ideas, based on our team's proven bottom-up stock-picking process. Significant hedging provides capital protection in an increasingly expensive market and a meaningful global allocation provides useful diversification into more attractively priced markets.

The global economy continued its slow crawl during the first quarter of 2013. The endemic debt crisis in the Eurozone reared its head in Cyprus, as a further symptom of the economic problems in the developed world. Developed market central banks continue to pour stimulus into the markets at an unprecedented rate in their continuing attempt to support the recovery. The Bank of Japan's recently announced 'Quantitative and Qualitative Monetary Easing Programme' had an immediate impact on risk assets around the globe.

Locally, weak export demand, buoyant but slowing consumer spending, slow infrastructure development and chronic labour unrest in the mining, transport and agricultural sectors all contributed to a sluggish economy. This, along with a high current account deficit, negatively affected the rand, which was the worst performing emerging market currency over the quarter. During this period, the rand lost 8.1% and 5.3% respectively against the US dollar and the euro.

Developed equity markets rebounded strongly during the quarter. Positively interpreted comments from the US Federal Reserve officials contributed to US equities gaining 10%, propelling the S&P 500 index to a new high. The Japanese equity market was a strong performer, with the Nikkei 225 index gaining 19.3%. European equities gained 5% during the period, underperforming the global market as the events in Cyprus seemed to dampen investor sentiment. The MSCI Emerging Markets index was down 9.7% (in US dollar terms).

Despite deteriorating macroeconomic fundamentals, the South African equity market continued to set new records, with the FTSE/JSE All Share index reaching an all-time high of 40984 in March. Given the debt woes and weak economic activity plaguing developed economies, South Africa has attracted significant foreign investment over the last few years. During the quarter, foreigners bought R3 billion of SA equities and R14.1 billion of SA bonds. Foreign investors now own more than one-third of the local bond market and of the shares trading on the JSE Securities Exchange - an all-time record for both asset classes.

The FTSE/JSE All Share index gained 2.5% over the quarter, with industrials up 6.3%, and financials up 5.9%. Resources (down 6.0%) continued to be weighed down by weakening commodity prices in part from weaker Chinese demand, as their economic growth moderates. However, the weaker rand should provide some support to resources earnings in the short term.

Most commodities relevant to South African miners lost ground in US dollar terms. Gold was down 4.6% and copper lost 7.1%. Platinum, however, was up 3.5%. The oil price (Brent Crude) rose above US$120/barrel for the first time in almost a year, but fell back as the US showed strong inventory figures, ending the quarter 2.2% lower.

The rand's depreciation has placed upward pressure on inflation expectations. The revised Consumer Price Inflation basket has now been implemented and inflation rose to 5.9% at its most recent reading for February. The effects of a weaker rand, rising food prices, rising administered prices such as fuel and electricity and real wage increases are the main upside risks to inflation, which we expect to breach the South African Reserve Bank's target band in mid-2013.

The Kagiso Equity Alpha Fund significantly outperformed the average fund in the South African Equity General sector over the quarter. This outperformance was driven by strong stock-selection as many of our highest conviction positions were rewarded. The absence of many expensive industrial shares (particularly retailers), which had a poor quarter, also contributed significantly to relative outperformance. The fund is number two in the Domestic Equity General sector since its inception in April 2004 - a testament to the value of our investment philosophy and process over the long term.

Strong performers for the fund over the quarter were Mondi (up 36.5%), AECI (up 27.9%), Sasol (up 12.3%) and Tongaat Hulett (up 7.6%), while our exposure to Impala Platinum (down 18.9%), MTN (down 6.2%) and Anglo American (down 6.0%) detracted from performance.
Looking ahead, we continue to be cautious given the contradiction between vulnerable global and local economies and a market at all-time highs. Ever-increasing monetary stimulus is continuing to distort local asset prices in certain sectors and the risk of permanent capital losses remains elevated.

The fund continues to be positioned in our best ideas, based on our team's proven bottom-up stock-picking process. Significant hedging provides capital protection in an increasingly expensive market.

Firm (but marginally slower) growth in emerging economies and relatively flat output in developed economies contributed to lacklustre overall global economic growth in 2012.

Within emerging markets, China remains the key driver of growth despite some deceleration since the double-digit growth rates of 2010. Developed market growth continues to struggle with the US recording average growth of 2% through much of 2012 and Eurozone economic activity remains weak. The peripheral Eurozone economies are still firmly in recession amid debt-fuelled austerity measures and a volatile political climate.

Locally, structural economic problems and weak global conditions continue to constrain prospects for economic growth. South Africa's macro fundamentals are weak and the marginal growth achieved has largely been driven by government and household consumption - largely debt-financed. Yet, despite the deteriorating economic environment, South African share prices continue to reach record highs.

Global markets were generally up during the quarter, with the exception of the US (S&P 500 Index), which was down 1.0% as uncertainty around the looming fiscal cliff deadline affected investor sentiment. The UK (FTSE 100 Index) was up 2.7%, Japan (Nikkei 225) was up 17.2% and the MSCI Emerging Markets Index was up 5.2% (in US dollar terms).

The FTSE/JSE All Share Index gained 10.3% during the quarter, ending the year near a record high. In terms of sector performance, industrials (12.4%) were the largest contributors, followed by financials (9.9%). Resources (7.3%) recovered a little as Chinese data improved and the iron ore price rallied. For the year, the FTSE/JSE All Share Index returned 26.7%. Industrials (40.7%) and financials (38.1%) performed well, with resources (+3.1%) lagging.

Foreigners were net sellers of South Africn equities worth R3.4bn in 2012, although there were inflows of R5.3bn in December as currency pressures subsided and labour issues appeared to stabilise.

Commodity prices weakened this quarter, with most commodities relevant to South African miners losing ground - platinum was down 5.2% (in US dollar terms), gold was down 5.5% and copper was down 2.7%. During the quarter, renewed optimism on Chinese growth led to an improvement in base metals.

Consequently, iron ore prices recovered strongly as buying was boosted by stronger activity and falling inventory levels. The oil price (Brent Crude) remained fairly static, down a mere 0.4% during the quarter.

The rand weakened by 1.9% against the US dollar and 4.4% against the euro. The rand depreciated notably in October at a time of severe labour unrest and the downgrading of South Africa's sovereign rating. However, it performed strongly in December, gaining 5.1% against the dollar as concerns about Europe's slowdown eased and the appointment of Cyril Ramaphosa as ANC Deputy President was well received by global markets.

South African consumer price inflation rose during the quarter, driven by higher petrol, electricity and food prices. Inflation remains in the upper region of the South African Reserve Bank's target band, where we expect it to remain in the medium term, with most of the upside pressure stemming from higher food and electricity prices, as well as the knock-on effects of a weaker rand. At its Monetary Policy Committee meeting during the quarter, the Reserve Bank left rates unchanged. The Bank continues to balance weak growth prospects and rising inflationary pressures.

The Kagiso Equity Alpha Fund slightly underperformed the average fund in the Domestic General Equity sector. While our current overweight position in resources shares and underweight position in industrials is affecting our short-term performance, we believe it is appropriate to position our clients in deeply undervalued shares in anticipation of strong capital gains and avoid the permanent capital losses we expect from vastly overvalued shares.

The fund remains number one in the Domestic General Equity sector since its inception in April 2004 - a testament to the value of our investment philosophy over the long term.

Implats (up 20.6%), ABSA (up 18.4%) and FirstRand (up 13.5%) were strong performers for the fund over the quarter, while our exposure to Anglogold Ashanti (down 10.1%), Tongaat Hulett (down 3.5%), AECI (down 2.5%) and Lonmin (down 2.1%) detracted from performance.

Looking ahead, meagre growth combined with heightened policy risk will remain concerns in 2013. We therefore remain cautious over prospects for developed economies with high levels of government debt, high levels of unemployment and demographic trends moving slowly against them. On the positive side, we believe that there are strong prospects for companies focused on emerging market consumers, although much of this optimism seems to be priced into South African consumer stocks. We are increasingly finding opportunities in large capitalisation IT stocks in the US with solid balance sheets and resilient cash flow generation abilities.

Going forward, we remain defensively positioned from an asset allocation point of view, with significant hedging in place. The fund continues to be appropriately positioned in our best stock selections, based on our team's proven bottom-up stock picking process.

Portfolio manager
Gavin Wood