Quarter Ended 30 September 2010

Q3 Fund Performance
A significant weakening of the US dollar and sterling was a key feature of the third quarter, and fund performance was subdued as a result.  While equity markets performed strongly in local currency terms in Q3, much of this was offset by the negative impact from exchange rate changes.  For example, in the US the S&P 500 index rose by 11%, but the US dollar weakened by 10% versus the euro.  Similarly, much of the 13% gain in the FTSE 100 index was eroded by a 6% fall in sterling against the euro.  In addition, within equity markets growth stocks outperformed value stocks, cyclical sectors gained more than non-cyclical companies and small-cap stocks rose more than large-caps.  Within the equity portion of our funds, Appian remains biased towards large-cap, blue chip value stocks which we continue to believe offer a significantly more attractive risk / reward outlook over the medium to longer term.  During Q3 the spot price of gold rose by 5% in dollar terms but this translated into a 5% decline in euro terms. 

Macro Economic Environment
Equities benefited in Q3 as investors expected that the Federal Reserve would reactivate their policy of quantitative easing.  Better than expected macro economic data helped to counteract double dip fears.  However, foreign exchange markets became extremely volatile as a weakening currency was seen as a possible solution for increased growth.  Paradoxically any weakness seen in macro economic data was beneficial for equity markets as investors perceived this as a precursor for further quantitative easing.  Generally corporate Q2 earnings were better than expected which has provided further support for the markets. 

European banks were stress tested although there remains a considerable discourse as to the validity of these tests.  Whilst it did not dampen the worries associated with these banks it did provide significant transparency.  Unfortunately this greater transparency encouraged investor to focus on Sovereign risk of the peripheral countries of the Eurozone.  Unusually the bond market was similarly correlated to the equity market over Q3 with the Euro 10 year bond yield moving from 3.31 to 3.01 and the US 10 year treasury moved from 2.94 to 2.5.  This is possibly a reflection of investors seeking greater security or fears of future inflation as commodities continued in an upward trajectory.  The subdued sup-par jobless recovery remains our central thesis despite some commentators referring to the risk of a double dip recession or an increase in mergers and acquisition activity. 

US Macro
Federal Reserve watchers noticed a difference of opinion amongst governors with regard to future monetary policy and unlike his predecessor Ben Bernanke remains comfortable with the airing of such views.  However, the continuing cause of concern for the Fed is the ability to funnel credit into the economic system.  Banks continue to repair their balance sheets and despite the best efforts of the Federal Reserve, via its quantitative easing programme in reducing the costs of borrowings their remains limited demand for credit from the consumer.  The consumer continues to repair their personal balance sheets with savings rate of disposable income nearing and stabilising at 6%.  There is unlikely to be a significant fiscal stimulus prior to the congressional elections of 2 November 2010.  Assuming a Republican Party victory the likelihood of a fiscal stimulus could be delayed until mid 2011 post much political negotiating. 

EU Macro
The ECB left interest rates unchanged at 1%, however and unusually there was no consensus as to the future direction of rates.  There were some suggestions that continued ECB funding of banks in peripheral countries remained essential.  However, other members of the ECB board suggested that the ECB should restrain from these exceptional actions.  Appian expects a slowdown in future GDP growth relative to the exceptional levels of growth recorded in Q2.

Ireland Macro
The greater write-downs associated with the final tranches of transfers to Nama disappointed macro economic commentators.  In Appian's opinion, the target of 3% budget deficit to GDP for 2014 is unrealistic and despite the likelihood of a severe budget at year end Department of Finance officials should be negotiating with their European Commission counterparts in extending such a target to the latter part of this decade.  The recent increased cost of funds for the Irish Government gives little leeway in its efforts to correct its fiscal position in the abbreviated timeframe.  Ireland's future growth will remain ever more reliant on net exports and hence our recovery becomes more dependent on the recovery of the global economy.  The ECB could provide exceptional support by introducing a quantitative easing programme but they have given no indication of enacting such policy and replicating the actions of the Federal Reserve and the Bank of England. 

Henkel versus Proctor & Gamble
Within the household products and personal care sector during Q3 we switched out of our holding in Proctor & Gamble (P&G) into Henkel, the German headquartered producer of brands such as Persil, Schwarzkopf and Loctite.  P&G is currently pursuing a strategy of trying to win market share through price competition.  However, many of its competitors are using the benefits of cost restructuring moves to counter P&G's price war.  As a result we are concerned (i) that P&G's strategy may not succeed in winning share, and (ii) that P&G is not pursuing cost cuts to the same extent as competitors so its pricing strategy may impact its own margins more than competitors.  Meanwhile, Henkel (which was trading at a slightly lower valuation than P&G) is well advanced in one of the deepest cost rationalisation programmes in the sector which gives us confidence that it can materially raise its margins.  Given that Henkel's margins have historically lagged those of its peers, we considered that there has been potential for some time for it to narrow this gap.  In addition, we expect that over the next 2-3 years Henkel will experience a stronger rate of sales growth in its adhesives business (50% of its revenue) than will be seen in household and personal care product categories. 

Centrica
During Q3, we took profits in our Centrica position which we fully exited.  The shares had risen by 35-40% from where we built the positions a year earlier and had reached a level which we considered was fully valued.

John Mattimoe
Senior Portfolio Manager
September 2010