Coronation Smaller Companies (CSC) manager Sunil Shah could never be accused of shying away from strong views. Alas, these have often produced erratic performance. This has been painfully evident since the market low in May 2003, with CSC's 83% capital appreciation trailing way behind its peer group's 115% average. With the top 15 stocks making up 71% of its equity holdings, big bets are still the order of the day. They may pay off this time, but with CSC, who can say?

Financial Times - 3 December 2004

The fund delivered a return of 14.4% over the quarter, compared to 12.9% for the small cap index, 12.4% for the mid cap index and 11.4% for the Industrial Index.
One sector which continues to show robust earnings momentum is retail, where buoyant consumer spending is providing an excellent backdrop to names such as Edgars, Mr Price, Mustek and Iliad. Although many of these counters have run hard, the growth in earnings still provides a supportive safety net to their valuations. We remain confident on their outlooks, particularly as these companies boast excellent cashflows to match their earnings.
The fund has maintained a strong underweight to gold - the most volatile of all sectors - and this has proved correct over the year, although gold shares bounced strongly in the quarter. The strength of the rand has virtually erased the earnings base, implying continued risks on the downside.
We were reassured to see Seardel's final results - commendable in the face of the surge in imports they encountered. More importantly, management have initiated a strategic review of their property portfolio in order to unlock shareholder value. We maintain there is enormous potential if management grasp the nettle, and we will continue to direct them to the corporate holy grail.
The major shift in sector selection (from domestic to export-oriented shares) will depend on the rand. Although South Africa's external trade position has deteriorated dramatically and this should result in some rand weakness, there is enough uncertainty in the US dollar (created mainly by their twin deficits) to improve the appeal of the peripheral high-yielding currencies such as the rand. In conclusion, some rand slippage seems inevitable in the next six months.
The fund is very well positioned to benefit from such a move - endowed with a diverse range of companies (from AECI to Oceana to Northam) which price their product in dollars and should witness a handsome expansion of their profit margins. Most importantly, these are companies that have been attacking their cost bases aggressively for the past two years - any help from the rand would just be icing on the cake.

The most glaring macro-economic variable confronting corporates for the last two years has been the surprising strength of the rand. The currency's ascent has caused a significant shift in economic activity, transferring profits from the export industry to the domestic companies that have enjoyed buoyant consumer spending trends. The over-riding challenge facing all managements is the extent to which they have embraced the new strong-rand paradigm and adapted their businesses to this environment.
The focus of this fund over the last year has been to scrutinise every holding and assess how well they have achieved this objective. Does the company understand that competitive conditions have intensified permanently due to cheaper imports and that rising margins will only be possible via consistent improvements in productivity? Has the company identified divisions that do not achieve an acceptable return, and are these divisions being eliminated?
Overall, we are confident that the companies held in this fund will rise to the challenge. Mr Price has reviewed its procurement to benefit strongly from cheaper imports, and accelerated its @home franchise expansion plans to capitalise on the growing home refurbishment market. Oceana has invested in the dominant pilchard brand in the UK (Glenryck) to provide a profitable outlet for its Namibian cannery. An acquisition by Tourvest makes it a significant player in the outbound leisure travel market, gaining significant economies of scale via bulk purchasing from airlines and holiday package operators.
Naturally, the strongest headwind is faced by the exporters. Northam is actively addressing its cost base and reviewing the profitability of each mine. The medium term earnings power remains excellent due to the outlook for platinum. Despite the blue sky potential in Mvela Resources, the current profits simply do not square up to the market valuation and we exited the stock. Seardel has finally assessed its (richly endowed) balance sheet and will begin to dispose of its non-core properties. Even a partial monetisation of its property register will create enormous value for its shareholders. Rest assured, we are actively encouraging management in this regard.
Two companies in the fund have decided to move their listings abroad as the ratings accorded there will be significantly higher than on the JSE. Aplitec's value virtually doubled (subsequent to the June quarter end) as Nasdaq investors considered the value of a global franchise for its smart card technology. Afgem's plans to list on Aim in London are well underway and should benefit the fund in the next quarter.
At the end of the day, it is valuations which provide the ultimate safety net. The average PE ratio of the fund stands significantly below the All Share PE, and the earnings prospects remain at least as bright. We continue to be positive on the relative prospects of the mid/small cap sector versus their larger brethren. Although the fund's performance (relative to small cap unit trusts) was sub-par in 2003, we remain confident on its relative prospects for the year, as the value of a number of the underlying companies begins to unfold on the market.

The name change from Coronation Specialist Growth will not erase a tardy track record. Over the past five years big bets have produced periods of blistering returns and big setbacks. It has shown below par longer-term returns, with a 12-month 45% return doing nothing to revive confidence. Nor does clinging to a 6% exposure to clothing manufacturer Seardel, which faces tough export markets and fierce import competition.

Effective from 15 Mar 04, the Coronation Specialist Growth Fund has changed its name to the Coronation Smaller Companies Fund.

Last year was dismal in relative terms for fund manager Sunil Shah, who was underexposed to the retail sector, which he has belatedly tried to fix by investing in Mr Price and Iliad and, more recently, in Truworths and Massmart. Shah says he took his retail exposure through clothing manufacturer Seardel, which was a poor performer last year, though Shah says it is now "gloriously cheap".

One of the striking features of the past quarter was the stellar performance of retail shares (the retail index was up 63% for the year). The sceptics highlighted the effects of rising interest rates and declining job growth prospects resulting from the stronger rand. However, the dramatic reduction in consumer debt levels over the last two years has left the household balance sheet in a far healthier position to weather the current storm. Hence the surprising sales growth of the retailers who focus on consumer discretionary spending. The fund performed mediocrely during the quarter with a return of 11.02% due to its underexposure to retail. Having taken stock of the sustainability of the retail outlook, we have added exposure to the more favourably priced retailers, namely Mr Price and Iliad, an upcoming home refurbishments play. During the last three months the fund manager's eliminated the funds position in Energy Africa, a stock that has done remarkably for the fund over the last two years. Valuation arguments due to the rand strength finally render the company's share price vulnerable, despite an excellent exploration record.

The overall market has been thrown into turmoil with the spectacular recovery in the rand. The world outlook continues to improve primarily due to the surprises posted in the US, but there is a risk that the tax stimulus provided does not lead to the self-reinforcing job creation that is required. This, coupled with a surging rand creates a formidable headwind for the resource-rich ALSI 40. Conversely, the mid/small cap sector is in a far better position to eke out further market share gains and hence insulate itself from the global uncertainty. At the end of the day, it is valuations which provide the ultimate safety net. The fund manager's continue to be positive on the relative prospects of the mid/small cap sector versus their larger brethren.