Mid and small cap shares continued to perform very well during the quarter, with the fund up approximately 15% over this period. While we do not consider the magnitude of these performance gains to be sustainable going forward, we remain bullish on the environment in which smaller companies operate and the health of the South African economy. In terms of the fairly substantial re-rating in smaller companies since March 2002, we believe that the significant change in interest rates and inflation that we have seen, and the effect that this has on equity valuations, more than justifies this re-rating and believe that there is a little more to come.

During the quarter, our more significant purchases included new positions in Nu-World, Famous Brands, Datacentrix and AG Industries.

Nu-World is primarily an importer of branded consumer durables and has benefited from the surge in spending by the SA consumer. Despite the company having to deal with considerable deflation, it looks set to report another good set of results. The company has a phenomenal track record of earnings growth stretching back 13 years, yet only trades on a forward PE of less than 7.5 times.

Famous Brands is a franchising company (Steers and Wimpy being the main brands) with high returns and attractive cash flow characteristics. These attractions are enhanced by the current strong volume growth and store roll-outs. Given that the group has a high fixed cost base, the volume growth benefits earnings significantly through high operating leverage. An added attraction of the group is their ability to channel the food buying power of their franchised stores through their own food services business. They are in the process of doing this with Wimpy and is part of the reason why we expect strong earnings growth for the next couple of years.

Datacentrix and AG Industries both suffered significant share price declines after very poor results. In both cases, we believe that this has presented long-term investors with an opportunity to buy into undervalued companies at a time when pessimism abounds. As such, we established positions in both companies late in the quarter.

Our more significant sales during the quarter included Medi-Clinic, Mustek and Net 1 Applied Technologies (previously JSE-listed Aplitec). Although we like the characteristics of the hospital businesses, we could not justify continuing to hold Medi-Clinic based on its valuation. Net 1, now listed on Nasdaq, is a remarkable story of a South African company with over 95% of its earnings coming from this country, changing its listing to the US and immediately attracting a significantly higher rating. We made good returns from Net 1 and were happy to sell out of a company trading on a PE of around 28 times! Mustek is another company which has done very well for the fund, but which breached our assessment of fair value during the quarter. The company released a disappointing set of results, confirming our assertion that while the rand remains strong, the deflationary pressures in this industry will continue to put pressure on margins. We are also slightly concerned that the company may need to restructure their empowerment transaction because of an inability to meet the targets required for equity to be issued.

The Coronation Smaller Companies Fund remains attractive in our view and trades on a rolling one-year forward PE and dividend yield of 9.6 times and 4% respectively - both indicating good value in our opinion.

Alistair Lea
Portfolio Manager

After seven months at the helm, manager Alistair Lea has yet to convincingly resuscitate what has been a poor performer for many years. But perhaps it is still too early to make a clear judgment. Since his appointment, Lea has made some radical changes in an effort to reduce volatility and dependence on the top 15 shares, which he has cut from 71% to 56% of the portfolio. He has got rid of long-standing duds such as Seardel.

Financial Mail - 26 August 2005

The Coronation Smaller Companies Fund had a relatively disappointing quarter with a 2.5% increase in the unit price. This was in a quarter where the mid cap index returned 6.7% and the small cap index 11.2% (total return including dividends).
The fund has gone through a phase of restructuring which invariably occurs with the introduction of a new manager. This process is largely complete with only one or two illiquid counters remaining to be sold. The fund has become more focussed with holdings in 36 counters and no individual counter having a weighting in the fund of less than 1.5%.
The strong performance from mid and small caps since March 2002 has made it a lot more difficult to find significantly undervalued shares, but not impossible. Two companies which we believe offer good value based on our estimate of normal earnings are Tiger Wheels and Group Five, both of which we have been buying in the fund.
The short-term problems that Tiger Wheels has been experiencing in its new US-based wheel manufacturing plant, and the associated negative news flow, has presented us with what we believe is an opportunity to buy into this company at levels considerably below fair value. Tiger Wheels will report a poor set of numbers to June 2005, but we expect very strong earnings growth from this company in the next two to three years, getting closer to our assessment of normal earnings of approximately R3.50 per share.
Group Five is, in our opinion, the most preferred of the listed construction counters. Our estimate of normal earnings is close to R2.50 per share, implying a current PE multiple on normal earnings of 6.1 times (using a share price of R15.25). Admittedly the road from the current earnings level of around R1.50 per share to R2.50 per share will not be easy, but our major assumption is a construction operating margin of 3.4% (1.5% in 2004) which should be achievable considering the new construction projects the company has been awarded in Dubai and the expected growth in infrastructure spend in South Africa.
During the quarter we sold our significant position in Seardel; no mean feat considering the lack of liquidity in this stock. We believe that this business will continue to struggle against the flood of clothing imports coming into South Africa, unless the rand depreciates significantly. We also sold our position in Wesco, the holding company which owns 25% of Toyota SA and 40% of listed Metair. Having appreciated some 20% since our purchase earlier in the year the upside to our fair value was not attractive enough to continue holding.
The Coronation Smaller Companies Fund remains very attractive in our view and trades on a rolled one-year forward PE and dividend yield of 8.6 times and 4.5% respectively - both indicating good value in our opinion.

Since March 2002, the mid cap index has outperformed the FTSE/JSE Africa Top 40 Index by a remarkable 90%, or 23% annualised. One might therefore be excused for thinking that the time has come to switch out of smaller companies (as measured by the mid cap index) into larger ones (as measured by the Top 40 Index).
The last time we saw such outperformance by smaller companies was in the late 1990s when investors seemed to lose sight of investment fundamentals and were willing to pay silly prices for new listings, mainly information technology related.
In the period from the beginning of 1996 to April 1999, the mid cap index outperformed the Top 40 Index by 34%, or 11% annualised. This was followed by a three-year period of underperformance of 55%, or 24% annualised, up until March 2002. Are we in for a similar experience over the next three years? We would contend not.
The major difference between the recent experience to that of the late 1990s is the rating of smaller companies relative to the larger ones. For much of the period leading up to April 1999, smaller companies actually traded at a premium, measured by PE multiples, to larger companies, of about 20%. This is despite the generally held view that because of better liquidity and better overall quality, large companies should trade at a premium to small companies.
As we stand today, the mid cap index trades at a 20% discount to the Top 40 Index. Because of this discount, because we have not experienced a spate of new company listings like we did in the late 1990s and because we have not seen irrational investor exuberance (probably the result of memories of the small cap crash of 1999), we do not believe that smaller companies will underperform their larger counterparts like they did post the April 1999 three-year period.
The Coronation Smaller Companies Fund remains very attractive in our view and trades on a rolled one-year forward PE of 8.7 times. Considering the strong fund performance of 2004, we have introduced some more defensive counters into the portfolio such as Medi-Clinic, Wesco and Hudaco. We are well positioned for a weaker rand through our holdings in counters such as AECI, Mustek, Oceana and Delta Electrical as well as our holdings in offshore listed Net 1 UEPS Technologies and Tanzanite One.

Alistair Lea, appointed as Coronation Smaller Companies' (CSC) manager in February, has the tough job of putting it back on track after a series of big bets that failed. Top holding Seardel is a glaring example. Says Lea: "My approach is more conservative; the fund will be less volatile in future." To this end Lea has cut the weighting of CSC's top 15 holdings from 71% to 58%. More defensive stocks have also been added, he says.

Financial Mail - 13 May 2005

The fund achieved a return of 24.3% over the quarter, resulting in a return of 48.1% over 2004. The three-year cumulative return is equally encouraging at 93% versus a return of 33.2% for the All Share Index over the same period. We have consistently highlighted the potential opportunities inherent in the mid/small cap sectors and it is reassuring to note the three-year results. Stock selection has been and will continue to be the key differentiator.
A number of retail shares held in the fund have done exceptionally well. We are still in the throes of a consumer boom, supported by low household indebtedness and a secular shift to lower rates. Edgars, Iliad and Mr Price have all benefited from strong earnings growth and, despite big moves in the shares, valuation levels still imply further upside. Enterprise Outsourcing, a niche IT services organisation, deserves special mention as it demonstrated its pedigree in a tough environment, making opportunistic acquisitions to bolster its footprint. Omnia in the chemical sector also doubled over the year, as investors acknowledged its more diversified base after the pro-chem acquisition.
With the benefit of hindsight, it is evident that the fund was overly exposed to the manufacturing sector, and this led to a slight underperformance of the fund versus its peers for the year. The surge in imports and the weaker unit prices that companies such as Seardel, Oceana and Delta faced compromised their earnings results. However we are confident that these companies are worthy investment candidates for 2005, where some rand relief, however slight, is inevitable.
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 fund versus the market - note the magnitude of the return is unlikely to match that of 2004. After all, one cannot expect +40% returns on a regular basis!