The fund had a good quarter on both a relative and an absolute basis, returning 3.8%. This was ahead of the benchmark which returned 0.8%, and ahead of the category mean, which returned 3.2%. On a 1-year basis, the fund has delivered a 51% return, comfortably ahead of the benchmark, but still behind the category mean which delivered a return of 57%.

The quarter past was a story of two halves: a big collapse in markets, followed by a big recovery. The prime driver of the collapse in markets in July was the global liquidity crisis sparked by the sub-prime mortgage issue. Global liquidity has supported strong markets for the past few years and enabled financial institutions to lend cheap debt to willing consumers. With US housing prices now under considerable pressure after years of phenomenal growth, many US consumers face the potential situation where the value of their homes might be less than the value of their mortgage debt. The increased level of debt defaults has resulted in this liquidity, or the willingness of financial institutions to lend money, having dried up.

The market recovery was sparked by two factors. Firstly, US and European central banks have been very vocal in committing to provide the necessary liquidity in order to avert any crisis, and secondly, the US Federal Reserve cut interest rates by 50 basis points.

These factors did impact on small and mid cap stocks, but not to the same extent as the Top 40 stocks. In the period 23 July to 17 August, the FTSE/JSE Top 40 Index was down 13.5%, whereas the FTSE/JSE Small Cap Index was down 7.3%. From 17 August to date, the FTSE/JSE Top 40 Index has recovered by 21%, while the FTSE/JSE Small Cap index has put on 12%. What this shows is that the larger shares have been far more volatile over this period. This contradicts the opinion held by many that small cap stocks are more risky. Small Cap stocks are effected far less by global issues such as commodity prices, currencies and liquidity, and as such, do not suffer as much from the roller coaster ride induced by the volatility in these uncontrollable factors. The spate of new listings, particularly on AltX, continues apace. Generally, the demand for shares in new listings far exceeds supply, resulting in share placements being heavily oversubscribed. This imbalance often spills over into the trading of these new shares, causing rapid share price appreciation. This story will remind many of the small cap listing boom of 1998/1999, which ended in tears. Whereas back then the primary driver was the IT company frenzy ahead of "Y2K", today it is a construction listing frenzy. In our mind, there are some important differences, but also many similarities. The main difference to us is that the buoyant cycle ahead of these construction new listings appears good for the medium term, probably anywhere between 5 and 15 years. Secondly, several of these new listings are companies that have been around for many years, through good and bad cycles. Yes, some have been cobbled together and dressed up for a listing, and we would be wary of these. Our attitude to this new listing cycle is the same as our attitude to any other investment opportunity - we assess each and every opportunity on its merit.

The fund now trades on a forward PE of 10.1 times, off its peak of 11 times reached in the first quarter of 2007. We said back then that we felt the market was extended, and while this would remain our view, there are some specific opportunities in companies whose current earnings are below normal levels and where pessimism abounds.

Alistair Lea
Portfolio Manager

The fund had a poor quarter on a relative basis, returning 5.3%. This was ahead of the benchmark which returned 4.2%, but behind the average of the competitor unit trusts, which returned 9.7%. We are not happy with this relative underperformance, but are happy with the way the fund is positioned going forward. We have not lost sight of the fact that high returns are often achieved by assuming higher risk, and with the small-cap index being up over 50% per annum for the past four years, we do not consider it prudent to be changing the risk profile of the fund at this stage.

Interest rates are now 24% higher than a year ago, when rate hikes began. On top of this, the National Credit Act (NCA) came into being on 1 June 2007, and to date has had a significant impact on credit advances. The combination of these two factors has placed a lot of pressure on the earnings of credit retailers and businesses that supply them, with resulting pressure on share prices. The fund is not significantly exposed to this - we do not own any predominantly credit retailers, although we do own both Amaps and Nu-World, companies that supply appliances and electronics to retailers. Both of these companies have performed poorly of late, especially Amaps, whose share price has declined 40% in the past five months and is now back to the same levels reached in September 2004, some three years ago. Based on the mid- point earnings expectation quoted in a recent Amaps trading statement, the company now trades on an approximate 10 or 11 PE based on June 2007 results. These results include a large adverse currency impact which we consider abnormal as well as a very poor result from their consumer electronics business. As such, we do not consider these results as a reflection of normal earnings. The NCA and the consumer spending slowdown will make life tough for Amaps in the short-term, but we think that this is more than priced in by the market. In addition, Amaps has over R200 million cash in the bank, giving them an opportunity to restructure their balance sheet, which would be value enhancing. This might be achieved by paying cash for an acquisition or by share buy-backs. All in all, now is a time of maximum pessimism for Amaps, and this is clearly reflected in the share price.

An area of the market which is suffering no headwinds is the construction sector. By and large, we think that the huge amount of optimism in this sector is more than priced into share prices, with some exceptions. New listings have been plentiful in this area of the market, evidence in itself of the boom times being experienced. The pricing and attractiveness of new infrastructure related listings is hugely divergent, necessitating diligent work before considering taking part in share placings. William Tell, a chipboard manufacturer, listed in June at 425c and trades there or thereabouts today. B&W Electrical and Instrumentation, an electrical contractor, listed in the same week at 100c, and trades today at 215c, up 115% in its first four days of trade!

The fund now trades on a forward PE of 10.4 times, off of its peak of 11 times reached in the first quarter. If every counter in the fund were to trade at our assessment of fair value, the fund would offer 22% upside. We do however think that at some time, corporate earnings will begin to reflect the 24% increase in rates in the past year, and that share prices will react accordingly. This will in our opinion, present opportunities to buy undervalued shares.

Alistair Lea
Portfolio Manager

The fund had a remarkable quarter, returning 21.9%. This compared favourably with the mid and small-cap indices which returned 19.8% and 19.7% respectively, and the Top 40 index which returned 10.7%. A return of 21.9% in a quarter is certainly more than we would have expected and continues the remarkable bull-run enjoyed by mid and small cap stocks. We sense that 2007 will be a lot tougher than 2006, a year in which the fund returned 46.7%. Finding value in this market, while still possible, has become much tougher. Overall, the fund is still not that expensive, trading on a 1- year forward p:e of 10x, but this is the highest level it has been since I started managing the fund in February 2005. Some of the new counters in the fund include Amalgamated Appliances (Amaps), Zeder Investments and Brait.

In December, Amaps announced a significant companytransforming transaction whereby they will acquire Steinhoff's local furniture manufacturing business. The company is effectively acquiring a business at a decent price, and will be funding the bulk of the purchase price with cheap debt. We considered the transaction to be materially value accretive and took the opportunity (the share price was down on the day of the announcement) to acquire a position. Zeder is an investment holding company with investments in agricultural-related assets such as Pioneer Foods and KWV. The underlying investments are generally undervalued and are all unlisted, which means gaining exposure to these businesses is only possible via Zeder. On listing, Zeder raised a significant amount of cash with a view to making more investments.

While this cash is not invested the attraction of the vehicle is significantly diluted, however we are of the opinion that there are enough opportunities for Zeder such that the cash will be wisely deployed. Brait is an interesting business. Its main business is private equity. They have an enviable record of raising, investing and realising private equity funds. They are in the process of closing a fourth fund, and will be making new investments in that fund in the near future. We rate this business highly. Their specialised funds business (hedge fund of funds) has grown rapidly over the past few years, and now manages some R4 billion in assets. The business has only just become profitable. Finally, Brait have a portfolio of on-balance sheet investments which contains assets we believe hold much promise. We rate management highly, and believe we will do well from our investment. Some of the more significant sales during the quarter include Massmart and Group Five.

Massmart is a fantastic business, but is now priced accordingly. In the second half of 2006, the stock was up 60%! We consider this too much, too soon, and took some profits. Like all other construction stocks, Group Five has been a very strong performer for a number of years. While we do not deny that these stocks will benefit from a fantastic macroenvironment for a good few years still, the question one needs to answer is the extent that this has already been priced into these shares. The big risk with construction stocks is that they conduct risky business. Construction by its nature is unpredictable, low margin business. Normally, a contract will be quoted on upfront, with the contractor then bearing the risk of unforeseen events. This is why historically, construction stocks have traded at healthy discounts to the overall market. Today, all the construction stocks trade at healthy premiums to the market, with the belief that these premiums will erode due to superior earnings growth. We believe that too much is being priced in, and that the risk-reward relationship of owning Group Five is no longer in your favour. There seems to be a common perception that investing in a "small cap" fund is riskier than investing in, say, a general equity fund. One must remember however, that the mandate of a small cap fund manager allows these funds to invest anywhere outside of the Top 40 index. This means that the fund can invest in a company such as Shoprite, a R14 billion market capitalisation company, hardly a small cap. The weighted market capitalisation of the fund is R3.7 billion, which would place the average holding in the fund in the small cap index (The JSE is the biggest company in the small cap index with a market capitalisation of R4.6 billion). The fund is therefore not exposed to the very small micro-caps listed on the JSE which can be risky investments, but remains true to its name (Smaller Companies Fund) by attempting to invest in the smaller, less researched part of the market.

We would actually contend that investing in small cap funds is less risky than investing in general equity funds, primarily because of the huge impact of volatile and difficult-to-forecast commodity prices and exchange rates on the large companies, and hence, general equity funds. Investors in small cap funds have been well rewarded for the past 5 years, and while we would not expect the same level of performance to continue, we do expect returns to be satisfactory going forward.

Alistair Lea
Portfolio Manager