Considering the global events impacting financial markets, the fund had a good quarter, with a flat return for the period. This is relative to the equity smaller company mean return of -10%. There is however still some way to go to make up the longer term underperformance relative to competitor funds. The fund is down 31% for the year-to-date against the mean fund return which is down 27%. The feature for the quarter has been the reversal of fortunes of resource shares versus domestic SA shares. The recent demise of resource counters has been driven mainly by falling commodity prices, which are responding to expectations of slowing global growth. We have for a long time believed that commodity prices and resource shares were overheated, so it is pleasing to see the correction underway. The de-rating in some of the resource counters has been dramatic, and for the first time in many years we think there are some interesting investment opportunities in this space.

The recovery in industrial counters has been more marked in the interest rate-sensitive shares, with the general retailer index up 24% for the quarter. The market is now firmly of the view that inflation is close to peaking and that the interest rate cutting cycle is near. We share this view, but remain cognisant of the risks which remain. Even if the rate cutting cycle does ensue in the first half of 2009, it will still take a while for consumers to feel the effect of these cuts. As such, we think that the trading conditions for many of the SA consumer facing businesses will remain tough, or get tougher, in 2009. We are therefore of the opinion that the significant recovery in many of the interest rate-sensitive stocks is a case of too much, too soon. The last few weeks have been some of the most volatile I have ever experienced in financial markets, with bank failures, bailout plans, job cuts and many other issues dominating headlines. Locally we also had some significant political developments, with the ousting of Mbeki and the appointment of Motlanthe as president of our country.

These incidents highlight the current uncertain environment we are living in, and as such, we think there will be continued volatility in equity markets in the short term. Uncertainty and volatility does however come with a silver lining, which is opportunity. The value of many businesses will not have changed significantly over the past year, despite the market prices of these businesses indicating otherwise. So if the present value of future cash flows (or the value) of a business is the same today as it was a year ago, yet the market price is 50% down, that represents a significant opportunity. In the current market environment there are many such opportunities. The fund trades on a one year forward PE of 7 times, which remains (it was at this level in June 2008) the lowest level since I began managing the fund in early 2005.

Alistair Lea
Portfolio Manager

It has been another tough quarter. The fund declined 13.6%, while the mid and small cap indices declined 9.8% and 14% respectively. For 2008 to date, the fund is down 30.5%. It feels as if investors/speculators are trampling over each other to sell their shares (particularly small cap shares), regardless of price or the underlying value of their investment. Single day share price declines of greater than 10% are not uncommon right now. I think we can safely say that there is a fair degree of panic selling going on. While it is difficult to stomach a 31% year-to-date decline in the value of your investment, we would urge investors to hang in there. The end of the world is not imminent. It is useful to highlight the typical investor response to declining and rising share prices. When prices are rising, people feel good about investing. There is comfort in the herd and everyone is making money. Liquidity flows into the equity market push share prices up in this environment, and the cycle of higher prices attracting more money becomes self-fulfilling, despite the fact that shares have become more expensive. When share prices start declining, the opposite happens, with the departure of cash out of the equity market driving prices lower. The lower prices go, the more tendency there is to panic. Yes, the economic environment has deteriorated significantly in the past year on the back of a series of rate hikes, but this is a cycle that will turn. Astute investors use opportunities such as this to buy assets on the cheap. It is always difficult to get the timing exactly right, but for an investor with a longer time horizon, we are confident that we will look back on this period as having been a very good opportunity to accumulate shares. It is interesting to look back in history for the last big buying opportunity in mid and small cap shares. In 2002, the prime interest rate increased by 4% from 13% to 17%. In June 2003, the rate cycle turned with the first rate cut in that month. The mid cap index bottomed in April 2003, having remained flat for the past year as rates were hiked. From April 2003 to June 2007, the mid cap index returned 43% compound per annum, driven by a 6.5% decline in interest rates. It would seem then that it is important to assess when the current rate hiking cycle will end as this could signal the end of these tough times. The interest rate cycle is driven by the inflation rate, which is sky high at the moment, hence the high interest rate. However, as we move into 2009, the primary drivers of inflation, the high oil and food prices, become part of the base off which inflation is measured going forward. So, if the oil price comes back to US$120 per barrel next year, this might well contribute to deflation (imagine that!). While it is very difficult to forecast things like the oil and maize price, we would contend that, off this high base, there is more risk to the downside than there is to the upside. As such, we forecast that inflation will peak towards the end of this year, which means that interest rates should follow suit shortly thereafter. As we know, the economy, consumers and the equity market thrive in a cycle of declining interest rates. Consequently, we think investors should start positioning themselves for this cycle rather than taking money off the table at this stage. To illustrate the state of the market at the moment, a case study on Iliad, a retailer of building materials, is very interesting. As we know, in July 2007, Iliad was the subject of a failed private equity bid at R24.50. Today, it trades 68% lower than this level at R7.94. Yes, the market for the bulk of Iliad's products has become a lot tougher than a year ago, but this is a quality company with a fantastic track record. On our earnings forecasts, the company now trades on a 5 times 1 year forward PE. This does not feel like rational investor behaviour to me. There are many more examples I could highlight. The bottom line is that there are some fantastic opportunities in the mid and small cap space right now. The fund now trades on a 1 year forward PE of 7 times, the lowest level since I began managing the fund in early 2005. To end off, I borrow a comment from Michael Lewis, a market commentator. "The first thing you need to know about recessions is that they don't signal the end of anything on Wall Street. They're more like a red flag during a Formula One race: The cars coast gently around the track until the wreckage is cleared whereupon they all roar off as if the accident never happened. The difference is that, on Wall Street, it's possible to make the disaster work for you. You can inch your car quietly forward so, when the race recommences, you're its surprise leader."

Alistair Lea
Portfolio Manager

The first quarter of 2008 has been particularly disappointing, with the fund declining 19.5%, while the mid and small cap indices declined 12% and 11% respectively. This underperformance requires explanation.

One of the prime drivers (on the upside) of the market during the quarter was the 19% depreciation of the rand from R6.80 to the US dollar, to R8.10 at quarter-end. This move in the currency caused resource counters to perform very well. The three largest resource counters in the benchmark, Northam, Mvela Resources and Hiveld Steel were up 74%, 50% and 47% respectively. Resources make up some 12% of the benchmark, while the fund's weighting in resources is a mere 2%. In a quarter where resources counters performed fantastically, the fund suffered.

While we have generally been bearish on the rand, we have been equally bearish on commodity prices; believing that they are in general well above long-term normal levels. As such, we have been reluctant to invest in resource shares and have preferred to take our rand hedge exposure by investing in industrial rand hedge counters, which we believe offer more upside in the long-term. However, these counters are not geared to the rand in that they do not have rand cost bases and dollar revenue streams. They are mainly offshore businesses with dollar cost bases and revenue streams, making them dollar 'translators'. Our biggest holding in this area, Mobile, was flat for the quarter, which we are disappointed with and indicates how differently the rand 'translators' performed relative to the rand 'geared' stocks. Some consolation is that these industrial rand hedge shares performed better than counters exposed solely to the local market.

The prime driver of the market on the downside was probably the continued pressure on companies selling goods to a fast deteriorating consumer. In addition to a series of interest rate hikes and the onset of the NCA (National Credit Act), consumer sentiment has been further hit by a new barrage of factors, Polokwane (political uncertainty), the Eskom crisis, a very wet January in Gauteng and the continued high levels of crime in SA. This has caused some sharp declines in various counters in the portfolio, some of which we list: Amaps -40%, Country Bird -36%, Nu-World -42%, Iliad -23% and Famous Brands -26%.

We would argue that now is the time of maximum pessimism for the two consumer electronic and appliance distributors held by the fund, Amaps and Nu-World. Yes business is incredibly tough at the moment, but both counters now trade below NAV. We remain optimistic that in the medium term, conditions will become more favourable for these two companies and that from these levels they will be good investments.

Illiad is one of the largest positions in the fund. Six months ago a private equity company offered R24 per share for the entire company, today it trades below R11 a share! 2008 will be a more difficult year for the company following a fantastic 2007. But even factoring in flat earnings, the counter is trading on a one-year forward P:E of less than 7 times.

Famous Brands is a company we like a lot. It has a defensive (people still eat in tough economic times) earnings stream, is a fantastically well managed business and seems to have made a very astute and shareholder value enhancing acquisition of Wimpy in the UK. For the premium business we believe it is, the current rating of less than 9 times forward is very attractive.

Country Bird, like all the chicken stocks, has come under considerable pressure in the past quarter. High maize prices which are not translating into higher selling prices due to industry overcapacity and weakening demand has caused the outlook for chicken stocks to decline. The future also looks uncertain, with global maize prices reaching new highs. The industry might well need to adjust to structurally higher feed input costs and lower returns than those achieved in the past three years. Despite this, Country Bird has a huge opportunity to grow its business in Africa, while the feed business is in its infancy and should be a much more profitable business in two to three years time. Where to from here? We have not changed our view on the best way to position the fund for rand weakness. We continue to believe that the resource counters are overvalued, primarily because of overheated commodity prices. This, coupled with the depreciation in the rand, causes us to see fit not to change our resource underweight. A 20% decline in a single quarter justifies some raised eyebrows. It is important to bear in mind that the long-term value of a business seldom changes much over a period of three months, and as such, in theory the fund is 20% more attractively valued today than at the start of the year. The fund now trades on a forward P:E ratio of 7.8 times, off of its peak of 11 times reached in the first quarter of 2007 and down from its 9.5 times level at the start of the year. While we still believe that the earnings base of corporate SA is likely to remain under pressure for a while still, we would argue that this is now being priced in by the market.

Alistair Lea
Portfolio Manager

In 2007, the fund returned 23.8%. While this was disappointing when measured against the average competitor fund which returned 33%, the performance was ahead of a market cap weighted mid and small cap benchmark, which delivered a 20.2% return. Investors in the fund might well ask why the fund has underperformed its competitors by some 9.2%, and we would answer as follows.

o The fund performance has been impacted by a few poor stock picks. Amalgamated Appliances would fall into this category. In addition, we missed a significant portion of the returns delivered by many of the construction stocks. For example, we did not hold Bell Equipment (up 104%) or Aveng (up 89%). We have generally been of the opinion that the construction stocks are expensive and have priced in the great infrastructure environment, which lies ahead.
o High returns are achieved by taking risk. Unfortunately, the converse is also true. A significant portion of the excess returns achieved in the small cap space in 2007 came from investing in Alt-X, which was up 78% for the year. We were not particularly successful in obtaining decent sized positions in the new Alt-X listings we liked, and on the whole have preferred to take a cautious approach to investing in the stream of new listings we have seen.
o After many years of superb performances by mid and small cap shares, the fund was relatively defensively positioned throughout the year. Defensive stocks such as Distell, Famous Brands, Spar, Adcorp and Country Bird all feature in the fund's top 10 holdings. While these stocks generally did not deliver returns to match many of the year's high-flyers, we would expect them to outperform in a tougher economic environment.

We believe that the fund is well positioned for the current market environment. The year ahead looks like it will be a tough one for any business selling durable goods to the South African consumer. Motor vehicle, furniture, electronic and clothing retailers will all struggle not to show a decline in earnings. The fund currently has very little exposure to this segment of the market, but share prices are beginning to approach levels, which would interest us as buyers. As an investor, the best returns are often made by taking brave and contrarian views and buying at the time of maximum pessimism. It is very difficult to get the timing of a buy exactly right and as a consequence, fund performance in the short term may be negatively affected. However, a good business experiencing a cyclical downturn invariably recovers in time.

Two other examples of companies where pessimism abounds are Astrapak and Illiad. These two counters have declined 37% and 39% respectively in the past 6 months. Astrapak is experiencing tough trading conditions as a result of its inability to pass on all of the raw material price hikes it has incurred, which have been significant, due to the link to crude oil prices. In addition, demand for Astrapak's product is likely to soften in line with declining consumer demand, but offset by the fact that Astrapak supply a significant amount of packaging into the defensive food and beverage sectors. We think that in the medium term Astrapak will recover from this tough environment, and have recently initiated a position in the company.

Illiad was the subject of a private equity offer at R24 per share during 2007, which was subsequently withdrawn. Today the share price is below R14, with the market worried about a slowdown in residential building and the impact this might have on Illiad. We have no doubt that trading has become more difficult, but believe that this will recover in the medium term. In addition, Illiad continues to do small value-accretive acquisitions and have publicly stated their intention to restructure their overcapitalised balance sheet. As such, we have been adding to our position in Illiad.

The fund is also invested in several smaller companies, many of them recently listed, whose prospects we believe are very good and not yet priced in by the market. O-Line Holdings, a cable support manufacturer, and Mazor Group, a steel and aluminium construction company are good examples.

The fund now trades on a forward PE ratio of 9.5 times, off its peak of 11 times reached in the first quarter of 2007. The outlook for the year ahead is difficult to call, with the earnings base of corporate SA likely to be under pressure. That said, we have created a diversified portfolio of smaller companies, which we consider to be undervalued, and as such, we expect the fund to deliver a positive return.

Alistair Lea
Portfolio Manager

The investment objective is to achieve superior capital growth over the longer term. This fund is an aggressively managed equity fund, which invests mainly in small to mid capitalisation companies in high growth and developing industries and recovery shares.

All JSE listed companies outside the JSE Top 40 at the time of investment.

The fund will invest in companies that fall outside of the Top 40 JSE listed shares by market capitalisation, at the time of investment.