The fund had a good quarter, returning 16.5%. On a relative basis, the fund underperformed the average competitor fund which returned 17.5%. The gap between the fund and its competitors over the past year is however most pleasing, with the fund's 11.3% return comfortably ahead of the average fund return of negative 1%. The fund is now up around 40% from its lows in mid-March. During this time, the historic PE of the mid-cap index has risen from 7.6x to 12x - a 58% re-rating. This re-rating is a combination of rising share prices and declining earnings. With corporate earnings still under intense pressure, it would seem that the easy money has been made. We feel that many companies will report trough earnings this year (probably not the construction companies). A poor 2009 business environment, coupled with one-off restructuring costs should mean that off this base, companies should be able to grow earnings. However, the market knows this, hence the 40% recovery.

While we have seen healthy recoveries in many share prices, several companies are still languishing near multi-year lows, with the market still unsure of the timing and extent of a recovery. Many companies which earn a living from spend on residential housing would fall into this category. Despite the 500 basis point interest rate cuts, spending on residential housing has declined substantially, mainly due to limited access to credit. As a result, the share prices of companies such as Dawn, Iliad, Ceramic and York are all back to levels last seen four to five years ago. In some cases there has been a small recovery from the lows, but generally the market is adopting a 'wait-and-see' attitude to companies exposed to this sector. Like all cyclical sectors, we believe spend on residential housing will recover in time and unless you are willing to invest when the outlook is bleak, the high potential returns from companies in this sector will be foregone.

As mentioned above, construction counters will in all likelihood still report decent earnings this year. This is mainly due to the late-cycle nature of these companies, where projects being completed today were conceived and approved two to four years ago. The current global economic crisis is therefore likely to be felt by the construction companies from 2010, being two years post the global credit crisis and the year in which the 2010 FIFA Soccer World Cup mega projects are completed. Admittedly, the huge state infrastructure spending programme will take up some of the slack, but we feel there is a real risk of earnings declines for the construction companies. Based on our forecasts, the average construction counter, while cheap today, trades on a similar rating three years hence to other better quality companies with far more predictable and consistent earnings streams. As such, we have taken a cautious stance towards investments in this sector.

Portfolio manager
Alistair Lea

The fund had a good quarter, returning 16.1%. On a relative basis, the fund was also strong, outperforming the average competitor fund which returned 14.7%. The gap between the fund and its competitors over the past year is also most pleasing, with the fund's return of -4.6% comfortably ahead of the average fund returning -23.7%.

The quarter was characterised by selective renewed interest in some of the smaller companies, with the mid cap, small cap and fledgling indices returning between 11.5% and 14.5%, relative to the 7.7% returned by the FTSE/JSE Top 40 Index. The AltX Index continued its dismal performance and was down a further 8.8% for the quarter. While we have seen some share price improvements in various stocks, corporate earnings appear to be under significant strain despite the rate cuts. Many companies we have seen, recently confirmed that Q2 of 2009 was a particularly tough quarter; even more so than the first quarter. It seems as if the balance of this year will be as tough. One of the primary reasons for these circumstances appears to be the unwillingness of banks to lend to both consumers and corporates. In previous cycles, interest rate cuts have stimulated the demand for credit, which has been forthcoming from banks and has resulted in renewed spending. This time round the credit is just not being given out as freely, and consequently the spending has not returned. It seems as if we are going to have to wait until mid 2010 before things become more positive from an earnings perspective.

The fund is constantly seeking to invest in the most undervalued companies. This typically means that we are selling the shares that have performed well, and are buying the shares that have performed badly. Often we don't get the timing spot on, but over a longer time period, it is a strategy that we think will deliver better returns.

A case in point would be our buying of Dawn. Dawn peaked at around R24 in October 2007, up 245% in two years. We had owned the share, but had sold it long before at around R9. Today the share price is R6. The fund started buying the shares earlier this year just below R7, and despite a very weak recent trading update, we have continued to buy the share at lower levels. It is not comfortable buying shares in a company whose earnings are slipping backwards at a rapid rate, but it is usually when this is occurring that the best opportunities present themselves. It is far easier to buy shares in a company whose earnings have strong upward momentum and everyone else is buying. The problem is that this is often when the shares are overvalued.

The demise of AltX has been staggering. The index is down some 70% from its November 2007 peak, and shows no sign yet of a rebound. One senses that now is the time of maximum pessimism for many AltX stocks. We are certainly not ignoring AltX. On the contrary, we have taken some small positions in some AltX stocks where we believe the risk/reward profile is strongly in our favour. These would typically be small positions in the fund which, if they worked out, would be meaningful to fund performance, but where we believe the downside to be limited. Typically these companies trade at a large discount to net asset value and our primary challenge is to assess whether the company has the ability to fund itself through these tough times and whether it will then emerge and be able to make a reasonable return on its invested capital. A 1% position in such a company can conceivably become a 3% position in a recovery, but should things not work out, the investment could potentially cost the fund 0.5% in performance. If we have done our work properly, this is an attractive payoff profile.

As a result of the bleak short-term outlook, there are many shares which have not recovered at all from their multi-year lows. Many of these shares now offer compelling value in the medium term and the fund intends to capitalise on these opportunities.

Portfolio manager
Alistair Lea

The fund had a reasonable first quarter of 2009 relative to competitors and the indices (see table), however, disappointed on an absolute basis. The fund was down 6.95% for the quarter.

The start of this year has been a follow-on from 2008; the smaller the stock, the worse the performance. There has been a flight from the smaller, often less robust, smaller companies. This is common in a market averse to risk, with investors preferring to invest in the more established and larger market capitalisation companies. This has resulted in some very attractively valued shares in the small cap/fledgling/AltX space. Until risk appetites return, we do not expect a rebound from these smaller companies. When the market turns, however, it will be these smaller companies which will in all likelihood outperform the larger mid cap companies.

We have not adopted a specific strategy to seek value and invest in these small, bombed-out counters. Instead, we have taken the opportunity to invest in quality businesses at attractive valuations. Our investments in AECI and Dawn are examples of this.

AECI is a business that has been around for decades. Its main asset is Chemserve, the chemicals distribution company. This is a fantastic business which, when separately listed, attracted a premium rating. It is interesting to note that in its latest published results, Chemserve made an operating profit of R851 million, or R612 million of after tax profits (if taxed at the statutory rate). We know that this was a bumper year for Chemserve, but nonetheless, taking the market capitalisation of the entire AECI (R5.3 billion) and using only Chemserves earnings, equates to a PE of 8.7. In other words, one can easily argue that Chemserve alone is worth more than the current market capitalisation of AECI. What we haven't taken into account is AECI's mining solutions business, AEL, nor the extensive land owned by AECI, which has been conservatively valued at R2.5 billion. AECI also has a fair amount of debt (but significantly less than the value of the land) which needs to be factored in. Bottom line, AECI is significantly undervalued.

The last time the Dawn share price traded at 700c (close to its current price), was in late 2005. In that year, the company made 53 cents of headline earnings per share. Since then, the company has made some fantastic acquisitions and has shown very strong organic growth, such that the company should report headline earnings per share of around 150 cents for its July 2009 financial year. The bizarre fact is that despite earnings being close on 3 times greater than they were in 2005, the share price is roughly the same as it was then (Dawn is trading at 690 cents today). It may have been slightly overvalued back then, but it is most certainly undervalued today.

We are bullish on the prospects for the fund in the medium to long term. The fund is populated with some quality companies on undemanding ratings as well as some companies which we think offer over 100% upside. In the short term, we cannot say with any certainty what the fund will do but we remain of the opinion that buying quality shares (or unit trusts) at attractive prices is the best long-term investment policy.

In 2008, the fund delivered a negative return of 38.7%, slightly better than the mean competitor fund return of negative 39.3%. This is only the second year of negative returns in the fund's 11- year history but is the worst year since inception. In hindsight, one feels that a negative year was due after six consecutive years of 20%-plus returns. The magnitude of the negative return, however, certainly exceeded any expectations. It was a brutal year for equities in general but more so for smaller companies (the rand weakness helped many of the larger global businesses). We think it is fair to say that a good deal of the selling pressure was induced by fear when investors throw up their arms and want out at any price. In addition, it is worth noting that a good deal of the activity in single stock futures was in the smaller companies, where a decline in a share price is magnified considerably by the leveraged position, often forcing positions to be closed out. This places more selling pressure on the affected shares. It is also interesting to note how significantly the rating (the multiple of earnings investors are willing to pay for a share) of small companies has declined. This time a year ago, the fund traded on a forward PE rating of 9.5 times. It closed 2008 on a rating of 6.6 times; a decline of 30.5%, largely accounting for the funds 38.7% negative return. The balance of roughly 8% would be accounted for by a decline in the earnings of the companies in the fund. The feature of the year ahead may well be a material decline in interest rates, with the market expecting rates to be 4% lower by the end of 2009. This expectation has caused a flurry of buying in many interest rate sensitive stocks towards the latter part of 2008, with Truworths, Massmart, Mr Price and Lewis being amongst the best performers (from a share price perspective) for the year past. While lower interest rates will be positive for these stocks, they generally trade at a 20% to 30% premium to the average mid cap stock; the biggest premium they have traded at since late 2001. It would then seem that if interest rates are not cut as aggressively as the market expects, or if the consumer does not rush back to the shopping malls, there could be some relative underperformance from these highly rated retailers. There are, however, other interest rate sensitive shares which have not re-rated at all, such as Iliad, Astrapak and Ceramic Industries. We think the risk return ratio of owning these stocks, as opposed to the already re-rated retailers, is a better strategy for the fund. Astrapak should also benefit in the year ahead from lower raw material prices, which have come down in sync with declining oil prices. Despite the expected rate cuts, we still believe that 2009 will be a tough year for many businesses and consumers in South Africa. The rapid decline in many commodity prices has placed severe pressure on many mining companies who are likely to lay off staff in order to cut costs. In addition, rate cuts will take some time before they have a meaningful impact on the consumer's wallet and state of mind. The market, however, tends to do a good job of looking through the immediate future and will in all likelihood begin to price in a rosier 2010. So what has been a perfect storm in 2008, in the form of declining ratings and earnings, could well turn around into a re-rating and improved earnings scenario, sometime in 2009. As such, we expect the fund to perform a lot better in the year ahead. Let's hope we are right.

Alistair Lea
Portfolio Manager