For the past year to 30 September 2010, the fund returned 20.5%, placing it third relative to its competitor funds. Over the past three years, the fund has returned -2.5% per annum, placing it fourth on a relative basis. While the three-year performance number looks poor on an absolute basis, the starting point of September 2007 was very close to the peak level the fund had reached. While the fund is called a "Small Cap" fund, its mandate allows investment outside of the top 40 shares listed on the JSE. As such, the fund's benchmark can be viewed as a mid and small cap market-capitalisation-weighted portfolio. Interestingly, this benchmark portfolio would comprise 86% mid caps and 14% small caps, and would have fared fantastically well in the past 3 years considering the significant underperformance of small caps relative to mid caps.

This outperformance has been driven by the strong performance of retail and property stocks, which dominate the mid cap index, and which have benefitted from low interest rates and the strong rand. While this might continue for some time still, we believe the share prices do not leave much room for error, and that risks to the downside exceed risks to the upside. As such, the fund currently has no holdings in clothing, furniture or food retailers.

Currently, 29% of the fund is invested in mid caps (way below the benchmark's 86%), with the balance being invested in smaller companies. This is an indication of where we believe most of the value exists in the investable universe. Part of the reason why the fund is able to invest the bulk of its cash in genuine small caps is the small fund size. At only R140 million, the fund is smaller than its peers. This enables the fund to invest in small companies and for these positions to be meaningful enough to make a difference.

The fund continues to seek out opportunities, some of which might at first raise a few eyebrows. The investment in York Timber 9 months ago would probably fit into this category. The fund (and other Coronation funds) underwrote the York rights issue at a time when the company was in a fair amount of distress. Since then, the company has made great strides to right-size the business for the current tough environment and will benefit from any pick-up in building activity. The investment has been a good one for the fund, up over 60% in less than a year. The recent investment in Buildmax, the contract miner, would fit into the same category. We think the end result may be similar to our York experience.

The fund trades on a forward PE of 9.5 times, nearer to the high-end of the 6.1 times to 11 times range it has traded in since March 2005. As such, we believe the fund is well placed to deliver reasonable, but not spectacular returns in the medium term (bearing in mind that the current low interest rate environment is very positive for equity prices, and slightly higher PE's are justified).

Portfolio manager
Alistair Lea

In the past year to end June, the fund returned 28.3%, placing it fifth relative to its competitor funds. Over the past three years, the fund has returned -4.2% per annum, placing it third on a relative basis. The three-year performance number looks poor on an absolute basis, but the starting point of June 2007 was very close to the peak level the fund reached.

In general, the much anticipated revival in the domestic economy, while starting to happen, is proving sluggish. The signals however, seem somewhat conflicting. Car sales are up 18% for the first half of 2010 and discussions with distributors of televisions reveal that business in this industry is good (probably in part due to the 2010 FIFA World Cup). Lumber sales are up 17% for the first five months of the year, yet cement sales, while not officially reported at the moment, are said to be down over 10%. Total new mortgages granted in March were up 56% on the comparative month, while mortgages paid out were only up 10% in the same month. Anecdotal information from the building material retailers indicate that conditions in this industry remain very tough, with negative volume growth persisting. Construction companies are still benefitting from the tail end of lucrative 2010-related projects, but the outlook for the next few years is not nearly as rosy. The contract mining industry is in disarray, with all three of the listed players announcing rights issues.

So, how is the fund positioned to prosper from this conflicting muddle of information?
?? We have bought shares in Nu-World and Combined Motor Holdings. Both companies have emerged from an extremely tough few years of trading and should benefit from the combination of a rejuvenated revenue line and a slimmed down cost base. Both companies are very well managed, attractively valued and look set to deliver strong growth in earnings. Our position in Nu-World was bought at close to a 30% discount to net asset value.
?? We have maintained our high exposure to building material retailers. Whilst industry conditions are not favourable, this is already reflected in the share prices. We are encouraged by the strong growth in new mortgages granted as reported in March, which should flow through to growth in mortgages paid out in the near future.
?? We are not heavily exposed to construction counters, and have preferred to take exposure via Wilson Bayly and Stefannuti Stocks, rather than the heavyweights Murray and Roberts and Aveng (both of which have fallen out of the FTSE/JSE Top 40 Index). The economic crisis of the past two years will only be felt by the construction industry in the next few years due to the extended duration of construction contracts from planning phase through to completion. Very few large, new contracts were awarded during the past two years, resulting in smaller order books coupled with tighter margins as industry players compete for what work is available.
?? We like PPC as a company, but are concerned about the industry overcapacity and the future ability of PPC to put through inflation-beating price increases, which it has been able to do for many years now. As such, we have not bought PPC shares despite it moving out of the Top 40 Index into the fund's investable universe.
?? We think we are near to the point of maximum pessimism on the contract miners. Now that these companies have all raised fresh equity finance, we believe the risk of company failure is very slim. As all three listed players are in the same precarious position, they will need to act in a rational manner and increase industry pricing in order to generate fair returns going forward. As such, we have taken small exposure to two contract mining companies. The fund trades on a forward PE of 8.4 times, close to the middle of the 6.1 to 11 times range it has traded in since March 2005. As such, we believe the fund is well placed to deliver reasonable returns in the medium term.

Portfolio manager
Alistair Lea

For the year to end March 2010, the fund returned 51%, reversing the negative returns of the previous year. This return did not quite match the market cap weighted mid and small cap benchmark performance of 53%, which was helped by a very strong performance (54.4%) from mid caps. Mid caps continue to outperform small caps (33% outperformance since Jan 2008), a trend that commenced at the start of the market crash in late 2007/early 2008. This is normal in a bear market, with the smaller, less established companies not faring as well in a tough economy. We certainly find more value in some of the smaller companies right now, which is reflected in the weighted market capitalisation of the fund holdings of R2.7 billion. The mid cap index is dominated by property companies and retailers (predominantly clothing and food), sectors which have run hard on the back of the lowest rate of interest since 1981. We struggle to find value in these sectors.

While Truworths and Mr Price both reached all time high share price levels in the past quarter, Dawn and Iliad (companies largely dependent on residential building activity) remain some 64% off their all time high share price levels. Many companies exposed to residential building have cut their cost bases aggressively in the past few years in response to two of the toughest years in decades, which should magnify the rebound when activity levels pick up. We sense that the pick-up in activity in this sector is imminent, and have a significant exposure to this through our positions in the likes of Dawn, Iliad, Ceramic Industries, Italtile and York Timber. While our holdings in these companies were the result of detailed bottom-up fundamental research, we are encouraged by the macro picture which we believe will unfold.

Portfolio manager
Alistair Lea

In 2009, the fund delivered a return of 32.2% - better than the mean competitor fund return of 24.4%. This places the fund second relative to its competitors. The performance was also pleasing when measured against the performance of the various indices in which the fund can invest as indicated below:

Mid Cap Index 35.7%
Small Cap Index 28.3%
Fledgling Index 24.3%
AltX Index -53.9%

2009 was a classic case of how the market prices in an earnings recovery long before it actually materialises. Small cap earnings (as measured by the Small Cap Index) have been decimated by the current harsh economic climate and are down a massive 77% since March 2009. Mid caps and the Top 40 shares have managed to stem their earnings drop to between 22% and 26%. Despite this, the Small Cap Index was up 28.3% in 2009. This combination of declining earnings and rising share prices has caused the historic PE of the Small Cap Index to rocket upwards to the highest levels in the past 14 years at 60 times!

The market is therefore expecting a big earnings recovery (albeit off a very low base) from the average small company, which we generally concur with. The current high PE of the index is misleading, in that within the index there are many 'low PE, low earnings' opportunities. These are shares where we believe earnings are low and which are not highly rated by the market. When the earnings recovery comes through, the rating normally follows, giving rise to a potent combination of earnings growth and re-rating.

Where in the cycle are we now?

2009 has been a good year for small cap shares despite a big decline in earnings for many companies. This follows a very poor year in 2008, where the market correctly anticipated the tough economic climate of the ensuing year. Despite this volatility, one must bear in mind that the index is still up nearly five fold from May 2003 - the start of the massive 5- year recovery in small caps. The exact point in the cycle is therefore not that easy to determine, but we would make the following points:

· The earnings base of the average small cap share is very low and should grow strongly off this base. Earnings (growth or contraction) is the most important driver of share prices.
· Small caps remain out of favour (just look at the performance of AltX for confirmation) and risk appetite locally is not particularly high at the moment. This means that investor focus on small caps is low.
· While the index is up 33% from its lows, many specific shares still trade close to their multi-year lows and offer compelling investment opportunities.
In the past 6 to 9 months, the fund has been able to identify many attractively priced shares such as Distribution and Warehouse Network, Kelly Group, Omnia, York Timber and Advtech, to name a few. It is not always easy investing in companies where earnings are under pressure and newsflow is poor, but these moments so often prove to be the most rewarding times to invest. We don't think it will be different this time.

Portfolio manager
Alistair Lea