2011 continues to be a difficult year for the fund and equities in general. The recovery in earnings post the global financial crisis fuelled recession is proving sluggish, with anecdotal evidence from companies pointing towards a continued tough business environment. Not even prolonged 30-year-plus low interest rates have been able to stimulate better economic growth, a sign of both a weak bank lending environment and weak confidence amongst consumers. Many sectors of the economy continue to struggle. This includes the construction and building materials industries, industries which compete with imported product (such as the poultry and ceramic tile industries), as well as the staffing industry which relies largely on employment growth, which has been non-existent. On the other hand, certain sectors of the economy continue to flourish - most notably clothing retail and unsecured lending industries, with the former benefitting from a very strong rand.

The very strong performance of the Mid Cap Index over the past three years has been driven primarily by the performance of these large clothing retailers. We have underestimated the ability of these companies to continue to prosper in this environment, and as such, have not owned them for much of the past three years, hurting performance. That said, the fund has comfortably outperformed the small cap and fledgling indices in the past three years. 70% of the fund is currently invested in stocks that fall within these two indices, with the balance of the fund invested in Mid Cap stocks. It is also pleasing to note that the fund has performed marginally ahead of the FTSE/JSE Top 40 Index, with considerably less volatility. As usual, the fund has meaningful exposure to businesses where pessimism abounds and are being priced accordingly. While this has had a negative impact on short-term performance, we believe that these businesses will eventually recover, positively impacting the fund. The portfolio weightings of these poorly performing (and undervalued as a consequence) businesses will always err on the conservative, so as not to place the overall portfolio under excess risk. While it is in our blood to seek out undervalued companies, we remain cognisant of the quality of the overall portfolio, and will seek to invest the bulk of the portfolio in high quality businesses which we are confident will be in business for many years to come. This would include companies such as Advtech, Omnia, Zeder, RMI Holdings, Bowler Metcalf, Metrofile, Pioneer Foods and Distell. All of these companies feature in our top 15 holdings.

The fund trades on a 1 year forward PE of 9.1 times, close to its average level of the past six years. Based on our assessment of normal earnings for each company in the fund, the forward PE on normal earnings is 7.4 times. This implies that we consider the level of earnings of the companies held by the fund to be on average 23% below normal. As such, on a medium term basis we would expect the fund to benefit from both a normalisation of earnings, as well as a small re-rating. Considering the confusing macro situation in the world currently, markets are likely to remain volatile in the short term, but based on the above metrics, we remain positive on the medium to long-term prospects of mid and small cap shares in South Africa.

Portfolio managers
Alistair Lea and Siphamandla Shozi

The fund returned -3.2% for the 6 months to June, placing it fifth amongst its competitors. The fund is one of the top performing funds in the sector over three years, returning 13.2% p.a.

During the quarter, we reduced our holdings in Italtile and Ceramic Industries as both companies performed well and approached our assessment of fair value. We however added to our holdings in Advtech, Omnia Holdings and Zeder Investments. The period also saw the successful listing of Curro Holdings, a private education business, on the Alt-X board. Their listing was also followed by a rights issue in which we did not participate. Given our large holding in Advtech, it may come as a surprise that we do not hold any Curro share and as such, we explain our stance on this matter below. Curro is a small private school operator which currently owns and operates 12 private schools, with aspirations of expanding to 40 schools by 2020. The poor state of public schooling, coupled with relatively low penetration of private schools should support above average growth in the private education market for the foreseeable future. By running a tight ship, Curro has been able to increase affordability by charging lower tuition fees than traditional private schools. This allows them to target a broader market of prospective learners. At first glance, this cocktail of growth mixed together with the defensive and cash generative qualities of schools, seems very attractive. Naturally, we were very excited when we first heard that they were coming to the market.

The fact that Curro looks destined to grow earnings strongly over the next few years, tells only half of the story as to whether it will be a good investment. The other half is determined by the price an investor is asked to pay for those earnings. At the current price of 600c per share an investor will be paying a PE multiple of 50 times based on 2013 earnings. This means that even if their earnings triple over the next couple of years, you are still paying a PE multiple of 17 times for a new Alt-X listing which does not provide the investor with a sufficient margin of safety. We believe the current share price does not adequately discount the risks inherent in an aggressive rollout of schools. A school rollout is fraught with logistical difficulties. Rezoning and securing properties could stifle any growth ambitions. Typically, a school takes 3 to 5 years before it operates profitably and involves a significant capital outlay. This fact, coupled with the market's demand for stable growth in earnings means that a measured approach to capacity rollout is probably best. The fact that Curro is taking the opposite approach should be properly discounted in the share price. Advtech, on the other hand, has an established track record of profitable growth. Their management team, having learned from the past, takes a measured approach to growth. Capital has been deployed in an exemplary manner over time as reflected by the 10-year average return on equity (ROE) exceeding 20%. We have no reason to believe that things will be any different in the foreseeable future. The stock is currently priced at 9.5 times to our assessment of normal earnings. On a risk-adjusted basis we believe that at current prices Advtech offers a better opportunity than Curro.

The fund trades on a forward PE of 9.5 times, close to its average of the past six years. However, based on our assessment of normal earnings for each company in the fund, the forward PE is 7.6 times. This implies that we consider the level of earnings of the companies held by the fund to be on average 20% below normal. As such, we remain positive on the prospects for the fund in the medium to long term.

Portfolio managers
Alistair Lea and Siphamandla Shozi Client

After a very strong final quarter of 2010 (the fund returned over 11%), 2011 started slowly with a negative return of 6.7% for the quarter to end March. Considering the destabilising nature of global events such as the political turmoil in Egypt and Libya and the resultant upward pressure on oil prices, together with the earthquake and tsunami in Japan, it is not surprising that a high beta sector of the market such as small cap equities, struggled. Small caps tend to outperform large caps in a bull market and underperform in a bear market (the definition of high beta). On a rolling 3-year basis, the fund has returned 6.5% per annum, better than the peer group average return of 0.65% per annum. This return places the fund third out of a total of seven competing small cap funds.

In our fund commentary for the first quarter of 2010, we highlighted companies exposed to the residential building sector as potential investment opportunities.

This is what we said:
'Perhaps the only interest rate sensitive sector which is yet to benefit from the low interest rates, is the residential building sector. Building activity is usually the last category of spending to recover, mainly because of the confidence required to commit to a big building project, as well as the long time frame involved between deciding to build, submitting plans and then finally breaking ground.'

Another year has gone by and the sector has yet to recover, with many companies reporting very weak results, and share prices falling further. While we do not expect the year ahead to show any meaningful recovery, we are reasonably confident that the worst is over. This is borne out by the statistics on building plans passed, one of the best indicators of the health of this industry, which show a steady recovery from a sharply contracting market to a market seemingly poised for growth (see chart). Due to the lag between plans passed and building spend, this optimism might only transpire towards the end of the year, or in 2012. We have used this period of pessimism in this industry to build some meaningful positions in various companies operating in this space. While this has been a drag on short term performance, we believe that we have invested in these companies at a large discount to their mid-cycle intrinsic value.

The fund trades on a 1-year forward PE of 9.2 times, close to its average level of the past 6 years. Based on our assessment of normal earnings for each company in the fund, the forward PE on normal earnings is 7.4 times. This implies that we consider the level of earnings of the companies held by the fund to be on average 24% below normal. As such, on a medium term basis we would expect the fund to benefit from both a normalisation of earnings, as well as a re-rating from the 7.4 times level to roughly 10 times (about 35% re-rating). As we all know, markets can be volatile in the short term, but based on the above metrics, we remain positive on the medium to longterm prospects of mid and small cap shares in South Africa.

Portfolio manager
Alistair Lea

In 2010, the fund delivered a return of 28.4%, better than the mean competitor fund return of 25.6%. This places the fund third 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 30.3%
Small Cap Index 24.7%
Fledgling Index 21.6%
Alt X Index 10.3%

A feature of the year has been the remarkable performance of the tier 1 retailers, the likes of Mr Price, Truworths and Shoprite to name a few. This has been the primary driver of the Mid Cap Index performance. The fund has unfortunately had very little exposure to this sector, believing the majority of these shares to be fair to overvalued. We still believe that better value is to be found in the smaller counters, which is reflected in the fund make-up. Only 29% of the fund is currently invested in mid caps, with the balance being invested in smaller companies.

The strong run in share prices meant that it has become necessary to search wider for undervalued shares. This typically means investing in smaller, less researched companies. The small size of the fund (currently R176 million) means that the fund is able to invest in these smaller companies and for these positions to have an impact on the fund performance.

As with 2008 and 2009, 2010 was another year where markets anticipated a recovery (or fall) in earnings long before this happened. The chart shows how the Small Cap Index earnings continued to fall well into 2010 (down 70% from the peak in mid-2008). Despite this, share prices continued the recovery seen in 2009, anticipating a strong recovery in earnings which came through in the second half of 2010. Earnings levels, in nominal terms are now back to mid-2007 levels, and unsurprisingly, so is the unit price of the fund.

The weighted fund PE is currently 10 times, a level last seen in October 2007 just before the crash. Back then the economy was at the tail-end of a very strong period, the prime interest rate was 13.5% (and rising), and the global financial crisis had yet to hit. Today, the prime interest rate is 9% and the economy is probably in the early stages of a recovery. The short-term outlook for corporate earnings from here is reasonably positive. As such, despite two very strong years for the fund and a reasonably high fund PE, I expect another year of inflation-beating returns, but which are unlikely to match that of 2010.

Portfolio manager Alistair Lea