The fund continued on a steady path this year, returning 13% year-to-date. The fund has returned 100% (21.4% annualised) from its March 2009 post global financial crisis lows, and has now surpassed its previous highs reached in late 2007. I imagine however, that there were not many people who had the courage to allocate funds to the equity market at the height of the global financial crisis. This behaviour reminds us of Warren Buffet's famous 'be greedy when others are fearful and fearful when others are greedy' quote. Had investors been greedy back in March 2009, they could have doubled the value of their investment. On the other hand, the situation we find ourselves in at present is an equity market at or near all-time highs and a similar position for the fund. It seems hard to believe that this situation exists considering the wholly uninspiring current state of the SA and world economies. But one needs to consider what alternatives investors have. All-time low levels of interest rates across most of the planet make many investment alternatives wholly unattractive relative to equities, which is why the SA equity market is hitting all-time highs when intuitively it feels like it shouldn't be. This, coupled with the fact that the forward PE on the fund at 10.3x is close to the previous peak levels reached in mid-2007 (months before the global financial crisis induced crash), lead us to believe that now is the time to err on the fearful, as opposed to greedy end of the spectrum. Despite what we have said above, we are still able to identify shares which we are not fearful to hold. Many smaller companies (for example Iliad, Dawn, Bowler Metcalf and Stefanutti Stocks) are trading well below their previous highs and at very attractive valuations. These stocks may have challenges in the short term, but we feel that the current risk/reward profile of owning undervalued shares facing short term headwinds are more appealing than owning overvalued shares facing short term tailwinds. Two shares we feel deserve a mention this quarter are Omnia and Niveus Investments. Omnia, through price appreciation (up 66% in the past year), has become the biggest single position in the fund. During the year, the company commissioned its R1.4 billion nitric acid plant, which was built on time and within budget - a significant achievement for a project of this size. We expect the benefits of this plant to flow in the current financial year, and while the market has to some extent recognised this, we are of the opinion that Omnia remains attractively valued on an estimated 9x normal PE. For a company with two market leading and dominant businesses in fertilizer and mining explosives, we think this rating is attractive. Niveus Investments was spun out of HCI, and houses 4 assets, the main one being Vukani gaming, the biggest Limited Payout Machine (LPM) operator in South Africa. The fund elected to swap a portion of its HCI shares in exchange for Niveus shares, as we are optimistic about the growth prospects for Vukani and the LPM industry. Limited information has been available on the assets within Niveus while they were housed in HCI, and this should now change, resulting in a better appreciation by the market of the value of these assets.
Portfolio managers
Alistair Lea and Siphamandla Shozi

The fund was flat for the quarter, returning -0.08%. Year to date, the fund is up 10%. After returning 93% (22% annualised) from the post global financial crisis lows reached in March 2009, underlying fund holdings have, on the whole, returned to more realistic valuation levels. Returns from these levels are likely to be more muted than that of the past three years. The past few years have been characterised by the market's appetite for quality shares. As a result, there is a large disparity in the ratings of quality shares versus shares perceived to be of lesser quality. The market seems willing to pay 15 - 20 times earnings for companies which have delivered consistent earnings growth in the past five years, but will often rate companies who have struggled to grow earnings at PE multiples of between 5 and 10. The thinking is that a multiple of around 20 quickly unwinds when a company is showing healthy earnings growth. This all works well for as long as the company continues to grow earnings above the market, but it can be a risky strategy in our opinion. You are investing in companies whose earnings base is often high, as well as its rating. If the earnings base declines, or even stops growing at a fast pace, the high multiple no longer becomes justified, and the share price decline can be amplified by falling earnings as well as a lower rating. We remain of the opinion that many tier 1 retailers (clothing and food) would fall into this category, and as such, we are not invested in these shares. While it has cost the fund not to hold these counters, our capital preservation instincts deem it prudent to hold our line in this regard. Several of the fund's larger holdings have done very well in the past year. Omnia (up 33%), Afrocentic (up 50%), Hudaco (up 30%), Trencor (up 47%) and Metrofile (up 66%) being the notable performers. The fund continues to hold many counters operating in industries which remain challenged, but where the upside potential is great should conditions improve. Again, the building materials, contract mining and construction industries would fall into this category. Many of the counters we hold in this space have restructured their businesses to cope with the current low activity levels, and should conditions improve, profitability growth should be significant. Here Iliad and Buildmax come to mind. The fund trades on a one year forward PE of 9.8 times, slightly above its average level of the past seven years. Based on our assessment of normal earnings for each company in the fund, the forward PE on normal earnings is 7.6 times. This implies that we consider the level of earnings of the companies held by the fund to be on average 29% below normal. As such, on a medium term basis we would expect the fund to benefit predominantly from a normalisation of earnings, as opposed to a re-rating.

Portfolio managers
Alistair Lea and Siphamandla Shozi

The fund delivered a return of 10.1% for the quarter. This is quite pleasing after the fund experienced a very tough 2011. Over a period of three years, the fund has returned 25.1% per annum, outperforming the small cap index which returned 24.0% per annum. The fund however underperformed the mid cap index which returned 28.9% per annum over the same period.

During the quarter we saw most of our rand-hedge stocks responding positively to the weakened currency. Our positioning in Hudaco, Trencor and Omnia was handsomely rewarded as these stocks reached new highs. In addition, the buoyancy in mining activity benefitted our position in Bell Equipment, which rose by more than 50%. Furthermore, we believe this bodes well for our position in contract miners who are also beneficiaries of mining activity.

Despite some acceleration in overall credit growth, mortgage loan growth remains subdued while unsecured credit growth continues to power ahead. As such, the residential market remains weak. One way to view the extent of the depressed nature of the residential market is to look at residential building spend as a percentage of GDP. The graph below shows that the only time this measure has been below its current level was in the early 2000s. We know this period was followed by one of the greatest booms in the residential market. Though we don't necessarily think that will be the case this time around, we still believe any slight improvement will be very beneficial for the sector. Having said that, our long-held positions in building material counters (Dawn and Iliad) have started reacting positively and outperformed the market for the quarter. We remain long-term shareholders in these businesses as we see significant longterm value.

The fund trades on a 1-year forward PE of 9.6 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 7.9 times. This implies that we consider the level of earnings of the companies held by the fund to be on average 22% 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 delivered a negative return of 2.52% for 2011, which is well below the average competitor fund return of +3.24%. Needless to say, we are disappointed with this short-term performance. However, this follows two years of returns in excess of 20% delivered by the fund since the global market recovery that commenced in 2009. The fund has returned 18.3% p.a. over a period of three years, placing it fifth out of seven competing funds.

Despite 30-year-plus low interest rates, the economic environment over the past year proved to be very difficult for many companies. Whilst some sectors of the economy, most notably clothing retailers and unsecured lending, have benefitted from low rates, the growth in the rest of the domestic economy has been sluggish. Economic activity in recruitment, construction, secured lending and building materials is still subdued with no sign of immediate recovery.

We have used this period of pessimism in some of these sectors to build meaningful positions in various companies which we believe are deeply undervalued. 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. As such we expect that we will be rewarded with good returns in future. We do however acknowledge that difficult times may be with us for a while, which is why we have dedicated the bulk of the portfolio to high quality businesses that should be able to grow earnings despite the tough environment. A weakened currency is likely to be a feature in the year ahead. Our exposure to rand hedge stocks (businesses that benefit from a weak currency) should stand us in good stead. The list of rand hedge stocks in the portfolio includes companies such as Omnia, Trencor, Hudaco and Grindrod.

The fund trades on a 1-year forward PE of 9.4 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 22% 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