The fund has continued its good year, returning 8.7% for the third quarter of 2013. Year to date the fund has returned 18.1%. For what it's worth, the fund's benchmark, being the market capitalisation weighted mid and small cap indices, is up 9.2% year to date. We have emphasised in the past that we do not construct the fund relative to a benchmark. For many years the fund has actually underperformed its benchmark, which by its construct is weighted heavily (approximately 85%) towards mid caps, while the fund has typically had higher exposure to small caps where we have found more value. The chart below shows that mid caps outperformed small caps from the beginning of 2008 until mid-2012, explained largely by the superb performance of retailers and property stocks which dominate the mid cap index. Since mid-2012 this trend has reversed, which is why the fund is now performing ahead of its benchmark. It is heartening to note that many of the fund's bigger positions have performed very well in the past year. Omnia, whose rights issue we backed in 2010 at R50 per share, has been a stellar performer (up 62% in the past year), and now trades at over R200. We have recently reduced our exposure, but the company continues to perform very well and on a price to normal earnings of 12 times, is not expensive relative to the market. HCI is another large holding which has performed well (up 53% in past year). HCI is now the fund's largest single position, at over 6% of the fund. We remain very excited about the company's prospects, especially its free to air satellite TV offering which is due to launch this month. The success of this offering hinges on whether they can gain viewership. This in turn depends on the quality of the content offering they can provide. The higher the viewership, the more advertising revenue they will generate. Knowing the quality of HCI and e.tv management, we suspect that they have spent many years preparing for this launch, and back this to be a significant and successful venture for e.tv and HCI. Some of the fund holdings that have made notable recoveries in the past year include Dawn and Phumelela. Dawn, in particular, is very pleasing considering the fact that we backed the company by underwriting a rights issue in 2009. The ensuing years were very tough for the company, but to their credit, they have done some hard and necessary work and it is now showing some very positive signs. The market has also noted this, pushing the share up 52% in the past year. It is always pleasing when your assessment of what a company is worth is recognised by another investor. In the past quarter we have held two companies which have been the subject of buyout offers: Kagiso Media and Afgri. Our attitude towards these offers is simple. Pay us what we believe the business is worth and we will consider the offer. It makes sense to divert cash invested in a business with no upside to undervalued opportunities. As we have said in our past few fund commentaries, we think that valuations of companies we can invest in are high, and leave little room for error. As such, we would expect the fund to deliver lower returns in the next three years when compared to the past three years.

In the first half of 2013, the fund delivered a return of 8.7% against the benchmark return of 3%. The past 6 months have seen the small cap index outperform the mid cap index, a trend that started a year ago (see graph below). This is something we have been anticipating for a while now, as we felt that valuations of some of the big constituents of the mid cap index, like retailers, were looking expensive. Interestingly, the general retail index is down 15% for the period. The fund has returned 16% p.a. over a period of three years. After a strong run in May, the general market saw a sharp decline in June as talk of the US Federal Reserve's withdrawal of stimulus gained ground. Bond yields also ticked up as the rand weakened further against major currencies. The fund has benefited immensely from holding rand-hedge shares like Omnia, Capco and Distell, which despite our view of further rand weakness, are starting to look fairly valued. What has been interesting of late is the steady improvement in the building material space. Long time readers of this commentary would remember that in 2010, we wrote: "Perhaps the only interest rate sensitive sector which is yet to benefit from the low interest rates, is the 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". The steady improvement is only now starting to filter through to the earnings of companies like Dawn, who recently reported a strong recovery in earnings albeit from a low base. Despite Dawn's share price gaining 30% since the beginning of the year, we believe there is still more to come as earnings in the sector continue to normalise. The graph below shows the 12- month moving average of building plans passed since 1994. Considering the valuations of the local market, we continue take a cautious stance on the outlook of returns going forward over the medium term. The fund trades on a 1-year forward PE of 11 times.
Portfolio managers
Alistair Lea and Siphamandla Shozi Client

The fund has made a good start to the year, returning 7.5% for the first quarter. The fund now trades on an 11 times 1 year forward PE, the highest rating since 2005. This is largely a consequence of the lowest interest rates in my lifetime. Asset prices generally rise when interest rates decline, as the discount rate used to discount future cash flows is low, resulting in higher asset valuations. In addition, low interest rates often render other asset classes such as bonds, cash or property unattractive due to their low yield. Consider the position faced by many equity investors today. Various stock markets, including the JSE, are at or near all time highs. Returns from equity investments have been fantastic, valuations are looking stretched, and it's time to consider lowering exposure to equities. The problem is the alternatives are not attractive at all. Bond and property yields are near all time lows (implying that their prices are near all time highs) and yields on cash are also wholly uninspiring. Oh well, better stick to equities then - but if I'm going to stick with equities, I'd better go for the low risk options, like consumer staples, beverage stocks or other low heartbeat type companies. Best to stay away from resources and small caps. I'm sure this is a train of thought that has been through many an investor's mind over the past 6 months. A possible consequence is that there could be a bubble forming in shares that are perceived to be lower risk. If interest rates stay low and economic growth does not tick down, this situation may continue for some time yet, but when the interest rate cycle turns, all asset prices could come under pressure, particularly those that are priced for perfection. Many shares outside the Top 40 have also delivered fantastic returns and are also looking fully valued. Part of the fund is invested in shares which we feel fit into this category, and for the most part, we have reduced our weightings in these shares. We have been careful not to lower the quality of the overall portfolio by investing in out-of-favour, low PE small caps, of which there are many, unless we are of the opinion that these businesses are well managed, well capitalised and have a very good chance of significantly improving their levels of profitability in the years ahead. Instead, we have invested more of the fund in quality shares that still offer upside. Examples of these would be HCI and Hudaco. HCI is a company that has created significant value for its shareholders for many years. Its two main assets, the JSE-listed Tsogo Sun Holdings and e.tv, are both high quality, cash generative assets well positioned for growth. Our calculations show that HCI trades at a discount to the value of its investments of over 20%. Considering the investment track record of HCI's management team, we consider this discount excessive. Hudaco has been one of the most consistent companies on the JSE for the past 10 years. It is a superbly managed business, but is currently facing a material tax query from the South African Revenue Service. This poses a risk to the investment case, but at the same time, presents an opportunity should the tax query fall away. We (and company management) feel their defence against this query is solid, and as such took advantage of the share price weakness to increase our position in the stock. After four years of stellar returns post the global financial crisis, we feel that the remainder of the year will be predominantly about capital preservation, and caution investors not to expect similar returns to the past few years.

Portfolio managers
Alistair Lea and Siphamandla Shozi

In 2012, the fund delivered a return of 20.1%, which is very pleasing given the difficult year we had in 2011. Over the threeyear period to end December, the fund has returned 14.6% p.a. Since the lows of 2009, the fund has more than doubled, surpassing the previous highs reached in 2007. The past year was characterised by the JSE reaching new highs as most domestic stocks benefited from multi-year low interest rates, both locally and internationally. However, this optimism was not matched by the performance of the economy which still remained sluggish. The much publicised government infrastructure program did not materialise as the state's finances continued to deteriorate. Fundamentally we believe most domestic stocks are now generally expensive. Despite this, through our focus on longterm value, we continue to find smaller companies that trade at significant discounts to fair value. The margin of safety offered by these shares is even more valuable now given how expensive the rest of the market has become. These shares include names like Iliad, Dawn and Bowler Metcalf. A weakened currency was also a feature in the past year as we expected. Our exposure to rand-hedge shares (businesses that benefit from a weak currency) stood us in good stead. These shares included names like Omnia (+68%), Bell (+51%), Trencor (+53%) and Hudaco (+42%). The fund trades on a 1-year forward PE of 11 times, equal to the peak it reached in April 2007. Based on our assessment of normal earnings for each company in the fund, the forward PE on normal earnings is 8.6 times. This implies that we consider the level of earnings of the companies held by the fund to be on average 22% below normal. Considering the valuations of the local market, we take a cautious stance on the outlook of returns going forward over the medium term.

Portfolio managers
Alistair Lea and Siphamandla Shozi