The fund declined 2.26% in the third quarter, more or less in line with the decline in the overall market. This brings the year to- date return to 8.3%, which is in line with our expectation of lower returns than have been experienced in the past 5 years. The overall theme of a generally expensive market where finding undervalued shares is difficult, still persists. That said, there have been some significant moves particularly in the last few months, most of which have come from the resource sector. The fund has very little (about 3% of fund) exposure to resources, and is unlikely to ever have much more than a 10% position, purely due to the limited opportunity set outside the Alsi Top 40. We are, however, seeing some value in a few good quality resource counters and may well increase our resource weighting in the next quarter.

There have been a few new listings in the small cap space in the past year, and the appetite for equity in some of these listings has been very strong. Having lived through the small cap listings boom of 1998 and the Alt X listings boom of 2006/2007, we are very cautious on new listings, despite the knowledge that there are short-term gains to be had. Two of the notable successes thus far have been Ascendis, the pharmaceutical company, and Anchor Group, a relatively new asset manager. Ascendis is up about 50% in less than a year since listing, while Anchor Group is up over threefold in less than a month. Without detracting from the quality of these two businesses, the share price moves remind us of the general exuberance (sometimes irrational) present in the market currently - a mood which usually results in share prices rising too high, too fast. The fund's three biggest sell trades in the third quarter were Astral Foods, Sappi and Arcelor Mittal. In the case of the former two shares, the fund has done very well from these positions, and with the share prices approaching our assessment of value, we sold out. In the case of Arcelor Mittal, we are becoming increasingly concerned about prospects for a recovery in the markets they sell into, particularly the infrastructure industry. This, coupled with the recent announcement citing plans to build a new steel plant in SA, funded by a Chinese steel company and the IDC, have introduced more risk into the Arcelor investment case than we are comfortable with.

The fund's three biggest buy trades in the third quarter were City Lodge Hotels, Wilson Bayly and Grindrod. While each of these companies have their own unique investment case, their overriding feature is their quality. All three are superbly managed businesses and leaders in their respective fields. We have been able to buy positions in these companies at reasonable prices relative to fair value. In a business environment which by all accounts is very tough right now, and seemingly getting worse, we believe it is more important than usual to be invested alongside quality management teams in businesses that have proven themselves through boom and bust cycles. The three businesses mentioned above fit that bill.

Portfolio managers
Alistair Lea and Siphamandla Shozi Client Service:

For the first six months of the year, the fund returned 10.8%. Much of the gain was realised in the second quarter during which the fund returned a whopping 8%. This has boosted the twelve-month return to 26%, a pleasant surprise given the high valuations of the market at the start of the year. We expect more muted returns over the next three years when compared to the past five years, during which time the fund returned 20% per annum.

The slow decline in earnings of the mid cap index, which started mid- 2013, accelerated during the current year, while the earnings of the small cap index have accelerated further in the same period. As a result, the small cap index has continued to outperform the mid cap index over a similar period, which has benefited this fund as it has a greater weighting toward the small cap index. Valuations have started coming back to reasonable levels for some counters in the mid cap index, hence we have started picking up some stocks, including clothing retailers like Foschini During the quarter, we reduced our position size in Comair, the airline operator which operates under the Kulula and British Airways brands. The share has rallied 77% over the past year, as the company started reaping the cost benefits of the fleet replacement programme instituted over the past couple of years. Although we believe there are still further benefits to be attained from the programme, the business is likely to also face several headwinds including rising fuel costs and weak volumes due to consumer discretionary spending coming under pressure.

The biggest contributors to performance in the past year have been our holdings in Iliad and HCI. Iliad has been a fantastic holding for the fund of late and appreciated by 90% over the past year. The fruits of internal re-structuring undertaken by management over the past three years are now starting to become apparent to the market, which has led to a re-pricing based on a more normalised level of earnings. Despite this strong performance, the share still trades at 8x our assessment of normal earnings, making it still attractive for a long-term investor.

The biggest detractor to performance has come from the fact that we didn't hold Sibanye Gold (SGL) and Telkom, which have rallied 326% and 175% respectively over the past year. We have been taken by surprise by the market's reaction to the improvement in short-term performance of these businesses, given their known long-term challenges which remain unresolved. While we have been impressed with Sibanye management's performance in turning around their core assets, we feel that the easy wins have been had and that the share price is now discounting continued favourable outcomes. SGL trades on 10.5x our assessment of normal earnings. We feel this is generous for a business whose core assets are steadily declining and are reasonably short lived. While mine life can be prolonged, this would require mining more marginal/higher risk mining areas and/or acquisitive growth.

Disappointingly, our small position (0.6%) in Esor, a second tier construction company, was a big detractor to performance. The share fell by 60% in the past year. The construction industry has had a tough period, with most of the work tendered for in the past at low margins coming to bite the companies through contract losses that have been incurred. Most construction players have needed to recapitalise their businesses either through rights issues or assets sales to boost liquidity. Esor has been no different, having faced a string of contract losses, till the point where they have had to sell their Geotech business (crown jewel) to an international competitor, which has helped with stabilising their balance sheet and pay a special dividend. Management changes have been done and controls tightened, which will hopefully lead to earnings reverting back to normal levels.

Portfolio managers
Alistair Lea and Siphamandla Shozi Client

The fund returned 4.7% in the final quarter of 2013, putting a shine on a strong year during which it generated 24% versus the benchmark return of 15%. As mentioned in previous commentaries we do not construct the fund according to the benchmark and as such performance can be expected to deviate from time to time. The fund has returned 13% p.a. and 20% p.a. over three- and five-year periods respectively.

After a dull first half, the JSE All Share index (J203) reached new highs in the latter part of the year, returning a formidable 21% for the 12-month period. This was driven by a stellar performance from the industrial 25 index (J211) which returned a whopping 38% for the year. This in turn can be attributed to the performance of big rand-hedge industrials like Naspers (+103%), Mondi (+100%) and Richemont (+59%). It is interesting to note that the same index grew its earnings by 15% and was rewarded by the market through the expansion of its historic PE from 19x to 23x during the year. However, the small cap index, which grew earnings by 20%, did not share similar fortunes in valuation as its historic PE stayed flat at 13x. The mid cap index on the other hand, showed no earnings growth, and yet its PE expanded from 14x to 16x.

We can learn a few things from the above crude analysis. Firstly, the valuation of the market in general is very high; more so for large industrial shares. The earnings of the mid cap index, which to a large extent are made up of consumer-facing companies, started to come under pressure, something we had been expecting for a while now. The risk of a derating is high, given the high starting PEs. On the contrary, most small cap stocks are still on reasonable ratings with decent earnings growth ahead. This is supported by the observation that at 30% discount to the All Share, the PE of the small cap index is now significantly lower than the 10-year average discount of 10%.

Given the commentary above, it is clear that there is still value to be had in the small cap space. This is partly why despite the fund's strong performance in 2013, we still find value in a range of shares in the fund. The list of main contributors to performance includes Omnia (48%), Zeder (+45%), Phumelela (+83%), HCI (+42%), AECI (+55%) and Dawn (+51%), which despite their strong performances still trade at reasonable multiples to our assessment of normal earnings and continue to offer long-term value. Detractors to fund performance include shares such as Hudaco (-4%), Afrocentric (-8%) and Astrapak (-1%), which we believe still offer attractive prospects for long-term value creation.

As we mentioned in our June commentary, we have been watching the building materials space with keen interest in the recent past. Our entrance to the space in 2011 through our purchases of Iliad and Dawn proved to be a little too early. We then endured the ensuing underperformance as industry trading conditions worsened more than we expected. However, through long-term focus our patience has been rewarded in Dawn, as its share price went up 51% in 2013. However, Iliad remains a detractor to performance.

Iliad, a building materials supplier, has come a long way since the boom years (2003-2007) in the construction sector. The ensuing tough times led to a decimation of earnings, forcing the group to do serious introspection. Eugene Beneke, the current CEO whom we rate highly, then took over a business that was in serious bad shape. He instituted a series of extensive restructurings which included amongst other things simplification of group structure, introduction of single national brand, closure of underperforming stores and strict cost controls. The business is now on a much stronger footing, which coupled with a strong balance sheet and a strong cash generating ability bodes well for future value creation. As such, we believe the market is severely underestimating the earnings power of Iliad. The share is trading at 7x multiple to our assessment of normal earnings, which we find very attractive in this market.

Given the valuations of the market, we continue to take a cautious stance on the outlook for returns. As such, we would expect the fund to deliver lower returns in the next three years when compared to the past three years. The fund trades on a 1-year forward PE of 11 times.