The tough investment climate in the mid- and small-cap space has continued, with the fund down 4.8% over the past year. The five year compound annual growth rate (CAGR) return of 4.0% for the fund is below inflation and shows how difficult it has been to produce decent returns, bearing in mind that the fund was the second best performing fund in the mid/small cap space over this time period.

Investing in small-cap funds is essentially a bullish call on South Africa and the rand. The fund has over 70% exposure to South African industrials, and a rand hedge component of only 20%. This is essentially a feature of our investable universe and our inability to invest in big global businesses. The subdued five-year return is therefore not surprising - the South African economy has had a very tough time over this period. Poor results from many companies bear testament to this.

Of more relevance perhaps is the outlook for the fund. It needs a healthier South African economy to produce inflation-beating returns. Right now, there is not much positive news around and it is hard to see how the economy can deliver GDP growth of 2% or above. But the market is pricing in this bleak scenario, and many shares are looking more undervalued than we have seen in a while. We are unlikely to see any pickup in the South African economy before the May 2019 elections, but what is clear is that the base is pretty low and the political landscape is significantly improved compared to just a year ago. It is difficult to invest amid the negative news which we are subjected to every day, but so often, times such as these prove to be the best time to invest.

Over the past year, the largest contributor to the fund's performance was the holding in Altron. This is gratifying in that we built a large position in Altron in 2016 after years of disappointing results caused the share price to decline from around R30 per share to R6 per share. New management and shareholders have done an outstanding job to reposition the company and the recent results show that this is now bearing fruit.

The biggest detractor to fund performance over the past year has been the holding in Dawn, a manufacturer, distribution and warehousing group, A few years ago, we participated in the recapitalisation of the company in the belief that this would give it the headroom to successfully restructure its operations. Unfortunately, this coincided with a brutal business environment which has made the turnaround extremely difficult, despite management's best efforts.

The largest addition to the fund in the quarter was the purchase of Life Healthcare, the hospital business with exposure to South Africa and the UK, having agreed to sell its stake in an Indian hospital business. Hospital businesses are generally of high quality, with high barriers to entry and constant and growing demand for their services, offset somewhat by the fact that they operate in a regulated environment. The significant decline in the share price of Life Healthcare means that it can now be bought on a 12 - 13 forward price earnings ratio, which we think is attractive.

The largest sale in the quarter was the position in Hammerson, the UK-based property stock. The environment for UK property owners is brutal right now with their customers (the retailers) under intense pressure and generally wanting less space, combined with rising interest and capitalisation rates. The Hammerson share price has held up reasonably well, possibly as a result of the failed offer from Klépierre to buy the company. Unless further corporate activity takes place, we think Hammerson will experience a difficult few years.

Over the past year, the fund returned 2.7%, slightly below its benchmark return of 3.7%. The fund has delivered 3.7% and 7.2% over three and five years respectively.

The past couple of quarters have been a see-saw ride. What started as Ramaphoria in the first quarter, rallying just about every domestic stock, quickly turned sour in the second quarter as various economic data laid bare the dire state of the economy. Coupled with the prospect of rising US interest rates and the impending trade war, this pushed the currency weaker against the dollar. The economic sensitive sectors such as the clothing retailers that had been pushed to stratospheric levels, have come back and are starting to look interesting. It is still our view that the local economy should improve over the next 3-5 years. Certain businesses will benefit more than others. Such businesses are likely to be those that are very well managed, have significant moats around their business and generate good free cash flows. Hence, we continue to favour strong businesses as the core holdings of the fund.

Having said that, we are not afraid to buy businesses that are in a turn-around stage and offer significant upside to fair value. For example, one of the largest contributors to performance over the past year is one such business. Altron Group had been a detractor for several years, as some of its underlying businesses became lossmaking in a deteriorating economic environment. The introduction of a strategic shareholder enabled the business to be restructured, which resulted in long-term value emerging and priced properly. The share has now more than doubled from its lows, and we remain positive about its future upside potential.

One of the largest detractors is Invicta, a distribution business, supplying mainly bearings to the mining sector, as well as capital equipment to the farming industry. A combination of a downturn in mining and drought in farming had presented us with an opportunity to buy this very well-run business. During those tough times management took steps to restructure the group, take out costs, and put the business on a very good footing. When the environment started improving, it saw an acceleration in earnings growth. The share rallied, and we halved our position as it approached our fair value. At the back of our minds we had always been uncomfortable with the BEE deal that was structured a few years ago, which had resulted in massive tax savings. Further, in our valuation we had always tried to normalise for it by valuing the business on a full tax rate. Management had repeatedly given the market their assurances that everything was above board with this deal. In the end, it turned out that everything was not in order after all, as Invicta now needs to repay a large sum of money to the South African Revenue Service as a result of the structure of the deal. When the news broke, its share price tanked. In hindsight, we could have sold more shares earlier. Having said that, given where the share price currently trades, we believe the market is certainly undervaluing the business, and as such we continue to hold it.

During the quarter we added Pan African Resources, a small lowcost gold mining company, to the portfolio. The bulk of the company's earnings are from tailings treatment projects. It is also very geared to the rand gold price. The share price peaked above 450c but is now trading just above 130c. Management had been on an acquisition spree over the past few years, which not only resulted in them making a poor acquisition (Evander) but also led to them taking their eye off the ball in day-to-day operations, which is evidenced by poor recent performance. Management seems to have heeded shareholders' call to focus on fixing current operations. A major restructuring is underway, which should result in improved business performance.

We continue to be cautious on the overall state of the domestic economy. As such, the bulk of the fund is invested in high quality counters that should continue to generate reasonable returns even in a tough economic environment. It is in these times that our longterm focus allows us to pick deeply undervalued businesses that have been mispriced by the market, which contributes positively to subsequent performance of the fund.