September 2008 brought a weak end to a tough quarter in both domestic and international equity markets that have continued into October. Record levels of volatility, plummeting commodity prices and almost daily announcements of the failures of global household names in the financial services industry have become the norm. In these circumstances, despite what we have considered a defensive positioning of the fund and record levels of cash, the fund has performed disappointingly. This is attributable largely to the resource component of the portfolio, which despite our reduction in the level of exposure two months ago, has fallen quickly.

An example is Merafe, a ferro-chrome producer, which has fallen 75% from its peak, on the markets expectation that its underlying commodity will fall substantially. On extremely conservative forecasts which not only takes into account a fall in the ferro-chrome price, but also takes into account the weakness in the rand, the company is on a forward PE of anything between 1.5 times and 3 times, cash generative, almost debt free and about to start paying dividends. Under these circumstances, we have been buying these shares back.

A similar situation exists for several other shares, which were originally acquired for their rand hedge characteristics and are now on low single digit PEs as a result of the collapse, we have seen in most commodity prices - effectively discounting severe declines in earnings. These include Metorex, Palamin, Grindrod and Bell Equipment.

Under difficult circumstances and following a full re-analysis of our inputs to our earnings forecasts, we have retained most of our worst underperformers and are confident that once sanity returns to the current turmoil, that the value will be realised.

June 2008 was another negative month for the small- and mid-cap sectors and brought an end to a tough period for the sector. The table below reflects the pressure that has been felt since the mid-cap sector peaked, already more than a year ago, in May 2007.Although small caps managed to scale an all time high in November 2007, year-to-date in 2008 it has fallen further than the mid caps.

Notwithstanding the absolute and relative performances of mid and small caps over the last year, as well as the fact that the sector is trading at a high discount PE rating to the market, we once again re-iterate an opinion that we have expressed to investors for some months. Namely that we remain extremely circumspect about the prospects for many small and mid cap companies, and believe a very conservative investment stance is still appropriate.

This opinion is based primarily on our view that business conditions for smaller firms in South Africa - particularly those with any form of dependence on the domestic consumer - are likely to remain under enormous pressure, facing the numerous well known headwinds which include rising fuel prices, rising interest rates, high food inflation, rising electricity costs and power shortages suppressing economic expansion and employment creation.

In the context of the above, readers will not be surprised to find that we are still sitting on our maximum cash position with the balance of the fund positioned as defensively as possible. Despite this positioning and under current market conditions, we have suffered under the indiscriminate sell-off that is taking place of even quality defensive businesses whose growth prospects remain intact.

We expect further and ongoing pressure to come from the forced selling activity produced by the withdrawals by investors from certain small cap funds, but more particularly from the Hedge Fund Sector, where several funds that have performed very poorly (particularly on a risk-adjusted basis) in recent months are seeing capital redemptions.

In March 2008, the fund's unit price declined by 1.1%, which should be compared to the performances of the JSE Mid- and Small- Cap Indices declines of 4.5% and 3.7% respectively.

In the context of the fund's benchmarks we are obviously pleased to have limited the downside suffered by unitholders in a bear market. This has vindicated the defensive rand hedge biased positioning of the portfolio, as well as our decision in mid-2007 to avoid the flurry of activity around the new listings boom - especially on the Alt-X.

Although the last few months have brought renewed volatility to the equity markets that have not been seen for several years, and particular extraneous events such as the sub-prime crisis have affected certain areas of business activity, we believe that the outlook remains fraught with risk and the volatility is likely to continue. This is certainly true in South Africa, where rocketing inflation (well beyond the Reserve Bank's target range), the high petrol price, the depreciating currency, heightened political uncertainty and power outages will have a negative impact on the future economic growth rate. In this context, we remain positioned in companies that we believe can prosper in these difficult times and to grow their profits and dividends.

In December 2007 the fund's unit price declined by 0.8%, which is satisfactory in the context of the declines reported by the JSE Mid-Cap Index0.6% and the JSE Small-Cap Index, which was down 1.1 %.
As hinted in our November report, we used the market weakness of December to raise our total equity exposure. This was done primarily through additions to existing holdings in cash-oriented, defensive counters that have no exposure to consumer credit; management are experienced with a competent track record and profit growth prospects are reasonable, notwithstanding our expectation of increasingly challenging economic conditions for the foreseeable future. These include City Lodge, Sun International, Adcorp, Paracon and Spar.

To repeat a theme mentioned in the November report, we remain averse to investing in the recent flurry of new listings - especially on the Alt-X, and market conditions in early 2008 confirm our opinion that the year ahead will prove a very challenging one for many of these companies. We expect investors to become increasingly demanding on valuations, and the high-flyers of 2007 will have to produce some spectacular results (backed with cashflow and dividends) in more challenging economic conditions which are the result of several interest rate hikes as well as rocketing food inflation and the fuel price. Any disappointments are likely to be severely punished - and there has already been one.

We have also recently become more circumspect about the valuations of the building stocks, which have done so well for our investors over the last few years. We have sold Group Five completely, and hold reduced positions in the higher quality Aveng and WBHO. We do, however, remain convinced that the country's fixed investment expansion program, whether driven by the private sector, state or para-statals is irreversibly on track, but our preference is to achieve exposure via materials suppliers such as Powertech (cable via Altron), Reunert, Bell Equipment and Hudaco (bearings and spare parts).
We look forward to 2008 with cautious and guarded optimism, and as at the beginning of 2007, would not expect the performance in the year ahead to match that of the year just passed.