Sanlam Small Cap (SSC) has lost the big lead it held earlier in 2004. Venturing into resource shares Northam, Mvelaphanda and the almost untradable Sallies has not helped. And while a high retail exposure has been correct, Mr Price as top holding has not. Since May the latter's 43% gain has lagged behind the sector's 64% and been trounced by Edcon's 117%. Despite SSC's solid one-year return, a rethink on share selections appears overdue.

Financial Mail - 10 December 2004

The Small Cap Index has continued its 3 rd consecutive year of outperforming the All Share Index. Since the start of the most recent small cap bull cycle (April 2002), small caps are up 96% vs. 1, 5% for the All Share Index. For the year to date, small cap stocks are up 21,3% vs. 13,2% for the All Share Index. For the 3 rd quarter of 2004 small cap stocks have lagged the All Share Index, returning 11,1% vs. 16,3%.

The strong outperformance of small caps has been supported by a number of factors. The most important of these have been very attractive valuations, a stronger rand and a very favourable interest rate environment that has supported very strong earnings growth from the smaller cap stocks.

The valuation gap between small caps and large caps has been closing and certain stocks have undoubtedly reached their fair value, compared to 18 months ago. There were many more smaller cap stocks trading at attractive discounts to fair value. In this environment, the focus on stock picking becomes even more important in delivering good performance. In the light of this we continue to find pockets of value, and in accordance with our investment philosophy will look to sell stocks that have reached our fair value, and switch into good quality businesses that are out of favour and still offer value.

It is also worthwhile noting that we have started to see some meaningful new mid and small cap listings on the JSE. While still very early days, it is signifying that the cost of equity capital is more attractive to these companies than in the past. In addition, while directors' trades tend to be poor short-term indicators of future performance, we are also starting to see an unprecedented number of companies whose directors are taking profits in their company's shares.

While we do not believe that, as an asset class, small cap stocks are expensive, we do believe that the extraordinary outperformance will start to slow. Small caps have rerated strongly, with the price-earnings (PE) multiple (excluding loss-making companies) having increased from 6,5x in December 2002 to 8,7x currently. The small cap sector discount to the overall market continues to hover between 30% and 40%. At the top of the previous small cap bull cycle, the small cap PE was at a substantial premium to the market.

As research in both South Africa and globally has shown, in the longer term small cap stocks should continue to outperform their large cap counterparts due to faster earnings growth.

We continue to caution on the impact that a much weaker and could have on our view, and should there be a "knee-jerk" weakening of the currency, it will result in relative underperformance of small caps vs. the All Share Index.

During the past quarter, we acquired meaningful new holdings in Argent, Howden, Hudaco and Kersaf and increased our stakes in Aflife and AECI. We sold out of, amongst others, our holding in Murray and Roberts, Metro Cash and Carry, and Mvelephanda Resources and took profits in Metropolitan Holdings Limited, Capitec, Astral Foods and Mustek.

The top 10 holdings account for 36 % of the Fund and the portfolio is invested in 46 counters. We target around 40 holdings in the portfolio, with the Top 10 accounting for 40% of the Fund.

The second quarter of 2004 continued to see mid and small caps outperform their large cap counterparts. For the quarter, small caps gave up 0.1% and mid caps 3.46%. This compares well with the Top 40 Index, which was down 5.46%. The fund produced a positive return against the Small Cap Index, albeit marginal.

The rand strength continued to play a role in the broader market underperformance. With smaller companies typically more focused on the domestic market, they tend to outperform during times of rand strength. Our view is that there is no fundamental reason to believe the rand will weaken materially, and various valuation models on the rand support a fair value of around R6,30.

Our stock selection will focus on companies that can create value for shareholders under the current rand scenario.

We believe the consumer sector of the market will remain robust and, given our view that interest rates are likely to stay lower for longer, we still see certain stocks in that sector offering value. The manufacturing sector is showing signs of a recovery despite the strong rand.

Given the very strong economic backdrop we remain positive on the small cap sector, which has a high exposure to the local consumer and manufacturing sector.

The Sanlam Small Cap Fund has also always looked at attractive turnaround opportunities (fallen angels) that have successfully contributed to the funds historical performance. These currently include companies like AG Industries, Grintek, AST and Sallies.

The Top 10 holdings make up 36,8% of the fund and the objective is to hold around 40 shares in the portfolio.

Small cap stocks still offer value. This is supported by the fact that we still see companies doing buybacks of their own shares, and listed companies continue to be taken private due to the attractiveness of their valuations and cash flows.

The 1 st quarter of 2004 got off to a good start for small caps, influenced largely by the still attractive valuation levels and the strong rand. For the quarter, small caps were up 9,2% and mid caps 1,9%. This compares to the Top 40 Index that was up 2,9%. The return of the Sanlam Small Cap Fund in the quarter was assisted by the overweight in the retail sector, which we in fact increased early in the quarter. The consumer sector of the economy is still very strong and we expect continued real growth in the retail spend for the remainder of the year.

The fund has been selectively adding to its resources exposure. During the quarter we introduced a stake in Sallies, SA Chrome and Northam. Our exposure to resources has been increased to just over 6%.

We have taken profits in Peregrine, PSG and Aquilla, all materially up since we invested in them. We felt better value existed elsewhere in the market. The cash was invested in Ellerine, Northam, Sallies, SA Chrome, AG Industries and Metcash. While the small cap index continues to outperform the rest of the market, we are still of the opinion that there are some good-quality businesses that offer value. Some of these companies trade at valuation levels that are similar to more risky and less attractive business models. This makes them very attractive to us.

The top 10 holdings make up 37,9% of the fund and the objective is to hold around 40 shares in the portfolio. We remain positive on the cycle, but must caution that a weaker rand may result in relative underperformance from small caps. The delistings wave continues and this supports our view that value still exists in the mid and small cap sector.

The smaller-companies sector has been home to some of the unit trust industry's worst dogs. And few barked louder than Sanlam Small Cap in its former Sanlam Select guise. At its worst, in June 2001, a series of four fund managers had delivered a negative 70% total return over three years, outdoing even the sector's horrific minus 47%.

This was the state of play when current manager Ricco Friedrich was given the unenviable task of restoring credibility. This he has done. Sanlam Small Cap has achieved capital growth of 65% during his tenure compared with the 50% sector average.

Its recovery has not been without setbacks. For instance, its performance was dented by high exposure to small banks in the first half of 2002. But since then, good share selection and a market recovery and heavy retail weighting have driven returns well ahead of even the toughest competitors. Friedrich says Sanlam Small Cap can invest in any share outside the top 40 and selection is on the basis of relative value.

"When you find better value elsewhere, you sell and redeploy your funds," he says. And before buying, Friedrich asks himself whether he would put his own money into the share.

Holdings include a number of shares that have delivered strong returns but are rarities in most unit trust portfolios. Examples include IT groups UCS and Mustek, building merchant Iliad and household appliance groups Nu World and Amalgamated Appliances.

Friedrich has more recently begun to increase resource exposure. Again, this is the path less trodden. Purchases include Sallies, a fluorspar producer, Northam Platinum and Mvelaphanda Resources. "We feel that these shares will perform well in a strong or weak rand environment," he says.

Sanlam Small Cap's 80,8% return over a year places it in number-one slot among all domestic equity funds. Another smaller-companies sector fund, Investec Emerging, is in second position. A tough act to beat but, given Sanlam's aim of market leadership, Friedrich can count on solid backing.

The small cap sector renewed its trend in the month by outperforming the Top 40 by more than 1%. For the year to date the small cap sector is now performing in line with the Top 40 with a return of 5,4%, while mid caps have delivered a lower return of 1,23% for the year to date.

New investments into the fund during the month included Sallies and Altech. We believe Sallies, under the able management of Peter Flack and Lindsay Robertson, is on track to become profitable in the not too distant future. We like the business model of Altech and believe the company is well positioned to deliver exciting growth opportunities on the back of Netstar (vehicle tracking), UEC (set top box manufacture) and the recent acquisition of Econet Wireless (Nigeria wireless network operator). We took profits in counters such as Murray and Roberts, Glenrand MIB and Peregrine after their very strong respective share performances.

The fund remains positively biased towards the construction sector, and while there will be some head winds in the short term, we remain upbeat on the medium-term cycle. Looking forward, we are still struggling to find good value in the small and mid cap resources sector and therefore remain underweight. We have however identified Sallies as a special opportunity.

The top 10 in the fund make up 38,9% of the equity portion and the objective is to hold around 40 shares in the portfolio.

Despite the strong performance from small caps in 2003, they are still trading below their long-term mean. We remain positive on the cycle, but must caution that a weaker rand may result in relative underperformance from small caps. The delistings wave continues and this supports our view that value still exists in the mid and small cap sector.

Effective from 1 Apr 04, the Sanlam Select Trust changed its name to the Sanlam Small Cap Fund.

The small cap sector ended on a very positive note for 2003, with the JSE small and mid-cap index showing a return of 42% and 28,3% respectively for the year. Major contributions to the performance of the fund in December came from companies in the construction sector. Group 5 was up 16%, Murray and Roberts up 13% and Illiad up 12%. Other companies that contributed positively to the fund's performance were Omnia (up13%) and Astrapak (up 12%). Value was destroyed by Afleases due to its decision to put certain operations on hold until the rand gold price improved.

The fund remains positively biased towards the construction sector, and while there are some short-term head winds, we remain upbeat on the medium-term cycle. Looking forward, we are still struggling to find good value in the small and mid-cap resources sector and hence remain underweight.

Despite the strong performance from small caps in 2003, they are still trading below their long- term mean. We still remain positive on the cycle, but must caution that a weaker rand may result in relative underperformance from small caps.

Sanlam Select Trust (SST) has made up for shoddy performance that in early 2002 saw its three-year return slump to 70%. Now, at 85%, SST's three-year return matches its benchmark small-cap index. For SST to deliver more of the same, a further hefty rerating of small- and mid-caps is needed. But with small- and mid-cap p:e ratings already at demanding levels, a broader- based value fund such as Investec Value may be a safer bet.