For small-cap shares the days of astronomic price gains are over for now, says Ricco Friedrich, manager of Sanlam Small Cap (SSC) Fund. But despite this he sees no reason to panic and leave the sector. Though he feels "risks are higher", all that has really changed is that the rerating of small caps relative to big-cap shares has come to an end.

He explains that at their lowest ebb in 2003 small-cap shares, excluding companies making losses, traded at an average 6 p:e. That put them at a discount of almost a third to shares in the top- 40, large cap index. That discount has now narrowed to about 17% and from here on, says Friedrich, share price appreciation of small caps is likely to be based far more on earnings growth than a further rerating.

Friedrich also dismisses fears that small caps are overvalued. He says: "In general valuations are fair; returns will still be very attractive." He adds that though the small-cap index's current 12 p:e (excluding loss makers) is not far off the 13,5 p:e seen at the index's peak in 1998, interest rates are now far lower.

And at about 8% today, indeed they are. When the index peaked in 1998, bond yields stood at 13,4%, and were fast on their way to 20%.

But despite his optimism Friedrich has this year been steering SSC's portfolio gradually away from high-flying consumer shares. "I am wary of the consumer side of the economy and will be looking for opportunities to lighten positions further," he says.

Where there is consumer exposure "it is highly selective" he adds. The two biggest retail holdings, Ellerine and Mr Price, make up almost two-thirds of SSC's exposure in the sector and have both proved to be good bets.

Friedrich is also betting selectively on building and construction shares and feels smaller companies will do better out of infrastructure spending than larger groups. "The big guys have been fumbling around," says Friedrich.

Though the fire may have gone out of small caps, Friedrich's confidence in sustaining returns at a slower yet solid pace looks well founded. For those that concur, Friedrich is a manager worth sticking with.

Financial Mail - 25 November 2005

The third quarter was the best so far this year for small cap shares (up 20%), much in line with the overall market. Since the start of the small cap up-cycle in April 2002, the JSE Small Cap Index is up 206% vs 53% for the JSE All Share Index. The extraordinary returns from small caps came about due to their very attractive valuations at the time and the favourable economic environment that followed. These opportunities do not come about very often.

A strong rand, lower interest rates and accelerating GDP growth have all played a significant role in the strong outperformance of this sector. While we do not see these factors changing dramatically in the near term, some red lights are starting to flicker. These are the risks associated with higher oil prices, a slowdown in the commodity cycle, which could impact on growth, and a weaker currency, which could fuel inflation. These factors would reduce the appetite for risky asset classes, resulting in a flight to perceived quality.

While the absolute valuation of small caps is currently below that of the previous peak of 1998, the relative valuation levels do indicate that the sector is fully priced.

We continue to believe that returns from smaller cap stocks will closely match the rest of the industrial market in the coming months and do not believe that the excess returns when compared to large cap stocks can be repeated.

A portfolio revamp and some good calls by manager Ricco Friedrich have given Sanlam Small Cap's (SSC) performance a strong boost since the sell-off of small caps in March and April. Since their lows four months ago only one of SSC's top-five shares, Astrapak, has lagged while the other four have averaged gains of 32% with the star, Control Instruments, jumping a full 50%. SSC is a solid choice for small-cap fans.

Financial Mail - 26 August 2005

The JSE Small Cap Index continues to deliver good real returns, albeit at a much slower pace than the previous two years. This is not out of line with expectations (at the end of 2004 we commented that the environment supporting small caps is "as good as it gets"). Since 2002 (when the small-cap bull cycle started), we have seen the valuation gap of small caps to the rest of the market close considerably.

We have also seen a marked devaluation of the Rand/$ exchange rate since the beginning of the year, which tends to favour the rand-hedged resource-based stocks relative to small caps. (We continue to caution about the effect that further weakening may have on relative small-cap performance.)

We continue to focus our efforts on identifying out-of-favour small-cap stocks that are trading at deep discounts to fair value or where we see ongoing shareholder wealth creation. As we broaden our coverage of the market we continue to find such stocks that fit our investment philosophy. In some cases this value is unlocked quite quickly, where corporate action is the catalyst, but in most cases one has to be patient.

We have been in search of opportunities that have been hit hard by the strong rand in the past and may benefit from our house view of ongoing rand weakness. In this area there are many mispriced stocks. In the light of this we have added Illovo and Bell Equipment.

The top ten holdings account for 10% of the fund.

There is no doubt that the "easy money" has been made in small caps as an asset class. However, being aware of the danger of averaging, we still continue to find individual opportunities that we believe offer excellent value, while others may be expensive. We reiterate that inflation-beating returns are highly likely for the asset class going forward, but we do not expect the returns of the last two years to be repeated.

A sharp fall in the value of the rand in March sent investors scrambling into big caps, pulling the rug from under smaller-cap shares. It also left small-cap funds in the unenviable position of having to dump stock into a weak market to meet redemptions.

The shake-out will have left many investors in funds such as Sanlam Small Cap (SSC) and its peers asking: are small caps still the place to be?

SSC's manager, Ricco Friedrich, puts it bluntly: "The days of big gains are over." But he does not feel the sector is about to crash . "The environment for small-cap earnings growth and valuations remains favourable."

Fortunately, the excessive speculation that drove small caps to unrealistic valuation levels in the late 1990s is not evident. But achieving superior returns in a sector where the portfolios of most funds are similar is a challenge.

"Picking the right shares is more critical than ever," says Friedrich. He feels increased focus and taking bigger positions "when one has a high level of conviction" are ways of differentiating SSC from its competitors.

To this end, Friedrich has already altered SSC's portfolio a fair deal this year. He says: "I have cut a number of holdings, some completely, and added others which have not yet attracted much interest." Among these is global vehicle electronics manufacturer Control Instruments, which has been ignored by most fund managers.

On furniture retailer Ellerine, at 5% SSC's biggest holding, Friedrich says: "It looks very bullish; the merger with Relyant offers big potential." He also holds a strong view on retailer Mr Price, SSC's second-biggest holding (4%). Though the share disappointed in 2004, he believes this was due to its position as a cash-only retailer and not because of poor fundamentals.

Friedrich's share selection proved effective in the first quarter and in April, when SSC beat its sector average. But producing better returns than more diversified general equity funds will be tough if the rand weakens and more funds move to big caps.

Financial Mail - 13 May 2005

The performance of The JSE Small Cap index surpassed our best expectations delivering a capital appreciation of 47.9% in 2004. A very strong backdrop for small caps has supported these returns, in particular:

The continued rand strength tends to favour the smaller cap stocks.

A continued reduction in interest rates is favourable for equity markets as a whole, but also supports a higher appetite for risk.

There is a very buoyant local economy to which small caps stocks tend to have most of their exposure.

Valuation levels were attractive as they stood at the beginning of the year.

The small cap bull cycle that started in April 2002 has so far delivered a capital appreciation in excess of 140%!

While we cannot predict any drastic changes in the environment above, we do feel that this is as good as it gets. The valuation levels more closely reflect the fair value of many stocks, and the number of companies trading at deep discounts to their fair value has diminished. We will be taking a very cautious approach and will have to become even more focused on stock picking.

Having said this, we still see more companies being taken private and the number of new listings has not increased materially from previous lows. This confirms the view that as a sector, small cap stocks are not expensive yet.

The Sanlam Small Cap Fund has benefited from the strong performance of the JSE Small and Mid-cap Indices. Stocks that contributed strongly to the performance in the 4 th quarter were Aflife (+33%), Astrapak (+47%), Edgars (+60%), Argent (+50%) and Astral (+50%).

We have started to take profits in a number of areas and will continue to reinvest in areas that still offer attractive returns.

New counters added to the portfolio during the quarter include Transhex, Concor, Advtech, Lewis and Value Group. Shares that we sold out due to strong performance or a change in outlook were Northam, Capitec, AG Industries, Dawn, Afgri, Massmart and Uniserv.

Making forecasts is difficult but given the continued strong performance of the domestic economy supporting above-average earnings growth in 2005, we feel inflation-beating returns are still possible from this asset class. We certainly do not believe the returns of the past two years can be repeated.