The small-cap sector appreciated by 9% for the third quarter of 2006. Despite this the small-cap sector has continued to underperform the JSE Allshare Index on a year-to-date basis. The key driver for this has been the significant weakening of the rand, which will always play a major role in terms of the relative performance of small caps vs the rest of the market.

A weaker currency and rising interest rates pose a threat to the rate of growth in consumer spending and earnings growth for the industrial sector. The small-ap sector is highly geared to the performance of the local economy and would be affected more than the rest of the market should we see a drastic slowdown in GDP growth.

Our view remains that the small-cap sector is fairly valued relative to the rest of the market. While we are not currently concerned about over-valuation, any appreciation in share prices ahead of earnings growth would change our view.

The fund has been positioned in non-resource rand-hedge stocks and together with the offshore investments should benefit from rand weakness.

We added Nu Clicks to the portfolio during the quarter. Now that legislation affecting pharmacies has been finalised, Nu Clicks is very well positioned to benefit from a change in industry structure. This was funded by the sale of Sanyati and Enaleni, which we believe were trading above fair value.

We do believe that small caps should remain a portion of one's long-term investment portfolio because of the diversification (risk reduction) benefits that they provide.

The second quarter of 2006 has been a defining moment in the current small-cap upswing. In fact, it could be marked as the turning point of the cycle (although only time will tell for sure). If nothing else, the most recent economic data points have highlighted how quickly prices correct at the first sign of contrarian data.

It is always difficult to determine exactly what the catalyst will be and when it will show itself to the market. This quarter saw a significantly greater current account deficit emerge, supporting the rise in interest rates. This heightened the flight to quality and rand-hedge stocks, which resulted in small caps underperforming the All Share by the worst margin since 2002. In fact, on a rolling 12-month basis small caps have underperformed the All Share Index by 8%.

The sell-off in equities has, in a rather perverse manner, created some great buying opportunities again. We have used the opportunity to buy more of those great businesses that we would be happy to own through an economic cycle.

Major purchases during the quarter included a new holding in Bytes Technology Group, which we believe has some great proprietary technologies and businesses that give them a good source of annuity income. We also added Spur. The company has an excellent long-term track record of consistent growth and is able to pay out a large portion of its earnings to shareholders. Finally, we also switched our holding in Mvelephanda Resources into African

Rainbow Minerals (ARM). We prefer the operating assets in ARM and the attractive long-term growth profile of the company. Other major sales included our stake in Howden and Paracon. In both instances we felt that the share price fully reflected the fair value of the underlying businesses.

Uncertainty will prevail in equity markets and share price movements will continue to create buying and selling opportunities. We remain very cautious of investments where earnings are at cyclical highs and prices are above long-term fair value. These would include mainly the credit-based retail sector and property. Companies that have experienced no or very little product inflation will benefit from price increases going forward. This would include many of the companies exposed to the manufacturing sector.

We continue to favour non-resource-based rand-hedged stocks with attractive business economics. Included in this category are Hudaco, AECI and Bell.

Any continued rand weakness will result in further underperformance of the JSE Small Cap Index vs the All Share.

Sanlam Small Cap (SSC) has slipped somewhat in the short-term rankings, in what manager Ricco Friedrich concedes is a difficult market for funds following a value investment style. For now, he feels, the market favours so-called momentum managers who go with the trend and are less concerned with value than with current favourites.

And right now the hot stocks are the big-cap resource shares. Unfortunately, there are only a limited number of smaller-cap resource shares, but this has not stopped Friedrich from taking advantage of special situations where they present themselves.

About 18 months ago Friedrich was an early investor in Aquarius Platinum, which, he says, has since risen 275%. At 4% of SSC's portfolio, it is now the second-largest holding.

Overall, SSC's focus is on domestic industrial shares, though Friedrich has also done well out of smaller-cap financials Sasfin and Peregrine. But he concedes exposure to financials could have been higher.

To an extent, he is also self-critical of having often "sold too soon". This is part of any true value manager's approach to investing, however. "As a share approaches fair value, you must start taking some profit off the table," says Friedrich.

He has been doing this with electronics group Control Instruments (CI), for example. Friedrich was one of a few fund managers who picked CI as a winner, which it proved to be, rising 180% in 2005 alone. In late 2005 CI was SSC's biggest holding, with a weighting of 6%; this has been cut to 3,5%.

But opportunities such as CI are now limited. A few years ago it was easy to distinguish between cheap and expensive shares, says Friedrich. This situation no longer exists, he adds.

Despite this, he does not view small caps as being expensive relative to the market as a whole. Adjusting for loss-making small caps, the sector is on an average 11 p:e, says Friedrich. This is 70% of the all share index's average p:e, which is more or less in line with the normal long-term relationship.

For small-cap fans, SSC remains a fund to stay with for the long haul.

Financial Mail - 12May2006

The first quarter of 2006 was another good quarter for small caps, with the JSE Small Cap Index yielding a return of 19.7% . This is the 12th consecutive quarter of positive returns for small caps.

Since the start of the small cap bull cycle, small caps are up 300% compared with 73% for the JSE All Share Index. The excess returns over large caps has recently diminished as the valuation gap to large caps has closed significantly over the past 3 years.

In addition, continued rand stability, supported by strong commodity dollar prices and unprecedented flows of foreign investment into our equity market, has remained supportive of mid- and small cap stocks.

While we do not see excessive overvaluations in the mid- and small cap stocks, there are not many deep-value stocks around when compared to 3 years ago. The absolute PE is still below the peak in 1998 (with much lower interest rates). In this environment we will continue to focus on picking good-quality companies that are priced similarly to or better than some poorer-quality businesses.

We have also seen, for the first time since 1998, a renewed interest by companies to list on the JSE. This again supports our view that markets have become an attractive place (and therefore no longer very cheap) to raise capital or for founders of businesses to realise profits.

Anecdotally, we are also seeing increased interest in SA equities by foreigners who were previously underweight South Africa. This has not been limited to our larger cap stocks, but is also extending down towards the smaller companies where we have seen a notable increase in foreign ownership.

Major new investments in the portfolios during the quarter included Eland Platinum, Hospitality Property Fund, Medi-Clinic, Adcorp and Metropolitan. The above purchases were funded from general profit-taking in other holdings.

The only major investment that we sold out of during the quarter was GijimaAST.

We continue to aim to hold around 40 investments in the portfolio (currently 46) and to attain a weighting of around 40% towards the Top 10 (currently 38%).

Our investment philosophy may result in us being too early in terms of taking profits on companies that are trading at fair value. This does not bother us, as we will always look at reinvesting the proceeds into companies that we believe make for better investments in the long term.