After a massive sell-off in the first part of the year the Small Cap Index has performed relatively well relative to the recent record-breaking sell-off of the Top 40 Index. Unfortunately the sector has not escaped the global sell-off and returns this year are still deep in negative territory.

Nevertheless, for the first time in three years the sector is showing significant value. The strategy of the portfolio is twofold:

1. Increasing our weighting in high-quality companies, with defensive earnings streams, strong balance sheets and good dividend yields.
2. 2. We are also taking advantage of the many "fallen angels" on the market. Companies whose share prices have been decimated and which are showing huge upside potential with limited downside risks.

Although the local economy will also be affected by the global economic crisis, we believe the share prices have more than priced in the worst-case scenario. This is providing excellent investment opportunities and makes us very exited about the prospects for the SIM Small Cap Fund.

At the time of writing this, the markets have fallen by another 3% - this on top of a dismal year (unless you had some Anglos or Billiton) and a 2% drop yesterday. Ex resources South Africa's JSE has been in a grinding bear market since the end of 2007. The reasons are clear: rampant inflation driven mostly by external events, a rising interest rate environment pushing the consumer to the brink, reduced private investment, lower GDP growth, etc. etc. It's been a long time since I have been so excited about investments and especially the space on which I focus, namely small and mid-caps. The reason is because in my career (which is still fairly short at 10 years) I have seen an almost identical cycle play itself out. This created some of the best buying opportunities any investor could hope for. Let's rewind the clock to 2001/02:

It's December 2001. The rand has just hit 11.90 to the US$ and the EUR looks equally shocking at 10.6. Inflation and the prime interest rates are rising fast. Consumer discretionary expenditure has hit a brick wall and GDP growth has slowed down to a crawl. Markets are selling down any company even remotely linked to local growth. Companies with solid track records, fantastic business models and good management are derating dramatically. People are seriously pessimistic and the queues at the emigration agents are growing by the day!

Back to the present: The rand has depreciated (especially against the EUR and GBP), inflation is rampant, interest rates are high and still rising, the consumer is dead and GDP growth is slowing. And the markets are retreating from their fantastic five-year run just like in 2002!

So where and when is it all going to end?
Well, things don't go up forever: Inflation will eventually turn, interest rates that are very high will start to come down, the consumer will recover (eventually) and GDP growth will return. No one can predict when this is going to happen, but happen it will!

There are two outstanding features about this cycle that may help determine the extent of the cycle. The first is that consumer indebtedness is much higher than in the previous cycle. This will probably result in a more protracted down-cycle in this sector. We will therefore continue to avoid this area (which would include most banking shares) for the time being. The second distinctive feature is the extent and acceleration of government infrastructure expenditure. This will continue to drive the building and civil construction sector for the foreseeable future. So let's turn to some of the good news the media tend to ignore:

Infrastructure spend is accelerating fast, driving employment growth. Agriculture and mining are booming, government finances are in good shape, telcos' deregulation is finally here, the World Cup is just around the corner, and at last we are getting a new president.

Just as the previous cycle created some of the best buying opportunities one could wish for, so will this one. As I have said before, no one can tell you with any degree of certainty when the cycle will turn, but value is emerging once again and for patient contrarian investors this is a great environment. We in the SIM small and mid-cap team are becoming very excited about the great opportunities that are presenting themselves.

Sanlam Small Cap Fund changed its name to SIM Small Cap Fund on 1 August 2008.

The first quarter of 2008 was characterised by extreme volatility combined with the continuing strong surge in resource-related stocks.

The volatility can largely be ascribed to an inflection point in the global and our local economies. The themes are well known: growth is slowing, the consumer, long an underpin of Western economies, is under pressure, and inflation is ticking up. These themes are counterbalanced somewhat by China- and India-led economic growth and massive global infrastructure investment.

After five years of strong earnings growth, positive news flow and strong rerating, the JSE small and mid-cap indices have faltered. The major contributor to any performance this year has been the resources sector. We have unfortunately been significantly underweight this area and have therefore underperformed.

In our view the key to outperformance over the long term is avoiding those companies whose earnings and valuations are inflated. Given the strong macro-environment over the past five years there are large sectors of our local economy with revenue, margins and earnings at record highs. The credit retail sector falls firmly in this space. Although it may look cheap on a PE ratio basis, once you normalise the earnings number the PE ratio rises significantly.

Another sector that is at a cyclical high in terms of earnings and valuations is the resources sector. The commodity cycle continues to break new records. News flow is still very positive, which propels massive fund flows, and continues to boost the sector. With revenue, margins and earnings at record highs we feel the share prices more than reflect the positive environment. Once these metrics are normalised the sector appears extremely expensive. As value managers we feel the downside risks outweigh upside potential and we do not see good investment opportunities here.

Conversely, we believe the agricultural, IT and infrastructure sectors are all only at the beginning of their upward earnings cycle. After years of underinvestment, poor revenue and highly competitive industries, earnings dropped to cyclical lows. Even poorer market performance caused excessively low valuations (with the exception of the high-profile construction majors, which we avoid). The environment for these sectors has changed radically and earnings prospects have never looked better. The recent indiscriminate sell-off in the markets has exacerbated situation. We are thus finding fantastic investment opportunities in these sectors.

For the first time in three years we are finding exceptional value in selected stocks. Although we cannot predict when this market correction will end we have not felt as excited about valuations and investment opportunities for some time.

Volatility continued to be a key factor in the fourth quarter. Despite this the year as a whole was a very strong one for small- and mid-cap stock. The Sanlam Small Cap Fund performed very well in nominal terms and relative to its peers and benchmark.

The key driver of the outperformance was an early and aggressive shift away from consumer stocks towards infrastructure-related companies. We continue to believe that the consumer slowdown has only just begun and that a movement back to consumer stocks at this stage would be premature.

During 2007 we also took up a number of newly listed shares. We continue to look for opportunities in this space, but are very strict with regard to our quality and valuation controls.

Going forward the fund continues to be positioned towards the following sectors: Infrastructure, certain select commodities, IT and offshore. We are also focusing on companies that can grow their earnings through the economic cycle and are therefore more defensive in nature.

The local market is by no means cheap and given the risks to the currency we continue to believe that it is prudent to maintain a substantial offshore allocation.

We are confident that our well-resourced and passionate small/mid-cap team will continue to find excellent investment opportunities that will outperform the market and our peers in the long run.