Market review
The FTSE/JSEAll Share Index gained 13% in rands in the third quarter - its best performing quarter since September 2005. Mid-cap stocks continue to lead the charge, returning 15% for the quarter, with the FTSE\JSE Small Cap Index following closely. Year-to-date, mid-cap stocks have significantly outperformed smaller cap stocks. Mid-cap stocks benefited from a recovery in cyclical stocks, such as in the transportation and automotive, retail and construction sectors and thus retraced their second quarter underperformance. The rally in these counters was supported by the release of data pointing towards an impending end to the recession. What remains a concern to us are the rising unemployment levels in SA. While typically a lagging indicator, higher unemployment levels may have a negative impact on consumer spend, which could remain under pressure due to falling disposable income.

What we did
New holdings added to the portfolio included Country Bird, Mvelephanda Resources, Steinhoff, Spar and Metropolitan. These were financed by the complete sale of Sentula, ARB Holdings, Austro, JD Group and Shoprite. Our main reason for selling them was that their share prices reached or exceeded our assessment of fair value.

What added to - and detracted from - performance
The SIM Small Cap unit trust outperformed the JSE Mid and Small cap Index during the quarter. Our bigger exposure to cyclical industrial sectors and IT contributed meaningfully to the strong performance during the quarter. More specifically, our significant position in very cheap IT stocks added meaningful alpha on the back of good results. These include our investments in EOH, Gijima, Paracon and BCX. We bought these companies on very attractive valuations, with material upside to fair value at a time when not too many investors were focusing on this area. Our offshore investments also delivered very strong results despite these returns being negatively impacted by the stronger currency.

SIM strategy
The Price to Earnings multiple of the FTSE/JSESmall Cap Index is in line with its long term average of 12,5x and a 10% discount to the market (also inline with the LT average discount). Given that in aggregate small caps do not appear overly cheap, the emphasis on stock picking becomes more important. We believe there are some good opportunities amongst the smaller cap stocks with valuations well above current share prices. The risk now lies in the timing and magnitude of the earnings recovery. South Africans are now preparing for the world cup and there is little that we can see that could derail a return to growth in 2010 (certainly the rebuilding of the inventory cycle will provide a strong short term boost to GDP). The housing market is starting to stabilize, market breadth has not yet deepened (which would be indicative of a broad based bull market), and valuations are not close to the excessive levels we saw in 2007. We remain cautious given that share prices seem to have run ahead of economic recovery and will focus our attention on companies with an adequate margin of safety to our assessment of their fair value. The current upside to fair value of the portfolio is just below 40%.

Market review
The JSE continued its strong rally into the second quarter of 2009, with both mid- and small-cap shares outperforming the JSE All Share Index during the period. November 2007 marked the end of the small-cap bull cycle. Over the preceding five years the JSE Small Cap Index appreciated by 476% (or 41% annualised). Notwithstanding this significant outperformance, smallcap shares have surprisingly only underperformed the broader market by 7% since then. The Market Cap Weighted Index, however, does not give the complete picture, with over 60% of the stocks actually doing much worse than this. The same is true for the JSE Mid-cap |ndex. Many of the stocks that underperformed were in the building materials, mining or construction sectors, with the more defensive stocks, property and retail, doing much better than the average mid- and small-cap company.

What SIM did
Following a difficult first quarter, the second quarter of 2009 saw a return to favour of more cyclical stocks relative to defensive companies. This worked well for us because many of the mispriced opportunities in which we are invested are oversold cyclical shares. We continue to focus the portfolio on mispriced and better-quality businesses. To this end we have added to our positions in Mondi, Argent, Barloworld and Sun International. This was funded by the complete sale of numerous investments. Overall the portfolio is now invested in 47 companies, down from 62 at the beginning of 2009.

Performance review
The SIM Small Cap Unit Trust has underperformed the JSE Mid- and Small-cap Index for the year to date. The major detractors from performance were not our highest-conviction investments, as represented by the top 10 holdings, but rather in the tail of smaller investments. These were mostly cyclical companies, trading at deep discounts to intrinsic value but with lower liquidity and, in some cases, poorer business economics. The portfolio benefited strongly from the rerating of shares such as Stefanutti Stocks, Sentula, TWP, Adcorp and Mondi. However, our investments in Yorkcor and Argent detracted from performance. Both companies are experiencing very challenging trading circumstances.

SIM strategy
A major theme playing itself out is the reversion in profit growth to the long -term average. Many companies have already published very negative trading updates and more are expected. As the value of shares is dependent on future, and not past, cash flows, we need to focus more on the level of earnings risk. A simple analysis comparing the fall in earnings to previous cycles seems to indicate that we are closer to the bottom than the top. We continue to have very little invested in retail, property and the junior mining companies. We believe the property and retail stocks are not cheap, especially when compared to the universe of small- and mid-cap companies. The junior mining companies tend to be marginal producers, which often suffer from a shortage of capital, making them very difficult to value. While we may miss out on potential upside from these companies, we believe there are better ways to allocate our clients' capital. In absolute terms, the number of attractively priced opportunities is starting to increase, with almost two thirds (66%) of the companies now trading at price-earnings (PE) ratios below 10 compared with 80% of companies when the market bottomed in 2002. In relative terms, small-cap stocks are trading in line with the long-term average discount to the rest of the market and there appears to be very little difference in relative values compared with the bottom of the previous small-cap cycle.

Market Review
The first quarter of 2009 was characterised by ongoing extreme volatility in financial markets, both globally and locally. The macroeconomic operating environment continued to deteriorate for most South African companies. Small cap counters remained out of favour in the first quarter of this year, as the JSE Small Cap Index underperformed its mid- and large-cap counterparts, falling 7.6% over the period. A steady flow of profit warnings and weak financial results reflected the vulnerability of smaller companies in this challenging economic environment. Rotation out of small-cap exposure, forced selling and constrained liquidity further exacerbated the underperformance of small-cap shares. Within the small-cap space, there was clear support for high quality companies, with healthy balance sheets that delivered sustained earnings growth and provided a defense for investors against the current economic turmoil. Education, pharmaceuticals, gold and defensive foodservice counters, like Spur and Famous Brands, outperformed the small-cap universe and we also saw continued outperformance from some of the interest-rate sensitive areas of property and retail building material suppliers (the likes of Cashbuild and Iliad), as two interest rate cuts took place during the quarter. In contrast, small-cap sub-sectors that led the downside included construction, financials, IT, media and resources and we saw severe contractions in the share prices of highly indebted companies, where heightened market risk aversion to excessive gearing continues to increase at this delicate point in the cycle. The SIM Small Cap Fund experienced a difficult quarter, as attempts to reduce our exposures to certain sectors was constrained by a lack of liquidity in those counters. However, indiscriminate selling of high quality small-cap companies has allowed us to continue building selected positions at exceptional prices, with the combined upside to intrinsic value of the SIM Small Cap Fund holdings now approaching 100%.

Performance
The SIM Small Cap fund declined by 14.16% in the first quarter of 2009, underperforming the JSE Small and Mid Cap indices, which declined by just less than 8% and 6% respectively over the period. The average return for small-cap unit trusts was -12.4% for the first quarter of 2009. The top three performance detractors for the quarter were Afgri (-28%), York (-67%) and Pick 'n Pay (-18%). Afgri, which constitutes just less than 6% of the SIM Small Cap fund, remains one of our top holdings. It is not well understood by the market; it is geared to the agriculture sector, which remains healthy in contrast to the broader South African economy, and its investment case is underpinned by an exceptionally attractive valuation. Despite its weighting within the portfolio amounting to less than 2%, the severe decline in York Timber's share price detracted from the quarter's performance and was precipitated by a rapid decline in the company's operating environment and negative sentiment towards companies with high gearing. The extent of the share price drop was exacerbated by the limited liquidity of the share. York remains a long-term holding within the SIM Small Cap portfolio, with an exceptional forestry asset underpin and the recent share price move highlights an excellent mispricing opportunity by the market. On the positive side, stocks that contributed most materially to performance were Cipla Medpro (+50%), Northam (+25%) and Simmers (+29%). After an exceptional run in the share price, we sold out of Aspen and switched into Cipla late last year, which was offering much better upside to intrinsic value and this position has done very well for us (4% of the portfolio). Our increased gold exposure (through Simmers) also did well, as gold stocks in general delivered the best performance on the JSE in the first quarter of 2009.

Trades (top buys/sells)
During the quarter, the top three buys were Aveng, Barloworld and Imperial. All three have been sold off aggressively and we see attractive upside and compelling valuations now apparent in these shares. The selected counters are also highly geared to early signs of economic stabilisation and recovery. Our top three sells were Aspen, Group Five and Hospitality B. We switched our investment in Aspen into Cipla and both Group Five and Hospitality B were fully priced and were sold out completely from the portfolio.

Outlook and Strategy
The environment for small cap investing remains challenging, both from a macroeconomic perspective as well as from a liquidity perspective. 2009 will continue to be dogged by earnings disappointments as the excesses of the past work their way out. Short-term visibility is limited and management teams of the small- and mid-cap companies that we engage with on a daily basis are reticent to forecast the performance of their own businesses at this point in time. The current aversion to small-caps is offering some fantastic investment opportunities that meet our investment criteria. At the same time, we remain vigilant of managing liquidity risk, which is typically most prominent within the small-cap space at this point in the cycle and thus warrants increased consideration within our decision-making framework. On the positive side, the key drivers all seem to be moving on favor of smaller cap companies. These are declining inflation expectations, falling interest rates and a stable and improving currency. When combined, these factors are setting the scene for a recovery in growth in 2010, which generally tends to favor the smaller companies relative to their large-cap counterparts. Our pragmatic value investment philosophy positions us well, as our primary focus is not on forecasting next year's earnings, but rather on investing in small-cap companies that will better survive through this downward cycle; that generate high returns on invested capital and are trading at large discounts to our estimates of intrinsic value. The consistent application of this philosophy forms the backbone of our process and the ongoing development of our small-cap research capability through this tough environment is invaluable. On that note, I would like to welcome Shamier Khan to the small cap team. He is a CA(SA) and is also a CFA charter holder. He has nine years investment management experience and we look forward to his contribution going forward