Market Comment

As foreign capital continued to flow into emerging markets during the third quarter of 2010, domestic equities, and particularly the early cycle domestic cyclical companies typically favored by offshore investors, continued to outperform. Within our mid- and small-cap investment universe, the retail sector was a significant beneficiary of these offshore equity flows, with the general retail index up 20% for the quarter versus the 13% increase in the broader market and mid-cap shares, while the small-cap index returned 10%.

In line with this theme, the industrial sector, which was driven by the retail, outperformed the financial and resource sectors handsomely (18.5% versus , 13.8% and 7.6% respectively). Small caps have not been a significant beneficiary of these offshore flows. However, as domestic cyclical companies, such as the retailers, extend their recent gains, so the relative attractiveness of shares in the small cap sector of the market will continue to improve.

What SIM did
The SIM Small Cap fund delivered a 7.5% return during the third quarter of 2010. A number of our high conviction ideas performed very well over the period, for instance the Fund's largest local holding, Cipla, gained an impressive 35% for the quarter. Positive contributions were also provided by Coronation (35%), EOH (26%), Combined Motor Holdings (25%) and Spar (16%).

The biggest detractors from performance during the quarter were Rare Holding (-32%), Esor Franki (-28%) and Sovereign Foods (- 20%). In most cases we have been using the weakness as an opportunity to establish or increase existing positions.

There were no major changes from a sector perceptive, except to highlight that our significant underweight to the retail sector detracted from relative performance versus the benchmark. Additionally, we reduced our large IT sector overweight slightly as the upside to fair value available across the sector no longer warranted the size of the investment. Our offshore exposure through SIM Global Best Ideas Fund held its own despite a very strong rand (+1%). We continuously engage with our SIMGlobal team to ensure that our investment in their Fund offers value especially when compared to the local investable universe. They continue to find attractive investment opportunities in offshore markets and we thus have increased our position in the fund slightly.

Outlook
With the drivers of positive small cap performance pointing in the right direction, namely positive GDP growth and a low interest rate environment, historic evidence suggests the outlook for the sector should improve. In line with the broader economic trend, in many cases share prices are already factoring in a positive earnings recovery. In spite of this, we are seeing more attractive valuation opportunities in the small- and mid-cap sectors when compared with the broader market. A bottom-up analysis of the fund's upside to our internal assessment intrinsic value at quarter end was 31% versus the 2% downside of the broader local market. This highlights the relative attractiveness of the local small- and midcap universe for investors with a long-term time horizon.

Market review
Global and local equity markets had a turbulent second quarter, with the MSCI World Index slumping 13% during the period and South African equities following suit and losing 8% during the quarter. While both resources and financials were put under significant pressure during the second quarter (falling 12% and 9% respectively), industrial stocks proved most resilient (down 5%). Given their dominance in the mid-cap universe, this supported theMid Cap Index, which contracted by a mere 0.7% in the second quarter of 2010. The Small Cap Index, which lost 3.6% in the second quarter, continued to underperform mid-caps, but proved to be a safer place than the broader market. Small-caps have significantly outperformed large-caps so far in 2010, as demonstrated by a 1.7% increase in the Small Cap Index during the first half of the year versus a 6% decline in the Top 40 Index. Mid-caps have continued to deliver superb performance, gaining 8% during the first half of this year.

What SIM did
Key purchases we made during the quarter were limited to raising the level of concentration in the portfolio and increasing our higher conviction bets. We exited certain positions and took profits where stocks had reached their fair value, such as Highveld Steel, Nuworld Holdings and Pick 'n Pay Stores.

What added to - and detracted from - performance
While more heavily weighted towards small-cap stocks, the SIM Small Cap Unit Trust delivered reasonable performance in the second quarter of 2010, contracting by 1.3% over the period. A number of our high conviction ideas delivered strong returns during the period, such as Mustek (+37%), Phumelela (+12%), Coronation (+12%), Argent (+8%), Nampak (+8%) and CMH (+7%).

Key detractors for the quarter were Gijima (-27%), Barloworld (- 17%) and Mondi PLC (-15%). Gijima's share price declined as a result of a dispute over a key contract, which has now largely been resolved. The market's overreaction presented a decent buying opportunity and we took advantage of this. In the case of Barloworld and Mondi, we maintain our positive long-term investment view of both counters and thus increased our holdings when prices were weak. From a sector perspective, our limited exposure to small-cap mining stocks protected our returns, given the significant decline seen in these shares during the quarter (Merafe: -24%; Wesizwe: -23%; Sentula: -20%; Simmers: -19%). From a mid-cap perspective, it paid off not holding the larger construction counters such as Raubex (-19%), Murray & Roberts (-11%) and Aveng (- 9%) and rather owning selected smaller constructionshares, such as Stefanutti & Stock (flat for the period), which are trading at more compelling valuations and added value during the second quarter.

On the negative side, our lack of exposure to retailers continued to hurt us in the short term, with some of these stocks in the mid cap space continuing to generate solid returns during the second quarter in response to excellent financial results notwithstanding a weak operating environment (Clicks: +14%; Mr. Price: +12%). We remain comfortable with our view that the valuations of these counters are fair and there is not significant upside potential at these levels.

Outlook

The recovery in corporate earnings priced into shares has started to materialise, as many companies have effectively rationalised their cost bases and, in this scenario, earnings are recovering even in a muted revenue growth environment. We remain concerned about revenue growth in the short- to medium-term, as many company management teams continue to express concern about not seeing any major recovery in demand for their products or services. Nevertheless, with the exception of the retail sector, in most sectors of the economy earnings have normalised back to a more sustainable base off which to grow and, while this theme is largely priced in across the board, through careful research we continue to find opportunities where valuations are disconnected from company prospects.

Our emphasis is on investing in companies that have a clear competitive advantage; an attractive cash flow profile; strong management experience and track record; operate in a sustainable economic space with limited risk from a debt perspective. Across the SIM research platform the small-cap universe continues to offer more mispriced opportunities relative to large-cap counters and our research remains focused on identifying these opportunities.

Market Comment

Risk aversion continued to wane as consumer and investor confidence improved on the back of positive economic data during the first quarter. As in the previous quarter, the mid- and small-cap indices, which typically lag the broader market during periods of heightened risk aversion, outperformed the All Share Index (Mid Cap +7.7%; Small Cap + 5.5% ; All Share +3%) again.Within this context, financials and industrials, which lagged the recovery of the resource counters in the previous quarter, made up some lost ground.

With the general improvement in consumer confidence, the returns delivered by the retail sector were particularly strong, with investors anticipating an improvement in discretionary consumer spending and company earnings. During the quarter some of the cyclical industrial and financial counters (e.g. Mondi, Metropolitan and Nampak) performed well, as well as some of the small-cap counters that posted decent results during the economic downturn (such as Spur, Advtech, Gijima and EOH). Following on this theme, it was pleasing to see the information technology (IT) sector, in which we have a meaningful investment, post solid operational results during the period. Sectors that lagged on a relative basis during the first quarter were the healthcare providers, construction and the life assurance sectors.

What added to - detracted from - performance

Good quarterly returns from a number of our higher conviction ideas, such as Mondi (+29%), Gijima (+25%), Nampak (+18%), Cipla (+18%), EOH (+16%), and Advtech (15%), managed to shield us from the relative underperformance we would have experienced as a result of our retail underweight. Additionally, our higher exposure to industrials and financials (relative to resources) clawed back some of the relative sector underperformance that we experienced during the last quarter of 2009.

Phumelela, Country Bird & Iliad detracted from short-term performance. In the case of Iliad & Phumelela, we remain confident of the long term prospects for both these counters and believe decent returns will be delivered to the patient investor as earnings normalise from current depressed levels.

The largest fund holding, our position in the SIM Global Best Ideas fund, continued to perform exceptionally well (+5.4%); particularly in the face of a persistently strong rand.

What SIM did

We added fewer new holdings during the first quarter as we focused on adding to existing positions in higher conviction ideas. The biggest additions were to our positions in Highveld, Bowler Metcalf and Super Group. A new holding in Metorex was added during the quarter.

We funded these incremental increases through a partial reduction of our offshore equity position (although it remains our single largest holding). We also took advantage of the strong retail sector's performance to reduce our position in Woolworths. Similarly we took some profits from our large Imperial and Mvela Resources overweights following their strong share price rerating. We exited positions in Simeka Business Group, Pick 'n Pay and CIC Holdings.

SIM Strategy

It appears that most of the balance sheet and liquidity risks that were concerning investors have now been addressed by management, either through rights issues or aggressive preemptive and reactive cost cutting programs. Now that the 'low hanging fruit' has been harvested through these cost cutting exercises (which are generally of a one off nature), future earnings growth is going to depend heavily on a company's ability to regain momentum in their top line revenues.

It is interesting to note that while share prices have significantly rerated in anticipation of future earnings growth and recovery, management teams as a collective are generally painting a more sober picture of the short- to medium-term earnings outlook. Company management consensus appears to be that while declining sales and earnings have come to an end, aggressive growth off this base will prove challenging.

In light of this, we retain our preference for being exposed to quality businesses in which we have a high level of confidence in future earnings, cash flow and company management. In addition to this core portfolio, however, we will continue to exploit mispricing opportunities that present themselves as a result of our broad and detailed coverage of the small-cap universe.

Market Comments
The final quarter of 2009 contrasted with the preceding two quarters of 2009, with resource shares leading the JSE All Share index higher, gaining 16% during the period, and industrial and financial shares lagging behind. Small- (up 6%) and mid-cap (5%) shares notably underperformed the broader market in the last quarter. While small- and mid-cap resource stocks did rally in the final quarter of last year, their relatively smaller sector contribution to the universe contributed to the underperformance of the broader universe of small- and mid-sized stocks relative to the overall market. The weak performance of discretionary retail, property and construction shares, which are significant in the small and mid-cap universe, exacerbated the underperformance for the quarter. Following the conclusion of a number of rights issues and weak earnings reported during the quarter, risk aversion in the market appeared to abate somewhat. This was reflected in the better performance of riskier smallcap stocks, such as Super Group, Sentula and Metorex, as a result of their more stable balance sheets and the prospect of earnings recovery ahead. Despite the deceleration at this end of the market during the final quarter, mid-cap stocks kept pace with the broader market for the full year. Smallcap stocks, however, lagged the rest of the market, with the Small-Cap Index gaining 28% in 2009 versus the 36% delivered by both the Mid-Cap Index and the JSE All Share index.

Portfolio
The SIMSmallCap Unit Trust performed in line with the Small-Cap Index and slightly outperformed the Mid-Cap Index in the fourth quarter. While our underweight exposure to resource shares detracted from performance, the fund's lack of exposure to property, retail and construction shares shielded the portfolio from the weak performance of these sectors. Positive contributors to performance were our overweight positions in IT/technology shares (EOH, Business Connexion, Gijima) and the food and drug retailers (Spar, Woolworths, Cipla Medpro), as well as selective exposure to cyclical, interest rate-sensitive stocks that delivered strong returns (Imperial, Iliad, Combined Motor Holdings, etc). The fund's offshore equity investments also performed exceptionally well in the face of sustained rand strength last year. New holdings added to the portfolio during the quarter included Peregrine, Ceramic Industries, Bowler Metcalf, Super Group, Nuworld and Paracon. These purchases were funded from the sale of Sanyati, CICHoldings, Mix Telematics and Mvela Group. Further additions were made to Kagiso Media, Phumelelaand Hudaco, while some profits were taken from Cipla Medpro, Spar and Advtech.

Outlook
The strong recovery in the equity market in 2009 is clearly pricing in an economic recovery after last year's recessionary conditions. Question marks remain, however, around the high levels of unemployment and consumer debt because these pose an ongoing risk to consumer demand. After an unprecedented collapse in 2009, a recovery in the manufacturing sector is now underway. This development, in conjunction with contained inflation and a stable rand, bodes well for smaller capitalisation stocks. It is evident that a number of shares within the small and mid-cap universe rerated during the course of 2009. However, we continue to find opportunities where earnings are recovering and valuations are attractive. In this environment stock picking is key and thus we continue to conduct detailed research so that we can identify those opportunities that offer value.