Market Analysis
Global equity market turbulence that characterised the second quarter was exacerbated in the third quarter by debt woes plaguing Europe and the US; a steady flow of weak global economic data and some concerns about the sustainability of Chinese economic growth. Volatility remained the order of the day and it was not uncommon to see equity indices across the globe gaining 3% one day and then losing 3% the next! This has been the backdrop for most of 2011 so far, with the South African market similarly affected. One key development worth mentioning was the significant weakening in the rand towards the end of the period after a long period of sustained currency strength. While this brings with it potential inflationary risks, the weaker rand has been welcomed by many South African companies, most notably those involved in the manufacturing sector. From an equity market perspective, the third quarter of 2011 saw the JSE All Share Index losing 5.8% for the quarter, with the index now in negative territory year-to-date, down 5.4% as at end -September 2011. In a continuation of the second quarter's trend, the drop in the market was largely driven by a continued sell off in resource shares, with both financial and industrial shares losing considerably less ground. Once again, the limited exposure to resources and concentration in industrial shares that typically characterise the small- and mid-cap sectors of the market resulted in the continued outperformance of both indices relative to the broader market, with the JSE Small Cap Index falling 2% in the third quarter and the JSE Mid Cap Index losing 2.3%. Year-todate, the JSE Small Cap index is now down 5.3%, while the JSE Mid-cap Index 3.5% lower.

Portfolio Analysis
The SIM Small Cap Fund had a difficult quarter and lost 6.1%. It is worth mentioning that quarterly performance is inclined to be volatile, as has been the case year to date, where the Fund rose significantly ahead of the market in the second quarter. As portfolio managers of the Fund, we do report back to clients quarterly, but we are not concerned by short-term volatility, as our main focus is on positioning the Fund with a medium to longer term investment horizon in mind so that we generate sustainable returns over the longer run. Many of the positions in the Fund that declined significantly in the third quarter were selected on the basis that they adhered to our investment philosophy and were priced below intrinsic value at the point that we invested. This contrarian positioning may take time to pay off, with room for short-term underperformance. The cycle has demonstrated many times that what is out of favour can stay out of favour for a protracted period and vice versa for stocks that appear expensive and remain expensive. We believe that we have positioned the Fund to realise significant outperformance longer term and we will stick to our investment philosophy of investing in companies that are performing below their normalised potential and are priced accordingly, offering material upside when they do normalise. During the quarter, stocks that added to performance included Gijima (+12% for the quarter), Cashbuild (+9%) and BCX (+8%). Detractors included EsorFranki (-24%), Iliad (-21%) and Sovereign (-19%). Both Iliad and EsorFranki are examples of shares that are trading below book value and are at a low point in their respective earnings cycles. Iliad is undergoing a significant their respective earnings cycles. Iliad is undergoing a significant restructuring and has closed various stores within its retail portfolio, while construction counter EsorFranki has loss-making contracts and an extremely weak trading environment to contend with at present. Both of these companies appear to be pricing in the prospect of bankruptcy, but our analysis indicates that they should survive and once the prospect of earnings recovery is absorbed by the market, both counters offer significant upside value. From a trading perspective, the one significant change within the SIM Small Cap Fund during the third quarter was the repatriation of the Fund's SIM Global Best Ideas Fund offshore holding. In light of recent rand weakness and the opportunities that we continue to find in the South African market, we decided to redeploy those funds locally into domestic holdings.

Outlook
While the local economic backdrop remains weak and of concern, a weaker rand introduces a whole new set of influences to the economy and the local equity market. Despite being at the bottom of the current interest rate cycle, with the next move likely to be an increase, it is interesting that many interest rate-sensitive shares have continued to outperform the broader market, such as the South African discretionary retailers. We regard this sector of the market as expensive and cannot justify buying these stocks in light of our disciplined application of our investment philosophy. These shares comprise a significant portion of the small and midcap universe, so we will continue to feel some element of relative performance pressure by not owning these shares. However, we are comfortable with this and are looking for alpha opportunities in more reasonably-priced segments of the market.

Market Analysis
It has been a turbulent year so far indeed! While the first quarter was characterised by volatile extraneous geopolitical events and natural disasters, the second quarter of 2011 was characterised by choppy global equity markets, plagued by concerns about slowing Chinese economic growth and a European debt crisis in Greece. Compared to the first quarter of 2011, we have seen more and more down days across key equity markets, although the actual underlying trend is difficult to discern.

The local equity market has been similarly characterised by volatility. Despite reports that show there's a clear economic recovery underway, certain sectors of the economy have remained under pressure, such as the manufacturing sector, displaying at best anaemic growth. At the same time, rising inflation and the potential for interest rate hikes remain a concern to local equity investors. The second quarter of 2011 saw the JSE All Share Index slipping 0.6%, with the Index now showing a paltry gain of 0.5% for the first half of the year. In contrast to the first quarter, the drop in the broader market was primarily driven by a selloff in resource shares, with the JSE Resource Index losing 6% in the second quarter. While financial shares were largely flat, industrial shares supported the market, as demonstrated by the JSE Industrial Index, which gained a healthy 4%. The limited exposure to resources and concentration in industrial shares that typically characterises the small and mid cap sectors of the market resulted in the outperformance of both indices relative to the broader market. The JSE Small Cap Index returned 2% in the second quarter and the JSE Mid Cap Index 3%. This was in sharp contrast to the first quarter, when small- and mid-cap shares dropped materially more than their large cap counterparts.

Portfolio Analysis
The SIM Small Cap Fund enjoyed a rebound during the second quarter of 2011, returning 4.6% for the quarter and outperforming both the Small and Mid-cap Indices as well as the median smallcap fund peer return of 2.8%. The Fund benefited from the strong returns delivered by Country Bird (up 30% for the second quarter), EsorFranki (+30%), Paracon (+29%), Digicore (+27%), Stefanutti-Stocks (+21%) and Basil Read (+18%). Positions that detracted from performance were Raubex (-14%) and Gijima (-13%). In the case of Gijima, the company's share price continued to be adversely affected by uncertainties related to the resolution of their contract with the Department of Home Affairs. We believe a worst case scenario has been priced into the share and thus that the counter offers significant upside at these levels when earnings normalise because it is not a permanent issue for the company.

In last quarter's feedback we noted that we had started building positions in the small cap construction sector during the latter part of 2010 and going into 2011; positions that detracted from first quarter performance (Raubex, EsorFranki, Basil Read and Stefanutti). With the exception of Raubex, each of these positions contributed materially to the Fund's positive returns during the second quarter and we continue to see significant value in this sector of the market. In the case of Raubex, we added to the position as the price weakened further, and we see this as a small cap construction share that offers significant upside potential for patient investors with a longer investment horizon, given the SA government's massive road-spend agenda.

Major purchases during the quarter included Pick n Pay Holdings, Cashbuild, Net-1 UEPS Technologies and Coal of Africa. New positions that were introduced during the quarter were Pick n Pay Holdings and Coal of Africa. Pick n Pay has been very weak and offers decent value over a longer term investment horizon, given the structural changes that are being made within that business. Major sales during the second quarter included taking some further profits from Barloworld, Nampak and Supergroup, with none of these being sold out of the portfolio yet.

Outlook
Despite volatility and some pullbacks in small bursts, equity markets have largely held up, keeping valuations at higher levels. What is concerning is that a relatively pedestrian local economic recovery continues to unfold. If market expectations do not materialise, we could see downside pressure on equity markets and, given this backdrop, we are increasingly positioning the SIM Small Cap Fund more defensively, migrating towards quality small - and mid-cap shares, where we have a higher degree of earnings visibility and confidence in the strong business economics of the investments we are making. Where we are considering investments with weaker business fundamentals, we require a significant margin of safety. We are finding these opportunities and, more importantly within the small and mid-cap universes, we are finding more opportunities than those offered by many of the large cap shares. Hence we feel confident that our Fund is wellpositioned to capitalise on these returns, while at the same time protecting our clients' capital.

Market review
After strong gains during the last quarter of 2010 amid signs that a global recovery was starting to gain traction, volatility took hold again when global events of a geopolitical and non-geopolitical nature (Middle East uprisings and the Japanese earthquake) introduced a significant amount of uncertainty in the minds of investors. This poured cold water on the market's optimism and thus the SA equity market treaded water during the first quarter of 2011. Within this environment, and as is often the case during periods of heightened uncertainty, small- and mid-cap sector returns were significantly weaker than those achieved by the broader market (-6%; -6% vs. -0.3%) as the market favored the safety offered by larger companies. The underperformance of the small-cap sector in particular during the quarter should be seen in conjunction with the very strong outperformance achieved during the fourth quarter of 2010, when the Small Cap Index returned 11.3%. During the first quarter, a fair amount of this past outperformance was given back.

Portfolio Analysis
The SIM Small Cap Fund returned -7.4% during the first quarter of 2011 as the fund's small-cap exposure, in particular, detracted from performance and the strong rand weighed on the fund's offshore exposure.

The fund's positions in Bowler Metcalf (+12%), Barloworld (+11.5%) and Country Bird (+7%) added value during the period. Fund returns were negatively impacted by weak performance from Iliad (-38%), which gave back a significant portion of the +62% return it delivered in the fourth quarter of 2010. We started building positions in the small-cap construction sector and although these positions have detracted from performance in the short term (Raubex, EsorFranki, Basil Read and Stefanutti), we remain confident that increasing value is becoming evident in this sector and significant rewards are likely to be achieved by the patient investor. Within the IT sector, positions in BCX and Gijima also detracted from performance during the quarter due to timing issues in earnings recognition in BCX's case and one-off costs associated with the resolution of Gijima's home affairs contract negatively impacting their ratings. We remain confident that earnings will normalise as these are not permanent issues.

Major purchases during the quarter included B&W Electrical, Adcock Ingram, Raubex and City Lodge. As discussed earlier, we have been building positions in B&W Electrical and Raubex at favourable prices, as the weakness in the construction and related sectors weighs on investor sentiment.

Major sales during the fourth quarter included taking some profits from Barloworld, Pioneer Foods, Coronation and Cipla Medpro. We have been using these proceeds to fund investments in businesses whose valuations are becoming ever more attractive due to share price weakness.

Outlook
As long as volatility and uncertainly prevails in the market, the short-term outlook for small caps will remain uncertain. Investors in the fund should take comfort that any past or future negative volatility in the sector relative to the broader market only serves to reduce the risk for the long-term small cap investor because we are presented with opportunities to buy businesses at attractive valuations, while funding these purchases from sales of positions that have reached levels closer to our assessment of fair value. Together this enhances potential available long-term returns in the Fund.

Market review

Equity markets experienced a notable rally in the final quarter of 2010, ending the year on a high note, with the JSE All Share Index returning 9.5% (19% for the full year) and closing near the previous all-time record levels achieved in May 2008. A clear rotation into small caps was evident in the final quarter of last year, as the J202 Small Cap Index delivered a return of 11.3%, while the broader market returned 9.5% and the J201 Mid Cap Index lagged, with a return of 6.6% during the period. This was in sharp contrast to the first three quarters of 2010, which saw midcap stocks leading the market aggressively, led primarily by the exceptional performance of food and clothing retailers and cyclical industrial stocks, Imperial, Barloworld and Nampak.

What added to - and detracted from - performance

The SIM Small Cap Fund generated a return of 11.3% in the final quarter of 2010 and 26.6% for the full year ending December 31, 2010, slightly ahead of the average small-cap unit trust peer return of 25.6% for 2010 (source: S&P Micropal). Returns were boosted by strong performance from key investment positions in Iliad (+62% for the quarter), Barloworld (+43%), Supergroup (+41%) and Sovereign (+29%). Both Sovereign and Supergroup were new positions, added after their respective share prices reflected severe pessimismby themarket despite the stabilisation of their respective capital structures. This is complete in the case of Supergroup and currently underway for Sovereign. Detractors from performance in the final quarter included Kelly (- 17%), Gijima (-9%) and Digicore (-9%), although these positions remain relatively small in the broader portfolio.

What SIM did

While we continued to focus on concentrating existing positions, major purchases during the quarter included Digicore Holdings, Mobile Industries, Grand Parade Investments and Pick n Pay Holdings. Digicore and Grand Parade are new positions in the fund. We bought Pick 'n Pay Holdings as part of our decision to restructure of our food retail position by switching out of our Spar Holding position after Spar's significant outperformance during the course of last year. Major sales for the fourth quarter included selling out of Reunert (which we partially consolidated into our Altron position) and Spar (as indicated above), while we took some profits on Cipla Medpro, effectively reducing our exposure there into significant price strength, but we did not sell out of this counter completely. Another noteworthy portfolio change during the quarter was to increase our offshore exposure as the rand strengthened below R7 to the US dollar. We purchased Net-1 UEPS (listed on the Nasdaq) with the dollar proceeds.

Outlook
The continued run in equities during the course of 2010 highlights the market's expectation of a healthy earnings growth trajectory going into 2011 against a decent fundamental backdrop. A recovery in manufacturing and rising employment would be needed to justify this expectation and clear evidence of this is yet to be seen. So we remain somewhat cautious about equity market prospects going into 2011.

The outperformance of small caps seen in the final quarter of last year reflects an investor shift towards an area of the market that we previously indicated offered decent opportunities. These remain available, despite some of our key positions realising generous returns over the past year and moving somewhat closer to our assessment of fair value (such as Cipla Medpro, Afgri, Zeder and Spur).

We will maintain a balance between high quality counters that will consistently grow their net asset value and offer a degree of earnings visibility, with sustainable and proven business models, as well as selected positions in stocks that have underperformed during 2010, but offer value based on our measure of normalised earnings.