Market review
After a fairly buoyant first quarter, the second quarter of 2012 was characterised by increased volatility, as the market dipped slightly in May, but stabilised thereafter. The JSE All Share Index rose by a muted 1% during the second quarter, bringing the year-to-date total return of the broader market to 7% as at the end of June 2012. From a size perspective, small- and mid-cap shares continued to marginally outperform during the second quarter. The JSE Small Cap Index returned 2%, while the JSE Mid-cap Index rose by 3%. The JSE Mid Cap Index has maintained its momentum relative to small- and large-cap shares; generating a 14% return for the first half of 2012 (the JSE Small Cap Index rose by 12% during the same period). Ongoing pressure on resource shares resulted in the JSE Top 40 Index returning a mere 0.6% for the second quarter, bringing the total return of the Top 40 Index for the first half of 2012 to 6%. The flight to relative 'safety' continues in the SA equity market. The share prices of industrial and financial companies that have predictable and defensive earnings streams have continued to rise. In contrast, the sentiment towards more volatile resource shares remains negative, as concerns about slower global economic growth; a slowdown in China and European Union financial woes dominate the global investment environment. At this stage, it would appear that the market has a limited appetite for shares that may appear attractively valued, but carry higher forecast and macro-economic risk (mining, manufacturing and construction). In contrast, the rating of most of the blue-chip industrial and financial companies reflects the premium that the market is prepared to pay for consistent dividends and earnings growth certainty and there is little value evident in these sectors of the market at this point in time.

Portfolio analysis
The SIM Small Cap Fund fell by 2% during the second quarter of 2012. During the quarter, stocks that added to performance included exposure to Distell (+20% for the quarter), Trencor (+12%) and Netcare (+12%). Detractors were Northam (-32%) and Kelly (-28%). From a trading perspective, Tsogo Sun Holdings and MMI Holdings were added as new positions within the fund.

Outlook
The SA economy's vulnerability to global macro developments is a key consideration and ongoing global financial woes highlighted above are likely to spill over into our domestic economy, retarding growth in the short term. A muted economic growth scenario is clear from two perspectives: on the production side of the economy, where a contraction in the manufacturing and mining sectors is evident, despite the relative weakness of the rand so far this year. Meanwhile, on the consumption side rand so far this year. Meanwhile, on the consumption side of the economy growth trends have definitely slowed down, yet remain fairly robust (vehicle sales and retail sales), but high consumer debt levels and a weak residential property market will continue to weigh on the wealth of consumers. A further interest rate cut is unlikely to provide much stimulation. All of these factors combined do suggest a scenario in which the domestic economy will 'chug along' in a lower GDP-growth mode, which does then imply a subdued outlook for SA equities. The small-cap sector is sensitive to local economic growth and while GDP growth is not an exciting catalyst in the short term, many of the smaller listed companies have been through a process of rationalisation and are well poised to grow their earnings in a more muted domestic demand environment. This is not yet being reflected in the valuations of many of the smaller companies' share prices and the market's general avoidance of 'out-of-favour' small cap shares at this point in the cycle continues to create opportunities for us. The SIM Small Cap Fund is philosophically managed with a value-bias. In line with our philosophy, we see considerably less value in mid-cap shares at this point in time, and have positioned the Fund to have exposure to small cap shares that we believe are undervalued and remain neglected by the market.

Market review
The first quarter of 2012 got off to a flying start, with the JSE All Share Index increasing by 8% between the end of 2011 and the beginning of February 2012. For the rest of the quarter, a sell off in the resource sector precipitated significant market volatility during March, resulting in a first quarter total return (including dividends) for the All Share Index of 7%. Small and mid-cap shares performed well during the period. The JSE Small Cap Index returned 10.4%, while the JSE Mid-cap Index also rallied by 10.6%. In contrast, given the significant weighting of resource shares, which fell by 3%, in the large cap universe, the JSE Top 40 Index rose by 5% during the first quarter of the year, underperforming the mid- and small-cap universes.

From a longer-term perspective, the rally in mid-caps that commenced in the beginning of 2008 and has seen the JSE Mid Cap Index outperforming the broader market and small caps for four years continued into the first quarter of 2012. The low weighting in resources and largely industrial, defensive core of this universe continues to drive its outperformance relative to other sectors in the market. However, it is clear that the mid-cap space is significantly more expensive than the rest of the market. The current trailing PE ratio of the JSE Mid Cap Index is 16 and is significantly above its long-term PE of 13 times. In contrast, small caps have underperformed the broader market and mid-cap universe for the past four years and the JSE Small Cap Index is trading on a trailing PE of 14 times, versus its long-term rating of 13 times. Portfolio analysis The SIM Small Cap Fund rose by 8% in the first quarter of 2012. During the quarter, stocks that added to performance included B&W Electrical and Instrumentation (+45% for the quarter), Barloworld (+33%), Clover (+26%), Argent (+25%) and WBHO (+24%). Detractors that underperformed the market included BCX (-16%) and Adcock Ingram (-5%). From a trading perspective, we bought Northam, Mvelaserve and Namibia Breweries and we continued to take profits on Barloworld.

Outlook
What we said last quarter remains relevant. The small cap sector has remained out of favour for a protracted period of time and shares here are at the bottom of their earnings cycles and are poised for a recovery. In contrast in the mid-cap space many of the companies that make up this universe have already experienced a recovery in their earnings, with construction the only lagging sector. In the small caps space, their lack of scale has meant these companies have had to adjust their businesses in the wake of a very weak demand environment and a lower level of economic activity relative to the boom times that were seen during the previous decade. After two to three years of declining earnings in the case of some companies, this process is largely complete. Small cap shares by nature are highly geared to the domestic economy. As the economic cycle gradually improves, the earnings of these companies will recover and this should facilitate an improvement in the rating of small cap shares after a very an improvement in the rating of small cap shares after a very difficult period. The SIM Small Cap Fund is well-positioned to benefit from this trend.

Given the fact that many small-cap companies are still at depressed points in their earnings cycle and are poised for a later -cycle recovery, it appears that the small-cap universe is offering more value relative to the rest of the market (large and mid caps). This fact is corroborated by our bottom-up fundamental research, where we continue to identify many interesting mispriced opportunities in the small-cap area of the market.

Market review
Despite ongoing concerns about European debt levels, a deceleration in China's growth and a general global economic slowdown, in true year-end style all equity markets other than Japan's Nikkei rallied during the last quarter of 2011. The JSE All Share Index rose by 8% during the final quarter, bringing the twelve-month total return of the market (including dividends) back into positive territory and ending the year up a fairly muted 2.6%. From a sector perspective, the final quarter's recovery was broadbased, with resources, financials and industrials all rallying higher.

Small-cap shares were the laggards of 2011, with the JSE Small Cap Index returning 1.1% for the full year and rising by 6.8% in the fourth quarter of 2011. Mid-cap shares, on the other hand, kept pace with the broader market in the fourth quarter, with the JSE Mid Cap Index adding 8% in the final quarter, bringing its fullyear total return to 4.7%. In essence, 2011 was a year in which the equity market's performance was driven by a combination of 'momentum' shares (i.e. the retailers) and defensive shares (healthcare, food retailers and producers, alcohol and insurance). What already appeared expensive in the beginning of 2011 simply got more expensive during the course of the year! In contrast, value stocks, with earnings cycles generally below normalised levels, struggled, and in many cases corporate earnings disappointed and struggled to gain traction in a weaker than anticipated economic backdrop. It is thus important for investors to be aware that different investment philosophies will produce different results and 2011 was a difficult year for a deep-value, contrarian investment philosophy.

What added to - and detracted from - performance
The SIM Small Cap Fund rose by 3.9% in the fourth quarter of 2011. During the quarter, stocks that added to performance included exposure to Pick 'n Pay Holdings (+26% for the quarter), Barloworld (+24%), City Lodge (+22%) and Spur (+21%). Detractors included B&W Electrical and Instrumentation Ltd (- 21%), CMH (-18%) and Phumelela (-15%).

B&W is a classic example of a deeply undervalued share at a cyclical low in its earnings cycle, exacerbated by a number of once-off contracts that extended significantly beyond their original scope and renegotiating them ate into earnings. Given these short-term developments, the current earnings base is depressed but in the longer term B&W remains a well-run, owner-managed business with a distinct niche and a strong competitive position.The company is trading significantly below its tangible net asset value, despite generating a normalised return on capital that should comfortably exceed its cost of capital.

These are the types of opportunities that we continue to mine in the small and mid-cap universe for (albeit that they tend to be more the domain of the under-researched small cap universe). Experience has shown that we are often a little early with these shares (as demonstrated by B&W above). However, liquidity is critical in the small cap space and generally a 'buying down' strategy is optimal if you want to build a stake and limit market impact in the process. The same applies with our selling strategy. From a trading perspective, the Fund sold its largest position, Paracon, due to corporate activity and the acquisition of Paracon by Adcorp. We received a combination of cash proceeds and Adcorp shares for this deal. New positions we added included WBHO Limited, Reunert and Sun International. Positions that were exited include Sovereign Food and Basil Read Holdings Ltd, as well as our stake in Textainer Group Holdings Ltd in the US. We repatriated funds raised in the latter sale as the rand weakened.

Outlook
The small cap sector has remained out of favour for a protracted period of time, exacerbated by liquidity constraints and heightened risk aversion. As the economic cycle gradually improves, small cap shares by nature are highly geared to this recovery and, while there is little evident value in the large and mid cap sectors of the market at present, small cap shares continue to offer fundamental value, as well as the prospect of further late-cycle earnings recovery after a very difficult period in the SA economy. Portfolio Manager BBusSc Honours, B. Com (Hons), CFA