Market review

After a fairly weak performance in the second quarter, the third quarter of 2013 saw a strong rebound in the SA equity market. The JSE All Share Index rose by 12.5% for the quarter, bringing the year-to-date total return (including dividends) of the broader market to 15% by the end of September. The rally was broadbased, as we saw financials, industrials and resources all gaining ground. The JSE Resource Index rebounded most sharply, rising by 19% during the third quarter, reversing previous losses and leaving the Resource Index flat year-to-date - a marked turnaround in just one quarter.

In contrast, SA economic data releases were volatile, with GDP growth expected to remain muted and depressed for this year, driven by weaker manufacturing and consumption dynamics. Nevertheless, the appetite for emerging markets clearly remains a core theme in global investing, contributing to the returns that we are seeing in our market.

Turning to small-cap shares, we saw the JSE Small Cap Index continue its strong performance so far this year into the third quarter of 2013. The Small Cap Index returned 12% for the third quarter, bringing the year-to-date total return of this area of the market to a very strong 22%. The JSE Mid Cap Index saw a small rebound, rising by 5%, but it continued to underperform the rest of the market.

The continued strength in small-cap shares coincided with the release of a number of buoyant results from various small-caps for the financial periods ending June and July. These included Spur, Super Group, JSE, EOH, Sibanye Gold, Eqstra, City Lodge, Group Five, Pan African Resources and Mpact, to mention but a few.

Portfolio analysis

The SIM Small Cap Unit Trust generated a total return of 7% during the third quarter of 2013. This was 1% ahead of the Fund's benchmark (a market-cap weighted Index based on the FTSE/JSE Mid Cap and FTSE/JSE Small Cap Indices), which returned 6% for the quarter.

For the year-to-date, as at end-September 2013, the SIM Small Cap Unit Trust was outperforming its benchmark by 4% after generating a total return of 14% for the first three quarters of 2013 compared with the benchmark's 10%.

The top five shares in the portfolio that contributed most to performance for the third quarter of 2013 were Adapt IT (generating a 75% total return for the quarter), Zeder (+18%), EsorFranki (+29%), Spur (+15%) and Adcorp (+12%). Spur and Adapt IT both produced superb results for the financial periods ending June 2013 during the third quarter. The five biggest detractors were B&W Electrical and Instrumentation (lost 48% for the quarter), Advtech (-5%), Astrapak (-19%), Country Bird Holdings (-13%) and Tsogo Sun Holdings (-3%).

It must be reiterated that in the case of Advtech and Tsogo Sun Holdings, which both feature in the top 10 holdings of the portfolio, the prospects for both businesses remain sound and intact and thus there has been no deterioration in their investment cases. As such, they remain core holdings in the Fund. In the case of BWI, Astrapak and Country Bird, these shares represent case of BWI, Astrapak and Country Bird, these shares represent deeply under-valued, out-of-favour small-cap shares that are all at extremely difficult points in their respective earnings cycles and we believe that these shares offer significant upside potential as they recover over the short to medium term.

New positions added to the portfolio during the third quarter include Sappi, Telkom and Grand Parade Investments. We exited our holding in Net-1 UEPS, which we held offshore (listed on the Nasdaq stock exchange). This trade was on the back of a sharp rise in that share price as well as a coincident weakening in the rand, resulting in us realising our fair value and repatriating the funds back to SA.

Outlook

The third quarter saw an increase in risk appetite, as resource shares rebounded aggressively. Simultaneously, the expensive defensive industrial and financial shares continued to outperform.

We reiterate that this more momentum-driven market environment constrains our ability to identify new stock ideas that fall within the parameters of our value-based investment philosophy, as many shares in the SA market are expensive and offer no value. Given the underperformance that we've seen in certain areas of the mid-cap space, we have identified some new opportunities that offer value and have accordingly rotated some of our portfolio into those shares that we believe are congruent with our investment philosophy (Telkom and Sappi as highlighted in the portfolio analysis above).

The SIM Small Cap Unit Trust remains biased towards small-cap shares within the portfolio. While many of the larger, more liquid small-cap shares have outperformed as they've reported much stronger earnings and have enjoyed a late-cycle run on the back of that industrial/financial theme highlighted above, we still see more opportunities in some of the smaller small-cap shares, where some decent bargains can still be picked up.

We believe that the small-cap shares we have picked offer much more value and significant upside when the fundamentals of these companies improve over time through normal business cycle trends. Typically the prices of these shares are reflecting their current depressed earnings into perpetuity, which is not realistic and ultimately offers us the opportunity to outperform. Astrapak, Country Bird and Iliad are all shares that hold these characteristics. At the same time, we remain cognisant of risk and our research process ensures that we are constantly as close to our respective investments as possible, to avoid any prospect of permanent capital loss.

Market review

We've reached the middle of 2013 and, reflecting back, we can see that volatility has dominated trading during the second quarter of 2013. After selling off in early April, the JSE All Share Index rallied in May, followed by another correction downwards in June. The trading patterns of the market in June were characterised by sharp moves both up and down, as investors battled with mixed global and domestic economic data; bouts of labour instability in the SA resource sector; a sharp correction in bond yields and a volatile, but generally weaker, rand. The net result was that the JSE All Share Index fell 0.2% in the second quarter of 2013, bringing the Index's total return to 2.3% year-todate as at end-June 2013. From a size perspective, small caps continued to outperform during the second quarter. The JSE Small Cap Index generated a total positive return of 0.4%, ahead of the JSE Mid-cap Index, which delivered a negative return (including dividends) of -1% during this period. Year to date, the JSE Small Cap Index is up a healthy 9%, while the JSE Mid Cap Index generated a total return of 2% for the first half of this year to end-June. Top 40 large-cap shares performed in line with mid-cap shares - the JSE Top 40 Index was virtually flat, falling a mere 0.2% during the second quarter, bringing the total return of the Top 40 Index for the first half of 2013 to 2%.

A new phenomenon that occurred in the market during the second quarter of 2013 was a sharp sell off in the listed property sector for the first time in a long while. This would have influenced the performance of both the small- and mid-cap universes, where property stocks are a material component of both indices. In line with the sharp correction in bonds that transpired between May and June, a rise in domestic bond yields from 40-year historical lows coincided with a marked sell off in property stocks. The JSE Property Index peaked towards the latter part of May and subsequently experienced a sharp contraction, with the Property Index falling 9% between May 20 and the end of June 2013.

Portfolio analysis

The SIM Small Cap Fund generated a total return of 1.2% during the second quarter. This was 1.8% ahead of the Fund's benchmark (Market-cap weighted Index, using FTSE/JSE Mid Cap and FTSE/JSE Small Cap Indices), which fell 0.5% during the quarter. For the year-to-date, the Fund was outperforming its benchmark by 3.3%, generating a return of 6.3% for the first half of 2013 compared with the benchmark's 3%. The top five shares that added most to performance during the second quarter included Raubex (generating a 14% total return for the quarter), Zeder (+8%), Torre Holdings (+33%), Distell (+10%) and Netcare (+16%). The largest five detractors from performance were Afrocentric (lost 15% for the quarter), Spur (-7%), Basil Read (-3%), Iliad (- 14%) and Northam (-19%). Despite the underperformance of Spur during the quarter, this remains a core holding in the Fund and the long-term fundamental prospects of the investment case remain intact.

Outlook

The volatility in equity markets creates a challenging environment to navigate. The dichotomy between the returns of defensive industrials/financials and that of risky resource shares demonstrates that investors remain fixated on more defensive, predictable assets that are growing earnings ahead of the market. This is placing a significant premium on these shares and leaving little value to be found for an investor with a value-based investment philosophy. We continue to strictly focus on investing within the parameters of our investment philosophy and the SIM Small Cap Fund has performed well on days when the market has sold off aggressively during the past quarter. This highlights our emphasis on protecting the returns of our unit holders and reflecting our adherence to our philosophy to not overpay for investments that we believe are not congruent with a value-based investment philosophy that can ultimately result in permanent capital loss.

The Fund has a number of positions within the portfolio that have remained neglected by the market and offer decent turnaround prospects that should provide attractive returns into the future. Many of these companies have survived a very difficult economic environment for smaller companies and are at the bottom of their earnings cycles, with lots of bad news in their share prices, thus offering attractive price entry points for us as investors. These investments are poised to recover under improved operating conditions and the Fund is well-positioned to reap the rewards of those returns on behalf of our unit holders.