UK Equity Smaller Companies Fund I Monthly Report

February 2008

UK Equity Smaller Companies Fund I Quarterly Report

March 2013

0%

10%

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30%

40%

Month 3 Months YTD 1 Year 3 Years (pa) 5 Years (pa) Since Launch (pa)

Fund Aim

The investment objective of the Fund is to achieve capital growth through investing in a

portfolio of investments which shall primarily consist of UK equities which reside in the

bottom 10% of the UK stock market in terms of market capitalisation.

Performance to 31 March 2013

Source: River and Mercantile Asset Management LLP

*Index: Numis Smaller Companies ex IT

¹Performance calculated on a mid to mid basis at close of business, net of annual management charge

²Inception 30 November 2006³Previously Institutional “Z” Class Shares. Renamed on 16/07/2012.

River and MercantileMarch 2013

UK Equity Smaller Companies Fund – Quarterly Report

Portfolio Summary Risk Analysis Summary

Retail “A” Class Shares Fund¹ Numis Smaller Co’s Index* Difference FTSE Small Cap

(ex IT)

Inst’l “B” Class Shares³ Fund¹Numis Smaller

Co’s Index* Difference FTSE Small Cap

(ex IT)

²

1

R&M UK Equity Smaller Companies Fund „A‟ Shares

R&M UK Equity Smaller Companies Fund „B‟ Shares

Numis Smaller Companies (Ex IT)

FTSE Small Cap (Ex IT)

Strategy AUM £35.6m Portfolio Beta 0.82

Strategy Capacity £400m Tracking Error 4.69 %

Number of stocks 60 Active Money 83.91 %

Largest Holding Optimal Payments 2.36 %

Month 1.06% 1.85% -0.79% 2.07%

Quarter 13.30% 12.29% 1.01% 11.00%

Year 36.57% 23.53% 13.04% 28.01%

3 Years (pa) 18.32% 16.24% 2.08% 13.87%

5 Years (pa) 12.34% 11.58% 0.76% 6.60%

Since Launch² (pa) 7.83% 7.56% 0.27% 1.36%

Month 1.11% 1.85% -0.74% 2.07%

Quarter 13.50% 12.29% 1.21% 11.00%

Year 37.89% 23.53% 14.36% 28.01%

3 Years (pa) 19.90% 16.24% 3.66% 13.87%

5 Years (pa) 13.92% 11.58% 2.34% 6.60%

Since Launch² (pa) 9.36% 7.56% 1.80% 1.36%

Market Overview

"I think it's a very tough job being Prime Minister. Obviously, if the ball came loose from the

back of a scrum... it would be a great, great thing to have a crack at…“ - Boris Johnson

Beppe Grillo‟s electoral success may have inspired Boris to come clean about his ambitions,

but the Italian political mess that ensued, despite being an entirely common post-war outcome

of “no clear winner”, helped cause a marked shift in investor behaviour during the quarter.

Having become comfortable that Euro-area sovereign debt risks were abating and US fiscal

cliffs sufficiently dampened or delayed, confidence in European politics subsequently

deteriorated. This was exacerbated by the actions of mainstream authorities in relation to the

economically immaterial problems in Cyprus, where they yet again failed to appreciate

contagion risk with the novel decision to punish depositors.

Following the best January in the equity market since 1989, this gradual erosion of market

confidence led to the Banks sector giving back early gains, such as RBS which was up over

13% in January but finished the quarter down 15%. Investors settled back into the comfort

zone of „Quality‟ investments and shunned „Value‟ characteristics, however the returns offered

by other asset classes remain relatively unattractive and overall the FTSE All-Share Index

rose a significant 10.3% over the quarter.

Monetary stimuli continue around the world, materially accelerating in Japan, the US ISM

survey is still supportive and, crucially, credit conditions continue to remain positive in the US

and the UK. China‟s slowdown in growth appears to have stabilised. Economic data, however,

has been mixed, allowing the long trend in underperformance from Mining shares to continue

apace. The loss of Moody‟s UK AAA credit rating, did not impact generally more domestically-

oriented mid and small-cap indices and another excellent quarter of returns was delivered.

The Numis Smaller Companies (ex IT) Index ascended 12.3% with the FTSE Small Cap

lagging (but ahead of large cap) at 11%. The Fund delivered a return of 13.5% during the

period, outperforming by 1.2%. This compounded an excellent 12 month period that saw the

fund rise 37.9%, 14.4% ahead of the Numis Index, and a top decile performance against the

smaller companies sector. Over three years the Fund is ahead of the benchmark by 15.3%

and over five years by 18.9%, with a total return of 91.9%.

Performance

This was a positive first quarter for the Fund. Stock selection dominated relative performance

(as usual) but sector attribution was also positive during the period.

Growth company Iofina rocketed up 93% after announcing significant progress with the roll-out

of its innovative iodine extraction process in the US. Internet gaming-exposed companies

issued a raft of positive trading announcements which were bolstered by the hugely significant

news that the US was beginning to re-regulate at a State level in Nevada and New Jersey.

Investment Commentary

2

Major potential beneficiaries in the portfolio include Optimal Payments, up 52%, 888 Holdings,

up 42%, and Playtech, up 48%, which also announced the successful sale of its JV operation

to William Hill.

Entry into new AIM holding InternetQ was swiftly rewarded with significant subsequent

performance and a return of 71%. The business has entered into new strategic partnerships

with major companies for its Akazoo service (essentially an emerging market Spotify) and

reported an excellent trading update for its other operations. A number of construction-

exposed holdings continued their robust outperformance from 2012 including SIG, up 31%

following last year‟s overdue appointment of a new CEO; Interserve, up 28%, announcing a

string of contract wins but yet to announce material progress in Qatar which has significant

potential for the group in 2013; and Lavendon, up 31%, also benefiting from activity in Middle

Eastern end-markets and improving returns. Finally of note was top ten Fund position St. Ives

which continued to outperform, up 33%, releasing a solid half-yearly update and a further

acquisition in line with the new strategy to diversify away from legacy print markets.

The biggest disappointment was GW Pharmaceuticals which was very weak during the quarter

on no specific newsflow until near the end of the quarter when the company announced an

unsatisfactory pricing outcome with regard to their licensed Sativex product in Germany and

that, due to (reportedly) significant US investor demand, a secondary listing in the US had

been registered. The stock investment thesis has always been long-term and material upside

potential exists if they successfully complete phase three cancer pain trials in the US in 2014.

Petroceltic was also weak during the quarter as the terrorist event in Algeria increased political

risk perceptions on the commerciality of their huge proven Ain Tsila development which is

worth more than the whole current market capitalisation. As with GW Pharmaceuticals, this

has presented a further buying opportunity.

Four company holdings suffered negative earnings revisions and/or released disappointing

trading statements during the period. These were Homeserve, Wolfson Microelectroncs,

Shanks and McBride. All positions are being materially reduced and the latter was exited after

quarter-end.

Philosophy & Process

Following on from last quarter, the number of Quality holdings continues to edge up. The

extent of the growth of capital allocation has been limited by further price strength from the

Recovery category. Quality allocation grew to 33.3%, matching Recovery. The main change

has been the reduction in the Growth category from 27.5% of the Fund to 22.7%, mainly via

the sales of ITE, IQE and Howden Joinery.

The skew to high-scoring stocks, as quantitatively measured by MoneyPenny, our proprietary

screening tool, remains high with 69.5% of holdings in the top four deciles. Our stockmarket

cycle work suggests we remain in the „trend‟ phase of the market cycle where positive returns

can be generated from all categories of Potential over the medium-term, hence the current

diversification.

3Source: River and Mercantile Asset Management LLP

1 2 3 4 5 6 7 8 9 10 Null

Weight 29.17 17.22 15.23 7.86% 4.94% 5.19% 8.46% 2.44% 0.00% 0.89% 0.19%

Pct of Count 30.00 16.67 15.00 8.33% 6.67% 5.00% 10.00 5.00% 0.00% 1.67% 1.67%

Count 18 10 9 5 4 3 6 3 0 1 1

0

2

4

6

8

10

12

14

16

18

20

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

Coun

t

Perc

ent

UK Smaller Companies Decile Skew March 2013

4

Our team philosophy document and historic quarterly reports discuss in detail my approach to

„value‟ in stock selection. A value bias was clearly beneficial in 2012; quantitative analysis,

however, suggests the effect to date has been mild, implying significant further returns are

ahead. Factset „style‟ analysis indicates that the portfolio has a positive bias to all measures of

value such as price-to-book, free-cash-flow yield and price-to-sales (except Dividend Yield,

due to growth allocation) against the benchmark. The weighted average PE ratio is 11.9x to

2014 vs. the small-mid cap market on 14.7x. The graph below highlights that this value bias

has been a headwind for the Fund in the past quarter, with underlying positive relative

performance driven for example by successful investments in on-line gaming stocks which

appear expensive on some „spot‟ valuation metrics. The Fund is hence not dominated by

„value‟; it is a lower risk multi-factor approach.

The table below gives more detailed quantitative analysis of the various style performances

over various time horizons. One can readily observe over all time periods the positive

attribution to Earnings Momentum (part of the T in our Philosophy) and the small-cap effect.

The Fund retains an overall bias to companies with positive earnings revisions. However, one

can also see the negative performance that price-to-book, and low PE have experienced in the

last three months

I strongly believe that this recent anti-value trend will reverse and then further significant peer

and index outperformance should accrue to the Fund.

Source: Datastream

FTSE Value Index vs. Growth – 1 Year

Source: Societe Generale

5

Quarterly Portfolio Activity

- Quality: Whilst I have highlighted a desire to increase exposure to Financial Services stocks

in recent quarters, the excellent performance of some of the Fund Managers within the

portfolio has led to the exit of both Henderson Group and Jupiter Asset Management.

Repositioning has been effected via the purchase of high quality franchises Close Brothers

and Tullett Prebon where much better valuation anomalies exist, scope for self-help resides

and there is less reliance on market beta. The latter lacks a strong Timing catalyst currently,

but regulatory change may occur swiftly in their favour, a lack of revisions being compensated

by an outstanding valuation for now.

- Recovery: Hogg Robinson, the world leading travel services business, returns to the

portfolio as cash generation continues to be managed effectively, end-markets improve, and

the valuation lags the market re-rating. Dairy Crest was also purchased, which offers

Recovery characteristics in its milk operations, and has developed a high Quality, growing

branded foods business (e.g. Cathedral City, Frijj, Clover) and retains considerable balance

sheet flexibility to improve shareholder returns.

- Growth: InternetQ, already mentioned in the performance section, was purchased. This

under-researched, high-growth company provides leading edge marketing services to

international telephone groups and offers exciting longer-term potential from its early-stage

Akazoo offering (music streaming).

- Online Gaming: 888 Holdings and Bwin Party joined Playtech in the portfolio, enhancing the

Fund‟s exposure to this high-returning, robustly growing, strongly cash-generative industry,

with re-regulation in the US opening up new growth opportunities.

-Valuation discipline: A number of successful investments were exited during the quarter (in

addition to the fund manager positions above) where relative valuations appear to have

become too rich and my conviction in the materiality of further positive earnings revisions has

waned. These included Anite, (held for a number of years, trading below 30p in early 2009),

now trading on 15x, which issued a relatively cautious update and was sold at an average of

£1.37. Russian B2B media exhibitions company ITE, purchased at £1.63, also re-rated to

15.1x and was sold at £2.65; Howden, purchased at £1.27 has re-rated to 15.5x and was sold

at £1.71, and Consort Medical, purchased at £6.05, announced a dilutive and unexpected

disposal and now trades on 17x and was finally exited at £7.73.

Sector and size positioning

AIM holdings were stable at 21.5% of the Fund, represented by a wide range of industry

investments. The removal of stamp duty by the Chancellor is welcome, and further progress

could be made in this area of the market by making AIM companies eligible for ISA tax

advantages.

The Fund remains significantly underweight FTSE 250 stocks in relation to the make-up of the

Numis Index, with a reduced 36.4% of portfolio capital in mid-caps vs. 78.8% of the

benchmark. This underweight of mid-caps has had a material bearing on the performance of

the strategy over the last few years vs. the stated benchmark, with the Numis Index

outperforming the FTSE Small Cap. Mid-caps have done exceptionally well, relative to

smaller, less liquid equities, however our Fund approach has always been to provide a „core‟

small-cap fund. In the last three years the smaller market cap FTSE Small Companies Index is

up 47.4%, significantly behind the Numis Index which is up 57.1%, which the Fund, up 72%,

has beaten despite this bias.

There is currently considerable relative value to be found smaller down the market-cap

spectrum rather than many of the £1bn+ market cap companies that pepper the top of the

renamed Numis Index. A number of these perceived and actual „Growth‟ and „Quality‟

companies have become even more relatively expensive in recent weeks.

6

There have been some changes to sector positioning during the quarter. Four of the five

largest overweights remain: the diverse Support Services sector, the Media sector, Oil & Gas

and Software & Services. These were joined (due to performance) by the Construction sector

via the US exposed holdings of Keller and Tyman. A number of the Support Services holdings

are also exposed to worldwide construction markets. Due to the sale of ITE and some profit

taking across the Fund‟s media holdings, the size of the overweight has narrowed by 3.5% to

+4%. The overall Technology exposure has also fallen, with currently 7.7% of the Fund

invested, a smaller overweight of 1.4%.

Within underweights, the biggest movement has been in Travel & Leisure, as a result of online

gaming purchases and subsequent positive performance. It remains a top five underweight

though (which is essentially a reflection of the strategy‟s zero exposure to low growth, low

return, highly leveraged pub, bus and rail companies), yet now has 8.4% invested with

Playtech, 888 Holdings and Bwin.Party totalling c.5%. Otherwise the largest sector

underweights broadly remain the same.

I remain underweight Real Estate, which experienced some support from markets during the

period, but where the discount to current NAVs in stock valuations appears to have narrowed

markedly. Other changes during the quarter included a move to neutral in General Retail, and

a reduction in Healthcare weighting via an exit of Consort Medical. Finally, cash has built up to

quite a high level relative to the Fund‟s history at 8.4%, giving decent firepower to exploit

further PVT opportunities that arise in the next few months. The Fund has almost no

Industrials exposure (Engineering, Electronics, Chemicals) where I remain concerned that

medium-term profitability assumptions are too optimistic, that historic cyclicality is being down-

played in favour of emerging market “structural growth” dynamics (there‟s always a reason

why the cycle will be “different this time”) and where equity valuations are rich. Relative

valuations in Capital Goods, e.g. Industrial Engineering, are expensive.

Source: Datastream

FTSE 250 Median, Upper and Lower Quartile PEs

Capital Goods P/Book relative

Source: Datastream

7

Outlook

There are two key aspects to markets currently. Firstly, the massive monetary stimuli, and the

ongoing debate about its effectiveness, nature and extent. Critically it continues, ensuring that

a deflationary spiral is averted in key economies until widespread confidence returns. Its

secondary effect is that equities remain relatively attractive to major alternative asset classes.

The graphs below illustrate the size of this financial „experiment‟ to date. The Japanese graph

will need updating and re-scaling shortly! No prizes will be awarded for identifying the territory

that has slipped back behind the pace; however, I expect this will not be for long.

Secondly there are the levels of corporate profitability achieved round the world, reaching and

now exceeding historic peaks in margins.

This is a source of concern as market forecasts do not currently expect any kind of mean

reversion. These margins have been achieved at the expense of wages, unemployment, via

lower depreciation (as a result of low capital expenditure for many years now), and artificially

low interest costs amongst a range of other factors. Many industries and companies will soon

need to invest in margin in order to drive top-line growth.

Size of the Fed balance sheet Size of the BOJ balance sheet

Size of the ECB balance sheet Size of the BOE balance sheet

Source: Bloomberg

US NIPA profit margins (before tax) and recessions

Source: BEA, NBER

8

In this respect, I am pleased to report that, on average, the holdings in the Fund have margins

well below the average company. Factset quantitative analysis suggests the Fund is actually

2.6 standard deviations away from the benchmark margin. The portfolio‟s weighted average

margin is 8.4%, well below the benchmark‟s lofty 13.2%. This is driven by a range of the

Recovery holdings totalling a third of the portfolio whose profits are well below their ten year

averages, and a reluctance on average to hold stocks, whatever „quality‟ they are, whose

returns are at, or beyond, peak, particularly when this is more than reflected in expensive

relative valuations.

The Fund is built via a bottom-up stock selection process based upon our PVT philosophy. I

have high conviction in the holdings which represent a diverse mix of high Quality, Growth,

Recovery and Asset-backed names with attractive valuation credentials and positive Timing

attributes. They are generally liquid securities with strong balance sheets in a broad and

attractively valued UK small-cap equity market which has significant profitability generated

overseas. The UK small-cap market is notably underweight (apart from AIM) the Base Metals

and Bulk Commodity stocks relative to the FTSE 100.

Richard Staveley

Portfolio Manager

Launch date 30 Nov 2006

Fund manager: Richard Staveley

IMA sector: UK Smaller Companies

Benchmark: Numis Smaller Companies

Tracking error range: 4-10%

Product capacity: £400m (pooled & segregated)

XD dates: 1 April & 1 October

Dividend/Accumulation payment date: 31 May and 30 Nov

Fund Facts

Share class: A B*

Launch price (shares): 100.00p 500.00p

Share classification: Retail Institutional

Type of shares: Income Accumulation

Fund charges:

Annual 1.50% 0.75%

Initial (up to) 5.25% 5.25%

*AMC charged outside the Fund

Minimum investment

Initial £1,000 £2.5 million

Subsequent £500 £50,000

Sedol B1DSZR9 B1DSZS0

ISIN GB00B1DSZR91 GB00B1DSZS09

Bloomberg RMUKSAI LN RMUKSEA LN

Important Disclosures:

The information in this document has been prepared and issued by River and Mercantile Asset Management LLP

(R&M) and is directed at professional clients only. Retail clients should not rely on the information provided for this

investment product. Retail clients requiring any information should seek the advice/assistance of a Financial Advisor.

R&M is authorised and regulated by the Financial Services Authority in the United Kingdom. The information

contained in this document is strictly confidential and may not be reproduced or further distributed.

The value of investments and any income generated may go down as well as up and is not guaranteed. An investor

may not get back the amount originally invested. Past performance is not necessarily a guide to future performance.

Changes in exchange rates may have an adverse effect on the value, price or income of investments. Please refer to

the River and Mercantile ICVC principal prospectus for further details of the financial commitments and risks involved

in connection with an investment in this Fund. The information and opinions contained in this document are subject

to updating and verification and may be subject to amendment.

The information and opinions do not purport to be full or complete. No representation, warranty, or undertaking,

express or limited, is given as to the accuracy or completeness of the information or opinions contained in this

document by R&M, its partners or employees. No liability is accepted by such persons for the accuracy or

completeness of any such information or opinions. As such, no reliance may be placed for any purpose on the

information and opinions contained in this document.

The Industry Classification Benchmark is a joint product of FTSE International Limited and Dow Jones Indexes, a

licensed trademark of CME Group Index Services LLC (”Dow Jones Indexes”), and has been licensed for use.

“FTSE” is a trade and service mark of London Stock Exchange and The Financial Times Limited. “Dow Jones” and

“Dow Jones Indexes” are service marks of Dow Jones Trademark Holdings, LLC. FTSE and Dow Jones Indexes and

their respective licensors and affiliates do not accept any liability to any person for any loss or damage arising out of

any error or omission in the ICB.

River and Mercantile Asset Management LLP

30 Coleman Street

London EC2R 5AL

Telephone: +44 (0)20 7601 6262

Facsimile: +44 (0)20 7600 2426

Email: enquiries@riverandmercantile.com

www.riverandmercantile.com

* Previously “Z” Class Shares with AMC charged outside the fund.15