<PAGE>
- - LETTER from Daren C. Heitman, Portfolio Manager:(1) September 30, 1998
- --------------------------------------------------------------------------------
Dear Shareholder:
The third quarter was a very difficult period for equity investors. Evidence
of an economic slowdown has companies and investors lowering their
expectations for 1998 and 1999 earnings. Predictably, this is having a
negative impact on share prices. Unfortunately, small company stocks bore the
brunt of the selling pressure, with the Russell 2000 Index declining 20.15% in
the third quarter compared to the 9.86% decline posted by the S&P 500 Index.
The Fund fared worse than the small cap market overall, declining 29.20% in
the period.
Stocks of small companies posting poor financial results were punished
unmercifully as investors sought safety in large companies or companies with
clear near-term outlooks. It is worth emphasizing that ultimately we own
shares in companies. Despite any short-term gyrations in the stock prices, the
value of those stocks will ultimately be determined by the future cash flows
of those companies. In my opinion, the value of the future cash flows of the
entire Fund did not decline by 30% during the past three months. I believe
fear and liquidity issues are driving many investment decisions to the
detriment of our style. In my view, these companies were undervalued when we
purchased their stocks, and now they are less expensive with no material
change in our long-term expectations.
I am not trying to gloss over the fact that we owned the shares of several
companies that required a downward earnings revision. That will often happen
with this style of investing. A few of these performed poorly enough to shake
my confidence in the company's long-term prospects, and they were sold. The
others were viewed as short-term setbacks. In these cases, the near-term
earnings outlook is of secondary importance to the company's long-term
earnings power in our decision to own the stock. In the third quarter,
however, intense selling pressure met any disappointment regardless of
valuation. For example, we now hold eight stocks selling at 50% of book value
or less. Yet most generate positive cash flows and have a solid balance sheet
to go with a credible strategy to improve results.
Farmers are notoriously stubborn. Farmers need to be stubborn to persevere
through the inevitable years when weather or commodity prices do not go their
way. Yet "bull-headedness" can lead either to demise or success depending on
how it is applied. For instance, a farmer might have hilly land with rocky
soil more suitable for mountain goats than corn. If he insists on planting
corn there year after year, he is doomed to fail. On the other hand, consider
a farmer with a good strategy of planting a crop on productive land. Even with
good land, that farmer is not guaranteed a profit each year. However, if he
keeps planting a crop year after year on productive land he will make a profit
over time.
The disappointing results of the fund to date will not cause a change in
strategy. Some years will simply be better than others. Over time, though, I
expect to have more good years than poor years, reflecting my confidence in
the strategy. This confidence is not based on wishful thinking. Independent
studies suggest that low price to book value stocks perform better than
average over the long term, and the effect is more pronounced for small cap
stocks. Currently, though, we are in the midst of significant underperformance
by small, "deep value" stocks. In my view, this implies there will eventually
be a period of catch-up that could prove quite powerful. In the end, valuation
matters.
I sincerely hope that everyone who experienced this tough period stays with
the strategy for the long term. I believe with conviction our discipline will
be rewarded.
[DAREN C. HEITMAN SIGNATURE]
<PAGE>
- - PERFORMANCE (%)(1)
- ---------------------------------------------
<TABLE>
<CAPTION>
3Q YTD Since
1998 1998 Inception(2)
<S> <C> <C> <C>
SMALL CAP CONTRARIAN -29.20 -29.20 -29.20
RUSSELL 2000 -20.15 -16.21 -12.94
S&P 500 -9.86 6.14 6.99
</TABLE>
- - SECTOR Weightings (as of September 30, 1998)
- -----------------------------------------------------------------
EDGAR REPRESENTATION OF DATA POINTS USED IN PRINTED GRAPHIC
<TABLE>
<S> <C>
Consumer
Discretionary 26.7%
Energy 6.8%
Financial Services 9.5%
Health Care 13.0%
Materials &
Processing 11.4%
Other 3.0%
Producer Durables 6.1%
Technology 10.4%
Cash 5.1%
Autos &
Transportation 8.0%
</TABLE>
<PAGE>
- - PORTFOLIO Characteristics(1)
- ---------------------------------------------
<TABLE>
<CAPTION>
SMALL CAP
CONTRARIAN RUSSELL 2000 S&P 500
PRICE/BOOK 0.93 2.17 3.99
<S> <C> <C> <C>
PRICE/SALES 0.43 1.15 1.66
P/E RATIO (MEDIAN) 14.2 17.5 20.0
-------------------------------------------------------------------------------
EPS GROWTH CURRENT 16.1% 17.4% 8.6%
FISCAL YEAR AVERAGE
-------------------------------------------------------------------------------
MARKET CAP $ WGHTD. $140 million $630 million $43 billion
MED.
PORTFOLIO VALUE $5.8 million $748 billion $8,124 billion
NUMBER OF HOLDINGS 40 1,965 500
--------------------------------------------------------------------------------
CUSIP #: 830833604 INITIAL INVESTMENT: $1,000
SUBSEQUENT $100
INVESTMENT:
</TABLE>
- - SECTOR Performance (as of September 30, 1998)
- -----------------------------------------------------------------
<TABLE>
<CAPTION>
3Q 1998 YTD 1998
- --------------------------------------------------------- ---------------------------------------------------------
SMALL CAP RUSSELL SMALL CAP RUSSELL
CONTRARIAN 2000 CONTRARIAN 2000
<S> <C> <C> <C> <C> <C>
FINANCIAL SERVICES -21.5% -14.9% CONSUMER STAPLES 91.8% -11.8%
- --------------------------------------------------------- ---------------------------------------------------------
TECHNOLOGY -21.7 -20.7 CONSUMER DISCRETIONARY -8.8 -14.5
- --------------------------------------------------------- ---------------------------------------------------------
OTHER -24.6 -25.2 AUTOS & TRANSPORTATION -15.4 -18.4
- --------------------------------------------------------- ---------------------------------------------------------
HEALTH CARE -24.7 -16.9 OTHER -17.4 -26.8
- --------------------------------------------------------- ---------------------------------------------------------
CONSUMER DISCRETIONARY -26.0 -24.7 FINANCIAL SERVICES -23.6 -12.7
- --------------------------------------------------------- ---------------------------------------------------------
AUTOS & TRANSPORTATION -28.2 -27.5 HEALTH CARE -27.3 -18.7
- --------------------------------------------------------- ---------------------------------------------------------
ENERGY -33.1 -30.8 PRODUCER DURABLES -35.4 -22.6
- --------------------------------------------------------- ---------------------------------------------------------
PRODUCER DURABLES -43.5 -24.5 ENERGY -42.9 -40.4
- --------------------------------------------------------- ---------------------------------------------------------
MATERIALS & PROCESSING -46.6 -24.4 TECHNOLOGY -46.5 -15.2
- --------------------------------------------------------- ---------------------------------------------------------
UTILITIES N/A* -10.0 MATERIAL & PROCESSING -52.8 -20.4
- --------------------------------------------------------- ---------------------------------------------------------
CONSUMER STAPLES N/A* -13.3 UTILITIES N/A* -0.4
- --------------------------------------------------------- ---------------------------------------------------------
* Not Applicable
</TABLE>
<PAGE>
- - STOCK Highlights(3)
- ---------------------------------------------
IMATION CORP. (IMN)
IMN, a specialist in imaging and data storage solutions, was created by the
spinout of several independent businesses from 3M in 1996. An agreement was
recently reached for the sale of one of those businesses for about $500 million.
This figure compares to debt outstanding of $300 million and an equity market
capitalization of about $700 million. The remaining businesses have the
potential to generate more than $3.00 per share in earnings before consideration
of any potential uses of the excess cash (e.g. share repurchases or accretive
acquisitions). The stock is selling below book value and at a very low multiple
of potential earnings.
WILLBROS GROUP, INC. (WG)
WG has serviced the oil and gas industry for more than 100 years, and has
developed a worldwide market leadership for construction projects in harsh
environments. For example, WG constructed a pipeline to recover oil and gas from
remote regions in Indonesia. After years of exploration in virgin areas by the
major and state oil companies, the industry is poised for more infrastructure
spending. Despite a healthy outlook for winning new business and a debt-free
balance sheet, WG is selling at about 75% of its book value, and a very low
multiple of potential earnings of $2.00 per share or more.
- - TOP Ten Holdings(3)
<TABLE>
<CAPTION>
% OF NET ASSETS
- ----------------------------------------------------------------------------
<S> <C>
WILLBROS GROUP INC.
Engineering/construction firm 4.5%
IMATION CORP.
Data storage products 4.1%
RIGHT MGMT CONSULTANTS
Outplacement & HR services 3.9%
QUEST DIAGNOSTICS INC.
Diagnostic testing services 3.4%
BIRMINGHAM STEEL CORP.
Steel mini-mill 3.1%
CLINTRIALS RESEARCH INC.
Contract research firm 3.1%
SPACEHAB, INC.
Lab & supply modules 3.0%
NAVIGATORS GROUP, INC. (THE)
Property & casualty insurance 2.8%
TRIGON HEALTHCARE, INC.
Health maintenance organization 2.8%
DT INDUSTRIES, INC.
Packaging equipment 2.8%
TOP TEN HOLDINGS 33.5%
</TABLE>
<PAGE>
(1) The performance for the period December 15, 1997 (inception) through
September 30, 1998, is an annual total return calculation which is described
in the Fund's prospectus. Of course, past performance is no guarantee of
future results. The principal value and return on your investment will
fluctuate and on redemption may be worth more or less than your original
cost.
The Russell 2000 Index is an unmanaged, market value weighted index
comprised of small-sized companies. The S&P 500 Index, a widely quoted stock
market index, includes 500 of the largest companies publicly traded in
America. All figures take into account reinvested dividends. All indexes and
portfolio characteristics are compiled by Frank Russell Company.
Sources: Frank Russell Company.
(2) Return is calculated from the Fund's inception on December 15, 1997.
(3) Fund holdings are subject to change and should not be considered a
recommendation to buy individual securities.
This report is not authorized for distribution unless accompanied or preceded by
a current prospectus.
There are risks of investing in a fund of this type which invests in stocks of
small companies, which tend to be more volatile and less liquid than stocks of
large companies.
Distributor: Funds Distributor Inc.
For 24-hour account information CALL: 1.800.828.2SKY
(1.800.828.2759)
To speak with a Skyline Funds Representative during
normal business hours CALL: 1.800.828.2SKY and press 0 when prompted.
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