<PAGE>
LETTER from William M. Dutton, Portfolio Manager:(1) September 30, 1998
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Dear Shareholder:
The third quarter was a terrible one for the stock market, particularly for
small company stocks. The Russell 2000 Index declined 20.15% during the
period, its worst quarterly decline since the third quarter of 1990 when the
United States was on the verge of a recession and about to enter the Gulf War.
The S&P 500 Index showed a decline of 9.86% during the period, less than the
small cap index due to investors' preference for large company stocks during
this turbulent time. Skyline Special Equities Portfolio performed similarly to
the Russell 2000 Index, posting a loss of 20.49% for the quarter. For the
first nine months of 1998, the Fund showed a loss of 16.34% compared to a loss
of 16.21% for the Russell 2000 Index.
The stock market took a serious turn down in the third quarter as investors
reacted to a number of negative events. Following a particularly strong period
in the economy in 1997 and the first quarter of 1998, signs of a slowdown
appeared by mid-year 1998. Second quarter GDP growth was much weaker than the
first quarter and it appears that the slowdown continued into the third
quarter. Most observers attribute this weakness to events in Asia, which have
reduced demand for many U.S. products and increased competitive pressures on
U.S. companies. Investors reacted negatively to these events, particularly as
they started to impact corporate earnings. It is clear today that earnings
growth for 1998 will be less than previously anticipated and investors are
worried that weakness will persist through 1999. This, in our opinion, is the
main reason for the stock market decline.
Regarding the Fund, many stocks showed large declines during the quarter and
nine months. In our opinion, while some of these stocks deserved to fall
significantly due to earnings problems, most of them declined far more than
was justified by their fundamentals. For example, a number of companies
reported that near term earnings would be roughly 10% below investor
expectations, and the stocks proceeded to drop 40% or more on the news. We
believe that such declines are due to highly negative investor psychology in
the current stock market environment. We are confident that most of these
issues will eventually show significant gains from current levels because they
are extremely undervalued today and have positive long-term fundamental
outlooks.
We are very upbeat about prospects for the Fund over a reasonable investment
time frame--the next few years--although the short-term could still be rocky.
Individual stocks in the Fund are very inexpensively priced on both an
absolute and relative basis. In terms of absolute valuation, the typical stock
in the Fund has a P/E of approximately 13 times trailing 12-month earnings.
This is the lowest P/E that the Fund has carried in recent years, with the
exception of the market low points in 1990 and 1994. Today's low valuation is
equally as impressive, however, because interest rates are so low. Normally,
investors expect that P/E multiples will move higher as interest rates
decline.
In terms of its valuation compared to large cap stocks, the Fund is the most
attractively priced in its history, as small cap stocks in general are trading
at their most attractive relative valuations in 20 years. One has to go back
to the early 1970s to find a period when small cap stocks were as inexpensive
on a relative basis as they are today. In fact, assuming similar growth in
earnings, small cap stocks would perform 40% better than large cap stocks if
they simply achieve a valuation equal to large caps at some point in the
future. We can't guarantee, but we believe that over the next few years, small
cap stocks will benefit from both growth in earnings and an improved relative
valuation. If that happens, performance results of small cap stocks would
exceed those of large cap stocks.
/s/ William M. Dutton
PORTFOLIO Characteristics(1)
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<PAGE>
<TABLE>
<CAPTION>
SPECIAL
EQUITIES RUSSELL 2000 S&P 500
<S> <C> <C> <C>
P/E RATIO (MEDIAN) 13.2 17.5 20.0
PRICE/BOOK 1.78 2.17 3.99
PRICE/SALES 0.59 1.15 1.66
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EPS GROWTH CURRENT FISCAL YEAR AVERAGE 12.8% 17.4% 8.6%
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MARKET CAP $ WGHTD. MED. $400 million $630 million $43 billion
PORTFOLIO VALUE $403 million $748 billion $8,124 billion
NUMBER OF HOLDINGS 84 1,965 500
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TICKER SYMBOL: SKSEX INITIAL INVESTMENT: $1,000
CUSIP #: 830833208 SUBSEQUENT INVESTMENT: $100
</TABLE>
<PAGE>
PERFORMANCE (%)(1)
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<TABLE>
<CAPTION>
3Q YTD
1998 1998 1 yr.
<S> <C> <C> <C>
SPECIAL EQUITIES -20.49 -16.34 -19.85
RUSSELL 2000 -20.15 -16.21 -19.02
S&P 500 -9.86 6.14 9.15
</TABLE>
<TABLE>
<CAPTION>
Calendar Years
1997 1996 1995 1994 1993
<S> <C> <C> <C> <C> <C>
SPECIAL EQUITIES 35.4 30.4 13.8 -1.2 22.9
RUSSELL 2000 22.4 16.5 28.4 -1.8 18.9
S&P 500 33.4 23.3 37.5 1.3 10.0
</TABLE>
SECTOR Weightings (as of September 30, 1998)
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EDGAR REPRESENTATION OF DATA POINTS USED IN PRINTED GRAPHIC
<TABLE>
<S> <C>
Autos &
Transportation 10.5%
Consumer
Discretionary 29.9%
Consumer Staples 1.1%
Energy 2.5%
Financial Services 15.9%
Health Care 5.6%
Materials &
Processing 12.7%
Producer Durables 9.2%
Technology 6.7%
Cash 5.9%
</TABLE>
<PAGE>
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<TABLE>
<CAPTION>
Since
3 yrs. 5 yrs. 10 yrs. Inception(2)
<S> <C> <C> <C> <C>
SPECIAL EQUITIES 14.08 12.28 17.19 15.50
RUSSELL 2000 6.86 9.10 11.15 9.20
S&P 500 22.73 19.99 17.29 14.90
</TABLE>
<TABLE>
<CAPTION>
1992 1991 1990 1989 1988 1987(2)
<S> <C> <C> <C> <C> <C> <C>
SPECIAL EQUITIES 42.5 47.4 -9.3 24.0 29.7 -16.9
RUSSELL 2000 18.4 46.1 -19.5 16.2 24.9 -24.3
S&P 500 7.7 30.6 -3.2 31.4 16.5 -12.0
</TABLE>
SECTOR Performance (as of September 30, 1998)
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<PAGE>
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<TABLE>
<CAPTION>
3Q 1998 YTD 1998
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SPECIAL RUSSELL SPECIAL RUSSELL
EQUITIES 2000 EQUITIES 2000
<S> <C> <C> <C> <C> <C>
HEALTH CARE 11.5 % -16.9% HEALTH CARE 42.3% -18.7%
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TECHNOLOGY -11.0 -20.7 FINANCIAL SERVICES 2.4 -12.7
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FINANCIAL SERVICES -12.0 -14.9 CONSUMER DISCRETIONARY -1.0 -14.5
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CONSUMER DISCRETIONARY -21.1 -24.7 AUTOS & TRANSPORTATION -20.7 -18.4
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AUTOS & TRANSPORTATION -22.4 -27.5 CONSUMER STAPLES -25.3 -11.8
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MATERIALS & PROCESSING -27.4 -24.4 MATERIALS & PROCESSING -31.9 -20.4
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PRODUCER DURABLES -31.2 -24.5 PRODUCER DURABLES -35.6 -22.6
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CONSUMER STAPLES -39.4 -13.3 TECHNOLOGY -37.3 -15.2
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ENERGY -41.7 -30.8 ENERGY -54.3 -40.4
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OTHER N/A* -25.2 OTHER N/A* -26.8
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UTILITIES N/A* -10.0 UTILITIES N/A* -0.4
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* Not Applicable
</TABLE>
<PAGE>
STOCK Highlights(3)
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BLACK BOX (BBOX)
BBOX is a direct marketer of computer communication, networking, and other types
of connectivity equipment. In our opinion, BBOX represents a superior,
relatively low-risk investment in the large, fast-growing telecom/datacom
market. As a distributor with a broad product offering, BBOX is able to service
this ever-changing market regardless of which new technologies gain acceptance.
The value-added nature of BBOX's business model is derived from its unparalleled
technical support capability, which is clearly evident in BBOX's 50%-plus gross
margin, which is exceptionally high for a distribution company. BBOX recently
began making acquisitions of on-site service companies. This strategy seems a
natural complement to its telephone-based technical support and provides
substantial cross-selling opportunities for BBOX products. BBOX has been able to
purchase these businesses at attractive prices, which should result in immediate
increase in earnings. Despite a superior growth outlook, a unique market niche,
and an outstanding track record, the stock trades at a substantial discount to
its growth rate and the market multiple.
O'CHARLEY'S, INC. (CHUX)
O'Charley's operates 92 casual dining, full-service restaurants in the Central
and Southeastern United States. CHUX prides itself on attention to detail,
particularly with respect to superior food quality and customer service, which
has led to an enviable record of same-store sales gains. In addition, the
relatively small store base has enabled CHUX's to expand comfortably, at close
to a 20% rate, and in the process fill in existing markets with new stores,
thereby enhancing profitability. This formula has produced a consistent record
of strong sales and earnings growth. Prospects for future growth remain strong.
Despite the bright outlook, CHUX trades at a very modest valuation.
TOP Ten Holdings(3)
<TABLE>
<CAPTION>
% OF NET ASSETS
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<S> <C>
MARQUETTE MEDICAL SYSTEMS, INC.
Monitoring equipment 2.3%
DELPHI FINANCIAL GROUP, INC.
Accident & health insurance 2.3%
WORLD COLOR PRESS, INC.
Commercial printer 2.3%
NEW ENGLAND BUSINESS SERVICE, INC.
Business forms 2.2%
FURON COMPANY
Polymer-based products 2.1%
DISCOUNT AUTO PARTS, INC.
Auto parts stores 2.0%
LANDSTAR SYSTEM, INC.
Truckload carrier 2.0%
INTERPOOL, INC.
Container leasing firm 1.9%
BLANCH (E.W.) HOLDINGS, INC.
Reinsurance brokerage 1.9%
AMERICAN HERITAGE LIFE INVESTMENT
Life insurance 1.9%
TOP TEN HOLDINGS 20.9%
</TABLE>
<PAGE>
(1) The performance for the one, three, five, and ten years ended September 30,
1998, and for the period April 23, 1987 (inception) through September 30,
1998, is an average 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 April 23, 1987.
(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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