What s Unsustainable Won t Be Sustained -

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1 KBI Global Investors What s Unsustainable Won t Be Sustained - The Recent Experience in Emerging Markets 1 KBI Global Investors

2 Intuition versus Outcome Over the longer term, investors in emerging market equities have generally had a positive journey. For $ based investors, 2/3 of quarters have been positive since 2000 delivering 8.7% per annum. More recently, while the experience has generally remained good with 7 positive quarters over the past 3 years, one large down-quarter in Q (-17.8%) has pushed the annualised 3 year number to -2.6%. It s worth noting the contrasting experience of euro based investors, who enjoyed an annualised gain of 6.5% over the same period (all figures above based on the MSCI Emerging Markets Index). In searching for insights, we feel that taking a closer look at the experience during the negative periods is a more worthwhile exercise. In periods of falling stock prices, investors generally expect some downside comfort if under-exposed to more growth-oriented, higher beta industry groups such as information technology. The strong likelihood that such groups will be more expensive than the overall market and also less likely to be providing the ballast of a reasonable dividend-payment to the stock-holder, further underpins that expectation. The experience of investors in emerging markets in recent years has not generally borne this out. Over the past 3 years for example, where negative annualised returns have been the norm across practically all industry groups, information technology has surprisingly bucked the trend: Chart 1. MSCI EM Sectors - Last 3 Years (NR annualised US$) 6.1% 1.5% -2.6% -6.1% -1.2% -6.1% -7.4% -5.8% -6.9% -4.6% -4.1% -4.3% MSCI EM Energy Financials Materials Industrials Utilities Telecoms Consumer Staples IT Healthcare Consumer Disc Real Estate. As at 31/12/2016. More particularly, an under-exposure to a handful of highly-valued, low or non-dividend-paying technology names in quarters when the overall market has fallen has counter-intuitively failed to provide the expected downside protection. 2

3 For $ based investors for example, over the past 12 quarters in emerging markets 5 quarters have been negative: Table 1. Isolating Negative Quarters Over Last 3 Years Negative Quarters TR US$ MSCI EM Samsung Electronics TR US$ Tencent Alibaba Naspers Baidu Expanding Earnings Multiple Trumps EPS Growth Positive Combined Contribution to Outperforming Index Q % -3.0% 9.0% 5.5% YES Q % -14.1% -2.5% -6.1% NO Q % 9.2% -2.5% 18.9% YES Q % -15.8% -16.4% -19.6% YES Q % 4.4% -10.9% -17.0% -14.7% -9.7% NO Under-exposure to the big 5 technology names of Samsung Electronics, Tencent Holdings, Alibaba Group, Naspers 1 and Baidu - which collectively now account for over 13% of the overall EM index - was a losing strategy in 3 of those 5 quarters. Of particular note in this context was Q In a quarter where the index recorded a very large negative % - the conventional expectation would have been to benefit strongly from an under-exposure to these names. However, not only was this expectation dashed, the opposite proved to be the case. For information technology in emerging markets in recent years, the stark dominance of an expanding earnings multiple over EPS growth is clear: Chart 2. MSCI EM Information Technology - EPS v PE EPS 29 P/E MSCI EM Info Tech $ EPS (lhs) MSCI EM Info Tech $ P/E (rhs) Unsurprisingly, this pattern is also strongly evident in the big 5 technology names of Samsung Electronics, Tencent Holdings, Alibaba Group, Naspers and Baidu referenced earlier. All have posted strong outperformance, a significant expansion in their PE multiple, while all except Baidu have experienced a fall in EPS. 1 Although effectively driven by its IT exposure, Naspers is classified as a media stock. 3

4 The experience of a classic, defensively-oriented industry group such as consumer staples over the same period is a telling contrast: Chart 3. MSCI EM Consumer Staples - EPS v PE EPS 22 P/E MSCI EM Cons. Staples $ EPS (lhs) MSCI EM Cons. Staples $ P/E (rhs) In this case, a contracting PE multiple has tracked falling EPS. In essence, the industry group can be understood as responding to fundamentals and consequently underperforming. This pattern is representative of many similar, defensively-oriented groups over the period. For us, it is no coincidence that the poor performance of such groups, and the strong performance of stocks such as the big 5 technology names in EM, has occurred during a period of collapsing global bond yields and discount rates. The collapse of bond yields into deeply negative real (and often nominal) territory has had a significantly positive impact on stocks such as the big 5 whose value lies disproportionately in the future. Such stocks have therefore posted very significant gains relative to the rest of the market. In bond parlance, they are the long-duration segment of the stock-market and have benefitted accordingly. By the same token, they are obviously very vulnerable to any movement back towards normality in the bond yield/discount rate environment. This in turn has had an important consequence on the evolution of the EM index over recent years - an evolution which we believe investors should be both aware, and from KBIGI s perspective wary of, in the period ahead. 4

5 EM Index Evolution The composition of the EM index has changed significantly in recent years. Consequent on the dramatically stronger performance of the big 5 technology names of Samsung Electronics, Tencent Holdings, Alibaba Group, Naspers and Baidu relative to traditional old economy stalwart companies in energy and materials, the composition of the index has shifted strikingly from the latter to the former. The inclusion of Chinese offshore names in November 2015, adding names such as Alibaba and Baidu, is worth noting in this context so too the expected inclusion of China A shares in coming years. The index now has a significantly greater tilt to this handful of highly-valued, low or non- dividend-paying technology names: Table 2. Top 10 MCSI EM Holdings Name Weight Industry Country 1 Samsung Electronics 3.8 Technology Hardware & Equipment Korea 2 Tencent Holdings 3.5 Software & Services China 3 Taiwan Semicon. Mnfg. 3.5 Semiconductors Taiwan 4 Alibaba Group Hldg.Spn.Adr. 1:1 2.5 Software & Services China 5 China Mobile 1.7 Telecommunication Services China 6 China Con.Bank H 1.6 Banks China 7 Naspers 1.6 Media Sth. Africa 8 Baidu A Adr 10:1 1.1 Software & Services China 9 Indl. & Coml. Bk. of China H 1.1 Banks China 10 Hon Hai Precn. Ind. 1.0 Technology Hardware & Equipment Taiwan 21.5 Table 3. Top 10 MCSI EM Holdings Name Weight Industry Country 1 Samsung Electronics 3.1 Technology Hardware & Equipment Korea 2 Taiwan Semicon. Mnfg. 1.9 Semiconductors Taiwan 3 China Mobile 1.8 Telecommunication Services China 4 Gazprom 1.8 Energy Russia 5 Petroleo Brasileiro Pn 1.5 Energy Brazil 6 America Movil L 1.4 Telecommunication Services Mexico 7 China Con.Bank H 1.3 Banks China 8 Itau Unibanco Holding Pn 1.3 Banks Brazil 9 Vale Pn 1.3 Materials Brazil 10 Petroleo Brasileiro On 1.1 Energy Brazil

6 The significant underperformance of Energy in particular has been the clear flip-side of this process: Chart 4. MSCI EM Energy v MSCI EM MSCI EM Energy $ - NET RETURN MSCI EM U$ - NET RETURN In different parts of the market, this movie has been seen many times before. For investors, we believe both awareness, and potential wariness of it, is warranted in the period ahead. The examples of Japan in the late 1980 s and information technology in the late 1990 s, both becoming very large components of the global index before shrinking spectacularly, spring especially to mind. A current phenomenon likely exacerbating the situation is the large inflows into passive vehicles. As with Japan in the late 1980 s and information technology in the late 1990 s, at a certain point the risk for investors increasingly resides in the index, and patient active management will necessarily prove to be the provider of downside protection. While we are not suggesting that a comparable bubble has now formed among this small group of increasingly large names in EM, the elevated valuations that most of them now enjoy is certainly worthy of highlight: Table 4. Current Price/Earnings of Big 5 Tech Names Stock Name Current P/E Q Samsung Electronics 12.9 Tencent Holdings 45.2 Alibaba Adr 53.7 Naspers Baidu Adr 13.0 Average

7 The Big 5 & Our Investment Approach As an investor with a definite and deliberate dividend and value orientation, we are unsurprisingly not invested in Samsung Electronics, Tencent Holdings, Alibaba Group, Naspers or Baidu. Despite beating the market over this 3-year period 2, albeit marginally, not owning these stocks has clearly hurt us from a performance perspective. Currently representing just 13% of the index, these 5 names in aggregate have been responsible for 25% of the index performance over the past 3 years; 42% in positive quarters, but only 2.3% in negative quarters. Not holding these names has clearly been a very strong headwind for our approach. We don t own these stocks because of their lack of shareholder focus/efficiency of capital management. Noting their increasing significance, an interesting exercise is to consider what possible changes these companies could make to become potential investments for us: Table 5. Examining These Stocks Cashflow and Potential to Pay Dividends NAME Tencent Alibaba Baidu Samsung Naspers FCF US$M TTM $5,500 $6,083 $1,580 $20,430 -$26,163 Div Paid US$M TTM $ $3,480 $170,923 Remaining FCF US$M $4,922 $6,083 $1,580 $16,950 -$197,086 Capex/FCF 15% 21% 35% 46% 117% FCF Div Cover % of FCF Currently Paid as Div 11% 0% 0% 17% 35% New FCF Div Payout US$M $1,925 $2,129 $553 $7,150 New DPS Old DPS New Div Payout Ratio 34% 38% 15% 45% New Dividend Yield 0.8% 0.8% 1.1% 3.1% Old Dividend Yield 0.2% 0.0% 0.0% 1.5% New FCF Cover FCF = Free Cash Flow, TTM = Trailing Twelve Months, DPS = Dividend Per Share Samsung have committed to paying out 50% of their FCF to shareholders recently. However, they have chosen to do most of this through buybacks. They are currently only paying out 17% of FCF in dividends. If minded, they clearly have scope to improve this. Such a change would make them potentially investable for us. More generally, excluding Naspers, all of these companies are generating significant amounts of cash and their Capex/FCF levels are not excessive. If minded, they clearly have the ability to pay much bigger dividends without hampering their current capital expenditure levels. It wouldn t take a great deal of change for these companies to become investable for us. For example, assume a conservative level of 35% of FCF to be paid out as dividends: If they paid this level of dividends, they all (ex Naspers) would make it through both step 1 and step 2 of our process. (see appendix for summary of our process) Given their valuations, Tencent and Alibaba are highly unlikely to make it through Step 3 and into our portfolio. However, Samsung and Baidu would certainly have a chance. Note: Naspers is unusual. It s essentially a holding company with more than 100% of its market value currently accounted for by its holding in Tencent. Currently with a negative FCF as their Capex exceeds their trailing 12m FFO, in order to generate positive FCF they would need to start selling down some of their Tencent stake. There is no indication of this at the moment. With a P/E of 106, its valuation is also very elevated for us. Given our approach, Naspers is unlikely to become investable any time soon. 2 KBI Emerging Market Equity Strategy +0.9% Vs MSCI Emerging Markets (NR) Index. Returns are gross of fees in USD as at 31st December 2016 using GIPS Composite. 7

8 This is obviously a purely theoretical exercise. However, we think it s an interesting illustration of the current relationship between The Big 5 and our investment approach, and the kinds of behavioural changes needed from them to potentially change this in the future. Simply put, we need to see these companies begin to show a greater interest in being more efficient stewards of their capital in the interests of shareholders. It is interesting to note the recent impact of activist investors in forcing changes at Samsung that have improved their commitment to shareholders by distributing more of their vast cash hoard. From our perspective, we think these companies could easily maintain more than sufficient earnings to invest back into their businesses to continue their growth trajectory, while also making a more meaningful distribution to shareholders. We also note their declining return on equity over recent years. This further highlights the drag of their excessive cash holdings on shareholder return, and how their capital stewardship is therefore sub-optimal: Table 6. Return on Equity - Last 3 Years STOCK NAME SAMSUNG TENCENT ALIBABA ADR NASPERS BAIDU A ADR Q Q Q Q Q Q Q Q Q Q Q Q Q % Change -49% -19% -60% -50% 68% Summary Conclusions Conventional expectation - that an under-exposure to highly-valued, higher beta information technology names should provide downside comfort during periods of falling stock prices - has been generally confounded in EM in recent years. To understand this counter-intuitive experience, the insight of Ben Graham is of particular benefit. In Graham terms, the dominance of voting over weighing in investor assessment of a handful of increasingly highly-valued, low or non-dividend-paying technology names - Samsung Electronics, Tencent Holdings, Alibaba Group, Naspers and Baidu - has been decisive. History shows that such dominance doesn t persist. Even during periods of falling stock prices, this has resulted in the counter-intuitive experience that an under-exposure to such names has generally been a losing strategy. The exceptionally strong performance of these big 5 technology names in recent years has significantly altered the composition of the index. In conjunction with their relatively elevated valuations, investor awareness and potential wariness of this evolution is prudent. We see clear echoes of previously painful episodes, where a passive mimicking of the index has proven to be very costly. We don t own these stocks because of their lack of shareholder focus/efficiency of capital management. While this has hurt our performance in recent years, they will remain outside our portfolio until this behaviour changes. As is often the case in investing, intuition is not necessarily a reliable guide to outcome. The need for deeper analysis to improve your chances of success is unavoidable. This is even more the case when it leads to conclusions which are diametrically opposed to what the gut would suggest. We believe that the experience of investors in EM in recent years, and more importantly their likely experience in the years ahead, falls firmly into this category.

9 Appendix Our goal in buying companies is to tilt our probability in favour of choosing the out-performing and avoiding the under-performing. Our anchor beliefs are in the benefits of diversification, and of having a dividend and value orientation in our portfolio. From the companies we invest in therefore, we demand the following: Step 1: we set a minimum relative hurdle that they must have a dividend yield that is at least the average of their regional, industry peer group. Step 2: we set a number of absolute hurdles Payout ratio, Free cashflow coverage, Dividend growth & Total payout. Step 3: we craft an aggregate portfolio with a definete tilt to excess dividend yield, excess dividend growth, cheaper valuation, and higher quality. KBI Global Investors Global Equity Strategies Team, March 2017 Back Row (left to right): James Collery Senior Portfolio Manager, Ian Madden Senior Portfolio Manager, Gareth Maher Head of Portfolio Management, John Looby Senior Portfolio Manager, Massimiliano Tondi Senior Portfolio Manager Front Row (left to right): David Hogarty Head of Strategy Development, Senior Portfolio Manager, Noel O Halloran Chief Investment Officer, Director 9

10 DISCLAIMERS: All Markets: KBI Global Investors Ltd is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. KBI Global Investors (North America) Ltd is a registered investment adviser with the SEC and regulated by the Central Bank of Ireland. KBI Global Investors (North America) Ltd is a wholly-owned subsidiary of KBI Global Investors Ltd. KBI Global Investors or KBIGI refer to KBI Global Investors Ltd and KBI Global Investors (North America) Ltd. IMPORTANT RISK DISCLOSURE STATEMENT Under MiFID II this is deemed marketing material and should not be regarded as investment research. This material is provided for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security, product or service including any group trust or fund managed by KBI Global Investors. The information contained herein does not set forth all of the risks associated with this strategy, and is qualified in its entirety by, and subject to, the information contained in other applicable disclosure documents relating to such a strategy. KBI Global Investors investment products, like all investments, involve the risk of loss and may not be suitable for all investors, especially those who are unable to sustain a loss of their investment. Stocks mentioned in this document are a representative sample of stocks that may or may not be in the strategy. The securities listed are selected based on objective, consistently applied, non-performance-based criteria. Size or profitability of stocks mentioned have not been used in determining the selection of stocks and their inclusion should not be construed as a stock recommendation. A complete list of all securities recommended for the immediately preceding year is available upon request. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS This introductory material may not be reproduced or distributed, in whole or in part, without the express prior written consent of KBI Global Investors. The information contained in this introductory material has not been filed with, reviewed by or approved by any regulatory authority or self-regulatory authority and recipients are advised to consult with their own independent advisors, including tax advisors, regarding the products and services described therein. The views expressed are those of KBI Global Investors and should not be construed as investment advice. 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Gross results shown do not show the deduction of investment management fees. A client s actual return will be reduced by the management fees and any other expenses which may be incurred in the management of an investment account. For example, a 1,000,000 investment with an assumed annual return of 5% with a management fee of 0.85% would accumulate 8,925 in fees during the first year, 48,444 in fees over five years and 107,690 in fees over ten years. GIPS Performance Disclaimer Our firm claims GIPS compliance and is annually verified by an independent verification firm to be so. The verification report from our verifier and our GIPS composite presentation are available upon request. The performance record disclosed here is that of the firm s composite for this strategy. 10 USA/CANADA SPECIFIC: Information about indices is provided to allow for comparison of the performance of the Adviser to that of certain well-known and widely recognized indices. There is no representation that such index is an appropriate benchmark for such comparison. You cannot invest directly in an index, which also does not take into account trading commissions and costs. The volatility of the indices may be materially different from that of the strategy. In addition, the strategy s holdings may differ substantially from the securities that comprise the indices shown. All MSCI data is provided as is. In no event shall MSCI, its affiliates, or any MSCI data provider have any liability of any kind in connection with the MSCI data. No further distribution or dissemination of the MSCI data is permitted without MSCI s prior express written consent. Net total return indices reinvest dividends after the deduction of withholding taxes, using (for international indices) a tax rate applicable to non-resident institutional investors who do not benefit from double taxation treaties.

11 MSCI EM: The MSCI Emerging Markets Index covers more than 800 securities across large and mid-cap segments and across style and sector segments in 23 emerging markets. Gross results shown do not show the deduction of Adviser s fees. A client s actual return will be reduced by the advisory fees and any other expenses which may be incurred in the management of an investment advisory account. See Part 2 of Adviser s Form ADV for a complete description of the investment advisory fees customarily charged by Adviser. For example, a $1,000,000 investment with an assumed annual return of 5% with an advisory fee of 0.85% would accumulate $8,925 in fees during the first year, $48,444 in fees over five years and $107,690 in fees over ten years. Performance returns for individual investors may differ due to the timing of investments, subsequent subscriptions/redemptions, share classes, fees and expenses. Stocks mentioned in this document may or may not be held in this strategy at this time. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the strategy. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. Discussions of market conditions, market high/lows, objectives, strategies, styles, positions, and similar information set forth herein is specifically subject to change if market conditions change, or if KBIGI believes, in its discretion, that investors returns can better be achieved by such changes and/or modification. Style descriptions, market movements over time and similar items are meant to be illustrative, and may not represent all market information over the period discussed. Form ADV Part 1 and Part 2 are available on request. AUSTRALIA SPECIFIC: KBI Global Investors (North America) Ltd is exempt from the requirement to hold an Australian Financial Services licence in respect of the financial services it provides to wholesale investors in Australia and is regulated by both the Central Bank of Ireland and the Securities and Exchange Commission of the US under US laws which differ from Australian laws. Any services provided in Australia by KBI Global Investors Ltd or other affiliates will be provided by the relevant entity as representative of KBI Global Investors (North America) Ltd. This material and any offer of investments is intended for and can only be provided and made to persons who are regarded as wholesale clients for the purposes of the Corporations Act of Australia and must not be made available or passed on to persons who are regarded as retail investors. It may not be reproduced or distributed, in whole or in part, without the express prior written consent of KBI Global Investors (North America) Ltd. The information contained in this introductory material has not been filed with, reviewed by or approved by any Australian or United States regulatory authority or selfregulatory authority and recipients are advised to consult with their own independent advisors, including tax advisors, regarding the products and services described therein. Name of Firm: Office Location: KBI Global Investors Headquarters 3rd Floor, 2 Harbourmaster Place, IFSC, Dublin 1, D01 X5P3, Ireland Website: Contact: Tel: (+353) info@kbigi.com 11