QUARTERLY COMMENTARY 31 DECEMBER 2017

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1 QUARTERLY COMMENTARY 31 DECEMBER of 15

2 COMMENTARY Sigma also distributes a variety of non-prescription or overthe-counter products, such as beauty and personal hygiene products, many of which are exclusively distributed in Australia by Sigma (e.g. Serum7, Boots Laboratories, and Optiva). SIMON MAWHINNEY, CFA Managing Director & Chief Investment Officer This quarter s report focuses on Sigma Healthcare Limited (Sigma), a company we have held for some time. Its significant underperformance this past year and our response offer valuable insights into our approach to investing in the face of uncertainty. Who is Sigma? Before jumping into these insights, some background on Sigma. Sigma is a wholesaler of pharmaceutical products. It acts as an intermediary distributor that buys drugs from manufacturers and sells them to the pharmacies that ultimately dispense these drugs to Australians in need. Some of these pharmacies operate under one of Sigma s banners (see Figure 1), while others are independently branded. Sigma does not own any of the pharmacies itself. A number of regulations in Australia govern the pharmaceutical industry. One important regulatory outcome for Sigma is the Community Service Obligation (CSO) Funding Pool. This taxpayer-funded pool supports pharmaceutical wholesalers who undertake to supply all of the medicines on the Pharmaceutical Benefit Scheme (PBS) to pharmacies across Australia within 24 hours of an order, regardless of a pharmacy s location and the relative cost of supply. Participation in the CSO Funding Pool is not compulsory but its existence is a necessary part of ensuring that every Australian has ready access to essential medicines. Sigma is one of five distributors/wholesalers eligible to participate in the CSO Funding Pool. Sigma s revenues come mainly from the sale of products to pharmacies but also from CSO receipts which subsidise otherwise loss-making sales to rural pharmacies and from low-value PBS products. Sigma s business is what some may describe as boring, with relatively stable and predictable earnings. It has annual revenues of a little over AUD$4 billion and earns an operating profit margin of between 2% and 2.5% (including CSO receipts). Relative to other wholesalers in Australia, this level of profitability is normal and most would expect Sigma s revenue base to increase in future, given Australia s growing and aging population. Figure 1: Some of the pharmacies and brands operating under Sigma s banners Sigma retail banner groups Private and exclusive product brands 2 of 15

3 Two surprises A number of unexpected events have conspired to make Sigma s future far less certain and it is against this backdrop that our interest in Sigma has been reinvigorated. Two events in particular stand out, neither of which have been fully resolved and both of which have contributed to significant share price weakness and uncertainty. 1. In May this year, Sigma s largest customer, Chemist Warehouse Group (CWG), announced its intention to source certain products from a competitor on better terms than Sigma had been supplying them. CWG hoped to cherry-pick its drug procurement; the high-margin drugs would be bought on better terms from Sigma s competitor and the low-margin drugs would continue to be purchased from Sigma. Quite a sensible commercial strategy, but one that Sigma took offence to as its trading arrangement with CWG was priced based on the entire basket of PBS drugs, not just the least profitable parts. CWG accounts for about 35% of Sigma s total sales, but less than this in terms of profits, reflecting the favourable trading terms that CWG enjoys. Sigma and CWG have agreed to a temporary fix (presumably even better trading terms) that will apply until their contract expires in The future post-2019 remains very uncertain. 2. In October, AstraZeneca, a large global drug manufacturer, announced it would bypass pharmaceutical wholesalers and exclusively distribute some of its higher value or higher volume products directly to pharmacies using DHL, a global logistics firm. While these products represented only 1% of Sigma s total sales, this followed a similar decision in 2010 by Pfizer, another large drug manufacturer. Today, fears abound that other drug manufacturers will follow and that Sigma s network of distribution assets will be bypassed on a much larger scale. In less than six months, these two events have transformed Sigma s business from a stable and predictable earner to one burdened by uncertainty. The sharemarket has dished out its own medicine, with Sigma s share price falling from $1.30 in early May to 75 cents soon after AstraZeneca s news was absorbed. At the same time, the broader sharemarket was on a tear. Acting in uncertainty Having reflected on Sigma s performance during the year, two things spring to mind: our sell discipline and our response to uncertainty. Despite having reduced the weight of Sigma in our portfolio by quite some margin prior to its weakness this year, hindsight tells us we were not aggressive enough. With the share price trading at, or close to, our estimate of fair value in 2016, we should have sold our entire holding. As reflected in Graph 1, we reduced Sigma s weight in the portfolio from over 6% in 2011 to 2% immediately prior to the onslaught of Sigma s bad news. We had sold some Sigma shares but, upon reflection, the allure of Sigma s defensive earnings stream and high calibre management team affected our judgement and we could have sold them all. By late 2016, Sigma was priced for perfection with little upside and plenty of downside. These are the very payoff profiles we try to avoid when we make our first investments in companies. Graph 1: Portfolio holdings in Sigma Healthcare compared with the share price Holdings (% of strategy) Jun-2009 Jun-2010 Jun-2011 Jun-2012 Jun-2013 Jun-2014 Jun-2015 Jun-2016 Jun-2017 Allan Gray Australia Equity Strategy Holdings in Sigma (LHS) Sigma Share Price (AUD) (RHS) Sigma Share Price (AUD) Source: Allan Gray. The Allan Gray Australia Equity Strategy includes the Allan Gray Australia Equity Fund and institutional mandates that share the same investment strategy. 3 of 15

4 Table 1: Sigma s enterprise value to operating profit Sigma at 75c Sigma today S&P ASX 300 Enterprise Value : Operating Profit 9.6x 12.5x 13.9x Note: A company s enterprise value is its market capitalisation plus its net debt. Source: Allan Gray; Factset, 31 December 2017 Acknowledging and learning from mistakes is important. Equally important is leaving the past behind and assessing an investment based on its future prospects without any emotional baggage. While in hindsight we made a mistake in not selling our entire holding in Sigma, the share price falls following bad news and great uncertainty forced us to look at the company again with fresh eyes and a clear mind. Sigma s underperformance is a stark reminder of the discount the sharemarket places on uncertainty, particularly when investors have come to expect the opposite. Seizing the opportunity But it is in the face of severe uncertainty that we think opportunity knocks loudest. Yes, Sigma s relationship with its largest customer is somewhat fractured. Differences of opinion between Sigma and CWG have largely been addressed, for now, but it is unclear what will happen post-2019 when the distribution agreement between the pair expires. Round one has been resolved amicably, but round two looms large in the minds of investors. And yes, there are risks associated with drug manufacturers bypassing Sigma s distribution network. In investing, the price one pays should be paramount. Sigma s uncertain future is now well appreciated by the sharemarket and, at least in part, reflected in the share price one pays today. Or it certainly was at its recent 75 cents-per-share lows. At its recent lows, Sigma traded at less than 10 times its forecast pre-tax operating profit and about 13 times its forecast aftertax earnings. This was a substantial discount to the broader sharemarket and, in our view, well in excess of what was warranted considering the range of possible outcomes. We increased our holding substantially. The future may be brighter than people think Amongst all the uncertainty, there are also silver linings. For example, there is a real possibility that the Australian Government stops manufacturers from exclusively distributing their drugs directly to pharmacies, as it makes it more difficult for CSO wholesalers to meet their commitments. This is arguably in the public interest, as the scheme s purpose is to ensure ready access to essential medicines listed on Australia s PBS. If the Australian Government did change the rules for manufacturers, the 1% revenue lost from AstraZeneca s decision may ultimately end up being an 8% revenue tailwind as Pfizer s drugs may also need to be channelled back through the CSO wholesalers (like Sigma). Anecdotally, this would also be supported by pharmacies, which would require less investment in working capital as CSO wholesalers are required to deliver within 24 hours. Pharmacies would also benefit from reduced operating complexity (and most likely cost) as they would deal with fewer suppliers. It is easy (and important) to obsess about the downside when it comes to investing, but it is helpful to turn the coin over from time to time to get a balanced view of a company s future prospects. Sigma s future is far from risk-free, but we feel its future prospects are better than the sharemarket believes, despite the uncertainty around its biggest customer. Sigma has since increased in price, but remains priced at a modest discount to the sharemarket. It is hard to know whether Sigma s future prospects are adequately reflected in the price one pays today, but we believe there is still relative value in owning the company. Investors remain concerned about CWG moving its business to a competitor, but the downside in Sigma s earnings are no more severe than the company s discount to the broader sharemarket. And this is not a certain outcome. Even if it did happen, offsetting the impact on the company s earnings would be a near $300m release in working capital that could be invested in other profitable endeavours. 4 of 15

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6 EQUITY FUND PERFORMANCE Allan Gray Australia Equity Fund Class A units ANNUALISED (%) Allan Gray Australia Equity Fund S&P/ASX 300 Accumulation Index Relative Performance Since Public Launch on 4 May Years Years Years Year NOT ANNUALISED (%) Latest Quarter Allan Gray Australia Equity Fund Class B units Allan Gray Australia Equity Fund S&P/ASX 300 Accumulation Index Relative Performance ANNUALISED (%) Since Class Launch on 26 October Years Years Year NOT ANNUALISED (%) Latest Quarter Highest and lowest annual return since launch Allan Gray Australia Equity Fund - Class A units Return % Calendar year Highest Lowest (45.9) 2008 Allan Gray Australia Equity Fund - Class B units Return % Calendar year Highest Lowest (4.7) 2015 Returns shown are net of fees and assume reinvestment of distributions. Returns are annualised for periods of one year and over. Annualised returns show the average amount earned on an investment in the relevant Class each year over the given time period. Actual investor performance may differ as a result of the investment date, the date of reinvestment of income distributions, and withholding tax applied to income distributions. The highest and lowest returns earned during any calendar year since the launch of each Class are shown to demonstrate the variability of returns. The complete return history for each Class can be obtained by contacting our Client Services team. 6 of 15

7 EQUITY FUND HOLDINGS (CLASS A AND CLASS B) Fund holdings as at 31 December 2017 Statement of net assets (unaudited) Security Market Value AUD 000 s % of Fund Woodside Petroleum 152, Newcrest Mining 131,567 9 Alumina 122,123 8 Origin Energy 118,631 8 Metcash 89,267 6 QBE Insurance Group 76,921 5 Sims Metal Management 56,623 4 Woolworths Group 51,125 3 AusNet Services 46,854 3 Sigma Healthcare 43,221 3 WorleyParsons 40,330 3 Chorus 39,530 3 Southern Cross Media Group 35,841 2 National Australia Bank 33,599 2 Austal 33,211 2 Navitas 32,909 2 Oil Search 29,491 2 HT&E Limited 29,415 2 Nine Entertainment Holdings 26,928 2 Peet 25,370 2 Downer EDI 24,515 2 Australia and New Zealand Banking Group 24,059 2 Telstra 19,890 1 Sirtex Medical 17,937 1 Starpharma Holdings 17,751 1 ImpediMed 17,107 1 ALE Property Group 16,760 1 Positions less than 1% 122,602 8 Total Security Exposure 1,475, ASX SPI 200 Futures Contract (03/2018) 49,063 3 Net Current Assets 7,589 1 Net Assets 1,532, Price per unit - Class A (cum distribution) AUD Price per unit - Class B (cum distribution) AUD Total Assets Under Management for the Australian equity strategy (AUD 000 s) AUD 5,338,567 Futures contracts are fully backed by cash holdings. Allan Gray Australia Pty Ltd also manages segregated accounts that have substantially the same investment goals and restrictions as the Fund. 7 of 15

8 BALANCED FUND PERFORMANCE Allan Gray Australia Balanced Fund Allan Gray Australia Balanced Fund Custom Benchmark* Relative Performance Since Public Launch on 1 March Latest Quarter * The Custom Benchmark for the Fund comprises 36% S&P/ASX 300 Accumulation Index; 24% S&P/ASX Australian Government Bond Index; 24% MSCI World Index (net dividends reinvested) expressed in AUD; and 16% JPMorgan Global Government Bond Index expressed in AUD. Returns shown are net of fees and assume reinvestment of distributions. Returns are annualised for periods of one year and over. Annualised returns show the average amount earned on an investment in the relevant Fund each year over the given time period. Actual investor performance may differ as a result of the investment date, the date of reinvestment of income distributions, and withholding tax applied to income distributions. 8 of 15

9 BALANCED FUND HOLDINGS Fund holdings as at 31 December 2017 Statement of net assets (unaudited) Security Market Value AUD 000 S % of Fund Equity Domestic Equity Woodside Petroleum 1,636 4 Newcrest Mining 1,523 3 Origin Energy 1,420 3 Alumina 1,263 3 QBE Insurance Group 1,197 3 Metcash 1,000 2 Sigma Healthcare Woolworths Group Sims Metal Management Peet WorleyParsons AusNet Services HT&E Limited Navitas Domestic Equity Positions less than 1% 3,560 8 Global Equity AbbVie 1,239 3 Bristol-Myers Squibb Royal Dutch Shell BP Chorus XPO Logistics Mitsubishi Alphabet Wells Fargo & Company Samsung Electronics American Intl. Group Imperial Brands Daito Trust Construction Global Equity Positions less than 1 % 9, Total Gross Equity^ 33, ^ The Fund holds derivative contracts which reduces the effective net equity exposure to 68% 9 of 15

10 BALANCED FUND HOLDINGS Security Market Value AUD 000 S % of Fund Fixed Income Domestic Fixed Income Australian Government Bonds 7, Global Fixed Income Global Fixed Income Positions less than 1% 1,734 4 Total Fixed Income 8, Commodity Linked Investments SPDR Gold Trust 1,359 3 Total Commodity Linked Investments 1,359 3 Total Security Exposure 43, Term Deposits and Cash 1,579 4 Net Current Assets 28 <1 Net Assets 45, Price per unit (cum distribution) AUD of 15

11 STABLE FUND PERFORMANCE Allan Gray Australia Stable Fund Allan Gray Australia Stable Fund RBA Cash Relative Performance Distribution ANNUALISED (%) Since Public Launch on 1 July Years Years Year NOT ANNUALISED (%) Latest Quarter Highest and lowest annual return since public launch Allan Gray Australia Stable Fund Return % Calendar year Highest Lowest Returns shown are net of fees and assume reinvestment of distributions. Returns are annualised for periods of one year and over. Annualised returns show the average amount earned on an investment in the relevant Fund each year over the given time period. Actual investor performance may differ as a result of the investment date, the date of reinvestment of income distributions, and withholding tax applied to income distributions. The highest and lowest returns earned during any calendar year since the public launch of each Fund are shown to demonstrate the variability of returns. The complete return history for each Fund can be obtained by contacting our Client Services team. 11 of 15

12 STABLE FUND HOLDINGS Fund holdings as at 31 December 2017 Statement of net assets (unaudited) Security Market Value AUD 000 s % of Fund Woodside Petroleum 8,156 4 Newcrest Mining 7,684 3 Origin Energy 6,111 3 Alumina 6,088 3 Metcash 5,075 2 QBE Insurance Group 3,391 1 Sigma Healthcare 2,471 1 Sims Metal Management 2,382 1 Positions less than 1% 15,433 7 Total Security Exposure 56, Term Deposits and Cash 172, Net Current Assets 1,066 <1 Net Assets 230, Price per unit (cum distribution) AUD of 15

13 INFORMATION ABOUT THE FUNDS Allan Gray Australia Equity Fund Allan Gray Australia Balanced Fund Allan Gray Australia Stable Fund Investment objective The Fund seeks long-term returns that are higher than the S&P/ ASX 300 Accumulation Index (Benchmark). To seek long-term returns that are higher than the Custom Benchmark. In doing so, the Fund aims to balance capital growth, income generation and risk of loss using a diversified portfolio. The Fund aims to provide a longterm return that exceeds the Reserve Bank of Australia cash rate (Benchmark), with less volatility than the Australia sharemarket. Who should invest? Investors looking for contrarian investment style exposure to the Australian sharemarket and who are able to take a long-term view and endure performance fluctuations. Investors with an investment horizon of at least three years who want to easily diversify their portfolio within a single fund and are looking for less ups and downs than investing solely in shares. The Fund invests in shares, fixed income, cash and commodity investments sourced locally and globally. Investors with a two-year or longer investment horizon who are looking for an alternative to traditional money market and income generating investments. The Fund s portfolio can hold a combination of cash and money market instruments (100% to 50%) and ASX securities (up to 50%) in pursuit of stable long-term returns. Dealing Daily (cut-off at 2pm Sydney time. A different cut-off applies if investing via mfund, where applicable). Buy/sell spread +0.2%/-0.2% +0.2%/-0.2% +0.1%/-0.1% Fees and expenses (excluding GST) Class A Management fee comprises: Fixed (Base) fee 0.75% per annum of the Fund s NAV. Performance fee 20% of the Class outperformance, net of the base fee, in comparison to the Benchmark. A performance fee is only payable where the Class outperformance exceeds the high watermark, which represents the highest level of outperformance, net of base fees, since the Class inception. Management fee comprises: Fixed (Base) fee 0.75% per annum of the Fund s NAV. Performance fee 20% of the Fund s outperformance, net of the base fee, in comparison to the Custom Benchmark. A performance fee is only payable where the Fund s outperformance exceeds the high watermark, which represents the highest level of outperformance, net of base fees, since the Fund s inception. Management fee comprises: Fixed (Base) fee 0.25% per annum of the Fund s NAV. Performance fee 20% of the Fund s outperformance, net of the base fee, in comparison to the Benchmark. A performance fee is only payable where the Fund s outperformance exceeds the high watermark, which represents the highest level of outperformance, net of base fees, since the Fund s inception. Class B Management fee comprises: Fixed (Base) fee Nil. Performance fee 35% of the Class outperformance in comparison to the Benchmark. A performance fee is only payable where the Class outperformance exceeds the high watermark, which represents the highest level of outperformance, since the Class inception. Minimum initial investment AUD 10,000/AUD 500 per month on a regular savings plan. Additional investment AUD 1,000/AUD 500 per month on a regular savings plan. Redemption No minimum applies for ad hoc redemptions. A minimum of AUD 500 per month applies on a regular redemption plan. Investors must maintain a minimum account balance of AUD 10, of 15

14 NOTICES Sources The source for the S&P/ASX 300 Accumulation Index and the S&P/ASX Australian Government Bond Index is Standard & Poor s. S&P is a trademark of S&P Global, Inc.; ASX and ASX 300 are trademarks of ASX Operations Pty Limited ( ASXO ); and S&P/ASX300 exists pursuant to an arrangement between ASXO and Standard & Poor s. The source for the MSCI World Index is MSCI Inc. MSCI is a trademark of MSCI Inc. The source for the JP Morgan Global Government Bond Index is J.P. Morgan Securities LLC. JP Morgan is a trademark of JPMorgan Chase & Co. The third party information providers do not guarantee the accuracy, adequacy or completeness of this information, and no further distribution or dissemination of the index data is permitted without express written consent of the providers. None of those parties shall have any liability for any damages (whether direct or otherwise). Returns Fund returns are gross of all income, net of all expenses and fees, assume reinvestment of distributions and exclude any applicable spreads. Risk Warnings Managed investment schemes are generally medium to longterm investments. Past performance is not indicative of future performance. Each Fund s unit price will fluctuate and the Fund s performance is not guaranteed. Returns may decrease or increase as a result of currency fluctuations. When making an investment in a Fund, an investor s capital is at risk. Subject to the disclosure documents, managed investment schemes are traded at prevailing prices and can engage in borrowing and securities lending. Fees The base fee and the performance fee (if applicable) are calculated and accrued daily, and paid monthly. A schedule of fees and charges is available in the relevant Fund s disclosure documents. US and European Persons The Funds do not accept US persons as investors and are not marketed in the European Economic Area (EEA). Investors resident in the EEA can only invest in the Fund under certain circumstances as determined by, and in compliance with, applicable law. Other Equity Trustees Limited, AFSL No is the issuer of units in the Allan Gray Australia Equity Fund, the Allan Gray Australia Balanced Fund and the Allan Gray Australia Stable Fund and has full responsibility for each Fund. Equity Trustees Limited is a subsidiary of EQT Holdings Limited, a publicly listed company on the Australian Stock Exchange (ASX:EQT). Allan Gray Australia Pty Limited, AFSL No is the Funds investment manager. Each Fund s Product Disclosure Statement and Information Booklet (together, PDS) are available from www. allangray.com.au or by contacting Client Services on (within Australia) or (outside Australia). You should consider the relevant Fund s PDS in deciding whether to acquire, or continue to hold, units in the fund. This report provides general information or advice and is not an offer to sell, or a solicitation to buy, units in the relevant Fund. Where the report provides commentary on a particular security, it is done to demonstrate the reasons why we have or have not dealt in the particular security for a Fund. It is not intended to be, or should be construed as, financial product advice. This report is current as at its date of publication, is given in good faith and has been derived from sources believed to be reliable and accurate. It does not take into account your objectives, financial situation or needs. Any implied figures or estimates are subject to assumptions, risks and uncertainties. Actual figures may differ materially and you are cautioned not to place undue reliance on such information. Subject to applicable law, neither Allan Gray, Equity Trustees Limited nor any of its related parties, their employees or directors, provide any warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Fees are exclusive of GST. Totals presented in this document may not sum due to rounding. 14 of 15

15 INVESTMENT MANAGER Allan Gray Australia Pty Ltd ABN , AFSL No Level 2, Challis House, 4 Martin Place Sydney NSW 2000, Australia Tel RESPONSIBLE ENTITY AND ISSUER Equity Trustees Ltd ABN , AFSL No Level 1, 575 Bourke Street Melbourne VIC 3000, Australia GPO Box 2307, Melbourne VIC 3001, Australia Tel of 15