Quarterly report. Prepared for Antares Core Opportunities Model Portfolio June 2014

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1 Quarterly report Prepared for Antares Core Opportunities Model Portfolio June 2014

2 Table of contents Quarter in review... 3 Fund performance... 4 Quarterly attribution analysis... 5 Major factors contributing to performance... 6 Portfolio Activity... 8 Outlook and strategy Contact Details Investor Services Phone: Fax: investorservices@antaresequities.com.au Quarterly Report prepared for Antares Core Opportunities Model Portfolio June

3 Quarter in review The Australian sharemarket experienced subdued performance despite strength in global sharemarkets. The S&P/ASX 200 Accumulation Index rose just 0.9% in the quarter but returned a solid 17.4% for the financial year. The best performing sectors were REITs (+9.3%) and utilities (+7.9%) that were supported by falling bond yields. The 4.6% rise in the oil price underpinned the energy sector (+5.2%). The materials sector (-3.1%) was negatively affected by the higher Australian dollar and a sharp fall in the iron ore price (-19.7%). The consumer discretionary sector also underperformed, as several retailers warned that sales had been affected by the fall in consumer confidence following the Federal budget. Merger and acquisition activity continued to be a focus, with over $5 billion in takeover announcements involving high profile companies such as David Jones and Goodman Fielder. The major deals included: South African based Woolworths Holdings made a bid for David Jones, offering to pay $4.00 cash per share. David Jones Board advised shareholders to accept the offer in the absence of a superior proposal and subject to an independent experts report. Wilmar/First Pacific made a non-binding, conditional bid for Goodman Fielder at $0.70 per share. Aurizon Holdings and Baosteel (Chinese steelmaker) offered to buy Aquila Resources for $1.42 billion Private equity firm, Kohlberg Kravis Roberts (KKR), made a $4.70 per share bid for Treasury Wine Estates which was rejected. Quarterly Report prepared for Antares Core Opportunities Model Portfolio June

4 Fund performance The following table shows the performance of the Core Opportunities Model Portfolio relative to its benchmark. Period Net fund return 1 % Benchmark return 2 % Performance differential % Gross fund return % Quarter months year years p.a Since Inception p.a. (22/11/2010) Returns are calculated using the market value and income of the Model Portfolio and is net of fees. The performance of individual portfolios may differ to the performance of the Model Portfolio due to cash flows, portfolio reweighting and timing issues. 2 S&P/ASX200 Accumulation Index. Quarterly Report prepared for Antares Core Opportunities Model Portfolio June

5 Quarterly attribution analysis The major factors positively contributing to performance were: Stocks Positioning Basis point contribution 3 Oil Search Overweight 32 Qantas Airways Overweight 17 WorleyParsons Overweight 16 Asciano Overweight 16 Stockland Overweight 15 CSL Not owned 13 Fortescue Metals Group Not owned 12 Ansell Overweight 12 AMP Overweight 12 Suncorp Group Overweight 7 The major factors negatively contributing to performance were: Stocks Positioning Basis point contribution 3 Coca-Cola Amatil Overweight -36 QBE Insurance Group Overweight -26 Iluka Resources Overweight -23 National Australia Bank Overweight -19 Westfield Corporation Not owned -16 BlueScope Steel Overweight -14 Rio Tinto Overweight -12 Commonwealth Bank Underweight -9 Woodside Petroleum Not owned -8 Treasury Wine Estates Not owned -7 3 Approximate basis point contributions and are not additive. Quarterly Report prepared for Antares Core Opportunities Model Portfolio June

6 Major factors contributing to performance Performance The Core Opportunities Model Portfolio returned 0.7% (net of fees) for the June quarter, underperforming its benchmark, the S&P/ASX 200 Accumulation Index that returned 0.9%. Contributors to performance Major contributors to performance over the quarter included: Oil Search (OSH, overweight) Oil Search continued to perform well, supported by the higher oil price that rose in response to ongoing geopolitical tensions in Europe and the Middle East. OSH also announced that it had been successful in exporting the first gas from PNG LNG to Japan. Much higher production volumes are expected from OSH as PNG LNG ramps up. Worley Parsons (WOR, overweight) An overweight position in WorleyParsons performed well as the company announced the reorganisation of its business following a strategic review. The company has implemented three new business lines Services (consulting and delivery), Major Projects (winning and executing work) and Improve (maintenance and capex) to replace its old commodity based structure. WOR expects the new structure to reduce corporate overheads and give the company a more competitive cost base. WOR also expects better margins to eventuate from FY15 onwards. In May and June WOR was awarded several new contracts, including: an engineering, procurement & construction management contract for the Trans Anatolian Natural Gas Pipeline Project; a portfolio management contract of four LNG trains for the Atlantic Company of Trinidad and Tobago; a front-end engineering design contract for the LNG Canada Project; an engineering and product services provider contract for Queensland Gas Company at its QCLNG facility; and a construction management support contract for Vale at a project in Brazil. Major detractors from performance during the quarter included: Coca-Cola Amatil (CCL, overweight) The Fund s overweight position in CCL detracted from performance as the company unexpectedly announced a 1H14 earnings downgrade, citing its Australian beverages business and Indonesia as the main sources of weakness. The company now expects 1H14 earnings before interest and tax to decline by around 15% which was well below analysts forecasts. CCL also gave negative guidance, with the company expecting challenging trading conditions to continue. QBE Insurance Group (overweight) An overweight position in QBE detracted from performance. QBE announced that it will be doing a strategic review of its US-based middle market business which represents about 5% of the group s gross written premium. QBE also held its AGM where it reiterated its guidance for CY14. Major selling pressure occurred in mid-april when QBE announced the conversion of US$250 million of subordinated convertible preference shares. This was viewed negatively by investors as it had the same effect as US$250 million worth of new shares being issued over the 35 trading days to 11 June. Quarterly Report prepared for Antares Core Opportunities Model Portfolio June

7 Iluka Resources (ILU, overweight) Mineral sands producer, Iluka Resources (ILU), experienced weak performance after releasing disappointing results for the March quarter as softer than expected demand caused the company to operate below full production capacity. Both rutile and ilmenite volumes were below the company s Q production levels but zircon production was up 13.6% on the previous quarter. Late in the quarter, ILU announced that it had entered into a joint development agreement and an intellectual property agreement with Vale S.A. to evaluate and potentially develop a major titanium deposit in Brazil. ILU was also forced to disclose to the market via an ASX query that it had presented a merger proposal to UK based Kenmare Resources plc that was rejected by the Kenmare Board. Quarterly Report prepared for Antares Core Opportunities Model Portfolio June

8 Portfolio Activity Major purchases / additions to the portfolio: The Portfolio purchased a new position in Ansell (ANN). At face value, Ansell offers a reasonable multiple of 15 times 1-year forward earnings which is below the ASX 200 Industrials average of 16.1 times (see Chart 1 overleaf), despite its projected ROE of 15% being well above the industrials average. Chart 1: Ansell 1-year forward PE relative to S&P/ASX 200 Industrials Index Source: Bloomberg While this has been the case for some time, we believe the time is now right to enter the stock for several reasons. Firstly, intermodal volumes in the United States (Ansell s biggest geographical exposure) are moving up significantly, along with shipping volumes from East Asia into the US, all suggesting that capital spending is increasing there. This is important to Ansell s biggest division which is Industrial. Further, we have seen a turnaround in European car sales. These are now trending strongly upwards from their trough mid last year. Again, Ansell s major division, Industrial, has significant exposure to this area. Finally, we have seen steep declines in the commodity prices of latex and cotton which are the two major raw ingredients used by Ansell in its production. We believe the market has marked the stock down on a poor first half result and with macro conditions seemingly improving in its core areas, we see Ansell being well placed to surprise the market on the upside and deliver a strong second half result. Existing positions in Santos, Rio Tinto and QBE Insurance Group were increased. Quarterly Report prepared for Antares Core Opportunities Model Portfolio June

9 Major sales / reductions to the portfolio: During the period we reduced the Portfolio s exposure to the banking sector and in particular Westpac Banking Corporation (WBC). Our decision is driven by the relative attractiveness between various financial stocks, rather than anything specific to WBC. At this stage of the cycle we feel that the banks are over earning and, although it is difficult to predict when earnings will normalise, we feel that they inevitably will. The main area of over earning stems largely from provisions, which have now been reduced to well below long term averages. This is best illustrated by using material from some recent presentations done by the banks themselves. Below is a chart of Westpac Banking Corporation s (WBC s) impairment charge back to Taking an average over this period yields a figure of 25.5 basis points which is almost twice the number reported in the last result. Chart 2: Bank impairment charges Source: Westpac Banking Corporation If we normalise the current impairment charge to the long term average, it would result in a charge of around $725m (vs the $341m shown in the table below). This equates to a 10% lower cash earnings number (all else being equal). Source: Westpac Banking Corporation Quarterly Report prepared for Antares Core Opportunities Model Portfolio June

10 Further compounding the over valuations is the fact that these inflated earnings are now being priced at relatively high multiples. Historically the banks have traded at a 10% percent discount to the industrial market (as shown in chart 3 below). In recent times, the PE relative has drifted higher to now be only a 5% discount. Chart 3: WBC PE relative to the market 1.10 WBC PE relative to ASX/S&P 200 Industrials (12m FWD) May 05 May 06 May 07 May 08 May 09 May 10 May 11 May 12 May 13 Source: Bloomberg Taking WBC as an example and normalising for a through the cycle bad debt charge and capitalising these earnings at the historic discount to the industrials market we arrive at a price that is some 15% below the current share price. Quarterly Report prepared for Antares Core Opportunities Model Portfolio June

11 Outlook and strategy Outlook The US economy now appears to be on a more solid footing, having recovered from the weather related Q1 weakness. Recent key data releases have been stronger than expected, particularly the May employment report that showed that the average job gain in the past three months of 234,000. The May ISM Index was also impressive, with a jump in the production component from 55.7 to With the outlook for US growth becoming more positive, investors will remain focused on the speed of further Fed tapering and, ultimately, the timing of the first interest rate rise. The pace of the economy will also be important, as stronger growth needs to feed into revenue and earnings growth for the market to continue to perform well on a longer term view Signs of a rebound in the US economy, further monetary policy easing by the European Central Bank and a stabilisation in the Chinese economy are all providing some underlying support for sharemarkets. Widespread merger and acquisition (M&A) activity and continued high levels of share buybacks are also positive themes. Bloomberg data shows that the total volume of share buybacks amongst S&P 500 companies in Q1 was in excess of US$150 billion, its highest level since Q July heralds the start of the Q2 earnings reporting season in the US which should give some insights into whether end user demand has started to generate revenue improvements. The Australian government s tough budget has significantly impacted consumer sentiment and this presents a risk to consumer demand in the second half of the year. Although very low domestic interest rates will continue to support growth, any slowing in consumer demand will make current growth forecasts hard to achieve given the likelihood of significantly weaker business investment as a result of the slowdown in the mining sector. The Reserve Bank of Australia (RBA) has held a neutral policy stance since its February Board meeting and this was reiterated in early July. However, the RBA may need to rethink this stance in coming months if growth slows materially. Looking forward, the Australian sharemarket will continue to be supported by very low domestic interest rates. However, the negative effect of the Federal Government s budget on consumer sentiment is likely to weigh on the market and could cause some earnings risk for consumer facing stocks going into the August reporting season. The market is also being constrained by weakness in the materials sector, particularly iron ore related stocks as the iron ore price has fallen to its lowest level since late Q Whilst the weakness in iron ore prices is partly related to uncertainty over Chinese growth, it is also a function of the expected large increase in iron ore supply later this year, suggesting a sharp rebound is unlikely in coming months. Quarterly Report prepared for Antares Core Opportunities Model Portfolio June

12 Strategy The Portfolio s main overweight position continues to be resource stocks although the size of this overweight position was reduced earlier this year. The Portfolio remains overweight mining stocks including Rio Tinto, BHP Billiton and Iluka Resources. The Portfolio also has exposure to the mining services sector through an overweight position in WorleyParsons. Companies that have a high proportion of their revenues denominated in US dollars are the main beneficiaries of $A weakness as a falling $A increases the value of revenues from an Australian accounting perspective. Within the Portfolio we currently have significant overweight positions in Computershare and Brambles which should benefit from this theme as they all have at least 50% of their revenues denominated in $US. Our overweight positions in Australia s major resource stocks should also benefit from ongoing $A weakness for the same reason. The Portfolio is overweight selected industrial cyclical stocks such as BlueScope Steel, Brambles and Qantas Airways that will benefit from stronger growth and are also experiencing significant structural changes which have improved their fundamental valuations. The Portfolio is overweight market linked earners with our main positions being in Computershare and AMP. These stocks are highly leveraged to stronger equity market performance and rising risk appetite. These stocks should also benefit from any increase in demand for equities as institutional and retail investors re-weight their portfolios back in favour of equities. The Portfolio is largely underweight defensive stocks. The main exceptions are Wesfarmers and Telstra where we remain overweight as these stocks have strong businesses that we believe will continue to perform well over the longer term for stock specific reasons. Exposure to bank stocks was reduced in April and now stands at approximately 5% underweight (for the four major banks). At this stage of the cycle we feel that the banks are over earning and, although it is difficult to predict when earnings will normalise, we feel that they inevitably will. The main area of over earning stems largely from provisions, which have now been reduced to well below long term averages. We feel there is better value in the insurance sector where we are now over 5% overweight, driven by our holdings in AMP, Suncorp Group and QBE Insurance Group. The main risk to the portfolio is that the strengthening in global growth that we expect in 2014 fails to materialise, causing a significant sell off in resource and cyclical stocks and a better performance from defensive sectors. In addition, the February reporting season showed that companies are still not experiencing an improvement in sales or volumes with most earnings growth being generated by ongoing cost cutting. This is not sustainable over the longer term. For the market to continue to perform well, we need to see the start of a trend towards earnings upgrades and some improvement in top line growth also needs to come through. Quarterly Report prepared for Antares Core Opportunities Model Portfolio June

13 F Contact Address Antares Capital Partners Limited Level 20, 8 Exhibition Street, Melbourne, Vic 3000 Postal address GPO Box 2007, Melbourne, Vic 3001 P F antarescapital.com.au The statements of opinion contained herein, and the information upon which they are based, are of a general nature only. They are not intended to be relied upon for the purpose of making an investment decision. It is not intended as financial advice to retail clients. Further information or professional advice should be sought. Except for any liability which cannot be excluded, the directors and employees of Antares Capital Partners Limited ABN , AFS Quarterly Licence Report No prepared disclaim for Antares all responsibility Core Opportunities for any loss Model suffered, Portfolio directly June or 2014 indirectly by any person acting in reliance 13 upon the information contained herein. Past performance does not guarantee future performance.