Quarterly Report June Ralton Australian Shares. Portfolio Structure. Performance. Key Portfolio Features

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1 Quarterly Report June 2013 Ralton Australian Shares Winner of the 2010 Standard & Poors Fund Awards - Separately Managed Accounts Catergory Ralton Investment Professional Profile Partners Portfolio A Professionally Managed Portfolio of Australian Shares The Ralton Australian Shares model portfolio is a separately managed account, or SMA, actively managed by Ralton Asset Management (Ralton). SMAs are professionally managed portfolios of direct shares whereby the investor receives beneficial ownership of the underlying securities. Winner of the 2010 Standard & Poors Fund Awards The Portfolio is designed - Separately for investors Managed whoaccounts Catergory - Seek long term capital growth & some tax-effective income Expect consistent above market returns Have a long term investment horizon of at least five years and accept the risk of significant price fluctuations. Investment Objective The objective of the Ralton Australian Shares SMA is to to provide investors with long-term capital growth and some tax effective income from a concentrated portfolio of Australian shares. The Portfolio aims to deliver a return superior to that of the market over periods of five years or longer while at the same time seeking to minimise the risk of investment capital loss. Key Portfolio Features Inception 1 February 2008 Benchmark Authorised Investments Number of Stocks Cash Allocation 0% to 10% Tracking Error 3% to 6% Investment Horizon Ratings S&P/ASX 300 Accumulation Index Companies in the S&P/ASX 300 Index or those amongst the top 300 by size. At least 5 years Portfolio Structure No. Company Name ASX Code 1 Australia and New Zealand Banking Grp ANZ 2 Commonwealth Bank of Australia CBA 3 BHP Billiton Limited BHP 4 Telstra Corporation Limited TLS 5 News Corporation NWS 6 Westpac Banking Corporation WBC 7 Amcor Limited AMC 8 Oil Search Limited OSH 9 Suncorp Group Limited SUN 10 QBE Insurance Group Limited QBE GICS Sector Ralton Index +/- Consumer Discretionary 11.5% 3.7% 7.8% Telecommunication Services 8.9% 5.4% 3.5% Performance Return % 1m 3m 1yr 3yrs 5yrs Incept* Ralton Aust Shares Income Return Growth Return S&P/ASX 300 Accum. Index Difference *Since Inception p.a., Feb 2008 Financials (ex-property) 39.0% 37.6% 1.4% Industrials 7.5% 6.6% 0.9% Information Technology 0.0% 0.8% -0.8% Utilities 0.0% 1.7% -1.7% Energy 4.2% 6.2% -2.0% Health Care 2.1% 4.7% -2.6% Materials 13.6% 16.8% -3.1% Property 3.6% 7.6% -4.0% Consumer Staples 3.9% 8.9% -5.0% Total 100.0% 100.0%

2 Quarter in Review Performance Summary The S&P/ ASX 300 Accumulation Index lost 2.83% during the quarter, with gains in Healthcare and Telecommunications offset by falls in the Materials and Industrial sectors. For the quarter the Ralton Australian Shares Model Portfolio added 0.74%, outperforming the benchmark by 3.57%. At a sector level, our overweight exposure to the Consumer Discretionary and underweight to the Materials sector were the key contributor to our positive performance. Portfolio Commentary The portfolio s international focused stocks featured heavily amongst the top performers in the quarter. Key stocks included QBE Insurance (QBE Insurance, +19.8%), Brambles (BXB, +10.3%), Amcor Limited (AMC, +9.3%) and Aristocrat Leisure (ALL, +10.4%). Consumer Discretionary stocks Aristocrat Leisure (ALL, +10.4%) and News Corporation (NWS, +17.0%) contributed heavily to portfolio performance. Late in the quarter, News Corporation (NWS) completed its demerger, forming two companies, New News Corporation (NNC) and Twenty-first Century FOX (FOX). NNC is the smaller entity post demerger, although it still has an US$8bn market capitalisation. Held within NNC are the Australian based assets of Fox Sports, 50% of Foxtel (the balance held by Telstra), a 62% holding in the listed REA Group (REA), News Corporation newspapers assets in US, UK and Australia. Additionally, NNC starts its corporate life with $2.6bn in cash and ownership of the US based education business, Amplify. Although currently loss making, Amplify has strong growth potential, offering online education, but supported by the content and distribution skills of one of the world s premier media companies. Offsetting these positives is the competitive dynamics of the education industry and perhaps, a long path to profitability. Post-split we have increased our holding in NNC. International focused stocks including Amcor Group (AMC, +9.3%) and Brambles (BXB, +10.3%) both performed well in the quarter, no doubt aided by the fall in the Australian dollar (i.e. increase in profits as US dollar profits are translated back into local currency). Brambles recent sales update for the nine months to March 2013 confirmed that momentum in the company s global transport operations, particularly in the US, continues to build. Economic growth in the US remains reasonable, however new business wins continue to be a feature, vindicating the decision by management to increase service standards 3 years ago. Brambles has also announced the demerger of the Recall document storage business in late Resmed s (RMD, +14.7%) recent 3Q13 profit result was well received by the market as the company continues to benefit from solid demand for its products in the obstructive sleep apnea (OSA) segment. Looking into the 2H13 Resmed will need to navigate through the recent introduction of pricing changes in the US, bought about under the banner of competitive bidding. Although competitive bidding is complex to interpret we do expect Resmed to experience some pricing pressure. However, such headwinds are typical of what most healthcare providers face year in and year out. As a counter, the market in volume terms for Resmed continues to grow, aided by ease of diagnosis and treatment since the introduction of home sleep testing (HST). The portfolio s diversified financial sector exposures including Henderson Group (HGG, +5.1%) and Magellan Financial (MFG), (which was purchased during the quarter), added to portfolio returns. Henderson is beginning to see an improvement in retail fund inflows in its key UK market, which bodes well for future profit growth. We expect these inflows to continue to build across the remainder of the year. Recent institutional mandate wins have enabled MFG to grow FUM levels strongly off a low base. Finally, QBE Insurance (QBE, +19.8%) performed well as investors begin to factor in the operational cost savings, benefits of the end of QE3 (QBE is a beneficiary from higher interest rates) and an improved outlook for US premium increases. QBE has indicated an initial cost savings target of $250m. However, as this is only a modest percentage of the overall company costs, we believe that that this figure could be exceeded over time. Quarterly Performance Attribution Top Contributors Amcor Ltd News Corporation Magellan Financial Group Positioning Key Detractors Positioning Cash Converters Int. Newcrest Mining Ltd Transpacific Ind. Group Ltd Oil Search Ltd Orica Ltd Aristocrat Leisure Ltd Macquarie Group Ltd Underweight Chemical companies Incitec Pivot (IPL, -7.4%) and Orica Limited (ORI) were the two of the largest detractors from portfolio performance during the quarter. Both companies recently reported reasonable profit results for the first half of FY13, largely in line with market forecasts. However, global pricing for both thermal and coking coal remain under pressure, impacting profitability of East Coast coal miners, a market where Orica dominate in terms of explosives supply. At current prices for thermal 02

3 coal, most of Australia s mines are unlikely to cease production in the near term, but the miners are also unlikely to expand or open new mines. With both Indonesia and United States exports causing a moderate oversupply for thermal coal, and China now looking at reducing pollution from high ash or dirty thermal coal, the whole seaborne market for thermal coal is under pressure. For Orica, without ongoing mine expansions, volume benefits from future mine expansions now appear highly unlikely until global supply rebalances. Given this headwind, the outlook for profit growth for Orica is now less certain and on this basis we firstly reduced our holding in Orica and in early June exited our entire position. We still expect Orica to maintain their current dominance of the East coast explosives market, and hence, will continue to monitor what we believe is a high quality company should the investment case for thermal coal improve. For Incitec Pivot (IPL, -7.4%) the FY13 profit result was tempered by issues with the ramp up in production for the company s flagship explosives manufacturing plant at Moranbah, QLD. Despite this hiccup we believe that the issues IPL have experienced are addressable and that the company will achieve its targeted production for the plant in due course. In comparison to Orica, IPL has a greater exposure to the improving United States economy. We expect IPL to benefit from rising demand for explosives from the quarry and construction market as the US housing market improves. Also, to a lesser extent, no further decrease in US domestic coal consumption and perhaps even some increase in demand, would be a positive. After several years of currency headwinds, IPL also looks set to benefit from a falling Australian dollar in terms of profit translation. On this basis, we used the recent price weakness to increase our position in IPL. AMP Limited (AMP, -18.4%), also detracted from portfolio performance during June. Although we reduced our exposure to the stock, a downgrade of profit expectations late in the month was not well received by the market. Despite solid performance across most of AMP s operations, the profit downgrade was driven by a step up in losses in its Wealth Protection division. This was driven by an increase in both claims and lapse rates. Such patterns of behavior are not uncommon during periods of economic weakness, although the market was surprised by the speed of these changes, given the adjustments made to underlying assumptions at the last profit results. From our mid-cap exposures the largest detractor from portfolio performance was Transpacific Industries (TPI, -19.2%). A profit downgrade from TPI and the announcement that the CEO is looking to resign in the near term were the key drivers of share price weakness. Specifically, TPI s profit results have been impacted by weakness in demand for maintenance and shutdown work across Australia. No doubt, this performance is a result of falling business confidence and pressure to defer or cut costs. Our investment thesis for TPI is focused on two key aspects to drive its profit growth in coming periods: (a) the scope for further operational cost savings; and (b) the progressive reduction in interest costs over the next 3 years. The underlying business of waste disposable is typically stable and should be expected to grow in line or above GDP over time. However, in the short term TPI are clearly not immune from poor economic conditions. Portfolio Adjustments During the quarter we... SOLD: BOUGHT: AGL Energy Ltd (AGK), ALS Ltd (ALQ), Ansell Ltd (ANN), Cash Converters International (CCV), Clough Ltd (CLO), Lend Lease Group (LLC), Miclyn Express (MIO), Newcrest Mining (NCM), Orica Ltd (ORI) Automotive Holdings (AHE), Federation Centres (FDC), Magellan Financial Group (MFG), ResMed Inc (RMD), Sky Network Television (SKT), Sydney Airport Holdings (SYD), Toll Holdings (TOL), Treasury Wine Estates (TWE) During the quarter we added several new stocks to the portfolio, including Magellan Financial Group (MFG), Treasury Wines and Toll Holdings (TOL). TOL is a well known Australian brand that dominates domestic transport services. TOL was built over many years by long-serving CEO Paul Little. In recent years, the group has faced several headwinds. Reduced growth rates for consumer discretionary spending in Australia, increased penetration of online sales (bypassing TOL s traditional clients) and less demand for time critical (express) services have pressured the group s profit growth. Several of its more recent offshore acquisitions have also failed to live up to expectations. Brian Kruger (CEO) is now rolling out his own strategy to cut costs, improve the businesses integration and sell non-core assets. This should assist in improving TOL s financial performance even in the face of economic headwinds. TOL also has a solid balance sheet and an attractive yield. Magellan Financial Group (MFG) was also added to the portfolio during May. Magellan is an International Fund Manager, founded by two high-profile, former investment bankers. Magellan s focus is on International equities, including a dedicated infrastructure fund, and in recent periods, performance and fund flows have been very strong. Our sense is that the business is well managed and well marketed and is likely to continue to gain traction and fund flows for some time. It is also a material beneficiary of any further decline in the Australian dollar. We also exited several stocks during the quarter, including Clough Limited (CLO), ALS Ltd (ALQ), Newcrest Mining (NCM) and Orica Limited (ORI, discussed earlier). 03

4 The sale of ALS Limited (ALQ) and Clough Limited (CLO) reflected our view that the operating outlook in the mining and oil & gas services areas was deteriorating somewhat faster than we had anticipated. Senior management changes at the global diversified miners with a new focus on cost reductions (including the volumes and margins of their suppliers), has seen these service companies under intense pressure. We will continue to monitor these companies to determine, when, and if, we should consider investing again. However, at this stage we cannot determine the full depth of the downturn in exploration and engineering construction over the next few years. With Newcrest Mining (NCM), we had held a positive view on both the free cash flow that was expected following recent capital expenditure on new mine expansions in NSW and Lihir Island, and secondly, a supportive view of the gold price. In terms of the gold price, it is useful to restate our previous comments, namely,.. Our view on gold has been that the level of indebtedness of sovereigns and/ or households in the US and Europe would required an extended period of negative real interest rates to effectively devalue the debt. In this environment gold should prosper. We will continue to test this theory to ensure it is the main driver of gold and other influences are not becoming more important., from our April 2013 report. We also sold our holding in Miclyn Express Offshore (MIO). Miclyn s April market update suggested that operating conditions, including the key boat rental (utilisation) metric have been somewhat sluggish for the current FY13 financial year. However, looking into the next financial year, MIO have now achieved substantial pre-commitments for boat rentals and are expecting solid profit growth for FY14. Of more concern however was the continued share register creep by MIO s two major investors, CHAMP and Headland Capital. On 23rd April, these two investors combined to increase their holding in MIO by 16.2%. Our sense from here is that CHAMP and Headland will now attempt to take control of the company without paying a takeover premium, taking advantage of the corporate law in Bermuda. We viewed this development as unfavourable to minority investors and elected to sell. It is clear however that both aspects of our investment thesis have recently come under considerable pressure. Starting with the gold price, financial markets globally have been focused on the US Federal Reserve, who recently indicated that it will reduce its stimulus to financial markets (quantitative easing). This has had a considerable impact on the price of gold, copper and bond prices to name just a few. Secondly, Newcrest again surprised the market with a revised view of their operating outlook. Its Business Review on 7th June included significant write downs on key assets and dramatically lowered the outlook for production and free cash flow that NCM are expecting in FY14 and beyond. This last aspect was particularly disappointing as we, and many in the market had expected that NCM were about to produce significant free cash flows. When combined with what was evidently a lower and more volatile environment for the gold price we elected to sell the position in Newcrest. 04

5 Investment Approach A Three Stage Investment Process Intensive bottom-up research is the cornerstone of the entire process, supplemented by top-down economic and thematic views. The process is disciplined and consistently applied, using a number of proprietary qualitative and quantitative techniques to ensure that targeted companies have been thoroughly scrutinised. The aim is to uncover undervalued businesses. The companies that Ralton typically invests in are those with strong and reliable management, good profit and dividend growth expectations, reasonably predictable future profits and cash flows, and a very clear business model. Stage 1: Defining the Investment Universe (Screening) The first stage of the process is to narrow the number of stocks in the investment universe by applying a number of screens. This approach systematically eliminates companies that do not meet certain minimum standards, allowing the Investment team to focus more intensely on companies of potential interest. Stage 2: Bottom-up Fundamental Company Research Ralton s research programme is focused on understanding the key drivers of business performance and returns, namely people, operations, products and services, and market dynamics. For companies remaining in the Investment Universe, a detailed assessment is made of executive management, interviews competitors and suppliers, reviews financials, and forms a clear view on the outlook for the company s industry. Stage 3: Portfolio Construction Risk management and capital preservation are key themes underlying the portfolio construction framework. With a focus on actively managing down-side portfolio risk for investors, Ralton constructs an efficiently diversified portfolio of high quality, undervalued companies, and invests for the long term (typically 3 to 5 years) in an effort to maximise after tax-returns. About the Manager Ralton Asset Management is part of the OC Group, a boutique investment specialist majority owned by members of its investment team and key executives. Ralton is a Value manager with a fundamental investment approach designed to identify quality businesses trading at a considerable discount to valuation. The process is guided by three fundamental beliefs: Markets are not perfectly efficient and the true value of a business is not always reflected in its share price; Undervalued companies can be identified through detailed and intensive research; and Capital preservation is critical to wealth creation. The Investment Team Andrew Stanley BEc, LLB, ACA, FFin, MA AppFin Portfolio Manager, Ralton Model Portfolios Andrew Stanley is the lead portfolio manager for the Ralton portfolios. He is supported by a dedicated and highly experienced team of investment professionals each with an average 18 years investment experience. Andrew has been working in financial markets for more than 19 years, including the past 5 years managing the Ralton portfolios. Prior to Ralton, he was an Executive Director at UBS in Hong Kong, and over the course of his career has held senior positions with major investment institutions in Melbourne, Hong Kong, Tokyo and New York. Andrew started his career at Arthur Andersen in Melbourne. Roger Walling BOptom, MBB Portfolio Manager, Ralton Model Portfolios Stephen Evans B Com, ACA, Portfolio Manager Stephen Sedgman Chairman OC Funds Risk Mgt Committee Robert Frost B Com, LLB, Portfolio Manager Robert Calnon Com, ACA, Portfolio Manager, Equities Dealer For Further Information Financial advisers seeking additional information can contact Ralton Adviser Services at: ablazey@raltonam.com.au This report provides general information only and does not take into account the investment objectives, financial circumstances or needs of any person. To the maximum extent permitted by law, Ralton, its directors and employees accept no liability for any loss or damage incurred as a result of any action taken or not taken on the basis of the information contained in the report or any omissions or errors within it. Before making an investment decision you should consider the latest PDS or FSG and assess whether the product and/or service is appropriate for you. It is advisable that you obtain professional independent financial, legal and taxation advice before making any financial investment decision. Ralton does not guarantee the repayment of capital, the payment of income, or the performance of its investments. Performance of the Ralton Wholesale SMA Service (PDS dated December 2009) is based on theoretical portfolio tracking of the model portfolio and is gross of investment management & administration fees, but net of transaction costs. Quoted performance is annualised for periods of 1 year or greater. 05