March 2016 Quarterly Report Schroder Wholesale Australian Equity Fund Total return % 8 Schroder Wholesale Australian Equity Fund (post-fee) S&P / ASX 200 Accumulation Index Relative performance (post-fee) 1 mth 3 mths 1 yr 4.76 4.73 0.03 -2.77 -2.75 -0.02 -14.74 -9.59 -5.15 3 yrs p.a. 5 yrs p.a. 2.13 5.40 -3.27 4.56 5.70 -1.14 10 yrs p.a. 4.82 4.43 0.39 Please refer to www.schroders.com.au for post-tax returns Past performance is not a reliable indicator of future performance Inception Date: 01 Jul 2002, 13 years and 9 months. 1 2 Market cap ASX 1 - 50 ASX 51 - 100 ASX 101 - 300 Non Index Cash Portfolio 82.6% 8.9% 4.6% 1.6% 2.2% Benchmark 80.7% 12.0% 7.4% Top ten holdings % National Australia Bank Limited BHP Billiton Limited Commonwealth Bank of Australia Westpac Banking Corporation Woolworths Ltd ANZ Banking Group Ltd. Telstra Corporation Limited Wesfarmers Limited Rio Tinto Limited Brambles Limited Total Portfolio1 7.9% 6.5% 5.9% 5.8% 4.7% 4.7% 4.7% 4.6% 4.5% 3.8% 53.1% Benchmark2 5.2% 4.1% 9.6% 7.6% 2.1% 5.1% 4.9% 3.5% 1.4% 1.4% 44.9% Characteristics No. of stocks Portfolio turnover* (1 yr) Sharpe Ratio (1 yr) Volatility (5yr standard deviation) Tracking error (3yr historic) Portfolio1 52 14.2% -1.05 12.4% 2.9% Benchmark2 200 -0.80 12.6% Commentary The S&P / ASX 200 Accumulation Index fell by 2.75%, while the Schroder Wholesale Australian Equity Fund (post-fee) fell by 2.77%, underperforming by 0.02% for the quarter. At last, some diversity. The March quarter for the ASX saw a myriad of stocks and sectors lead and lag in performance. A motley lot – South32, Medibank Private, Newcrest, Vicinity, Santos and Transurban – were the best performers, whereas Macquarie, Incitec, the major banks, Computershare, Woolworths and Caltex were among the worst. Even though bonds still rallied through the quarter, it was a marginal move and the path was wild, and equity markets followed accordingly. It continues to be intellectually vacuous to believe that Bonds are expensive whilst maintaining that the best performing stocks on the ASX through the past few years, which are almost wholly Bond sensitives, continue to have the best prospects. Of these broad themes, one stood out. Banks wobbled, mostly after ANZ disclosed bad debts had risen by $100m because of a few, large exposures, and after Westpac confirmed net interest margins are flat this half even after two repricings. Australian Banks have enjoyed a generational “stronger for longer” run that dwarfs anything the resources market enjoyed before the consequent fall. To wit, BHP this year will make the same ebit it made a decade ago; CBA made $5b pre tax a decade ago and will make $13b this year. The driver for this increased profitability is simple; flat margins, and other revenues and costs growing in line with revenues, have meant that volume growth has been the game, set and match for bank earnings through this time. A little more than a decade ago, monthly housing finance approvals were $10b, and today they are in excess of $30b. No products innovated nor exported, no global competitive advantage, no efficiency in production, but some lessons were learnt from abroad as ASIC is now making public. It can be rightly argued that the banks have been rational in maintaining pricing through this strong volume environment, but BHP moved to a market linked price for iron ore as demand increased as well. If management for the Banks is as subject to human frailty as us all, and volume growth drove the great generation of performance, what has caused market nervousness through the quarter as to the prospects for the sector? Forecasts were too optimistic, on every line, but especially credit. Of course bad debts had to rise from all time lows relative to the like asset base. The issue now becomes what is a sustainable credit loss rate? We continue to assume a level above this year’s experience. We also model a “recessionary hit”, material bad debt charge, which we deduct from book value in our valuation. Valued on this basis, major banks on a lower price to net tangible asset basis now look good value relative to the market; the higher multiples attaching to CBA and Westpac continue to be world leading for banks, and subject to ongoing pressure as regulatory forces continue to crimp the extraordinarily high return on equity that have accrued to Australian mortgage portfolios in recent years. Apart from pressures on the banks, the dispersion in drivers in return across the Australian equity market through the quarter followed the scrip written by Larry Summers in “The Age of Secular Stagnation”. On quantitative easing, he wrote “… More important, these policies are running into diminishing returns and giving rise to increasingly toxic side effects. Sustained low rates tend to promote excess leverage, risk taking and asset bubbles …” All four factors have impacted upon Australian market performance. Sustained low rates have promoted “yield” stocks and bond sensitives, notably infrastructure and property, to the point where the dispersion between them and materials stocks is as wide as it ever has been. If the forces for low rates abate, we would expect at least some of this outperformance to unwind. And thus it went through the quarter. 1 The 'Portfolio' is the Schroder Wholesale Australian Equity Fund 2 Benchmark is the S&P / ASX 200 Accumulation Index Unless otherwise stated all figures are as at the end of March 2016 Please note numbers may not total 100 due to rounding *Turnover = ½(Purchases + Sales - ∑Cashinflows + ∑Cashoutflows) / ½(Market Value(T0)+ Market Value(T1) - ∑Cashflows) Further, excess leverage is the financial drug of choice for corporate manic depressives. Nothing propels the highs, higher, nor the lows, lower. Consider the oil sensitives - Qantas as a winner and Origin Energy as a loser. Woodside has of course underperformed because it shares a reliance upon the oil price for its economics, but its underperformance has been half of Origin’s. Part of this is due to lesser operational leverage, but much more is due to lesser financial leverage. In 2013, Origin produced $1.1b in operating ebit and had $6.8b in net debt. In 2019 we forecast those same metrics at remarkably similar proportions - $2.2b and $11.5b. And yet, Origin’s share price has more than halved from the $10 per share seen in 2013, due to the need in the interim to raise $2.5b and issue a large number of shares in an endeavour to address leverage woes arising from malinvestment. Qantas management have done a stellar job since 2008. Schroder Wholesale Australian Equity Fund Quarterly contributors % Alumina Limited South32 Ltd. Commonwealth Bank of Australia Brambles Limited Iluka Resources Limited Quarterly detractors % Newcrest Mining Limited National Australia Bank Limited Scentre Group Woolworths Ltd Amcor Ltd Position * Attribution Overweight Overweight Underweight Overweight Overweight Position * 0.41 0.32 0.31 0.21 0.21 Attribution Underweight Overweight Underweight Overweight Underweight -0.25 -0.25 -0.20 -0.15 -0.14 Quarterly Report March 2016 Commentary continued The equity performance, though, has been magnified by not just the oil price fall but also the operational leverage embedded in all airlines and entities with large on and off balance sheet lease liabilities (just ask any Woolworths shareholder). In the Australian equity market context, we do not believe undue risk taking is rife among Australian corporate management now. Leverage, though, is meaning that the penalty for undue risk previously assumed, as in the Origin case, is now being called. The bigger area of undue risk for investors continues to be in the multiples paid for income streams perceived to be defensive; the gap in multiples between the highest and lowest rated industrial stocks continues to be at record levels. If asset bubbles exist in Australia, this is where they sit. Again, the quarter past was interesting in that for the first time in several years, on days when the market was pressured, low cost resource companies with lower levels of debt often performed better than infrastructure stocks. History would suggest that resource names outperforming in down markets in Australia is common, which is counter intuitive, but an essence of what is needed for our portfolio to continue to outperform. * Portfolio weights versus benchmark are average weights over the quarter Contributors Distribution details for the financial year ended 30 June Total CPU (i) Capital gains (ii) Discount capital gains Non discount capital gains Franking % (iii) Growth component (iv) Distribution component (v) Return (post-fee) Benchmark (vi) 2013 2014 2015 3.44 3.57 4.24 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 90.37 95.25 102.00 21.29% 12.47% -1.04% 4.34% 3.58% 3.82% 25.63% 16.05% 2.78% 22.75% 17.43% 5.68% i) CPU: Cents Per Unit. ii) Annual cash distribution represented by capital gains. iii) Franking for financial year ending 30 June. Franking Levels Per FSC calculation being franking credits as % of cash distribution multiplied by (1-tax rate) divided by the tax rate. iv) Growth return is the price to price return excluding distributions. v) Distribution return includes both income and realised capital gains where applicable. (vi) Benchmark is the S&P / ASX 200 Accumulation Index Alumina (o/w, +14.7%) Alumina performed strongly during the quarter following some moderate strength in the alumina price, but also reflecting a low starting multiple which had been crushed following several years of material underperformance by the company. Alumina continues to bear negligible financial risk and is trading on a mid-cycle ebit multiple of five times. South32 (o/w, +37.6%) South32 has a high level of exposure to Alumina and hence benefited from the same factors as those that drove Alumina’s performance. It also released a result which highlighted the majority of the US$300m cost reduction target had already been achieved, which is a material sum for a company we expect to make $900m on a sustainable basis. Commonwealth Bank (u/w, -10.0%) CBA underperformed, along with all banks, as the market started to better appreciate the headwinds on volumes, margins, costs, bad debts and capital confronting the sector. Many of these factors have been tailwinds for much of the past two decades, and at 2.5 times net tangible assets downside exists to the CBA multiple as these earnings pressures play out. Detractors Newcrest (u/w, +30.8%) All that glitters was Gold during the quarter, and as the largest and most liquid gold stock Newcrest was a prime beneficiary. Management are optimising production to a greater extent than had been the case in recent years but as has always been the case, the prime factor that drive Newcrest’s performance remains exogenous, being the gold price, NAB (o/w, -9.9%) As with CBA, NAB felt the wrath of sectoral pressures through the quarter. Our overweight position in turn hurt performance. NAB continues to trade at a material discount on a net tangible asset multiple basis to its two more domestically focused peers, and yet its return profile is now converging given the portfolio changes of the past year. Scentre (u/w, +8.5%) As with many bond sensitives, Scentre performed strongly through the quarter. On our mid cycle earnings Scentre currently offers a 3% ebit yield on enterprise value. In turn, we continue to believe the equity is materially (almost 30%) overvalued. Schroder Wholesale Australian Equity Fund Fund objective Commentary Continued To outperform the S&P/ASX 200 Accumulation Index after fees over the medium to long term by investing in a broad range of companies from Australia and New Zealand. Outlook Quarterly Report March 2016 In previous commentaries we have highlighted the six principles driving our fundamental views. They remain prima facie headwinds for earnings, and whilst multiples continue to adjust they are not yet cheap, but better described as fair. These principles also ignore two, critical, issues; the price paid for the equity purchased, and the management intent to generate good returns on investment, even in the face of challenging conditions. We continue to seek to increase our exposure to positions where we feel operational leverage – evident across the breadth of the market, as discussed above by reference to the bank and energy sectors, but equally applicable more broadly – is accommodated within current valuations. Investment style Schroders is a bottom-up, fundamental, active growth manager of Australian equities, with an emphasis on stocks that are able to grow shareholder value in the long term. Andrew Fleming Fund details APIR code Fund size (AUD) Redemption unit price Fund inception date Buy / sell spread Minimum investment Distribution frequency Management costs (p.a.) SCH0101AU $1,838,142,450 $0.9938 July 2002 0.25%/0.25% $25,000 Normally twice yearly - June and Dec 0.92% Sector exposure versus the benchmark % -8.0 -6.0 -4.0 -2.0 0.0 2.0 Energy 4.0 6.0 2.7 Materials Construction Materials 0.2 Containers & Packaging -1.5 Metals & Mining 9.0 Paper & Forest Products 0.0 Industrials 1.4 Consumer Discretionary -1.4 Consumer Staples 3.3 -4.3 Information Technology 0.2 Telecommunication Services -0.3 Utilities -0.8 -1.4 Capital Markets Financials Consumer banks -3.4 Diversified Fin Services 1.1 Insurance -3.3 Real Estate Mgmt & Dev Property Trusts 10.0 1.3 Chemicals Health Care 8.0 0.7 -5.4 Unless otherwise stated all figures are as at the end of March 2016 Benchmark is the S&P / ASX 200 Accumulation Index Contact www.schroders.com.au E-mail: simal@schroders.com Schroder Investment Management Australia Limited ABN 22 000 443 274 Australian Financial Services Licence 226473 Level 20 Angel Place, 123 Pitt Street, Sydney NSW 2000 Phone: 1300 136 471 Fax: (02) 9231 1119 Investment in the Schroder Wholesale Australian Equity Fund ('the Fund') may be made on an application form accompanying the current Product Disclosure Statement available from the Manager, Schroder Investment Management Australia Limited (ABN 22 000 443 274 AFSL 226473) (“Schroders”). This Report is intended solely for the information of the person to whom it is provided by Schroders. It should not be relied on by any person for the purposes of making investment decisions. Total returns are calculated using exit price to exit price, after fees and expenses, and assuming reinvestment of income. Gross returns are calculated using exit price to exit price and are gross of fees and expenses. The repayment of capital and performance of the Fund is not guaranteed by Schroders or any company in the Schroders Group. Past performance is not a reliable indicator of future performance. Unless otherwise stated the source for all graphs and tables contained in this report is Schroders. Opinions constitute our judgment at the time of issue and are subject to change. This report does not contain and is not to be taken as containing any financial product advice or financial product recommendation. For security reasons telephone calls may be recorded.