Investor Update November 2013 Agenda Outlook for the Australian - - PowerPoint PPT Presentation

Investor Update November 2013

Agenda

• Outlook for the Australian Economy
• Investment strategy
• Share market outlook
• Questions

2

Booms i inevitably b bust

20 40 60 80 100 120 140 CY11 CY12E CY13E CY14E CY15E CY16E

Mining Transport Utilities Community Manufacturing NBN Other

A$bn

Australian Investment Profile

• Based on GS Project Probability

Are we we abo bout ut t to

• fall i

into t the he mi mining d g ditch?

1 2 3 4 5 6 7 % of GDP

Mining investment

Source: ABS, J.P.Morgan. Level implied from ABS capex expectations '13-14

88 93 98 03 08 13

Compos positi tion

• n o
• f the Austral

alian E n Econom nomy

5

700 900 1100 1300 1500 1700 2012 2014 2016

Consumption Dwelling Investment Govt Inventories Net exports Other

Forecast $bn

+3.6%yoy +2.0%yoy +3.7%yoy

(Trend Growth = +3.25%)

50 100 150 200 250 300 2012 2014 2016

Engineering Construction Machinery & Equip Non-res Building Intangibles

Forecast $bn

+15.1%yoy

• 10.7%yoy

+2.3%yoy

A sof

• fter

er hous househol ehold d sec ector

• r
• Household income growth has

averaged 6.5% from 1990. We expect it to drop to 3-4% in the medium term.

• Employee compensation

continues to slow

• Rising unemployment, ongoing

cost focus of business and high $A = low employee compensation

• Lower rates – less benefit to

mortgages going forward; businesses continue to de-lever

• Government transfers benign –

Public sector consolidation under conservative government

6

11 12 72 15 20 7 1 17 5

20 40 60 80 100 120 140

GOS Dwellings Mixed income Comp of Employees Property income receiveable Welfare Mortgage interest Consumer interest Income tax Other

Share of household disposable income

• 5

5 10 15 20 1/03/1986 1/06/1992 1/09/1998 1/12/2004 1/03/2011

Employment growth Wages per hour growth Av hours worked per employee Compensation of Employees

YoY% Compensation of Employees

Demogr

• graphi

phics a and delev everagi aging ng weigh gh o

• n c

consum umpt ption ion

7

• 0.5

0.5 1 1.5 2 1980 1990 2000 2010 2015 2020

Population Growth by Age Group

20-29 30-39 40-49 50-59

2 4 6 8 10 12 14

• 0.50

0.00 0.50 1.00 1.50 2.00 2.50 Jun-89 Jun-04 Jun-19

Growth in pop aged 20-59 less pop 60+ (LHS) Nominal consumption growth (RHS)

%YoY

Consumption and age structure

%YoY 50 75 100 125 150 175 00 02 04 06 08 10 12 14

Debt to disposable income

US France Germany Australia New Zealand UK Spain Percent Source: BEA, ECB, RBA, RBNZ

NAB’s Business Conditions Survey: Ongoing weakness in GDP

“Business conditions undershoot

• again. Capacity utilisation falls

sharply – especially in manufacturing, construction, mining and retail – despite low interest rates and improved housing and equity markets. Other forward indicators deteriorate, paring back earlier gains and implying a continuing soft outlook for domestic demand” NAB Business Survey

10 20 30 40 50 60 70 80 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 $bn, real per qtr LNG IRON ORE COAL

Outlook for 2014 and beyond

Australian exports by commodity

Outlook Summary:

• Weaker growth as mining investment

begins to run off and household sector remains subdued

• Some countercyclical support from

government but not be enough to counter softness in private sector

• $A is the wild card- a lower dollar will

support activity Medium term Outlook:

• Growth in household income should

improve from subdued levels

• The investment in mining will start to

deliver dividends from 2015 onwards

10

Resources

“Is it over for mining shares?”

Resources Financials Defensives Industrial Cyclicals Small Caps

Tom Richardson Portfolio Manager

11

Th The B e Boo

• om i

m is o

• ver…

The last decade has seen unprecedented growth in:

• Terms of trade
• TWI
• Capital expenditure
• Commodity prices

These tailwinds have now peaked and the boom is over.

12

…however not a bust

• Chinese demand unlikely to

collapse.

• Equilibrium to be re-established

with increased volume and lower prices.

• Low cost miners will still

generate strong profits in a lower price environment

13

Not all commodities are the same

• Individual commodities have different life

cycles with the demand profile varying through industrial development.

• In the early stages, large amounts of steel

are required as this has the highest productivity payoff.

• The growth baton then passes from

construction to manufacturing and plant.

• As a country becomes more developed and

living standards improve, growth in bulk commodities slow, and demand for consumer items accelerates.

14

We are cautious on Australia’s bulks

IRON ORE

• Chinese steel demand +8% this year – well

ahead of expectations and this has supported the iron ore price.

• However the low-cost operators are expanding

production which will flatten the cost curve.

• The majors will benefit at the expense of high

cost operators.

COAL

• Australia has seen a dramatic shift up the cost

curve driven by widening strip ratios, infrastructure tariffs and significant operating inflation.

• China is relatively self-sufficient in coal and new

investment in East-West rail has reduced

• perating costs.
• Thermal coal has come under further pressure

from the abundance of new shale gas increasing US coal exports.

15

Industrial Metals – Mixed outlook

Demand to remain strong as China continues electrification and consumer growth Supply impacted by

• Declining grades
• Production disruptions
• Mine closures not being

replaced by the industry

COPPER ALUMINIUM NICKEL ZINC

Supply surge driven by new technology – Nickel pig iron. Mine closures due to low prices is helping balance the market, but still a way to go. Demand will continue to rise as China develops, however structural oversupply of smelting capacity. Alumina is now largely priced

• n spot and will benefit from

any bauxite shortages. Positive outlook for zinc driven by a number of major mines scheduled to close by end-2016. However it is difficult to gain exposure to zinc through Australian listed companies.

16

Th The e out utlook for

• r some c
• me commo

mmodi dities is s strong ng.....

Mineral Sands

• Long term structural demand for titanium dioxide

as shown in the chart produced by Rio Tinto.

• Demand for zircon will continue to be driven by

higher urban living standards in China.

• Highly favourable industry structure in both

zircon and titanium dioxide. This was evident in 2012 when Rio and Iluka suspended production keeping the market tight.

Lithium

• Demand for lithium-ion batteries has increased

30% pa over the last decade and now accounts for one third of lithium demand.

• Smartphones and tablets have driven the growth,

with electric vehicles to supercharge this.

• Highly concentrated industry structure with

currently four major producers controlling the market.

Commodity Demand Trajectories Concentrated Lithium Supply

17

Resources Synopsis

• 80
• 60
• 40
• 20

20 40 60 80 100 Aug-92 Dec-93 Apr-95 Aug-96 Dec-97 Apr-99 Aug-00 Dec-01 Apr-03 Aug-04 Dec-05 Apr-07 Aug-08 Dec-09 Apr-11 Aug-12 Relative P/E

Mining vs Industrial P/E

Current NTM P/E: Miners vs Industrials=-29.7%, -20.4% below 20-yr average

While the mining boom may be over, we are not expecting a mining bust

• Though commodity markets are well off their highs, they are still above historical prices
• Commodity markets are not as tight as previously as supply has responded to higher prices
• The economics of investing in mining companies is very much in tact and many remain profitable at

trend commodity prices

• While valuations in most sectors look full, mining shares look okay here given upgrades and low

relative multiples

18

Financials

“Is this as good as it gets for Australian Banks?”

Resources Financials Defensives Industrial Cyclicals Small Caps

Omkar Joshi Investment Analyst

Australian banks are in a ‘sweet spot’…

19

• Australian banks are in a position of strength

and have outperformed both the broader Australian market and most global banks in the last 12 months

• Profitability has been strong due to disciplined

margin management, deployment of cost-cutting initiatives and improving bad debt charges

• Historically low interest rates and tightening of

mortgage lending standards after 2008 have led to improved asset quality

• Strong levels of organic capital generation

have meant banks were among the first globally to adhere to new Basel III capital requirements

90 100 110 120 130 140 150 160 170 180 190 Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12 Nov 12 Dec 12 Jan 13 Feb 13 Mar 13 Apr 13 May 13 Jun 13 Jul 13 Aug 13 Sep 13 Oct 13 Nov 13

Relative Price Performance of Australian Banks

ASX 200 Banks Acc. Index ASX 200 Acc. Index 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Global Banks' Total Returns by Region

Source for both charts: Reuters, Watermark Funds Management estimates

…but pressures are emerging

20

• Margin pressures building with lower cash rates and limited ability to claw-back

margins

• Bad debt charges are at a cyclical low point with impaired assets still elevated and

bad debt charge write-backs unlikely to continue

• Regulatory uncertainty is building
• APRA is still to announce its final position regarding further capital requirements
• Coalition government has pledged to conduct a financial system inquiry
• Banks now look expensive compared to their historic trading range, long-term

average P/E multiple and based on their long-term average P/E multiple relative to the broader Australian market

Margin pressures building

21

• Persistently low system credit growth has led to

banks using the price lever to keep growing housing loans

• Ongoing decline in cash rates are negatively

impacting margins

• Deposit price competition has only marginally

eased

• Wholesale funding costs have neared their

lowest levels in 5 years and have minimal room for further improvement

• Out-of-cycle interest rate changes have

become increasingly politically sensitive

Source: RBA

1.50% 2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Australian Major Banks’ Net Interest Margins

ANZ CBA NAB WBC

Source: Company data

• 5.0%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% Sep 77 Mar 79 Sep 80 Mar 82 Sep 83 Mar 85 Sep 86 Mar 88 Sep 89 Mar 91 Sep 92 Mar 94 Sep 95 Mar 97 Sep 98 Mar 00 Sep 01 Mar 03 Sep 04 Mar 06 Sep 07 Mar 09 Sep 10 Mar 12 Sep 13

Australian annual system credit growth

System credit growth Long term average

Can bad debts go lower?

22

• Bad debt charges appear to have reached a

cyclical low point

• Rising net-write-offs have been funded through

declining provision coverage

• Bad debt charges have benefited from

provision write-backs as asset quality has improved

• The quantum of bad debt charge write-backs

recently seen is unlikely to continue

Source for both charts: Credit Suisse

0% 2% 4% 6% 8% 10% 12% $0bn $5bn $10bn $15bn $20bn $25bn 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Australian Major Banks’ Impaired Assets

Impaired Assets (LHS) Impaired Assets % Total Loans (RHS) 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% $0.0bn $2.0bn $4.0bn $6.0bn $8.0bn $10.0bn $12.0bn $14.0bn 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Australian Major Banks’ Bad Debt Charges

Bad Debt Charge (LHS) Bad Debt Charge % Average Loans & Acceptances (RHS)

No underlying profit growth

23

Lower bad debt charges primarily underpinned EPS growth in the recent bank reporting season

1.9%

• 0.6%

1.3% 0.0% 2.2% 1.5% 3.7% 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% Revenue (ex Trading & Treasury) Trading & Treasury Total Revennue growth Efficiency improvement Underlying profit growth Lower Bad & Doubtful Debts Tax and Other EPS growth

Decomposition of Major Banks’ 2H13 EPS growth

• 1.3%

Source: UBS

Regulatory uncertainty building

24

• APRA is yet to finalise its domestic systemically

important bank (D-SIB) requirements in Australia, as well as the Level 3 capital adequacy standards

• Regulatory uncertainty limits scope for further

increases to dividend payout ratios

• Coalition have indicated their intention to hold a

broad-ranging financial system inquiry

• Terms of reference for inquiry are still unknown
• Potential for near-term adverse sentiment to

weigh on major bank share prices but with regional banks potentially benefiting

55% 60% 65% 70% 75% 80% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Major Banks' Average Dividend Payout Ratio

Source: Credit Suisse

Banks now appear expensive

25

• Bank share prices are trading at all time highs compared to their historic trading range
• Banks have re-rated significantly and are now trading at historically high P/E multiples
• Banks are expensive compared to their long-term average P/E multiple relative to the

broader Australian market

Source for both charts: IBES, Reuters

6.0x 7.0x 8.0x 9.0x 10.0x 11.0x 12.0x 13.0x 14.0x 15.0x 16.0x Sep 91 May 92 Jan 93 Sep 93 May 94 Jan 95 Sep 95 May 96 Jan 97 Sep 97 May 98 Jan 99 Sep 99 May 00 Jan 01 Sep 01 May 02 Jan 03 Sep 03 May 04 Jan 05 Sep 05 May 06 Jan 07 Sep 07 May 08 Jan 09 Sep 09 May 10 Jan 11 Sep 11 May 12 Jan 13 Sep 13

Banks Sector 12mth fwd PE

Banks Sector 12mth fwd PE Average

50% 60% 70% 80% 90% 100% 110% Jun 92 Aug 93 Oct 94 Dec 95 Feb 97 Apr 98 Jun 99 Aug 00 Oct 01 Dec 02 Feb 04 Apr 05 Jun 06 Aug 07 Oct 08 Dec 09 Feb 11 Apr 12 Jun 13

Banks Sector 12mth fwd PE relative to ASX 200 ex-banks

Banks Sector PE relative to ASX 200 ex-banks Average

26

Defensive Sectors

“Are Defensive shares still the best place to invest?”

Resources Financials Defensives Industrial Cyclicals Small Caps

Joshua Ross Investment Analyst

27

Re Recove

• very l

y led by de defen ensive s sectors

• In a normal business cycle, cyclical shares exposed to a recovery in economic activity would lead the
• market. This recovery has been highly unusual in that up until very recently, defensive sectors have

lead the market higher.

• Aggressive monetary easing from policy makers has forced reluctant investors to take on risk in the

share market. These investors have bought defensive securities offering attractive yields as a substitute for income securities.

• Furthermore, because the recovery has been so weak outside of mining, profit momentum for cyclical

shares has been very disappointing.

• We have been Overweight Defensives and remain so given the soft economic outlook

Cyclical Earnings Underperform Defensive Earnings

60 70 80 90 100 110 120

Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 12mth forward EPS Cyclical Industrials Forward EPS Defensive Industrials Forward EPS

28

De Defen ensive S Sector

• rs - Low g
• w growt

wth

• Utilities & Infrastructure – highly regulated, we will

invest in monopoly assets with stable regulatory

• versight. Australian Energy Regulator signaling

intention to reduce return at a time when RAB multiples are at their peak.

• Preferred pick is Transurban – regulated toll-roads,

modest traffic growth and predictable toll escalation. Privileged position with a raft of new opportunities as government looks to outsource infrastructure.

• Retail Staples – Wesfarmers attractive; Successful

turnaround of Coles, Bunnings store-rollout.

• Gaming – Macau structural growth. Crown preferred

exposure, City of Dreams mass-market leader.

0.95x 1.05x 1.15x 1.25x 1.35x 1.45x Aug-10 Feb-11 Sep-11 Apr-12 Oct-12 May-13 Regulated Asset Base Multiple

SKI SPN DUE ENV

Coles as a % of Woolworths Annualised Sales per sqm Annualised EBIT per sqm 2009 77% 39% 2010 80% 41% 2011 84% 47% 2012 88% 53% 2013 91% 58%

29

Growth Defensive Sectors

• Healthcare – Healthcare is a strong growth

sector, underpinned by ageing populations across developing countries, rising obesity levels and disease incidence, and a burgeoning middle class in emerging markets.

• Australia has developed world leading science

in biotherapies (CSL) and medical devices (Cochlear, Heartware, Resmed).

• Telecom and the digital economy –

investments in data infrastructure and access

• technologies. These include Amcom, NextDC,

Telstra, Big Air and Netcomm Wireless.

Comparison of obesity trends in the US

30

Cyclical Industrial Sectors

“Is it time to shift into cyclical shares? ”

Resources Financials Defensives Industrial Cyclicals Small Caps

Justin Braitling Portfolio Manager

Where are we in the cycle?

31

We are of the view that we are in the midst of a rotation into cyclical stocks characterised by a sell off in bonds resulting in rising yields

2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 1Y 2Y 3Y 4Y 5Y 7Y 9Y 10Y 15Y

Australian Yield Curve

One Year Ago One Month Ago Now

Source: Reuters Source: Pring Turner

The search for cheap cyclicals

32

• Investors are looking to shift into cheap cyclicals as the market continues to become

increasingly expensive

• Cyclicals have significantly outperformed the broader Australian market in the last 12

months

• We are cautious on the outlook for cyclical securities at present given our soft outlook

Sector 12M Return Media 68.8% Discretionary Retail 65.0% Developers & Contractors 10.1% Transport 37.9% Steel 65.0% Building Materials 50.6% ASX 300 23.9%

Source: Reuters, IRESS

Sector positioning

33

• Media: New media continues to take share from old media, however pockets of
• pportunity exist around this theme
• Discretionary retail: Preference for high quality retailers and those with hard asset

backing

• Developers & contractors: It’s an extremely tough operating environment where

management are the key differentiators. We are witnessing an enormous divergence in performance

• Transport: Preference for companies with cost-out potential as top line remains

muted

• Building materials: Preference for companies exposed to US housing recovery as

the pick up in demand from Australia has been largely priced in

Summary

• We expect growth to be soft next year. Because of this company profits will grow

modestly at best.

• Shares have risen well ahead of profits in 2013 in expectation of a robust recovery –

shares are now primed for disappointment if a weaker outlook does emerge.

• Shares may well rise further however, assisted by ultra easy monetary conditions.
• Risks are building. Asset bubbles, debt sustainability and policy tightening are
• ngoing risks that may manifest in a market reversal as shares become overvalued.
• We will continue to maintain our cautious portfolio settings. As markets advance

further we will shift out of equities into cash.

34

35

Reported Performance as at 31 October 2013 ALF 1 YEAR 3 YEARS (P.A.) 5 YEARS (P.A.) SI (P.A.) Long 33.6% 18.1% 23.9%

• Short

4.9%

• 1.1%

4.5%

• Net

44.5% 22.2% 26.2% 16.5% All Ords Accum Index 24.7% 9.3% 11.1% 9.8% Net Outperformance 19.8% 12.9% 15.1% 6.7%

Australian Leaders Fund Returns

36

5 Year NTA Performance % 5 Year Share Performance %

Source: Bell Potter Research

Performance drives returns

AFI ARG DJW AUI CYA MLT BKI CIN DUI WHF AMH CAM FSI MIR WAM WIC WAX WAA CTN ALF XAOAI 5 10 15 20 25 30 35 2 4 6 8 10 12 14 16 18 20

5yr NTA vs. Share Price Performance 30 September 2013

37

Australian Leaders Fund Limited (ALF)

Australian Leaders is a listed investment company with an absolute return focus that invests in the shares

• f leading and emerging companies listed on the Australian Stock Exchange. ALF is different to a traditional

fund in its use of hedging strategies to enhance returns and manage market risk. The investment manager Watermark has established a successful track record in Absolute Return Funds.

Top 10 Long Holdings ANZ Westpac BHP Billiton Rio Tinto Mayne Pharma Transurban WorleyParsons Wesfarmers QBE CBA Fund Statistics - 31st October 2013 Long (Millions) $488 Short (Millions)

• $331

Net Exposure (Millions) $157 Cash and Hybrids (Millions) $159 Fund NAV AUD (Millions) $316 Net returns since inception (p.a) 16.5% All Ordinaries Accumulation Index 9.8% Outperformance 6.7% Company Statistics Share Price – ALF $1.67 Option Price - ALFO $0.32 Market Cap (Millions) $343 NTA @ 31st October 2013 after tax $1.47 Premium/Discount to post-tax 14% Dividend Yield (2013 12c FF) 7.2% Management / Performance Fee 1/20%

• 30%
• 10%

10% 30% 50% Consumer Discretionary Consumer Staples Energy Banks Real Estate Other Financials Health Care Industrials Materials Utilities & Telecos

Long Short Sector Exposure

QUESTIONS

38