Ellerston Overlay ASF · Ellerston Overlay ASF – Monthly Newsletter 3 The Tech sell-off in the US...

Level 11, 179 Elizabeth Street Sydney NSW 2000

Ellerston Capital Limited

ABN 34 110 397 674

AFSL 283 000

Tel: 02 9021 7797

Fax: 02 9261 0528

[email protected]

www.ellerstoncapital.com APIR Code: ECL0012AU

The investment objective of the Ellerston Overlay ASF (Fund) is to provide investors with a return that outperforms

the S&P/ASX200 Accumulation over time. The Fund aims to achieve this by investing in a concentrated portfolio

comprising of no more than 30 Australian listed securities and where possible, enhancing income through the use

of Derivatives and shorter term trading strategies. The Fund aims to be invested with a minimum of 90% in physical

securities at all times and must maintain a net exposure of 50% or greater. At least 75% of the Fund will be aligned

to the portfolio of the Ellerston Australian Share Fund (EASF).

Ellerston Overlay ASF Performance

Gross Benchmark Excess Net

1 Month 0.52% 0.17% 0.34% 0.44%

3 Months 1.64% -1.58% 3.22% 1.39%

Financial Year 2017 17.24% 14.09% 3.15% 16.44%

2 Years (p.a.) 10.74% 7.11% 3.63% 9.82%

3 Years (p.a.) 9.28% 6.63% 2.65% 8.29%

5 Years (p.a.) 13.83% 11.81% 2.02% 12.68%

Since Inception (p.a.) 4 Jan 2012 12.77% 11.12% 1.64% 11.60%

Since Inception (CUM) 93.63% 78.61% 15.02% 82.89%

Ellerston Overlay ASF

PERFORMANCE REPORT June 2017 PERFORMANCE REPORT February 2014

Returns are calculated using the Fund's redemption price and are net of fees and expenses. Returns are also calculated on the basis that distributions are reinvested. Returns of the Fund may include audited and un-audited results. The benchmark is the S&P/ASX200 Accumulation Index. Past performance is not a reliable indicator of future performance. Since Inception is 4 January 2012.

Ellerston Overlay ASF – Monthly Newsletter 2

Market Commentary Whilst June turned out to be a fairly sombre month, equity markets globally performed very well during the Financial Year ending 2017. Investors generally looked through a late rush of earnings downgrades domestically, the unravelling of the Trump reflation trade and ongoing geopolitical turmoil to lock in strong gains for the year.

US equity markets experienced a volatile June, impacted by the global “risk-off” trade and prompted by the ongoing political events pertaining to Trump's sacking of former FBI Director and pending Russian intervention probe. The S&P500 ended the month +0.48%, with economic data painting an increasingly positive picture and activity surveys continuing to suggest economic expansion coupled with solid labour force data. The S&P 500 reached an all-time high of 2,453 on June 19, but couldn’t hold that level through to the end of the month, finishing at 2,423. Midway through June, following a two-day meeting in Washington, Federal Reserve officials forged ahead with an interest-rate increase and delivered additional plans to tighten monetary policy, despite growing concerns over weak inflation numbers. Policy makers agreed to raise their benchmark lending rate for the third time in just six months, maintained their outlook for one more rate hike in 2017 and set out some new details on how they intend to unwind their $4.5 trillion balance sheet later this year. The Federal Reserve’s decision brings the Fed funds target rate (covering overnight loans between banks), to a range of 1.0% to 1.25%.

In a press conference after the decision was announced, Chair Yellen commented that the normalisation plan could be put into effect "relatively soon" if the economy continued to show ongoing strength and evolve as the central bank expected. She stated that "near-term risks to the economic outlook appeared roughly balanced, but that the committee was monitoring inflation developments closely. The committee expected to begin implementing a balance sheet normalisation program this year, provided that the economy evolved broadly as anticipated." Policy makers also issued forecasts showing another three quarter-point rate increases in 2018, similar to previous projections in March.

Immediately after the rate hike, US Treasuries rallied, with the yield on 10-year notes falling 9 basis points to 2.13% on the weak readings on inflation, where core inflation (excluding key food and energy components) slowed for the fourth straight month to 1.7% in May, which was below the Fed’s stated target. Not surprisingly, with British and German politics taking centre-stage, European markets sold off this month, with the Eurostoxx 600 -2.72%.The UK market did not escape the continental election fallout and Brexit imbroglio, with the FTSE100 falling -2.76% in the month. Whilst the hung parliament in the UK was a surprise to the investment community, the impact was mostly contained to Foreign Exchange markets, with other global equities mostly shrugging it off as a non-event.

UK equities underperformed after the shock election result which saw the Conservative Party unexpectedly lose its majority. More reassuring for the Eurozone was the French political backdrop, where President Emmanuel Macron's cemented his electoral victory with his party winning a clear majority in the second round of parliamentary elections. The standout equity market in the region was Germany, which outperformed on strong economic data, as the IFO institute raised its forecast for German economic growth. The euro weakened against most major currencies, while the British Pound weakened heavily against all other major currencies following the election result. Over the past month, European activity data remained relatively strong, while inflation pressures eased moderately. Europe's May composite PMI stayed at a six-year high of 56.8, against some expectations for moderation, with the underlying details pointing toward broad-based strength, high levels of business optimism, very strong employment dynamics and robust manufacturing export activity. Strength in German manufacturing and strong services in France underpinned the result. Eurozone unemployment in April fell further to 9.3%, below March's initial 9.5% print (revised to 9.4%). Despite ongoing strong GDP growth at almost 2% y/y, inflation in May was weaker than expected, with headline easing to 1.4% from 1.9% y/y, while core eased from 1.2% to 0.9%. Despite this, the ECB, as expected, dropped its interest rate easing bias, arguing the risks to the outlook were now broadly balanced. That said, ECB president Draghi argued that a substantial degree of monetary policy accommodation remains necessary.


The Tech sell-off in the US in the middle of the month was the event that really caught investors off-guard, with some of the more crowded big cap single stock names giving back as much as -10%, leaving investors wondering whether the curtains were being drawn on the multi-year rally in Tech. The ripple effect in Asia from the sell-off in Tech was mostly contained to the Apple supply chain names, with the more compelling bottom up stories like Nintendo, Tencent and Samsung all pushing up to new highs by month end. The importance of China in the Asian Investment region has been further elevated with the China A-shares finally qualifying for inclusion into the MSCI Emerging Markets Index following a lengthy 2-year courting process. The rebalance will be implemented in a 2-step process over the next 12-18 months, with the weight of MSCI China A stocks being approximately 0.73% of MSCI Emerging Markets Index after the 5% partial inclusion factor. It is estimated that the expected passive inflows into China A shares could be roughly USD2.1 billion.

With the Fed pushing the button on another rate hike and strengthening their commitment to moving away from emergency financial accommodation, Asia continues to perform well, led by Korea (+24% YTD), India (+23%) and Taiwan (+19%), with Australia (+3.2%) and the Shanghai Composite (+3%) lagging. The Australian share market (+0.17%) underperformed its global peers in the month of June, with the ASX200 Index closing at 5,721.5 after digesting a raft of local earnings downgrades during the so called "confession season". Hot on the heels of a plethora of downgrades in May (Sigma, Vocus, Mayne Pharma, Myer, Sirtex, James Hardie), companies such as QBE, Infigen Energy, Ardent Leisure, Retail Food Group, all issued profit warnings and were subsequently punished by the market. On the commodities front, iron ore rallied 14% to end the month at US$65/t as sentiment improved around China with the 3M SHIBOR trending down and June PMIs holding in expansionary mode. Oil fell (-4.5%) as supply concerns ratcheted up. Base metals rebounded in June, with the LME Metals Index up 3.4%. Gold declined 2.2%, halting its recent rally, amidst hawkish comments from major central banks.

Locally, the South Australian government attempted to mirror its Federal counterpart by introducing its own Bank Levy. In its budget delivered on 22nd of June by Treasurer Tom Koutsantonis, it set a 1.5bps state base levy to applicable liabilities on the major banks and Macquarie. However post June 30 the opposition Liberal Party has stated that it would vote against the move, effectively killing the policy. Whilst this is a small win for the banks it is worth noting the Federal Bank Levy has already led to higher taxes. Moreover the experience from overseas, where in the UK, the Bank Levy was raised on nine occasions from 5 bpts to 21 bpts is concerning. It is possible the other states may look to follow SA's lead (as alluded to by the Western Australian State Government) and introduce their own levies on the banks. Additionally, with the Federal election just 12-18 months away, further increases in the Federal Bank Levy cannot be ruled out, especially if the Australian Federal Budget comes under pressure. At the company level, CBA (36bps), CSL (27bps), ANZ (14bps) and QAN (8bps) added the most points to the ASX200 index during the month, while WES (-20bps), BHP (-13bps), WPL (-11 bps) and QBE (-10bps) were the biggest single detractors. The best 5 performing stocks in the ASX 100 index during the month included VOC (+19.5%), BSL (+14.9%), MFG (+14.5%), QAN (+14.2%) and ALQ (+10.4%). The worst 5 performers included FXJ (-11.6%), ORG (-10.9%), STO (-9.8%), DMP (-9.4%) and DXS (-8.8%). The best performing sector was Healthcare returning 6.1% (led by CSL and Cochlear), whilst the Energy sector -6.9% was the weakest for the month. For the month of June, the S&P/ASX Small Ords fared better than the broader market, posting a gain of 1.62%, led by the Small Industrials which rose 1.99%, with Small Resources flat for the month. Financial Year Ended 2017 Five companies accounted for over 600 points of the circa 1400bps ASX 200 total return for the year: CBA (+162bps) added the most single value, with the other top four contributors being: ANZ (+136bps), BHP (+133bps), NAB (+121bps) and CSL (+86bps) combining to propel the overall market. Alongside TLS (-81 bpts - so much for the it's safe as houses dividend yield trade when your capital has evaporated), other major companies that filled out the key list of significant market detractors included WFD (-32 bps), BXB (-27 bps), SCG (-25bps) and VOC (-22 bps). The Top 5 performing stocks by percentage gain for FY17 included Whitehaven Coal (WHC +167%), A2 Milk (A2M +114.9%), Qantas (QAN +111%), Bluescope (BSL +108.8) and Sims Metal (SGM +99.9%). Conversely, the 5


worst performing stocks by percentage loss included Vocus Group (VOC -58.9%), Syrah Resources (SYR -53.6%), TPG Telecom (TPM -50.1%), Aconex (ACX -46.8%), and Mayne Pharma (MYX -43%).

Source: Morgan Stanley Research

At the broader sector level, Financials (+7.24%), Materials (+3.86%) and Healthcare (+1.06%) continued to be the key drivers of returns, whilst Telcos (-1.16%) and Real Estate (-0.40%) constrained the overall return.

Source: Morgan Stanley Research


Company Specific News

The Misses

Fairfax Media (FXJ -11.6%) Fairfax had a relatively benign month right up until the final trading session. With formal offers from its two private equity suitors due by June 30, market rumors emerged that Hellman & Friedman (H&F) were not going to bid. Both H&F and the original suitor TPG confirmed they were walking away post June 30, putting further pressure on the FXJ share price. The company plans to continue with its strategy to separate its Domain operations. Origin Energy (ORG -10.9%) Origin’s fortunes over the month mirrored much of the energy sector. With crude falling from US$50/bbl. at the start of the month to US$45 by period end, earnings expectations came under pressure. Origin’s issues are further exacerbated by a stretched balance sheet and breakeven expectations, for its soon to be completed gas project APLNG, at US$45/bbl. Ardent Leisure (AAD - 9.2%) Ardent Leisure released FY17 earnings guidance during the month, disappointing investors. Its US operations, Main Event, remain under pressure experiencing both negative like-for-like sales growth and declining margins. New CEO Simon Kelly is also taking a more conservative approach to the roll-out of new sites and whilst this may be sensible over the longer term, it confirms the difficulty of market conditions. QBE Insurance (QBE - 8.4%) The accident prone QBE announced another shock disappointing profit downgrade during the month, with the share price falling 11% on the day. The culprit on this occasion was the Emerging Markets business which saw a spike in claims which have taken the combined ratio for the business to 110...i.e. they lose 10c for every $1 of premium they write. Whilst only a small part of the overall company (circa 10% of revenues), the poor performance in emerging markets has caused a 7% reduction in group earnings expectations for CY17. The overall impact to group earnings was somewhat mitigated by better investment earnings than expected. The downgrade continues a historical pattern where one part of the global insurance business has a claims issue each year. Bendigo Bank (BEN -1.7%) Bendigo announced accounting changes regarding how they treat unrealised profits from its subsidiary Homesafe. They will no longer mark-to-market the portfolio (60% Melbourne/40% Sydney). In FY16, Homesafe represented approximately 5% revenue and 13% cash profit. The positive is that it removes some of the volatility in earnings. The negative is it will also reduce cash earnings. The cynical view – does it highlight that they believe the property market has peaked?

The Hits

Sirtex (SRX +35.5%) The Sirtex rollercoaster continues, this month being the best performing name in the ASX 200 index. Driving the performance was a cost savings program announced by new CEO, Andrew McLean just weeks after his appointment. Sirtex plans to cut staff numbers by 15% as it attempts to get its operations back on an even keel. Vocus (VOC +19.5%) After an incredibly difficult 12 months for shareholders, which saw multiple profit warnings and the shares fall ~70%, private equity interest was crystallised. KKR launched an indicative and non-binding proposal to acquire 100% of the shares in Vocus for $3.50. Vocus’ Board is considering the offer and should it look to engage with KKR, it will be interesting to see if any other private equity interest is aroused. A2 Milk (A2M +18.2%)/Bellamy’s (BAL +36.6%) The two listed infant formula companies were very strong performers during the month. A2M announced their third profit upgrade for the year, causing the share price to rise 18.2% during the month. As per previous upgrades, it was driven by very strong performance in its infant formula business which has resulted in sales growing 4% faster than previous expectations. Bellamy’s announced a $78m capital raising to fund two strategic actions that materially reduces the risks around the company. The first is the acquisition of an infant formula canning facility, with the second being the payout of take or pay manufacturing penalties to Fonterra. The combined impact of these actions and the company re-iterating previous earnings expectations drove the share price. Metcash (MTS +17.1) Metcash delivered a solid FY17 result, underpinned by growth in its Hardware and Liquor divisions and cost cutting to stop the bleeding in its Grocery operations. Moreover, cash conversion was excellent at >100%, which saw net


debt fall to less than $100m. This gave the board confidence to re-instate the dividend, declaring a 4.5c per share payment. For a company trading on a PE of ~11x, this greatly bolstered its investment credibility and has brought it back on investors radar. Insurance Australia (IAG +6.6%) IAG’s review of it reserve releases for FY17 indicated an outcome equivalent to at least 5% of net earned premium (NEP) vs. previous expectation of “at least 2%”. The better outcome reflects further favourable conditions against underlying assumptions for claim size and inflation. As a result of the bigger reserve releases, IAG upgraded its reported margin guidance range for FY17 from 10.5-12.5% to 13.5-15.5%.

Performance The Fund returned +0.52% for the month of June, outperforming the benchmark return of +0.17%. This brings the Financial Year 2017 return to a healthy 17.24%, outperforming the benchmark return of 14.09%. We are pleased to have delivered this outcome in such a strong market, especially given the Fund was zero weighted to the big 4 banks and Macquarie (which drove the bulk of the market return) and the fact that the portfolio was positioned defensively. We have been reasonably cautious for the past six months (and remain so) given the current global geopolitical environment, associated tail risks and Fed embarking on its well-orchestrated tightening cycle. Our superior mid cap stock selection again drove our returns and alpha. For the month of June, the biggest detractors to performance was the overweight position in GNC which fell 8.2% during the month and the Fund's zero weighting to the big Banks which rallied hard off their intra-month lows and subsequently outperformed.

Securities Held

Securities Not Held

-0.4%, CBA █████████████████ ███████ BHP, 0.1%

-0.3%, CSL █████████████ ██████ WPL, 0.1%

-0.1%, ANZ ██████ █████ NAB, 0.1%

-0.1%, QAN ████ █████ QBE, 0.1%

-0.1%, SUN ████ █████ ORG, 0.1%

-0.7%, GNC ████████████████████████████████ ███████████████████████████████████████ HSO, 0.8%

-0.2%, NUF ████████████ █████████████████ LNK, 0.3%

-0.2%, SGR ███████████ ███████████ SCO, 0.2%

-0.1%, DLX ██████ ████████ APO, 0.2%

-0.1%, CTX ██████ ████████ ORI, 0.2%


Activity

The Fund was highly active in June, repositioning the portfolio to better negotiate the current market conditions and outlook. We strengthened the Fund’s existing Treasury Wines, Dulux, GrainCorp, JB Hi Fi, Healthscope and Link positions. These are all stocks that we believe are still mispriced by the market given their medium to longer term earnings and/or turnaround potential. These additional purchases were funded by completely exiting our Wesfarmers holding, where we have acknowledged that the headwinds facing Coles and the company's homeware expansion plans into the U.K. will act as a drag on medium term profitability and returns. The surprise move by Amazon to buy Whole Foods is a shot over the bow for both Woolworths and Wesfarmers. Towards month end, one of our larger holdings, Link Administration, announced that it had entered into an agreement with Capita PLC to acquire its Asset Services division for £888m. Capita, which hit troubled waters at the beginning of the year, announced a sale process of its prized Asset Services division to sure up its financial position. We were hopeful that LNK would acquire these assets which sit right in the middle of its core competencies, particularly in share registry. Moreover our belief is that the uncertainty of Brexit and the impact to Sterling present a unique window to invest in the United Kingdom.

To fund the deal, LNK tapped the market, offering shareholders the opportunity to participate in a 4 for 11 entitlement rights issue at $6.75, a 10% discount to its previous closing price. We participated fully and picked up further shares in the institutional shortfall book-build. We feel that the acquired assets are a great fit for Link and will add approximately £315m of revenue and £72m of EBITDA to the company, prior to any revenue or cost synergies. The company expects to conservatively extract £15m of synergies over the medium term, which has fueled EPS upgrades of circa 20% across sell-side analysts. This deal is akin to Amcor buying Alcan's flexible packaging business, Aristocrat buying VGT in the US and Treasury Wines acquiring Diageo's wine business - all company makers. This will prove to be a company transforming asset for Link. We believe the company can grow earnings by double digit percentage over the medium term and trading on a FY19 PE of ~15x, it represents outstanding value.


Strategy & Outlook

Except for the changes highlighted in the activity section above, the strategy and portfolio positioning remains the same. That said, we are always revisiting areas of interest and retesting the investment thesis. We recently revisited some of the out of favour growth stocks highlighted below, many of which have pulled back sharply.

Source: Shaw and Partners Research FINDINGS: We are happy to stay on the sidelines. While we note that many of these growth companies are in a strong market position today, we have our concerns about their medium and longer term earnings growth. We expect to see increased levels of maturity and even greater reinvestment to fight off competition or to deliver future growth. Despite valuations having come off this year, we remain content to observe, but not invest and look for better value and opportunities elsewhere. We still remain cautious the banks – as Pandora's Box is now officially open Just six weeks after the announcement of the Federal Government's Bank Levy, the banks are already being further targeted by stretched government budgets. Although South Australia's Levy may fail at the legislative hurdle, it is an event that investors should fear. There is no doubt that the Australian banks remain strong, profitable, well run organisations and with the recent share price sell off, it could be argued that some of the extreme valuation stretch has disappeared. That said, on 13.2x PE and 1.8x Price to Book, the domestic Banking Sector is by no means cheap enough yet. Apart from it being the top of the housing market and the bottom of the bad debt cycle (with BDD charges at ~9 basis points), we remain cautious on the outlook for the banks given the myriad of headwinds that we have discussed in detail in previous communiques. We struggle to see what will drive bank share prices sustainably higher when they undoubtedly require more regulatory capital (which apart from ANZ selling off its Wealth Management arm, and perhaps CBA potentially following suit) which cannot be internally generated. We feel there are far better opportunities on a risk/reward basis in other select mid-cap stocks, where we are more confident superior earnings growth will be delivered.

After flirting with the 6,000 index level in April, the ASX 200 rose to a high of 5956.5 on 1st May, it has subsequently seen a circa 4% correction, and remains above its long-term trading multiple.


Source: Citi

The Market is still relatively stretched with weak earnings momentum, especially for domestic cyclicals. Whilst earnings growth in the FY17 year is expected to be strong (+14%), it is driven by a big recovery in Resources. However, there is little follow through, with EPS growth expected to slow in FY18 to +7.5% and in FY19 to just 4.5% - furthermore, earnings revisions remain negative.

Source: Morgan Stanley


Conclusion

Market Outlook: volatility will remain a hallmark in the next 12 months for equity markets. Persistent themes in the portfolio include: High quality franchises Stocks with defensive characteristics Strict focus on future cash flow generation Cyclical recovery and global growth recovery plays, especially those with sustainable offshore earnings (TWE, Link Administration etc) Selective turnaround stories Strict emphasis on valuation MOST IMPORTANTLY : STAYING TRUE TO LABEL

Source: Ellerston Capital Warm Regards,

Chris Kourtis Portfolio Manager

9.6

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52

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15

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3.4

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59

.6%

20

.7%

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Top 20 21 - 50 51 - 100 101 - 200 201 - 300

Portfolio ASX 200 Active

Mid - Caps


Asset Class Exposures

Exposure (% NAV) Net

Equity 97.9%

Long Option 0.0%

Short Option (6.7%)

Effective Cash 8.8%

Grand Total 100.0%

Active Sector Exposures*

* Active sector exposures are determined by subtracting fund sector weights from benchmark weights. Positive percentages represent over-weight sector exposures relative to benchmark and negative percentages represent under-weight sector exposures relative to the benchmark.

Core Holdings

APN OUTDOOR GROUP

DULUXGROUP

GRAINCORP

HEALTHSCOPE

LINK ADMINISTRATION HOLDINGS

NUFARM

PRIMARY HEALTH CARE

RIO TINTO

STAR ENTERTAINMENT GROUP

TREASURY WINE ESTATES

(30%)

(25%)

(20%)

(15%)

(10%)

(5%)

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About the Ellerston Australian Share Fund

The Fund aims to achieve its performance objectives by adopting a fundamental “bottom-up” investment approach to stock selection whilst delivering additional income where possible, through option strategies. Because of the nature of the strategy, at least 75% of the Fund’s exposure is aligned to the portfolio of the Ellerston Australian Share Fund. The Investment opportunities for the Fund are identified by analysing and understanding the factors affecting (amongst other things): business model, industry structure, management team and overall valuation. Ellerston Capital typically favours businesses that can sustain high returns or improve their return on capital and looks to invest in businesses with a market value below the value we attribute to them. Benchmark weightings do not drive our stock decisions; our approach is totally benchmark independent.

Note: Unit prices reflect Class A only.

Strategy Funds Under Management $214 Million

Funds Under Management - Overlay ASF $25 Million

Application Price (cum) $1.1429

Redemption Price (cum) $1.1372

Number of Stocks 21

Inception Date 4 January 2012

DISCLAIMER This newsletter has been prepared without taking account the objectives, financial situation or needs of individuals. Before making an investment decision about the Ellerston Overlay ASF (Fund) you should read the Fund’s Information Memorandum dated 11 January 2012 which can be obtained by contacting [email protected] and obtain advice from an appropriate financial adviser. Units in the Fund are issued by Ellerston Capital Limited. This information is current as at the date on the first page. The inception date for the Fund is 4 January 2012.

This material has been prepared based on information believed to be accurate at the time of publication. Assumptions and estimates may have been made which may prove not to be accurate. Ellerston Capital undertakes no responsibility to correct any such inaccuracy. Subsequent changes in circumstances may occur at any time and may impact the accuracy of the information. To the full extent permitted by law, none of Ellerston Capital Limited, or any member of the Ellerston Capital Limited Group of companies makes any warranty as to the accuracy or completeness of the information in this newsletter and disclaims all liability that may arise due to any information contained in this newsletter being inaccurate, unreliable or incomplete.

Past performance is not a reliable indicator of future performance.

Ellerston Overlay ASF · Ellerston Overlay ASF – Monthly Newsletter 3 The Tech sell-off in the US...

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