Our Fund Manager Focus Newsletters focus on a fund manager within our investment portfolio and provide information to help our clients understand their investment philosophy and outcomes.

This newsletter focuses on Alternatives.

Introduction
We have not provided you with this newsletter for some time. Most recently, we provided a commentary on our investment process in place of this newsletter. Again we will diverge from our regular format to talk more about an asset class rather than a specific fund. This sector is generically known as ‘Alternatives’.

Basically, ‘Alternatives’ cover assets that do not conform to the standard asset classes i.e. equities, property, fixed interest etc. The asset class is most often identified with ‘Hedge Funds’, itself another catch all for non-standard investment classes.

The theory of using ‘Alternatives’ in your portfolio is to provide returns that are less correlated with standard assets. Correlation is the measure by which different assets move in a similar manner i.e. Australian Equities and Global Equities markets will broadly move in the same direction, whereas equities and fixed interest markets will generally move in different directions, for a given policy or economic event. Currently you will find at least some exposure to Alternatives in most pre-set superannuation investment options. The managers of these funds are trying to reduce the capital volatility of your benefits, and academically the data would support this approach.

As yet, we have not introduced this option to our tailored portfolios. We have been researching Alternatives and the various product providers for over two years. In some regards, we have been lucky that this has had no impact on these portfolios. In fact given the performance of traditional assets classes, an early foray into Alternatives would have detracted from portfolio returns over the recent past. This is because low correlation works both ways – if traditional asset classes are down, alternatives can provide relief by producing positive returns; if traditional asset classes are strong, alternatives will tend to provide less attractive returns. The following table illustrates:

To be fair, the performance of equity markets has been exceptional over the past 5 years. Moreover these returns include the rebound from the GFC. Nevertheless, this illustrates the point about lowly correlated returns – it just happens that during this period. it would not have worked in your favour.

Our research into product providers in this sector has resulted in the production of a short list of potential candidates that we may, in time, recommend for inclusion in your portfolio. As there are many sub-sectors within the alternative space. we have sought managers that can provide exposure to a range of strategies and who can rotate through these strategies as their analysis dictates. This removes the need to select specialists in specific strategies, potentially adding several funds to your portfolio. Other key considerations include liquidity; some managers only provide monthly investments/redemptions, and cost. In so far as liquidity is concerned. we prefer full liquid daily investment/redemption providers. However, this narrows the opportunity set. In regards to cost, this has been a real issue in the past. Even today, a number of products charge 2% of assets plus 20% of gains. In our view, this is not an attractive value proposition.

The other major consideration is transparency. Prior to the GFC, the approach seemed to be ‘trust me’. That did not work out so well. Incidentally, during that period a number of alternative funds saw their return correlations converge with traditional assets classes, just when low correlation was required. Given a low level of transparency, it was difficult to determine the underlying drivers of this convergence. Like any of the fund managers we use, we prefer to be able to look through a product with the manager to understand the underlying exposures and risks within a fund. This too has narrowed the opportunity set we are considering.

The following is a typical range of subsectors in which an alternatives manager can operate:

We are also aware of new alternative investment strategies that may be of interest in due course (alternative alternatives?). Amongst the most interesting of these is a fund that provides exposure to volatility indices. As you may be aware, the major index of market volatility is the VIX. This is an index of implied market volatility based on options pricing – it is also known as the fear index. In simple terms, as market volatility rises, the index rises. There is a widely traded and very liquid derivative offered by the Chicago Board Options Exchange (CBOE) that enables investors to buy and sell this index.

As this index is generally negatively correlated with movements in share markets (it goes up when shares go down), the potential to hedge equity risk is attractive. You should note that our research in regards to products in this sphere is still developing. Nevertheless, it is illustrative of the range of options becoming available within the ‘Alternatives’ sector.

We expect that at some time in the future, we will recommend an exposure to ‘Alternatives’. However we have yet to decide on the best approach to this sector. As you know, we are committed to ensuring your portfolio provides the optimal opportunity to meet your personal financial outcomes. You will also know that we are sceptical of the fashion and fads that permeate the investment sector. We see no point in adding to a new sector unless it can;
a) improve risk-adjusted returns
b) provide adequate liquidity
c) provide value for money

In the meantime, we will continue to work with you to ensure your portfolio is optimised to meet your long term personal objectives.

Please contact this office if you require further information in this regard or have any other queries in respect of our investment approach.

David Graham CFP® SSA
7th August 2014.

Our Fund Manager Focus Newsletters focus on a fund manager within our investment portfolio and provide information to help our clients understand their investment philosophy and outcomes.

This newsletter focuses on The Ironbark Karara Australian Small Companies Fund.

Introduction
It has been some years since we have invested into the Australian Smaller Companies equity space. Even now, we are only recommending this exposure to those a little higher up the risk curve. There are a number of issues with investing in the small cap* universe, particularly in a relatively small market like Australia:

» The index is heavily weighted towards small resource companies. This makes the index quite volatile and a difficult benchmark with which to assess managers in this space.
» As the size of the market is quite small, good managers in this space quickly reach capacity and effectively close to new investments.

The attraction of this sector is that there are substantial valuation inefficiencies. This means a good manager can find significant opportunities to add value, providing their analysis is sound. Although many companies in this sector will be familiar to you, i.e. JB HiFi, Flight Centre etc, many others will be less familiar.

As noted above, you will generally find the price volatility of smaller companies substantially higher than the more familiar large companies. Even good quality companies in this sector will be affected by changes in the macro-economic environment. If investing in this sector, you should be clear in this respect and expect significant variability of capital.

Nevertheless, as this sector has substantially underperformed the large cap market in recent years, we believed it is opportune to re-enter the Australian Small Caps equity sector. In selecting the appropriate manager for this exposure, we referred to our base investment philosophy – invest in companies with strong balance sheets, strong cash-flows and sustainable business models. We believe this approach helps ensure that while stock prices may vary, quality stocks will rebound and continue to grow over the longer term.

About the Manager
Karara capital was established in 2007, following the re-organisation of several predecessor investment management companies. Ironbark Asset Management was established in 2009, and is the distributor and responsible entity for the fund.

These administrative functions are outsourced to allow the fund managers to concentrate on their primary undertaking.

The fund is run on a day-to-day basis by Nick Greenaway who has over 14 years’ experience, the last 8 of which specifically in the small cap area. The managing partner and founder of the company is David Slack, who has over 35 years’ experience, and was previously involved with the establishment of small cap investment capacities at some of the biggest managers in this space. As Karara Capital is wholly owned by its employees, we believe the interests of the manager are well aligned with those of investors.

Investment Philosophy
The investment philosophy of the manager is consistent with our approach in that they search for high quality companies with sustainable earnings and/or are materially under-priced compared to their asset position. One of the key factors relevant to this approach is avoiding companies that are impaired or in structural decline i.e. investing in companies that are on the up, rather than on the way down. Because of the approach of the manager, the fund will generally have a lower than benchmark exposure to exploration companies and the resource sector in general.

The fund is relatively concentrated with the manager generally holding between 25 – 55 stocks. Various risk management parameters are employed to ensure the portfolio is diversified and concentration in any one stock is avoided.

The following table illustrates the performance of the fund to September 2013 (after fund manager fees):

It is worth noting that this fund ranks in the top quartile in terms of returns compared to peers since inception and over 5 years. Over shorter time frames, the fund ranks in the second quartile of its peers. This information highlights the limitations of comparison to the index in the above table – in this case most good managers out-perform the index, it is a matter of by how much and by what means this is accomplished.

Over the 12 months to 30 September 2013, the Small Ordinaries Index grew by 0.28% (before dividends). However when this index is further dissected, Small Cap Industrials contributed a performance of 22.4% while small cap Resources contributed a performance of -41.5%. This illustrates the potential divergences within sectors in the Small Cap universe. The conservative approach followed by this manager helps to meet our criteria of providing adequate returns with a lower level of capital volatility.

The following provides an illustration of the fund’s top 10 holdings as at September 2013:

The manager has protocols in place to deal with investments that grow to the extent that they are no longer part of the Small Caps universe. An example of this is Ramsay Health Care. The fund has been invested in this company for many years, and it has grown to such an extent that it is now included in the S&P/ASX 100. The managers continue to maintain a holding in this company, choosing to divest the holding only when valuations suggest it is prudent to do so.

We expect this manager to keep providing returns in excess of its benchmark while the broader market retains a focus on quality. The fund is likely to underperform in an environment where markets are driven by momentum, rather than underlying company performance. Again, we stress that any exposure to small cap shares will increase volatility of capital. However, these should be rewarded by superior long-term returns.

For further information regarding this or any other investment, please contact this office.

*Small Caps refers to small capitalisation. These are listed companies that generally sit outside the S&P/ASX 100 index. The relevant index for these companies is the Small Ordinaries Index.

Our Fund Manager Focus Newsletters focus on a fund manager within our investment portfolio and provide information to help our clients understand their investment philosophy and outcomes.

This newsletter focuses on The Schroder Fixed Income Fund.

Introduction
The past year has seen equity type investments provide significant positive returns. We are of course thankful for this, but it is easy to forget that the above average returns experienced are but the opposite side of the ‘volatility’ coin. We are generally only concerned about capital volatility when it is moving against us. In context of the past 5 – 6 years, we can recognise that the rate of return on growth assets will vary considerably, but will hopefully provide an acceptable level of average returns over the long term.

Defensive investments, such as fixed interest, serve two purposes. They provide steady income and provide capital protection. The level of capital security you require will determine your relative exposure to defensive assets, compared to growth assets. This obviously becomes more important when you retire, and your opportunity to recover from short term losses is limited. Your need to draw down on your retirement assets further exacerbates this problem. While fixed interest investments provide a lower level of capital volatility, some variation in capital is to be expected. This is because all assets are generally marked to market each day, i.e. the portfolio is valued at the price at which it could be sold each day. One of the main determinants of this price is the change in market interest rates each day.

When constructing the defensive portion of your portfolio, capital security is foremost in our considerations. This leads us to select a range of active managers who are either specialist in a particular subsector of interest rate products, or run a portfolio of assets diversified across the various fixed interest subsectors. These subsectors can include cash, Government bonds, corporate bonds and hybrids. We will generally recommend a higher exposure to diversified funds to allow for more targeted and active management of assets across these subsectors. These funds are also more able to manage what is known as ‘duration risk’. In short, duration risk describes the degree to which the value of an asset changes in response to changes in interest rates. In very broad terms, rising interest rates negatively affect the capital value of a fixed interest asset and vice versa.

About the Manager
Schroder Investment Management Australia is a part of the Schroder Asset Management Group. Established in London in 1804, the group now manages over $300 billion in assets across 32 countries, and employs over 2,700 staff. Schroder Investment Management Australia has been providing asset management services in Australia since 1962.

The Schroder Fixed Income Fund was established almost 10 years ago and is managed by Simon Doyle. While the fund can invest on a global basis, the emphasis tends to be towards Australian Fixed Interest.

Investment Philosophy
The managers have a fundamental view that fixed income is generally held for defensive purposes. This includes capital preservation and the ability to diversify equity risk. In regards to capital volatility, the manager does not see this as a risk per se. They prefer to consider risk in absolute terms i.e. losing money.

The fund strategy involves constructing a core portfolio and adding value by identifying opportunistic and thematic investment ideas. These can include credit risk management, country selection and duration risk. The fund aims to outperform the UBS Composite Bond Index over the medium term, while ensuring the defensive characteristics are not compromised.

Since inception, the fund has produced an annualised return after fees of 6.79% p.a., compared to the UBS Composite Bond index return of 6.45% p.a. over the same time period. Generally the fund will distribute income on a quarterly basis. However, this can vary depending on market conditions in any given period.

The following table illustrates the performance of the fund to June 2013 after fees:

The fund currently holds 653 securities with an average credit rating of A. While over 56% of the portfolio is comprised of Australian bonds, no Government bonds are currently held. Instead the manager has preferred semi-Government bonds such as Queensland Treasury Corp and Treasury Corp of Victoria – both state Government funding authorities. These have been preferred, as they provide higher yields with little additional credit risk.

The manager has, for some time now, held a significant portion of the fund assets in cash and cash equivalents. This reflects the manager’s concern in regards to the valuations of fixed interest assets and the potential impact of higher interest rates. Cash & cash equivalents currently comprises over 32% of the portfolio assets.

Although this can lead to lower income returns in the short term, this strategy effectively lowers impact on the portfolio of higher interest rates. While it is true that official Australian interest rates are likely to be further reduced in the short term, long term rates have in fact been rising in the past months. This is a result of the recent indication by the U.S. central bank that monetary accommodation strategies were likely to be curtailed in the medium term. Thus the perception in global bond markets is that the long term interest rate easing cycle is coming to an end. This has prompted heavy selling of bonds, and has pushed yields up across global markets. As cash and short term fixed interest assets are less impacted by rising rates, the strategy of the manager has succeeded in its prime objective of preserving capital.

We believe this active approach to managing the portfolio, and the willingness of the manager to take a view contrary to market consensus helps to deliver capital stability, as well as an acceptable level of income over the medium term. By including this fund in your portfolio, we are able to achieve a higher level of confidence that the defensive part of your portfolio remains true to label.

The fund provides an anchor point in your portfolio that allows us to pursue additional strategies with other managers to enhance the level of income provided by this sector. Apart from your allocation to cash, your investment in this fund is designed to be, essentially, boring.

For further information regarding this or any other investment, please contact our office.

Our Fund Manager Focus Newsletters focus on a fund manager within our investment portfolio and provide information to help our clients understand their investment philosophy and outcomes.

This newsletter focuses on The Walter Scott Global Equity Fund.

Introduction
As you may be aware we spend considerable time trying to create portfolios that will help you meet your long term financial goals. There are two parts to this i) ensuring maximum returns and ii) minimising risk. The definition of risk often depends on the conditions in which it occurs i.e. the risk that returns will not be enough, the risk that your capital may depreciate. There are always trade-offs in this regard, however we believe that building a portfolio on strong foundations can mitigate risk in the long term. Over all sectors, we try to pick investments that reflect this approach. The price of assets go up and down for various reason in the short term, however where a portfolio is made up of quality assets long term value should be recognised. We can think back to 2008 and see many companies were priced for disasters that never arose. To be fair, some never came back, but quality companies that kept growing and making profits, are in some cases trading at all time high prices.

The global equities sector is no different. While this sector lacks some of the tax advantages available to Australian companies, the range of companies and industries available for investment dwarfs the Australian market. Our approach to investing in this sector is, as suggested above, focussed on quality. Nevertheless we appreciate that different managers have different capabilities in term of the individual sub-sectors of global equities i.e. small companies, emerging markets, etc. We are also aware that there is a risk of overlap in respect of the holdings of various managers i.e. Nestle may be held by large company managers, yield driven managers, European focussed managers etc. In this respect owning three funds in this manner may just increase your exposure to the same company, albeit for different reasons. For the record Nestle earns nearly 40% of its revenue from emerging markets, making it even more difficult to ‘pigeon hole’ this company.

For these reasons our global equity portfolios tend to comprise a range of managers concentrating on specific sectors or themes. We have also tended to position a range of concentrated funds around 1 or 2 more broadly based funds. This helps to minimise stock overlap and provide exposure to a wider variety of companies. A concentrated fund will generally hold between 20 – 60 stocks with relatively high exposures to each company. A concentrated fund will thus tend to vary in performance relative to the relevant index or benchmark. In such a portfolio there is additional pressure to ensure quality research as stock selections that do not succeed will have a greater impact on overall performance.

About the Manager
Walter Scott is an Edinburgh based investment company that was established in 1983. While the company is now owned by BNY Mellon (a U.S. bank) the manager remains operationally independent. The fund is distributed in Australia by Macquarie Investment Management.

An investment team of 37 is led by Roy Leckie and Charles Macquaker, who have 17 and 21 years’ experience respectively.

Investment Philosophy
Walter Scott targets absolute long term real returns of 7% – 10% p.a. and believe the best way of achieving this is by investing in companies with high rates of internal wealth generation – that is companies that can grow their business in a profitably and sustainable manner. The manager will construct a diversified portfolio consisting of 40 – 60 stocks. These will be drawn from a pool of potential candidates that appear capable of generating strong internal rates of return. Risk is managed by focussing on companies that, amongst other things, have sustainable earning and strong free cash flow generation and avoiding companies with high gearing levels.

The portfolio will generally display considerable deviation from sector and geographic benchmarks. This is a result of the purely company driven focus of the portfolio construction. For example the fund has exposure to Spain, not because of the Spanish economy, but because the fund holds Inditex (the name behind Zara, amongst other brands). An overweight position in the IT sector is not a bet on the future prospects of the sector, but arises from research generated exposures to the likes of Adobe Systems. Interestingly, the fund does not hold investments in market heavy weights such as Apple Inc and Exxon Mobil, at this point in time, as they do not meet the manager’s criteria for inclusion in the portfolio.

Since inception (31 March 2005 in Australia), the fund has produced an annualised return after fees of 3.6% p.a., compared to the relevant index return of 1.00% p.a. over the same time period.

The following table illustrates the performance of the fund to 31 March 2013 (after fund manager fees):

The returns over the past year have lagged the relevant benchmark. However we believe this is a cyclical factor driven by the out-performance of lesser quality companies leveraged to global economic recover. We are comfortable in this regard as it provides us with confidence that the portfolio consists of higher quality companies with long term operational capabilities. The outperformance over the longer term is instructive when you consider the impacts of the events of 2008.

The following table indicates the current top 10 holdings of the fund. These represent a total of 21.3% of the portfolio:

We expect that while markets remain generally buoyant, this fund will tend to underperform the relevant benchmark. During down markets we would expect the fund to outperform as the broader market tends to ‘retreat to quality’ during market uncertainty. The fund will tend to have little overlap with the companies held by other funds in this part of the portfolio.

For most, the table above will contain a number of names that are unfamiliar (Novo-Nordisk may be familiar to Diabetics, Essilor to those of us wearing corrective lenses). Nevertheless we are confident that the rigorous processes of the manager will provide strong risk adjusted returns over the longer term.

We believe the fund blends well with other Global Equity funds by providing a concentrated exposure to companies with significant growth potential.

For further information regarding this or any other investment, please contact this office.

Our Fund Manager Focus Newsletters focus on a fund manager within our investment portfolio and provide information to help our clients understand their investment philosophy and outcomes.

This newsletter focuses on The BlackRock Global Small Caps Fund WS (Hedged).

Introduction
The market capitalisation of a company is essentially the value of a company at the current share price. Globally there are over 10,000 listed companies of various sizes. For the purposes of establishing relevant indices, listed companies are broadly divided into large and small companies by capitalisation (cap). For instance, within Australia the All Ordinaries index comprises over 500 shares. The top 100 companies by market capitalisation are considered ‘large cap’ and the remainder ‘small cap’. The dividing line is arbitrary and the producers of indices regularly review an index to include or omit a company from a particular index as their value changes. BHP is the largest company on the Australian market with a market value (cap) of $183 billion and ranks number 37 in global terms. Currently the companies at the bottom of the top 100 will have a value of around $1.9 billion. This varies to some extent with market movements.

Globally, large cap companies that are listed and have a minimum ‘free-float’ of shares, number about 1,500. This is the universe from which most global share fund managers will generally build a portfolio. Consequently companies outside of this universe are automatically excluded from portfolios and receive only modest attention from investment analysts. Adjusting for minimum size and liquidity benchmarks, the MSCI Global Small Cap Index includes around 6,400 companies.

Over the longer term small companies can grow in to large companies as their businesses grow. For example at the last re-weighting of the ASX/S&P 100 index in December, Flight Centre and Carsales.com were included at the expense of Paladin Energy and Seven West Media (large companies can also revert to small companies in certain circumstances).

We believe there is merit in including an allocation to global small caps to provide exposure to smaller companies with greater growth prospects. Successful smaller companies that can be identified at an early stage can provide a portfolio with significant growth opportunities. However as you would expect, the prospect for higher growth is accompanied by higher risk. The failure rate of smaller companies is generally higher than large companies. Moreover, smaller companies also display significantly greater price volatility during market disruptions. It is for these reasons that we generally only recommend an exposure to this sub-sector in portfolios where clients have a higher tolerance for capital volatility.

About the Manager
Blackrock is one of the largest investment management firms in the world. The ‘Global Small Caps’ team is based in Philadelphia & Boston, and led by Tom Callan. Tom has over 22 years’ experience in portfolio management, and has been with Blackrock since 1998. He is supported by a staff of 15 investment professionals including 11 stock analysts.

Investment Philosophy
The manager seeks to build a globally diversified portfolio of quality small and mid-sized listed companies. The manager researches over 100 industry sub-sectors to assess the relative attractiveness of these sectors on a global basis. From this point, stocks within sectors considered attractive are assessed on a fundamental basis. The manager attempts to identify companies that are undervalued by the market and operate in industries with long term growth potential. The portfolio will generally hold between 125 – 175 stocks. This is designed to provide broad diversification within this subsector. The average capitalization of companies in the portfolio tends to be between US$1 – 2 billion.

Since inception the fund has produced an annualised return after fees of 6.42% p.a., compared to the relevant index return of 1.44% p.a. over the same time period.

The following table illustrates the performance of the fund to 31 December 2012 (after fund manager fees):

The fund does not benchmark its geographic exposures. These arise as a derivative of the sector and stock analysis used to create the portfolio. As you would expect, the stocks held in the portfolio are unlikely to be familiar household names in Australia. Nevertheless many of the companies held have global operations belying their relative size. Moreover, a number of the companies held operate in industries you may not be familiar with i.e. Subsea 7 is a Norwegian company that provides ‘sea-bed to surface’ engineering and construction services to resource companies. SBA Communications builds, owns and operates wireless communications infrastructure (towers etc) throughout the Americas. While both companies are relatively small on a global scale, both have a market capitalisation near US$9 billion (about the same size by market cap as Orica or Transurban on the Australian Stock Exchange).

The following table indicates the current top 10 holdings of the fund. These represent a total of 12.7% of the portfolio:

While the fund has a good long term record when compared to the relevant benchmark, shorter term returns (1 – 3 years) have lagged the relevant benchmark. This is in large part due to the manager’s cautious approach during this period. While global equity markets are being driven more by liquidity than fundamentals, we would expect the manager to continue to underperform the index. This reflects the manager’s bias towards assessing the fundamental quality of a company’s growth prospects over the longer term. We would expect this approach to provide more sustainable long term returns in a sector that is inherently sensitive to changes in economic conditions.

We believe the fund blends well with other Global Equity funds by providing access to investment opportunities outside the scope of large cap managers.

For further information regarding this or any other investment, please contact this office.

Our Fund Manager Focus Newsletters focus on a fund manager within our investment portfolio and provide information to help our clients understand their investment philosophy and outcomes.

This newsletter focuses on Grant Samuel Epoch Global Equity Shareholder Yield Fund.

Introduction
The reasons for investing in international equities are occasionally contentious. For the better part of a decade the performance of this asset class was at best variable. Looking back there were many good reasons for this. March 2000 saw global equity markets peak and severe falls in markets, centred on the ‘tech-wreck’ followed. Some encouraging returns 2003 – 2007 were enjoyed, but these still tended to underperform relative to Australian stocks. Of course we all remember 2008 – 2009 all too well. It also seemed that the impact of unfavourable currency movements was timed precisely to erode incipient gains on international share investments. Nevertheless we persist with our view that exposure to international shares can provide broader investment opportunities compared to those available in Australia. Furthermore, while issues in international markets can impact Australian markets, the opposite is rarely the case. Familiarity with Australian companies is often comforting, but as you read this, you may look around you and notice the brands of many companies that are based outside of Australia (if you are reading this on a computer there will be at least 3 right in front of you).

Gaining access to international shares will generally be more effective via a fund manager, but selecting a manager from the hundreds available requires careful analysis. Most will have an exposure to this asset class via a number of managers. Each of these is chosen because of a special skill or approach that blends with our overall investment philosophy. As the name suggests, the Grant Samuel Epoch Global Equity Shareholder Yield Fund has an approach that many investors in Australian shares will be familiar with – yield.

About the Manager
The Grant Samuel Epoch Global Equity Shareholder Yield Fund is distributed in Australia by Grant Samuel Funds Management and run by Epoch Investment Partners in New York. Epoch Investment Partners was established in 2004 by Bill Priest, an investment manager of some 47 years’ experience (he recently turned 70 y.o.). Epoch Investment Partners is a publically listed company in which staff retains approximately 40% ownership. This specific fund was established in May 2008, although Mr Priest and his associates have been running the strategy for institutional clients since 2004.

Investment Philosophy
The managers of this fund have a fundamentally different approach to investing in equities, believing that cash flow is a more accurate determinant of long term investment returns than traditional metrics such as price/earnings ratios etc. Priest & Co provide evidence that companies that pay dividends out-perform other stocks over the long term, with a lower level of capital volatility. The following table based on the S&P 500 demonstrates by dividing companies in this index into categories reflecting their dividend payment history. Long term returns are then determined for comparison purposes. The volatility of the prices of shares is an important consideration and is illustrated using ‘Standard Deviation’ as a measure:

The Grant Samuel Epoch Global Equity Shareholder Yield Fund aims to identify companies that return excess cash-flows to investors in the form of dividends, share buybacks and/or debt reduction – the latter of which improves the enterprise value and cash flow position. Bill Priest articulates what he calls the ‘9% solution’ – comprising 4.5% from dividends, 1.5% from share buy-backs and/or debt reduction and 3% from growth in operating cash-flows. These are the broad parameters from which stock selection begins.

These stocks must meet certain minimum criteria including:
» High current income yield.
» Cash from operations exceed dividends over trailing 3 years.
» Growth in operating cash-flow over 5 years.
» No dividend cancellation over available history.
» Market capitalisation >USD500 million.

These initial screens help to ensure only stocks with reliable cash-flows and sustainable dividends are considered when constructing a portfolio of stocks. An example of a company typically meeting these criteria is Johnson & Johnson. While you may be familiar with this company you may not be aware that this company has increased its dividend each year for 50 consecutive years. Other familiar names such as Coca-Cola, Nestle and Kimberley-Clark have generally been included in the portfolio subject to continuing qualification under relevant criteria.

The manager is truly global in its outlook and will occasionally include investments in Australian stocks, provided the analysis is supportive. For instance the managers added Telstra Ltd in the past quarter as they became convinced, not only that the dividend was sustainable, but that the growth in wireless and broadband businesses would support growth in cash-flows.

The following table illustrates the performance of the fund to August 2012 (after fund manager fees):

Given the investment approach of the fund, you can generally expect that the fund will out-perform during falling markets and under-perform in rising markets, relative to the benchmark. The short term performance in the table above is indicative in this regard. As markets became more confident over the past few months, more speculative stocks have been favoured.

The following table indicates the current top holdings of the fund. These represent a total of 17.2% of a portfolio comprised of around 100 stocks.

Although this fund has a relatively short history we believe it can provide access to the international equities asset class with a lower level of risk. For clients with a preference or need for income generation the fund provides an additional income source. The fund generally makes distributions on a quarterly basis. The fund can be accessed as a hedged or unhedged version. We have generally preferred the hedged version as part of our broader management of currency risk in this asset class.

Our Fund Manager Focus Newsletters focus on a fund manager within our investment portfolio and provide information to help our clients understand their investment philosophy and outcomes.

This newsletter focuses on The Perpetual WS Industrial Share Fund.

Introduction
Those who have been receiving investment advice from us for some time will have noticed few changes in the ‘Australian Shares’ part of your portfolio over recent years. Where we feel no change is required we tend to leave well enough alone. We also prefer to employ as few individual managers as we can, as long as we can generate an effective level of diversification. We periodically test our blend of managers to assess whether the combination meets our criteria of better returns with lower risk. In terms of risk, we are generally trying to minimise the variability of returns without having a substantially negative impact on those returns. Often we see significant deviation of returns between managers in the short term and this prompts clients to ask why we persist with a particular laggard. Different parts of the market have specific performance attributes at different times in the economic cycle. Rather than try to pick the changes in the economic cycle, we attempt to select a blend of managers that will generate acceptable risk adjusted returns across the cycle.

As a general rule, Industrial Share funds do not invest in mining & resource stocks. Therefore the performance can deviate from the broader market quite significantly. As mining & resource companies have increased their prominence in the market in recent years, so has their impact on market returns. Mining & resource booms are a regular feature of the Australian economic landscape. During the boom stages of the current cycle it appeared that mining & resource stocks were the only place to invest. As the current cycle has started to mature the market has become more circumspect in regards to mining & resource stocks. Other Australian equity managers in your portfolio will have an appropriate exposure to mining & resources and will adjust these as their analysis dictates. Investing in a fund not directly affected by resource related booms & busts provides an anchor for this part of your portfolio. Industrial shares will generally provide higher dividends, above average franking credits and more stable long term growth prospects.

About the Manager
There are various fund managers who invest exclusively in industrial shares however Perpetual virtually invented the concept. The Perpetual Industrial Share Fund was established in September 1996. Although the fund has had a number of portfolio managers come and go since inception, the strength of this fund is the underlying investment process. This process has been consistent and repeatable despite staff changes. The recent departure of John Serviour saw Matt Williams become Head of Equities and Senior
Portfolio Manager at Perpetual. Matt has been an investment professional for 21 years, 18 of which have been at Perpetual. The fund is currently managed by Charlie Lanchester, an investment professional for 18 years, 12 of which have been with Perpetual.

Investment Philosophy
Across all of its fund offerings Perpetual maintains the same investment style. This is described as the ‘Value’ approach to investing. Generally a ‘Value’ manager will seek out stocks that appear undervalued. By investing in companies that appear undervalued the risk of over-paying for an asset is reduced. This appears to be a rather simple concept but trying to establish if a company is undervalued because it is misunderstood by the broader market or ‘out of fashion’ is different to determining if a company is cheap for good reason. A number of ‘high flying’ companies over the years became progressively cheaper over time prior to disappearing altogether. Perpetual portfolio managers seek to identify companies with strong business models and sustainable earnings. One of the keys to this process is assessing the strength of the management of individual companies. The portfolio managers and their analysts perform regular company visits to assess the management capabilities of companies in which they invest or may potentially invest in.

Since inception the fund has produced an annualised return after fees of 10% p.a., compared to the ASX/S&P300 Industrial Accumulation index, which return 8% p.a. over the same time period. This return is made up of 7.3% p.a. of income and 2.7% p.a. growth. The manager expects distributions over the next 12 months will include dividends with a combined franking level of 90%. This compares with a broader market average of 70 – 80%.

The following table illustrates the performance of the fund to April 2012 (after fund manager fees):

The fund currently holds 46 stocks which includes a number of stocks outside of the S&P/ASX 300 index. Some of these non-index holdings are included in the following illustration of the fund’s top active weights as at April 2012:

The returns from Australian equity markets in the past 18 months were largely driven by the mining & resource sectors of the market. This has meant the Perpetual Industrial Share Fund has tended to provide lower returns than the broader market. Nevertheless the fund continued to provide acceptable returns in both relative and absolute terms. More recently, as commodity markets have cooled, industrial shares have tended to out-perform the broader market. This is clearly illustrated in the table above (S&P/ASX 300 Industrial Accumulation Index vs. S&P/ASX Blended ordinaries Accumulation Index) and we believe this justifies past decisions to retain this fund. At this time we remain confident that a blend of investments including this fund will help to deliver acceptable returns over the long term, with a lower level of capital volatility.

For further information regarding this or any other investment please contact this office.