From the Undergrowth July 2018

Debt up to our ears

My generation loves to remind today’s younger Low interest rates are here to stay generations that first mortgage rates were near 20% in the So why are interest rates likely to stay so very low for an mid-1980’s. This fact is often recalled within a statement extended period, and why should we put aside such recent of either “toughen up” or “be careful it could happen history? The answer is the world is awash with debt. To again”, directed at today’s younger generations buying offset the depressing effect of the GFC, governments and exorbitantly priced houses. That though was over 30 years households have taken on mountains of debt to maintain ago and the world has changed immeasurably since then. employment, sustain incomes and to take advantage However, only 10 years ago the RBNZ Overnight Cash of the very low interest rates to buy assets, particularly Rate (OCR) was 8.25%; today it is 1.75% and it has been at property. In household debt was $14b that level since November 2016. Having experienced very in 1985, $135b in 2008 and $211b today. Increases in high interest rates in such recent history does dominate interest rates today, would apply to a far greater pool of many investors thinking. This tends to create undue household debt, and therefore affect consumer spending caution to their investment decisions today or creates in a far greater way than it would have in earlier years. This undue expectations of what represents fair and sustainable significantly increases the power of the RBNZ (through medium term returns. So many investors are caught up in the level of interest rates) to impact the wider economy. It this old paradigm. also suggests that even modest lifts in interest rates could cripple many households, reducing the chances that this will be allowed to occur. The situation is no better in many other western nations. In for example, household debt in 2008 was $1.1 trillion whereas it is $2.5 trillion today. The Australian economy is now in effect held hostage by the mortgage market. Shares will remain attractive to investors It is very difficult for many of us to get high-interest rates out of our investing mindset. Yet when the level of global debt is analysed, it really does suggest that the upside risk to interest rates is limited, relative to our recent memories. That also suggests that we all have to re-engineer our businesses and lifestyle for this new paradigm. It also means that shares will ultimately remain a core part of investors portfolios long into retirement. Living entirely off interest from term deposits and government bonds is a strategy most likely destined for the distant memory just like 20% mortgage rates. You At the most recent RBNZ OCR review, Governor Orr signed can all thank households’ off by saying that they would ensure the OCR is at the appetite for ever increasing current expansionary level for a considerable period. That mortgages for that. is, a sub 2% OCR is here for the foreseeable future unless something materially changes, which is not currently on the Bruce McLachlan RBNZ radar. Chief Executive Your portfolios — What’s been going on since we last spoke?

The sport of investing Harry Smith, Senior Investment Analyst

One of my favourite past times while at Otago University The core driver behind this growth is the inclusive nature was heading down to the House of Taine (or Pain of video games — you don’t have to be a professional depending on your vintage) to watch the rugby. Jerseys athlete to get involved. There are over 2.2 billion gamers were loose, rugby was played under the winter sun and globally, playing video games that are competitive in both seats and terraces were packed to the rafters with nature. Another driver is being able to identify with your supporters. Watching the Auckland Blues the other day, hero as they are in a similar age bracket (18-35) and I was struck by how empty the stadium was. It reminded are playing your game just like you, which is engaging. me of my recent trip to the US and research of video This compares to the ever widening gap between pro game publishers. and amateur athletes in traditional sports. Top players like Tyler ‘Ninja’ Blevins, who is 27, can command up to Declining viewership of sports isn’t just an issue with 250,000 viewers per game and earn $500,000 a month rugby, most traditional sports have a diminishing from playing the hit game Fortnite. supporter base and declining TV ratings. In contrast to this trend, multiplayer competitive video gaming, Even though e-sports currently only generates around $2 commonly known as e-sports is running hot. You only of revenue per fan compared to $54 for other traditional need to pick up the newspaper to witness the explosion sports in the US, there is a race from video game around new game, Fortnite. publishers, media companies and telecommunication firms to capture a slice of this rapidly growing market. In 2017 385 million viewers tuned in to watch an e-sport event. Audiences have grown 24% yearly since 2014 Also battling it out for eyeballs are the major tech giants. and it is expected that viewers will grow to 850 million In 2014 Amazon brought video game streaming platform, by 2025. The packed stadium below is the League of Twitch and its 55 million monthly users (now 100 million) Legends video game World Championship! for $824 million. The website had only been founded 3-years earlier in 2011! It was reported that Google was also bidding for the streaming site. Through Twitch, YouTube (owned by Google) and Facebook gaming, viewers can subscribe to a gamers channel for between $5 and $25 a month or tip a player for skilled game play. As active investors, finding growth themes is one thing, but finding companies with the ability to maintain competitive advantage over competitors, capitalising on the theme, is a lot harder. Through our investments in Facebook, Google (streaming platforms) and PayPal (online payments) we currently have indirect exposure to the rise of e-sports and online gaming. On recent trips to the US we have meet with all major US video game publishers, including Activision-Blizzard, Electronic Arts and Take Two, and also attended the E3 video gaming industry convention alongside 20,000 video game enthusiasts in Los Angeles. Our search for potential investments in this space continues. Investing is not about growth at all costs, it is also about capital Source: https://euw.leagueoflegends.com/sites/default/ preservation and ensuring the businesses you invest in files/styles/wide_small/public/upload/photo-1_0. have a franchise that ensures they will continue to profit jpg?itok=2o14n4bd for many years to come.

FISHER FUNDS 2 FROM THE UNDERGROWTH : wearing out the shoe leather Sam Dickie, Senior Portfolio Manager

There are two pieces of art on the wall next to my desk Xero is the market leading provider of cloud-based at work — both are quotes by Peter Lynch, the former accounting software for small-to-medium businesses manager of the rockstar Magellan Fund. The first is “There and their accountants in NZ, Australia and the UK, with is absolutely no better investment technique than wearing growing presences in the USA and other markets such out shoe leather and visiting companies”. The second is as SE Asia and EMEA. We assume Xero will continue to “Know what you own and know why you own it”. be the innovators of the industry, allowing it to retain its market leading positioning in Australia/NZ and the UK, grow its foothold in the US market, as well as overtime, grow its rest-of-world business. Combined with the huge market opportunity (global penetration less than 3%) and the wide MOAT Xero is building around its small business customers, we think Xero has material future earnings growth and the UK will be a key driver of that growth. The UK: a lucrative opportunity Gary is one of the longest standing executives at Xero and has presided over the UK operations of Xero since inception almost 10 years ago. Not only has the UK gone from less than 25,000 subscribers and less than 15% of group revenue 5 years ago to more than 325,000 subscribers and more than 20% of group revenue today, importantly we see the UK as the strongest revenue growth driver for the next 5 years. Xero has around 1.4m customers globally today and we There are two potential reactions to those pieces of art — agree with Gary that there is no reason Xero cannot reach either we need to inject some flair into our taste in art or, over 1m customers in the UK alone and we forecast them given that as the manager of the Magellan Fund between reaching that milestone within the next 5 years. 1977 and 1990, Lynch averaged a 29.2% annual return, consistently more than doubling the S&P 500 market index A powerful tailwind for the business is the UK and making it the best performing mutual fund in the government’s mandate requiring firms to lodge world, perhaps we should heed his advice. consumption tax (VAT) returns digitally from April next year. Given approximately only 1 in 7 of the 1.4m VAT While the former may be true, we decisively follow the registered companies in the UK currently use accounting latter and agree whole-heartedly with Lynch’s advice. There or tax software, this will help ensure the impressive is no substitute for looking in the eye of the managers at a growth rates we have been witnessing continue. business — it accelerates the knowledge process and gives us confidence that there are layers of quality management The secret to Xero’s success in the still relatively below the “C” suite. Given more than 50% of the revenue nascent cloud accounting software market in the UK from the NZ Growth Fund is derived from offshore, we will continue to be great product, great people, strong recently visited several of the offshore operations of the relationships with the accountant channel as a key portfolio companies in the NZ Growth Fund as well as route to market and the courage to continue to be the global competitors of these companies. innovator of the industry. One of the highlights of the trip was an opportunity to It is face to face meetings like this that are invaluable spend some time with the head of Xero’s UK operation, in building our further understanding of portfolio Gary Turner. companies like Xero.

FISHER FUNDS FROM THE UNDERGROWTH 3 Believing in Brambles Frank Jasper, Chief Investment Officer

Last month I was in Wellington where I had the chance centre network to a standard similar to its more efficient to meet with some clients. As I am originally from the European network. While these initiatives all make sense Hutt Valley I can say this; Wellington was on its very best to us, these actions with the exception of surcharges, are Wellington behaviour. It was tempestuous, with that not a short-term fix and we expect pressure to still be special horizontal rain that I am convinced blows straight evident on the company’s near-term earnings. in from Antarctica and has a gift for finding a way down the neck of your jacket and then chills you to the bone. Brambles’ balance sheet pressures are currently being reflected in its share price, and the valuation of the One of the things I covered in my presentation was company, based on metrics like the price to earnings the idea that building long-term wealth requires a little ratio, is sitting at five year lows. We believe this is the bravery — being brave enough to take positions that feel opportunity. Brambles is growing its revenues in mid- a little uncomfortable at the time or that may even seem single digit levels, and we believe the company will counterintuitive. Ultimately, though, swimming against the continue to keep growing at such rates for years to popular tide has on many occasions resulted in our best come. As Brambles solves its short-term cost challenges, long-term successes. margins should improve turning forecast revenue growth into even healthier profit growth. While the environment for one of the Australian companies in our portfolio Brambles, hasn’t been quite We love buying shares in high quality, growing as tempestuous as a Wellington southerly, it has been companies on sale and have added to our investment difficult. On this occasion though we think the storm has in Brambles. We believe now is the time to be patient, delivered us the opportunity to increase our investment ride out the storm and enjoy the good weather to come. at a very reasonable price. While it takes a little bravery to We all know you can’t beat Wellington on a good day. add to an investment when the news on the company isn’t Fingers crossed out increased investment in Brambles exactly great, this is precisely the right time to do it, given gives us that same warm feeling. our belief that Brambles is a high quality company with sound long-term growth prospects. Brambles is the leading global supplier of pooled pallet and reusable crate solutions to its customers, primarily in the fast moving consumer goods sector. The company has a long history of generating shareholder wealth and a track record of making smart strategic decisions. At the moment, Brambles is facing transport and plant cost pressures in its key US pallets market. The list of challenges is long; higher fuel prices, driver shortages, some changes in customer behaviour in response to higher transport costs, higher lumber costs, inefficiencies due to capacity constraints, and changes in commercial relations with some retailers. These headwinds have pressured Brambles’ profit margins in the US. The company is working to relieve these pressures by implementing surcharges and adjusting contract terms as contracts roll over. It is also investing in a plant automation programme that will modernise its US service

FISHER FUNDS 4 FROM THE UNDERGROWTH Highlights and lowlights

A snapshot of the key factors driving the performance of markets and your funds last month

It was again a strong month for the New Zealand portfolio, rising 4.2% and comfortably outperforming the S&P/NZX50G index which was up +3.3%. Fisher & Paykel Healthcare, Xero and Vista Group were the Fund’s top performers on little news flow, and drove a meaningful share of both absolute return and the majority of our outperformance relative to the index. There were no material detractors during the month, but we were surprised with the announcement from Michael Hill that it will immediately close all six remaining Emma & Roe stores, rather than undergoing the trial phase announced in March.

In June the Australian portfolio returned 3.3% trailing the benchmark ASX 200 which was up 3.7% for the month. Our performance was relatively broad based with the healthcare and commercial sectors leading the way. Top performer was Nanosonics, gaining 19% for the month off the back of news of regulatory approvals in some key international markets for their second generation Trophon. Double digit growth was also achieved by Insignia (+15%), APN Outdoor (+10%) and Wisetech Global (+17%). The biggest drag on performance was Ramsay Healthcare, down 12% for the month after being plagued by revenue headwinds.

The International portfolio was up 2.2% in June, outperforming our global benchmark which was up 1.3%. After a strong start to June, global markets retreated late in the month and closed broadly flat as trade fears re-emerged. Defensive sectors including utilities and consumer staples outperformed, while industrial and technology companies underperformed. Our top performing company was logistics software company Descartes (+11%), on the back of a small acquisition and reporting revenue growth of 23% and EBITDA growth of 16% for the first quarter, ahead of management’s 10-15% long-term guidance. Strong performers were also TJX Companies, the off-price retailer (+5%) and heart valve manufacturer Edwards Lifesciences (+6%). The notable drags on performance were jewellery retailer Pandora (-11%), and parcel delivery giant UPS (-8%). Pandora’s decline was after weak monthly results. New launches in the coming months are expected to support sales and management have reaffirmed guidance of 7-10% sales growth for the year.

Our Property and Infrastructure portfolio performed solidly in June and was up 2.2% for the month. Aeroports de Paris (AdP) was the standout performer (+10% in local currency), rallying on the news that the French Government will sell at least part of its majority stake (subject to Parliamentary approval). We reduced our position in Zurich Airport during the month following the unexpected proposal by the regulator to force Zurich Airport’s non-regulated business to subsidize it’s aeronautical-business, which if enacted will reduce the likely revenue from airline tariffs from mid-2020.

Our preference for highly rated government bonds over those offered by lower rated corporate issuers was again the key contributor to performance this month. This as trade wars raged and economic data softened. We are cognisant though that too much exposure to government bonds will greatly reduce the yield, or expected income, of the portfolio whilst also leaving it exposed should interest rates rise quickly. That is why pairing these investments with carefully selected corporate bonds remains key to maintaining both an attractive level of income and diversification across the Fund. Our investment in Boparan was the largest drag on performance this month. A weak quarterly earnings release was the initial reason for a fall in the price of our bonds. But a confusing and, at times, frustrating conference call between management and debt investors following the earnings release, was the cause of a more protracted slide in the bonds over subsequent days. Unsatisfied with the answers management provided, we arranged a one-on-one call with the incoming Chief Financial Officer, Craig Tomkinson. The result of which has helped cement our investment thesis, despite this recent weakness in the bonds.

For a copy of any of our product disclosure statements, visit our website fisherfunds.co.nz or phone 0508 FISHER (0508 347 437) The information and any opinions herein are based upon sources believed reliable, but the Company, its officers and directors make no representations as to its accuracy or completeness. All opinions reflect our judgement on the date of this report and are subject to change without notice. The information contained in this publication should not be used as a basis for making an investment decision about any particular company. Professional investment advice should be taken before making an investment. Past performance is not a reliable guide to future performance. Fund facts (as at 30 June 2018)

Fund performance Since Fund Returns (after fees and before tax) Unit Price $ 1 Month 1 Year 2 Years* 3 Years* 5 Years* 7 Years* Inception*

New Zealand Growth Fund 8.8625 4.2% 20.3% 15.9% 17.0% 14.7% 16.0% 12.2%

Australian Growth Fund 3.8376 3.3% 20.1% 11.8% 10.7% 7.4% 8.5% 7.5%

International Growth Fund 2.1370 2.2% 21.8% 20.0% 10.8% 11.9% 8.6% 7.5%

Property & Infrastructure Fund 2.4348 2.2% 10.6% 11.5% 12.1% 13.2% 11.4% 12.2%

Income Fund 1.0095 0.2% 2.3% 2.5% 3.4% 4.4% 4.7% 4.6%

KiwiSaver Growth Fund 2.1444 1.9% 13.6% 12.2% 9.8% 10.6% 10.0% 7.7%

KiwiSaver Conservative Fund 1.6001 0.7% 5.0% 4.2% 5.0% 6.0% 6.0% 5.4%

* Annualised returns

Market Indices 1 Month 1 Year 2 Years 3 Years 5 Years 7 Years

S&P/NZX 50 Index Gross 3.4% 18.9% 15.3% 17.4% 16.5% 16.1%

90 day bank bill 0.2% 2.0% 2.1% 2.4% 2.7% 2.7%

S&P/ASX 200 Index (NZD 70% hedged)* 3.7% 14.9% 14.8% 9.0% 10.1% 8.5%

S&P PMI/EMI Blended Index (NZD 50% hedged)** 1.3% 17.1% 18.1% 8.7% 13.1% 11.5%

Income Fund Composite Index*** 0.3% 2.9% 1.9% 3.9% 4.5% 4.7%

* S&P/ASX Small Industrials Index (Inception to 31/1/2012), S&P ASX 300 Industrials ex top 20 70% hedged to NZD (1/2/2012 — 31/3/2015), S&P/ASX 200 70% hedged (1/4/2015 to now) ** Global Small Cap Index (Inception to 31/3/2015, S&P PMI/S&P EMI 50/50 blend 50% hedged to NZD (1/4/2015 to now) *** New Zealand Government Stock Index (Inception to 31/10/2016), S&P/NZX 2 Year Swap Index (1/11/2016 to now) Biggest contributors/detractors Share Price Contribution Share Price Contribution New Zealand Change to Return Australia Change to Return

Fisher & Paykel Healthcare 13% 1.5% Seek Limited 8% 0.6% Corporation Limited

Xero Limited 11% 0.5% Nanosonics Limited 19% 0.5%

Ryman Healthcare Ltd. 6% 0.5% Ramsay Health Care Limited -12% -0.4%

Share Price Contribution Share Price Contribution International Change to Return Property & Infrastructure Change to Return

Alphabet Inc. Class A 3% 0.4% American Tower Corporation 5% 0.6%

TJX Companies Inc 5% 0.4% Crown Castle International Corp 5% 0.4%

Descartes Systems Group Inc. 11% 0.4% Kinder Morgan Inc Class P 6% 0.4%

Biggest holdings New Zealand Australia International Property & Infrastructure

Fisher & Paykel Healthcare 12.0% CSL Limited 7.1% Alphabet Inc. 7.2% American Tower 7.5% Corporation Limited Class A Corporation

Mainfreight Limited 9.6% Seek Limited 6.9% PayPal Holdings Inc 5.6% Union Pacific Corporation 6.7%

Freightways Limited 9.2% Carsales.Com 6.4% TJX Companies Inc 5.2% Crown Castle 5.8% Limited International Corp

Cash 5.0% Cash 8.9% Cash 6.3% Cash 7.8%

Top 10 holdings 73.8% Top 10 holdings 54.3% Top 10 holdings 50.1% Top 10 holdings 55.7%

Further information about all of our funds (including a full breakdown of the portfolio holdings, investment team profiles and current fund fact sheets) can be found at fisherfunds.co.nz.

Fisher Funds Management Limited Postal Address Private Bag 93502, Takapuna, Auckland 0740 | Freephone 0508 FISHER (0508 347 437) Telephone 09 445 3377 | Facsimile 09 489 7139 | Email [email protected] | Website fisherfunds.co.nz