Quarterly Commentary 31 December 2016 Commentary

wave of initial public offerings (IPOs) are a case in point.

IPOs are supposedly engineered to deliver good outcomes for investors and many remember the extreme success of the demutualisations and government sell-downs in the 1980s and 1990s. 2016, however, has been a particularly bad year for these newly-listed companies and the complacent investors who backed them. Not only have newly-listed companies been disproportionately represented in 2016’s corporate collapses, many of those that remain standing have significantly underperformed the broader sharemarket.

Dick Smith, Vocation and McAleese were all placed into Simon Mawhinney, CFA administration recently with none of these managing to Managing Director & Chief Investment Officer chalk up their three year anniversary as a listed company. Excluding these corporate failures, seven of the ten worst performing shares in the S&P ASX All Ordinaries Index this It has been a great year for our investors with performance year were newly-listed companies. None of the best bouncing back very strongly after a disappointing 2015. performing ten were newly-listed. Readers may be pleased to know that, despite our recent success, we enter 2017 with the same razor-like focus and Picking on the worst performers is not necessarily investment rigour as we entered 2016. representative of the entire sample of newly-listed companies. Over the past ten years, there have been 141 There is never a good time to be complacent when it comes IPOs of Australian companies with market capitalisations of to investing and we continue to scour the market for great greater than $200m. Table 1 shows how these IPOs have opportunities. Exercising caution is critical and the recent performed relative to the broader sharemarket.

Table 1 : IPO performance relative to S&P/ASX 300 Index after one and three years of listing

Average Over/(Under) Sample size Number of Number of performance Outperformers Underperformers

After 1 year 9% 124 58 66

After 3 years (11%) 74 25 49

Source: FactSet, Allan Gray Australia, Deutsche Bank

2 of 12 Q4 2016 Of the 141 IPOs analysed, 124 have a track record greater shareholders, who know the most about their businesses, than one year (i.e. 17 were listed in the past year). These with fee-gouging investment banks close behind. These companies have, on average, outperformed the sharemarket companies often outperform in their first year as a listed by 9% in their first year of trading. Extending the analysis to company but go on to significantly underperform the broader those with a three-or-more year track record reduces the sharemarket when the cycle turns or their very optimistic sample size to 74. These companies have, on average, projections reflected in the prospectus are not achieved. underperformed the sharemarket by 11%. In both It is for these reasons that we don’t typically participate in categories there are more underperformers than IPOs. Not only do we not have access to the same outperformers. information as the sellers of these businesses, it is usually This should not come as a surprise. IPOs today usually better to wait for less rosy outlooks to prevail, with resulting follow extremely favourable business conditions and are prices which more adequately compensate a buyer of floated when the outlook is extremely optimistic. They are shares for the risks they take on. One such example is Nine usually priced for perfection, with exiting shareholders Entertainment Company which listed in December 2013 eager to extract as high a price as possible. The greatest and today trades at about half its listing price. Tim Hillier beneficiaries are the exiting founders or private equity discusses below.

The favourable structure of the TV industry made networks very profitable businesses for many years. TV was the dominant form of home entertainment and consistently attracted large audiences. This enabled the TV industry to win a major share of total advertising revenues – approximately 30%. There were also only three Government-issued licences available, thereby limiting competition for audiences and the corresponding advertising dollars.

More recently, external competition for both audiences and advertising dollars has increased. This started with the arrival of subscription TV, but has accelerated with the availability of online content, from internet downloads, to Tim Hillier, CFA the recent arrival of subscription streaming video-on- demand (SVOD) services, like Netflix. Analyst Like the other networks, Nine has had a colourful ownership Nine Entertainment Company history. The Packer family has owned it twice, having sold it to Alan Bond before repurchasing it at a significantly lower Nine Entertainment Company (Nine) owns one of the three price. More recently, CVC (a large private equity firm) commercial, free-to-air TV networks that broadcast into purchased Nine in a debt-laden acquisition prior to the large Australian cities. Commercial TV networks make global financial crisis. This debt burden ultimately forced money by selling advertising space. The larger their Nine into a restructuring from which lenders Oaktree and audience, the more the network can charge. To attract Apollo emerged as owners of the company in 2012. In these audiences, the networks have to create or buy December 2013 Nine was finally sold to the general public sought-after content (sport, drama, etc.). in an IPO at $2.05 per share.

3 of 12 Q4 2016 Expectations at the time of the IPO

In the lead up to Nine’s IPO, TV’s share of national from 35% in 2007 to 38-39% at the time of the IPO. This is advertising expenditure continued to be largely unchanged represented in Graph 1. at 30%. Meanwhile, Nine’s share of audiences had grown

Graph 1: Nine’s audience share grew while TV’s share of advertising expenditure remained constant

40 40

35 39

30 38

25 37

20 36 air TV audience in key - to - 15 35 geographies

10 34 % of national advertising % of national advertising expenditure 5 33 % share % share of free

0 32 2006 2007 2008 2009 2010 2011 2012 2013

TV share of advertising expenditure - full years only (LHS) Nine's share of TV audiences (RHS) Source: Nine prospectus, November 2013

The outlook for the TV industry was reasonably positive at The outlook for the TV industry deteriorates the time of the IPO. Many expected TV to retain its share of national advertising expenditure, which itself had grown a Since Nine’s IPO, TV audiences have declined as a range of bit above inflation over time. The more optimistic new platforms and content have become available and been forecasters expected TV to command a greater share of embraced by consumers. Not least of these is Netflix, which national advertising, as a rapidly changing media market launched in Australia in March 2015 and enables users to meant TV remained the only effective way to reach a mass pay a monthly subscription to watch content at a time they audience. However, it turned out that even the less bullish choose with no advertising interruptions. Advertisers also expectations of maintaining national advertising share now have a greater range of platforms upon which to screen were too optimistic. video content (e.g. news websites and social media) where previously TV was the only choice.

Nine’s run of ratings (share of audience) improvements also ended, as several of its new shows underperformed and Channel Ten regained lost ground. Graph 2 shows Nine’s 12-month rolling average share of commercial free-to-air audience.

4 of 12 Q4 2016 Graph 2: Nine’s audience share has decreased

40

39

38

37

36

35

34 five capital cities

33

32

Nine's % share of free-to-air TV audience in Nine's % share of free-to-air 2010 2011 2012 2013 2014 2015 2016

Source: Allan Gray Australia, November 2016

Meanwhile, content costs for the industry have continued Warner Bros. This approach will allow Nine to better to grow, most notably as TV companies have outbid each respond to changes in both the advertising cycle and the TV other to win the rights to broadcast sport. With lacklustre industry’s fortunes. Expected reforms to media regulation revenue growth, this has been a recipe for poor returns. in Australia, a response to the rise of online competition, could also result in a substantial reduction in Nine’s c.$35m TV’s deteriorating prospects, the fall in Nine’s audience p.a. annual licence fee costs. Nine also has a strong balance share and concerns about content costs have resulted in sheet, a luxury its fellow broadcasters don’t enjoy – we Nine’s share price underperforming the sharemarket by estimate the company to have net debt of less than $50m. over 50% since its IPO. Pessimism reigns supreme and the outlook for free-to-air TV broadcasters is widely believed to Nine presents an attractive opportunity be dire. But we think the outlook is too pessimistic and Nine’s share price more than adequately compensates Today, Nine’s market capitalisation and net debt total investors for TV’s challenging outlook. around $950m. We expect Nine to generate approximately $140m in operating profits (before tax) in 2017. There is The market has become too pessimistic about Nine’s prospects certainly some risk that earnings fall from here, but at seven times these operating earnings (relative to the broader Advancements in technology will continue to change the sharemarket at 12 times) much of this risk appears to be competitive landscape, with viewers being presented with priced in. more convenient ways to access a broad range of content. The market certainly isn’t pricing in the potential for any However, over the years live TV has remained popular, positive developments, like success in Nine’s SVOD venture. despite the arrival of VCRs, box-set DVDs, internet Nine and Fairfax each own a 50% interest in Stan, the downloads (both legal and illegal) and streaming. We number two SVOD player in Australia behind Netflix. With consider it highly likely TV will continue to attract large 600,000 active subscribers today, Stan is expected by audiences, and therefore advertising dollars, in the years to management to reach one million subscribers by 2018 and come, as the ‘live’ element of TV is difficult to replicate. to break even in profits. While SVOD may prove to be a tough business to compete in, we believe Nine and Fairfax Nine’s core audience today tunes in on weekdays from are as well placed as any to be successful. 6-9pm and on the weekends for a line-up dominated by news, current affairs, Australian-produced content and While we don’t know how TV audience numbers or Nine’s sport. This content is well suited to the live mass broadcast share of those audiences will evolve, we do know that Nine’s provided by TV and yesterday’s TV content continues to be share price reflects a high degree of pessimism. If things a talking point on many a daily coffee run. turn out to be just a little better than the current dire outlook, Nine’s shareholders should be rewarded. And if Nine has also followed a pragmatic approach in reducing its things go well for the company, then shareholders may cost base and making it more flexible. For example, Nine enjoy very handsome returns indeed. terminated an expensive content purchase agreement with

5 of 12 Q4 2016 Equity Fund Performance

Allan Gray Australia Equity Fund — Class A units

Since Public Launch on 10 Years 5 Years 3 Years 1 Year Latest Quarter 4 May 2006

ANNUALISED (%) NOT ANNUALISED (%)

Allan Gray Australia Equity Fund 8.0 7.1 15.3 12.0 34.8 8.1

S&P/ASX 300 Accumulation Index 5.3 4.4 11.6 6.6 11.8 4.9

Relative Performance 2.7 2.7 3.7 5.4 23.0 3.2

Allan Gray Australia Equity Fund — Class B units

Since Class Launch on 3 Years 1 Years Latest Quarter 26 October 2012

ANNUALISED (%) NOT ANNUALISED (%)

Allan Gray Australia Equity Fund 14.3 11.7 33.4 7.8

S&P/ASX 300 Accumulation Index 10.5 6.6 11.8 4.9

Relative Performance 3.8 5.1 21.6 2.9

Highest and lowest annual return since launch

Allan Gray Australia Equity Fund - Class A units Return % Calendar year

Highest 55.1 2009

Lowest (45.9) 2008

Allan Gray Australia Equity Fund - Class B units Return % Calendar year

Highest 33.4 2016

Lowest (4.7) 2015

Returns shown are net of fees and assume reinvestment of distributions. Returns are annualised for periods of one year and over. Annualised returns show the average amount earned on an investment in the relevant Class each year over the given time period. Actual investor performance may differ as a result of the investment date, the date of reinvestment of income distributions, and withholding tax applied to income distributions.

The highest and lowest returns earned during any calendar year since the launch of each Class are shown to demonstrate the variability of returns. The complete return history for each Class can be obtained by contacting our Client Services team.

6 of 12 Q4 2016 Equity Fund Holdings (Class A and Class B) Fund holdings as at 31 December 2016 Statement of net assets (unaudited)

Security Market Value AUD 000’s % of Fund

Woodside Petroleum 116,337 10

Alumina 115,517 10

Origin Energy 105,355 9

Newcrest Mining 95,687 8

Metcash 74,551 6

Sims Metal Management 43,892 4

AusNet Services 42,495 4

National Australia Bank 41,814 4

WorleyParsons 33,669 3

Southern Cross Media Group 31,839 3

APN News & Media 31,326 3

Austal 29,791 3

Woolworths 28,841 2

Downer EDI 27,609 2

Sigma Pharmaceuticals 24,397 2

Australia and New Zealand Banking Group 24,385 2

Nine Entertainment Holdings 22,787 2

Iluka Resources 22,443 2

Chorus 21,768 2

Peet 17,453 2

Fairfax Media 17,322 1

QBE Insurance Group 15,280 1

ALE Property Group 14,548 1

ImpediMed 13,032 1

Positions less than 1% 89,849 8 Total Security Exposure 1,101,987 95

ASX SPI 200 ™ Futures Contract (03/2017)† 31,534 3

Net Current Assets 26,159 2 Net Assets 1,159,680 100

Price per unit - Class A (cum distribution) AUD 1.5500

Price per unit - Class B (cum distribution) AUD 1.5643

Total Assets Under Management for the Australian equity strategy (AUD 000’s)‡ AUD 4,529,139

† Futures contracts are fully backed by cash holdings. ‡ Allan Gray Australia Pty Ltd also manages segregated accounts that have substantially the same investment goals and restrictions as the Fund.

7 of 12 Q4 2016 Opportunity Fund Performance

Allan Gray Australia Opportunity Fund

Since Public Launch 5 Years 3 Years 1 Years Latest Quarter on 1 July 2011

ANNUALISED (%) NOT ANNUALISED (%)

Allan Gray Australia Opportunity Fund 7.6 7.8 7.4 14.4 3.7

RBA Cash 2.8 2.6 2.1 1.8 0.4

Relative Performance 4.8 5.2 5.3 12.6 3.3

Distribution 4.3 4.2 3.4 2.6 0.5

Highest and lowest annual return since public launch

Allan Gray Australia Opportunity Fund Return % Calendar year

Highest 14.4 2016

Lowest 2.1 2015

Returns shown are net of fees and assume reinvestment of distributions. Returns are annualised for periods of one year and over. Annualised returns show the average amount earned on an investment in the relevant Fund each year over the given time period. Actual investor performance may differ as a result of the investment date, the date of reinvestment of income distributions, and withholding tax applied to income distributions.

The highest and lowest returns earned during any calendar year since the public launch of each Fund are shown to demonstrate the variability of returns. The complete return history for each Fund can be obtained by contacting our Client Services team.

8 of 12 Q4 2016 Opportunity fund Holdings

Fund holdings as at 31 December 2016 Statement of net assets (unaudited)

Security Market Value AUD 000’s % of Fund

Origin Energy 5,600 4

Woodside Petroleum 5,585 4

Newcrest Mining 5,271 4

Alumina 4,896 4

Metcash 3,365 2

Sims Metal Management 2,166 2

Austal 2,048 2

Nine Entertainment Holdings 2,036 1

Positions less than 1% 11,083 7 Total Security Exposure 42,050 30

Term Deposits and Cash 96,884 70

Net Current Assets 358 <1 Net Assets 139,292 100

Price per unit (cum distribution) AUD 1.1843

9 of 12 Q4 2016 Information about the Funds

Allan Gray Australia Equity Fund Allan Gray Australia Opportunity Fund

The Fund aims to provide a long-term return that The Fund seeks long-term returns that are higher exceeds the Reserve Bank of Australia cash rate Investment objective than the S&P/ASX 300 Accumulation Index (Benchmark), with less volatility than the Australia (Benchmark). sharemarket.

Investors with a two-year or longer investment horizon who are looking for an alternative to Investors looking for contrarian investment style traditional money market and income generating exposure to the Australian sharemarket and who Who should invest? investments. The Fund’s portfolio can hold a are able to take a long-term view and endure combination of cash and money market instruments performance fluctuations. (100% to 50%) and ASX securities (up to 50%) in pursuit of stable long-term returns.

Dealing Daily (cut-off at 2pm Sydney time. A different cut-off applies if investing via mFund, where applicable).

Buy/sell spread +0.2%/-0.2% +0.1%/-0.1%

Class A Management fee comprises: Management fee comprises:

• Fixed (Base) fee – 0.75% per annum of the Fund’s NAV. • Fixed (Base) fee – 0.25% per annum of the Fund’s NAV. • Performance fee – 20% of the Class’ • Performance fee – 20% of the Fund’s outperformance, Fees and expenses outperformance, net of the base fee, in comparison net of the base fee, in comparison to the Benchmark. to the Benchmark. A performance fee is only A performance fee is only payable where the Fund’s payable where the Class’ outperformance exceeds outperformance exceeds the high watermark, which the high watermark, which represents the highest represents the highest level of outperformance, net level of outperformance, net of base fees, since the of base fees, since the Fund’s inception. Class’ inception.

Class B Management fee comprises: • Fixed (Base) fee – Nil. • Performance fee – 35% of the Class’ outperformance in comparison to the Benchmark. A performance fee is only payable where the Class’ outperformance exceeds the high watermark, which represents the highest level of outperformance, since the Class’ inception.

Minimum initial investment AUD 10,000/AUD 500 per month on a regular savings plan.

Additional investment AUD 1,000/AUD 500 per month on a regular savings plan.

No minimum applies for ad hoc redemptions. A minimum of AUD 500 per month applies on a regular redemption plan. Redemption Investors must maintain a minimum account balance of AUD 10,000.

10 of 12 Q4 2016 Notices S&P/ASX 300 Accumulation Index Other The source for the S&P/ASX 300 Accumulation Index is Standard & Equity Trustees Limited, AFSL No. 240975 is the issuer of units in Poor’s. ASX 300TM is the trademark of ASX Operations Pty Limited the Allan Gray Australia Equity Fund and the Allan Gray Australia (ASXO); S&P/ASX 300TM exists pursuant to an arrangement between Opportunity Fund and has full responsibility for each Fund. Allan ASXO and Standard & Poor’s; S&PTM is a trademark of Standard & Gray Australia Pty Limited, AFSL No. 298487 is the Funds’ investment Poor’s, a division of The McGraw-Hill Companies, Inc. manager. Each Fund’s Product Disclosure Statement and Information Booklet (together, PDS) are available from www.allangray.com.au or Returns by contacting Client Services on 1300 604 604 (within Australia) or +61 2 8224 8604 (outside Australia). You should consider the relevant Fund returns are gross of all income, net of all expenses and fees, Fund’s PDS in deciding whether to acquire, or continue to hold, units assume reinvestment of distributions and exclude any applicable in the fund. spreads.

This report provides general information or advice and is not an offer Risk Warnings to sell, or a solicitation to buy, units in the relevant Fund. Where Managed investment schemes are generally medium to long-term the report provides commentary on a particular security, it is done investments. Past performance is not indicative of future performance. to demonstrate the reasons why we have or have not dealt in the The Fund’s unit price will fluctuate and the Fund’s performance is not particular security for a Fund. It is not intended to be, or should guaranteed. When making an investment in the Fund, an investor’s be construed as, financial product advice. This report is current capital is at risk. Subject to the disclosure documents, managed as at its date of publication, is given in good faith and has been investment schemes are traded at prevailing prices and can engage in derived from sources believed to be reliable and accurate. It does borrowing and securities lending. not take into account your objectives, financial situation or needs. Any implied figures or estimates are subject to assumptions, risks Fees and uncertainties. Actual figures may differ materially and you are The base fee and the performance fee (if applicable) are calculated cautioned not to place undue reliance on such information. Subject and accrued daily, and paid monthly. A schedule of fees and charges is to applicable law, we do not provide any warranty of accuracy or available in the relevant Fund’s disclosure documents. reliability in relation to information in this report or accept liability to any person who relies on it. Fees are exclusive of GST.

US and European Persons The Fund does not accept US persons as investors and is not marketed in the European Economic Area (EEA). Investors resident in the EEA can only invest in the Fund under certain circumstances as determined by, and in compliance with, applicable law.

11 of 12 Q4 2016 INVESTMENT MANAGER Allan Gray Australia Pty Ltd ABN 48 112 316 168, AFSL No. 298487 Level 2, Challis House, 4 Martin Place Sydney NSW 2000, Australia Tel +61 2 8224 8600 www.allangray.com.au

RESPONSIBLE ENTITY AND ISSUER Equity Trustees Ltd ABN 46 004 031 298, AFSL No. 240975 Level 2, 575 Bourke Street Melbourne VIC 3000, Australia GPO Box 2307, Melbourne VIC 3001, Australia Tel +61 3 8623 5000 www.eqt.com.au