Australian Equities High Conviction Portfolio Performance Report – May 2020

Market overview and portfolio performance Portfolio overview

Investment bias Style neutral Designed for Investors with a medium-term investment objective focused on achieving portfolio growth with less focus on generating excess income and is prepared to accept higher volatility in pursuit of higher Jamie Nicol Scott Bender growth Chief Investment Officer Portfolio Manager Benchmark S&P/ASX 200 Accumulation Index

The DNR Capital Australian Equities High Conviction Investment objective To outperform the S&P/ASX 200 Accumulation Index by 4% p.a. Portfolio outperformed its benchmark for the period. (before fees) over a rolling three The S&P/ASX 200 Accumulation Index was up 4.36% year period during the period. Information Technology (+14.5%) was Investable universe ASX listed securities with a focus the best performing sector for the period. The was on the S&P/ASX 200 predominantly on the back of ’s (APT) strong Number of stocks 15–30 performance, but also reflected the broader rally in non-defensives. Communication Services (+8.4%) also Asset allocation Australian equities 80–100% outperformed as the trio of online advertisers (REA Group Cash 0–20% (REA), SEEK (SEK) and .Com (CAR)) reacted Stock limit 15% maximum weighting strongly to the reopening of the economy. Minimum suggested 5 years Health Care (-5.34%) lagged the index as investors investment timeframe lightened their defensive exposures in names like CSL (CSL). These trades had become crowded in the depth of the lockdowns, a situation duplicated in Consumer Staples (-0.40%), where supermarket names Woolworths Group (WOW) and (WES) sold off as we exit the worst of the pandemic.

Gross active return

1mth 3mth 6mth 1yr 3yr 5yr 7yr 10yr Incep.* % % % % % % % % % High Conviction Portfolio 6.08 -9.17 -17.46 -5.66 3.29 5.53 8.83 9.83 11.38 S&P/ASX 200 Accumulation Index 4.36 -9.92 -14.59 -6.70 4.35 4.27 6.73 7.25 8.41 Excess Return 1.72 0.75 -2.87 1.04 -1.06 1.26 2.10 2.58 2.97 * Inception date—October 2002

Excess return (calendar year)

Source: DNR Capital

Performance data relates to the DNR Capital model portfolio. Performance of an investment in this model portfolio through a Portfolio Service may have different performance to the performance in this monthly update as a result of different policies and procedures at different Portfolio Service operators. Past performance is not an indication of future performance. No allowance has been made for taxation and fees are not taken into account.

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Market review

Over the past month equity markets continued to rally. attempted to price companies based on our expectations The health impact of COVID-19 was less than feared for earnings in 2022 and beyond. For those companies and the reopening of economies occurred earlier than with greater cyclical exposure, we have been more expected. The resultant positive news flow supported conservative with our forecasts. Over the past month we markets and encouraged a rotation into some value have become a little more optimistic (or more correctly, stocks in the market. This month we examine the news less pessimistic) than we were regarding the near-term flow for a range of companies before examining current earnings. In some instances, this translates to a better market positioning and valuations. We also review recent outlook in the longer term. However, the risks remain high economic data. regarding that outlook. In cases where stocks have run hard, reducing the attractiveness of the risk versus return News flow trade off, we have been looking to trim positions. A range of companies announced results in May and provided commentary regarding current economic Asset allocation conundrum conditions. Much of the data was better than feared. Here Supporting markets is the broader positioning of market are snapshots from a range of commentaries: participants. Cash levels remain high. In addition, alternative asset classes are not all that appealing. } In the six weeks to 15 May, James Hardie’s North Low interest rates, uncertainty regarding retail and American volumes were down 3% and Australian office property, some difficulties for high-yield credit and volumes were flat. This was substantially better than some hedge fund strategies means equities become expected, with housing activity remaining open more a necessary asset class for many investors if they are than other businesses. We do expect activity levels to looking to preserve purchasing power over the long term. deteriorate over the year. This is illustrated when we compare yields on equities to } In May 2020 total new car sales (59,984) were down the miserly yields on offer from the banks or bonds. 35% yoy … but had bounced 54% mom from 38,926 Cash as % of equity market capitalisation in April 2020.

} Retail sales transacted online grew 59% yoy in April reflecting a lack of mobility in the month. Total retail sales year to date are up on last year with strong food and pharmacy sales offsetting the drop in discretionary spend. Consumer spending has held up for those retailers able to sell their goods thanks to JobKeeper and JobSeeker.

} SkyCity Casino reopened and reported pokie revenues down only 20% despite distancing restrictions, reflecting pent-up demand and easing of fears of socialising.

} New jobs on SEEK’s site in the two weeks to 31 May are up 49% from the April average, although are still less than half the level of February. In China, job are down in the mid-teen levels from being 35% down in February. Source: Alpine Macro } The ANZ loan-assistance scheme showed that more customers were seeking assistance. From late April to late May there was a 24% increase in those seeking Grossed up yield on equities versus bonds and cash assistance, with a worrying 18% of those being commercial entities.

} Hospitals were able to increase elective surgeries but are not yet at full capacity.

} REA Group saw listing volumes return. At its lowest, it was down a better-than-expected 20%.

} Some companies have benefited, particularly those supporting people staying at home. Breville enjoyed strong sales of coffee machines and Domino’s continued to see strong growth in some markets (offset by softness in those areas where there was a harsher lockdown). Clearly COVID-19 is having a significant impact on the broader economy and this is impacting the earnings outlook for many companies. We have not been overly Source: DNR Capital concerned about near-term downgrades, but rather have Page 2 of 7 Performance Report May 2020

Valuations An earlier than anticipated reopening of the economy The forward PE chart highlights the market at the and flattening of the COVID-19 curve, combined with upper end of its range. We are mindful that one-year unprecedented government stimulus, helps explain a forward earnings is impacted by the lockdown and not large part of the momentum reversal. Nonetheless, the necessarily reflective of future value. The difficult task valuation dispersion remains at extremes. is to consider what earnings will look like beyond this High PE firms trade at a 85% premium to the market, period. How long-lasting will the impact of COVID-19 which is 31% above the 20-yr average be? How effective will the stimulus be? Will it drive inflation and eat into the purchasing power of money at low interest rates? If interest rates stay low, then equities don’t look all that expensive and should we be willing to pay more, especially for growth stocks? The range of possible answers to these questions suggest significant opportunities will emerge for stock pickers. Rolling forward PE looking expensive

Source: FactSet, Goldman Sachs Global Investment Research

Low PE firms trade at a 53% discount to the market, which is 8% below the 20-yr average

Source: DNR Capital

… but cheap relative to bonds (earnings yield versus bonds yield)

Source: FactSet, Goldman Sachs Global Investment Research

Since the financial crisis, there has been a particularly strong trend of defensive and growth outperformance over value, driven, for the most part, by growth scarcity and very low interest rates. Most periods of cyclical and value outperformance typically coincide with rising bond yields. Bond yields remain extremely low, albeit there has been a modest shift higher recently and there remains the possibility of further steepening of yield curves. This Source: DNR Capital remains a key catalyst.

Value rotation Growth has outperformed value since the GFC One of the interesting characteristics of the first phase of the rally was the leadership of growth and defensive companies. This reflected the impact of policy support in reducing tail risks for investors, but there was still lingering uncertainty about when economies would trough and infection rates slow. Over the past couple of weeks markets have moved into a second phase, with a further rally in equities being driven by a sharp rotation of leadership: 1. Cyclicals outperformed defensives 2. Value outperformed growth 3. Small caps outperformed large caps Source: Datastream, Goldman Sachs Global Investment 4. Weak balance-sheet stocks outperformed strong. Research

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While value/cheap/low-PE/cyclical stocks continue to look The US has seen a large increase in unemployment and appealing on valuation, a sustained economic recovery is a collapse in labour participation, but this has coincided more likely required to deliver sustained outperformance with a large pickup in the savings rate. Consumers are of these stocks. Until this occurs, it is likely that: in pretty good shape. They have de-geared while they are locked up at home. It is possible that US consumers } growth will remain scarce—so growth companies will will be able to support economic growth as they emerge likely continue to do well out of lockdown. Australian household debt remains } income will remain scarce—so sustainable dividend high but government debt levels are more supportive, payers will be keenly sought meaning the government will need to do the heavy lifting in . } debt levels will be higher—so strong balance sheet companies will better ride this cycle. Household debt: peaked or peaking What are the lasting impacts on the economy? There has been much written about how COVID-19 will affect the way economies operate in future—we all enjoy speculating at the change to working from home and to social interaction. COVID-19 may well be a major game changer of behaviours but it is difficult to base investment decisions on what might or might not occur in the future. A critical component of behavioural change will be whether a vaccine, or effective treatment options, allow people to return to behaviours of the past. People will return to international travel, crowd into bars and restaurants and attend large sporting and cultural events if they feel safe. The experience of COVID-19 will have some enduring economic and political effects. On the negative side, Source: BCA Research, Bank for International the path to economic recovery will be rocky and long- Settlements run growth is likely to be negatively affected. Current debt levels and low interest rates will give policy makers In our view we are through the worst of the crisis, but the less flexibility in the future. Inflation could eventually trajectory for economic improvement remains uncertain. become a problem and the drift away from globalisation Equities are supported by the lack of alternative to nationalism reinforces this trend. On a more positive investments but will be vulnerable to periods of volatility note, businesses are finding new ways to boost efficiency given the broader economic uncertainty. There continues and maybe there will be progress in reducing extreme to be opportunities in companies impacted by COVID-19 levels of inequality. where expectations have been reduced substantially, but some areas of the market remain expensive. As some economies begin to reopen, monitoring the economic data is difficult. China is seeing a pickup in activity earlier than other economies as financing Portfolio commentary improves. For example, excavator production has increased in anticipation of improved activity. Over the past month we have monitored the risk versus reward opportunities across a range of businesses. China aggregate financing versus China excavator In cases where stocks have run hard, reducing the production attractiveness of the risk versus return trade off, we have been looking to trim positions. Among these we lightened Domino’s Pizza Enterprises (DMP), (ALL), (JHX) and SEEK (SEK). We topped up our positions in Suncorp (SUN), Iress (IRE) and (CPU), which had lagged the rally and offered more upside and some interesting long- term, bottom-up opportunities.

Source: Alpine Macro Page 4 of 7 Performance Report May 2020

Portfolio attribution

Sector weightings % The top stock contributors were: } CSL (CSL, no holding)—after a period of outperformance, CSL struggled to keep pace with the market over the month as investors focused on valuation rather than near-term earnings. Collection centre volumes have also been impacted negatively during the crisis. However, inventory lead times means this will not impact its earnings until next year.

} James Hardie Industries (JHX)—outperformed over the month as the company announced its Q4 results were up 17%, consequently beating market expectations. The surprise in North American volumes in the six weeks post year end were also better than feared at 3%, positively contributing to the markets’ optimism. The company continues to win share. Source: DNR Capital } (QUB)—raised $500m in capital through a 1 for 6.35 entitlement offer at $1.95ps, 12 month - top contributors and detractors putting its liquidity at ~$1.2b. Qube expects a minimum $420m of capex between April 20 and June 21, has no debt maturing during FY20–21 and Top 3 contributors Alpha* has material headroom to its debt covenants. Qube James Hardie Industries Overweight 2.07% intends pursuing growth opportunities with the new capital, potentially organic growth within its operating ANZ Banking Group No Holding 1.35% division, acquisitions and/or accelerated Moorebank Domino's Pizza Enterprises Overweight 1.21% warehousing development. The top stock detractors were: Top 3 detractors } (TWE)—underperformed over CSL No Holding -2.25% the period as investors grappled with both the potential spin off of the Penfolds brand and demand in the Virgin Money UK Overweight -1.24% Chinese market only slowly recovering despite China’s No Holding -0.83% economy returning to normal. Political tensions between Australia and China added extra pressure to the outlook with the wine being explicitly mentioned as being at risk in trade dispute. Monthly - top contributors and detractors } Afterpay (APT, no holding)—outperformed during May Top 3 contributors Alpha* as the market responded enthusiastically to a strategic equity stake taken by Tencent Holdings and the user CSL No Holding 1.41% base reaching five million in the US. The service proved popular during shelter-in-place orders as it James Hardie Industries Overweight 0.55% recorded impressive North American customer and Qube Holdings Overweight 0.53% merchant additions, as retailers and consumers further embraced online shopping during lockdown.

Top 3 detractors } Goodman (GMG, no holding)—was up over the period Treasury Wine Estates Overweight -0.36% as the company provided a strong operational update and reaffirmed full-year guidance. The logistical Afterpay No Holding -0.21% nature of the assets has proved defensive through Goodman No Holding -0.19% the pandemic, particularly in comparison to its retail and office peers. Many now expect demand for the asset class to increase as the shift to ecommerce * Alpha is the portfolio return less benchmark return. These tables represent the stocks contribution of alpha to overall accelerates (supporting logistics) and the future portfolio alpha and is determined by the stocks active weight of office and retail real estate assets comes in to relative to the benchmark and share price return relative to the question. benchmark.

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Portfolio positioning Portfolio moves Our current positioning is as follows: Purchase of Computershare (CPU) Key overweights: Computershare has suffered a number of downgrades over the past year as lower interest rates hurt its } Major diversified resources benefiting from strength in business given it earns a margin on cash at bank. iron ore price and global stimulus. However, we see the investment case as asymmetrical. } Diversified financials offering value— If interest rates go to zero around the world the downside (MQG), Suncorp (SUN) is modest ($20m) and yet tailwinds are emerging over the next year (bankruptcy, corporate actions, home-loan } Information Technology companies with resilient delinquency foreclosure fees, delinquent loan sub- earnings—Iress (IRE), Computershare (CPU), servicing fees). The stock is trading on a low multiple (XRO) with earnings subdued—what remains is defensive with } High-quality global franchise businesses—James counter-cyclical characteristics. Hardie Industries (JHX), Aristocrat Leisure (ALL), Computershare meets DNR Capital’s five-point quality SEEK (SEK) web: } High-quality domestic franchise businesses—REA 1. Industry structure—it is a global market leader in Group (REA), Wesfarmers (WES), Sydney Airport share registries and employee plan administration. It Holdings (SYD), Qube Holdings (QUB). has competitive strengths as a result of its scale and IT Key underweights: leadership. The mortgage business (20%) is of lower quality but represents a strong growth opportunity. } Banks and property trusts due to structural concerns. 2. Earnings strength—despite recent weakness, } A selection of expensive defensives—Woolworths Computershare continues to earn an 18% return on (WOW), CSL (CSL), Group (TCL). equity (ROE) and string margins. It has low capital intensity and thereby is strongly cash generative with a free cashflow yield of 10%. Key risks 3. Balance sheet—is solid with 2.2x net debt to earnings before interest, tax and amortisation (ND/EBITDA) and a Key risks to the Portfolio include: 4x covenant. } COVID-19 disruption. The longer and deeper the 4. Management—is highly regarded, driving efficiency disruption from the COVID-19 pandemic, the greater and allocating capital effectively. the negative impact on equity markets. 5. Environmental, social and governance (ESG)—risk } Interest rates. Low interest rates are the prime driver is largely regarding privacy and handling data and in of markets at present. Any change to the inflation this regard, Computershare has a long history and is a outlook would have a significant impact on valuations. market leader. } Inflation. Given valuations have been supported by low Valuation/Thesis interest rates, the emergence of inflation and higher bond yields could be a negative for markets. Computershare has taken the earnings hit on interest rates and corporate actions are at a 10-year low. Despite } Political environment. It is an election year in the this it is on a lowish multiple of 12.5x (post downgrade). US, which adds to potential uncertainty. Further Given quality characteristics a market multiple of 16x geopolitical uncertainty could create negative is justified. Longer term upside will be presented by implications for stocks and portfolios. earnings bottoming. While interest rate rises do not } Growth. Rising interest rates in the US increase the look likely anytime soon, that is free upside here. In the risk of an economic slowdown. Potential disruption to meantime, cost out, corporate actions, delinquencies, global growth is largely expected by the market so the bankruptcies and new business opportunities with alternative, which is a pickup, could have a greater registered agents could present meaningful growth off the impact on valuations of defensive holdings. FY21 low.

} Emerging market risks. Implications of slowing growth PE multiple in emerging markets and impacts from currency instability.

Source: DNR Capital

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Investment strategy Platform access

The Australian Equities High Conviction Portfolio has } AMP PPS an investment style best described as ‘style neutral’. } BT Panorama (Direct, Compact and Full) The security selection process has a strong bottom-up discipline and focuses on buying quality businesses at } Colonial First State FirstWrap reasonable prices. We define quality businesses as being } Federation Alliance those with the following five attributes: } HUB24 } earnings strength (particularly improving return) } Linear } superior industry position } Macquarie Wrap } a sound balance sheet } Mason Stevens } strong management } Netwealth } low environmental, social and governance (ESG) risk. } OneVue Where we are satisfied that a security possesses quality characteristics, then it is eligible for inclusion } Powerwrap in the portfolio. However, it must also represent value and sit comfortably within our portfolio construction } Praemium requirements. } Wealthtrac A range of valuation methodologies are used depending on the nature of the business being assessed to identify mispriced opportunities. The portfolio construction process is influenced by a top-down economic appraisal and also considers the risk characteristics of the portfolio, such as security and sector correlations.

Investment philosophy DNR Capital believes a focus on quality businesses will enhance returns when it is combined with a thorough valuation overlay. We seek to identify quality businesses that are mispriced by overlaying a quality filter, referred to as the ‘quality web’, with a strong valuation discipline. The portfolio is high conviction and invests for the medium term.

Disclaimer This document has been prepared by DNR Capital Pty Ltd, AFS Representative - 294844 of DNR AFSL Pty Ltd ABN 39 118 946 400, AFSL 301658. It is general information only and is not intended to be a recommendation to invest in any product or financial service mentioned above. Whilst DNR Capital has used its best endeavours to ensure the information within this document is accurate it cannot be relied upon in any way and you must make your own enquiries concerning the accuracy of the information within. The information in this document has been prepared for general purposes and does not take into account the investment objectives, financial situation or needs of any particular person nor does the information constitute investment advice. Before making any financial investment decisions you should obtain legal and taxation advice appropriate to your particular needs. Investment in a DNR Capital managed account can only be made on completion of all the required documentation. DNR Capital does not guarantee the repayment of capital from the portfolio or the investment performance of the portfolio. If you have invested in Equities High Conviction Portfolio via a service such as investor directed portfolio service, managed account service or separately managed account (‘Portfolio Service’), you can obtain information from the Portfolio Service operator. If you invest via a Portfolio Service, different terms may apply to your investment. You should read the disclosure document for that Portfolio Service and consider your circumstances prior to investing.

Office address Postal address Telephone Email Website Level 23 GPO Box 3263 07 3229 5531 [email protected] www.dnrcapital.com.au 307 Queen Street Brisbane QLD 4001 Brisbane QLD 4000 DNRHCIR.4.10.2005

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