QUARTERLY COMMENTARY 31 DECEMBER 2017
1 of 15 Q4 2017 COMMENTARY
Sigma also distributes a variety of non-prescription or over- the-counter products, such as beauty and personal hygiene products, many of which are exclusively distributed in Australia by Sigma (e.g. Serum7, Boots Laboratories, and Optiva).
A number of regulations in Australia govern the pharmaceutical industry. One important regulatory outcome for Sigma is the Community Service Obligation (CSO) Funding Pool. This taxpayer-funded pool supports pharmaceutical wholesalers who undertake to supply all of the medicines on the Pharmaceutical Benefit Scheme (PBS) to pharmacies across Australia within 24 hours of an order, regardless of a pharmacy’s SIMON MAWHINNEY, CFA location and the relative cost of supply. Participation inthe Managing Director & Chief Investment Officer CSO Funding Pool is not compulsory but its existence is a necessary part of ensuring that every Australian has ready access to essential medicines. This quarter’s report focuses on Sigma Healthcare Limited Sigma is one of five distributors/wholesalers eligible to (Sigma), a company we have held for some time. Its significant participate in the CSO Funding Pool. Sigma’s revenues come underperformance this past year and our response offer valuable mainly from the sale of products to pharmacies but also from insights into our approach to investing in the face of uncertainty. CSO receipts which subsidise otherwise loss-making sales to Who is Sigma? rural pharmacies and from low-value PBS products.
Before jumping into these insights, some background on Sigma’s business is what some may describe as ‘boring’, with Sigma. Sigma is a wholesaler of pharmaceutical products. It relatively stable and predictable earnings. It has annual acts as an intermediary distributor that buys drugs from revenues of a little over AUD$4 billion and earns an operating manufacturers and sells them to the pharmacies that ultimately profit margin of between 2% and 2.5% (including CSO dispense these drugs to Australians in need. Some of these receipts). Relative to other wholesalers in Australia, this level pharmacies operate under one of Sigma’s banners (see Figure of profitability is normal and most would expect Sigma’s 1), while others are independently branded. Sigma does not revenue base to increase in future, given Australia’s growing own any of the pharmacies itself. and aging population.
Figure 1: Some of the pharmacies and brands operating under Sigma’s banners
Sigma retail banner groups
Private and exclusive product brands
2 of 15 Q4 2017 Two surprises by Pfizer, another large drug manufacturer. Today, fears abound that other drug manufacturers will follow and that A number of unexpected events have conspired to make Sigma’s network of distribution assets will be bypassed on a Sigma’s future far less certain and it is against this backdrop much larger scale. that our interest in Sigma has been reinvigorated. Two events in particular stand out, neither of which have been fully In less than six months, these two events have transformed resolved and both of which have contributed to significant Sigma’s business from a stable and predictable earner to one share price weakness and uncertainty. burdened by uncertainty. The sharemarket has dished out its own medicine, with Sigma’s share price falling from $1.30 in 1. In May this year, Sigma’s largest customer, Chemist early May to 75 cents soon after AstraZeneca’s news was Warehouse Group (CWG), announced its intention to absorbed. At the same time, the broader sharemarket was on a source certain products from a competitor on better terms tear. than Sigma had been supplying them. CWG hoped to cherry-pick its drug procurement; the high-margin drugs Acting in uncertainty would be bought on better terms from Sigma’s competitor and the low-margin drugs would continue to be purchased Having reflected on Sigma’s performance during the year, two from Sigma. Quite a sensible commercial strategy, but one things spring to mind: our sell discipline and our response that Sigma took offence to as its trading arrangement with to uncertainty. CWG was priced based on the entire basket of PBS drugs, Despite having reduced the weight of Sigma in our portfolio by not just the least profitable parts. CWG accounts for about quite some margin prior to its weakness this year, hindsight 35% of Sigma’s total sales, but less than this in terms of tells us we were not aggressive enough. With the share price profits, reflecting the favourable trading terms that CWG trading at, or close to, our estimate of fair value in 2016, we enjoys. Sigma and CWG have agreed to a temporary fix should have sold our entire holding. As reflected in Graph 1, (presumably even better trading terms) that will apply until we reduced Sigma’s weight in the portfolio from over 6% in their contract expires in 2019. The future post-2019 2011 to 2% immediately prior to the onslaught of Sigma’s bad remains very uncertain. news. We had sold some Sigma shares but, upon reflection, 2. In October, AstraZeneca, a large global drug manufacturer, the allure of Sigma’s defensive earnings stream and high calibre announced it would bypass pharmaceutical wholesalers and management team affected our judgement and we could have exclusively distribute some of its higher value or higher sold them all. By late 2016, Sigma was priced for perfection volume products directly to pharmacies using DHL, a global with little upside and plenty of downside. These are the very logistics firm. While these products represented only 1% of payoff profiles we try to avoid when we make our first Sigma’s total sales, this followed a similar decision in 2010 investments in companies.
GRAPHGRAPHGraph 1 | Portfolio1:1 |Portfolio Portfolio holdings holdingsholdings in Sigma in in Sigma Sigma Healthcare Healthcare Healthcare compared compared compared with with the with sharethe theshare price share price price
7 7 1.6 1.6
6 6 1.4 1.4
1.2 1.2 5 5 1 1 4 4 0.8 0.8 3 3 0.6 0.6 2 2
0.4 0.4 Sigma Share Price (AUD) Sigma Share Price (AUD) Holdings (% of Holdings strategy) Holdings (% of Holdings strategy)
1 1 0.2 0.2
0 0 0 0 Jun-2009Jun-2009Jun-2010Jun-2010Jun-2011Jun-2011Jun-2012Jun-2012Jun-2013Jun-2013Jun-2014Jun-2014Jun-2015Jun-2015Jun-2016Jun-2016Jun-2017Jun-2017 AllanAllan Gray Gray Australia Australia Equity Equity Strategy Strategy Holdings Holdings in Sigma in Sigma (LHS) (LHS) SigmaSigma Share Share Price Price (AUD) (AUD) (RHS) (RHS)
Source:Source:Source: Allan AllanAllan Gray. Gray.Gray. The The TheAllan AllanAllan Gray GrayGray Australia AustraliaAustralia Equity EquityEquity Strategy StrategyStrategy includes includes the Allanthe Allan Gray Gray Australia Australia Equity Equity Fund Fund and andandinstitutional institutionalinstitutional mandatesmandatesmandates that thatthat share shareshare the thesamethe same investment investment strategy. strategy. 3 of 15 Q4 2017 Table 1: Sigma’s enterprise value to operating profit
Sigma at 75c Sigma today S&P ASX 300
Enterprise Value : Operating Profit 9.6x 12.5x 13.9x
Note: A company’s enterprise value is its market capitalisation plus its net debt. Source: Allan Gray; Factset, 31 December 2017
Acknowledging and learning from mistakes is important. The future may be brighter than people think Equally important is leaving the past behind and assessing an investment based on its future prospects without any Amongst all the uncertainty, there are also silver linings. For emotional baggage. While in hindsight we made a mistake in example, there is a real possibility that the Australian not selling our entire holding in Sigma, the share price falls Government stops manufacturers from exclusively distributing following bad news and great uncertainty forced us to look at their drugs directly to pharmacies, as it makes it more difficult the company again with fresh eyes and a clear mind. Sigma’s for CSO wholesalers to meet their commitments. This is underperformance is a stark reminder of the discount the arguably in the public interest, as the scheme’s purpose is to sharemarket places on uncertainty, particularly when investors ensure ready access to essential medicines listed on Australia’s have come to expect the opposite. PBS. If the Australian Government did change the rules for manufacturers, the 1% revenue lost from AstraZeneca’s Seizing the opportunity decision may ultimately end up being an 8% revenue tailwind as Pfizer’s drugs may also need to be channelled back through But it is in the face of severe uncertainty that we think opportunity the CSO wholesalers (like Sigma). Anecdotally, this would also knocks loudest. Yes, Sigma’s relationship with its largest be supported by pharmacies, which would require less customer is somewhat fractured. Differences of opinion investment in working capital as CSO wholesalers are required between Sigma and CWG have largely been addressed, for to deliver within 24 hours. Pharmacies would also benefit from now, but it is unclear what will happen post-2019 when the reduced operating complexity (and most likely cost) as they distribution agreement between the pair expires. Round one would deal with fewer suppliers. has been resolved amicably, but round two looms large in the minds of investors. And yes, there are risks associated with It is easy (and important) to obsess about the downside when drug manufacturers bypassing Sigma’s distribution network. it comes to investing, but it is helpful to turn the coin over from time to time to get a balanced view of a company’s future In investing, the price one pays should be paramount. Sigma’s prospects. Sigma’s future is far from risk-free, but we feel its uncertain future is now well appreciated by the sharemarket future prospects are better than the sharemarket believes, and, at least in part, reflected in the share price one pays today. despite the uncertainty around its biggest customer. Or it certainly was at its recent 75 cents-per-share lows. At its recent lows, Sigma traded at less than 10 times its forecast pre-tax operating profit and about 13 times its forecast after- tax earnings. This was a substantial discount to the broader sharemarket and, in our view, well in excess of what was warranted considering the range of possible outcomes. We increased our holding substantially.
Sigma has since increased in price, but remains priced at a modest discount to the sharemarket. It is hard to know whether Sigma’s future prospects are adequately reflected in the price one pays today, but we believe there is still relative value in owning the company. Investors remain concerned about CWG moving its business to a competitor, but the downside in Sigma’s earnings are no more severe than the company’s discount to the broader sharemarket. And this is not a certain outcome. Even if it did happen, offsetting the impact on the company’s earnings would be a near $300m release in working capital that could be invested in other profitable endeavours.
4 of 15 Q4 2017 5 of 15 Q4 2017 EQUITY FUND PERFORMANCE
Allan Gray Australia Equity Fund — Class A units
Allan Gray Australia S&P/ASX 300 Accumulation Equity Fund Index Relative Performance
ANNUALISED (%)
Since Public Launch on 4 May 2006 8.9 5.8 3.1 10 Years 6.9 4.0 2.9 5 Years 15.4 10.1 5.3 3 Years 14.9 8.8 6.1 1 Year 19.2 11.9 7.3
NOT ANNUALISED (%) Latest Quarter 11.2 7.7 3.5
Allan Gray Australia Equity Fund — Class B units
Allan Gray Australia S&P/ASX 300 Accumulation Equity Fund Index Relative Performance
ANNUALISED (%)
Since Class Launch on 26 October 2012 15.0 10.8 4.2 5 Years 14.8 10.1 4.7 3 Years 14.6 8.8 5.8 1 Year 18.3 11.9 6.4
NOT ANNUALISED (%) Latest Quarter 11.1 7.7 3.4
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 15 Q4 2017 EQUITY FUND HOLDINGS (CLASS A AND CLASS B)
Fund holdings as at 31 December 2017 Statement of net assets (unaudited)
Security Market Value AUD 000’s % of Fund
Woodside Petroleum 152,148 10
Newcrest Mining 131,567 9
Alumina 122,123 8
Origin Energy 118,631 8
Metcash 89,267 6
QBE Insurance Group 76,921 5
Sims Metal Management 56,623 4
Woolworths Group 51,125 3
AusNet Services 46,854 3
Sigma Healthcare 43,221 3
WorleyParsons 40,330 3
Chorus 39,530 3
Southern Cross Media Group 35,841 2
National Australia Bank 33,599 2
Austal 33,211 2
Navitas 32,909 2
Oil Search 29,491 2
HT&E Limited 29,415 2
Nine Entertainment Holdings 26,928 2
Peet 25,370 2
Downer EDI 24,515 2
Australia and New Zealand Banking Group 24,059 2
Telstra 19,890 1
Sirtex Medical 17,937 1
Starpharma Holdings 17,751 1
ImpediMed 17,107 1
ALE Property Group 16,760 1
Positions less than 1% 122,602 8 Total Security Exposure 1,475,727 96
ASX SPI 200 ™ Futures Contract (03/2018)† 49,063 3
Net Current Assets 7,589 1 Net Assets 1,532,379 100
Price per unit - Class A (cum distribution) AUD 1.7803
Price per unit - Class B (cum distribution) AUD 1.7831
Total Assets Under Management for the Australian equity strategy (AUD 000’s)‡ AUD 5,338,567 † 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 15 Q4 2017 BALANCED FUND PERFORMANCE
Allan Gray Australia Balanced Fund
Allan Gray Australia Balanced Fund Custom Benchmark* Relative Performance Since Public Launch on 1 March 2017 13.7 8.4 5.3 Latest Quarter 6.3 4.8 1.5
* The Custom Benchmark for the Fund comprises 36% S&P/ASX 300 Accumulation Index; 24% S&P/ASX Australian Government Bond Index; 24% MSCI World Index (net dividends reinvested) expressed in AUD; and 16% JPMorgan Global Government Bond Index expressed in AUD.
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.
8 of 15 Q4 2017 BALANCED FUND HOLDINGS
Fund holdings as at 31 December 2017 Statement of net assets (unaudited)
Security Market Value AUD 000’S % of Fund
Equity
Domestic Equity
Woodside Petroleum 1,636 4
Newcrest Mining 1,523 3
Origin Energy 1,420 3
Alumina 1,263 3
QBE Insurance Group 1,197 3
Metcash 1,000 2
Sigma Healthcare 774 2
Woolworths Group 730 2
Sims Metal Management 596 1
Peet 495 1
WorleyParsons 493 1
AusNet Services 489 1
HT&E Limited 481 1
Navitas 463 1
Domestic Equity Positions less than 1% 3,560 8
Global Equity
AbbVie 1,239 3
Bristol-Myers Squibb 730 2
Royal Dutch Shell 626 1
BP 590 1
Chorus 579 1
XPO Logistics 506 1
Mitsubishi 501 1
Alphabet 496 1
Wells Fargo & Company 487 1
Samsung Electronics 468 1
American Intl. Group 464 1
Imperial Brands 462 1
Daito Trust Construction 462 1
Global Equity Positions less than 1 % 9,520 21
Total Gross Equity^ 33,250 74
^ The Fund holds derivative contracts which reduces the effective net equity exposure to 68%
9 of 15 Q4 2017 BALANCED FUND HOLDINGS
Security Market Value AUD 000’S % of Fund
Fixed Income
Domestic Fixed Income
Australian Government Bonds 7,199 16
Global Fixed Income
Global Fixed Income Positions less than 1% 1,734 4
Total Fixed Income 8,933 20
Commodity Linked Investments
SPDR Gold Trust 1,359 3 Total Commodity Linked Investments 1,359 3 Total Security Exposure 43,542 96
Term Deposits and Cash 1,579 4
Net Current Assets 28 <1
Net Assets 45,149 100
Price per unit (cum distribution) AUD 1.1448
10 of 15 Q4 2017 STABLE FUND PERFORMANCE
Allan Gray Australia Stable Fund
Allan Gray Australia Relative Stable Fund RBA Cash Performance Distribution
ANNUALISED (%)
Since Public Launch on 1 July 2011 7.6 2.6 5.0 4.2
5 Years 7.6 2.1 5.5 4.3 3 Years 7.9 1.8 6.1 3.5 1 Year 7.5 1.5 6.0 4.1
NOT ANNUALISED (%) Latest Quarter 3.3 0.4 2.9 0.5
Highest and lowest annual return since public launch
Allan Gray Australia Stable 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.
11 of 15 Q4 2017 STABLE FUND HOLDINGS
Fund holdings as at 31 December 2017 Statement of net assets (unaudited)
Security Market Value AUD 000’s % of Fund
Woodside Petroleum 8,156 4
Newcrest Mining 7,684 3
Origin Energy 6,111 3
Alumina 6,088 3
Metcash 5,075 2
QBE Insurance Group 3,391 1
Sigma Healthcare 2,471 1
Sims Metal Management 2,382 1
Positions less than 1% 15,433 7
Total Security Exposure 56,791 25
Term Deposits and Cash 172,660 75
Net Current Assets 1,066 <1
Net Assets 230,517 100
Price per unit (cum distribution) AUD 1.2250
12 of 15 Q4 2017 INFORMATION ABOUT THE FUNDS
Allan Gray Australia Allan Gray Australia Allan Gray Australia Equity Fund Balanced Fund Stable Fund
Investment objective The Fund seeks long-term returns To seek long-term returns that The Fund aims to provide a long- that are higher than the S&P/ are higher than the Custom term return that exceeds the ASX 300 Accumulation Index Benchmark. In doing so, the Fund Reserve Bank of Australia cash rate (Benchmark). aims to balance capital growth, (Benchmark), with less volatility income generation and risk of loss than the Australia sharemarket. using a diversified portfolio.
Who should invest? Investors looking for contrarian Investors with an investment Investors with a two-year or investment style exposure to horizon of at least three years longer investment horizon who the Australian sharemarket and who want to easily diversify their are looking for an alternative to who are able to take a long-term portfolio within a single fund and traditional money market and view and endure performance are looking for less ups and downs income generating investments. fluctuations. than investing solely in shares. The Fund’s portfolio can hold a The Fund invests in shares, fixed combination of cash and money income, cash and commodity market instruments (100% to 50%) investments sourced locally and and ASX securities (up to 50%) in globally. 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% +0.2%/-0.2% +0.1%/-0.1%
Fees and expenses (excluding Class A Management fee comprises: Management fee comprises: GST) Management fee comprises: • Fixed (Base) fee – 0.75% per • Fixed (Base) fee – 0.25% per • Fixed (Base) fee – 0.75% per annum of the Fund’s NAV. annum of the Fund’s NAV. annum of the Fund’s NAV. • Performance fee – 20% of the • Performance fee – 20% of the • Performance fee – 20% of the Fund’s’ outperformance, net Fund’s outperformance, net of Class’ outperformance, net of of the base fee, in comparison the base fee, in comparison to the base fee, in comparison to to the Custom Benchmark. A the Benchmark. A performance the Benchmark. A performance performance fee is only payable fee is only payable where the fee is only payable where the where the Fund’s outperformance Fund’s outperformance exceeds Class’ outperformance exceeds exceeds the high watermark, the high watermark, which the high watermark, which which represents the highest level represents the highest level of represents the highest level of of outperformance, net of base outperformance, net outperformance, net of base fees, since the Fund’s inception. of base fees, since the Fund’s fees, since the Class’ inception. 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.
Redemption No minimum applies for ad hoc redemptions. A minimum of AUD 500 per month applies on a regular redemption plan. Investors must maintain a minimum account balance of AUD 10,000.
13 of 15 Q4 2017 NOTICES
Sources US and European Persons The source for the S&P/ASX 300 Accumulation Index and the The Funds do not accept US persons as investors and are not S&P/ASX Australian Government Bond Index is Standard & marketed in the European Economic Area (EEA). Investors Poor’s. “S&P” is a trademark of S&P Global, Inc.; “ASX” and resident in the EEA can only invest in the Fund under certain “ASX 300” are trademarks of ASX Operations Pty Limited circumstances as determined by, and in compliance with, (“ASXO”); and “S&P/ASX300” exists pursuant to an arrangement applicable law. between ASXO and Standard & Poor’s. Other The source for the MSCI World Index is MSCI Inc. “MSCI” is a Equity Trustees Limited, AFSL No. 240975 is the issuer of units trademark of MSCI Inc. in the Allan Gray Australia Equity Fund, the Allan Gray Australia Balanced Fund and the Allan Gray Australia Stable Fund and The source for the JP Morgan Global Government Bond Index has full responsibility for each Fund. Equity Trustees Limited is is J.P. Morgan Securities LLC. “JP Morgan” is a trademark of a subsidiary of EQT Holdings Limited, a publicly listed company JPMorgan Chase & Co. on the Australian Stock Exchange (ASX:EQT). Allan Gray The third party information providers do not guarantee the Australia Pty Limited, AFSL No. 298487 is the Funds’ accuracy, adequacy or completeness of this information, and investment manager. Each Fund’s Product Disclosure no further distribution or dissemination of the index data is Statement and Information Booklet (together, PDS) are permitted without express written consent of the providers. available from www. allangray.com.au or by contacting Client None of those parties shall have any liability for any damages Services on 1300 604 604 (within Australia) or +61 2 8224 (whether direct or otherwise). 8604 (outside Australia). You should consider the relevant Fund’s PDS in deciding whether to acquire, or continue to Returns hold, units in the fund. Fund returns are gross of all income, net of all expenses and This report provides general information or advice and is not fees, assume reinvestment of distributions and exclude any an offer to sell, or a solicitation to buy, units in the relevant applicable spreads. Fund. Where the report provides commentary on a particular security, it is done to demonstrate the reasons why we have or Risk Warnings have not dealt in the particular security for a Fund. It is not Managed investment schemes are generally medium to long- intended to be, or should be construed as, financial product term investments. Past performance is not indicative of future advice. This report is current as at its date of publication, is performance. Each Fund’s unit price will fluctuate and the given in good faith and has been derived from sources believed Fund’s performance is not guaranteed. Returns may decrease to be reliable and accurate. It does not take into account your or increase as a result of currency fluctuations. When making objectives, financial situation or needs. Any implied figures or an investment in a Fund, an investor’s capital is at risk. Subject estimates are subject to assumptions, risks and uncertainties. to the disclosure documents, managed investment schemes Actual figures may differ materially and you are cautioned not are traded at prevailing prices and can engage in borrowing to place undue reliance on such information. Subject to and securities lending. applicable law, neither Allan Gray, Equity Trustees Limited nor any of its related parties, their employees or directors, provide Fees any warranty of accuracy or reliability in relation to such The base fee and the performance fee (if applicable) are information or accepts any liability to any person who relies on calculated and accrued daily, and paid monthly. A schedule of it. Fees are exclusive of GST. Totals presented in this document fees and charges is available in the relevant Fund’s disclosure may not sum due to rounding. documents.
14 of 15 Q4 2017 INVESTMENT MANAGER RESPONSIBLE ENTITY AND ISSUER
Allan Gray Australia Pty Ltd Equity Trustees Ltd ABN 48 112 316 168, AFSL No. 298487 ABN 46 004 031 298, AFSL No. 240975
Level 2, Challis House, 4 Martin Place Level 1, 575 Bourke Street Sydney NSW 2000, Australia Melbourne VIC 3000, Australia Tel +61 2 8224 8600 GPO Box 2307, Melbourne VIC 3001, Australia www.allangray.com.au Tel +61 3 8623 5000 www.eqt.com.au
15 of 15 Q4 2017