Australian Value Portfolio Performance Portfolio Modestly Outperforms Rising Market Display 1 Investors were buoyed by encouraging trends in the US economy and major Good Equity Market Returns Globally equity markets made good ground. Our portfolio finished ahead of the 4Q:2010 Country Returns benchmark as industry and company fundamentals began to gain Percent recognition. This augurs well for our approach as it generally does well under 12 such conditions. 10 8 6 A Wrestle Between Hope and Worry competitor. Legislative passage of the 4 Equity market events in the December first step in the creation of the NBN 2 quarter were emblematic of the year as caused investors to look at Telstra and 0 A d K a a whole: there was a struggle between the wider telco arena with renewed S da U i U a ral Japan n Worl a ust hope and anxiety, optimism ultimately respect. C A prevailed and positive returns were the Return for Australia S&P/ASX 300 Accumulation Index All other country returns from Morgan Stanley Capital result (Display 1). Despite jitters in Better Signs for Value Investing International (MSCI) and in local currencies Europe over weak public finances, We noted in our September report that Source: Bloomberg tensions in the Korean peninsula and we had begun to detect signs of a Display 2 Globally Leveraged Sectors Among Chinese policy tightening, markets were revival for value factors. Adversaries of Outperformers heartened that US consumer spending value investing such as stock return 4Q:2010 Sector Returns rose at its fastest pace since 1Q07 and correlations are declining, as should the Percent November retail sales exceeded effectiveness of short horizon macro Materials expectations. strategies. Such developments, coupled Healthcare with good stock selection, helped the Energy Information Technology Australian equities—as measured by the portfolio to finish ahead of the bench- Telecommunications S&P/ASX 300 Accumulation Index—rose mark in the December quarter. Industrials with the global tide, finishing up 4.7% Financials Utilities in the December quarter. Australia’s Commodity producers Incitec Pivot, Rio Consumer Discretionary economy, which has impressively Tinto and Sims Metal as well as the Consumer Staples outperformed most of its developed portfolio’s other steel companies (10) 0 10 20 world peers, entered a quieter patch. contributed to outperformance. Energy Returns based on S&P/ASX 300 Accumulation Index Uncertainty stemming from global firms Oil Search and Beach Energy also Source: Bloomberg events and the weight of official interest featured among winners. Despite rate hikes have motivated households to depressed industry conditions in the emphasize saving over spending. instances of Incitec Pivot and Sims later in the report for more of our Metal, and occasional unease stemming thoughts on Rio Tinto, Incitec Pivot and Thanks to rising minerals and metals from changes in Chinese economic portfolio steel companies. Performance prices as well as the tighter oil market, policy that can affect Rio Tinto shares, setbacks experienced by NAB and the materials and energy sectors our research leads us to believe that the Qantas countered some of our winning outperformed (Display 2). CSL’s vigour companies can surpass naysayers’ stocks’ contributions. We are undaunted drove healthcare, as the company’s expectations. by what we judge to be market fortunes brightened on the back of a over-reactions and are abiding by all product recall that hurt a major See the Portfolio Positioning section three attractively valued names. These statements reflect the performance of the majority of accounts. Individual account performance may vary due to a variety of factors, including benchmark, account guidelines, investment vehicle implementation (if any), fees charged and timing of cash flows. 4Q 2010 QUARTERLY REPORT 1 This page is intentionally left blank 2 4Q 2010 QUARTERLY REPORT Australian Value Portfolio Positioning Stock Picking Becoming More Rewarding Display 1 After a lengthy period of hostility to active investing, capital markets are China Is a Major Raw Materials moving to a point where better returns from stock selection can be Consumer envisaged. Although there are market qualms over China's policy China©s Share of Total Global Consumption Percent tightening, parts of the commodity arena remain alpha sources, according 60 to our research. 50 40 Encouragement for Active Investing the foreseeable future. Road building, 30 Stock return correlation is the active housing construction, and bridge, port 20 investor’s enemy. When stocks of all and airport construction, particularly in 10 0 stripes broadly move in the same the vast underdeveloped hinterland, will 00 01 02 03 04 05 06 07 08 direction, it is far harder than normal ensure that FAI continues to represent Iron Ore (Seaborne) Copper for stock pickers to beat the bench- around 40% of GDP for years to come. Steel Oil marks. At such times, there is consider- The upshot is that lofty raw materials As of December 31, 2010 Source: Brook Hunt, BP, IISI, Bernstein ably less reward than usual for owning consumption will persist, we believe. the atypical stock that can outperform. Display 2 Our optimism is measured, however. Rising Iron Ore Imports Needed Thankfully, stock return correlation is Commodity demand growth should be Sources of Iron Ore Kilo Tonnes of Iron slowly loosening its grip on the market healthy over the medium term, but we 600,000 and active investors like us can look think it will be below the stunning forward to better relative returns by levels of the past decade. Consequent- 500,000 taking risks intelligently. We have been ly, certain commodities and commodity 400,000 responding to the potential for greater producers that can prosper in a less 300,000 Imports reward by increasing our active weights hectic demand environment dominate 200,000 to step up the portfolio’s alpha-gener- our resource investments. 100,000 ating power. Select parts of the Domestic Chinese Production commodity arena can generate superior Our sense of discrimination contrasts 0 00 01 02 03 04 05 06 07 08 09 returns, as we discuss below. with the excitement that appears to As of December 31, 2010 have gripped the wider market. The Source: Brook Hunt, BP, IISI and Bernstein Staying the Course in Commodities shares of small, pure-play miners Because of its immense raw materials offering immense commodity price appetite, China is the biggest influence leverage have been surging of late. By Iron Ore Majors Favoured on the demand for and pricing of a host measures such as earnings sustainabili- Their size and asset quality coupled of minerals and metals (Display 1). We ty, the rich valuations of the ‘minors’ is with iron ore riches makes us well-dis- anticipate some easing in the pace of unwarranted, to our thinking. posed to Rio Tinto and BHP Billiton. China’s economic acceleration, but don’t Domestic Chinese iron ore production is expect it to threaten the producer- Many small firms have short life assets. struggling to meet the supply needs of friendly supply-demand balance for the By contrast, Rio Tinto and BHP Billiton’s the indigenous steel industry, and ore global seaborne iron ore, coal and key assets will be productive decades quality is deteriorating while costs are copper trades, for instance. from now. This alone is reason for rising. Increasingly, resorting to the caution towards the smaller players and global seaborne iron ore market is the Fixed asset investment (FAI) will be the informs our preference for large, only way for China to fill the shortfall largest source of economic activity for diversified resources companies. between domestic production and 4Q 2010 QUARTERLY REPORT 3 consumption (Display 2, previous will enable IPL to produce at low cost page). This is music to the ears of Rio but sell at higher global prices. Display 3 Tinto and BHP Billiton, endowed with Low Current Margins world-class iron ore assets low on the Increasing Steel Exposure North American Explosives Margins cost curve. Unlike other materials stocks, excess Unit EBIT (USD/t) capacity has been burdening the global 250 IPL's Coming US Turnaround steel industry. Nevertheless, we have 200 These are also good days for Incitec been slowly increasing our steel 150 Pivot’s (IPL) fertilizer business. A holdings, buying more of BlueScope 100 populous world needs more food and Steel, OneSteel and Sims Metal 50 hence more fertilizer. In this arena too, Management (Sims) in anticipation of China’s shadow is apparent as Beijing improvement. 0 IPL (US) Orica (US) Brownfield prioritizes domestic usage over export Expansion (US) for its fertilizer output. This is helping Like their industry peers, all three are to support higher global fertilizer enduring tough days. The pessimism As of December 31, 2010 Source: Company reports and Bernstein prices. But IPL is much more than a surrounding BlueScope is so deep that fertilizer story. The turnaround it currently trades below 1 times book Display 4 prospect for the company’s depressed value. This assumes that the company Scrap Metal Prices Should Rise US explosives business is especially will be unable to earn its cost of capital Ferrous Raw Materials Prices appealing to our value sensibilities. in perpetuity! BlueScope Steel manage- Index (July 1 2010 = 100) Because of the weakened state of the ment has been implementing a big 140 US construction industry, explosives cost-out program and margins, 130 Iron Ore demand has been subdued. Our US presently around 30% lower than 120 research suggests that the gloom is average, should recover when demand 110 Scrap Metal slowly lifting. picks up. 100 90 IPL is the largest participant in the US OneSteel’s domestically driven business 80 explosives industry, in which three firms has been assaulted on two fronts. The Jul Aug Sep Oct Nov Dec 10 10 10 10 10 10 dominate.