QUARTERLY COMMENTARY

31 MARCH 2017

1 of 14 Q1 2017 COMMENTARY

Graph 1 shows that banks and other financial shares have been a significant driving force behind the overall sharemarket’s returns, having increased 5.7% p.a. over the past 10 years (and 18.6% p.a. since March 2009).

Graph 1 also shows that resources companies have fared far worse. The energy sector is down 0.7% p.a. over the past 10 years and the materials sector has increased a paltry 1.1% p.a.

Extending the analysis further back to capture the stellar run SIMON MAWHINNEY, CFA that resources companies enjoyed in the early 2000s does not Managing Director & Chief Investment Officer change the results. The financials sector outperformed during this period too. The most recent quarter has been no exception, The Australian sharemarket has returned 4.2% p.a. over the with financials contributing over half of the 4.7% gain of the past 10 years, slightly lagging its 100-year average of 7% p.a. broader sharemarket. This stellar performance, combined with These modest returns are heavily impacted by the starting point the possibility that sector earnings are near a peak (having used, in this case the sharemarket levels immediately prior to benefited from incredible Australian household credit growth, the onset of the financial crisis. Since March 2009, the limited competition and exceptionally low bad debts), have sharemarket has returned 12.8% p.a., well above long-term directed our attentions elsewhere. averages.

Graph 1: 10-year sharemarket and sector returns

2

1

0.5 Total return index (March 2007 = 1) = 2007 (March index return Total

0.25 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Energy Financials S&P ASX 300 Accumulation Index Materials

Source: Iress

2 of 14 Q1 2017 Our portfolio remains heavily skewed towards those companies We’ve previously written about our energy and materials which trade at reasonable multiples of current depressed investments, which appear to be cheap relative to our earnings. We think they stand to benefit greatly when their assessment of their sustainable future earnings. Whilst not a respective cycles turn and with them, their profitability. We resources company, Metcash is another company which is have tried to avoid exposure to those sectors of the sharemarket currently facing several cyclical and structural headwinds and that are enjoying favourable or elevated cyclical conditions which appears to be attractively priced relative to our which have greatly benefited their earnings and which are expectations of its future earnings prospects. Dan Abeshouse priced for current favourable conditions persisting over the discusses this below. medium to long term.

store format were suitable to shopper needs and the competitive reality.

Between 2012 and 2016, a loss of market share and a decline in prices saw Metcash food and grocery profit margins (before interest and tax) fall to under 2%, and profits more than halved. Sharemarket sentiment towards the company became very negative, as reflected in the share price, which had collapsed from above $4 in mid-2013 to $1 in September 2015. Commentators and analysts started to question whether independent grocers would continue to exist. However, the DAN ABESHOUSE changes the company initiated began to make a visible Analyst and Portfolio Manager difference, and its customer base of independent grocers started to see an improvement in their own performance. Metcash Limited Ritchies Stores, which is one of Australia’s largest independent Metcash is a distributor of food, groceries, liquor and hardware grocery chains and a key Metcash customer, recorded a rebound to independent retailers, including IGA, The Bottle-O and Mitre in net profit from $2.5m in 2014 to $9.7m in 2015 and $12.4m 10 branded stores. It sources products, operates a logistics in 2016. network to fulfil orders to its retailer customers, and provides marketing and operational support to those retail networks. Figure 1: Metcash retail network key brands

A decade ago, things were going very well for Metcash – Coles was in a funk, and Woolworths was taking advantage of the situation by operating efficiently and making healthy profit margins without having to compete on price. At the checkout counter, the prices of food and grocery items were increasing each year, which was beneficial to the profits of wholesalers and retailers. With Metcash operating in a benign competitive environment, it was plain sailing as the company reaped some healthy profit margins of its own – the core food and grocery division recorded profit margins before interest and tax in excess of 4% as recently as 2012, which is at the high end of what a typical wholesaler can expect to earn.

All good things must come to an end… Then the clouds started to gather. Coles had improved its game, and was starting to take market share from Woolworths. Aldi appeared on the Australian scene, initially on the eastern seaboard, with a very attractive offering to price-sensitive Source: Metcash Limited customers. In light of a resurgent competitive environment, the independent grocers who formed the Metcash customer base began to suffer as it became apparent that their stock range, In the past 18 months, the Metcash share price has recovered pricing, and general store environment was not matching to above $2. We have held Metcash shares in our portfolios shoppers’ needs or expectations. At the same time, industry since late 2010 and, as sometimes happens, with hindsight our prices were stagnating or falling as competition heated up. initial investment in Metcash was way too early. Fortunately, our willingness to buy more at lower prices where we retain …but the next chapter began conviction in long-term value saw us buy considerably more at Metcash needed to respond in order to ensure its customer prices well below $2, and as a result our initial losses have been network remained competitive. In 2013, under new somewhat mitigated (refer to Graph 2). management, it took action to make sure its range, prices and

3 of 14 Q1 2017 Graph 2: Metcash share price and number of shares held in Allan Gray Australia Equity Strategy

5 140

120 4

100

3 80 Price AUD Price 60 2

40 Holdings (number of shares, millions) shares, of (number Holdings 1 20

0 - 2010 2011 2012 2013 2014 2015 2016 2017

Allan Gray Australia Equity Strategy Holdings Metcash Price AUD

Source: Allan Gray. The Allan Gray Australia Equity Strategy includes the Allan Gray Australia Equity Fund and institutional mandates that share the same investment strategy.

Threats remain, but there’s good news too Opportunity in uncertainty Metcash is by no means out of the woods. Aldi continues to pose a threat as it expands in South Australia and Western Australia, This reflects low market expectations for the company and and for the first time in many years Metcash faces a market in investor aversion to uncertainty, and therefore our opportunity which both Coles and Woolworths are on top of their game. as contrarian investors. Our willingness to accept the There has been considerable recent press coverage of the uncertainty delivers us a discount price which we believe more expected entry of Amazon to the local retail market, as well as than compensates for the downside risk. speculation of the impending arrival of Aldi’s European rival, The result is that Metcash merely needs to not do terribly in Lidl. Further, a return to inflation in food prices is not a certainty. food and grocery, and maintain reasonable performance in the But the good news for investors is that all of these risks to the other divisions, in order to make it a rewarding investment at future profits of Metcash are widely discussed and well current market prices. With debt levels low, a reinstatement of understood by the market. Furthermore, after success in the dividend in 2018 is possible. If the performance of the food building the liquor and hardware divisions, food and grocery and grocery division stabilises, and the perception of uncertainty represents only 60% of total profits. Margins are no longer that weighs over the company lifts, it will be once again viewed inflated, but rather at the lower end of what wholesalers as a defensive, stable earner with a strong balance sheet and generally earn, providing some support to future profits. For healthy cash flows – a company which should be somewhat example, another major Australian wholesaler, Sigma insulated from the broader domestic economic cycle and which, Pharmaceuticals (which features in the portfolio), has sustained in an otherwise expensive market, could make many investors underlying profit margins before interest and tax of around reassess its attractiveness as an investment. Should Metcash’s 2.3%, considerably higher than the current Metcash food and food and grocery division enjoy a rebound to more normal grocery margins of 1.9%. wholesale margins, then the returns for investors could be very Today, Metcash’s shares trade at around $2.47, which gives the good indeed. Until then, we maintain around a 6% position in company a market capitalisation of just over $2.4bn. In a the portfolios and believe it has the potential to contribute prudent step, the company ceased paying a dividend and used meaningfully to future performance. its cash flows to reduce debt over the past few years. Net debt now stands at $200m (as at 31 October 2016), down from over $900m in 2012. For $2.4bn of total enterprise value (a metric used to compare the market value of companies with varying debt levels), the business currently generates profits of around $300m before interest and tax. In other words the shares trade at roughly eight times these profits; significantly lower than the ASX sector and broader market averages of 13 times 2017 expected profits.

4 of 14 Q1 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 8.3 5.6 2.7

10 Years 7.0 4.2 2.8 5 Years 13.9 10.8 3.1 3 Years 11.9 7.5 4.4 1 Year 33.0 20.2 12.8

NOT ANNUALISED (%) Latest Quarter 4.9 4.7 0.2

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 14.6 11.0 3.6

3 Years 11.6 7.5 4.1 1 Year 31.1 20.2 10.9

NOT ANNUALISED (%) Latest Quarter 4.7 4.7 0.0

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.

5 of 14 Q1 2017 EQUITY FUND HOLDINGS (CLASS A AND CLASS B)

Fund holdings as at 31 March 2017 Statement of net assets (unaudited)

Security Market Value AUD 000’s % of Fund

Woodside Petroleum 119,772 10

Origin Energy 115,064 9

Alumina 108,825 9

Newcrest Mining 107,069 9

Metcash 84,488 7

AusNet Services 49,146 4

Sims Metal Management 42,284 3

National Australia Bank 36,874 3

WorleyParsons 36,871 3

APN News & Media 33,712 3

Southern Cross Media Group 32,573 3

Woolworths 31,714 3

Downer EDI 30,759 2

Nine Entertainment Holdings 30,615 2

Austal 29,620 2

Sigma Pharmaceuticals 26,533 2

Australia and New Zealand Banking Group 25,507 2

QBE Insurance Group 25,408 2

Chorus 23,933 2

Iluka Resources 23,523 2

Peet 21,141 2

Navitas 19,584 2

Fairfax Media 17,356 1

ALE Property Group 15,309 1

PMP 13,129 1

Positions less than 1% 90,679 7 Total Security Exposure 1,191,488 96

ASX SPI 200 ™ Futures Contract (06/2017)† 27,486 2

Net Current Assets 17,516 2 Net Assets 1,236,490 100

Price per unit - Class A (cum distribution) AUD 1.6253

Price per unit - Class B (cum distribution) AUD 1.6379

Total Assets Under Management for the Australian equity strategy (AUD 000’s)‡ AUD 4,709,684

† 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.

6 of 14 Q1 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 2.3 1.9 0.4

* 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.

7 of 14 Q1 2017 BALANCED FUND HOLDINGS

Fund holdings as at 31 March 2017 Statement of net assets (unaudited)

Security Market Value AUD 000’S % of Fund

Equity

Domestic Equity

Origin Energy 1,080 4

Woodside Petroleum 1,071 4

Newcrest Mining 1,010 3

Alumina 930 3

Metcash 833 3

QBE Insurance Group 459 2

Sigma Pharmaceuticals 457 2

AusNet Services 450 2

WorleyParsons 436 2

Chorus 416 1

Woolworths 412 1

Navitas 384 1

Peet 370 1

Sims Metal Management 353 1

Nine Entertainment Holdings 347 1

APN News & Media 303 1

Domestic Equity Positions less than 1% 1,577 5

Global Equity

Royal Dutch Shell 445 2

BP 419 2

AbbVie 391 1

Motorola Solutions 386 1

Nissan Motor 374 1

Berkshire Hathaway 323 1

XPO Logistics 316 1

Anthem 308 1

Bayer 307 1

Samsung Electronics 304 1

Global Equity Positions less than 1 % 6,971 23

Total Equity^ 21,432 72

^ Includes derivatives contracts used by the Investment Manager to manage stockmarket exposure.

8 of 14 Q1 2017 BALANCED FUND HOLDINGS

Security Market Value AUD 000’S % of Fund

Fixed Income

Domestic Fixed Income

Australian Government 2.75% 21 Oct 2019 1534 5

Australian Government 5.75% 15 May 2021 1144 4

Australian Government 2.00% 21 Dec 2021 992 3

Australian Government 1.75% 21 Nov 2020 990 3

Australian Government 4.25% 21 Jul 2017 504 2

Global Fixed Income

JPMorgan Chase & Co 7.9% Fix to Float Perpetual 322 1

Global Fixed Income Positions than 1 % 729 3

Total Fixed Income 6,215 21

Commodity Linked Investments

SPDR Gold Trust 555 2 Total Commodity Linked Investments 555 2 Total Security Exposure 28,202 95

Term Deposits and Cash 1,516 5

Net Current Assets 174 <1%

Net Assets 29,892 100

Price per unit (cum distribution) AUD 1.0349

9 of 14 Q1 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 7.7 2.7 5.0 4.2

5 Years 7.4 2.4 5.0 4.1 3 Years 7.5 2.1 5.4 3.4 1 Year 12.4 1.6 10.8 2.6

NOT ANNUALISED (%) Latest Quarter 2.0 0.4 1.6 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.

10 of 14 Q1 2017 STABLE FUND HOLDINGS

Fund holdings as at 31 March 2017 Statement of net assets (unaudited)

Security Market Value AUD 000’s % of Fund

Woodside Petroleum 5,916 4

Newcrest Mining 5,797 4

Origin Energy 5,007 3

Alumina 4,696 3

Metcash 4,217 3

Nine Entertainment Holdings 2,399 1

Austal 1,824 1

Peet 1,691 1

APN News & Media 1,628 1

Positions less than 1% 9,184 6

Total Security Exposure 42,359 27

Term Deposits and Cash 115,475 73

Net Current Assets 942 <1

Net Assets 158,776 100

Price per unit (cum distribution) AUD 1.2021

11 of 14 Q1 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 Class A Management fee comprises: Management fee comprises: 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, which the high watermark, which the high watermark, which represents the highest level of represents the highest level of represents the highest level of outperformance, net of base fees, outperformance, net outperformance, net of base 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.

12 of 14 Q1 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. ASX 300TM is the trademark of ASX Operations Pty resident in the EEA can only invest in the Fund under certain Limited (ASXO); S&P/ASX 300TM exists pursuant to an circumstances as determined by, and in compliance with, arrangement between ASXO and Standard & Poor’s; S&PTM is a applicable law. trademark of Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. Other Equity Trustees Limited, AFSL No. 240975 is the issuer of units The source for the MSCI World Index is MSCI Inc. MSCI is a in the Allan Gray Australia Equity Fund, the Allan Gray Australia trademark of MSCI Inc. Balanced Fund and the Allan Gray Australia Stable Fund and has full responsibility for each Fund. Equity Trustees Limited is a The source for the JP Morgan Global Government Bond Index subsidiary of EQT Holdings Limited, a publicly listed company is J.P. Morgan Securities LLC. JP Morgan is a trademark of on the Australian Stock Exchange (ASX:EQT). Allan Gray JPMorgan Chase & Co. Australia Pty Limited, AFSL No. 298487 is the Funds’ investment The third party information providers do not guarantee the manager. Each Fund’s Product Disclosure Statement and accuracy, adequacy or completeness of this information, and no Information Booklet (together, PDS) are available from www. further distribution or dissemination of the index data is allangray.com.au or by contacting Client Services on 1300 604 permitted without express written consent of the providers. 604 (within Australia) or +61 2 8224 8604 (outside Australia). You should consider the relevant Fund’s PDS in deciding Returns whether to acquire, or continue to 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 an fees, assume reinvestment of distributions and exclude any offer to sell, or a solicitation to buy, units in the relevant Fund. applicable spreads. Where the report provides commentary on a particular security, Risk Warnings it is done to demonstrate the reasons why we have or have not dealt in the particular security for a Fund. It is not intended to Managed investment schemes are generally medium to long- be, or should be construed as, financial product advice. This term investments. Past performance is not indicative of future report is current as at its date of publication, is given in good performance. Each Fund’s unit price will fluctuate and the faith and has been derived from sources believed to be reliable Fund’s performance is not guaranteed. Returns may decrease and accurate. It does not take into account your objectives, or increase as a result of currency fluctuations. When making an financial situation or needs. Any implied figures or estimates are investment in a Fund, an investor’s capital is at risk. Subject to subject to assumptions, risks and uncertainties. Actual figures the disclosure documents, managed investment schemes are may differ materially and you are cautioned not to place undue traded at prevailing prices and can engage in borrowing and reliance on such information. Subject to applicable law, neither securities lending. Allan Gray, Equity Trustees Limited nor any of its related parties, their employees or directors, provide any warranty of accuracy Fees or reliability in relation to such information or accepts any The base fee and the performance fee (if applicable) are liability to any person who relies on it. Fees are exclusive of GST. calculated and accrued daily, and paid monthly. A schedule of fees and charges is available in the relevant Fund’s disclosure documents.

13 of 14 Q1 2017 RESPONSIBLE ENTITY AND ISSUER INVESTMENT MANAGER Equity Trustees Ltd Allan Gray Australia Pty Ltd ABN 46 004 031 298, AFSL No. 240975 ABN 48 112 316 168, AFSL No. 298487 Level 2, Challis House, 4 Martin Place Level 2, 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

14 of 14 Q1 2017