Australian Equities High Conviction Portfolio Performance Report – July 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 Jamie Nicol Scott Bender higher volatility in pursuit of higher Chief Investment Officer Portfolio Manager growth Benchmark S&P/ASX 200 Accumulation Index The DNR Capital Australian Equities High Conviction Investment objective To outperform the S&P/ASX 200 Portfolio outperformed its benchmark by for the period. Accumulation Index by 4% p.a. Key stock contributors were ALS (ALQ), CSL (CSL, (before fees) over a rolling three no holding) and (TAH). Key stock year period detractors were (LLC), (FMG, no holding) and Goodman (GMG, no Investable universe ASX listed securities with a focus holding). on the S&P/ASX 200 Number of stocks 15–30 The S&P/ASX 200 Accumulation Index was up 0.50% during the period. The best performing sector was Asset allocation Australian equities 80–100% Materials (+5.8%), as commodity prices recovered and Cash 0–20% the price of gold rallied. The uncertainty in the market, Stock limit 15% maximum weighting as well as fears of the effects of increasing money Minimum suggested 5 years supply due to fiscal stimulus, have been key to gold’s investment timeframe rise. Information Technology was an outperformer again, spurred once more by (APT, +25.0%) and helped by cloud-service providers NextDC (NXT, +17.1%) and Megaport (MP1, +10.4%)—all are expected to continue to benefit from the pandemic. Health Care was a key underperformer during the period as CSL (CSL, -6.7%) continued to fall from its April highs as the concerns around collection centre volumes grew. Industrials also underperformed, with concerns about a second wave’s impact on the economy seeing cyclical stocks weaker.

Gross active return

1mth 3mth 6mth 1yr 3yr 5yr 7yr 10yr Incep.* % % % % % % % % % High Conviction Portfolio 0.80 11.04 -13.81 -6.38 4.78 6.68 9.25 10.27 11.56 S&P/ASX 200 Accumulation Index 0.50 7.62 -14.25 -9.87 5.37 5.15 6.78 7.39 8.52 Excess Return 0.30 3.42 0.44 3.49 -0.59 1.53 2.47 2.88 3.04 * 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. Page 1 of 8 Performance Report July 2020

Market review This month we discuss the impact that a resurgence in The most concerning aspect for authorities is quantum COVID-19 cases, globally and domestically, is having on of community-based transmission and a concerning our portfolio. The ‘second wave’ raises further concerns proportion of unknown local contacts. regarding the shape, and sustainability, of the recent economic recovery. Without a viable vaccine or effective Community-based transmission cases treatment, are we facing a series of rolling lockdowns, and if so, what does this mean for the economy? Increasingly, the markets will focus on the progress of the development of a vaccine. Governments face difficult choices in the absence of a timely solution. Aside from obvious economic impacts, there will be longer‑term health consequences from prolonged lockdowns. Cancer detection has fallen significantly as individuals avoid medical facilities, social isolation is exacerbating mental health disorders, and the deterioration in public health budgets yields longer-term consequences for the population. Source: Department of Health, States & Territories Report Second wave versus reopening of economies 6/8/2020 Second-wave infections and subsequent lockdowns have frustrated efforts to reopen the broader economy. Following escalating suburb-based, shelter-in-place A marked spike in cases from the end of June has been orders and despite furious lobbying by industry and driven by Victorian outbreaks. business (with some minor concessions), onerous stage four restrictions are now in place in the nation’s Australian COVID-19 Cases second most populous state. Other anxious governments are now imposing cascading interstate travel bans to avoid a similar fate, meaning the impacts will extend beyond Victoria’s 23% contribution to GDP. Disrupted international and interstate supply chains and reduced domestic travel and tourism will provide further drag on the nation’s economy. Updated Treasury estimates put the incremental impact at between $10 billion to $12 billion, cutting 2.5% off GDP and pushing the unemployment rate to 10%, up from previous estimates of 9.25%. The US has paradoxically seen increasing new cases but moderating daily deaths. There is no consensus among experts, but several explanations have been proposed. Are cases being caught earlier, with better outcomes Source: Department of Health, States & Territories Report from hospitalisation? Are new infections weighted to 6/8/2020 younger demographics with better survival rates than the elderly, who are successfully isolating? Is the virulence of While Australia has enjoyed relative success in managing COVID-19 in decline? fatalities during the pandemic, the Victorian situation has seen a deterioration in our global standing. U.S. Coronavirus activity Global confirmed COVID-19 deaths

Source: Johns Hopkins CSSE Source: Johns Hopkins University, Principal Global Investors. Data as of July 28, 2020

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Mortality Rate Sweden’s GDP has materially contracted but still managed to outperform most of its European peers.

The pandemic has hit some European economies harder than others

Source: Johns Hopkins University, Principal Global Investors. Data as of July 28, 2020 Source: Refinitiv, FT The debate rages across political divides as to whether Whether the Swedish strategy will yield better economic restrictive lockdowns deliver the best outcomes for and public health outcomes in the long term remains to society when weighed against the economic and social be seen, but the debate rages as to the correct course of costs of their implementation. Sweden is the commonly action, which will only be apparent in hindsight. referenced alterative model for managing COVID-19, with its “light touch” approach. Early in the crisis, initial The much-feared second wave phenomenon is underway cases and fatalities were globally high, but the country is in a number of countries, Australia included. While the experiencing no second wave and currently reporting low composition of each countries’ resurgence is nuanced daily deaths. (Victoria case in point), the impact can be observed through a flattening in activity as restrictions are Country specific number of deaths reintroduced. Change in mobility

Source: Google Mobility Reports, Principal Global Asset Allocation. Data Source: Johns Hopkins CSSE is based on the 7-day moving avg. of retail & recreation, workplace & transit categories of Google’s Mobility Reports. Data as of July 25, 2020 Daily new cases As the reality of second waves prolonging economic recovery sets in, hopes of COVID-19 elimination and V-shaped recoveries are fading. The frustration and anxiety of possible subsequent waves is intensifying the focus on vaccine development. COVID-19 vaccine development With unprecedented resources and regulatory support, the development of a COVID-19 vaccine has been like Source: Worldometer, 2020 no other. A decade-long process has been collapsed into Daily deaths several months. The optimistic time frames to deliver a viable vaccine are made possible by running phases of the process in parallel, where possible. By undertaking manufacturing and distribution steps prior to final approval, successful vaccines could be available around the world once the green light is given. Many countries have already placed orders for the unapproved vaccines.

Source: Worldometer, 2020 Page 3 of 8 Performance Report July 2020

Vial statistics Sinovac Biotech (China, inactivated platform). Phase three trials began in July, targeting 8,700 participants in Brazil. Wuhan Institute of Biological Products/Sinopharm (China, inactivated platform). Phase three trials began in July, targeting 15,000 participants in the UAE. BioNTech/Fosun Pharma/Pfizer (US, RNA platform). Phase three trials began in July, targeting 30,000 participants. The companies indicated they could apply for approval as early as October 2020. The world will wait eagerly for any news of clinical success. Bottom-up news —COVID-19 winners and losers Source: The Economist As the market wrestles with top-down challenges, a number of companies have provided updates which help The World Health Organization’s Draft landscape frame the overall outlook. We are seeing winners and of COVID-19 candidate vaccines has identified 26 losers across the spectrum: trials in clinical evaluation. While the quantum sounds encouraging, many vaccines fail large-scale trials, and }} Consumer stocks benefiting from stimulus. Updates even when approved, the success of a vaccine has a from domestic retailers like (SUL) range of outcomes. Varying degrees of efficacy and and Nick Scali (NCK) have confirmed the positive suitability may require multiple doses, be unsuitable for ABS retail sales data and are setting the scene for specific demographics, or only prevent death but not halt consumer discretionary to benefit from unprecedented transmission. Despite the world’s ability to move on from stimulus, early superannuation withdrawals and limited the pandemic resting on a successful vaccine, regulators opportunities to spend on travel. and health authorities will not risk the hard-fought }} US housing is holding up. US home builder Lennar acceptance of immunisation programs by compromising surprised the market with total orders down only scientific rigour. 10% yoy with delivery flat. This was a very resilient While difficult to pinpoint when successful vaccines could outcome given the number of states still hampered by be available, Morgan Stanley has estimated accelerated shutdowns. Household debt is in reasonable shape, FDA approvals between October and December 2020, with the first quarterly decline in credit card balances and more broadly available doses by April 2021. since 2014 observed, driven by reduced consumer spending. Actual/estimated new case count (United States, non‑cumulative) Household debt service payments as a percent of disposable personal income

Source: FRED Economic Data

}} Volatile markets helped (MQG) deliver a strong quarter. US investment banks also Source: Morgan Stanley reaped the benefit from market volatility. European and There are currently five candidates progressed Wall Street investment banks delivered outsized gains to Phase III, which is the final hurdle to beginning from their fixed-income, currency and commodity distribution. The range of vaccine platform types, public/ trading desks, with JP Morgan up 120%, Barclay’s private partnerships and geographical locations provides +95%, Deutsche +39% and Credit Suisse +53%. an encouraging diversification of contenders. }} Big tech continues to win. The well-flagged impact of Oxford University/AstraZenca (UK, non-replicating FAANG continues to have outsized impact on market viral vector platform). Phase three began in late May, performance. Strong results from Amazon, Microsoft with trials in the UK, Brazil and South Africa, and has and Shopify highlighted to us the benefits that the recruited 10,260 participants across 13 cities. crisis has delivered to large tech companies. Moderna/NIAID (US, RNA platform). Phase three began on July 27, targeting 30,000 participants across 89 sites in the US.

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FAANG Stocks versus Market Earnings yield versus Bond yield

Source: DNR Capital Value investors are awaiting a cyclical recovery in growth strong enough to fuel inflation and warrant central bank tightening down the track. They are looking for a recovery Source: BofA Global Investment Strategy, Bloomberg that is not dependent upon extraordinary stimulus, nor central bank fun and games. They are looking for the }} Bank dividends cut and uncertainty regarding loan yield curve—the spread between long-term bond yields deferrals. The current environment remains difficult and short-term policy rates, to steepen materially. They for banks with uncertainty around the proportion want organic earnings recovery to support cheaper of loans that have been deferred. The government cyclical exposures. We note this remains highly and regulator are encouraging the banks to support uncertain. If we see a vaccine solution, then a rotation stakeholders like businesses, staff, and customers to value stocks would gather pace. Failing that, the at the expense of shareholders. Shareholders are environment looks difficult for the more cyclical parts of playing second fiddle to team Australia. the market.

}} Stock-specific opportunities. It is an odd cycle. Some Momentum crowding at extreme stocks are doing well, like the retailers mentioned above. There are also stock-specific opportunities emerging. ALS (ALQ), for example, is benefiting from structural trends like the pick-up in gold prices and increased regulation for COVID-19 testing.

}} Online classifieds see continued improvement. SEEK (SEK), REA Group (REA) and .com (CAR) closely tracked weekly volumes reflect a continued recovery in volumes, providing an encouraging read on economic activity. We note that the Victorian lockdown measures will negatively impact this data while restrictions are in place.

}} Commodity price differences. The COVID-19 pandemic is also creating winners and losers within Source: J.P. Morgan commodities. Iron ore is benefiting from improved demand in China and supply disruption in Brazil. We see the need for balance across the portfolio: Conversely, oil is negatively impacted by a decline in }} The economic outlook is uncertain, so some demand for flights and travel. defensiveness is prudent.

}} Challenges for office property and regional retail. }} Growth stocks can maintain large premiums while Working from home and an increase in online interest rates are low and the alternative, cyclicals, shopping has accelerated already negative trends for have a difficult economic backdrop. some property areas. }} This can change if a vaccine is successfully Valuations remain attractive relative to alternatives. developed. COVID-19 impacted stocks look very However, within the market the gap between growth and cheap, but the opportunity is binary (a vaccine would value remains high. result in a recovery, but they are difficult investments otherwise).

}} Quality characteristics remain important. Strong companies can win share in a difficult operating environment.

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Portfolio attribution

Sector weightings % The top stock contributors were: }} ALS (ALQ)—Outperformed as the company announced a strong first quarter at its AGM. A pickup in capital raisings for junior gold mining stocks bodes well for future growth in mineral’s testing and COVID-19 testing presents additional opportunities.

}} 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 the 2021 fiscal year.

Source: DNR Capital }} Tabcorp Holdings (TAH)—Outperformed as wagering turnover data highlighted stronger than expected growth. Management transition plans were also 12 month - top contributors and detractors announced, which further supported the stock. The top stock detractors were: Top 3 contributors Alpha* }} Lendlease (LLC)—Underperformed after reporting Overweight 2.34% a softer result for FY20. The company continues Domino's Pizza Enterprises Overweight 1.59% to make progress exiting the troubled engineering business, however the recent Victorian shutdowns are ANZ Banking Group No Holding 1.21% likely to result in construction delays.

}} Fortescue Metals Group (FMG, no holding)— Top 3 detractors Outperformed as iron ore supply from Brazil remains CSL No Holding -1.69% disrupted. However, stimulus in China has meant demand has remained sound. Consequently, the Virgin Money UK Overweight -1.23% iron ore price has traded strongly and supported the Fortescue Metals Group No Holding -1.22% company.

}} Goodman (GMG, no holding)—Was up strongly as fears of a resurgence in COVID-19 resulted in a Monthly - top contributors and detractors flight to safety within the REIT sector. With office and retail both challenged, industrial remains the choice Top 3 contributors Alpha* exposure. Ahead of results, Goodman remains one of the few REITs with guidance intact. ALS Overweight 0.56% CSL No Holding 0.51% Portfolio positioning Tabcorp Holdings Overweight 0.19% Our current positioning is as follows:

} Top 3 detractors } Strong global franchise stocks—James Hardie Industries (JHX), SEEK (SEK), Cochlear (COH), Lendlease Overweight -0.39% (ALL).

Fortescue Metals Group No Holding -0.36% }} Strong domestic franchise stocks—REA Group (REA), Goodman No Holding -0.20% (RHC), (WES) and Cochlear (COH).

* Alpha is the portfolio return less benchmark return. These }} Quality mid-caps—Domino’s Pizza Enterprises (DMP), tables represent the stocks contribution of alpha to overall Iress (IRE), (CPU) and portfolio alpha and is determined by the stocks active weight (QUB). relative to the benchmark and share price return relative to the benchmark. }} Resources—Overweight (RIO) and BHP Group (BHP).

}} Underweight banks.

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Key risks Valuation Following the payment of a special dividend ~$0.50 Key risks to the Portfolio include: and the in-specie distribution of Tuas Group/ Mobile (current book value of ~$0.60), we estimate that }} COVID-19 disruption—the longer and deeper the disruption from the COVID-19 pandemic, the greater TPG is trading on a synergy-adjusted EBITDA multiple the negative impact on equity markets. of ~8x, a free cash flow yield of ~7% and an underlying PE of ~15x. This represents an attractive valuation given }} Interest rates—low interest rates are the prime driver the potential revenue synergies above our underlying of markets at present. Any change to the inflation assumptions. outlook would have a significant impact on valuations. Conclusion }} Inflation—given valuations have been supported by The merger between TPG Telecom (TPG) and low interest rates, the emergence of inflation and Hutchison Australia (VHA) to create TPG Telecom (TPM) higher bond yields could be a negative for markets. is highly complementary from a customer perspective, }} Political environment—it is an election year in the asset mix and opportunity to realise synergies. The US, which adds to potential uncertainty. Further investment opportunity represents underlying defensive geopolitical uncertainty could create negative characteristics as well as growth potential; both implications for stocks and portfolios. characteristics are expected to be highly sought after in the current environment.

Portfolio moves Investment strategy Purchase of TPG Telecom (TPM) Equities High Conviction Portfolio has The merger between TPG Telecom (TPG) and Vodafone an investment style best described as ‘style neutral’. Hutchison Australia (VHA) has created Australia’s newest The security selection process has a strong bottom-up fully integrated operator. discipline and focuses on buying quality businesses at TPG Telecom meets DNR Capital’s five-point quality web: reasonable prices. We define quality businesses as being those with the following five attributes: 1. Industry structure—The telecommunications industry has largely consolidated into an attractive three-player }} earnings strength (particularly improving return) market structure. TPG Telecom remains the challenger }} superior industry position brand with ~20% market share in mobile, relative to (~50%) and (~30%). }} a sound balance sheet 2. Earnings strength—We believe TPG’s underlying }} strong management earnings will reset during FY20 and expect double }} low environmental, social and governance (ESG) risk. digit growth over the next 3–5 years as synergies are realised and a more rational competitive environment Where we are satisfied that a security possesses emerges in mobile. quality characteristics, then it is eligible for inclusion in the portfolio. However, it must also represent value 3. Balance sheet—TPG’s balance sheet is solid with and sit comfortably within our portfolio construction ND/EBITDA at ~2x. requirements. 4. Management—The management team is strong. A range of valuation methodologies are used depending David Teoh (executive chairman and CEO of TPG) on the nature of the business being assessed to identify is the chairman of the merged entity. He founded mispriced opportunities. TPG and will maintain a 17% stake in the business. Inaki Berroeta ( CEO) is the CEO The portfolio construction process is influenced by a of the merged entity. He is a 20 year veteran of top-down economic appraisal and also considers the the telecommunications industry and long-serving risk characteristics of the portfolio, such as security and Vodafone executive. sector correlations. 5. Environmental, social and governance—The company has a low ESG exposure. Investment philosophy Key risks DNR Capital believes a focus on quality businesses will There are a number of key risks. These include a: enhance returns when it is combined with a thorough clash of corporate cultures, execution risk and synergy valuation overlay. We seek to identify quality businesses realisation, an escalation of competition in mobile and the that are mispriced by overlaying a quality filter, referred 5G network rollout and capex. to as the ‘quality web’, with a strong valuation discipline. The portfolio is high conviction and invests for the medium term.

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Platform access

}} AMP PPS

}} BT Panorama (Direct, Compact and Full)

}} Colonial First State FirstWrap

}} Federation Alliance

}} HUB24

}} Linear

}} Macquarie Wrap

}} Mason Stevens

}} Netwealth

}} OneVue

}} Powerwrap

}} Praemium

}} Wealthtrac

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 the Australian 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 .4.10.2007

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