Ellerston Australian Share Fund PERFORMANCE REPORT May 2017

The investment objective of the Ellerston Australian Share Fund is to outperform the S&P/ASX 200 Accumulation Index (Benchmark). The Fund aims to achieve this by investing in a concentrated portfolio of no more than 25 Australian listed securities.

Ellerston Australian Share Fund Performance to 31 May 2017

Gross Benchmark* Excess Net 1 Month 1.14% -2.75% 3.89% 1.04%

3 Months 5.11% 1.52% 3.59% 4.81%

FYTD 2017 18.64% 13.89% 4.75% 17.41%

Rolling 12 Months 13.79% 11.10% 2.69% 12.51%

2 Years (p.a.) 6.88% 4.14% 2.74% 5.72%

3 Years (p.a.) 9.03% 6.03% 3.00% 7.85%

5 Years (p.a.) 13.13% 11.86% 1.27% 11.92%

Since Inception (p.a.) 11.51% 10.47% 1.04% 10.31%

Since Inception (CUM) 143.49% 125.46% 18.03% 122.79%

The return figures are calculated using the redemption price for Class A Units and on the basis that distributions are reinvested. The Gross and Excess return figures are before fees and expenses whereas the Net return figures are net of fees and expenses for the Class A Units. Returns of the Fund may include audited and un-audited results.

Past performance is not a reliable indicator of future performance. * The benchmark was changed from the S&P/ASX 200 Accumulation Ex REITS Index to the S&P/ASX 200 Accumulation Index on 1 July 2012.

Ellerston Capital Limited Level 11, 179 Elizabeth Tel: 02 9021 7797 [email protected] APIR Code: ECL0005AU ABN 34 110 397 674 Street Sydney NSW 2000 Fax: 02 9261 0528 www.ellerstoncapital.com AFSL 283 000

Market Commentary

Global markets reacted positively early in the month to the victory of Independent Centralist Emmanuel Macron in the final round of the French Presidential elections. The U.S. “complacency” VIX index of volatility immediately dropped to its lowest point since 1993. However, mid-month, U.S. political events triggered a minor sell-off in equities (causing the VIX index to spike 46% in one day). This sell-off proved to be short-lived, with equities quickly resuming their upward momentum. The FOMC left interest rates on hold in May and revealed a plan to scale back its US$4.5 trillion balance sheet. Exceptionally strong U.S. and European reporting seasons also buoyed equity markets. Information Technology outperformed and energy underperformed. Of particular interest, was the heavy sell-off in US Department Stores (the sector fell 11% over the month) on poor results that highlighted fears of a structural shift towards online retailing.

Most major equity markets posted solid returns during the month of May, with all three Wall Street indices enjoying reasonable gains. The S&P500 Index (+1.2%) climbed to new record highs, closing at 2,412 with the Dow closing above 21,000 points. The FTSE100 Index (+4.4%), also posted record highs and enjoyed its longest winning streak since May 2013. In Asia, Japanese, Korean and Hong Kong equities rallied throughout May, despite ongoing geopolitical tension in the region surrounding North Korea. The MSCI China index performed strongly, though the China Shanghai "A" shares index retreated. Late in May, Moody's downgraded China's sovereign debt rating one notch to A1 from Aa3 and changed the outlook to "stable" from "negative" - the first downgrade from Moody's since 1989.

The Australian equity market bucked the trend and was the only major developed market to post a loss, significantly underperforming its global peers. The local share market was dragged down by a big sell-off in bank stocks (the ASX200 Banks index fell 9.8% over the month). The problems for banks started with a lacklustre reporting season. Additionally, talk of a domestic housing bubble (and its possible imminent bursting) reached fever pitch during the month, further weighing on sentiment. However, the final blow for the sector was the Federal Government's announcement in its annual Budget of a 6 basis point "levy" to be imposed on the Big 4 majors and on asset manager Macquarie Bank. Banks were the worst performing sub-sector during the month. Not far behind was Discretionary Retail (falling 8.9% over the month), which was hit by several high-profile retailer bankruptcies, profit warnings as well as continued Amazon-related structural fears. Industrials (+4.7%), Telecoms (+3.4%) and Energy (+2.0%) were the top 3 performing sectors.

Government bond yields which initially rose in the first half of the month subsequently fell in the second half, ultimately finishing lower. The U.S. yield curve continued to flatten as the US 3 month T-Bill yield rose to its highest level since October 2008 (reflecting expectations of an impending Fed rate hike), while the U.S. 10 year Treasury yield fell to 2.20% on further unwinding of the 'Trump reflation trade'.

Most key U.S. economic indicators beat expectations. Payrolls for April grew a better-than-expected 211,000 (consensus: 185,000, previous: 79,000) and the unemployment rate fell to 4.4%, the lowest level since May 2007. Real GDP growth for Q1 was also revised up to 1.2% q/q annualised from a previously reported 0.7%.

The biggest currency story of the month was the Euro, which rallied against all major currencies as Emmanuel Macron comfortably won the final round of the French Presidential elections. The British Pound weakened on jitters over the upcoming general election, as well as soft U.K. economic data.

Commodities continued on their downward trajectory in May. The iron ore price fell to its lowest level since October 2016 (-15.0%) as stockpiles of the commodity mounted in Chinese ports. Likewise the coking coal price pulled back sharply (-39.0%) from the previous month's weather-induced peak of US$300/ton, while Crude Oil fell -2.0%. OPEC announced on the 25th of May that it would extend cuts in output to March 2018, but the market was expecting deeper cuts.

On the economics’ front in Australia, consumer sentiment slipped in May by -1.1% to a level of 98 points and retail sales for March fell a much worse-than-expected 0.1% m/m, bringing the pace to just 2.1% y/y, the slowest in almost four years. Residential building approvals fell a much worse-than-expected 13.4% m/m (consensus: -4.0%) to an annualised pace of 198,000, but later in the month, April approvals were stronger-than-expected +4.4% (consensus: +3.0%) to an annualised pace of 209,000, with March approvals revised up to a 10.3% fall. Despite the generally soft data, the RBA left the cash rate on hold at 1.5%.

On May 9th, Treasurer Scott Morrison released the Federal Budget, which saw an increase in both taxes and spending. The government has shown its political hand and the highlight of the Budget was the announcement of a proposed 'Bank Tax', which sent the banks reeling . Smaller banks were also impacted, as Standard and Poor’s downgraded ratings on 23 Australian Financial Institutions.

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The only winners out of the Budget were Infrastructure/Construction, with the big lift in planned spend to $75billion, Medical Centres/Diagnostics, with the lifting of MBS Indexation for GP’s and Diagnostic Imaging and the Australian economy in general, with the improved budget position which was AAA friendly.

Company Specific News

The Hits

GrainCorp (GNC +15.7%) GrainCorp pleasingly beat the street’s expectations by reporting an underlying net profit of $100.1m in the 6 months to March 2017, up an impressive 211% on pcp. Underlying EBITDA of $235.9m was up 77%. The company reiterated guidance for underlying EBITDA of $385-425m and underlying NPAT of $130-160m. Better-than-expected outcomes in Storage & Logistics and Marketing drove earnings and reminded investors of the earnings power at GNC with strong east- coast crops. The outlook commentary is broadly unchanged and focus will now switch to winter rains across the eastern seaboard.

Fairfax (FXJ + 17.5%) Fairfax has been caught in the crosshairs of two private equity firms. After several attempts by TPG to cherry-pick the premium assets (namely Domain, SMH, AFR and The Age), it widened its bid to include the entire group and lifted its offer price to A$1.20. This flushed out Hellman & Friedman with a bid range of $1.225-$1.25 per share. With both private equity houses entering the data room to conduct due diligence, long suffering Fairfax shareholders may finally have reasons to cheer.

Qantas (QAN +18.2%) Qantas conducted its investor day in early May and outlined several aggressive long-term targets for the group. The loyalty division is now targeting 7-10% earnings CAGR through FY22 and the domestic airline division is looking to produce ROIC above 10% through FY20. For a notoriously volatile and low return industry, these long-term projections gave plenty of investor comfort.

Flight Centre (FLT +13.7%) Building on the positive comments from QAN regarding passenger growth, Flight Centre continued its rally from what was a tough previous six months. There is an increasing view that airfare prices are beginning to bottom, which will assist total revenue and support near term earnings. Is it enough to offset structural headwinds from the shift to online? Only time will tell.

Boral (BLD +11.2%) During the month, Boral completed its acquisition of Headwaters International, earlier than market expectations and without having to offer any anti-trust concessions. Boral has confirmed management structures and assessed synergy opportunities in collaboration with the Headwaters team. Management confidence in the realisation of >USD100m in synergies appears to be high. It’s early days, but the integration is off to a good start.

Aristocrat Leisure (ALL + 11.0%) Aristocrat Leisure reported a very solid 1H17 NPATA of $272.9m (+49% YoY) which was above consensus of c$250- 255m, driven by comfortable EBIT beats from all segments except Aust/NZ (which was broadly in-line).It achieved this result despite incurring significantly higher than forecast corporate costs, a $4m adverse FX impact and higher than expected tax expense (c$3m impact).

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There were a plethora of Misses

Banks (ANZ -11.6%/ CBA -8.9%/ NAB -9.8%/ WBC -10.6%) The banks had a very tough month, with an average fall across the majors of ~10%. It began with a soggy reporting season which saw top-line growth almost non-existent, with cost control delivering limited growth to the bottom line. With sentiment beginning to turn south, the sector was further rocked by the announcement of a 6bps levy on outstanding liabilities from the Government’s Federal Budget. The levy will be applied to the big 4 and Macquarie Bank, which are clearly seen as an easy target for cash strapped politicians. The levy seeks to raise approximately $1.5bn per annum and on the surface, will impact the bottom line for the banks to the tune of 3%, pre any offsets.

Retailers (MYR -22.1%/ SUL -18.5%/ GXL -17.2%/ HVN -10.0%) One cannot pick up a newspaper without finding a prominent article on the arrival of Amazon and the potential wrecking ball that it will swing through the retail landscape. Sell side brokers are also falling over themselves to capture the downside and grab headlines. This, along with broader economic concerns and a weak trading update from Myer, saw a huge sell-off in the sector. Nearly all discretionary retailers are trading more than one standard deviation below their historical multiples. No doubt Amazon will change the game and the weak may well fall by the wayside. However efficient and well run retailers should benefit from sharper pricing and industry consolidation. In a turbulent market place, opportunities will no doubt selectively emerge.

Sigma Health (SIG -34.8%) Sigma was the worst performing company in the ASX 200, collapsing 34.8% in May. A double whammy of a 10% EBIT downgrade and taking legal action against its largest client Chemists Warehouse (representing over 30% of sales) did maximum damage. Chemists Warehouse is now looking to source certain generic pharmaceuticals from an alternate supplier at more attractive prices, which Sigma has refused to supply. The deterioration of the relationship to the point of legal action does not bode well for the continuation of the agreement which doesn’t expire until 2019.

Oroton (ORL -26.2%) Oroton suffered its second downgrade in 2017 on the back of very poor sales in April and May in both the Oroton brand and GAP. Questions remain over the viability of the GAP joint venture, which disappointingly, will be loss making again this year. ORL have an option to exit in FY19, though the $6m price tag will be painful for shareholders.

Sirtex (SRX -22.8%) Sirtex slumped after announcing the failure of further clinical trials (aimed at increasing the indications) for its lead SIR sphere’s product. These trial failures come hot on the heels of a trial failure just announced in late April. The culmination of the failures means that SRX’s SIR sphere product will likely be constrained to its current salvage market for the colorectal and liver cancer markets.

Asaleo Care (AHY -22.0%) Asaleo Care hit an air-pocket mid-month when surprisingly to the market, CEO Peter Diplaris sold 50% of his holding in the company. Whilst one can argue the merit of this red flag, the impact was further exacerbated 3 days later, when CFO Paul Townsend suddenly tendered his resignation.

Automotive Holdings (AHG -21.2%) Automotive Holdings downgraded its guidance for FY17, with operating profit after tax now expected to be $87m-89m, compared to previous guidance of "above $97m." Weak new vehicle sales in Western Australia and on the East Coast was the main culprit.

Mayne Pharma (MYX -19.3%) Mayne Pharma fell sharply in the month following a shock profit downgrade at its strategy day. The company noted that sales from the recently acquired Teva portfolio would be below prior expectations, due to a more competitive generic pricing environment. Recent industry data suggests the difficult generic pricing environment is ongoing.

Vocus (VOC -16.3%) Perennial offender Vocus again downgraded guidance for FY17, with revenue falling to ~$1.8 bn (from ~$1.9bn), underlying EBITDA to $365m-375m (from $430m-450m) and underlying NPAT to $160m-165m (previously $205m-215m.) This is the third downgrade for the group and stemmed from a trifecta of issues including: accounting reviews, higher expenses and lower billings. Credibility is in tatters and only private equity rumours stopped it from falling further.

CSR (CSR -14.9%) CSR reported a weak FY17 result, with misses in Building Products, Viridian and Property, partly offset by strong Aluminium earnings. While no guidance was provided for FY18 (as normal), management highlighted that the Australian housing market has likely peaked, with demand to remain steady in FY18. Prior to this result, Viridian EBIT recovery was

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encouraging and perceptions were that the worm had turned. However, it now appears further investment in re-structuring is required and some believe Glass industry issues may be structural.

APN Outdoor (APO -14.9%) During the month, APN Outdoor announced that it had terminated its proposed merger with oOh!media (OML). The Statement of Issues released by the ACCC made it very clear that the merger would result in a substantial lessening of competition and was highly unlikely to get through without offering material concessions. Whilst both companies disagreed with the findings, the merits of the transaction no longer held and the proposal was thus abandoned.

James Hardie (JHX -13.6%) Market darling James Hardie also reported a very disappointing 4Q, due to a weaker US margin, as higher input costs impacted. The company downgraded FY18 expectations for the 4th consecutive quarter. Specifically, management expects North American EBIT margins to be within the 20-25% target range, compared to expectations at the top end, or even above the range.

Southern Cross Media (SXL-12.0%) Southern Cross Media was another cyclical to warn, with the company lowering FY17 guidance to EBITDA of $168m, compared to previous guidance of `$177m. The downgrades came from weakness across all three divisions namely i) Weaker metro radio market growth at just 2.2% in the first four months of 2H17 vs 2-3% historically. ii) Regional TV markets in "mid-single digit declines” vs. -1.4% in 1H17. iii) Weaker regional radio growth.

Performance

With explosions seemingly going off everywhere, we are very pleased to report strong performance in the month of May, with many of the Fund’s core holdings outperforming significantly in a market that hit an air-pocket and retreated.

The Fund’s return of +1.14% comfortably outperformed the benchmark return of -2.75%.

The main contributors to this months outperformance were GrainCorp (GNC +15.7%), Primary Health Care (PRY +8.6%), Treasury Wine (TWE +8.5%), Caltex Australia (CTX 10.7%), DuluxGroup (DLX +4.0%) and RIO Tinto (RIO +3.9%). The main detractors were Healthscope (HSO -8.6%) and APN Outdoor (APO -14.9%).

Securities Held

-0.6%, HSO █████████████████ █████████████████████████████████████████████ GNC, 1.49% -0.5%, APO ████████████████ ███████████████████████████ PRY, 0.88% -0.3%, SGR ██████████ █████████████████████ TWE, 0.68% -0.1%, SCO ███ █████████████████ CTX, 0.57% -0.1%, AWE ██ █████████████ DLX, 0.45% -0.1%, GWA ██ ████████████ RIO, 0.4% █████████ ORI, 0.3% █████ LNK, 0.2% ████ BLD, 0.2%

Securities Not Held

-0.2%, TLS ███████ ██████████████████ CBA, 0.6% -0.2%, BHP █████ █████████████████ ANZ, 0.6% -0.1%, ALL ███ █████████████████ WBC, 0.6%

-0.1%, SYD ███ ██████████ NAB, 0.3%

-0.1%, QAN ███ ██ JHX, 0.1%

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Activity

JB Hi-Fi

We introduced JB Hi-Fi (JBH) to the portfolio this month in what at first glance may seem bizarre given the media hyped Amazon tsunami approaching. Since the beginning of the year, JBH has fallen 20% and is now off more than 30% from its recent highs post announcing the acquisition of The Good Guys (TGG). This sell off has come despite JBH reporting impressive top-line sales growth. So what has built the wall of worry? We highlight four main issues:

 Amazon confirming its physical (albeit limited) entry into Australia;  Growing concern about a slowdown in the domestic housing market;  Weak consumer sentiment; and  Sluggish retail spending data, particularly in discretionary.

Against this backdrop we have seen a big spike in short sellers come back in the name. The chart below highlights that the short interest is now back towards the long-run average of 12%.

Source: Ellerston Capital

Current trading defies doom & gloom

Whilst we are not brushing aside these key concerns, we note that JBH continues to be one of the top performing retailers in the country. Like-for-like (LFL) sales in the JB Hi-Fi banner jumped 8.2% in the March quarter, with total sales up 10.8%. The Good Guys (TGG) lifted LFL sales 1.2% and total sales up 2.6% despite the challenges of integrating a new acquisition.

Strong sales momentum bodes well for earnings and a growing belief of ours is that JBH should exceed the top-end of its guidance range for FY17 of $200m to $206m. Moreover we believe JBH has significantly under-cooked its synergy target for TGG acquisition. Its estimate of $15-20m, barely accounts for the ability to extract buying synergies in our view. If it were to achieve just 10bps of COGS across the total business, that would amount to $50m (a big number relative to a FY17 NPAT of ~$200m.) We think the company has been deliberately coy with respect to the synergy target as it goes through delicate discussions with its major suppliers. Additionally, management may want the firepower in their back pocket to under promise and over deliver. So as the market sits here fretting about potential FY18 downgrades, we think the opposite could happen.

In a further positive for the company, former CEO and well respected retailer, Terry Smart has come back to the fold to run TGG. We are comforted that Smart would’ve conducted significant due diligence on the opportunity before risking his hard won reputation.

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Valuation opens the investment window

The selloff has presented us with a rare buying opportunity in this quality, well managed specialty category killer with a ~20% market share in electronic retailing (this is no Myer). JBH is now 1STD below historical range and is trading on a PE of just 11.5x FY18 consensus (which we think given all our channel and industry checks is cum upgrade) and a 5%+ sustainable fully franked dividend yield. This discount was last seen in 2011/12 when severe earnings downgrades impacted the sector as price discovery and leakage to offshore retailers (A$=US$) killed earnings and future expectations. The fear index is now just as huge and the reality is very different…

Apart from the above, we strengthened the existing position in Dulux (DLX), added to the Fund’s Healthscope (HSO) holding and strengthened the position in Star Entertainment (SGR)

Strategy and Outlook

Market Valuations are above fair value based on longer term averages

Source: IBES, S&P, Datastream, Citi Research

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Source: Factset, S&P, Morgan Stanley Research

Our broader strategy remains as per last month and with the exception of adding JB Hi Fi to your portfolio, we have not changed course.

We are not index huggers, are true to label, and remain zero weighted to banks, telcos, utilities and REITs for reasons articulated in the past, ad nauseam. The Fund only holds two of the top ASX 20 stocks as summarised in the below table.

80% Portfolio ASX 200 Active

60%

48.1% 59.6%

40% 36.1%

21.2% 15.6%

20% 15.2%

12.1%

11.0%

8.0%

7.2%

3.0% 3.0% 0.0% 0%

Top 20 21 - 50 51 - 100 101 - 200 201 - 300 5.6%

-20% - Mid - Caps

-40%

48.5% -

-60%

Warm Regards,

Chris Kourtis Portfolio Manager

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Top 10 Holdings Active Sector Exposures*

20% APN OUTDOOR GROUP

DULUXGROUP 10% GRAINCORP 0% HEALTHSCOPE (10%) LINK ADMINISTRATION HOLDINGS

(20%) NUFARM

(30%) PRIMARY HEALTH CARE

RIO TINTO (40%)

STAR ENTERTAINMENT GROUP

Energy Utilities

Materials TREASURY WINE ESTATES

Financials

Industrials HealthCare

Effective Cash Effective Consumer Staples Consumer

Information Technology Information Consumer Discretionary Consumer

Other (inc Index Hedges) OtherIndex (inc

Telecommunication Services Telecommunication

* Active sector exposures are determined by subtracting fund sector weights from benchmark weights. Positive percentages represent over-weight sector exposures Arelativebout to the benchmark Ellerston and negative Australian percentages Share represent Fund under -weight sector exposures relative to the benchmark.

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The Fund aims to achieve its performance objectives by adopting a fundamental “bottom-up” investment approach to stock selection which is focused on identifying and then constructing a portfolio of the highest conviction ideas.

Investment opportunities for the Fund are identified by analysing and understanding the factors affecting (amongst other things): business model, industry structure, management team and overall valuation. Ellerston Capital typically favours businesses that can sustain high returns or improve their return on capital and looks to invest in businesses with a market value below the value we attribute to them.

Benchmark weightings do not drive our stock decisions, our approach is totally benchmark independent.

Due to the high conviction nature of the portfolio and the resulting deviation in portfolio composition relative to benchmark weighting, it is expected that the returns from the Fund will differ significantly from the broader market indices.

Fund Facts

Strategy Funds Under Management $2.73 Billion Funds Under Management - ASF Unit Trust $3 Million Application Price $1.0620 Redemption Price $1.0568 Number of Stocks 19 Inception Date 1 April 2009

DISCLAIMER This newsletter has been prepared by Ellerston Capital Limited ABN 34 110 397 674 AFSL 283 000, responsible entity of the Ellerston Australian Share Fund (ARSN 135 591 534) without taking account the objectives, financial situation or needs of individuals. Before making an investment decision about the Fund persons should read the Fund’s product disclosure statement dated 21 October 2013 which can be obtained by contacting [email protected] and obtain advice from an appropriate financial adviser. Units in the Fund are issued by Ellerston Capital Limited. This information is current as at the date on the first page. The inception date for the Ellerston Australian Share Fund is 1-April-2009.

This material has been prepared based on information believed to be accurate at the time of publication. Assumptions and estimates may have been made which may prove not to be accurate. Ellerston Capital undertakes no responsibility to correct any such inaccuracy. Subsequent changes in circumstances may occur at any time and may impact the accuracy of the information. To the full extent permitted by law, none of Ellerston Capital Limited, or any member of the Ellerston Capital Limited Group of companies makes any warranty as to the accuracy or completeness of the information in this newsletter and disclaims all liability that may arise due to any information contained in this newsletter being inaccurate, unreliable or incomplete. Past performance is not a reliable indicator of future performance

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