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Australian Equities High Conviction Portfolio
Performance Report – June 2017
Portfolio overview
Market overview and portfolio performance
Global equity markets hit all-time highs in June, although
they did give back some gains towards the end of the
month. This was in response to a sell-off in bonds,
with several central banks indicating the possibility of
decreased stimulus measures. The big political news for
the month was the election result in the UK, which saw
the ruling Conservative Party lose its majority.
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 higher
volatility in pursuit of higher growth
The domestic market provided a small return for the
month with the S&P/ASX 200 Accumulation Index up
0.17%, but overall the 2017 financial year closed up
strongly at 14.09%. The best performing sector for June
was Health Care and the worst performer Energy. Banks
continued to be under scrutiny, with South Australia
announcing it would introduce its own state-based bank
levy on the five major banks (including Macquarie), just
six weeks after the Federal government announced a
bank levy that aims to raise $6.2 billion.
Benchmark
S&P/ASX 200 Accumulation Index
Investment objective
To outperform the S&P/ASX 200
Accumulation Index by 4% p.a.
(before fees) over a rolling three
year period
Investable universe
ASX listed securities with a focus
on the S&P/ASX 200
Number of stocks
15–30
Asset allocation
Australian equities 80–100%
Cash 0–20%
Stock limit
15% maximum weighting
Investment timeframe
5 years
Portfolio managers
Jamie Nicol
(Chief Investment Officer)
The DNR Capital Australian Equities High Conviction
Portfolio outperformed its benchmark by 0.17%.
Scott Bender (Portfolio Manager)
Gross active return
1mth
3mth
6mth
1yr
3yr
5yr
7yr
10yr
Incep.*
0.34
0.17
0.17
0.61
-1.58
2.19
4.81
3.16
1.65
19.42
14.09
5.33
11.71
6.63
5.08
16.80
11.81
4.99
13.41
8.94
4.47
7.88
3.61
4.27
13.06
9.22
3.84
%
High Conviction Portfolio
S&P/ASX 200 Accumulation Index
Excess Return
* Inception date—October 2002
%
%
%
%
%
%
%
%
Portfolio Excess Return
Annualised excess return
6%
5%
4%
3%
2%
1%
0%
1yr
5.33%
2yr
5.14%
3yr
5.08%
4yr
5.10%
5yr
4.99%
6yr
3.97%
7yr
4.47%
8yr
4.14%
9yr
5.15%
10yr
4.27%
Inception*
3.84%
Portfolio Excess Return
Excess return (calendar year)
12%
10%
8%
6%
4%
2%
0%
2016
2.36%
2015
9.97%
2014
0.44%
2013
10.02%
2012
0.90%
2011
3.60%
2010
2.12%
2009
5.37%
2008
4.58%
2007
1.01%
2006
3.02%
2005
2.59%
2004
8.08%
2003
1.74%
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.
Performance Report June 2017
Sector weightings %
Portfolio attribution
The top stock contributors were:
Real Estate (5.4)
Consumer Discretionary (8.7)
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Consumer Staples (9.6)
Energy (1.1)
Financials (33.1)
Health Care (4.3)
}}
Industrial (19.2)
Information Technology (4.9)
Materials (11.4)
Telecommunication (0)
Utilities (0)
Cash (2.3)
Source: DNR Capital
}}
12 month - top contributors and detractors
Top 5 contributors
Alpha*
Healthscope (ASX:HSO)—Shares rebounded as
margin concerns appeared overplayed. Medical
specialist attendance growth (~3.5%) remains
essentially in line with its 10-year average.
ALS (ASX:ALQ)—Major gold miners have
recapitalised and are now approaching a net cash
position. In 2016, junior gold miners raised the
most equity in five years. Exploration budgets have
troughed, and it is estimated that the capital raised by
the juniors alone could underpin a 50% increase in
exploration activity over the next two to three years.
ALS also benefited from broker earnings upgrades.
Wesfarmers (ASX:WES, no holding)—Shares came
under pressure during the month as the company
announced the need for greater price investment in
the Coles business, which will weigh on margins.
Telstra Corporation
No Holding
1.58%
The top stock detractors were:
Treasury Wine Estates
Overweight
1.27%
}}
Lendlease
Overweight
1.14%
ALS
Overweight
0.99%
South32
Overweight
0.89%
Healthscope
Overweight
-1.40%
Brambles
Overweight
-1.12%
ANZ Banking Group
No Holding
-0.61%
SKYCITY Entertainment Group
Overweight
-0.51%
Cash
Overweight
-0.44%
Top 5 detractors
}}
Monthly - top contributors and detractors
Top 5 contributors
Alpha*
Healthscope
Overweight
0.35%
ALS
Overweight
0.33%
Wesfarmers
No Holding
0.20%
Janus Henderson Group
Overweight
0.14%
IRESS
Overweight
0.13%
CSL
No Holding
-0.26%
QBE Insurance Group
Overweight
-0.24%
SKYCITY Entertainment Group
Overweight
-0.18%
Brambles
Overweight
-0.16%
ANZ Banking Group
No Holding
-0.13%
Top 5 detractors
* Alpha is the portfolio return less benchmark return.
These tables represent the stocks contribution of alpha
to overall portfolio alpha and is determined by the stocks
active weight relative to the benchmark and share price
return relative to the benchmark.
}}
CSL (ASX:CSL, no holding)—Haemophilia accounts
for 16% of CSL’s sales and the company has high
hopes for its latest products. At its research and
development day in late 2016, the company said that it
expected new haemophilia products IDELVION (Hem
B) and AFSTYLA (Hem A) could generate ~US$700m–
US$1b in revenue in four to five years, well above the
FY20 US$550m estimate.
QBE Insurance Group (ASX:QBE)—QBE downgraded
its group combined operating ratio to 94.5–96.0%,
from 93.5–95.0% previously, due to ‘higher-thanexpected claims activity’ in its emerging markets’
business. QBE shares fell 10.3% on the day of the
announcement which appeared to be an overreaction
given the size of the downgrade but reflected
disappointment given the company had previously
appeared to be over its recent woes.
SKYCITY Entertainment Group (ASX:SKC)—The
Chairman of SKYCITY Entertainment Group, Chris
Moller, has announced his retirement from the Board,
effective 31 December 2017 and a major shareholder
sold a stake.
Market review
This month we review the 2017 financial year and the
outlook for the following year. The past year has seen a
strong return by the market of 14.09%, and our portfolios
have enjoyed good outperformance. The major drivers
of the market were a rebound from a Brexit selloff late
last year before improving economic data, and Trump
policies that drove expectations in a pick up of inflation.
This resulted in a strong rotation in market leadership
from growth stocks to value stocks. The market then
consolidated across the first half of 2017, before
softening as the domestic economy showed some signs
of weakness for the consumer, and the Federal bank levy
impacted the bank sector.
Here we discuss the stocks that were the major winners
and losers for the portfolio in the 2017 financial year.
Performance Report June 2017
Major Winners
ALS (ASX:ALQ, +55%)—A pick up in commodity prices
drove an increase in spending on exploration, resulting
in a pick up in ALS’s commodity-testing business.
Furthermore, it announced the intention to sell its lossmaking oil business and make further acquisitions in
the life sciences (food and environment). This resulted
in an improvement in the outlook for a business with a
very strong market position that continues to take share
globally. We are particularly interested in its food testing
business. This is a market that is fragmented globally
yet has very strong growth rates, as consumer and
government interest in maintaining safety standards and
understanding the health content of food increases.
South32 (ASX:S32, +78%)—As commodity prices
increased, this former BHP Billiton (ASX:BHP) selloff
enjoyed a strong run. Profits in the 1H17 were up from
US$141m to US$479m and the company had US$859m
in cash, affording it flexibility to announce a US$500m
buy-back and further exploration opportunities. Its focus
on cost out and capex discipline means it continues
to produce significant levels of cash to support further
capital management initiatives.
Lendlease (ASX:LLC, +37%)—Lendlease enjoyed
another solid year with profit up 12% to 1H17. The shares
have been volatile in recent years despite steady profit
growth. It has oscillated between concerns regarding
settlement risk on apartments, to interest in the potential
expansion in infrastructure spending in Australia, and
the winning of development opportunities offshore. As
apartments settle, Lendlease is deploying excess capital
into cheaper markets offshore. Furthermore, it is seeking
to sell a proportion of its retirement village business,
which will further free up domestic capital for investment
elsewhere.
Treasury Wine Estates (ASX:TWE, +45%)—Profit in
the 1H17 was more than double the prior year. TWE
benefited from Chinese middle-class demand for wine
and its US Diageo Wine acquisition. The company also
announced the launch of a French wine portfolio that
will be sold into China, and increased long-term profit
margin expectations as it continued to evolve towards a
premium-branded consumer business.
Major Losers
Healthscope (ASX:HSO, -20%)—HSO had a poor 1Q17
as a range of factors impacted hospital admissions.
These included affordability concerns that caused delays
to surgeries, and pressure from over-servicing concerns,
creating some constraints on activity by doctors.
Following this, admissions stabilised in 2Q17 and HSO
adjusted its cost base and delivered a better-thanexpected February result (relative to post-September
expectations) with group EBITDA up 5%. However,
the stock struggled as the market remained concerned
regarding these factors impacting admissions. The past
half we have seen some volume improvement, bouncing
off lows of 2–3% growth to 3–4%. These figures were
still below long-term trends of circa 5%. Longer term, the
demographics of an ageing population provide support
for volumes and the opening of North Shore Hospital will
be a key driver for Healthscope.
Brambles (ASX:BXB, -19%)—A change in leadership
and increased competition resulted in a poor 1H17 result
and a downgrade in long-term growth expectations.
Underlying profit was up a disappointing 2% in the 1H17
on sales growth of 5% (which indicated a low single digit
2Q17). Management lowered long-term sales growth
expectations from high-single digits to mid-single digits.
After absorbing the downgrade in expectations, sales
growth stabilised during the 3Q17. Furthermore, some
of the competitive pressures have eased (lumber prices
have increased). Going forward, management will focus
on improved capital efficiency and execution and move
towards outlining its growth plan.
Outlook for 2017/2018
In assessing the outlook for the market, we are thinking
about a range of issues that include the global growth
outlook, the potential for inflation to raise its head, the
pressures on the consumer in Australia and the political
environment.
Global growth
Recent data continues to support the global growth
outlook. US manufacturing data has been particularly
strong with the Purchasing Managers Index (PMI)
accelerating to 57.8 in June, which is at a three-year high
and signals strong expansion. Likewise, we have seen
continued economic improvement in Europe with the PMI
at 57.4, the strongest since April 2011.
Inflation
Clearly markets have anticipated this economic
improvement to some extent, given the run in share
prices. The question we are asking is ‘When will inflation
begin to pick up in response to a tightening of capacity?’.
There is some debate in the US as to the level of
unemployment that will drive such a tightening. Wage
growth has remained stubbornly soft. An argument exists
that new technology, like robotics, and competition from
outsourcing has reduced the level that unemployment
needs to be at before it impacts wage inflation.
Nonetheless, while business confidence remains strong,
we are inextricably moving towards such a tightening and
a drive towards a pick up in bond yields. This can then
influence market valuations and portfolio positioning.
Goldman Sachs has recently noted that low interest rates
have driven the attractiveness of ‘low volatility’ stocks to
such an extent that the beta on these low volatility stocks
is now similar to high volatility stocks. This suggests
that we are better off looking at stocks with volatility for
opportunities.
Performance Report June 2017
The PE of the market is sitting in line with long-term
averages at 15.7x, but remains cheap when compared
to bond yields. Bond yields are, however, exceptionally
low. The market has been concerned with deflation
rather than inflation and should that change, bond yields
could move faster than the market is anticipating. The
question is ‘How will equities respond to a sharp move in
bond yields?’. In theory, bond yields are currently 2.66%
and we estimate that they could move to 4.6%. Equities
would still represent fair value by comparison. However,
in practice, we would expect the performance of equities
to depend on the drivers of a bond move. If it is due to
a pick up on growth, rather than an inflation shock, then
equities would perform reasonably well. However, an
inflation shock would create difficulties for certain parts
of the market like bond proxies and other low volatility
stocks.
Domestic consumer pressures
The domestic economy remains mixed. The consumer,
and consumer-exposed companies, had a difficult
two months in March and April, most likely because of
the poor weather, multiple public holidays and higher
electricity and mortgage costs. Consumer confidence
remains soft and household debt is high. In addition, we
expect housing prices to at least moderate, which creates
some risks for the domestic economy. However, at odds
to this is the fact that business confidence is strong, we
are seeing a pick up in mining activity, travel remains
strong (reflected in a recent Flight Centre Travel Group
upgrade), export sectors like agriculture and tourism
are performing well, and infrastructure projects are
accelerating. There are mixed signals for the domestic
economy, and an opportunity for judicious portfolio
positioning to add value.
The political environment
The political environment remains a long-term concern.
The last 10 years have seen slow economic growth
resulting in underemployment for the young but
educated, while low interest rates have driven up housing
prices, locking them out of asset markets. This is creating
a ripe economic environment for populists and we are
seeing surprising political outcomes as a result—Brexit,
Trump, Corbyn, Sanders. Many of the economic policy
solutions of populists are inflationary (infrastructure
spending, tax cuts) and others are anti-globalisation (antitrade). This creates risks for long-term growth rates.
Conclusion
The economic outlook appears reasonably robust.
Valuations are fair, and as a consequence the outlook for
the market appears reasonable. A range of uncertainties
overhangs the markets, particularly the political
environment. The overwhelming issue though is the
effect that the improving economic environment will have
on inflation in the next year.
Low interest rates have been a critical driver of markets,
and a major shift in this regard could cause some
destabilisation and a rotation in leading companies in the
market.
Portfolio moves
No major changes to the portfolio during June.
Performance Report June 2017
Investment philosophy
DNR Capital believes a focus on quality businesses will
enhance returns when it is combined with a thorough
valuation overlay. We seek to identify quality businesses
that are mispriced by overlaying a quality filter, referred
to as the ‘quality web’, with a strong valuation discipline.
The portfolio is high conviction and invests for the
medium term.
Investment strategy
The Australian Equities High Conviction Portfolio has
an investment style best described as ‘style neutral’.
The security selection process has a strong bottom-up
discipline and focuses on buying quality businesses at
reasonable prices. We define quality businesses as being
those with the following five attributes:
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earnings strength (particularly improving return)
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superior industry position
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a sound balance sheet
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strong management
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low environmental, social and governance (ESG) risk.
Where we are satisfied that a security possesses
quality characteristics, then it is eligible for inclusion
in the portfolio. However, it must also represent value
and sit comfortably within our portfolio construction
requirements.
A range of valuation methodologies are used depending
on the nature of the business being assessed to identify
mispriced opportunities.
The portfolio construction process is influenced by a
top-down economic appraisal and also considers the
risk characteristics of the portfolio, such as security and
sector correlations.
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
Level 22
307 Queen Street
Brisbane QLD 4000
Postal address
GPO Box 3263
Brisbane QLD 4001
Telephone
07 3229 5531
Email
[email protected]
Website
www.dnrcapital.com.au
DNRHCIR .4.04.1706