You are on page 1of 19

SelectorFundQuarterlyNewsletter# 29

In this quarterly edition we look at the macro impact on valuations, investor sentiment and retail investments. Cover shot. Retailers. Opportunity or paradigm shift?

SelectorFundsManagementLimited ACN102756347AFSL225316 Level3,66HunterStreet SydneyNSW2000Australia Tel61280903610 www.selectorfund.com.au

September2011

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

DearInvestor, The quarterly q new wsletters are our o way of ex xplaining the e investment rational that underpins the ch hoices we ma ake and the world w that we e see. We spend a considerable time articulating a ourth houghts with the aim that t our investor rs are better informed. i But at times it is i better to just cut to the cha ase. In short, our share m market is chea ap. It is perha aps dangerou us to be so blunt, , because wh hen it comes to markets, sometimes it ts the things s we dont kn now rather thanthe t thingswe eprofesstounderstandthatcantakeyoubysurpris se. Today y, there is a lot to worry about. a The US S Governmen nts finances are under co onsiderable strain n while the tw wenty seven countries c in t the European Union and the seventeen n countries opera ating under th he Euro curre ency are battling to keep things t in chec ck. Closer to home, our depen ndencyonAs siaandoursp pecificrelianc ceonChinese edemandrem mainingstrongbecomes even more paramount. Our tw wo speed eco onomy and a Government that is doin ng its level bestto t placefurtherfinancialst trainonindiv vidualsandbu usinessesisalsotakingitstoll. We have a Reserv ve Bank that appears out of touch wit th the majority of small businesses, b who are struggling with grow wing business costs and new n competit tive forces. Consumers C have learnt the art a of restrain nt, exercising g caution at the retail ch heckout. Ban nks have a moun ntain of cash to dole out but demand d is weak, wh hile housing d demand is on a steady retrea at. Yes, on the surface, the ere is a lot to o be concerne ed about, but t everything has a price and to oday, as we will w explain a little further on, investors s are bailing o out of the sto ock market 1 and running into the t relative safety of cash h, even thoug gh company v valuations and dividend yields sonofferaretradingonex xtremelyattractiveterms. Accor rding to the latest Westp pacMelbourn ne Institute consumer c sen ntiment survey, almost 40%of o consumersnowthinkth hatbankdepo ositsarethebestplaceforsavingswhilethenext best strategy s to fo ollow is paying down deb bt, followed by real estat te and finally y 7% think buyingsharesisth hewaytogo. Inthis squartersne ewsletterweexplorethisc currentphenomenoninourleadarticle eFlightto safety y but at what w cost. We W follow thi is up by revi iewing the Funds current portfolio makeup, consider the case for and against share buyba acks, explain why a compa anys most impor rtantassetisn ntevenrecordedintheac ccountsandconsider c themeritsofreta ailstocks. In a particularly challenging period which h saw world d stock mark kets suffer their worst quarterly result si ince the pea ak of the glo obal financial crisis, the F Fund delivere ed a gross performance in line with the local index, , reflecting both b the bru utal and indi iscriminate mann nerinwhichst tockshavebe eenhandled. Toallourinvestors swetrusttha atyoufindthereportinformative. Regar rds TonyScenna Corey yVincent
Select torFundsManag gementLimited d ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

Table eofContents Page1:Lettertoin nvestors Page3:Performan nceSeptembe erQuarter2011 Page3:Performan ncetablesince einception Page3:PortfolioTop T 10 Page5:Theflightto t safetybu utatwhatcos st Page10:Intangible eassetspeo ople Page12:Whencom mpanybuybacksmaysen nse Page13:Retailsec ctorontheno ose Page17:Company yvisitdiarySe eptemberQuarter2011

Select torFundsManag gementLimited d ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

PerformanceSeptember2011 For th he quarter en nding Septem mber 2011, the Fund delive ered a gross n negative retu urn of 11.07% % ascom mparedthe11.28% 1 fallintheAllOrdinariesAccumu ulationIndex. . Performancetable esinceincept tion %Returns R Fun nd% AllO Ords AllOrdsAcc Gro oss Inde ex% Index% 3months m 11 1.07 12 2.66 11.28 3ye ears 0.25 4.21 0.02 Sinc ceinceptioncompound c pa a 5.08 0. .48 4.70 Top p10Septemb ber2011* Top10June2011* Blac ckmores CampbellBrothers Cam mpbellBrothe ers Cochlear r Fligh htCentre FlightCe entre IOO OFHoldings IOOFHoldings 3 IRES SSMarketTec chnology IRESSMa arketTechnology New wsCorporatio onInc NewsCo orporationInc c ResMedInc ResMedInc. SEEK SIRTeXMedical M SIRT TeXMedical Whiteha avenCoal WhitehavenCoal WorleyP Parsons Top p10=67.69% % Top10=67.8% *Liste edinalphabet ticalorder Select torrunsahig ghconvictionindexunawarestockselec ctioninvestm mentstrategywithtypically y 1525 5 stocks chos sen for the Fund. As sh hown above, , the Funds top 10 posi itions usually y representthegrea atmajorityof f itsequityex xposure. Current and past portfolio com mposition has s histor ricallybeenveryunliketha atofyourave eragerunofthemill indexhuggerfu undmanager. Our stock s selectio on to this po oint has not included eith her retail ban nks or the la arge resource e comp panies, RIO an nd BHP. Our r goal remain ns to focus on o truly differ rentiated bro oad cap stock k select tionratherth hanthecloset tindexhuggin ngportfoliosofferedbymostlargefund dmanagers. Performanceattributionforthequarter
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

Top5stockcontributors Blac ckmores Cath hRX ResM MedInc New wsCorporationInc Woo olworths % 0.84 0.24 0.21 0.08 0.08 Top p5stockdetr ractors IRESSMarketTe echnology Flig ghtCentre BillabongInternational Coc chlear SIRT TeX % 1.28 1.27 1.22 1.11 1.10

As we e noted in ou ur opening co omments, th he past quarter was a par rticularly toug gh period for r invest tors to stoma ach. Obviously trying to make sense of events when n they extend d well beyond d the normal, make es the task so much hard der. In many y ways, our investment approach that t focuse eson theind dividual businessesrather than the broa ader macrod drivers should d cometothe e fore during d these periods, p but as a events hav ve unfolded much m of what t has taken place p has little e todowithrational lthoughtand dmoretodowith w fear. That said we have e confidence in the busin nesses that make m up the portfolio and even more e impor rtantly, the majority m of the e company balance sheets s are debt fre ee while grow wth prospects s arein nthemain,qu uitepositive.Lookingoutb beyondthecurrentmalais se,whichweacknowledge e 4 many yinvestorsare estrugglingwith, w thevalua ationsnowonofferlookhistorically h cheap. During the past qu uarter, the winners w were few but did include healt thcare busine esses, notably y comp plementarymedicinesprov viderBlackmo oresandsleepdisorderedbreathinggr roupResMed. Both businesses are in the top t ten of stocks held by the Fund and in ea ach instance, management have e set a very clear path for f continued d solid grow wth in earning gs. A smaller r position in cardia ac catheter player CathRx also adv vanced durin ng the quart ter with our r expec ctations thatcurrent negotiations with internationaloperatorsto o distributetheirproducts s islikelytobeunve eiledbytheco ompanydurin ngtheDecem mberquarter. Onthe negative side, businesse es includingIRESS,FlightCentre C and SIRTeXretreate ed along with h the general marke et despite bu usiness prosp pects remaini ing bright for r all three. In n the case of f both Billabong an nd Cochlear, the Fund to ook decisive action during the quarter following g comp pany specific events. e In ter rms of Billabo ong, we cut the Funds po osition by half f at $5.00 per r share prior to the e companys full year re esults. This proved p fortuit tous and wh hile the Fund d contin nues to hold d a smaller position, we e are review wing both th he business and industry y implic cations.Weprovide p morecommentary ylaterinthereview. r As to Cochlear, a business the e Fund has he eld since ince eption, we to ook the tough but correct t decisi ion to sell out t of our holding complete ely during Sep ptember at $6 60 per share following the e comp panys voluntarily recall of o its latest N Nucleus cochlear implant. . While the company c will updat te investors at a the forthcoming annua al general me eeting, our re eading of eve ents suggests s the lo ong term bus siness franchise is strong enough to sustain this cu urrent hit. With W the stock k now travelling t bel low $50 per share we took the decisi ion to reent ter the stock with a small positionposttheend e ofquarter.SFM Thefl lighttosafety ybutatwh hatcost?
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

Gyrations in world d financial ma arkets have investors in a spin and ma any are now retreating to o higherground.Itdoes d begthequestion q sh houldtheyha avebeenther reinthefirstplace?Unlike e y asset classes s, investing in n a business carries consid derable risk. On the flip side, as a part t many owner, a successfu ul investment t can also deliver wonderful returns. The T key as we e see it is not t to avo oid shares as s an investment but to ap ppreciate wh hat is at stake e. The notion n that capital losses s should be avoided a is ce ertainly a nob ble target to strive for bu ut far from realistic r in its s pursu uit.Whatismorecriticalishowmanyofthesebecom mepermanen ntcapitalloss ses. s an important distinction n because ge etting the tim ming wrong is s easily done and more so o This is when conditions are a as treacherous as the ey currently are. a However r, irrespective e of the price e p in a business wi ith poor inve estment qualities is a far more critical paid, avoiding a purchase ion in our opi inion. The ma arkets recent t downward path has man ny businesses s now trading g decisi at wh hat appear to t be attract tive valuation ns. In many respects, th his has made e the task of f invest ting even harder for som me. As any co ompany discla aimer will hig ghlight, past performance e provid des no indication of future e returns and d the same ca an be equally y said of a bus sinesss share e valuat tion. Today y, this has been made all the t more diff ficult with a number n of str ructural issues at play. The e 5 takeup u ofonlinetechnology, t asurgingAust traliandollarandourvaria ableeconomy yhasexposed d many y industries and traditiona al business m models. With that as a ba ack drop, sim mply buying a business because it trades on a low price to o earnings (P PER) multiple or an attractive yield is a strate egythatdoesnotsitcomfo ortablywithus. u Table e 1 highlights a growing lis st of businesses trading on o single digit t PERs and in n some cases s doubl le digit divide end yields, pe erhaps best illustrating the e current inve estment envir ronment. The e difficu ulty as we ha ave noted, is that while m many business ses are now trading t at his storically very y attrac ctive levels, th he jury is wel ll and truly ou ut when it co omes to asses ssing that in the context of f future eearnings. Long established companies c in ncluding Fairf fax Media, Pe erpetual and newer listed d players like e Harve ey Norman Ho oldings are all grappling with w their resp pective busin ness models. The adoption n of on nline technolo ogies has Fa airfaxs tradit tional print business b bad dly exposed while w Harvey y Norm man concedes s that consum mers are now w far more prudent p with h their spend ding and as a result t more inform med. Financial market op perators like Perpetual ha ave fared litt tle better, as s volatile markets and a staff dep partures have e seen investors exit the e market, the ereby placing g strain nsonfeeincomegeneratio on. Table e1.
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

Com mpany Mye er QBEInsurance Tatts sGroup Perp petual DavidJones Telst tra BillabongInternational OneS Steel Fleet twoodCorp Com mmonwealthBank B AMP P Wes stpac Harv veyNorman CSR ASX Dulu uxGroup JBHifi Wes sfarmers Challenger Fairf faxMedia BHPBilliton SharePri ice$ 2.06 12.62 2 2.19 20.97 7 2.98 3.10 3.34 1.25 11.25 5 45.16 6 3.85 20.48 8 2.14 2.35 29.85 5 2.47 15.09 9 31.61 1 4.25 0.81 34.78 8 PER(x)2011 7.9 8.3 9.8 11.6 9.3 10.9 7.1 6.5 12.2 10.9 10.3 9.7 8.7 10.0 14.9 11.6 11.2 17.3 8.3 6.7 8.7 Yield%2011 1 10.5 1 10.2 9 9.8 9 9.6 9 9.4 9 9.0 8 8.7 8 8.0 7 7.8 7 7.5 7 7.5 7 7.2 6 6.2 6 6.1 6 6.0 6 6.0 5 5.6 5 5.0 4 4.1 3 3.4 2 2.7

*Asat t29September2011 2 &rankedin ntermsofyield

Gener rally speaking g investors ca an cope with change, how wever, the eve ents of recen nt times, both h here and abroad, has shaken confidence t to the point where the r real risk may y lie in those e retrea ating to highe er ground. In most cases, t this has resul lted in a dash h for cash or other o annuity y typeinvestments. During September r the US Government sold d $US21 billio on of benchm mark 10year notes at the e lowes st yield on rec cord, at just 2%. Since the en the yields have fallen below b this lev vel, trading at t 1.72% %, while 30year bonds were yielding 2.98%. As Gr raph 1 illustr rates, US 10year y treasury y notes s having peak ked at 16% du uring the earl ly eighties have continued d their downw ward trend to o curren ntlevels. Today y, investorsarebettingtha atrateswill, at a best,rema ainatcurrent tlevelsfor the eforeseeable e future e.Inouropinion,thisisabet b fraughtw withconsidera ablecapitalrisk.Investorswhoarenow w seekin ngshelterinbond b typeinv vestmentsathistoricallylo owyieldsmay yruetheirde ecision. Equally, businesses who operat te high qualit ty operations and enjoy st trong financia al metrics will embra ace the curre ent low inter rest environm ment as an opportune o tim me to expand d and lock in n relativ velycheapfin nancecosts. Graph h1.
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

The so o called equit ty risk premiu um the price demanded by investors to buy share es rather than n bonds s is at extre eme levels. As A Table 1 illu ustrates, divid dend yields o on stocks are much higher r than bond yields as a investors have h raced fo or safety. On almost every y metric, be that PERs or r stockyieldsthema arketsarepricingintheworst. 7 Listed d financial ser rvices group Challenger, C h has cleverly played on inve estor concern ns, promoting g thesh hiftfromriski ierassetclass sesincludingsharestogua aranteedinco omeproducts s.AsGraph2 highlights, Challen ngers analysi is of the loca al superannuation market t notes that fixed income e type investments makes m up lessthan 13% ofthecurrent$1.4trillion market, while eother OECD D count tries that includes the Uni ited States, h have an avera age allocation n of 48% dedicated to this s asset class. Furthe ermore, Chall lenger argues s that this sh hift to income e products is s structural in n naturedrivenbyanageingpopulationandadesiretopro otectcapital. Graph h2.

Graph h3.
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

During the recent full year resu ults update, Challengers C organic o retail annuity sales s rose 56% to o $1.46 6 billion, drive en in large pa art by the ong going equity market m volati ility. CEO Dom minic Stevens s expec cts annuity sa ales to contin nue to grow noting that while Challe engers annuity sales have e alread dy grown by an annual co ompound rat te of 33% sin nce 2006, we e believe were still at the e early stages of a fundamental f change in th he Australian retirement s savings mark ket. To match h 8 expec cted demand we have gro own our distr ribution team m and are building our con nsumer brand d through a national l advertisingcampaign c wh hich appearsto t beresonat ting stronglywith retirees. For 2012 were ta argeting 25% retail annuit ty sales grow wth, 10% net retail book growth g and a record d$430millionliftincashearnings, e up7 7%forthelife ecompany. The shift s to annu uity type inve estments by investors is certainly un nderstandable e and in the e conte extofanagein ngpopulation n asensiblec coursetotake e. Thatsaid,a annuitiesareunderpinned d by a diversified d po ortfolio of inc come producing assets, ranging from th he most liquid, being cash h and AAA A rated sec curities, right through to B rated assets s. These asset ts are not ent tirely without t risk and investors should be mindful that in n pursuing a guaranteed g in ncome stream m the type of f assets sthatsuppor rtthepaymen ntsarewellunderstood. The surge s in annu uity sales als so highlights what investors are curre ently seeking g certainty. Unfor rtunately run nning from one asset clas ss to seek sh helter in anot ther does no ot necessarily y guaranteelongter rmsuccessor rcertainly.SF FM A200 0yearprospe ectiveontheUSmarket At extreme times in history, extreme e view ws seem to manifest m them mselves. Diverging themes s seem to pop up everywhere e and weary inv vestors are le eft none the wiser. One view v that has s recently surfaced on o the news wire (source The Australia an Septembe er 2011) is tha at of financial histor rianProfessor rSyllafromNew N YorkUniv versitysStern nSchoolofBusiness. Graph h4.
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

Thest tudyoftheUS U marketext tendsbackto1790,withtheannualret turnsdepicte edinGraph4. 9 Rathe er than a com mmentator ex xpressing a point of view, Professor Sy ylla used 10year y averages s of ann nual market returns, r inclu uding dividend ds and adjust ted for inflati ion. The data showed that t USsto ockshaverise enandfalleninsurprisingl lyconsistentwavesformo orethan200years. y Impor rtantly, when n 10year av verage annua al returns dip p below 5 p per cent and in fact turn n negat tive, as was the case in 200809, ma arkets tend to t bottom o out and begin n recovering. Simila arly when inv vestors get ov verconfident, , markets top p out when a average retur rns exceed 15 5 perce ent. His an nalysis is not suggesting that t stocks w will rise by the 6.5 per cen nt average an nnual returns s that the t historical l data would d indicate but rather that t this could be the avera age achieved. ProfessorSyallnot tedThereisalotofexces ssiveshortte ermthinkingabout a thesto ockmarket.In n the 19 980s, it look ked terrible with w those low w returns, bu ut I tell my students that wasnt w such a bad time to buy stocks. s My guess g is that even if we had h a couple e more years s of bouncing g aroun nd,2013to20 022wouldbe emuchbetter r. Apart t from the Gre eek share ma arket, other m major European markets h have yet to hit 2008 levels. That said, s the hit to t confidence e has been su ubstantial with major mark kets including g the German n and French markets down over r twenty perc cent year to date. d The 17 countries tha at may up the e Euro zone are gra appling with an issue that wont go away a that easily. As our Reserve R Bank k Gover rnor Glenn St tevens noted d, the seeds of Europes current c sover reign debt wo oes had been n sown last decade when major economies s such as Germ many and Fran nce were allo owed to flout t theEU Usbudgetary yrules. Graph h5.
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

*Asat t7September20 011

10

The fa allout from th he 2008 crisis s remains too o fresh in inve estors minds s. Today, inve estors require e both conviction an nd courage to o put those d difficulties int to some sensible context. The shift out t of ass sets classes now n deemed risky may ma ake perfect sense s but not t when fear and a panic are e the chief drivers of o such actions. As we no oted in our opening o line, investors ar re once again n runnin ng to the exit ts, seeking co omfort in gua aranteed annuity products s and cash. In n the process, comp panies that ha ave been cau ught up in th he maelstrom m of uncertainty have had d their prices s impac cted to a leve el out of prop portion to the e business do ownside. The events of 20 011 appear to o be a mini repeat of those th hat took place in 2008 and as such keeping thi ings in some e persp pectivewillpa aydividendsinthelongrun.SFM Intang gibleassetspeople People are the lif fe blood of a business b but their valu ue appears nowhere n on a companys s balance sheet. Yet t if you speak k to any succe essful busines ss person and d ask what ar re the secrets s to the eir success, si itting high on n the list are t the executive e and manage ement teams s who make it t allhappen. When n we look at the merits of f investing in n any busines ss, we consider four criter rias. In crude e terms s they include e, the busines ss, the financ cials, capital management m record and people. p Some e of the ese things can n be easily measured while others requ uire an under rstanding of what w makes a business tick. Over r the past quarter we caught up with a number of m management t teams and a comm monthemeam mongstthemore m successfulbusinesses sistheroleth hatstaffplays s.
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

Of particular note the Monadelphous Group p, WorleyPars sons, Data#3 and Flight Ce entre all have e a trac ck record of delivering lo ong term success in their respective fields. Colle ectively these e businesses employ y some 53,250 people, operate o in se ervice orienta ated fields and rely on a ied customer r to generate ongoing reve enue. Genera ally speaking business mar rgins are hard d satisfi fough htandemploy yeecoststhebusinessesla argestimpost t. Table e2. 2005 2006 2 2007 20 008 200 09 2010 2011 Mon nadelphous Sales($m) 391 532 9 959 95 54 1,123 1,275 5 1,444 EBIT T($m) 23.8 41.4 8 83.7 96 6.7 101 1.1 112.6 6 128.9 8.9 Marg gin(%) 6.1 7.8 8 8.7 10 0.1 9.0 8.8 UNP PAT($m)* 16.7 29.4 6 60.4 69 9.5 74.2 83.2 95.1 Wor rleyParsons Sales($m) 1,248 2,397 3 3,478 4,6 605 5,79 95 5,060 0 5,605 EBIT T($m) 93.8 199.6 3 319.1 48 83.5 561 1.2 373.0 0 442.7 7.9 Marg gin(%) 7.5 8.3 9 9.2 10 0.5 9.7 7.4 11 UNP PAT($m)* 62.3 140.0 2 224.8 34 43.9 390 0.5 291.1 1 398.5 Data a#3 Sales($m) 196.5 239.0 2 284.7 36 62.9 529 9.7 598.6 6 696.2 EBIT T($m) 5.7 7.8 9 9.9 12 2.1 13.4 4 15.2 20.3 2.5 2.9 Marg gin(%) 2.9 3.3 3 3.5 3.3 3 2.5 UNP PAT($m)* 4.1 5.7 7 7.2 9.1 1 9.8 10.9 15.0 Fligh htCentre 1,521 Sales($m) 871.1 973.7 1 1,122 1,4 408 1,474 1 1,633 EBIT T($m) 106.3 111.1 1 161.3 20 00.3 89.0 206.1 1 236.0 14.5 Marg gin(%) 12.2 11.4 1 14.4 14 4.2 6.0 13.6 UNP PAT($m)* 76.9 79.9 1 120.8 14 43.2 97.6 139.9 9 171.9
*UNPA AT=Underlyingnetprofitaftertax

TheFundhasanin nvestmentinallbutoneof fthese,Mona adelphous,adecisionthat twe unfortunatelyregr retinhindsigh ht.AsTable2highlights,despite d unsett tledbusinessconditions, eachhas h continued dtodeliverhigher h salesan ndgrowingprofitsoverth hepastsixyea ars.Apart fromWorleyParsons,whoissue ednewsharesaspartofanacquisitionin2006,allof o thegrowth during gthisperiodhasbeenfundedfrominte ernallygener ratedcashflows,quiteara arefeat consid deringthema assiveequityrecapitalisati ionsthattook kplacepostthe t 2008financialcrisis. Thepointwewishtomakehere eistheimportanceofhav vingalignmen nt.Inarapidly yconverging world d,alignmentof o interestiscrucial c forbuildingsuccess s.Asanexam mple,Qantasisat loggerheadswithstaff s andthelongtermdangertoboththebusinessbrandandem mployee
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

moraleisobvious.Similarly,com mpaniesthatrewardexec cutiveswithin nflatedbonus sesatthe expen nseoflongse ervingstaffislikelytoleadtoseriousdiscord.Weseekalignment tbetween execu utives,staffan ndshareholdersinanyinv vestmentwhe ereseriousco onsiderationis i given.Ifwe e canse eealignment, ,itmaynotprotect p usfrom minvestment tlossesbutfr romourexpe eriencethe chanc cesoffailurewould w havebeen b largelyr reduced.SFM M When ncompanybu uybacksmay ysense Go ba ack thirty yea ars and inves stors wouldnt be necessa arily aware of o them, fast forward and d today y, share buybacks b have become b comm mon place. While W the inte entions of a buyback are e sound d, there have e been many occasions where shareho olders have suffered s at th he hands of a poorly y thought ou ut strategy an nd sold by management as a a capital m management initiative. In n our Se eptember 20 010 quarterly newsletter titled Unders standing wha at your busine ess is worth, Warre en Buffett pi icked up on this point in n the 2009 Berkshire B Hathaway Inc. annual a report t comm mentarytoshareholders.In nonesection nheadedAnInconvenien ntTruth,Buff fettzeroedin n onthe egroupsowndistasteinissuing i shares stocomplete emergers, Char rlie and I enjo oy issuing Be erkshire stock k as much as we relish pr repping for a colonoscopy y. The re eason for our r distaste is si imple, if we w wouldnt drea am of selling Berkshire in its i entirety at t 12 the cu urrent market price, why in i the world should we se ell a significan nt part of the e company at t thesa ameinadequa atepricebyis ssuingoursto ockinamerge er? Thesa amecanbesaidofacomp panythatembarksonbuy yingbackitssharesandthe etoolsituses s to ena act it. Too oft ten,the moti ives for undertaking a buy yback are to support a sha are price that t has weakened w in value, v often with w the use of debt. On other occasio ons, management in their r wisdo om,seefittopaytopdolla arwhenflushwithcash.Id deallybuybac cksonlymake esensewhen n the shares s are tr rading well below a com mpanys intr rinsic value. While deter rmining what t constitutes a comp panys intrins sic value is a moving targe et, unless management ha ave a sensible e and clear understa anding of that value, spen nding good money m to buy more may no ot be a smart t move e. Twoexamples e high hlightingdive ergentmotive esforbuyingbackstockinclude,RioTin ntoandNews s Corpo oration a sto ock the Fund does own. In n the case of Rio Tinto, having stubbed d its toe badly y during g2008,theco ompanyemb barkedonave erydilutiveca apitalraisingduring2009at$28.29per r share.Todaywithrecordmetal lprices and asharepriceapproaching a $65.00,Riois sundertaking g a $7.0 0 billion capit tal return pro ogramme. Flu ush with cash, is this a sen nsible policy or o one driven n by ma arket pressur re? Perhaps the one redee eming feature e is the use of o cash rather r than debt in n under rtakingthebu uyback. In total contrast, News N Corpora ation has avo oided the nee ed to issue scr rip in recent times, having g learnt t from its nea ar death expe erience with bankers during the early 1990s. Rather, the group p has av voided calling g on banks fo or capital, pr referring to use u long dated public debt t, with expiry y period ds stretching out to 2096 on interest r rates averagin ng 6.8% per a annum. The higher h cost of f debtis i offsetwiththeknowledgethatthefu undscantbe epulledanyti imesoon.Atbalancedate e
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

June 2011, News Corps gross s debt stood at $US15.5 billion while its cash balance totalled d $US12 2.7 billion. In n essence, the companys net debt po osition stood at just $US2 2.8 billion but t with cash earning g next to zero in the ban nk, the comp panys cash is s providing little value to o shareholders. u Rio Tin nto, News Co orp shares ha ave barely moved m from 2 2009 levels of o $16.00 per r And unlike share, despite earnings before interest and tax (EBIT) ad dvancing from m $US3.5 billi ion to $US4.9 9 billion n over the period. Follow wing its recen nt decision to withdraw its takeover offer for the e balance of British h Sky Broadc casting Group p PLC (BSkyB B) shares outstanding, th he board has s annou unced an acceleration of its current bu uyback progr ram to $US5.0 0 billion. This s compares to o the stocks s curre ent market capitalisation c of $US43.5 5 billion. On n this score, , we believe e management are sensibly s deplo oying their ex xcess cash tobuyback sha ares trading well w below its s intrinsicvalue. Today y,companiesintheUSSta andard&Poo ors500stock kindexhaveacombined$US976 $ billion n in cas sh and shortterm investm ments on hand, the highe est level in h history. In Au ugust, 198 US S comp panies author rised buybac cks of shares s, the highes st monthly to otal since Fe ebruary 2008, puttin ng calendar 2011 2 as the th hird busiest buy b back year on record. Even Warren n Buffett who o has previously arg gued against buybacks, as motivated by managem ment to pum mp or support t 13 the st tock price, announced las st month its i intention to repurchase r sh hares in his own o Berkshire e Hatha away,butonlyuptoavalu uationoftenpercentaboutitsstatedb bookvalue. When n done for th he right financial and com mmercial reasons, buybac cks are a sens sible strategy y for sh hareholders who w remain on o board, as t they end up enjoying a larger proportional stake in n theco ompanysfutu ureearnings.SFM Retail lstocksonth henose Everyonelovesabargain b itseem ms,butnotw whenthebarg gainisthebusiness.Weha avebeentold d thatour o loveaffair rforshopping g isonthewa ane.Consumershavebecomeprudent t,preparedto o savemore m andasaresultspend dless.Graph5appearstoconfirmthistrend. Tracked back to 1999, 1 the rela ationship bet tween consumer income and spending has flipped d aroun nd since 2009 9,withconsum mers now far r morecautio ous intheir ha abits. The inte ernet andthe e takeup u ofonlinetrading t has be eentargeted as anobviou us reason for theslowdow wn,alongwith h a grow wing nervous sness among consumers t that things may m just get a whole lot to ougher in the e period d ahead. Des spite the Rese erve Bank of Australia telling us that an economic boom b is upon n us,itseems s thatco onsumersare entprepared dtobankthat tjustyet.
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

Graph h5.

Our ta ake on things s is that the discretionary d dollar has be een whittled away from th he consumer, 14 as rising living cos sts places further strain on o family bu udgets. So wh hile the char rt above may y indica ate a rising savings s ratio, we think it reflects mo oney being s set aside to meet future e comm mitments. Obv viously a pos sitive byprod duct is a prop pensity for co onsumers to pay p for goods s now rather r than using u credit or o delaying th he purchase altogether. a Ta able 3 outlines some well knowretailersand dsomefinanc cialmetricsth hattellastory y. Table e3. Share Ma arket NPAT Net Fix xed FreeCa ash PER Yield Y Buyout t
Myer DavidJones Kathm mandu Billabong Oroto onGroup Super rRetailGroup TheRejectShop Price $ 2.06 2.98 1.75 3.34 7.80 5.97 9.37 Cap C $ $m 1, ,177 1, ,460 440 4 825 8 319 3 776 7 246 2 FY11 $m 159.6 168.1 39.1 119.1 24.8 55.6 16.2 Debt $m 382 120 42.9 468 9.2 73.5 39.3 Cover Rat tio* 2.0 2.3 2.5 2.1 2.7 1.8 1.4 Flow w $m** * 66.4 101.0 0 27.9 242.6 6 17.1 24.5 1.0 2011 2011 2 (x) (%) 7.9 10.4 9.3 9.4 11.3 4.5 7.1 8.7 12.9 6.4 14.0 4.9 13.6 3.3 (%)*** * 16.7 15.6 13.1 12.1 11.0 10.3 10.1

TableRa ankedinorderofBuyoutratio *Fixedcoverratio=earningsbeforeintere est,tax,operatingleases/netintere estexpense+operatingleasepayments atingcashflowcapital c expenditure **Freecashflow=Opera yout=earningsbe eforeinterest,tax/marketcapitalisa ation+debtcash h ***Buy

But the numbers alone do no ot tell the fu ull story. Sim mply comparing the PER or yield of a comp pany may lea ad the investor to form a potentially wrong view of a busine ess. From our r vantage point,the e traditional department d st tore retailers s David Jones and Myer ap ppear to be in n
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

a wor rld of pain ri ight now, wh hile the smal ller niche op perating chain ns look to be e faring a lot t better. In many ways w the com mments from OrotonGroup CEO Sally Macdonald really hits the e markforus; Not all retail sho ould be pain nted with the e same brush h. We are not finding co onditions any y tough herthantheyhavebeen fo orthepastth hree years.Za araandApple earealsodoin nggreat.You u canno ot go to mark ket with the same things you did five years ago an nd expect to gain traction n with consumers. c You Y have to change and m move on. We are always lo ooking at what we can do o better r The point p is valid but also hig ghlights that retailers are subject to f fashion trend ds. The larger r depar rtment store es are aimin ng to avoid playing the fashion sta akes by prov viding an all encom mpassing reta ail offer, but t in trying to be all things to all shop ppers they ru un the risk of f remai ining relevan nt only on price. In stark contrast, ope erators like O OrotonGroup p, Kathmandu u andBillabong B have ehitchedtheirwagontos specificprodu uctofferings.Theytellast toryandbuild d a bran nd around the image they y create. The strategy isnt t full proof but the chance es of creating g longterm t brandlo oyaltymakesalotmorese ensethanthedepartmentstoreoffering g. Over the past month a numbe er of these businesses hav ve announce ed their profit t results with h 15 mixed d success. Th he larger players, Myer a and David Jo ones reported d disappointi ing sales and d profit t numbers, while Kathman ndu in particu ular, delivered d both strong g top line and d bottom line e growt th. Theco ompanysfoc cusonprovidingoutdoorapparel a andequipment e at taffordableprices p looksto o be a winning form mula. The gr roup now op perates 111 stores throug ghout Austra alia and New w Zealan nd, with grou up sales of NZ$306 million n, earnings before b interes st and tax (EB BIT) of NZ$64 4 million and a botto om line profit t of NZ$39.1 million up fro om NZ$25.2 m million during g 2010. In the e nearterm, t manage ementistarg geting150sto ores,whileaim mingtoliftAu ustraliansalespenetration n toasimilarlevelto othatachieve edinNewZea aland. This would w appear r to be a tall order considering the ext traordinary lo ocal success the t group has s achiev ved to date, , as reflected d in the foll lowing numb bers. During 2010, Kathm mandus New w Zealan nd store foot tprint achieved sales of $NZ94.3 $ millio on, equivalen nt to NZ$23.4 41 per capita a popul lation.Incontrast,Australianoperation nsdeliveredNZ$142 N millio on in sales,or rNZ$6.86per r capita a population. Even a parti ial success of f this strategy y would back k managemen nts view that t sales could lift by over NZ$100 0 million und der the existi ing store footprint, a rise of over 70% % fromitscurrentAu ustraliansales sbase. The Kathmandu K investment sto ory is a very g good one. Sim milarly the Or rotonGroup has h defied the e retail downturn, with w sales up 12% to $164 million and EBIT E rising 14 4% to $36.5 million m for the e 2011 year. With management t continuing to invest in new stores both locally and in Asia, invest tors should measure m the groups ong going success s in years no ot months. That T said, the e Oroto onbrandenjo oysexcellentmarketprese ence,ledbyanexperience edmanageme entteamwith h CEOMacdonald M at tthehelm.
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

While ewe aresupp portiveofreta ailbusinesses sthatcanbui ildbrandwhi ilemaintainin ngintellectual prope erty ownership, there is th he risk that a brand fades s. Think of Co olorado, Brashs and Harris s Scarfe e to name bu ut a few. In most cases, d debt plays a large part in n the demise of any retail chain. In Table 3 we w highlight debt in two forms. There e is the straig ght forward bank debt as s depict ted in the ne et debt colum mn, a term m most investo ors would be familiar with h. An equally y impor rtant number r is the fixed d cover ratio. . This ratio co onsiders how w many times s the groups s annua al operating leases or rent tal payments s are covered by group earnings. In retail, a number r greate er than two would be pre eferred altho ough there ar re times whe en oneoff ev vents, like the e Queenslandfloods s,candistortthenumbersaswasthecaseforTheReject R Shop. For Bi illabong Inter rnational, a very low PER o of 7.1 and a highly h attract tive dividend yield of 8.7% % also fails f to tell the full story. The T groups transition t from a pure wh holesale provi ider of action n sports s to a more vertically v inte egrated mode el that includes retail own nership has most m investors s asking gwhetherthe emodelwillwork. w It is a little too ear rly to answer r that questio on but the debt the compa any has taken n on board to o fulfil its strategy and a the tough retail cond ditions in bot th the local a and US market, has made e things s a little tigh ht for our likening. The share price has virtually y halved sinc ce the group p annou unced a disa appointing se et of earning gs numbers in early Augu ust, with the e shares now w 16 tradin ngatclosetoanalltimelo owfollowingi itslistingin2000. As an n overview, th he strength of o the Austra alian dollar ha as arguably h highlighted th he local retail sector to offshore e players. At t the same t time, the acc ceptance of the t internet as a tool to o purch hase goods has h bought these offshor re players clo oser to the consumers. So while the e consu umer may be e suffering fr rom a short term dip in demand, int ternational co ompetition is s increa asingly arrivin ng into the sector, s typifie ed by the Sy ydney retail launch of Spa anish fashion n group p ZARA Intern national during the past quarter. As such, s these developments d s suggest the e issues sfacingthere etailsectorar reasmuchst tructuralascy yclical. While ewehaveonl lytouchedon nafewissues s,thetoughprevailing p con nditionsinret tailarehaving g theireffect e oninve estorexpecta ations.Withr retailsharepr ricesdownan ndyieldsonthe t rise,most t would d agree thatvalue v is onof ffer.Forourp part, theFund dhas asmall holding inBillabongbutif f tempt ted our inte erest would certainly lie e in considering the spe ecialty retailers including g Oroto onGroup and Kathmandu in particular, , while giving g the bigger department d stores s a wide e berth.SFM
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

Comp panyvisitdiar rySeptemberQuarter201 11 July n n/a Cost tcositevisit P PXS Phar rmaxisQ4con nferencecall D DTL Data a#3managem mentmeeting g O ORG OriginEnergycon nferencecall Augus st N NVT Navi itasFY11resu ultspresentat tionconferen ncecall n n/a JimRodgers R hard d&softcomm moditiesprese entation R ResM RMD MedFY11res sultspresenta ation F FXL Flexi igroupFY11results r presen ntation C COH Coch hlearFY11res sultspresenta ation C COF CoffeyInternationalFY11resu ultspresentat tion C CPU Com mputershareFY11 F resultspresentation p conference c ca all N New NWS wsCorpFY11results r presen ntationconfe erencecall T TLS Telst traFY11resultspresentationconferenc cecall P PXS Phar rmaxismanag gementmeet ting C CRZ Cars sales.comFY1 11resultspresentationcon nferencecall C CSL CSLFY11resultspresentation p conferencecall c B BKL BlackmoresFY11resultsprese entationconferencecall R REA REAGroupFY11results r presen ntationconfe erencecall B BBG BillabongInternationalFY11re esultspresen ntationconfer rencecall P PTM Plati inumAssetManagement M F FY11resultspresentation p D DTL Data a#3FY11resu ultspresentat tionconferencecall O ORG OriginEnergyFY1 11resultspre esentation S SEK SEEK KFY11results spresentation nconferencecall F FLT Fligh htCentreFY11resultspres sentationcon nferencecall M Mon MND nadelphousGroup G FY11re esultspresent tationconfere encecall W Wor WOR rleyParsonsFY Y11resultspr resentationconference c ca all IRE IRESSMarketTec chnologiesFY Y11resultspre esentation M MAP MAp pGroupFY11resultsprese entationconf ferencecall C CWN Crow wnFY11resultspresentati ionconferenc cecall P PPT Perp petualFY11re esultspresentationconfer rencecall W WOW Woo olworthsSitevisitFY11FY1 11resultspresentation B BKL Blackmoresmana agementmee eting IOOF IFL FresultsFY11 1resultspresentationconf ferencecall B BBG BillabongInternationalmanag gementmeeting Septe ember C CBP Carb bonPolymersmanagemen ntmeeting P PXS Phar rmaxissitevis sit U UBI Univ versalBiosens sorsmanagem mentmeeting g
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au

05 5/07/11 21 1/07/11 22 2/07/11 28 8/07/11

02 2/08/11 03 3/08/11 05 5/08/11 08 8/08/11 09 9/08/11 10 0/08/11 10 0/08/11 11 1/08/11 11 1/08/11 12 2/08/11 16 6/08/11 17 7/08/11 18 8/08/11 18/08/11 19 9/08/11 19 9/08/11 22 2/08/11 23 3/08/11 23 3/08/11 23 3/08/11 23 3/08/11 24 4/08/11 25 5/08/11 25 5/08/11 25 5/08/11 26 6/08/11 26 6/08/11 26 6/08/11 26 6/08/11 31 1/08/11

17

01 1/09/11 02 2/09/11 06 6/09/11

Septem mber2011SelectorAustralianEq quitiesFundQuarterlyNewslett ter#27

WCB W D DTL IRE C COH K KMD C CXD K KZL B BKL WarrnamboolCheese&Butte erFactoryFY1 11resultspre esentation 06 6/09/11 Data a#3managem mentmeeting g 07 7/09/11 IRESSMarketTec chnologyman nagementme eeting 12 2/09/11 Coch hlearproduct trecallconfer rencecall 12 2/09/11 Kath hmanduFY11resultsprese entationconf ferencecall 21 1/09/11 Cath hRxmanagem mentmeeting 21 1/09/11 Kaga arastrategyday d conferenc cecall 21 1/09/11 Brick kworksFY11resultspresentation 22 2/09/11

18

Select torFundsMa anagementLi imitedDiscla aimer The in nformation contained in this t documen nt is general information only. This document d has s not been b prepared taking in nto account any particu ular Investor s or class of Investors invest tmentobjectives,financialsituationorneeds. TheDirectors D andourassociate estakenores sponsibilityfo orerrororom mission;howe everallcareis s takeninpreparingthisdocume ent. The Directors D and d our associa ates may hold units in th he fund and may hold investments in n individualcompaniesmentione edinthisdocu ument.SFM
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au