Dear Investor,: June 20 011 Selector Qu Arterly Newslett Ter #32

June20 011SelectorQuarterlyNewslett ter#32
DearInvestor, In a recent r Austra alian Financia al Review interview, successful US inv vestor Charles Brandes, who started his in nvestment fu und managem ment busines ss, Brandes I Investment Partners P in oesnt invest in the share emarket; he invests in 1974, noted that when he invests, he do omeone would see the nee ed to make such a clear businesses. It may sound rather odd that so toryisverymuch m onhissid de. distinctionbuthist It is rather r appropriate that when w confron nted with the big global issues facing g investors today y; China, the US U economy, Europes debt woes and sovereign ris sk, he offers So, whats new? Hecontinue esTheresno othingnewg goingon...theissuesofemployment,inf flation,are all pretty much th he same wor rries we alwa ays have. I th hink its a go ood thing inv vestors are erned about something. s To T me, its more of a wor rry if investor rs arent wor rried. Then conce thereissomething gtoreallyworryabout,aseveryonethi inksthereisblue b skyandno n onecan losemoney. m Itmay ynotbenew, ,howeverinv vestorsareclearlyworried d.Globalmarketsareonce eagainina spin and a investors are rattled about a the fallo out from wha at may or ma ay not eventu uate. These are difficult d times s, however staying s focus sed on busin nesses rather than mark kets makes perfec ctsenseandsomethingwe w haveconsis stentlyspoke enaboutinpa astnewsletters.Suchan appro oach doesnt t suggest av voiding the issues i but rather contro olling someth hing more impor rtant,aninve estorsemotio ontodosome ething. As Bra andes notes, I try not to o look at Wall Street, I dont want to invest in shar res. I dont care what w shares on o the Dow do d each day. I want to inv vest in busine esses. Busine esses that I under rstandandth hinkwilldowell.Thatway, ,Iamnotgoingtogetsha akenoutorne ervousand emotional when th he price falls from $38 to $15. Because e I really know w the manage ement and whattheyaredoin ng,Iwillbein napositionto ounderstandwhytheyhav vefallen,whattheyare g and will the en decide to buy more as s I wont be feeling emotional about the fall in doing price. In this quarters newsletter n we e review the e local bankin ng sector and d cast an eye e over the burge eoning energ gy market. Both B are und dergoing sign nificant chang ge and the long term conse equences are uncertain. In I addition w we focus on the Funds current portfolio makeup andwhy w we are co onfident on their business s prospects. For F the 2011 f financial year r, the Fund record ded a 2.6% positive p gain despite a pa articularly dif fficult last qu uarter, where e the index record ded a decline e of 4.8%. Wh hile the first half gains we ere eroded, the Funds pe erformance sincethefinancialcrisisin2008 8,ofapositiv ve3.4%grosscompoundannual a returncompared tothe eindexreturn nofanegativ ve0.2%overt thesameperiodisneverth helessverypl leasing. We ex xtent our bes st wishes to all a our investors and trust t that you enj joy this latest quarterly report. 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

June20 011SelectorQuarterlyNewslett ter#32
Table eofContents Page1:Lettertoin nvestors Page3:June2011 1 Page4: 4 PortfolioTop T 10 Page5:Bankingsto ocks Page10:Energyse ector pfortheRese erveBankofAustralia A Page13:TimesUp Page14:Company yvisitdiaryJu uneQuarter2011 2
Select torFundsManag gementLimited d ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au
June20 011SelectorFun ndQuarterlyNewsletter#32
June2011 2 In a similar s vein to o Brandes, we w focus our attention on n the busines sses and the management t teams s who run them. As our to op 10 business holdings highlight, h they y represent a collection of f comp panies operating in all face ets of industr ry. Important tly they have a few things s in common, which hmakesusve erycomfortab bleinowningthem. Firstly y, many operate as either leaders in th heir industry or enjoy a co ost competitive advantage e over rivals. r Second dly, managem ment have be een instrumen ntal in their s success either as founders s of the e business or r as key exec cutives, wher re remunerat tion is largely y linked to th he companys s success. ly, the financ cials and the track record d delivered thus far sugg gests they have a winning g Thirdl formu ula, largely built b around organic grow wth and augmented with h complemen ntary bolt on n acquis sitions. f they understand th hat the owners of the bus siness are ind deed the shareholders. As s And finally such they t run cons servative balance sheets and a are prudent with thei ir capital spending. During g the 20 008 financial crisis, none of o these businesses neede ed to raise ne ew capital to survive, thus s avoiding the painful dilutive pe eriod that affe ected so many other listed d companies. In fact, six of f the to op ten busin nesses held, hold healthy y cash balanc ces, undersco oring the str rength of the e business. While e these are all wonder rful business s traits, the ey dont protect agains st failure or r disapp pointments. Understanding what ma akes a busine ess worth what w it is and d having the e confid dence to hold d on when th he world is unsteady u is in n short not an easy thing to do but an n impor rtantdisciplin neallinvestor rsshouldstriv vefor. As Table 1 illustrat tes, the majo ority of these businesses are reporting solid profit numbers, with h one year y forward d estimates guiding to reasonable earnings gro owth, undem manding PER R multip ples and att tractive divid dend yields. Importantly y, the returns generated d on capital emplo oyedarehigh handmanage ementhavesteeredthebu usinessespru udentlyinthe epastandour r expec ctationsareth hatthiswillcontinuefortheforeseeab blefuture.
Marke et sentiment is extremely y cautious at t the present time t and mac cro events, be they China, Greec ce or ongoing g commentar ry from our Reserve Bank surrounding local intere est rates, are e collec ctively having g a direct and d powerful im mpact on investor confide ence. While these t periods s create ewonderfulbuying b oppor rtunities,they yalsorequire enervesofste eelandabala ancedviewof f theworld. w During the June quarter, q the Funds large exposure to healthcare r related busin nesses took a share price hit with investors concerned abo out the impact the rising A Australian cu urrency would d haveon profitsand in the caseofPharmaxis s, theunexpe ectednegativ vevotefromthe t European n
Selecto orFundsManag gementLimited ACN102756347AFSL225316 3 66HunterStr reetSydneyNSW W2000,Australi ia Level3, Teleph hone61280903610 3 Webwww w.selectorfund.co om.au
Medic cines Agency (EMA) regar rding the com mpanys mark keting applica ation for its flagship f cystic c fibros sis drug Bronc chitol. While we had expe ected a positiv ve decision, we w were also o mindful that t regula atory bodies are conserv vative in nat ture and additional reas ssurance may y have been n requir red before any final Euro opean approv val was grant ted. As such we reduced our portfolio o position by some 60% 6 prior to the EMA dec cision at around the $3.00 0 share price mark m thereby y substa antiallyprote ectingourdow wnside. Table e1:Top10Ho oldings
Financ cialScreen Busine ess Earnings 2010(a) NPAT$m 24.3 155.2 139.9 79.3 57.2 2,770.0 190.1 11.3 55.1 291.1 Ea arnings 2011(e) 2 NP PAT$m 26.4 180.6 170.6 110.0 62.0 3 3,354.3 212.4 7.8 18.2 351.2 Earnings Valuatio on 2012 2(e) NPAT T$m 28 8.7 220 0.6 186 6.9 118 8.0 69 9.2 3,87 79.6 251 1.8 13.0 184 4.3 421 1.7 2012(e) PER 15.3 17.6 10.9 11.9 16.1 11.8 17.8 21.3 14.6 16.2 Valuation DivYield % 5.0 4.2 4.6 8.0 5.5 1.2 1.4 3.4 3.8 Financial Leverage NetDebt (cash) $M 26.0 17.3 (83.9) (123.4) (143.5) 4,611.0 (551.8) (41.4) (49.8) 533.0 ROCE ROCE % 38 43 33 16 221 13.0 22 79 9 17 Share Price 2011 % Move +21.4 1.3 +35.8 +13.0 +7.8 +30.0 19.9 +2.5 +25.1 +33.2
Blackm mores Cochle ear FlightCentre IOOFHoldings IRESS NewsCorporation ResMed Sirtex xMedical White ehavenCoal Worle eyParsons
The Fund F continues to hold Pharmaxis P in the portfolio o and having g examined the t reasoning g behindthenegativ vevote,we re emainconfidentthatthecompany has s an extremel lystrongcase e to add dress the EMAs concerns, which does not to exten nd to any safe ety concerns regarding the e drug,butmorearo oundhowtointerpretthetrialdatares sults. Under the appeal process that t is currently under way, Pharmaxis w will resubmit its reasoning g for ap pproval to a separate body the Scientific Adviso ory Group allowing for r experienced d clinicians to exami ine and repor rt back to the e central body y of the EMA A. A final decis sion from the e regula ators is expected in October 2011 and d assuming a positive rec commendatio on, Pharmaxis s would d be open to o sell Bronch hitol througho out the 27 countries c that comprise the t European n marke et, thus joining Australia a, which was s granted ma arketing approval by the e Therapeutic c GoodsAdministrat tioninFebrua arythisyear. At the e current sha are price of $0.93, $ it is o our intention to increase our Funds holding h in the e comp pany as we consider the share price s sell off over done and th he companys s strong data a profile ecompelling. .SFM
Banki ingprofile Banki ingbackdrop p In this review we take a look at the bankin ng scene in this t country and ask whe ether investor r expec ctations need d to be recalibrated. While e the Fund has never held d an investm ment in any of f there etailbanks,th hereasonsfo orthishaveva ariedoverthe eyears.Ourreluctance r to oinvestinthis s sector initially cen ntred on the multitude of better inve estment oppo ortunities ava ailable at the e time. However in more recent t years our re easoning to avoid a this sector has firm med, primarily y due to o a string of industry conc cerns. In isola ation these tr rends may no ot manifest in nto much but t collec ctively they ha ave the potential to cause e considerable heartburn e even for themost vocal of f suppo orter. Overthe t pastfour rdecadesthebankingland dscapehasch hangedconsid derably.Below wweprovide e our own o snapshot t on how the banking world has cha anged and ho ow this has damaged d the e businessmoatund derpinningthetraditionalbankingfranc chise. 1970 s During the 1970s and perhaps s going back decades bef fore, banking was conside ered a special relatio onship betwe een a banker and his custo omers. In ord der to obtain credit, custo omers needed d to show complete e loyalty stre etching over considerable e years. If an nd only if yo ou met these e hurdle es were you u then considered for a loan, accompanied by all manner of personal guarantees. With such s a captiv ve audience, banks were able a to explo oit the relationship as only y banke ersdo. Inban nkingcircles,theterm spreadrefersto othedifferenc cebetweent thelevel ofin nterestit pays s for de eposits and other o sources s of funds, an nd the level of interest it t charges its borrowers. It t should not come as a any surpri ise that in ke eeping deposit rates low and a borrowin ng rates high, banks s enjoyed ver ry attractive spreads. s Also known as ne et interest ma argins, they sat s above 4%, illustr rating how pr rofitable the banking business could be e and how w wide and deep p the banking g moathadbecome. 1980 s If the ere was a decade of chan nge for the banks b it prob bably was the e 1980s. In fact it was a tumultuous time all a round. Th he HawkeKea ating Labor Government G set off a ser ries of events s follow wing their ele ection victory y in 1983. In December 1983, the Aus stralian dollar r was floated d allowingthecurrencytofindits sownlevel.T Thiswasfollow wedbytheis ssuingofforty ynewforeign n excha ange licences and thereaft ter sixteen new banking licences in 19 985. With a string s of new w comp petitors,bankswereforced dtocompeteforcustomersandnewbusinessdeals s. Dereg gulation was sold as a po ositive develo opment and in i theory it m made sense, however the e back half of the de ecade highlighted some disturbing realities that oft ten accompan ny new levels s ofcom mpetitionla axlendingpra actices.Thet termnegative epledge(unsecuredlendin ng)soontook k onne ewmeaningand a itsimpact twasfeltwith hthecollapse eofproperty ygiantHookerCorporation n in198 89owingcred ditors,whowere w mainlyth hebanks,ove er$1.8billion.
BankStatistics* Share ePrice($)8June e2011 CashNPAT(SM) 2010 2011(e) 2012(e) NetIn nterestMargins s(%) 2010 2011(e) 2012(e) Costto t IncomeRatio o(%) 2010 2011(e) 2012(e) Retur rnonEquity(%) ) 2010 2011(e) 2012(e) CoreTier1 2010 2011(e) 2012(e) CashEPS() 2010 2011(e) 2012(e) Dividend() 2010 2011(e) 2012(e) PER(x) 2010 2011(e) 2012(e) DividendYield(%) 2010 2011(e) 2012(e) PricetoBankBookValue V (x) 2010 2011(e) ANZ 21.14 5,024 5,623 6,067 2.46 2.45 2.35 45.5 45.5 45.6 15.5 16.4 16.4 8.04 8.68 9.11 194 212 226 126 139 146 10.9 10.0 9.4 6.0 6.6 6.9 1.6 1.5 CBA 49.25 6,101 6,848 7,318 2.10 2.14 2.13 45.0 45.0 44.3 18.7 19.7 19.6 6.86 7.58 8.13 380 421 441 290 319 336 13.0 11.7 11.2 5.9 6.5 6.8 2.2 2.2 NAB N 24 4.17 4, ,581 5, ,404 5, ,835 2.25 2.21 2.13 45.4 45.4 44 4.9 13.5 14 4.9 14 4.9 6.80 7.30 7.88 213 24 47 262 152 173 186 11.3 9.8 9.2 6.3 7.2 7.7 1.5 1.5 WBC W 21 1.60 5,8 879 6,3 308 6,5 566 2.2 22 2.19 2.16 41 1.1 41 1.1 40 0.2 16 6.2 16 6.0 15 5.6 7.5 50 8.2 26 8.9 90 19 92 20 03 20 09 13 39 15 55 16 65 11 1.3 10 0.6 10 0.3 6.4 4 7.2 2 7.6 6 1.8 8 1.6 6 Combined C 2 21,585 2 24,184 2 25,787 2 2.26 2 2.25 2 2.19 4 44.2 4 44.2 4 43.7 1 16.2 1 17.0 1 16.8 7 7.26 7 7.91 8 8.46
2012 2(e)
*Sourc ce UBS
1.4
2.1
1.4
1.5
1990 s The aftermath of the t 1987 share market crash impacted d business an nd banks in general. While e thelo ocalpropertymarkettookoffimmediat tely afterthecrash, itwas sshortlivedand a itandthe e rest of o the econo omy hit the skids in the early part of o 1990, lead ding Treasure er Keating in n Novem mber 1990 to o now famou usly remark th hat Australia was in a recession that Australia A had d to ha ave. The co onsequences of such were felt deep p and wide, leading to a number of f bankr ruptciesthatalmostinclud dedoneofthe emajorfourbanks,Westp pac.
In 199 92, the bank k recorded a $1.6 billion loss, which was w the largest loss for an a Australian n corpo oration, dismissed staff an nd raided its s own supera annuation fun nd to sustain n its viability. Havin ng come close e to insolven ncy, the bank k survived with an injecti ion of new capital c before e under rtaking a series of acquisit tion that now w has it place ed as the num mber two ban nk in terms of f marke etcapitalisati ion. Westp pacs near death experie ence was a m massive wak ke up call to banks and regulators in n gener ral. Lessons that t had bee en forgotten were soon remembered d as the banking industry y redisc covered new w ways of ma aking money y. While com mpetition was s still pronou unced, banks s focuse ed on buildin ng profits on two fronts, by cutting co osts and liftin ng charges. Su uch has been n the banks success s on this fron nt, that they now boast on o average op perating marg gins of about t ( a costs s to income ratio average e of 45%), an nd non inter rest income (measured ( as s 55% (with incom me other than n interest inco ome) now making upward ds of 25% of the banks to otal operating g incom me. So despite e the slip ear rly in the dec cade, banks quickly q regrouped, benefit tting from an n extendedperiodofstrongcreditgrowthand dunderpinnedbyabuoyanthousingmarket. m 2000 s Havin ngfendedoffthecrisisofthe t previous decade, bank ks embarked on driving gr rowth,fuelled d by str rong credit de emand. To meet m the need ds of the mar rket and com mpete effectiv vely with new w entrants, the bank ks saw the ne eed to ramp up u its own ba alance sheet l leverage ther reby reducing g its need to raise more m equity. From F a regula ators point of view, maint taining such strict s levels of f capita al, defined as s Tier 1 and Tier T 2 capital, measures th he banks fina ancial strengt th and is held d to pro otect against t unexpected losses. Hold ding a buffer r for a rainy day makes perfect p sense, howeverifthepas stisanyguide etothefutur re,whenthing gsdogetnastytherejustdoesntseem m tobeenoughcapit talinreservetomeetallth hedudloanswritten. Unfor rtunatelyevents sincethestartofthis decadetypify yhowexpose edbanks and investorsare e when the econom mic climate ch hanges for th he worse. The explosive u use of offsho ore wholesale e fundin ng that fuelle ed more secu uritisation lending accomp panied by a drop in the ris sk capital that t banks s needed to hold h against residential r mortgage loans, benefited t them handso omely as they y delive ered higher profits with lower levels s of capital employed. It is little wo onder banks reported returnsof o capital emp ployed in excess of 20% an nd indulged in paying the vast majority y tosha areholdersvia afullyfranked ddividends. The events e post the t 2008 fina ancial crisis highlight how w exposed b banks are wh hen things go o wrong g. As it turned out, things went horribl ly wrong and while our ba anks have rep portedly done e very well w in comp parison to ou ur offshore competitors, c the scrabble e to raise ad dditional new w capita al saw the banks underta ake massive raisings with h commensurate earnings s dilution for r shareholders who chose not to o participate. The lessons s for investors unfortunate ely are that a banks s business model is one of o leverage, b both on the up, when supe er profits are e on offer and d onthe edown,whenwriteoffsoccur o enmass se.
Andnow n Bank bashing has become a po opular sport a among politic cians, regulators, financial analysts and d disgru untledcustom mers.Howeve erifthetruthbeenknown n,thegloryda aysofstrongcreditgrowth h andla axregulatorysupervisionis i offtherada arforthenea artermatlea ast.Sowheredothebanks s gofro omhere? The Australian A Financial Review w due diligen nce article dat ted 30 May 2011 2 is repro oduced below w asitpinpoints, p inour o opinionth hecentralissuefacingthebankingsect tor,thatofho ousing. Bank ksfeelthechillwindofho ousingAus stralianFinan ncialReview3 30May2011 a their mind dboggling co omplexity, ba anks are large ely a play on n house price es. During the e For all pasttwo t decades,housepriceshaverisenan ndsohasthe esizeofmortg gages.Aspeo oplegetmore e equity y in their hom mes they feel richer and sp pend more on n their credit c cards. This ha as made for a briskturnover t ofeverlargermo ortgages.Ten nyearsagope eoplestayedintheirmort tgagedhouse, , onav verage,forsev ven years.No ow itsjustov ver four years s.Houseprice esarenoweit ther fallingor r going gnowhere.Th heeffectonAustraliasban nkswillbepro ofound. Asoneseniorbank kerexplains,when w mortga agecreditgrowthwasrunn ningat15per rcent,abank k could get 10 per cent revenue growth g even n if you werent any good. You just had d to be in the e marke et. Suddenly we hit a wal ll about two years ago. Youre Y not getting the ear rnings growth h anymore and its really only coming thro ough now, he h says.It d does change a lot of the e assum mptionsabouthowyouma akemoneyinbanking. There ehasbeenalotof focuson nthetepidst tateofthebu usinesscreditmarket,buthousing h isthe e biggerworry.Hous singcreditisgrowingatit tsslowestpac cein30years s.Themostre ecentReserve e Bank of Australia figures f show total mortga age credit gre ew by 6.6 per r cent in the 12 months to o March h. In the deca ade and a ha alf between the t early 1990s recession and the fina ancial crisis, it t grewbetween10per p centand20 2 percenteveryyear. More than any oth her factor a series s of hous sing booms is s what has fuelled the growth in banks profit ts. Mortgages s are banks single bigge est asset clas ss (including mortgages offshore o they y make up 65 per ce ent of total assets a at Com mmonwealth Bank B and We estpac, 55 per r cent at ANZ Z and 50 5 per cent at t National Au ustralia Bank). They are als so more profi fitable than any other type e of loa an. The avera age margin on n a mortgage e for a big fo our bank is a neat 1 per ce ent. For smal ll andmedium m busin ness loansthe emarginishig gher,about2.15 2 percent, ,butsoareth heloan losses s and th he capital tha at must be held. The reta ail arms of ba anks typically deliver a return on equity y (ROE) )of25percen ntbutthebus sinesslending gdivisionsdeliver18percent. Some simple num mbers illustra ate the pickle the banks are in. Acc cording to th he Australian n Prude ential Regulation Authorit ty, there was s just over a $trillion of mortgages sitting s in the e banki ing sector in March. Grow wth at 6.6 per p cent mea ans $66 billio on more mor rtgages in 12 2 month hs. Applyinga one percentage point ne et interest ma argin the dif ifference betw ween the rate e atwh hichabankbo orrowsmoney yandlendsit tmeansthe eentirebanki ingsectorcan nexpect$660 0
million in addition nal revenue in n the next 12 2 months from m mortgages s. If housing credit c growth h was running r at 15 5 per cent, as s it did for mo ost of the las st two decade es, the additi ional revenue e would d be $1.5 billion. Thats ju ust under $90 00 million tha at is no longe er trickling into the banks, , andmost m ofitwou uldhavegone estraighttothebanksbot ttomline. There e is no way an n increase in business lend ding will plug g the gap. Fir rst, there are less business s loans around, abo out $800 billion in total. S Secondly, the e rosiest pred dictions of bu usiness credit, t, such as a those ofNABs NA econom mist, have busi iness creditgrowing g in line e with housin ng, not faster r. The la ack of new cu ustomers is se ending many assumptions s on how to m make money from f banking g out th hewindow.One O of themis s howbankst treateachothersexisting gcustomerba ase, knownas s the ba ank book. Mortgage exit fees coupled d with similar r rates meant t customers rarely r moved d. The bank b book wa as sacrosanct. But banks desperate fo or new customers, especia ally NAB, are e going goutonpoach hingraids. If you ure a Westpa ac customer paying p 7.16 per cent on yo our variable mortgage m (allo owing for the e 0.7 of f a percentag ge point disco ount that eve eryone gets) then NABs rate of 6.97 per p cent looks s pretty y attractive. NAB N will also pay switchin ng fees. Last week, w NAB sta arted offering g a mortgage e rate of o 6.59 per ce ent for custo omers who br ring their mo ortgages from m elsewhere and a buy their r new mortgage m through NABs ultra low co ost online su ubsidiary Uba ank. Banks do d not like to o confir rm it, but the ey are now fo orced to offer discounts to existing cust tomers to kee ep them from m switch hing. And thi is is starting to show up i in their result ts. The margin in Westpa acs retail and d busine ess bank whe ere its homeloan business s lies, fell fro om 2.08 per cent c in Septem mber 2010 to o 2.05 per p cent in March. M That ca ame despite r relatively stea ady funding costs and Wes stpac pushing g throughanadditio onal0.1ofapercentage p po ointrisetoitstandard s vari iableratelastNovember. Havin ng just succee eded in gettin ng a mortgage e rate cut we e can confirm that banking g competition n is aliv ve and well. Net N interest margins m for b banks average e around 2%, , a far cry fro om the above e 4% lev vel experienc ced in earlier decades. And while many y may be pun nting on hous sing being the e banks s ongoing sav viour we feel that this asse et class will struggle s to ga ain further tra action. As the e article eimplied,the eharshreality yforbanksisthatthebankingcowhasbeenmilke edforallthat t itisworth w andthewayforward ditlessobvious. Weco ommentedin nearliernews slettersthatthebranddam mageinflicted dbythebank ksonbusiness s customers from 20 008 onwards, , would be lo ong lasting. Th he evidence t thus far certa ainly supports s that view v and the situation is unlikely u to ch hange anytime soon. Busin ness demand d is down and d more importantly many have re r thought th heir long term m exposure to t banks. Inst tead business s leaders have tur rned to alte ernative fund ding channe els including offshore debt d raisings, shareholderequity yraisingsand duseoflongt termdebtfinancing. Banks shavedonethemselves t en normous dam mageandbus sinessleaders sclearlynowacknowledge e theris skofhavingtoo t muchdeb btonthebala ancesheetthatisowedtobanks. This will w not be th he end of ban nking and the e substantial profits that a are made. Bu ut the truth is s plain to see that th he banks are particularly e exposed, carr rying small am mounts of cap pital to offset t
the po ossibility of in ncreasing lev vels of loan de efaults. While e the default levels remain benign, the e case for f banks as an investme ent is suppor rted by curre ent valuation ns and attrac ctive dividend d yields s. However, in n our opinion n we suspect that the banks have entered an era un nlike previous s period ds. Having pulled p every revenue leve er it is hard to imagine what further r options are e availa able. It now appears that changing investment patterns w will dictate le ess need for r traditionalbanking ginthevolum mesthatexist tedsomeyearsback. And while w volume es are unlike ely to reboun nd anytime soon s the real risk for inv vestors is the e degre ee to which banks b drop their t lending standards to o achieve revenue and profit p targets. Hopef fullythescarsofthelastserious s recess sionin1991are a stilletche edinthemind dsofsomeof f our se enior bankers but equally y, investors should not think that bank ks are never ending profit t machines. Unfortu unately they certainly give e that impres ssion, until so omething goe es wrong and d whenitdoes,itten ndstogowro ongbigtime. And in nvestors do need n to take heed. A look k at the share e market inde ex would conf firm what we e all kn now, that ba anks form a material pa art of an inv vestors port tfolio. While BHP Billiton n represents the lar rgest single st tock in the ASX200 A index x with a 13.4% weighting, , the big four r major r banks nam mely, Commo onwealth Ban nk, Westpac, , ANZ and National N Australia are all individually ranked d in the top five in terms o of market we eightings and collectively represent r just t on23%oftheoverallindex. Banks s have weath hered many storms in the past and we w expect th hat they will do so in the e future e. However their sizable exposure e to m major segmen nts of the ma arket, particularly housing, warra antscaution.At A thisjunctio onthejuryisstillout,butalreadythere earesufficientmarkersto o sugge estthatinvest torsshouldproceedwithadded a caution.SFM Energ gy Whyis i it that justwhen all thepiecesseem tobe falling intoplace an neventoccur rsthatthrows s everything into dis sarray? Perha aps we can put it down to o a fortuitous wakeup call that helps to o put th hings into some perspecti ive. In the case of the worlds w increas sing energy demands, d the e event ts at Japans Fukushima Daiichi nuclear r power plants have certa ainly thrown things upside e down. Figuratively y speaking the nuclear f fallout has already spread to China and a Europes s indust trialpowerho ouse,German ny. China announced it has tempo orarily suspen nded approva al of nuclear power proje ects, including g those e in the preliminary stag ges of development. With plans to build 28 new n reactors, equivalent to 40 per p cent of the worlds total plants under construction, the signif ficance of the e annou uncementsho ouldnotbelo ostonanyone e. Howe ever while ma any doubt that this event t will seriously derail Chinas nuclear expansion e the e situat tioninGerma anyissomewhatdifferent. .Followingits sannouncem mentinlateMay M thatitwill now shut down all a its nuclear plants with h a phaseou ut due to be wrapped up p by 2022, it t becom mes the first t major indu ustrialised po ower to take e this step. W With 17 nuc clear reactors s
10
curren ntly inplace, atomic energ gy providestheGermaneconomy e with h its largestenergy source, sitting g at 23 per ce ent. This is fo ollowed by lig gnite also at 23%, hard co oal at 20 per cent, natural gas 13 per cent and wind at 6.7 6 per cent. Some may argue a that this is a knee jerk j reaction, d to ramp up u other energy sources s however if Germany sticks to this path it will need icantlyandqu uickly. signifi InAus stralia,thepo oliticaldebate earoundaca arbontaxcon ntinues.Thish hasledtoacall c totaxcoal minin ng in particular and prom mote cleaner energy sourc ces including g that of gas. Already the e Intern national Ener rgy Agency has h given Au ustralia the big b thumbs up, u predicting that it will becom me the world ds largest producer and exporter of liquefied na atural gas (LN NG) by 2020, ttle wonder then, that LNG providers including earnin ng $36 billio on annually by then. Lit g Wood dside and Oil l Search are spending vast sums on bringing b mor re production n capacity on n stream m. However the big sp pend is in the Eastern States of Australia, cen ntred on the e development of unconventiona al gas, more familiarly ref ferred to as coal seam ga as (CSG). This s gas which w is mostly methane is trapped in the coal seams typically 300 to 600 metres m below w surfac ce, with the gas g being held in place by y water. When it is extract ted, there are e two pipes onefo orgasandon neforwater. Presently four plan nned projects s in Queensla and account for f almost $8 80 billion wor rth of upfront t invest tment. They include The Gladstone LN NG (GLNG) project, a partnership betw ween Santos, Petronas of Malay ysia and Fren nch petroleum m group Tota al, targeting t two trains to o produce 7.8 8 milliontonnesofgas g ayearbeg ginning2015. The second, The Queensland Q Curtis C LNG pr roject (QCLNG G), owned by y the BG Gro oup (formerly y British h Gas) has pe ermits to ope erate up to five trains but t will initially build two tra ains targeting g 8.5milliontonnesofgasayearwithproduct tionalsoexpe ectedtostart tin2015. The third advance ed project is The Australia an Pacific LNG (APLNG) a joint vent ture between n Origin nEnergyandUSbasedpet troleumgiant tConocoPhillipswiththe eaimtoproce ess16million n tonne esayearusinguptofourtrains, t withastartdateofproductionin n2014. Finally y the Shell Australian A LNG G (SALNG) pr roject propos ses two trains, each with a capacity of f fourmillion m tonnes s,howeveritisstillawaitin ngenvironme entalapprova al. The numbers n invo olved are min nd numbing and the play yers involved vast but despite all this, there still remain serious envir ronmental co oncerns that need n to be addressed. Secondly, while e almos st everyone is s in agreemen nt that gas is the energy of o the future, all these pro ojects need to o gener rateanadequ uatecapitalre eturn.Andas stheeventsinJapanhave eshown,acce eptedwisdom m can change quite suddenly. In the case of CSG, the env vironmental issues may pose a serious s threat tdownthetr rackbutperh hapsmoreimportantlyare etheeconom micrisksto the emodelsthat t justify y the huge up pfront capital spend. And perhaps the e two big exte ernal risks re evolve around d event tual LNG prici ing and comp petitive respo onses from ot ther suppliers s. Left field events are the e wildca ards and the ey have a nas sty habit of t turning up ju ust when eve eryone is hai iling the next t boom mindustry.
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For th his fledging in ndustry the potential p wild dcard in the worlds w dema and supply eq quation could d come in the form of shale gas. Most pronounced in the US, shale ga as has transfo ormed the US S from a market de ependent on n imports int to a potential major exp porter of en nergy. Official hale gas reser rves were rec cently doubled to 827 trilli ion cubic feet t enough to o estimates of US sh rdomesticgas sconsumptio onforthenex xt36years. cover Andas a theAustralianFinancialReviewrecen ntlynoted,A Australias$220billionliqu uefiednatural gas in ndustry may have h just met t its stronges st match: the US shale gas s industry, wh hich in theory y can deliver gas at far leaner pri ices than those on offer in n Asia and Eu urope. BHP Billiton, B which h pts to build an a LNG facilit ty in the US in 2007, has s seen fit to en nter the shale e failed in its attemp g out $5 billio on acquiring t the Fayettevi ille shale gas acreage from m Chesapeake e business, splashing gyinFebruary y. Energ f Exxo onMobils $31 billion acqu uisition of shale operator XTO Energy in 2009. BHP P This followed Billito on have comm mented that they believe US shale bre eaks even at a gas price of just under r uires $US8 pe $US4 per million British B therma al units (Btu) while Australian LNG requ er million Btu u beforeitmakesmo oney. At the e other end of o the scale, coal looks to o be in seriou us strife if the headlines regarding r the e carbo ontaxareany yguide.Howe ever,oursense isthatthe edemandand duseofcoalwill w remainin n place for many yea ars to come. So much so t that the Quee ensland Gove ernment has turned t to the e privat tesectortoassistinthefu undingofa$6 6.2billionexp pansionofAb bbotPointco oalterminalin n North h Queensland d. This would d lift capacity y by 120 million tonnes to o a combined d 300 million n tonne es, making it one of the worlds w larges st coal termin nals and importantly opens up further r accesstotherichcoal c depositsoftheBowen nandGalileeBasins. Ultimately the ene ergy choices available are e limited but as developm ments in Japan and the US S illustr rate, investors need to con nsider the bu usiness implic cations of when something g goes wrong g or som mething new w emerges. In the case of nuclear, it cle early goes int to the too ha ard basket for r now,forCSGawaitandseeap pproachwould dseemtoma akegoodsense,while forcoal,anytalk k ofitsdemiseseem mstobesome etimeoff.SFM M Memo orablecomm mentonEurop pesdebtcris sisScottMinerdGuggen nhelmPartne ers At the e height of th he debt crisis during June, the following comments summed thin ngs up well in n ouropinion. Isthe eEuropeanUnion U goingto ostepinandcomeupwithapermanentsolutionfo orGreeceand d there estoftheproblemnations sinEurope,o oraretheygo oingtotrytok keepkickingthe t candown n the ro oad and see if the marke et can sort it t out for them, asked Guggenhelm Partners P chief f invest tment officer r Scott Miner rd. The bott tom line is, if they keep kicking the can c down the e road,wearegoing gtofaceadis sasterandIthinkthatsthe t pathwereon.
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Andthenthecoun nterviewCitisWillemB Buiter Citis global chief economist, e Lo ondon based d and former advisor to th he Internation nal Monetary y er,offersacounterview. FundWillemBuite Thenotionthatwe w arehelples ssandhaveto okickthecan ndownthero oadbecausethe t sovereign n defau ult would be the t end of th he world as w we know it, is complete no onsense. Whe en sovereigns s gobro oke,countrie esdontshutdown, theyd do not getbro okenup, they ydont get pu utup for sale. To co ompare Lehm mann with what w will happen if and when Gree ece, Ireland and Portugal restru ucture is, I th hink both uninformed and d quite irresp ponsible. If th he European Central Bank k stepsinandmakes sitsownreso ourcesavailab bletheycanbail b outtheentireeurozone. pproachistha atEuropemust m movetow wards abreak k it,youown it,covenant.Government t Hisap that borrowed b too o much will either e have to o suffer fiscal l pain, or suff fer the conse equences of a defau ultandinvesto orswouldhee edthelosses.SFM Time sUpfortheReserveBank kofAustralia a(RBA) We have no doub bt that many will disagree e with our vie ews regardin ng the role of f the Reserve e Bank of Australia. However our o concerns expressed in i previous n newsletters including i our r March h 2008 and th he more rece ent March 2010 articles, se eem to have some justific cation judging g by the e latest mont thly update fr rom the RBA. . Our gripe is not that monetary policy y hasnt a role e to pla ay in keeping g things on tr rack but rathe er that the policy p makers s are so far re emoved from m what is actually happening and d so enamou ured with the eir own econ nomic modelling that they y miss the big pictu ure. For mon nths, the sign ns of econom mic stress on n business lif fe have been n obvious. Our discu ussions with business lea aders coupled d with our o own sense of f the growing g pressu uresfamiliesandthegene eralpopulatio onarefeeling gledustoonerealisticcon nclusion,that t econo omic growth would slow and that the constant focus on inte erest rates se ettings would d tempe eranydesireforbusinesstoexpandbe eyondconservativelimits. Offset tting these concerns c hav ve been the e coming res sources boo om. Unfortu unately while e Austra alias terms of o trade are hitting all tim me highs, thereby driving g our dollar higher, many y minin ngprojectssti illrequire ser riouscapital investment.And A thecrack ks arenow ap ppearing,with h costblowouts b andprojecttimedelayslikelytoresultinsomenotgett tingoffthegr round. Not surprisingly th he RBAs late est monthly u update in early July has them t less buoyant on the e econo omys outlook, downgradi ing Australia s economic growth g and e effectively pu utting interest t ratesonhold. Unfor rtunately, the ese updates whilst w endeav vouring to pro omote transp parency and confidence c in n the RBAs R policies s, plays havo oc with those e running businesses and d managing daily d financial decisi ions. Critical to t any investment decision is the confi idence to act t and the constant will we, wont t we stance that the RBA has embarke ed on in regards to setting g interest rat tes is just bad d policy yanddeserve esaseriousre ethink.
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As we e wrote in Ma arch 2010, U Unfortunately y, monetary policy is a blu unt tool and the danger is s that in trying to st tem excessive e behaviour in one asset class c we chok ke off investm ment in other r more productive fields f of the economy. e We e remain hop peful that the e RBA is sensitive to these e s and has le earnt from it ts previous a actions in raising rates b based on his storically pre issues determinedformu ulas.Ontheevidence e thus sfarthisdoesntseemtobethecase.SFM S Comp panyvisitdiar ryJuneQuarter2011 April NVT Na avitasUBSem mergingcomp paniesconfere ence 06 6/04/11 SVW Se evenGroupHoldingsUBSemerging e com mpaniesconfe erence 06 6/04/11 FLT FlightCentreUBSemergingcompaniesco onference 06 6/04/11 exigroupUBS Semergingco ompaniesconference 06 6/04/11 FXL Fle gcompaniesconference IFL IOOFHoldingsUBSemerging 06 6/04/11 FWD Fle eetwoodUBS Semergingco ompaniescon nference 06 6/04/11 ORL Or rotonGroupUBS U emerging gcompaniesconference 06 6/04/11 PXS Ph harmaxisQ3conference c ca all 14 4/04/11 SRX Sir rtexmanagem menthospital lsitevisit 19 9/04/11 RMD Re esMedQ3con nferencecall 29 9/04/11 May SEK Se eekinvestorday d 03 3/05/11 REA RE EAGroupMac cquarieconfe erence 04 4/05/11 SKE Sk killedGroupMacquarie M con nference 04 4/05/11 CPB Ca ampbellBroth hersMacquar rieconference 04 4/05/11 COH Co ochlearMacquarieconfere ence 04 4/05/11 AGK AG GLEnergyMa acquarieconfe erence 04 4/05/11 TGA Th hornGroupMacquarie M con nference 04 4/05/11 CDD Ca ardnoMacqua arieconferen nce 04 4/05/11 FLT FlightCentreMacquarie M con nference 04 4/05/11 SGH Sla ater&GordonMacquarieconference 05 5/05/11 SUL Su uperRetailGr roupMacquar rieconferenc ce 05 5/05/11 SMX SM MSManagement&Techno ologyMacqua arieconference 05 5/05/11 CCL Co ocaColaAmatilMacquarie econference 05 5/05/11 BPT Be eachEnergyMacquarie M conference 05 5/05/11 RMD Re esMedMacqu uarieconference 05 5/05/11 NWS Ne ewsCorpQ3conferencecall 05 5/05/11 SKC Sk kyCityEnterta ainmentGrou upMacquarie econference 06 6/05/11 N/A Vo olkswagonGroupMacquar rieconferenc ce 06 6/05/11 ARP AR RBCorporatio onMacquarie econference 06 6/05/11 EPW ER RMPowerMa acquarieconf ference 06 6/05/11 SRX Sir rtexmanagem mentsitevisit t 11 1/05/11 OTH On nthehousemanagementmeeting m 24 4/05/11 PPT Pe erpetualmark ketupdatemanagementmeeting m 26 6/05/11 CPB Ca ampbellBroth hersmanagem mentresultsmeeting m 27 7/05/11 PXS Ph harmaxisman nagementme eeting 30 0/05/11
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June ASZ DTL PAB COF N/A SMR MTE BWD N/A GUF AS SGGroupBBY YITconferenc ce Da ata#3BBYITconference c Pa atrysmanagem mentmeeting Co offeyInternat tionalmanage ementupdate e Hu unterImmuno ologyIPOpre esentationma anagementm meeting Sta anmoreCoalRBScoalconference MetrocoalRBScoalconference Bla ackwoodCorpRBScoalco onference Am mbreEnergyRBS R coalconf ference Gu uildfordCoalRBScoalconf ference 01 1/06/11 01 1/06/11 02 2/06/11 08 8/06/11 14 4/06/11 15 5/06/11 15 5/06/11 15 5/06/11 15 5/06/11 15 5/06/11
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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

Dear Investor,: June 20 011 Selector Qu Arterly Newslett Ter #32

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Dear Investor,: June 20 011 Selector Qu Arterly Newslett Ter #32

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