Australian Leaders Fund Level 5, 139 Macquarie Street NSW Sydney 2000

TEL (02) 9252 0225 FAX (02) 9252 1220 info@wfunds.com.au | www.australianleaders.com.au

QUARTERLY REPORT | September 2011

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AUSTRALIAN LEADERS FUND QUARTERLY REPORT | September 2011

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Greece is burning

The owl was the symbol of the city of Athens and was featured on the city’s silver coins from 500 BC. As Athens mined its own silver and was fabulously rich, “bringing owls to Athens” as the colloquialism goes was pointless.

Merchants and creditors knew they could trust the “owl” to contain full weight of the best silver. How fortunes quickly changed; within a century of the first owls coming into circulation, expensive wars had driven Athens into bankruptcy - the first recorded sovereign default in history.

Sovereign debt defaults are remarkably common, with some 250 reported cases over almost as many years (Fig. 1). In Reinhart and Rogoff’s (2009) “This Time is Different” we can see that defaults typically occur in clusters; the most recent episodes can be observed in the emerging market defaults of the1980s and 1990s. Given the severe dislocation created by the global financial crisis (GFC), we should not be surprised to see defaults potentially starting with Greece.

FIG 1DEFAULT CLUSTERS IN HISTORY

(Percentage of countries in external default or restructuring)

Greece has in fact defaulted on its debts no fewer than five times since separating from the Ottoman Empire in 1822 and has been insolvent for half of its modern history. It is a wonder it was ever considered for inclusion into the European Monetary Union (EMU).

In Rogoff’s view, policy makers are on the wrong track, and the current course will end badly:

“The current policy is to act as if a liquidity crisis could be overcome by handing out enough loans to jump-start growth” says Rogoff. “But it’s the wrong diagnosis. We have a solvency crisis, and we have European countries and regions that are fundamentally bankrupt. No loan in the world, no matter how big, will save Greece, nor will it save Portugal and probably not Ireland, either, and Italy is also very worrisome.”

The antecedents of today’s crisis can be found in the flagrant breaches of the original Maastricht Treaty convergence criteria (1992), specifically in the failure to comply with fiscal disciplines outlined in the Stability and Growth Pact. Members failed to honour their commitments to keep annual budget deficits to within 3% of GDP and national debt levels below 60% of GDP.

The European Commission and the Council of Ministers charged with enforcing these limits failed dismally in their duties of stewardship.

Source: Carmen M. Reinhart and Kenneth S. Rogoff, “This Time is Different: A Panoramic View of Eight Centuries of Financial Crisies”

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Greece broke all the rules to get accepted into the EMU

Greece was already well over its head in debt when it joined the Monetary Union in 2000. The country’s public sector borrowings exceeded 100% of GDP, dramatically higher than the 60% limit agreed to in the Maastricht Treaty. Since 2000, successive administrations have revealed how Greece has manipulated the figures reported to Eurostat since joining. Italy, which is now threatened with loss of market access to investors, also joined the EMU with debt levels exceeding 100%.

Entry into the euro-zone was a double-edged sword. Promoted as the panacea for reforming Greece’s finances and instilling the discipline of the Growth and Stability Pack, inclusion had the opposite effect. Fiscal discipline was lost as Greece was able to borrow at interest rates in line with those the German government paid on its bonds. “The euro was a paradise of sorts... once they had joined the euro zone, Europe’s southern countries gave up trying to sort out their finances”, says then Greek Finance Minister Yiannos Papantoniou.

Simply because the 17 countries that make up the euro-zone shared the same currency, investors were no longer distinguishing between the credit worthiness of each country despite fundamental differences in competitiveness and debt serviceability. They clearly did not read or believe in the “no bailout” clause in the Maastricht Treaty.

As can be seen from Fig. 2, there has been a sharp deterioration in relative competitiveness between northern and southern states since the EMU was formed. Inflexible work practices, poor tax coverage and bloated government bureaucracies have led to a steady erosion of competitiveness.

FIG 2UNIT LABOUR COSTS ACROSS EURO-ZONE

Source National Statistics, Haver Analytics, GS Global ECS Research

Not only was the country uncompetitive with a bloated government sector, tax revenues at less than 30% of national output were the lowest in the euro-zone. With the black market accounting for one quarter of the economy, a significant portion of income is untaxed. It is no wonder the country continues to run deficits that have to be funded through further borrowing.

Not all countries were borrowing more to fund consumption. The Germans, recognising the emerging debt problem, actively pursued painful “Agenda 2010” and “Hartz IV” reforms to their welfare and labour markets, delivering substantial improvements in labour productivity. Instead of choosing to follow the more difficult path of reform, their southern neighbours became less competitive and borrowed more. Eventually the day of reckoning came with the GFC; these countries found themselves uncompetitive and out of work, placing a further burden on the public purse. In contrast, the Germans, having implemented painful reforms, are now reaping the rewards with unemployment below pre-crisis levels.

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Whilst investors focus on the sovereign debt and banking crisis, the loss of competitiveness in southern Europe has also fuelled a balance-of-payment crisis, hidden below the surface and receiving scant attention. In a closed exchange rate union like the EMU, current account imbalances accumulate as a liability with the European Central Bank (ECB) which sits at the centre of the payments system. Reserve money flows from the ECB to fund capital and trade account deficits.

No leadership shown by European core—everyone was breaking the rules

Germany and France were also busy defying the Maastricht rules by exceeding budget limits. The two countries elected not to submit to sanctions and completely undermined the Stability and Growth pact in exercising their majority in the European Council to cancel the European Commission’s sanction procedure. Since the Euro’s formation, not a single euro-zone country has ever been penalised, despite the many breaches.

The promises set out in the Maastricht Treaty were all compromised. Instead of limiting government debt, debt has doubled with only a handful of countries still compliant with the original debt limits. Similarly, only a few countries run deficits below the 3% threshold with the majority having moved well beyond. Most importantly, the executive power vested with the European Commission was consistently undermined and subjugated to the interests of member countries.

The Monetary Union promised a convergence of European economies that would make them stronger in a globalised world, and with it came an obligation to manage debts and deficits. It was clear under “Article 125” there would be no bailouts; no country would be liable for the debts of others. The ECB was to be a fortress, ensuring the value and integrity of the Euro.

In the first real test of the EMU we currently have Northern Europe pitted against its weaker Southern neighbours, political disunity, bailouts and a central bank laden with junk sovereign debts.

The wake-up call - the party’s over

In January 2009, Standard & Poor’s downgraded Greek government bonds to the lowest rating in the euro-zone. All of a sudden, investors recognised Greek debt was no longer risk free and started dumping their bonds. In April 2010, Standard & Poor’s downgraded Greece’s bonds by a further three notches to junk status. As a result they lost market access to private investors and turned to the European Commission, ECB and the IMF for help.

The first assistance package in May 2010 was followed by the establishment of a European Union rescue fund: The European Financial Stabilisation Facility (EFSF), which was quickly called upon to support the other two “program” countries, Ireland (November 2010) and Portugal (April 2011).

The original aid packages were designed to provide these countries with time to implement the reforms necessary to restore credit worthiness and return to the market for financing in a couple of years.

However, it quickly became clear that Greece’s efforts to consolidate its budget, introduce reforms and privatise government enterprise were off track. Moreover, the economy was contracting at an alarming rate.

In testing for solvency, economists forecast economic growth, budget balances and funding costs to project future levels of indebtedness. This modelling suggest that debt levels will continue to rise under almost all scenarios even if Greece manages to meet the conditions of its loan program by implementing onerous austerity measures and returning to structural surplus. On this basis, the country is considered insolvent and likely to default. The question therefore becomes not whether Greece defaults, but when it defaults.

European policy makers have been trying to keep Greece afloat and avoid a full default until 2013, when the successor to the EFSF - the EMF - is up and running and able to provide legitimacy to any bailout. Though the 6th Tranche of the current program has now been approved, the heavy refinancing due in the first quarter of 2012 looks like a formidable hurdle and is the next likely trigger for any default.

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The next step in the bailout, announced in July 2011, was to move to a voluntary loan restructuring, reducing the debt burden via a bond exchange with official creditors (EU, ECB, IMF) and a principal haircut from private sector bondholders. However by October a voluntary restructuring providing a 21% haircut already looked grossly inadequate.

According to the fourth European Commission Review, “Greece’s debt-to-GDP ratio under this restructuring would peak at 186%... and could reach as high as 200% if bondholder haircuts remained unchanged at 21%”. It estimates Greece would need a further €450 million bailout to fund it until 2020. Creditor nations have made it clear they will not fund any further bailouts. By late October the European Commission was calling for much steeper haircuts in the order of 50%.

Official creditors (IMF/EFSF/ECB) are reluctant to take a principal haircut, which is illegal under the “no bailout” clause. The ECB did not tender its bonds into the first bond swap, despite being the largest single holder of Greek debt. Official lenders in general have avoided having to write-down their loans to Greece. Therefore the onus of principal reduction falls entirely on private sector investors (mainly European banks).

Given Greek banks in particular hold €48 billion of Greek bonds, their capital will be wiped out by the write-downs and they will have to be recapitalised. This will only add further to Greek debt levels.

All of this keeps Greece’s debt-to-GDP ratio high as official creditors and Greek banks already account for a lot of the country’s overall debt. According to the Union Bank of Switzerland’s (UBS) estimates, a 50% haircut will only provide a modest 22% reduction in debt levels. Greece would further require a €109 billion bailout, and its debt-to-GDP ratio would still be an eye-watering 110% in 2020. Even after this latest cut, the country is still bankrupt.

The crisis spreads to core Europe and the Banking System

The “European Sovereign Debt Crisis” is both a sovereign and banking crisis. Most countries will never face a liquidity crisis because their government can rely on the central bank to provide a backstop for its fiscal authority and, if required, issue currency to honour commitments.

On the other hand, the 17 individual countries that make up the euro-zone have no independent central bank and no national currency. The spreading crisis across Europe in recent months beyond the periphery to the systemically important countries of Italy and Spain is a consequence of the absence of such a backstop.

Government debt has to be rolled over on an ongoing basis, making euro-zone governments beholden to the ongoing support of investors. As investors came to realise the Crisis Management Framework was only designed to support the smaller periphery countries and was insufficient in dealing with the emerging needs of these larger economies, investors quickly withdrew their support. Confidence was further eroded by the ECB’s insistence that it would not act as a lender of last resort.

This was a significant escalation in the crisis, given the much larger size of the Italian and Spanish bond markets at €2 trillion. The crisis had entered a more dangerous phase with the prospect of one or both of these large economies requiring a bailout of the sort provided to Greece, Ireland and Portugal.

All efforts are now designed to retain market access for these two systemically important countries, thus giving them time to introduce fiscal and market-based reforms. In fig 3, economists at UBS have forecast future levels of indebtedness for all euro-zone members under different growth and structural adjustment scenarios. Under a low growth scenario which looks increasingly likely, the debt levels of Italy, Ireland, Spain and Portugal are clearly unsustainable.F

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France, which provides important guarantees to the rescue fund and the ECB, could also quickly lose its triple-A rating undermining the substance of these guarantees. Importantly, these forecasts do not assume Europe moves back into recession or that there are further banking sector bailouts; both are highly probable and would clearly make current debt positions more perilous. In its adverse scenario, UBS assumes low growth with slower fiscal reforms. The number of euro-zone members with critical debt levels rises accordingly.

Given the zero-risk weighting assigned to sovereign bonds by the regulator and the attractive repurchase terms offered by the ECB, banks have historically kept a significant portion of their liquid assets in Government bonds. Due to this exposure, European banks are particularly vulnerable to any deterioration in the value of these bonds.

Whereas the US banking system was comprehensively restructured through the GFC via closures, forced mergers and capital raisings, their European peers largely circumvented this orderly resolution process,

FIG 3EMU COUNTRIES’ SOVEREIGN DEBT IN 2025

Source: UBS

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leaving them in a far more precarious state. This is clearly evident by the large number of European banks still on extraordinary liquidity support with the ECB three years after the financial crisis. In contrast to their US peers, the European banks have remained in a fragile state since 2007.

If these banks were in a stronger position, a comprehensive restructuring of Greek debt would have occurred last year. The commitments announced last week to recapitalise core European banks is seen as the first step in resolving the crisis.

The fragilities in Europe’s banking system cannot be solved without solving the sovereign debt crisis, and you cannot solve the debt crisis without first stabilising the banks.

Crisis management

European leaders at the crisis summit last weekend announced they will employ a three-stage resolution process. First, banks have agreed to accept a 50% reduction in the value of outstanding debt to restore solvency. Second, region-wide banks will recapitalise, raising €100 billion so they can absorb write-downs of this scale. Third, the size of the rescue fund (EFSF) would be enhanced by guarantees for €800 billion to €1.3 trillion of bonds issued by countries like Spain and Italy.

The Rescue Fund (EFSF)

The most likely option for enhancing the size of the EFSF is financial engineering, which as we know was the root cause of the financial crisis in the first instance.

One proposal is to use the EFSF to guarantee the first losses on newly issued bonds. This option does not fundamentally increase any of the guarantees and so consequently does not require parliamentary ratification or treaty changes. If the EFSF is used for a 20%-first-loss insurance as mooted, the firepower of the EFSF can be boosted to around €1.1 trillion.

This is a pyramid of guarantees dependent on the retention of triple-A ratings by Germany and France; France in particular is clearly at risk of compromising the whole structure. If France were to be downgraded, the size of the EFSF would also be downsized, given 40% of the EFSF is already committed, the amount left to be leveraged would shrink disproportionately. Investors clearly have serious reservations, with the spread on EFSF bonds over German Bunds blowing out even before the new proposal is implemented (Fig. 4).

FIG 410y EFSF/BUND SPREADS

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Wolfgang Münchau of the FT put it succinctly when he said “Any leveraging of the EFSF will threaten the rating of the triple-A-rated countries, eventually threatening the fund’s rating as well. With the matter becoming more and more political, and with Germany and France stating that they are ready to help but only up to a point, leveraging the EFSF could lead to a catastrophe”.

Münchau argues that “The simple reason why there can be no technical quick fix is that the crisis is, at its heart, political. The triple A-rated countries have left no doubt that they are willing to support the system but only up to a certain point. And we are well beyond that point now. If Germany continued to reject an increase in its own liabilities, debt monetization through the European Central Bank and Eurobonds, the crisis would logically end in a break-up. There is no way the member states of the euro zone’s periphery can sustainably service their private and public debts and adjust their economies at the same time”.

Where to from here? Cut Greece Loose!

Again, the latest crisis solution only buys time and keeps Greece on life support until the rest of the euro-zone is sufficiently firewalled to allow for Greece’s orderly exit from the EMU. With debt levels above 110% of GDP after the restructuring, an economy deep in recession, and no prospect of regaining market access for at least a decade, Greece is still insolvent.

It remains a matter of time before Greece defaults and leaves the EMU, simply because the country cannot return to growth until it has regained competitiveness. This can only occur in a timely manner through real depreciation in one of two ways: further deep structural reforms, which look unlikely given fatigue and social unrest, or devaluation by exiting the Euro.

The October rescue package will be evaluated in the short-term by the success in ring fencing the rest of the euro-zone and maintaining market access on reasonable terms for Italy and Spain. With €900 billion of capacity, the EFSF can just cover the requirements of Italy and Spain for the next two years. The banks have been recapitalised and firewalled against Greek restructuring or exiting the EMU.

Greece, with cooperation and assistance from the EU, will most likely work towards an orderly exit from the Euro later in 2012 or 2013, at which stage the financial and political impact will have been quarantined from the rest of Europe.

Under an alternative scenario where growth in Europe is much softer, budget deficits are reined in and spending cuts weigh on activity, the financial standing of Italy and Spain looks far more troublesome (refer again to UBS forecasts Fig. 3).

As we move forward and the funds available in the EFSF are steadily drawn, investors will anticipate Spain and Italy returning to the market. If insufficient fiscal adjustment has been achieved and access is denied at affordable spreads, the future of the Euro will again be called into question.

Though these measures will provide breathing room for indebted European countries in the short-term, the real issues still need to be addressed. First, southern European countries have become uncompetitive. Like a loss-making corporation, countries need deep structural reforms to restore competitiveness. Otherwise, Europe will find itself in the same mess further down the road. Second, a true lender of last resort needs to be established to provide core European countries with liquidity when market access is denied. Third, if Europe is to move towards full fiscal integration, stricter regulatory institutions need to be put in place to ensure enforcement of prudent fiscal practices.

In a detailed report “The Ticking Euro Bomb: What Options are Left for the Common Currency?” the German newspaper Der Spiegel concludes, “In the end, only two possibilities will remain: a transfer union, in which the strong countries pay for the weak; or a smaller Monetary Union, a core Europe of sorts that would consist of only relatively comparable economies”.

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The German Constitutional Court has ruled out any further bailouts, including leverage without parliamentary approval. Recent polls show 70% of Germans are opposed to any further transfers of German wealth to nations with debt problems. The political structure is shifting away from being pro-Euro at a time when Germany is being asked to be its effective banker. Any centralisation of power towards Brussels (European Commission) at the expense of German fiscal and monetary sovereignty will be extremely difficult to enact.

The crisis is at an important juncture. The ultimate outcome is one of two possibilities; either the euro-zone moves closer to a full fiscal union with full socialisation of debt where each country guarantees the debts of others - a ‘shotgun marriage’ if you like. The alternative is the EMU will break up as smaller contributing states exit, fearful of the rising costs of supporting struggling members.

Policy makers are avoiding the tough decisions and prolonging the inevitable, preferring instead to muddle through with the support of temporary solutions that appear increasingly unworkable.

China

Whereas markets have been absorbed with the crisis unfolding in Europe, Chinese banks are also showing early signs of stress with losses accumulating on property and local government lending.

Excessive credit growth by Chinese banks in 2009 and 2010 to fund the government’s fiscal package helped the country avoid recession, but has also sowed the seeds of deteriorating loan quality.

Announced in 2008, China’s $600 billion stimulus package was instrumental in laying the groundwork for the post-GFC recovery. Most of this money was spent on infrastructure and land development through local government bodies.

By law, local governments are supposed to run balanced budgets and avoid accumulating debt. To get around

Transfer Union

One can quickly see from Fig. 5, Germany is the key creditor to deficit countries in the South. It is ostensibly up to Germans to decide if they wish to continue funding bailouts in support of the Monetary Union.

FIG 5CLAIMS OF EURO AREA MEMBERS

(Netting of Euro System Cross-Border Payments)

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this, they have set up off-balance sheet funding platforms (LGFP) which, along with directly held debt, are estimated by Moody’s to total RMB 12 trillion or 30% of GDP. Many of these loans are covered by land and property collateral from local governments, but a large portion were extended on simple guarantees. As proceeds from land sales account for 40% of local government revenue, their ability to service these loans is also closely tied to land prices which are now under pressure.

The primary problem is with LGFP’s, where the credit quality of some of the underlying projects is questionable. Estimates of losses on these loans range between 30% and 60%. With typical recoveries of 30%, the losses could end up between RMB 3 and 5 trillion or up to 10% of GDP. This is a clear and present danger given half of these loans are repayable before the end of 2012.

In sorting through these problem loans, local governments will ultimately fund most of the losses via fiscal transfers from the central government. This will inevitably place considerable strain on local government spending which is already slowing.

Another concern is with “informal lending” which has exploded in China in recent years, as highly stressed developers and small businesses unable to access loans from state banks have been forced into the grey market at usurious rates. Credit Suisse estimates informal lending has reached RMB 4 trillion or 8% of outstanding loans.

Alarmingly, while the central government has cut down on lending to property developers, new loans extended from the informal market over the last year are now equal in size to those from commercial banks. Fitch believes formal banks have transferred risky off-balance sheet loans to the shadow banking industry and that lending to this sector has not slowed nearly as much as the official numbers would suggest.

Most of the loans are to property developers caught by falling prices and softer sales, with many now paying rates above 30%. The informal lending market is a long debt chain of which the true size and scale is unknown.

These losses are most likely manageable and will ultimately be consolidated centrally, worked through via asset management companies (as occurred in mid 1990s) or refunded via issuance of local government bonds.

After including local government debt, China’s total public debt-to-GDP ratio now stands at 65%, which is still quite manageable given China’s savings ratio of 50%. As long as nominal GDP grows at historical levels, the debt ratio will fall quickly in the medium-term.

The key message to emerge from this is that leverage in China has increased significantly post GFC, small businesses and property developers are under considerable stress and local government investment in social programs should moderate. At a macro level, China, like many western countries with elevated public sector debt ratios, has less scope to backstop growth through further stimulus if global activity again slows.

Outlook for Global Equity Markets

So what does all this mean for investors in Australia? How does it play out now that Greece has called a referendum on the rescue package creating further uncertainty? Returning to Rogoff’s earlier observation “you cannot solve a debt crisis simply by creating more debt” i.e there is no simple panacea for Europe. We are either in for a long and painful period of structural adjustment marked by slow growth or else a disorderly default and break-up of the Euro. Under either scenario risks for capital markets will be elevated for some time and return expectations should be tempered accordingly.

Efforts to stimulate the global economy in the wake of the GFC have consumed much of the remaining capacity of the treasuries of the western world. China having also invested heavily in the recovery process also has less scope to launch a second round of stimulus if called upon.

This leaves a disproportionate weight on accommodative monetary policy to boost activity, yet as central banks invent new ways of making credit cheaper the private sector retreats as deleveraging continues. We are in a classic liquidity trap where demand for money is weak no matter what the price.

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10 AUSTRALIAN LEADERS FUND QUARTERLY REPORT | September 2011

Qantas - Caught in a storm

As you know ALF has a significant investment in Qantas. Management have pursued the right course in confronting the unions in their endeavours to restructure the International airline which is losing just under $1 million a day. These losses are clearly unsustainable. Management were left with few options other than arbitration once it became clear the unions would continue to obstruct the company’s strategy in returning Qantas International to profitability.

The new industrial relations laws under Fair Work Australia have given unions additional powers in pursuing legal strike action in the interests of job security. What the unions fail to appreciate is that Qantas as a public company cannot continue to fund losses of this scale indefinitely and the business must be restructured.

The International business has been under pressure for a number of years. Market share has collapsed from 45% back in 1995 to 18% currently (ref Fig #). This loss of share has largely been driven by the deterioration of its competitive position. Qantas is disadvantaged in over half the routes its flies given crews and ground staff are far more expensive for an Australian based carrier, this situation has only been made worse by the higher Australian dollar.

While costs are comparable with US competitors on the pacific route, a significant increase in capacity from new entrants has seen yields diminish and profitability evaporate. The huge growth in Asian traffic has not been captured by Qantas as the lack of a network hub and an ineffective schedule has seen customers move to other carriers.

QANTAS MARKET SHARE IN/OUT OF AUSTRALIA

You can be sure that the overhead and support structure supporting the international airline is largely unchanged while the business has lost passengers and share. These overheads need to be downsized to reflect a smaller business.

Qantas finds itself in the same predicament as Bluescope Steel who recently announced the closure of the export steel mill at Port Kembla and the loss of thousands of jobs. Similarly, while the domestic airline is highly profitable, where Qantas competes internationally they are losing money. If the unions aren’t careful, the prospect of a Qantas plane in every international port will, like Port Kembla, Pan Am and TWA, be a distant memory.

Let’s be perfectly clear, Qantas is a very well-run company that is significantly undervalued. No other national carrier has been able to replicate Qantas’s success in launching a low cost carrier in Jetstar and many have tried. Jetstar was a master stroke, conceived as both a stalking horse for the mainline carrier, keeping costs contained while protecting the low end of the market from new entrants.

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Their strategy for returning Qantas International to profitability will be modelled on Jetstar’s success. As a premium airline, hubbed out of Singapore or Kuala Lumpur with a more competitive cost structure it stands a much better chance of achieving acceptable returns.

When we look for opportunities to invest, the best ideas often emerge from considering a full acquisition. This is how a trade buyer or private equity would approach a business opportunity – but of course we don’t have to pay a premium. Qantas is a combination of high return businesses in Qantas domestic, Jetstar and Frequent Flyers, and a problematic business in Qantas International. If we assign a fair value to the profitable businesses we find at the current share price the International business, with a relatively new fleet of aircraft in the books at $4bn, has a negative value. Alternatively if we were to sell the International airline or liquidate the fleet we could be confident in receiving most of the $4 billion of book value. On this basis we would end up acquiring the profitable businesses at a fraction of fair value.

While under the Qantas sale Act it is highly unlikely we would be allowed to sell the national carrier, the exercise clearly demonstrates the deep embedded value in Qantas shares.

It is our understanding, the arbitrator will only rule on pay and conditions leaving Qantas to pursue its strategy.

The first priority is to return Qantas International to profitability. Route rationalisation will play a key role. The recently announced change to Dallas as the US hub is a good example with incremental yield improvements available. Europe is more challenging, with Qantas unable to establish a hub in the region. The group will look to stem the losses through the reduction in services and further consolidation with airline partners such as BA. Addressing the cost structure of the International business is another key plank in the strategy. Streamlining heavy maintenance bases, moving to maintenance on demand and catering efficiencies will all be crucial in reducing unit costs and restoring profitability.

The launch of a new premium airline based in either Singapore or Kuala Lumpur will help given the vast majority of Australian travellers use other carriers for Asian travel. The strategy will follow on from the success of Jetstar, enabling the low returning Qantas aircraft to be utilised in the new venture. The new airline will have a cost structure more akin to its competitors allowing the company to regain lost share.

As mentioned in a previous quarterly newsletter, we see an opportunity for Qantas to grow earnings and create shareholder value through the Jetstar brand in Asia. Given the absence of low cost carriers in Asia, Jetstar Asia is attempting to replicate the achievements of Ryanair in Europe and Southwest Airlines in the US. LCC’s currently account for only 20% of flights in Asia compared to 40% in Europe and the US. Although operating in Asia can be difficult at times, Jetstar Asia has a recognised brand and will look to partner with local airlines as the business expands. While there is a land-grab for terminal slots, Jetstar Asia holds a first-mover advantage alongside Air Asia, Tiger Airways and Cebu Pacific Air. This business is still quite small operating 12 aircraft in the region, but the opportunity is large, and we suspect Jetstar Asia could have a fleet of up to 200 aircraft by the end of the decade. Our belief was further vindicated by the recent launch of Jetstar Japan – an exciting JV between Qantas, Japan Airlines and Mitsubishi.

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12 AUSTRALIAN LEADERS FUND QUARTERLY REPORT | September 2011

In Figure 6 you can see the drag on revenues from the PTSN (in orange). As Telstra exit the PSTN we are left with the faster growing mobile and internet businesses. Furthermore, the capital intensity of this company is reduced and cash generation significantly enhanced as the company’s network dependency diminishes.

Going forward every time NBN disconnects a copper pair, Telstra receives a cheque. They will be investing less on their outside plant while receiving a reliable stream of access revenues from NBN Co.

Payment of $11bn from the NBN Co/Government: The payment from NBN Co/Government will compensate Telstra for the loss of earnings in its copper network. It will replace the earnings with annual payments for the leasing of infrastructure and decommissioning of its copper network. As a result, earnings from Telstra’s fixed-line business are likely to be maintained. We expect that this will underpin Telstra’s dividend in the medium term.

In figure 7 we can see Telstra is guaranteed a steady flow of infrastructure and disconnection payments as the NBN is deployed.

Looking for a Safe Investment in Difficult Times:

The Investment Case for Telstra:

We remain positive on Telstra as we believe the $11bn National Broadband Network (NBN) agreement is a good deal for shareholders with the company selling a depleting asset for a very full price. Furthermore, Telstra has strong operating momentum with further prospects for capital management and is a safe haven in volatile markets.

Key risks to our investment case would be a delay in the NBN process or a change in Government prolonging the NBN deployment.

Positive Drivers:

The Agreement Struck with the NBN for $11bn is a Good Deal for Shareholders.

Exiting a business in structural decline: Telstra is effectively exiting its copper network where profits are in structural decline. Revenue from the fixed copper voice network (PSTN) are declining by around $500m per annum as households disconnect fixed lines and take up mobile devices.

FIG 6TELSTRA – CHANGE IN REVENUE

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FIG 7

FIG 8

PAYMENTS RECEIVED FROM NBN Co

EBITDA OF FIXED LINE BUSINESS

Cash flows and margins are sustained where previously they were under pressure (figure 8)

Greater regulatory certainty: By agreeing to co-operate with the Government, Telstra believes it has achieved greater regulatory certainty and avoided regulatory issues regarding the ability to bid for wireless spectrum and a divestment of Foxtel.

Telstra well-placed in NBN world: We believe Telstra is well-placed to compete in an NBN world where there is effectively structural separation. Its competitive advantages remain: ability to bundle; strong networks (e.g., mobile, backhaul); and balance sheet strength to invest in new products.

Strong Operating Momentum, Particularly In Mobiles:

Strong momentum: Since the middle of 2010, Telstra has invested around $1bn to win back market share. It has slowed churn in its fixed-line business and has won market share in all product groups.

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Momentum likely to continue: We expect Telstra’s momentum, particularly in the mobile arena, to continue given Telstra has the advantage of its ubiquitous network, is competitively priced against Optus and Vodafone who have a record number of customers coming out of contract.

Dividend Yield and Prospect of Capital Management:

Strong dividend yield: Telstra has a fully franked yield of 8.9% compared to a yield of 4.7% for the ASX 200. Given strong and sustainable cash generation we believe this level of dividends will continue.

Further capital management: Telstra may announce its capital management strategy at its 1H12 results upon finalisation of the NBN deal. Given lack of excess franking credits, Telstra’s only real option is an on-market buyback. Telstra could implement a sizable on-market buyback to move its balance sheet to the low end of its debt targets.

Safe Haven in Volatile Markets:

Telstra exhibits defensive characteristics compared with stocks in other industries. These include solid defensive earnings streams that are not as leveraged to the economy as other industries and a strong dividend yield. The Telstra board has effectively guaranteed a 28c dividend for FY12 and FY13.

FIG 9MOBILE MARKET

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Sector Allocation (ASX) All positions as % of shareholder’s funds Company Name Investment %Long %Short Net Weight ALL Ords Weight

DEFENSIVES 20,183,215 39% -13% 26% 20%Infrastructure QR NATIONAL LTD -2,114,100 0% -3% 0.7%Infrastructure ASCIANO GROUP 4,081,411 5% 0% 0.4%Infrastructure MACQUARIE ATLAS ROAD GROUP -394,500 0% -1% 0.1%Utilities ORIGIN ENERGY 3,417,000 4% 0% 1.2%Utilities HASTINGS DIVERSIFIED UTILITIES 849,750 1% 0% 0.1%Telecom TELSTRA CORPORATION LTD 4,913,500 6% 0% 3.4%Telecom IINET LIMITED 291,653 0% 0% 0.0%Retailing Staples WOOLWORTHS LIMITED 4,623,960 6% 0% 2.7%Healthcare CSL LIMITED 1,632,400 2% 0% 1.4%Healthcare RESMED INC 1,358,483 2% 0% 0.4%Healthcare SONIC HEALTHCARE LIMITED -815,032 0% -1% 0.4%Healthcare RAMSAY HEALTH CARE LIMITED -1,034,607 0% -1% 0.3%Healthcare COCHLEAR LIMITED 778,842 1% 0% 0.2%Healthcare ANSELL LTD -4,216,460 0% -5% 0.2%Healthcare PRIMARY HEALTHCARE 1,396,715 2% 0% 0.1%Healthcare SIGMA PHARMACEUTICALS LTD -487,500 0% -1% 0.1%Gaming CROWN LTD 3,108,300 4% 0% 0.5%Gaming TATTERSALL’S LTD 3,523,400 5% 0% 0.3%Gaming ECHO -730,000 0% -1% 0.2% FINANCIALS 18,060,207 38% -14% 24% 33%

Banks COMMONWEALTH BANK OF AUSTRALIA 4,557,961 6% 0% 6.2%Banks WESTPAC BANKING CORP 4,158,310 5% 0% 5.5%Banks AUSTRALIA & NEW ZEALAND BANKING 4,271,718 6% 0% 4.5%Banks NATIONAL AUSTRALIA BANK LTD -2,013,300 0% -3% 4.4%Banks BENDIGO BANK LIMITED -1,485,750 0% -2% 0.3%Diversified Financials IOOF -870,400 0% -1% 0.1%Diversified Financials HENDERSON GROUP PLC 1,051,162 1% 0% 0.1%Insurance QBE INSURANCE GROUP LIMITED 2,464,253 3% 0% 1.2%Insurance AMP LIMITED 2,670,145 3% 0% 0.9%Insurance SUNCORP-METWAY LTD -877,800 0% -1% 0.9%Insurance INSURANCE AUSTRALIA GROUP LTD 1,661,000 2% 0% 0.6%Real Estate WESTFIELD GROUP 2,480,000 3% 0% 1.6%Real Estate STOCKLAND 4,800,915 6% 0% 0.6%Real Estate GPT GROUP -2,920,200 0% -4% 0.5%Real Estate LEND LEASE CORP 1,064,195 1% 0% 0.4%Real Estate DEXUS PROPERTY GROUP -2,952,000 0% -4% 0.4% INDUSTRIAL CYCLICALS -759,812 32% -33% -1% 12%

Media CONSOLIDATED MEDIA HOLDINGS LTD 1,353,442 2% 0% 0.1%Media TEN NETWORK 2,340,932 3% 0% 0.1%Media SALMAT LIMITED -480,230 0% -1% 0.0%Consumer Services BRAMBLES LIMITED 1,520,450 2% 0% 0.8%Consumer Services NAVITAS LIMITED -1,762,699 0% -2% 0.1%Consumer Services SAI Global -616,200 0% -1% 0.1%Contractors LEIGHTON HOLDINGS LIMITED 1,145,514 1% 0% 0.6%Contractors WORLEYPARSONS LTD -1,052,000 0% -1% 0.5%Contractors CAMPBELL BROS LTD -833,400 0% -1% 0.2%Contractors NWH Holdings Limited -680,419 0% -1% 0.1%Contractors EMECO -965,774 0% -1% 0.1%Contractors MACMAHON HOLDINGS LTD. -1,706,516 0% -2% 0.0%Contractors RCR TOMLINSON LTD 1,268,001 2% 0% 0.0%Contractors SERVICE STREAM LIMTED 1,226,104 2% 0% 0.0%Discretionary Retail HARVEY NORMAN HOLDINGS LTD 1,512,153 2% 0% 0.2%Discretionary Retail MYER 1,917,600 2% 0% 0.1%Discretionary Retail CARSALES.COM -1,852,500 0% -2% 0.1%Discretionary Retail BILLABONG INTERNATIONAL LTD 1,629,788 2% 0% 0.1%Discretionary Retail KATHMANDU HOLDINGS LIMITED -1,304,259 0% -2% 0.0%Discretionary Retail OROTON GROUP -531,300 0% -1% 0.0%Discretionary Retail MCPHERSONS LTD -478,000 0% -1% 0.0%Transport QANTAS AIRWAYS LIMITED 2,133,843 3% 0% 0.3%Transport TOLL HOLDINGS LTD 970,200 1% 0% 0.3%Transport FLIGHT CENTRE LTD -2,040,000 0% -3% 0.2%Transport MERMAID MARINE AUSTRALIA -636,000 0% -1% 0.1%Steel ONESTEEL LIMITED 1,604,999 2% 0% 0.1%Steel BRADKEN LTD -1,244,767 0% -2% 0.1%Building Materials FLETCHER BUILDING -2,103,500 0% -3% 0.4%Building Materials BORAL LIMITED 2,163,245 3% 0% 0.2%Building Materials DULUXGROUP -1,625,982 0% -2% 0.1%Paper/Chem/Agric ORICA LIMITED 2,632,413 3% 0% 0.7%Paper/Chem/Agric AMCOR LIMITED -2,252,250 0% -3% 0.7%Paper/Chem/Agric INCITEC PIVOT LTD -2,207,250 0% -3% 0.5%Paper/Chem/Agric CALTEX AUSTRALIA -1,299,600 0% -2% 0.3%Paper/Chem/Agric PAPERLINX SPS TRUST 1,494,150 2% 0% 0.0% RESOURCES AND ENERGY 13,253,527 35% -18% 17% 25%

Diversified Miners BHP BILLITON LIMITED 7,264,269 9% 0% 9.9%Diversified Miners RIO TINTO LIMITED 2,410,200 3% 0% 2.4%Precious Metals NEWCREST MINING LTD 2,797,968 4% 0% 2.3%Precious Metals MEDUSA MINING -1,021,500 0% -1% 0.1%Precious Metals ALACER GOLD GROUP 426,400 1% 0% 0.1%Precious Metals ST BARBARA LIMITED -1,291,500 0% -2% 0.1%Precious Metals OCEANAGOLD -452,000 0% -1% 0.1%Precious Metals INTEGRA MINING LIMITED -1,316,000 0% -2% 0.0%Precious Metals TERANGA GOLD CORPORATION 861,283 1% 0% 0.0%Base Metals ALUMINA LIMITED 1,184,000 2% 0% 0.3%Base Metals PAN AUSTRALIAN RESOURCES LTD 381,000 0% 0% 0.1%Base Metals INDEPENDENCE GROUP NL 648,000 1% 0% 0.1%Base Metals MIRABELLA 385,150 1% 0% 0.1%Base Metals DISCOVERY METALS -789,000 0% -1% 0.1%Base Metals CUDECO -2,361,623 0% -3% 0.0%Base Metals KAGARA LTD 881,711 1% 0% 0.0%Base Metals TIGER RESOURCES 265,985 0% 0% 0.0%Base Metals REX MINERALS -739,397 0% -1% 0.0%Base Metals YTC RESOURCES LTD 440,729 1% 0% 0.0%Bulk Commodities FORTESCUE METALS GROUP LTD 1,326,000 2% 0% 1.2%Bulk Commodities WHITEHAVEN COAL 1,439,100 2% 0% 0.2%Bulk Commodities AQUILA RESOURCES -1,012,349 0% -1% 0.2%Bulk Commodities ASTON RESOURCES LIMTED -1,006,000 0% -1% 0.2%Bulk Commodities SUNDANCE RESOURCES -989,000 0% -1% 0.1%Bulk Commodities COCKATOO COAL LIMITED 1,288,395 2% 0% 0.0%Bulk Commodities GUILDFORD COAL LTD -1,087,153 0% -1% 0.0%Bulk Commodities STANMORE COAL LIMITED 491,855 1% 0% 0.0%Bulk Commodities METROCOAL LIMITED -178,500 0% 0% 0.0%Other Resources PALADIN ENERGY LTD 592,717 1% 0% 0.1%Other Resources MINERAL DEPOSITS -877,330 0% -1% 0.0%Other Resources GREENLAND MINERALS AND ENERGY -771,902 0% -1% 0.0%Other Resources BASE RESOURCES LTD 776,300 1% 0% 0.0%Energy SANTOS LIMITED 1,139,399 1% 0% 0.9%Energy OIL SEARCH LTD 1,709,320 2% 0% 0.7%Energy DRILL SEARCH 437,000 1% 0% 0.0%

SMALL CAPS 129,890 6% -5% 1% 9%

CASH 25,848,040 NET SHAREHOLDERS FUNDS BEFORE PERIOD END ADJUSTMENTS 76,715,068 All positions as % of Sharholders Funds

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16 AUSTRALIAN LEADERS FUND QUARTERLY REPORT | September 2011

Sector Exposure LONG SHORT NET INDEX ACTIVE

Consumer Discretionary 21.8% -11.0% 10.9% 5.0% 5.9%

Consumer Staples 6.0% 0.0% 6.0% 8.6% -2.5%

Energy 13.7% -6.0% 7.7% 9.2% -1.6%

Banks 16.9% -4.6% 12.4% 21.2% -8.9%

Real Estate 10.9% -7.7% 3.2% 6.7% -3.4%

Other Financials 10.2% -2.3% 8.0% 6.2% 1.8%

Health Care 10.6% -11.4% -0.8% 3.4% -4.2%

Industrials 16.1% -13.2% 2.9% 8.0% -5.1%

Materials 36.4% -25.8% 10.6% 25.4% -14.8%

Utilities & Telecos 7.9% -2.4% 5.5% 6.4% -0.9%

TOTAL 150.7% -84.4% 66.3% 100.0% -33.7%

Market Cap LONG SHORT NET INDEX ACTIVE

ASX Top 100 121.3% -35.0% 86.3% 83.3% 3.1%

100 - 200 10.5% -31.5% -21.0% 8.3% -29.3%

Ex 200 18.9% -17.9% 1.0% 8.4% -7.4%

TOTAL 150.7% -84.4% 66.3% 100.0% -33.7%

ALF 1 MONTH 3 MONTHS 1 YEAR 3 YEARS (P.A.) SI (P.A.)

Long -8.1% -15.5% -1.4% 13.7% -

Short -6.9% -9.1% -10.5% -0.3% -

Gross -8.2% -17.6% 4.1% 19.1% 15.7%

Net -8.4% -18.2% -0.6% 13.4% 12.2%

Index -6.3% -11.3% -8.4% 0.0% 7.2%

Net Alpha -2.1% -6.9% 7.9% 13.4% 4.9%

Portfolio Returns to September 2011

ALF Historic Exposure

FY Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun ALF FY INDEX

2004 - - - - - - - 0.4% 1.4% 0.2% -0.0% 2.3% 4.3% 9.0%2005 1.1% -0.3% 4.6% 2.8% 4.4% 2.4% 0.3% 1.3% -0.9% -6.1% -0.4% 4.8% 14.3% 24.7%2006 2.0% 2.7% 4.8% -3.0% 3.9% 3.7% 1.5% 2.0% 6.4% 2.9% -2.1% 1.4% 29.0% 24.2%2007 -3.2% 4.3% 1.7% 7.2% 2.8% 2.5% 3.1% -1.6% 3.5% 1.1% 2.7% 2.0% 29.2% 30.3%2008 -1.0% 3.4% 3.3% 1.0% -0.3% -1.9% -11.5% -8.4% 1.4% 4.4% 1.5% -7.2% -15.5% -12.1%2009 -1.3% 5.1% -5.4% -16.3% -6.6% 3.0% 2.2% 2.9% 16.0% 6.7% 7.9% 7.0% 18.7% -22.1%2010 9.2% 12.4% 6.5% -0.7% 0.8% 0.1% -3.5% 2.2% 4.2% -2.1% -7.1% -2.3% 19.9% 13.8%2011 2.8% -3.9% 2.3% 0.0% 2.7% 12.0% 2.0% 1.9% 3.6% 1.7% -1.8% -1.8% 22.9% 12.2%2012 -4.1% -6.8% -8.4% - - - - - - - - - -18.2% -11.3%

Monthly Net Returns

Fund Statistics

Fund NAV AUD (Millions) $78

Long (62) 151%

Short (51) -84%

Gross Exposure 235%

Net Exposure 66%

Cash 34%

Top 5 Holdings

BHP Billiton Ltd. 9.5%

Telstra Corp. Ltd. 6.4%

Stockland Australia 6.3%

Woolworths Ltd. 6.0%

Commonwealth Bank of Australia 5.9%

Funds Snapshot

Portfolio Exposure as of September 2011

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Level 5, 139 Macquarie Street NSW Sydney 2000

TEL (02) 9252 0225 FAX (02) 9252 1220 info@wfunds.com.au | www.australianleaders.com.au

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