ContractorsINFRASTRUCTURE TRUMPS RE

Cash ExpectationsLOWER GROWTH LEADS TO CLOS

I N S I G H T S2 0 1 8 I S S U E O N E

Investment StrategyInfrastructure – Essential Services

Australian EquitiesThemes for 2018

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Publisher: Ord Minnett Limited Editor: Simon Kent-Jones Contributors: Athena Kospetas, Sze Chean Chuah Senior Designers: Felicity Everest, Sarah-Jane Edis

ords.com.au 1

2 Infrastructure – Essential Services In recent decades, the opportunity to own infrastructure assets has expanded greatly.

6 Asset Allocation

8 Australian Equities Strategy: Themes for 2018 New themes include inflation beneficiaries and companies with balance sheet appeal.

10 Leading Lights – Preferred Stocks

12 Investment Fundamentals

14 Interest Rate Securities We favour securities with maturities between three and five years.

16 International Stocks

18 Currency

19 Alternative Investments

20 Primary Forecasts

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2 Ords Insights | 2018 ISSUE ONE

INFRASTRUCTURE Essential Services

Almost every day we rely on infrastructure to make our lives a little easier – communication towers, oil and gas pipelines, railroads, toll roads, airports and ports.

In recent decades, the opportunity to own these infrastructure assets has expanded greatly. The attraction is that they typically generate reliable earnings by providing essential services to the community, yet with limited competition. Through time, these predictable cash flows are expected to deliver income and capital growth for investors.

For long-term investors reliant on regular income, they are particularly attractive, given the long-dated nature of the concessions that infrastructure assets often incorporate.

Infrastructure companies are generally less heavily regulated than utilities, which allows companies to benefit from a greater number of people using their services.

As economies develop, aviation, shipping and vehicle traffic increase, as does demand for communications and energy.

Given the essential nature of these services, the fees charged to use them can be varied with limited impact on demand. As a consequence, earnings are more reliable than those for a typical industrial company and generally enjoy inherent protection against inflation. This dependability is also the reason that infrastructure companies can support higher levels of leverage.

The Australian stock market has a well-developed infrastructure sector, thanks in no small part to the efforts of local investment banks such as Macquarie supporting its expansion. Within the sector we have several preferences: APA Group, Qube Holdings, Sydney Airport and Transurban.

APA Group Category: Pipelines Market Cap’n: $9.4bn Price: $8.05 FY19E Yield: 5.8% (0% unfranked)

APA Group owns and/or manages 15,000 kilometres of natural gas pipelines across mainland Australia, valued in excess of $20 billion. This network connects sources of supply with 1.3 million Australian homes and businesses, delivering half the nation’s natural gas usage. The group also has interests in gas storage facilities, gas-fired power stations and wind farms.

At its 2017 full year result announced last August, APA reported underlying earnings (before interest, tax, depreciation & amortisation) of $1.47 billion, above the top end of guidance and 11% above the previous year’s result. This was the eighth consecutive year of growth for the company.

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Qube Holdings Category: Transport & Logistics Market Cap’n: $3.8bn Price: $2.30 Price Target: $3.00 FY19E Yield: 2.5% (100% franked)

Finding a solution to NSW’s complex and inefficient import/export logistics chain isn’t likely to be easy, but it should be rewarding. Qube’s solution is to realign the leading stevedore with the key logistics operator and drive greater acceptance of rail by investing in Sydney’s largest integrated intermodal terminal. In our view, this solution should see all the squares line up for Qube shareholders.

By way of background, Qube is an integrated provider of import and export logistics services. It operates three divisions covering

automotive, bulk and general stevedoring; landside logistics; and strategic development assets.

Qube has been focused on growth through acquisition. With the purchase of a 50% interest in Patrick, Australia’s leading stevedore, it has evolved into an execution-based strategy for logistics infrastructure investment. That is, investors in the stock are taking a view on the success of the new intermodal terminal at Moorebank. The company’s other businesses will continue to ride the ups and downs of the broader economic cycle, but Moorebank has the potential to change the logistics landscape for the state.

Why? Because over the next 25–30 years we are expecting the volume of shipping containers passing through Port Botany in Sydney to grow from 2.6 million per annum today to 8.4 million by 2045. The existing logistics infrastructure, however, is unable to handle this volume. Hence the need for a solution, which Qube offers.

The Patrick acquisition creates a strong commercial alignment between stevedore and logistics operators that should drive efficiency gains and lower freight costs for customers, and ultimately lead to greater acceptance of rail as an alternative to road. Anyone faced with driving on Sydney’s clogged roads would be nodding their head at this point.

Moorebank is therefore a pivotal move for Qube. We expect that Moorebank could be contributing up to a third of the group’s earnings in 10 years’ time.

APA also announced $1.2 billion in new projects, which is testament to its ability to help customers with their requirement for reliable and affordable energy. These projects, entailing gas transmission, midstream processing and renewable power generation, will start delivering $70 million of additional revenue in 2019 and $200 million in 2020 and beyond.

One of the key value drivers for APA is operating cash flow, which increased 13% in 2017. This is the amount of cash flow generated from operations, after subtracting interest and tax payments, and it is what APA uses to continue to grow the business and pay distributions to shareholders.

APA has a prudent approach to distribution growth, which has meant that distributions have increased every year since listing in 2000.

The attraction of infrastructure assets is that they typically generate reliable earnings by providing essential services to the community, yet with limited competition.

39,950 PJ

17,384 PJ

55,218 PJ

31 PJ

Sydney

860 PJ

199 PJ

1,017 PJ

2,483 PJ85 PJ350 PJ

Mondarra Gas Processing& Storage Facility

Emu DownsWind & Solar Farm

BadgingarraWind FarmPerth

KKP

EGP

YGP

YPS

GGP

PPSNGP

TGP

AGP

CGP

EPXMSP

CWP CRP

SESASGP

MGPOrbost Gas Processing Plant

Dandenong LNG Facility

VTS

SWQP

RCWP

RBP IOC

BWPWGP

DPS & LPS

BGP

WPP

MP

PGP

MMGP

Darwin

Mount Isa

Brisbane

Melbourne

Gladstone

Wallumbilla

Daandine PS &Kogan North GPP

Darling DownsSolar Farm

DirectlinkTipton West GPP

North Brown Hill Wind Farm

AdelaideGas storage

Wind farm

Solar farm

Integrated operations centre

Gas-fired power station

Gas processing plant

LNG plants

Natural gas and ethane 2Preserves, as at November 2017Source: EnergyQuest December 2017

APA assets and investments

APA operated assets

Other natural gas pipelinesElectricity interconnectors

APA’s uniquely integrated energy assets

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Source: APA financial report

4 Ords Insights | 2018 ISSUE ONE

Sydney Airport

Category: Airports

Market Cap’n: $15.3bn

Price: $6.72

Price Target: $8.45

FY19E Yield: 6.0% (0% unfranked)

Sydney Airport operates the Kingsford Smith Airport in Sydney. The company develops and maintains the airport infrastructure and leases terminal space to airlines and retailers.

The stock offers investors significant leverage to a number of attractive characteristics:

Strength in international passenger growth – An international passenger generates around three times the revenue of a domestic one. A number of factors support our belief that international visitors growth will continue at a healthy pace: the burgeoning middle-classes in Asia; potential depreciation of the Australian dollar; and an ongoing

decline in the cost of air travel, fuelled by further evolution in the types of air travel.

Exposure to one of Australia’s most productive retailing precincts – We estimate that the international terminal achieves average sales per square metre of $25,000–50,000 depending on whether it's duty free or non-duty free. This is well in excess of the most productive specialty stores in a conventional shopping centre.

SYDNEY

NORTHERNBEACHES

KURNELL

PARRAMATTA

SYDNEYAIRPORT

PRECINCT

PORTBOTANYPRECINCT

COOK RIVERINTERMODAL TERMINAL

MOOREBANKINTERMODALTERMINAL

MACARTHURINTERMODALSHIPPINGTERMINAL

CHULLORAINTERMODALTERMINAL

ENFIELDINTERMODALLOGISTICS CENTRE

PROPOSED WESTERN SYDNEYINTERMODAL TERMINAL

BADGERYCREEKAIRPORT PRECINCT

YENNORAINTERMODAL

TERMINAL

CLYDEINTERMODAL TERMINAL

BANKSTOWNAIRPORT MILPERRA

CBD

Transport Gateway

Shared Heavy Rail Proposed Motorway Extension

Road/Motorway Investigation

Transport Investigation

Intermodal Terminal

Dedicated Freight Rail

Motorway

Motorway Expansion

Sydney’s Infrastructure Assets & DevelopmentsLarge scale cities like Sydney require investment in a complex set of infrastructure assets. APA, Qube, Sydney Airport and Transurban are integral to the delivery and management of these essential assets.

Source: Sydney Metropolitan Strategy

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Enviable car parking margins – We estimate car parking operating margins of 70–75%, above those of other airports of 56–66% and 40–45% for non-airport operators. Furthermore, capacity expansions have generated a return on investment of 35–65%, so further car park development should be accretive.

The development of the second Sydney airport at Badgerys Creek, due to open in 2026, is a longer-term risk, but probably overstated. It’s not clear that the increased competition will result in a significant drag on Sydney Airport’s earnings growth, let alone an earnings reduction over the foreseeable future. It’s expected that about 80% of passengers passing through Badgerys Creek will be domestic travellers, and mainly leisure rather than business, making it best suited for low-cost carriers. This suggests Kingsford Smith Airport should retain its position as the preferred airport for domestic and international full-service carriers due to, among other things, its proximity to Sydney’s CBD and its established transport network.

Transurban

Category: Toll roads

Market Cap’n: $26.5bn

Price: $11.68

Price Target: $14.35

FY19E Yield: 5.2% (10% franked)

Transurban manages and develops urban toll–road networks in Australia, with 13 assets spanning Sydney, Melbourne and Brisbane, and also in the United States, with two roads in the Washington DC area.

The group also has several construction projects underway including the NorthConnex tunnel in Sydney, the West Gate Tunnel Project in Melbourne and the 395 Express Lanes in Virginia.

The company’s $9 billion development pipeline and management initiatives should assist it to continue to grow toll revenues and operating earnings at a rate in exceeding local economic growth in the near term.

In addition, there is the potential for acquisitive growth to enhance this, whether it’s a stake in the WestConnex toll road in Sydney, or a U.S. toll road that possibly comes up for sale.

The distribution outlook is also favourable. We forecast 3-year compound annual distribution growth of around 10%.

A question that is consistently raised about infrastructure stocks is what the impact of rising interest rates will be. Typically when long-term interest rates have risen, as we’ve seen recently, there has been a short-term sell-off in bond-proxy stocks. However, these stocks outperformed strongly thereafter. We believe this reflects firstly, investor realisation that inflationary expectations are often too high – that is, the normalisation of long-term interest rates takes longer.

Also, infrastructure stocks are insulated from a gradual rise in inflation through, in Transurban’s case, CPI-linked tolls, as well as active debt management – that is, taking advantage of historically low rates to lock in cheap debt as well as extend maturities.

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6 Ords Insights | 2018 ISSUE ONE

CashInterest ratePropertyEquities

Strategic allocation

Dynamic allocation

55%

10%

30%

5%

60%

10%

22.5%

7.5%

Dynamic allocation

70%

10%

15%

5%

75%

10%

7.5%

7.5%

Strategic allocation

Risks to our outlook � Greater volatility

� Higher inflation

� Positive correlations between bonds and equities

ASSETALLOCATIONOutlookOur macro views remain constructive: growth momentum is robust, global inflation is normalising but unlikely to see a dramatic uptick, and the Federal Reserve will continue to tighten policy but remain accommodative. Domestically, the latest reporting season finished with a slight improvement in profit expectations while the RBA will remain on the sidelines. This background supports our overweight position in equities over fixed income, however, an escalation in trade tensions between the U.S. and China threatens global growth. For this reason we recently trimmed our near-term risk exposure by reducing the International Equities position and reallocating into Cash.

Source: Ord Minnett Research.

Asset ClassDynamic Positioning Comments

Equities

Australian O/W Reporting season offered further fundamental support. Our preferred themes: global over local; balance sheet appeal; inflation beneficiaries; and areas of structural growth.

International O/W Underpinned by strong corporate fundamentals. Valuation attractive following the technical sell-off in February. Regionally, hold unhedged Japanese exposure through iShares MSCI Japan (IJP) and Eurozone via EuroStoxx ETF (ESTX), as well the U.S. tax trade through iShares S&P Small Cap 600 (IJR). Sector-wise, with inflation normalising, hold international financials via Betashares Global Banks (BNKS).

Property Neutral The sector struggled with the recent bond sell-off, but their defensive characteristics produced outperformance as equities sold off. Positioning may change once direction of bond markets is clearer. Favour developers with growth options.

Interest rate Favour variable over fixed rate.

Fixed rate U/W Rising inflation expectations have triggered bond sell-off, compounded by more hawkish rhetoric from the Federal Reserve. Hold 3-6 month term deposits. Wrong point in cycle to hold large position in fixed-rate bonds.

Credit Neutral Limited potential for further spread tightening. However, support comes from demand exceeding supply ($7 billion in listed interest rate securities will be redeemed this year).

Cash O/W RBA unlikely to move near-term. O/W based on geopolitical tensions.

Balanced allocation Growth allocation

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CA

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Strategic Allocation Dynamic Allocation

Asset class Co

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ive

Mo

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y co

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Bal

ance

d

Gro

wth

Hig

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Position Variation Implementation

Equities 25% 30% 55% 70% 85%

Australian 20% 25% 40% 45% 55% O/W +0.0 to 2.5% ListedO/W Offshore earners (ALL, BLD, RHC), balance sheet appeal (ANZ, AWC, ORA, RIO, SSM), inflation (AGL, OSH, QUB)U/W Bond proxies, consumer, telecoms

UMACore Equities Portfolio, Emerging Companies Portfolio

International 5% 5% 15% 25% 30% O/W +0.0 to 2.5% ListedMarket ETFs: iShares Global 100 (IOO & IHOO - Hedged), EuroStoxx ETF (ESTX), Shares MSCI Japan ETF (IJP), iShares S&P Small Cap 600 ETF (IJR).

Sector ETFs: Betashares Global Banks (BNKS - Hedged)

UMAInternational equities portfolio

Property 5% 10% 10% 10% 10% Neutral 0% ListedO/W Developers (CHC, GMG), diversified (GPT)

UMAZurich Australian Property Securities,Resolution Capital Global Fund (International)

Interest Rate 50% 45% 30% 15% 0%

Fixed rate 25% 20% 15% 5% 0% U/W -5.0 to -7.5% ListedCorporate Bond ETFs (PLUS, VACF)

UMAPIMCO Diversified Fixed Interest

Term deposits3-6 months offers most attractive term premium

Credit 25% 25% 15% 10% 0% Neutral 0% ListedListed Interest Rate Securities Model Portfolio, floating rate bond ETFs (FLOT, QPON)

UMAInterest Rate Securities Portfolio,Bentham Global Income (International)

Cash 20% 15% 5% 5% 5% O/W +0.0 to 2.5% ListedAustralian High Interest Cash ETF (AAA)

FundAccelerator Cash Account

Strategic asset allocation and dynamic positioning

Source: Ord Minnett Research. Shaded weightings next to Equities – Australian and international, and interest rate - fixed rate and credit are suggested weightings only.

8 Ords Insights | 2018 ISSUE ONE

AUSTRALIAN EQUITIES STRATEGYSome trends from 2017 should continue in 2018, including Australia’s de-synchronisation from other developed markets, so the global-over-local theme remains relevant. New themes include inflation beneficiaries and companies with balance sheet appeal. Recent additions to our preferred lists include Alumina (balance sheet appeal), Aristocrat (global over local), Austal (structural growth) and Qube Holdings (inflation hedge).

Global over local The global economy should sustain above-trend economic growth in 2018. Compositionally, this assumes better growth in emerging markets such as India and Latin America, a

modest slowdown in China’s growth, and a steady Europe and U.S. By comparison, we expect Australian growth at a below-average pace of 2.7%.

Corporate earnings growth overseas is also forecast to be double that of Australian companies in 2018. Based on our currency views, regional earnings growth forecasts and outlook for offshore equity markets, having meaningful global exposure makes sense. Our International Equities Portfolio is discussed in detail on pages 16 and 17.

Among Australian stocks, slot machine manufacturer Aristocrat sources around 80% of revenues

Themes for 2018

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The global economy is expected to sustain above-trend economic growth in 2018.

AGL Energy is favourably exposed to higher electricity prices – one of the few sources of inflation in Australia – having pushed through price increases to retail customers in the past year. Another beneficiary of higher energy prices is Oil Search. Oil prices have risen as OPEC extends its output cuts to the end of 2018, while LNG prices have increased after regulation was introduced to restrict Australian exports. Oil Search is one of the few producers able to take advantage of this pricing environment, given it is producing above nameplate capacity and is able to sell additional tonnage on spot markets. Following QBE’s new CEO rebasing guidance, we think the share price could be near a bottom. Our analysts think there is an increased chance that global insurance premiums will rise following 3Q17 losses sustained by the industry. Furthermore, higher global inflation will induce higher bond yields, which would benefit QBE’s investment yields. Finally, we see Qube Holdings pushing through higher port infrastructure charges following a move by one of its key competitors, creating some revenue upside in its Patrick’s division. We expect this could also increase the appeal of its Moorebank project, helping it lock in further tenancy agreements this year.

Structural growth This theme covers companies that may not deliver earnings upside in the near term, but we are willing to be patient around the investment thesis given leverage to longer-term structural trends – such as the ageing population, growth in superannuation assets, infrastructure and renewables. Our positive view on Austal, a WA-based shipbuilder, is premised on it being well-positioned to benefit from a strong pipeline of opportunities in the defence sector, especially given the geopolitical climate. Other structural growth stories include AMP in superannuation, APA Group in infrastructure and renewables, and Ramsay Healthcare in private hospitals.

offshore, primarily in the US, but also in Asia and Europe. It is also diversifying its revenue sources by investing in the high-growth digital space as consumers shift towards online gambling channels. Another stock providing offshore exposure is Boral (a building materials provider leveraged to U.S. construction and rebuilding activity, as well as local infrastructure works).

Balance sheet appeal Given financial stability risks in Australia and the patchy track record our market has had in meeting earnings expectations, it is hard to go past companies with sound balance sheets. These companies should offer some defensiveness should financial stability risks increase, yet still have flexibility to pursue earnings accretive strategies (e.g. acquisitions, share buybacks). ANZ is our preferred retail bank given it has one of the stronger capital ratios of the major banks, opening up the possibility that it could look at capital management options in 2018. Rio Tinto and Alumina are our preferred resources exposures given their relatively under-geared balance sheets, valuation upside, and exposure to our preferred base metal, aluminium. Service Stream is currently in a net cash position, which it is likely to use for bolt-on acquisitions, supplementing its revenues from the NBN rollout, but giving it flexibility for capital returns as well. Similarly, Orora has capacity to pursue further acquisitions.

Inflation beneficiaries We anticipate global inflation will rise in 2018, driven by input cost pressures (including energy prices) and tightening labour markets. Yet the scene in Australia is different, with spare capacity in labour markets and increasing competition creating disinflationary risk. We seek companies that can hedge against both outcomes – that is, their ability to push through price increases that can either offset local disinflationary pressures or absorb the risks emanating from rising global inflation.

%

10 Ords Insights | 2018 ISSUE ONE

LEADING LIGHTSPreferred Stocks

2019

Company Name Price Price/

Earnings (x)Dividend

Yield Franking Comment

Core blue chip

AGL Energy $22.01 12.4 6.0% 80% Free cash flow generation increasing with improving retail margins and higher electricity costs.

ANZ $28.01 11.4 6.0% 100% Valuation upside while the bank continues to improve its operating  model.

CSL Ltd $166.59 30.6 1.4% 0% Core health-care exposure as global leader in supply of plasma products.

GPT Group $4.79 15.2 5.4% 0% Property portfolio is in sound shape, with steady income and distribution growth over coming years.

Oil Search $7.18 17.4 2.7% 0% Well placed to weather commodity price volatility due to the low-cost nature of its assets.

Ramsay Health $62.93 20.3 2.5% 100% Additional growth potential and further procurement savings.

Rio Tinto $76.64 11.5 5.2% 100% Long-life mining investment opportunities.

Transurban $11.68 39.9 5.2% 10% Infrastructure remains an attractive asset class.

Westpac $29.52 12.0 7.3% 100% Domestic mortgage focus is proving advantageous.

ords.com.au 11

2019

Company Name Price Price/

Earnings (x)Dividend

Yield Franking Comment

Value (Income)

AMP Limited $5.23 13.9 5.4% 90% Offers organic growth due to revenue margin compression and improvement in its wealth protection business.

APA Group $8.05 36.3 5.9% 0% Owns and operates Australia's largest natural gas infrastructure business as well as gas storage and wind farms.

Charter Hall $5.91 13.0 6.5% 0% Earnings and distributions are supported by continued capital inflow into the asset class.

Event Hospitality $13.77 17.0 4.2% 100% Improved conditions will generate stronger returns for hotels division, while strong film slate provides medium-term support.

NAB $29.34 12.2 6.7% 100% Dividend yield well ahead of its major bank peers.

Suncorp Group $13.75 14.5 5.1% 100% Solid yield through capital management initiatives.

Wesfarmers $43.56 18.2 5.2% 100% Generating significant cash flows.

Growth

Aristocrat Leisure $25.22 20.8 1.9% 30% Strong recurring revenue and exposure to fast-growing Americas.

Boral Limited $7.42 15.6 3.7% 100% Strong earnings trajectory driven largely by road infrastructure spend and construction materials price increases.

Caltex Australia $31.63 13.0 4.2% 100% Core business remains attractive, with refiner margins supporting earnings growth and cash generation.

Macquarie Group $105.39 13.9 5.0% 40% Valuation upside, supported by an improving outlook from the group.

Magellan $25.79 16.1 4.7% 100% Exciting opportunities from new strategies.

Orora Limited $3.35 17.8 4.0% 0% Strong cash-flow generation gives ability to invest in value-creating opportunities.

Treasury Wine Estate

$17.30 28.5 2.4% 80% Company’s turnaround continues, with multiple drivers of earnings growth.

Small caps

Afterpay Touch $6.88 34.4 0.0% 0% Dominant player in the rapidly expanding 'Buy Now, Pay Later' space.

Austal Limited $1.79 15.0 2.2% 0% Solid balance sheet and impressive tender pipeline.

Corporate Travel $24.63 25.5 2.2% 50% Well positioned with market share gains from a low base and international expansion strategy.

Hansen Technologies

$4.34 19.8 1.4% 100% IT services company that combines recurring revenue from a diversified customer base and material M&A option value.

Hub24 Ltd $10.28 35.3 2.3% 0% Investment platform continues to show strong momentum, with significant upside from existing clients and technology.

People Infrastructure

$1.15 10.0 5.5% 100% Expanding temporary labour and workforce management company with sound safety record and compelling sector exposures

Pinnacle Investment

$4.30 22.6 4.2% 100% Strong growth expected based on impressive average growth in funds under management at a number of affiliates.

RCR Tomlinson $4.15 11.6 3.4% 0% A construction, services and engineering services contractor operating in infrastructure, energy and resources markets.

Service Stream $1.62 12.9 4.9% 100% As a contractor to the NBN, it is well positioned to participate in the rollout and increased mobile infrastructure spending.

Steadfast Group $2.70 20.0 2.9% 100% Earnings are defensive with strong free cash flow generation.

WorleyParsons $14.92 18.1 2.7% 0% Improving market conditions for resources and energy companies will increase the company’s activity levels.

LEA

DIN

G L

IGH

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Source: Iress, Ord Minnett Research.

12 Ords Insights | 2018 ISSUE ONE

INVESTMENT FUNDAMENTALS

EPS Growth

(FY17-19 p.a.)

Price/ Earnings

(x)

Price/ Earnings Growth

(x)

Price/ Book

(x)Dividend

Yield

S&P/ASX 200 9% 15.5 1.7 1.9 4.6%

Consumer discretionary

6% 17.6 2.8 2.3 3.9%

Consumer staples

7% 18.7 2.8 2.4 4.2%

Energy 18% 15.1 0.8 1.4 3.4%

Financials 3% 13.1 3.9 1.7 5.8%

Banks 3% 12.4 3.9 1.6 6.2%

Healthcare 11% 27.2 2.4 5.2 1.9%

Industrials 11% 21.2 1.9 3.1 4.1%

IT 14% 25.7 1.9 5.1 2.2%

Materials 31% 15.4 0.5 2.2 3.7%

Property 6% 14.9 2.6 1.0 5.4%

Telcos -2% 11.7 -7.6 2.3 5.9%

Utilities 15% 19.5 1.3 2.0 5.6%

Source: Datastream, Ord Minnett Research. Price/earnings, price/book and dividend yield use 12-mth forward consensus estimates. Price/earnings growth uses 3-yr EPS Growth.

Recent earnings growth has allowed the price/earnings ratio of the Australian market to level off.

Source: Datastream. 12-mth forward consensus estimates are used. Red line represents the average ratio.

Source: Datastream, Ord Minnett Research. 12-mth forward consensus estimates.

The market’s dividend yield of 4.6% is near the long-term average, while the payout ratio has retraced to a more sustainable level.

Resource stocks are offering the highest earnings growth in coming years, which underpins low price/earnings growth ratios. Banks and telcos are trading at the lowest price/earnings across the market while property is the only sector trading at book value. Banks offer the highest dividend yield.

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14 Ords Insights | 2018 ISSUE ONE

INTEREST RATE SECURITIES

Business conditions are positive and non-mining business investment is increasing, with higher levels of public infrastructure investment supporting the economy.

On housing, market conditions have eased in Sydney and Melbourne, helped along by Australian Prudential Regulation Authority's (APRA) efforts to contain the build-up of risk in household balance sheets. That said, household debt remains at record levels.

Despite strength in labour markets, wage growth remains low and is expected to remain subdued. A run of weak inflation outcomes,

reflecting low growth in labour costs and strong competition in retailing, is forcing the Reserve Bank of Australia's (RBA) hand. The central bank's efforts continue to be hindered by a resilient Australia dollar which, should it appreciate further, will slow the pick-up in economic activity and inflation.

Low interest rates continue to support our local economy, with further progress in reducing the output gap and the expectation that inflation returns to the RBA’s target range, although progress is likely to be gradual.

We continue to believe the RBA cash rate will remain at 1.50% for the remainder of 2018.The Australian economy is expected to grow more rapidly in 2018 than it did last year. However, fourth-quarter GDP figures missed expectations and this consolidates our view that the cash rate will remain firmly on hold. Stretched household balance sheets and stagnant wage growth mean the outlook for consumption remains a persistent source of uncertainty, with the subdued consumer ultimately hindering growth from returning to above 3%.

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Market wrap and outlookListed interest rate securities had a solid year in 2017, delivering over 6.1% on a net basis, driven by strong demand and shrinking supply. Fundamentally, low volatility drove global bond spreads to record lows and supported pricing, as did the strengthening of the banks’ capital positions following the finalisation of the Basel III framework.

This almost two-year price run has pushed valuations into overvalued territory at the start of 2018, but since then we have seen a pick-up in volatility across all risk assets. Hybrids have not been immune from this, experiencing a sustained sell-off and a subsequent return to more palatable valuations.

Term premiums, the additional return received for accepting longer-dated maturities, were essentially eroded. However, we are now seeing a return of the term premium and a healthier looking yield curve versus the flat curve that has characterised the hybrids market for the past six months.

During the period of correction in early February, Australian equites shed 3.7%, while hybrids fell just 0.43% over the same period, adhering to historical performance patterns during periods of elevated uncertainty – hybrids typically do a better job of holding their value than ordinary shares.

Overall, the backdrop for listed interest rate securities is positive and we see credit positives, both technical and fundamental.

The technical backdrop is expected to remain robust, with almost $7 billion in listed interest rate securities expected to be redeemed this year. Given banks are operating well in excess of their capital requirements, with some even announcing buybacks, it’s unlikely we’ll see the appetite for funding from banks that we’ve become accustomed to in recent years. We expect scarcity of supply and persistent demand will continue to support the pricing of listed interest rate securities.

Fundamentally, APRA’s efforts to bolster the domestic banking system have effectively removed some of the risks related to investing in these securities, thereby increasing their appeal. In addition, corporate earnings remain robust and corporate debt levels are stable.

Positive economic momentum continues to drive market interest rates higher globally and Australia will inevitably follow suit, at least at the mid-to-longer end of the curve. While we acknowledge capital values will face volatility in the near term as long term interest rates undergo repricing, a pick-up in interest rates will serve listed interest rate securities investors well in the medium to long term through higher distributions.

Preferred securitiesOur preferred securities list is comprised of additional tier 1 hybrids, as subordinated note valuations remain stretched, despite the recent correction.

Given term premiums remain suppressed, we favour securities with maturities between three and five years. In saying this, both Bendigo Bank CPS 4 (BENPG) and Bank of Queensland Capital Notes (BOQPE) are undervalued according to our fair value assessment and compensating investors for accepting the longer maturity date.

Commonwealth Bank PERLS VII (CBAPD) is one of our preferred securities, offering capital upside and a modest income stream.

Other preferred securities include ANZ Capital Notes IV (ANZPG), CBA PERLS IX (CBAPF) and NAB Capital Notes II (NABPD). In each case, we retain a ‘fair value’ assessment, with each offering value on both an absolute and relative basis. Each of them have relatively high coupon margins; these types of securities generally trade at a premium and should therefore experience less capital price volatility than a security such as Westpac Capital Notes II (WBCPE), which has a lower coupon margin of 3.05% for the same time to call.

Code IssueExpected Maturity

Last Price

Coupon Structure

Coupon Rate (Net)

Running Yield

Yield to Maturity

Trading Margin

ANZPG ANZ Capital Notes IV 20/03/2024 $104.60 BBR90 + 4.70% 4.55% qtly 6.16% 4.16% 1.5%

BENPG Bendigo CPS 4 13/06/2024 $98.80 BBR90 + 3.75% 3.85% qtly 5.50% 6.80% 4.1%

BOQPE Bank of Queensland Capital Notes

15/08/2024 $99.90 BBR90 + 3.75% 3.88% qtly 5.51% 6.47% 3.7%

CBAPD CBA PERLS VII 15/12/2022 $96.40 BBR90 + 2.80% 3.20% qtly 4.71% 6.10% 3.5%

CBAPF CBA PERLS IX 31/03/2022 $100.82 BBR90 + 3.90% 3.98% qtly 5.60% 5.98% 3.5%

NABPD NAB Capital Notes II 07/07/2022 $106.15 BBR90 + 4.95% 4.73% qtly 6.32% 6.06% 3.5%

Source: Iress, Ord Minnett Research. Coupons, yields and margins incorporate franking credits.

Preferred interest rate securities

16 Ords Insights | 2018 ISSUE ONE

Ord Minnett manages an international equities portfolio on behalf of clients, which currently holds the stocks on the opposite page.

In this edition of Insights we highlight ASML, a technology company that produces extremely complex machinery that forms an important step in the production of microchips.

SA MLCOMPANY ASML Holdings

TICKER ASML.AMS

EXCHANGE Amsterdam

SECTOR Technology

SUB-INDUSTRY Semiconductors

DescriptionASML counts all the world’s top microchip companies as its customers. The increasing demand for smaller and faster microchips, enabled by ASML’s leading-edge technology, supports a strong outlook for the company over the longer term.

ASML’s machines focus on the lithography stage of the chip production process. The machines are essentially projection systems using laser light to lay out the transistors (the ‘brain cells’ of a microchip).

The light is projected using a mask (also known as a reticle), containing the blueprint of the pattern that will be printed. A lens or mirror focuses the pattern onto the wafer – a thin, round slice of semiconductor material – which is coated with a light-sensitive material. When the unexposed parts are etched away, the pattern is revealed. Lithography patterns the structures on a microchip and therefore plays an important role in determining how small the features on the chip can be and how densely chip makers can pack transistors together.

Investment thesis

The guiding principle for ASML is to continue the push towards ever-smaller, cheaper, more powerful and energy-efficient semiconductors. The long-term growth of the semiconductor industry is based on the principle that the power, cost and time required for every computation on a digital electronic device can be reduced by shrinking the size of transistors on chips.

The cost and size reductions achieved by ASML’s technology in high-volume manufacturing will drive a wave of innovation by enabling microchips supporting artificial intelligence at the edge of the network, in devices such as smartphones, personal computers, the Internet of Things endpoints, automobile, as well as next-generation memory chips.

INTERNATIONAL STOCKS

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Consumer

Diageo PLC UK GBp 106 20 8% 2.9% Distiller

Estee Lauder Companies Inc USA USD 68 30 12% 1.2% Beauty products

Masco Corp USA USD 17 14 14% 1.1% Home improvement and building products

McDonald's Corp USA USD 158 19 8% 2.8% Quick service restaurants

Nestle SA Switzerland CHF 318 18 9% 3.5% Multinational packaged food company

Relx NV Netherlands EUR 55 17 8% 3.0% Media publisher and information provider

Energy

Total SA France EUR 186 12 5% 6.6% Integrated oil, gas and chemical producer

Financials

BlackRock Inc USA USD 114 17 12% 2.3% Global investment management company

Intercontinental Exchange Inc USA USD 56 19 12% 1.4% Financial exchange operator

Mastercard Inc USA USD 242 25 18% 0.6% Payment solutions supporting credit and debit transactions

Partners Group Holding AG Switzerland CHF 25 25 7% 2.9% Private equity manager

Healthcare

Edwards Lifesciences Corp USA USD 37 27 13% 0.0% Products and services to treat cardiovascular disease

Johnson & Johnson USA USD 455 16 5% 2.9% Consumer, pharmaceutical and medical devices

Thermo Fisher Scientific Inc USA USD 109 18 11% 0.3% Analytical instruments and supplies

Industrials

Honeywell International Inc USA USD 146 17 10% 2.2% Diversified technology and manufacturing

Raytheon Co USA USD 79 19 15% 1.7% Defence and homeland security technologies

Technology

Alphabet Inc USA USD 1,006 23 17% 0.0% Widely used web-based search engine

Amazon.com Inc USA USD 965 101 85% 0.0% Online retailer and IT services

ASML Holding NV Netherlands EUR 114 23 21% 1.1% Equipment for microchip manufacture

Capgemini SE France EUR 28 15 9% 1.9% IT services contractor

Facebook Inc USA USD 680 20 22% 0.0% Leading social media company

Tencent Holdings Ltd China HKD 689 NaN 25% 0.2% China-based IT exposure

Other

iShares MSCI Japan ETF USA YEN 36 13.1 34% 1.0% Japanese stock market exposure

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18 Ords Insights | 2018 ISSUE ONE

CURRENCYExchange Rate Forecasts

Further U.S. dollar (USD) weakness at the start of the year has prompted a number of changes to our currency forecasts. The Australian dollar (AUD) is affected by this dynamic, and so we have marked our AUD forecasts for 2018 higher than they were in 2017.

For currencies such as the euro and swiss franc, the forecast revisions have been driven by both USD weakness and some supportive region-specific factors. For the AUD, it is harder to make the case that a shift in domestic fundamentals requires currency upgrades, but the persistence of USD weakness doesn’t look like it will fade anytime soon.

RATES* CURRENT JUNE-18

AVERAGE FOR QUARTER

DEC-18

Source: IRESS, Ord Minnett Research

* Per Australian Dollar

Fundamental anchors for a lower AUD/USD are compelling:

� Rate differentials versus USD are negative (the US cash rate will easily exceed the Australian cash rate by year end);

� Cyclical divergence between the Australian and global economies will persist; and

� Our forecasts see little upside for Australia’s key commodity prices.

But from a valuation perspective, the AUD is close to its long-run average on a real effective exchange rate basis. This is consistent with the idea that, while we retain bearish trajectories for the AUD, the decline is reasonably modest.

For the AUD/USD rate, the last couple of years have delivered a strong technical uptrend, and so we are mindful of the possibility that the currency continues to mark higher lows over time, limiting the extent of any depreciation.

While we retain bearish trajectories for the AUD, the decline is reasonably modest.

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ords.com.au 19

Alternative investments are generally defined as investments that fall

outside the normal asset allocation guidelines. The compelling trait of alternative investments is that they tend to be lowly correlated with traditional asset classes. The desired outcome is that sensible use of alternative investments will further optimise an investment portfolio’s risk and return characteristics. Examples of alternative investments include hedge funds, precious metals, infrastructure (non-listed) and private equity1.

In this section, we’ll review an alternative asset investment product that Ord Minnett can provide access to through various investment platforms. In this edition we cover the Partners Group Global Value Fund, which invests in private equity.

Private equity is a common term for investments that are typically made in non-public companies through privately negotiated transactions. The private equity market is diverse and can be divided into different segments, which may exhibit distinct characteristics based on combinations of various factors. These include the type and financing stage of the investment, the geographic region in which

the investment is made and the vintage year.

Partners Group is a global private asset management firm specialising in private forms of equity, debt, infrastructure and real estate. The firm manages a broad range of funds for an international clientele of institutional investors, private banks and investors. Partners Group is headquartered in Zug, Switzerland and has offices in Europe, the U.S. and Asia. The firm is listed on the SIX Swiss Exchange and is majority owned by its partners and employees.

The Value Fund, which was launched in Australia in 2012, is an Australian unit trust with the objective of achieving capital growth over the medium and long term by investing in private equity. It provides investors with broad diversification across geographies, financing stages and investment class types. The fund uses Partner Group’s relative value investment approach to systematically invest in those segments and investment types that offer attractive value at a given point in time, in order to significantly enhance risk adjusted returns.

The Value Fund allows investors to subscribe and redeem shares on a monthly basis, thus avoiding the long lock-up periods common in most private equity funds.

Management fees are capped at 1.75% per annum, a standard rate for private equity funds.

In terms of the portfolio composition, at the end of 2017 geographically it was invested 44% in Europe, North America 41%, Asia-Pacific 12% and Rest of World 3%. Exposure by financing stage was 72% buyout, 25% special situations, and the remaining 3% venture capital. By transaction type, 60% was direct, 26% primary and 14% secondary.

Partners Group Global Value Fund investment returns

YearAnnual Return

Cumulative Value of $100 invested

in 2007

2007 -4.7% 95

2008 7.6% 103

2009 -7.6% 95

2010 20.5% 114

2011 12.4% 128

2012 7.7% 138

2013 18.1% 163

2014 16.5% 190

2015 12.3% 214

2016 9.2% 233

2017 9.2% 255

1 Due to the characteristics associated with many alternative investment strategies, including the lack of transparency and liquidity constraints, alternative investments should represent a small percentage of an investment portfolio. Furthermore, alternative investments typically attract higher fee levels, which can impact performance.

ALTERNATIVE INVESTMENTSPartners Group Global Value Fund

PRIMARY FORECASTS

FORECASTS & STRATEGY

18%

MSCI EM

MOVEMENTJapan TopixUK FTSE

Euro StoxxUS S&P 500

ASX 200

Japan Topix

UK FTSE

Euro Stoxx

US S&P 500

ASX 200

13%

11%

18%

6%

8%

Category 1Q18 2Q18 3Q18 4Q18 2018 2019

Economic growth

Global 3.4 3.5 3.4 3.3 3.4 3.2

Developed 2.1 2.4 2.3 2.2 2.4 2.1

Emerging 5.6 5.3 5.2 5.1 5.2 4.9

Australia 3.5 3.1 2.4 1.7 2.7 2.6

US 2.0 2.3 2.5 2.5 2.5 2.2

China 7.4 6.6 6.3 6.3 6.8 6.4

Rates (period end)

RBA 1.50 1.50 1.50 1.50

10yr yield 2.70 2.68 2.80 2.90

US Fed 1.75 2.00 2.25 2.50

10yr yield 2.85 3.00 3.05 3.15

Currency

AUD/USD 0.77 0.78 0.76 0.75

US DXY 114 116 114 113

USD/JPY 106 111 108 106

USD/CNY 6.33 6.28 6.27 6.25

Commodities

Iron ore fines (US$/t) 70 65 65 60

Brent (US$/bbl) 70 78 68 60

Copper (US$/t) 7,120 7,300 7,500 7,700

Gold (US$/oz) 1,340 1,380 1,450 1,460

MarketsWe expect positive returns in 2018 from

most major stock markets.

The Japanese market, we believe, offers

the greatest upside, followed by the

Euro zone and the U.S.

The Australian and U.K. markets are

showing less potential on a price basis,

but given their higher yield, total returns

will be more closely matched to the other

markets mentioned above.

ords.com.au 21

PRIMARY FORECASTS

Ord Minnett Limited ABN 86 002 733 048; ASX Market Participant AFS Licence Number 237121

ords.com.au ords.com.hk

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GUIDELINES Ord Minnett recommendations are based on the total return of a stock – nominal dividend yield plus capital appreciation – and have a 12-month time horizon.

SPECULATIVE BUYWe expect the stock’s total return (nominal yield plus capital appreciation) to exceed 20% over 12 months. The investment may have a strong capital appreciation but also has high degree of risk and there is a significant risk of capital loss.

BUYThe stock’s total return (nominal dividend yield plus capital appreciation) is expected to exceed 15% over the next 12 months.

ACCUMULATE

We expect a total return of between 5% and 15%. Investors should consider adding to holdings or taking a position in the stock on share price weakness.

HOLD

We expect the stock to return between 0% and 5%, and believe the stock is fairly priced.

LIGHTEN

We expect a loss of between 0% and 15%. Investors should consider decreasing their holdings.

SELL

We expect a total loss of 15% or more. Investors should decrease their holdings.

RISK ASSESSMENT

Classified as Lower, Medium or Higher, the risk assessment denotes the relative assessment of an individual stock’s risk based on an appraisal of its disclosed financial information, historic volatility of its share price, nature of its operations and other relevant quantitative and qualitative criteria. Risk is assessed by comparison with other Australian stocks, not across other asset classes such as Cash or Fixed Interest.

OFFICES Adelaide Level 5, 100 Pirie Street, Adelaide SA 5000 Tel: (08) 8203 2500 | Fax: (08) 8203 2525

Brisbane Level 31, 10 Eagle Street, Brisbane QLD 4000 Tel: (07) 3214 5555 | Fax: (07) 3214 5550

Buderim, Sunshine Coast 1/99 Burnett Street, Buderim QLD 4556 Tel: (07) 5430 4444 | Fax: (07) 5430 4400

Caloundra, Sunshine Coast 79-81 Bulcock Street, Caloundra QLD 4551 Tel: (07) 5491 3100 | Fax: (07) 5491 3222

Canberra 101 Northbourne Avenue, Canberra ACT 2600 Tel: (02) 6206 1700 | Fax: (02) 6206 1720

Coffs Harbour Suite 4, 21 Park Avenue, Coffs Harbour NSW 2450 Tel: (02) 6652 7900 | Fax: (02) 6652 5716

Gold Coast Level 7, 50 Appel Street, Surfers Paradise QLD 4217 Tel: (07) 5557 3333 | Fax: (07) 5574 3377

Mackay 45 Gordon Street, Mackay QLD 4740 Tel: (07) 4969 4888 | Fax: (07) 4969 4800

Melbourne Level 7, 161 Collins Street, Melbourne VIC 3000 Tel: (03) 9608 4111 | Fax: (03) 9608 4142

Newcastle 426 King Street, Newcastle NSW 2300 Tel: (02) 4910 2400 | Fax: (02) 4910 2424

Sydney Level 8, 255 George Street, Sydney NSW 2000 Tel: (02) 8216 6300 | Fax: (02) 8216 6311

Hong Kong 1801 Ruttonjee House, 11 Duddell Street, Central, Hong Kong Tel: +852 2912 8980 | Fax: +852 2813 7212

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