© 2016 Morningstar, Inc. All rights reserved.

Daniel Needham

President & Chief Investment Officer

Part 2 – Valuation Driven Asset Allocation

Our Investment PrinciplesValuation Driven Asset Allocation

We strive to

minimise costs.

Outline

gWhat are valuations and why do they matter?

gHow do we respond to changes in valuation?

gHow do valuations, sentiment and fundamentals combine?

gAre our valuation models perfect?

gWhere do we see opportunities and why?

gSummary and questions

What are valuations and why do they matter?The origins of valuation-driven asset allocation

“Earnings in any one year tend to be affected by short-run considerations […]We extend our moving average even further than Graham and Dodd did, on thesupposition that even more smoothing is advantageous, and Graham and Dodddidn't have the data then to make such smoothing possible.”

is what you get

”“Price is what you pay; value

- Warren Buffett, 2008 Letter to Shareholders of Berkshire Hathaway Inc.

- Robert Shiller (1996), following the advice of Graham and Dodd, calculate

the “CyclicallyCyclicallyCyclicallyCyclically----Adjusted PriceAdjusted PriceAdjusted PriceAdjusted Price----totototo----Earnings RatioEarnings RatioEarnings RatioEarnings Ratio”

“”

US Cyclically-adjusted Price Earnings Ratio (CAPE)What are valuations and why do they matter?

Source: Shiller, Morningstar

What are valuations and why do they matter?US CAPE and 10-year Real Returns

Source: Shiller, Morningstar

Price to fair value drives returns and lossesHow do we respond to changes in valuation?

Source: Morningstar

How do we respond to changes in valuation?Australian profit margins were unsustainably high post the resources boom

Source: Ibbotson

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Index ex-REIT Average 1985 to 2003 and 2003 to 2012 Average

How do we respond to changes in valuation?In April 2011 our valuation-implied returns were very unattractive

Source: Ibbotson, CFA Institute Presentation May 2011 Daniel Needham

S&P/ASX 200S&P/ASX 200S&P/ASX 200S&P/ASX 200

How do we respond to changes in valuation?Australian equities were used to fund other growth assets with superior risk adjusted returns

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European Equities weighting

Japanese Equities weighting

AREITS weighting

Australian Equities Weighting

Source: Ibbotson

How do we respond to changes in valuation?Higher and smoother returns by investing in other growth assets

Source: Ibbotson

++++78%78%78%78%

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Value of $1,000 invested in our mix of growth assets Value of $1,000 invested in the Australian Equities index

+58%+58%+58%+58%

How do we respond to changes in valuation?AREITs were not a ‘busted asset class’ post the GFC

Balance Sheet

Earnings

Payout

Positioning

Sentiment

Valuation

Yield

Recapitalisation/Divestments

Higher Quality

Sustainable

Underweight

Extremely Poor

Cheap!

Attractive

Highly Leveraged

Low Quality

Borrowed

Overweight

Positive

Expensive

Unattractive

2007200720072007 2010201020102010AREITSAREITSAREITSAREITS

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A-REITs Weighting Australian Equities Weighting

How do we respond to changes in valuation?Change in allocations for Australian equities versus AREITs in the Growth Trust

Source: Ibbotson

AREIT allocation > Australian equity allocationAREIT allocation > Australian equity allocationAREIT allocation > Australian equity allocationAREIT allocation > Australian equity allocation

How do we respond to changes in valuation?AREITs significantly outperformed Australian equities

Source: Ibbotson

++++109%109%109%109%

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Value of $1,000 invested in Australian Equities index Value of $1,000 invested in A-REITs index

+58%+58%+58%+58%

How do valuations, sentiment and fundamentals combine?Japan emerging from decades de-leveraging

Source: MSCI

How do valuations, sentiment and fundamentals combine?Extract from Internal Presentation 30 September 2012

Source: Ibbotson The Case for Japan – Bianca Rose and Greg Clarke September 2012

How do valuations, sentiment and fundamentals combine?Change in Japanese equities allocations over time

Source: Ibbotson

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Growth Trust weighting for Japanese Equities [RHS] Value of $1,000 invested in the Japanese Equities index [RHS]

Value of $1,000 invested in the Australian Equities index

++++106%106%106%106%

+58%+58%+58%+58%

Are our valuation models perfect?U.S. Profit Margins 1985-2015 – were earnings unsustainably high since 2011?

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US profit margins expanded significantly over the last 30 years, moving from 6% to 9%

U.S. PM

Average

Source: MSCI, Ibbotson

Are our valuation models perfect?Change in US equities allocations over time

Source: Ibbotson

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Growth Trust Weighting Value of $1,000 invested in the index [RHS]Value of $1,000 invested in our mix of growth assets [RHS] +116%+116%+116%+116%

+78%+78%+78%+78%

Are our valuation models perfect?Intellectual honesty and the importance of being humble

Are our valuation models perfect?

But need to account for structural change in corporate payout policy…

Source: MSCI, Ibbotson

Are our valuation models perfect?

S&P 500 buybacks have exceeded dividends in 8 of the 10 past calendar years

Source: MSCI, Ibbotson

Source: MSCI, Ibbotson

Are our valuation models perfect?Total Yields (1871-2014)

Total Payouts have been stable over time

Are our valuation models perfect?Earnings Trend pre- versus post 1980

For illustrative purposes only. Source: Straehl and Ibbotson (2015), The Supply of Stock Returns: Adding Back Buybacks, Working Paper

…leading to a structural increase in earnings per-share growth

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Are our valuation models perfect?U.S. profit margins expansion driven by financials and technology

Source: MSCI, Morningstar Inc.

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Margin expansion in the technology and financial sector largely explain increase in U.S. margins, while margins of the “rest” of the market were largely flat

U.S. PM

Rest PM

FN & Tech

PM

Are our valuation models perfect?U.S. Real EPS vs. Implied Normal EPS – additional fundamentals improves valuations

Source: MSCI, Morningstar Inc.

95.29

92.7692.46

70.98

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Implied Normal E (ROE)

Implied Normal E (CAPE)

Implied Normal E (Margin)

Log S

cale

Are our valuation models perfect?Enhanced approach for fair values and valuation-implied returns

Valuation-Implied Return = Total Yield + Growth (Adj. for Buybacks) + Change in Valuation

Dividends Dividends Dividends Dividends and and and and

Buyback Buyback Buyback Buyback YieldYieldYieldYield

Trend Fundamental GrowthTrend Fundamental GrowthTrend Fundamental GrowthTrend Fundamental Growth CAPE, ROE and CAPE, ROE and CAPE, ROE and CAPE, ROE and

Profit Margin ModelsProfit Margin ModelsProfit Margin ModelsProfit Margin Models

UK Equities

Australian Equities

Global REITS

European Equities Japanese Equities

US Equities

Korean Equities

Chinese Equities Emerging Market Equities

Taiwanese Equities

Australian REITSDM Infrastructure

US HY Credit EM Local Ccy Sovereigns

EM Hard Ccy Sovereigns

EU Utilities

Australian LinkersGlobal Corporate Credit

EU Energy

Global Aggregate Bonds Australian Gov Bonds

Australian Comp BondsAUD CashRiskier

Assets

Less

Risky

Assets

Where do we see opportunities and why?The opportunity set for an Australian investor

Lower Returning Assets

Higher Returning Assets

Source: Ibbotson

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U.S. Corporate High Yield

Pan-European High Yield

Source: Reuters/ Morningstar

Where do we see opportunities and why?There are pockets of opportunity outside traditional government bonds

Emerging Market Debt Yields (%)Emerging Market Debt Yields (%)Emerging Market Debt Yields (%)Emerging Market Debt Yields (%)High Yield High Yield High Yield High Yield Credit (%)Credit (%)Credit (%)Credit (%)

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Brazil Mexico Poland

South Africa Indonesia Malaysia

USA

High Yield indices – option adjusted spreads since 1998 Emerging Markets Local Currency 10 year yields the last 5 years

Where do we see opportunities and why?Cash flows of European energy to benefit from declining capital expenditures (CAPEX)

Source: Deutsche Bank

Where do we see opportunities and why?Need to be selective in Emerging Markets

12.4%

10.4%9.7%

8.3%

7.2% 6.9%6.5%

6.1% 6.1% 6.0%5.2% 5.0%

4.5%3.8% 3.8% 3.8% 3.7%

3.2% 2.8% 2.5%1.9%

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14%10-Year Valuation Implied Returns (Real): Emerging Markets (Local Currency)

Source: Ibbotson

Where do we see opportunities and why?High conviction investment positions of different vintages

2010 2012 2014 2016

ΠIncrease A-REITS

+ Initiate Japanese Equities

ΠIncrease Unhedged Currency

– position for falling AUD

Š Decrease AU Equities

Š Decrease US Equities

ΠIncrease EU Equities

ΠIncrease Japanese Equities

ΠIncrease AU Cash

ΠIncrease EM Equities

+ Initiate EU Energy

+ Initiate EM Debt

ΠIncrease AU Cash

Š Decrease EU Equities

Š Decrease AREITS

+ Initiate Global Quality Strategy

+ Initiate European Utilities

ΠIncrease EU Equities

+ Initiate US HY Credit

Š Decrease Global Infrastructure

2011 2013 2015

Where do we see opportunities and why?Growth Trust allocations

Source: Ibbotson – as at 31 March 2016 -5.0% -2.5% 0.0% 2.5% 5.0%

Japan Equities

Australian REITs

Emerging Market Equities

Cash and Currency

Global Infrastructure

Other Developed Equities

International REITs

Euro Equities

International Bonds

Euro Utilities

Australian Equities

Inflation Linked Bonds

Australian Bonds

Euro Energy

Alternatives

US Equities

Emerging Market Debt

▲ since March 2015

Alternatives14.5%

Cash and Currency21.8%

Inflation Linked Bonds2.1%

International Bonds2.7%

Australian Bonds4.6%

Emerging Market Debt4.8%

International REITs0.2%

Australian REITs6.4%

Global Infrastructure1.7%

US Equities3.6%

Euro Equities12.6%Japan Equities

7.1%

Emerging Market Equities

8.1%

Other Developed Equities

1.1%

Australian Equities8.7%

Holding cash is uncomfortable, but not as uncomfortable as doing something stupid.

- Warren Buffett ”“

Summary

gThere are many investment opportunities other than Australian equities.

gValuations and fundamentals are joined at the hip.

gThere is no point buying something “cheap” if it’s low quality and not in the price – a robust process helps you avoid overpaying.

gIf an asset class doesn’t give you a better opportunity than cash, don’t invest.

gAn active approach to asset allocation leads to a proactive response to changes in valuations.

gBe humble and open minded – ask the question – how could we be wrong and think about ways to improve.

gHolding cash is uncomfortable, but not as uncomfortable as doing something stupid.

gPrice is what you pay; value is what you get.

Questions

Be independent-minded – sometimes the best positions are contrarian, making you feel uncomfortable, because you’re the only one there.

Valuation has driven returns around the world… and prospective losses.

Build portfolios holistically by ensuring that every investment plays its part.

We put investors first by investing their savings in asset classes only when it makes sense to do so.

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