REPORT TO THE UNIT HOLDERS IN THE ASPIRING FUND FOR THE QUARTER 30/6/2006
| April Month |
+1.34% |
| May Month |
+1.29% |
| June Month |
+1.73% |
| June Quarter |
+4.54% |
| Since Inception ( 01/02/06 ) |
+12.87% |
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The Aspiring Fund’s performance is calculated after providing for all taxes and fees.
As most unit holders will be aware, this was a volatile quarter in global markets. MSCI compile the most widely followed international equity indices and only one of their indices was positive for the quarter (Emerging Markets Eastern Europe which was up 0.4% in local currency terms). Their World Index was down 2.9% for the quarter. We appreciate that some of our investors may regard any discussion on index returns as having limited relevance for a fund which is focused on achieving absolute returns. However, in the long term they do provide a backdrop and basis for evaluating the quality of our performance. In the short term, any time that markets get crunched the Fund will not escape unscathed.
Even in the relative quiet of New Zealand, there was significant volatility which resulted in some markedly divergent performances with the NZSE Mid Cap Gross Index returned 7.65% for the quarter while the NZSE50 Gross Index returned - 3.15% . The miserable performance of New Zealand’s largest listed company, Telecom, is largely responsible for this divergence although the 7.65% return from the Mid Cap Index could not have been achieved without some very impressive absolute returns from a large number of its constituents. This highlights, yet again, the opportunity which the widespread industry practice of benchmarking to a market-cap weighted index provides to investors freed of this constraint. The implicit assumption inherent in this practice is that there is a close correlation between a company’s size and its merits as an investment proposition. In some cases this will be true but, as this quarter demonstrated, it is not a sensible basis for portfolio composition or risk measurement.
ACTIVITY
Our outlook comments in the last quarterly report concluded:
“The central themes dominating global equity markets currently are abundant investor liquidity and rampant M & A activity which only serves to increase liquidity and risk tolerance. While the cost of capital remains so low we can see little reason for the party to end any time soon. In New Zealand the extent of recent market gains and the softening outlook for corporate profitability have heightened our caution about the near term outlook. Combining this with our, still negative, view on the Kiwi Dollar means we are likely to increase our exposure to major international markets outside New Zealand over the next quarter.”
Despite these comments we spent most of the quarter reducing our exposure to international markets and increasing our exposure to New Zealand. This warrants some attempt at an explanation. The most important point to make is that New Zealand is where we believe we have a sustainable competitive advantage. We know the companies, their management and many of their competitors, customers and suppliers. We have a broader investment universe (in the main this means we can and will invest in smaller and less liquid companies) than many others including both local and international fund managers. We intend to remain at a size where this will always be the case.
Therefore the outlook comments at the end of March represented a tactical view of where we expected the near term opportunities to lie rather than a strategic view of where we intended to position the fund in the medium term. As it turned out the ink was barely dry before we started to change our view. Globally the most significant change to the investment climate was a rise in the cost of capital with inflation fears causing central banks around the world to raise rates. These inflationary concerns heightened investors’ worries that the peak in official interest rates- particularly in the United States- might be quite a bit higher than earlier expectations and, in early May, investors globally took fright.
Risk appetite collapsed along with commodity prices and global equities. Risk appetite was slowly returning to more normal levels by the end of the quarter but we expect interest rates to remain higher for longer which should limit any further outbreaks of sustained irrational exuberance- not just in equity markets but in other areas like real estate, commodities and bonds.
Early in the quarter we also became less confident about the prospects for the New Zealand dollar’s continued depreciation. This coincided with a growing nervousness about the implications of rising global interest rates for equity markets which felt pretty frothy and we chose to take profits on our currency hedges and all of our investments in the United States.
However we remained confident about 3 main investment themes outside New Zealand;
| 1 |
The global commodity super cycle which had been buoying Australian resource stocks,
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| 2 |
The long term benefit to the Australian wealth management industry from compulsory superannuation,
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| 3 |
The sustainability of the resurgence in the Japanese economy.
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We gave effect to these big picture themes by investing in big picture exposures such as BHP and Japanese iShares which are effectively an index exposure in Japan. One need only look at a chart of BHP’s share price which fluctuated between 24.40 and 32.00 or the Nikkei which fell by over 10% to understand why, regardless of our long term confidence in those views, we never had more than 15% of the fund’s assets exposed to these themes. We are far more confident about our ability to add value using bottom-up stock picking as our main investment tool.
During the quarter we maintained our normal programme of company visits in New Zealand and Australia. As so often happens when we get out and “kick the tyres” we were pleasantly surprised to find more opportunities for investment than we had hoped for. This enabled us to recycle the proceeds from the sale of our offshore investments and to maintain the fund’s equity exposure between 70-80% of assets throughout the quarter (the balance being cash).
Unfortunately it was difficult to invest as much as we would have liked in a number of these companies before the prices started to move away on us. This is always a challenge in small and mid-cap stocks and, in a market which we generally regarded as fully priced, we were reluctant to chase prices hard. As a result we ended the quarter with a total of 26 separate equity exposures with most accounting for less than 4% of the fund’s assets. In the long term we would expect to concentrate our portfolio into bigger investments in fewer stocks but, for now, we are very comfortable that we have not overpaid for anything and that the portfolio is not exposed to excessive risk.
Participation in the Delegats and Rakon IPO’s along with a number of smaller IPO’s and placements in Australia added over 2% to the fund’s pre-tax performance and we managed to avoid the two major landmines- Telecom and Contact- which blew up the index-huggers. The performance of these two stocks is largely responsible for perceptions that the New Zealand market had a terrible quarter. Nothing could be further from the truth. The median return from the NZSE 50 stocks was 3.2% and 39 of the 50 constituents posted positive returns with 6 of these up by more than 15%. The NZSE Small Cap Index also recorded a robust 4.0% performance.
A logical consequence of stocks performing this well in an environment where interest rates are rising while consumer confidence and domestic economic activity are falling is that valuations become less compelling. Given our view that the market was close to fully valued at the beginning of the quarter it is almost inevitable that we now regard valuations as stretched. We do not see a crash as likely but we are concerned that there is a level of unwarranted complacency about the risks inherent in the New Zealand market.
Our stock selection process means the fund has a lower P/E than the market. While this provides a measure of protection from market risk we have attempted to reduce it further by trimming our most expensive holdings. This has involved some difficult decisions in stocks like Sky TV and Pumpkin Patch, which we have always viewed as core portfolio stocks. If we have to pay more to get them back we will regard that as a small price to pay for the reduced risk in the interim. Our other core risk reduction strategy was to maintain a relatively high cash weighting. At the end of the quarter our effective cash weighting was 27.5% (effective because the Waste Management shares were certain to become cash the following week).
SIGNIFICANT INVESTMENTS
Positions with a weighting above 5% of the portfolio at quarter end.
| CASH |
15.0% |
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| New Zealand Equities |
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| Waste Management |
12.5% |
| Mainfreight |
8.5% |
| Macquaries |
5.6% |
| Telecom* |
5.2% |
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|
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International Equities |
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| BHP |
5.0% |
*We know this will look odd but our average cost is 4.04 - a price we believe discounts for most of the risk.
HOUSEKEEPING MATTERS
TAX CHANGES
The Taxation (Annual Rates, Saving Investments, and Miscellaneous Provisions) Bill has been through its first reading in Parliament and will now be subjected to the select committee process. From the perspective of the Aspiring Fund the most important aspect of the changes within this bill relates to the tax free treatment of capital gains on Australasian equities from 1st April 2007. We have made a written submission to the select committee and expect to present in person to it during the next quarter. However, based on discussions we have had so far, we are confident that the changes in tax treatment for pooled funds that result from the bill’s final passing will be as we have anticipated. This will be to the advantage of the Aspiring Fund unit holders in that capital gains from trading in Australasian equities will become tax free from the beginning of the next tax year.
PREMISES
We will be moving to new premises at the beginning of August. The new physical address will be
Level 8,
Forbar House,
764 Colombo Street,
Christchurch.
Our postal and telephone numbers will remain unchanged.
WEBSITE
We are currently upgrading our website, www.aaml.co.nz. We intend in the future to introduce a news update section, which will be used to inform unit holders of the impact on the fund that may result from events of significance that may occur during any quarter. Whilst this facility will be used sparingly, we felt that communication of this kind would be useful in the event of an occurrence that may have a meaningful influence on the value of the fund.
DISTRIBUTION
As has been previously foreshadowed, we intend to distribute the imputed dividends and tax paid capital gains that have accrued to the fund on a semi annual basis, with the first distribution being in October. Unit holders elected to receive distributions in cash or receive additional units at the time they filled in their application but these elections can be changed at any stage.