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Global equity investing Should we have listened to our parents?

Global equity investing Should we have listened to our parents?. Sam Stobart Perpetual Global Equities January 2009. Agenda. Setting the scene – world sharemarkets Investment lessons our parents taught us ‘High quality’ companies that follow these lessons

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Global equity investing Should we have listened to our parents?

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  1. Global equity investing Should we have listened to our parents? Sam Stobart Perpetual Global Equities January 2009

  2. Agenda • Setting the scene – world sharemarkets • Investment lessons our parents taught us • ‘High quality’ companies that follow these lessons • Research into the long-term performance of high quality stocks

  3. How much debt is too much?Goldman Sachs’ leverage ratio

  4. US corporate profits as a percentage of GDP % 18 16 14 12 10 8 6 4 2 0 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 All companies Non-financials Source: US Federal Reserve.

  5. Return on equity: Australian and global sharemarket 20% 18% Australia 16% 14% 12% 10% 8% Global 6% 4% 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 Source: UBS Australia Limited.

  6. Corporate credit riskJP Morgan Credit Index BBB Asset Swap Spread Basis points 400 350 300 250 200 150 100 50 0 2002 2003 2004 2005 2006 2008 1999 2000 2001 2007 Source: Bloomberg.

  7. Credit market cyclesInvestment grade credit spreads 1990 to 2008 Sub-prime 600 500 High grade corporate 400 Junk bonds Emerging markets 300 200 100 0 Jan-90 Jan-94 Jan-02 Jan-06 Jan-08 Jan-92 Jan-96 Jan-98 Jan-00 Jan-04 Source: Bloomberg.

  8. Emerging market equity riskMSCI World Index v MSCI EM Index 600 500 400 300 200 100 0 2002 2003 2004 2005 2008 1998 1999 2000 2001 2006 2007 MSCI EM Index (USD$) MSCI World Index (USD$) Source: Bloomberg..

  9. BC (Before Crunch) Profits inflated by leverage Banks in vogue Globalisation of capital markets, IT revolution and inflation-targeting central banks Interest rates declined and risk became more engineered, less transparent and easily sold Rising household debt led to a global housing boom An environment of low economic risk became one of high financial risk High momentum seen as key to investment success AD (After De-leveraging) Sustainability of profit More stable, better-regulated banks Long-only the dominant approach Fundamentals recognised as long-term key to investment success BC versus AD

  10. Good housekeeping • Make sure you have a good steady income • Don’t borrow more than you can afford to • Don’t spend everything you earn • Keep some cash for a rainy day

  11. Total: an example of a quality stock • Integrated oil major – upstream and downstream • Superior production growth to peers • Reducing capex growth, boosting cash flow • Consistent dividends and buy-backs

  12. Return on equity – efficient allocation of capitalTotal v Repsol 40 35 30 25 20 15 10 5 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total Repsol Source: Factset.

  13. Nestlé v Kraft Foods Nestlé S.A. Op CF to sales (NESN-CH) Op CF to sales (KFT-US) ROE (NESN-CH) ROE (KFT-US) 14 22 20 13 18 12 16 11 14 10 12 10 9 8 2000 2001 2002 2003 2004 2005 2006 2007 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 LT debt to equity (NESN-CH) DPS growth (NESN-CH) DPS growth (KFT-US) LT debt to equity (KFT-US) 180 120 160 100 140 120 80 100 60 80 40 60 40 20 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2000 2001 2002 2003 2004 2005 2006 2007 Source: Factset, Reuters Global Fundamentals

  14. Portfolio value $ 20,000 Nestlé Kraft 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 Jun-06 Oct-06 Feb-07 Oct-07 Feb-08 Jun-05 Jun-08 Oct-05 Feb-06 Oct-08 Jun-07 Time Nestlé v Kraft share price performance

  15. Canon: an example of a quality stock • Technology leader, strong market position • Very profitable – operating margin expanded from 6% to 17% from 1996 to 2007 • Dividend yield high for sector at 1.8% • Low debt, 15% of market cap in cash

  16. Debt to equity – balance sheet strengthCanon v Xerox % 1,000 Xerox Canon 800 600 400 200 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Factset.

  17. 18,000 Canon Xerox 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Oct-08 Jun-06 Jun-05 Oct-05 Feb-06 Jun-08 Time Canon v Xerox share price performance Portfolio value $ Data ranges between June 2005 and October 2008.

  18. Nokia v Motorola Nokia Op CF to Sales (NOK1V-FI) Op CF to Sales (MOT-US) ROE (NOK1V-FI) ROE (MOT-US) 20 50 40 15 30 10 20 10 5 0 0 -10 -20 -5 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 LT Debt to Equity (NOK1V-FI) DPS Growth (NOK1V-FI) DPS Growth (MOT-US) LT Debt to Equity (MOT-US) 40 70 35 60 30 50 25 40 20 15 30 10 20 5 10 0 0 -5 1998 1999 2000 2001 2002 2003 2004 20'05 2006 2007 2000 2001 2002 2003 2004 2005 2006 2007 Source: Factset, Reuters Global Fundamentals

  19. Portfolio value $ 25,000 Nokia Motorola 20,000 15,000 10,000 5,000 0 Feb-07 Feb-08 Feb-06 Jun-07 Jun-05 Jun-06 Oct-06 Oct-07 Jun-08 Oct-08 Oct-05 Time Nokia v Motorola share price performance Data ranges between June 2005 and October 2008.

  20. Wells Fargo: an example of a quality stock • A bank, not a financial engineer • Conservative underwriting; strong deposit base • Highly profitable asset base – 1.5% return on assets • Increased dividend 10% in July 08 • Part of the solution

  21. Leverage – recourse to wholesale borrowingWells Fargo v Washington Mutual loan to deposit ratio % 160 150 140 130 120 110 100 90 80 70 60 1994 1995 1996 1997 1998 1999 2000 2001 2002 2007 2006 1988 1989 1990 1991 1992 1993 2003 2004 2005 Washington Mutual Wells Fargo Source: Factset.

  22. Wells Fargo v Washington Mutual share performance Portfolio value $ Wells Fargo 16,000 Washington Mutual 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 Jun-05 Oct-05 Feb-06 Oct-08 Jun-07 Jun-06 Oct-06 Feb-07 Oct-07 Feb-08 Jun-08 Time Data ranges from 1 April 2005 to 1 October 2008.

  23. Tesco v Sainsbury Tesco PLC Op CF to Sales (TSCO-GB) Op CF to Sales (SBRY-GB) ROE (TSCO-GB) ROE (SBRY-GB) 20 8 15 7 10 6 5 5 0 4 -5 3 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 LT Debt to Equity (TSCO-GB) DPS Growth (TSCO-GB) DPS Growth (SBRY-GB) LT Debt to Equity (SBRY-GB) 20 80 10 70 0 60 -10 50 -20 40 -30 30 -40 20 -50 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Factset, Reuters Global Fundamentals

  24. Quality filters Sound management Conservative debt Quality of business Recurring earnings Wal-Mart: an example of a quality stock Stock specifics Worldwide sales 2007 - US$378 billion P/E (2009) 17x 7,000 stores (3000 outside US in 14 countries) DY (2009) 1.7% Receives $1 out of every $9 spent at US retailers 100 million US customers visit each week Performance since October market peak (Indices rebased, 9 Oct 2007 = 100) US$5.5 billion in cash on the balance sheet 130 130 Dividend growth each year since 1974 Wal-Mart Accumulation Index 120 120 Since Oct 07 outperformed MSCI by 33% 110 110 100 100 90 90 S&P 500 Accumulation Index 80 80 Oct-07 Jan-08 Apr-08 Jul-08

  25. LT debt to equity (WMT-US) LT debt to equity (8267-JP) ROE (WMT-US) ROE (8267-JP) 30 120 100 20 80 60 10 40 20 0 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 -10 Op CF to sales (WMT-US) Op CF to sales (8267-JP) DPS growth (WMT-US) DPS growth (8267-JP) 7 50 6 40 5 30 4 3 20 2 10 1 0 0 2001 2002 2003 2004 2005 2006 2007 2008 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Better quality all-roundWal-Mart v Aeon Source: FactSet

  26. Wal-mart v Aeon share price performance Portfolio value $ 18,000 16,000 Wal-Mart Aeon 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 Feb-07 Feb-08 Feb-06 Jun-07 Jun-05 Jun-06 Oct-06 Oct-07 Jun-08 Oct-08 Oct-05 Time Data ranges from 1 April 2005 to 1 October 2008.

  27. CRH v Lafarge CRH PLC Op CF to sales (CRG-IE) Op CF to sales (LG-FR) ROE (CRG-IE) ROE (LG-FR) 25 15 14 20 13 15 12 11 10 10 9 5 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 LT Debt to equity (CRG-IE) DPS growth (CRG-IE) DPS growth (LG-FR) 35 LT Debt to equity (LG-FR) 140 30 130 25 120 110 20 100 15 90 80 10 70 5 60 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 0 2000 2001 2002 2003 2004 2005 2006 2007 Source: Factset, Reuters Global Fundamentals

  28. Defining a global universe of quality stocks MSCI World Index High debt and non-dividend payers removed Rank the remainder by quality factors • Top 20% ranked companies in each region and in each sector within each region by seven year averages for: • Return on equity • Dividend growth • Cash flow / sales ratio Top 20% of each Industry group in each region Quality universe Top 20% by region

  29. 900 MSCI World Index 800 Quality stocks 700 8.9% pa 600 500 7.1% pa 400 300 200 100 0 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Quality outperforms over the long term Quality Universe vs MSCI Global Index - cumulative total return (AUD) since 1988 Source: Morgan Stanley; Perpetual.

  30. But it doesn’t outperform all the time 12 month excess return of the quality universe v MSCI World 12 month rolling return 1 year excess return 60% 50% 40% Since the beginning of the credit crunch quality has 30% begun to outperform 20% 10% 0% Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 -10% -20% MSCI World 1 year rolling return 12m excess return -30% Excess credit creation and low risk pricing -40% led to low quality out-performing 2004-06 Source: Morgan Stanley; Perpetual.

  31. Excess credit creation doesn’t favour qualityFed Survey of Bank Loan Officers - net % tightening loan standards % 70 60 50 40 30 20 10 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 (10) (20) (30) Loans to large and medium firms Source: US Federal Reserve.

  32. Conclusion • Quality stocks outperform the market in the long run • The market doesn’t always reward quality during bubbles • When banks create excess credit, risk aversion disappears and low quality usually outperforms • There was abnormally fast credit growth from 2004 to 2006 • Now that the credit bubble has burst, normal service ie outperformance – can resume for high quality equities • Will we see a bank credit bubble again in the next 10 years?

  33. “My favourite holding period is forever”

  34. This information has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426 for financial advisers only. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. • The relevant product disclosure statement (PDS) for Perpetual’s International Share Fund issued by PIML, should be considered before deciding whether to acquire or hold units in the fund. The PDS can be obtained by calling 1800 062 725 or visiting www.perpetual.com.au. • No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital. Total returns shown for Perpetual’s International Share Fundhave been calculated using exit prices after taking into account all of Perpetual’s ongoing fees and assuming reinvestment of distributions. No allowance has been made for taxation. Past performance is not indicative of future performance.

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