Huntleys Your Money Weekly

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1 28 June 2012 Forecast Huntleys Your Money Weekly Forecast Count down to Teens Decade Bull Market This bi-annual feature is written on the premise of a subscriber asking what could be the key issues, trends and risks in the sharemarket and economy over the next year. It will help you understand how we approach the issues and how we update them during the year in our weekly overview. I look at many trends in the context of a decade cycle which tends to run in the classic pattern of a low point in the first year or two usually two and reaches a high point late in the decade from seven on, usually later. I write this forecast as yet another European crisis grabs headlines, a crisis yet again handled by last minute packages subject to 11th hour stop and go negotiations. It should have been settled by a mighty big monetary Bazooka put behind the European banking system, but instead it is itsy bitsy. The Germans want a USA-style central fiscal and workplace system in return for the Bazooka, and itsy bitsy grinds the PIGS (Portugal, Italy Greece, Spain) down to where they might accept peace terms. Or leave. The European affair has been bubbling since the GFC so many players are well set in advance. That is a positive as shocks cause the worst turmoil. The GFC was a major left field shock on top of a nasty oil price rise. The ECB has stated it will stand behind solvent banks, presumably it and other major central banks will stop any knock-on effects from bank failures if the Eurozone is to break up. One point many miss is that serious money in Europe has already piled into Germany as a safe haven. If Greece, Spain and Italy leave the Eurozone, then (a) their currencies would devalue sharply (b) the German currency would rise sharply (c) the serious money would make even more serious currency gains and would buy into very cheap assets in those Club Med countries. Former Italian PM Berlusconi, in suggesting Italian senior businesses want to leave the Euro would be highly aware of this. Forecast reasonable since mid 2009 Since mid 2009 I suggested the years through to the current, possibly early next year, would feature a work out strategy not dissimilar to Australia post 1987 through to January Yes the current global problems are worse than , not so for Australia. But a significant bull market can emerge BEFORE the developed world economies are firmly set on a recovery path. I looked to a broad 4,000 to 5,000 trading range on the All Ordinaries ahead of a Teens Decade bull market developing latish 2012, just possibly early The trading range view has proved remarkably correct it allowed for slippage to 3,800. So as I write the market is yet again testing the 4,000 level on the All Ordinaries Index, my most probable floor for this market with a possible slip to 3,800, and a very worst case of a downer to 3,500. My key call is that a sell off this year to these levels amid nasty panic headlines, will set the stage for the Teens Decade Bull Market, discussed further at the end of this article. The resource sector may well provide bargains as extreme pessimism provides the launch pad for a bullish surge. That first surge is a wonderful thing!! This corrective market is likely to run through to September October, with a lower probability of extending to early Current negative forces are Europe and fears of a fiscal cliff the end of various stimulatory tax cuts in particular in the US. That fiscal cliff is likely to be climbed not far ahead of the November Presidential election. There are also short term fears on the Chinese economy but by October further interest rate cuts there and additional fiscal stimulation but not on the giant 2009/10 scale will be evident. There will also be significant monetary easing in Europe. As the Top 20 goes, so do the major indices. What s interesting is that our forecast NPAT, EPS, and DPS are all rising, but the PE multiple is down, and the dividend yield is up. As the Dividend Yield table shows price weakness in the major resource Continued on page 2 Australia s Leading Independent Investment Newsletter Since 1973 Ian Huntley Editor Australian Share Market 6 Outlook Still defensive, dividend yields paramount Resources 8 Important to stick to quality, infrastructure-flush names Financials 11 Banks remain attractive. Yield supports selective AREITs and Infrastructure Consumer & Industrials 14 Safe havens Staples, Healthcare, Telecommunications Copyright warning: Our newsletter is available to paid subscribers only and no reproduction is permitted. If you work for an organisation that would like to take out multiple subscriptions to any of our products, our customer service department will be happy to advise you of the discounts available or site licenses.

2 2 Overview continued from Page 1 Key Terms : Substantially undervalued. Accumulate: Modestly undervalued. : Appropriately priced, neither buy nor sell. Reduce: Sell part holding. Sell: Sell all holdings now. Avoid: Not investment grade. : The moat is the competitive advantage that one company has over other companies in the same industry. Wide moat firms have unique skills or assets, allowing them to stay ahead of the competition and earn above-average profits for many years. Returns on their invested capital will exceed the cost of that capital. and Share price risk: The analyst s opinion of a company s business and share price risk relative to other stocks. Cyclical and speculative companies will be riskier on both counts. Low-risk businesses can be overpriced and high risk businesses can be cheap. Morningstar Equity Style Box: is a nine-square grid that provides a graphical representation of the investment style of stocks. It classifies securities according to market capitalization (the vertical axis) and growth and value factors (the horizontal axis). groups drives dividend yield up, while the banks are gradually increasing their dividends against flattish share prices. The table shows the change in dividend yields on the three major resource stocks against our forecasts since December and clearly illustrates the emerging dividend yield story. Further interest rate falls ahead good for defensive income stocks If that Teens Decade bull market does not emerge on my timing and that is my top probability I remain happy with a continuing bull market in TOP 20 Table June 2012* Actual F'cast Y1 F'cast Y2 PE (x) NPAT Growth (%) EPS Growth (%) Div Yield (%) /Intrinsic Value (%) 75.2 * June 2012 Actual figures include companies that reported December year end. TOP 20 Table December 2011 Actual F'cast Y1 F'cast Y2 PE (x) NPAT Growth (%) EPS Growth (%) Div Yield (%) /Intrinsic Value (%) 75.7 Morningstar Forecasts defensive income stocks, always a favourite. Expect at least another 50 basis points drop in Australian bank short term lending rates over the next six months, with the RBA dropping official interest rates perhaps by as much as 75 basis points to achieve this. With Forecast comes our list of Morningstar moat stocks, our Best Businesses, those we see as having a significant competitive advantage that will last many years the best place to search for defensive stocks that suit this era and most other eras. To get your mind around Moats, go to special TOP 50 Table June 2012* Actual F'cast Y1 F'cast Y2 PE (x) NPAT Growth (%) EPS Growth (%) Div Yield (%) /Intrinsic Value (%) 78.6 * June 2012 Actual figures include companies that reported December year end. TOP 50 Table December 2011 Actual F'cast Y1 F'cast Y2 PE (x) NPAT Growth (%) EPS Growth (%) Div Yield (%) /Intrinsic Value (%) 79.4 Investment Style Value Blend Growth Mkt Cap Large Dividend Yield % NPAT ($m) EPS (cps) Actual FY1 FY2 Actual FY1 FY2 Actual FY1 FY2 Jun Jun-11 BHP Billiton BHP ,890 20,411 23, Jun-11 Rio Tinto RIO ,054 14,994 17, Dec-11 Woodside WPL ,601 1,924 2, Small Dec Jun-11 BHP Billiton BHP ,819 27,233 25, Jun-11 Rio Tinto RIO ,216 16,701 17, Ratios and Data NPAT: Net Profit After Tax before one offs. EBIT: Earnings before interest and tax. ROE: Return on Equity (net profit before one-offs / shareholders equity) Net Interest Cover: EBIT / net interest expense Annual Share Turnover %: number of shares traded as a percentage of total shares outstanding over the last 12 months. Div Yield %: Historic numbers: dividends paid for that year divided by the average monthly closing share price for that year. Forecasts: dividends paid divided by last close share price. P/E: Historic numbers: average daily closing share price for that year divided by earnings per share. Forecasts: last close share price divided by earnings per share. 31-Dec-10 Woodside WPL ,545 1,570 1, Investors please note: To the extent that any of the content constitutes advice, it is general advice that has been prepared by Morningstar Australasia Pty Limited ABN: , AFSL: without reference to your objectives, financial situation or needs. Before acting on any advice, you should consider the appropriateness of the advice and we recommend you obtain financial, legal and taxation advice before making a decision. Please refer to our Financial Services Guide for more information at Contact Details Tel: [email protected] Declaration Declaration of all equities analysts' personal shareholdings, disclosure list for Forecast These positions can change at any time and are not additional recommendations. AAO, ABC, ACG, ACL, ACR, AFI, AGK, AGS, AGX, AKF, ALL, ALS, AMP, ANO, ANP, ANZ, APA, APN, ARD, ARG, ASB, ASZ, ATI, AVX, BEN, BFG, BHP, BKI, BKN, BLY, BND, BNO, BOL, BOQ, BSL, BTU, BWP, BXB, CAB, CBA, CCL, CDD, CGS, CIF, CND, COF, COH, CPA, CPB, CRK, CRZ, CSL, CSS, CTN, DJS, DOW, DTE, DUE, EGL, EGP, EPX, EQT, ERA, ESV, EVZ, FMG, FXJ, GBG, GCL, GFF, GMG, GPT, GWA, HIL, HSN, HST, IAG, IFL, IGR, IIN, ILU, IPD, JMB, KAR, KBC, KCN, KEY, KMD, LEG, LEI, LLC, MBN, MCR, MFF, MIO, MPO, MQG, MSB, MTS, MUN, MYR, NAB, NEU, NHC, NMS, NUF, NUP, NVT, NWS, OSH, OST, PBG, PBT, PGA, PGM, PMP, PMV, PNR, PPT, PRE, PRG, PRY, PTS, QBE, QFX, QUB, RCR, REX, RFE, RHC, RHG, RIO, RKN, RQL, SAKHA, SEK, SFW, SGP, SGT, SHV, SMX, SOL, SRH, SRX, STS, SUN, SVW, TAH, TCL, TEN, TLS, TOL, TPM, TRF, TRS, TSE, UGL, UXC, WAL, WAM, WBB, WBC, WCB, WDC, WES, WHC, WHG, WOW, WPL, ZGL.

3 Huntleys Your Money Weekly 28 June Top 20 earnings and dividend forecasts Actual FY12 FY13 1 BHP EPS EPS Growth 56.7% -3.8% 14.9% Fair value Dividend Grossed up dividend Grossed up yield 4.8% 5.2% 6.9% Dividend yield 3.4% 3.7% 4.8% PE CBA EPS EPS Growth 10.2% 4.0% 3.5% Fair value Dividend Grossed up dividend Grossed up yield 8.8% 9.0% 9.3% Dividend yield 6.2% 6.3% 6.5% PE WBC EPS EPS Growth 5.8% 1.3% 3.9% Fair value Dividend Grossed up dividend Grossed up yield 10.8% 11.4% 11.9% Dividend yield 7.5% 8.0% 8.3% PE ANZ EPS EPS Growth 18.2% 0.8% 5.1% Fair value Dividend Grossed up dividend Grossed up yield 9.4% 9.9% 10.3% Dividend yield 6.6% 6.9% 7.2% PE NAB EPS EPS Growth 16.1% 5.2% 7.3% Fair value Dividend Grossed up dividend Grossed up yield 10.6% 11.1% 12.0% Dividend yield 7.4% 7.8% 8.4% PE TLS EPS EPS Growth -16.8% 10.6% 9.4% Fair value 3.85 Dividend Grossed up dividend Grossed up yield 11.0% 11.0% 11.0% Dividend yield 7.7% 7.7% 7.7% PE WES EPS EPS Growth 12.7% 13.0% 13.7% Fair value Dividend Grossed up dividend Grossed up yield 7.3% 8.1% 9.3% Dividend yield 5.1% 5.7% 6.5% PE Actual FY12 FY13 8 WOW EPS EPS Growth 6.4% 4.6% 7.9% Fair value Dividend Grossed up dividend Grossed up yield 6.6% 6.8% 7.3% Dividend yield 4.6% 4.8% 5.1% PE RIO EPS EPS Growth 0.2% 0.9% 17.4% Fair value Dividend Grossed up dividend Grossed up yield 3.6% 4.2% 5.1% Dividend yield 2.5% 2.9% 3.6% PE WPL EPS EPS Growth 1.4% 18.9% 15.5% Fair value Dividend Grossed up dividend Grossed up yield 4.7% 4.9% 7.4% Dividend yield 3.3% 3.4% 5.2% PE CSL EPS EPS Growth -6.3% 12.7% 7.9% Fair value Dividend Franking 6.2% 6.2% 6.2% Grossed up dividend Grossed up yield 2.1% 2.3% 2.4% Dividend yield 2.1% 2.2% 2.4% PE WDC EPS EPS Growth -20.8% -0.3% 8.8% Fair value 9.45 Dividend Franking 0% 0% 0% Grossed up dividend Grossed up yield 6.8% 5.3% 5.5% Dividend yield 6.8% 5.3% 5.5% PE NCM EPS EPS Growth -6.6% 4.6% -14.3% Fair value Dividend Franking 0% 0% 100% Grossed up dividend Grossed up yield 2.2% 2.2% 3.2% Dividend yield 2.2% 2.2% 2.2% PE QBE EPS EPS Growth -53.1% 113.7% 7.5% Fair value Dividend Franking 14.31% 15% 15% Grossed up dividend Grossed up yield 7.3% 7.6% 8.1% Dividend yield 6.9% 7.1% 7.6% PE Actual FY12 FY13 15 ORG EPS EPS Growth 2.4% 37.3% -4.0% Fair value Dividend Grossed up dividend Grossed up yield 5.7% 5.7% 5.7% Dividend yield 4.0% 4.0% 4.0% PE STO EPS EPS Growth 15.4% 35.6% -10.4% Fair value Dividend Grossed up dividend Grossed up yield 4.0% 3.9% 3.9% Dividend yield 2.8% 2.7% 2.7% PE AMP EPS EPS Growth -9.8% na 7.2% Fair value 5.60 Dividend Franking 60% 30% 30% Grossed up dividend Grossed up yield 10.1% 8.3% 8.5% Dividend yield 8.0% 7.4% 7.5% PE SUN EPS EPS Growth -18.3% 24.8% 44.0% Fair value 9.00 Dividend Grossed up dividend Grossed up yield 6.4% 7.2% 9.6% Dividend yield 4.5% 5.0% 6.7% PE BXB EPS EPS Growth 0.3% 12.9% 13.7% Fair value 7.50 Dividend Franking 20% 20% 20% Grossed up dividend Grossed up yield 4.6% 4.9% 5.3% Dividend yield 4.2% 4.6% 4.9% PE MQG* EPS EPS Growth -26.7% 22.0% 15.7% Fair value Dividend Franking 0% 0% 0% Grossed up dividend Grossed up yield 5.5% 6.0% 6.7% Dividend yield 5.5% 6.0% 6.7% PE Source: Morningstar Analysts MQG is a March balance date. Actual is FY12. Note: grossed up dividends are dependant on an individual's tax status. reports, and scroll down to Economic Moats the cornerstone to long term investment success. Gold: These debt supercycle problems should dictate yet another leg in the gold bull market though some players may be liquidating holdings to offset distress elsewhere. A rise through US$2000 would not surprise through the next months. Our Forecasts since mid 2009 on track As part of my range trading forecast I argued in following Overviews/Forecasts Australia was well positioned with a sound banking system, a buoyant trading partner in China, but an issue with the overleveraged household needing to pay down debt which could still take another two to three years from now. We have the major advantage employment wise of a giant resource investment boom, which offsets the deep freeze on the usual recovery driver, housing, with its immense multiplier effects through retail and services. Strong employment underpins the ability of our households to pay down their mortgages and with a savings rate of just on 19%, including the 9% superannuation levy, we are sure doing that. The Resource Investment Boom is now moving into its peak phase, and looks likely to be sharply lower in activity in three years time. But then Australian households should have debt under control. Mid last year we estimated approximately three years for this to be achieved. As in the US a third of Australian households have mortgage debt, a third own their own home, and a

4 4 YMW Portfolio Total Return (x) YMW Portfolio ASX All Ords Accum. Index /88 05/92 05/96 05/00 05/05 05/08 05/12 third rent and have no significant debt at all. So some households have plenty to spend. In the US over the last three years household equity measures have actually been lifting! There have been swathes of defaults so the drag of weak to negative equity on the average home equity has fallen quite sharply. US home prices are levelling out, perhaps lifting a touch in the mid to upper brackets. Heaps of problems remain in the US housing market. It will be long slow recovery before it really gathers steam later this decade, the main reason to expect very low interest interests in the US through to 2014/5. Our market sees a gradual price fall, no disaster. YMW Portfolio asset preservation through these times In 1987 I certainly predicted the crash and suggested 50% crash funds, then becoming bullish in late 1990 early January 1991 sufficiently bullish to spend all my available cash to buy back my business which I had sold early post crash. Unfortunately I did not foresee the severity of the disaster though I consistently warned against debt, particularly margin loans to finance portfolios. I also stressed the need for a quality, income producing, diversified portfolio, similar to the YMW Portfolio. Here we have slightly underperformed the All Ordinaries Accumulation Index but we have not seen anything like a wholesale smashing of our assets. Income held up extremely well, gently rising, though the portfolio is designed for a mix of growth and income. It does not include any discretionary retailers, heavily hit on all fronts in this market. I also avoided airlines and mining services. United Group does not have the majority of its business in mining services! I am wary of mid tier miners, but hold copper/gold rich OZ Minerals remaining positive on both metals. Newcrest, a major, is one of the best of our resource companies, again exposed to gold and copper. I try to only buy stocks with a genuine long term appeal, though will cut from time to time when I feel they have run out of gas for instance Fairfax at $4.00 some years back! Harvey Norman, too. The Australian index is dominated by the four major banks, the two major resource companies and Telstra, the key elements of the Top 20. It does not necessarily indicate the way your portfolio travels. For instance a quality portfolio of good dividend yielding stocks would have been in a bull market for some time now, led by Telstra kicking off from the late 2010 low of $2.60. I was a little early beating the Telstra drum, strongly recommending purchases up to $3.25 in 2010 and overweighting the portfolio, personally too. The annual dividend income at 28c a share fully franked easily won the day with the stock now at $3.60. Quality, defensive, dividend payers are a more important area than many of our so called sectors by nature of business. I say so called as in our small market by global standards; the sectors can include very diverse businesses. In the health sector to be reviewed next week, CSL, Ramsay Health Care, and Sonic are very, very different, in business and in operational geography. We have strongly recommended income stocks over the last two years, with our Income Portfolio nicely outperforming. In a world of falling interest rates, the chance of locking in high income for the medium to longer term is invaluable. Hybrids which set their rates at a margin over a declining bank bill rate simply do not measure up, for your income declines with the bill rate. That looks to have more downside, given our deep frozen housing industry. The Banks solid dividends! David Ellis brings an excellent note with this Forecast. But just a few points. The European crisis has been long brewing and many preventative steps have already been taken by financial institutions and companies. The Big Four have sufficient wholesale funding, local and offshore, to withstand several months of a shutdown in global offshore funding markets, an unlikely event given the predilection to 11th hour action by the ECB and other central banks. Through 2008/9, thanks to our annual superannuation inflows of $100bn and rising, a huge swag of our companies and property trusts were very well recapitalised. Sure, shareholders who did not take up bargain basement rights issues were savagely diluted, but the potential for major bad debts and nasty unemployment was rapidly relieved. We also have a major buffer as a commodity exporter in our currency, as it can fall sharply and offset weakness in commodity prices particularly when, as now, there are little inflationary pressures. I prefer the Big Four banks, and own CBA, NAB and Westpac. CBA is my favoured bank stock. Energy gas a major global game changer Mark Taylor explores this issue further on. But a few points. The huge change in the US energy market spells a major plus for the global economy in the coming decade or so. The explosion in shale gas and oil development in the US is a major game changer, even allowing it to switch from potentially being a major importer of LNG, to being a minor exporter. Over the next two years it is reasonable to expect the price of gas in the US to rise from current levels around US$2.60 per mmcf to industry

5 Huntleys Your Money Weekly 28 June History of energy consumption in the United States, Petroleum Hydroelectric Coal Wood Natural Gas Nuclear quadrillion Btu Source: U.S. Energy Information Administration Annual Energy Review 2009 Current US annual energy consumption of all types is around 92.5 quadrillion Btu. Gas reserves are 1,500 quadrillion Btu. That is gas reserves equate to an impressive 15 years of total US energy consumption assuming zero growth, no further increase in gas reserves, and total substitution of the USA s very substantial resources of oil and coal in particular. It does lead the US to (1) at least close to energy independence and (2) significantly cheaper energy. Australia has huge shale gas resources, and will share in these same benefits particularly, as with the US; we have the pipeline infrastructure largely in place. breakeven (after depreciation/interest etc) around US$6.50. Then to at least US$8.00 to restore industry profitability. BHP s Petrohawk purchase was correct! In the last two years there has been an explosion in supply of shale gas and last winter was the warmest in 100 years, so demand was down. In the US land is leased in 640acre lots for shale gas production and one producing drill hole has to complete within 15 months to hold the lease. That spelled an explosion in gas production and the price collapsing from $US12mmcf to $US2mmcf, now $US2.60. Drilling is shifting rapidly to oil prone shales where gas as a by product is far more limited. The initial flow rate from each shale gas well drops at least 50% in the first year, so supply will rapidly equate to demand as overall drilling is curtailed until price improves. Shale gas is at least a 50 year resource for the USA, some arguing 100 years. Now the US is self sufficient in gas, it is rapidly taking steps to replace oil and dirty old King Coal as much as possible. Gas is used increasingly in electricity generation. More importantly LNG is increasingly used to fuel long distance trucks, rather than petrol/diesel. Shell just announced plans to build 100 LNG stations to service long distance trucks across the US in their clearly defined routes. Volvo is churning out LNG truck engines. US road transport is the single largest user of oil in the world, so this cheaper alternative could gradually cap the price of oil driven upwards by Hubberts Peak considerations. The US is at least four years ahead of the rest of the world in harnessing shale gas, so over the next 10 years we will see not only an explosion in the US harnessing gas to replace oil in as many situations as possible, but around the rest of the world. US gas is not likely to put much of a dent in traditional Asian markets for our LNG, but it s possible other East Asian or Siberian sources just might. But that s not likely until post China is not our major LNG market and is likely to keep any shale gas development for its own lustily growing appetite. It may well need LNG to fill the gap through to 2020, and supplement own gas beyond that. Bottom Line: What the International Energy Agency estimates as a 40% increase in global gas reserves will cap the prices of many energy equivalents oil, coal, uranium, and blunt the effects of the Hubberts Peak syndrome with traditional sources of oil. The rapid supply overshoot with gas in the US is a contributing factor to current oil price weakness, plus the obviously weak global economy. The Teens Decade Bull Market I ve argued there will be a major bottom between now and end September, maybe even out to early That s a low with very bleak headlines and we see that developing around us. Gloom on Europe, Gloom on USA. Gloom on China, loads of gloom, and that s what makes major lows. So what am I looking for? 1. My first point relates to the nature of commodity booms. Following a steep sell off as in 1999 with copper at 60USc a lb, you get a massive boom which usually lasts about 10 years with very high prices. Those high prices encourage new supply. The quicker the new supply the quicker the price retreats. The following decade sees a downward sloping plateau effect, they don t just collapse. At present we have a major hiccup in commodity prices, which will likely make its grand finale around that low I expect later this year. Resource stocks will become excellent at least medium term buying. The Chindia affect is far from over. Copper, in particular, continues to face supply shortages, iron ore may see the supply equation come into place far earlier You will see from my notes on the Top 20 how weakness in the major resource stock prices is leading to higher and higher dividend yields. From the point of view of the buyer, this could get better yet! 2. Expectations of further monetary easing in Australia, China, Europe, and the USA. In particular our local bank loan rates look to fall by at least 50 basis points, led down by a 75 basis point cut in the Reserve Bank official rate. Good for defensive, quality, income stocks. Bad for all that money on bank deposit, though the capital is secure. Look to our Moat stock review with this Forecast, and look for yield, and where the yields are low, very carefully consider whether the growth in earnings and dividend in the years ahead justify this high PE/low yield. The baby boomers average 55years old today and they seek income increasingly! 3. I m looking for a minimum two year surge with market breaking out of the current trading range. I d look to a mid cycle correction and then another move to a peak later in the decade as the US economy gathers steam. China too. K

6 6 Australian Share Market Outlook Still defensive, dividend yields paramount Andrew Doherty Head of Equities 33Global economic woes are likely to persist for some time, creating a slow growth environment with occasional shocks to confidence and asset prices. 33The sell-off in resources appears overdone and, while this may go further, there is value for patient investors. Australia s top four banks also offer value and healthy fully franked yields. 33Grocery retailers (supermarkets) are attractively priced and offer more certain earnings growth and dividends than most industries. 33The uncertain, slow growth environment points to a healthy portfolio weighting to moat companies with strong balance sheets and above-average yields. Despite the global uncertainties, we think the market is mildly undervalued, though unquestionably less so than in December last year following the lowering of fair values of a number of stocks in that time. A contrarian investor could take this as a signal that we are approaching a market low. The median discount to fair value for our coverage universe is 12%, down from 20% last December. The market was flat over the period. Analysts are finding it difficult to make outright positive or negative calls. Some 51% of stocks covered are in the range, with 11% and 29% Accumulate. The remaining 8% are Reduce, Sell or Avoid. Debt reduction and the resources boom are dominant themes The economic climate appears to be deteriorating with business and consumer confidence constantly hit by news of deepening sovereign debt issues in Europe and lack of political consensus on how to rectify massive fiscal imbalances. The 0.7% fall in Germany s industrial production in the year to April demonstrates a declining ability of Europe s largest economy to support the periphery. At least the US economy is growing, albeit at a slow pace, which better positions it to handle its debt load. Consumer spending and job creation maintain positive trends despite a slowing in growth in recent months. Unemployment appears to be heading toward 8% by year-end which along with record low interest rates supports a recovery in housing. Spending cuts and tax increases are scheduled for early next year but policymakers are likely to agree to postpone and restructure these to avoid recession. The resources boom should drive the Australian economy to outperform western peers in the next couple of years. Strong business investment should continue to be a clear positive so long as a financial catastrophe is avoided in Europe. Commodity prices are off historic highs on European crisis and China growth concerns and will likely ease further over time, though some support will be found if supply is adjusted through delays in expansion. Demand is weakening in much of Australia s non-resources economy, pressuring margins. Consumers are bunkering down due to a focus on debt reduction, lower job security and the negative wealth effect of lower house prices. The carbon tax net of government handouts is also likely to detract from spending power. Housing activity could worsen further, dragged by affordability problems and limited land supply. Building approvals were down as much as 24% in the year to April. Fiscal policy is tightening as the Government endeavours to balance the budget. The case for further rate cuts is virtually made though it is likely the Reserve Bank will wait for a couple of months to assess the impact of recent moves. Resources and banks are the most undervalued industries Resources companies continue to be pressured by commodity price falls and rising operational and capital costs. While these issues could persist for some time, we think the sell-off is overdone, offering opportunities for patient investors willing to accept the characteristic heightened volatility in this space. On our numbers, resources stocks are as much as 27% undervalued. We favour BHP and RIO which have diversified revenue streams, vast long-life, low-cost assets and healthy balance sheets. Woodside is our favoured Energy exposure given ongoing earnings growth as planned expansions in the next two years offset lower commodity prices. Banks are 26% undervalued and offer fully franked yields of 6 8%. We favour investment in Australia s top four banks given their strong competitive positioning, solid capital ratios and likelihood of mildly positive earnings growth supported by weak but positive credit growth and cost containment, offsetting pressures from higher wholesale funding costs and softening house prices. Food & Staples retailing is undervalued by 16%. The three companies in this sector Metcash,

7 Huntleys Your Money Weekly 28 June To see our full list of moat companies, please go to We will be publishing our Best Ideas and Income Ideas in the following weeks. Wesfarmers and Woolworths each benefit from scale efficiencies and a not-overly competitive market. The repeat nature of food and grocery retailing provides the basis for recurring earnings streams. On current prices the fully franked yields of 5 7% are also attractive. Utilities and healthcare are fully valued but offer some opportunities for yield investors Utilities and Healthcare stocks have been popular for their stable yields and on the whole are now trading slightly above our fair value estimates. Some exposure to these sectors remains prudent given the uncertain climate. SP AusNet and AGL Energy and have Accumulate recommendations and an unfranked yield of 8.0% and partly franked 4.1% respectively. None of our healthcare stocks are undervalued at this time. We remain wary of discretionary retail due to weak consumer sentiment and the shift online and offshore hastened by the high Australian dollar. Traditional retail margins remain high relative to international peers and are set for further falls. Conditions are likely to worsen further, and the lack of competitive advantages supports a negative outlook. We do see some opportunities in the higher-risk mining services space but peaking demand, full share prices for many stocks and a lack of companies with sustainable competitive advantages means this is not one of our preferred areas. Moat businesses bought cheaply make excellent investments Companies with structural competitive advantages, or economic moats, should be the first added to any long-term investment portfolio. They are able to invest capital at rates of return exceeding the cost of capital for many years ahead, thereby growing the business sustainably and creating value for investors. Around 50 stocks in our coverage universe have moats and each is discussed in the sector reports that follow. We will highlight attractively priced moat companies in the Best Ideas and Best Higher Yield Stocks tables published next week. A full list of moat companies can be found on line. Across our research, we have discovered five moat sources: Intangible assets, switching costs, network effects, cost advantage and efficient scale. Intangible assets include strong brands (examples being Coke and Gillette) which encourage repeat sales and support price rises over time. Intellectual property rights like patents, trademarks, copyrights and government approvals are other intangible assets that can lead to moats. Switching costs make it too expensive or time-consuming to shift to an alternative supplier. Computer software providers frequently enjoy this advantage. It can take substantial effort to learn and implement a computer system, so we tend to refrain from switching to another unless we really have to. The network effect is a virtuous cycle allowing strong companies to get even stronger. It occurs when the value of a particular good or service grows as the number of users grows. An example is a stock exchange, where transaction costs decline as transaction volumes increase. Cost advantage can derive from increased scale and efficiency, allowing the company to increase margins. Efficient scale occurs when a limited market is effectively served by existing players and the profit opportunity does not justify entry by others. Airports, ports and shopping centres tend to benefit from efficient scale. Performance of moat companies has been well above market in the past year, median total return being +0.4% compared to median of -5.5% for S&P/ASX200. The top moat performers were defensive businesses where investors sought refuge from market volatility and uncertainty. Telecom NZ, Telstra, Ramsay Health Care, SP AusNet, Coca-Cola Amatil and CSL all returned above +18%. James Hardie also made the cut here, benefiting from its good performance in a terrible US housing market which may now be bottoming. Monadelphous benefited from increasing resources infrastructure work. The worst performers amongst the moats list in the past year were cyclicals RIO, BHP, Woodside, QBE, GWA and Leighton, all producing returns below -18%. These are point-topoint returns and don t take into consideration our recommendations. Over the last five years, median return of our moat companies of -2.2%pa was slightly ahead of S&P/ASX200 return of -2.7%pa. Defensive moat companies posted an impressive +3.7% pa over this period. Top defensive company performers were Ramsay Health Care, +17% pa, APA, +13% pa and Coca-Cola Amatil, +11%. Iress and Wesfarmers posted worse than -2% pa. Cyclicals performed relatively poorly in the past five years, with -4.9% pa total return. The worst of these (Goodman Group, Asciano and GPT) posted returns below -20%pa, dragged by financing problems and capital raisings. K

8 8 Resources Important to stick to quality, infrastructureflush names reasons, including the emergence of mega-scale laterite nickel projects and the role of nickel pig iron as a large but higher cost source of supply. Nickel pig iron utilises sub-scale, obsolete steel plants so the capital cost barrier to entry is dramatically lowered. Basic Materials, Energy, Utilities Mark Taylor Mathew Hodge Gareth James Per Capita GDP compared to the US Japan Taiwan Korea China India 100% 80% 60% 40% 20% 33The iron ore market can be expected to be more balanced from 2015 and investors should stick to miners with sustainable competitive advantages low costs and long life. 33We don't believe shale gas is a material threat to Australian LNG exporters, particularly in the short to medium term. 33The best placed players are those with a head-start on infrastructure spend. Metals and Mining: For nearly a decade miners rode a wave of surging Chinese demand to stellar profits. A sharp and sustained slump in commodity prices represents the greatest risk for most. The threat is less for those occupying a favourable position on the cost curve. Large, low cost, and expandable assets are the litmus test for staking out an economic moat in the mining industry. Worldwide industrial production and fixed-asset investment are crucial to demand and the trajectory of emerging-market demand is particularly important. For some metals like copper, recent world-class discoveries have been few and far between, average head grades are declining and labor-related production disruptions significant leading to a rather tight near term outlook. Gold follows a similar script, as miners battle the headwinds of declining grades and deeper mines. The supply outlook for aluminium is less constrained as a sharp decline in consumption early in the recession forced warehouse inventories to record levels while global smelting capacity increased. Nickel supply is also less constrained for several 0% Source: Vale The fate of bulk commodities rests on steel demand where the real question centres around what will happen outside the US namely in Europe and China. softness in late 2011 gave way to modest improvement to US$140 per tonne plus in the first quarter 2012 but in the second quarter prices again softened, briefly dipping below US$ 130 per tonne delivered to China. Weakening growth in demand stems from soft global growth in the first half and concerns about the global economic outlook. Global steel production is up only 0.7% for the first four months of Over the same period last year, global steel output was 9.1% above 2010 levels as volumes surged in almost all major producing regions. But the post-global financial crisis boom is over now, replaced by renewed liquidity concerns, contagion in Europe and potential spillover effects to the rest of the world. Steel consumption is highly correlated with per capita GDP, so demand was traditionally strongest in the developed world with production concentrated in these areas. But the past decade has brought substantial developing economy growth with China now consuming half of the world's steel. The developing world did not suffer the dramatic cyclical declines that the developed world did in In fact, 2009 was a record year of consumption for China, since eclipsed in 2010 and This year we expect only moderate growth in steel demand as the global economy slows, weighed down by the issues in Europe and the US and credit tightening in China, a credit tightening which is now rapidly loosening. We expect the iron ore market to be more balanced from fiscal 2015 as low cost producers like BHP Billiton (BHP), Rio Tinto (RIO) and Brazil s Vale expand at the expense of high cost supply, particularly from China. There is also potential for new high grade, low cost supply from Africa in the second half of the decade. As producers in the highest quartile of the cost curve exit, the iron ore price can fall sustainably. This gels with the outsized returns on new invested capital. With all up cash costs of roughly US$50 per tonne and assuming a benchmark fines price of US$130 per tonne, low cost miners make a fat pre-tax margin of approximately US$80 per tonne or US$56 after tax. Even at a record high capital costs of US$200 per

9 Huntleys Your Money Weekly 28 June Iron Ore (US cents per DMT unit of Fe {FOB}) Fines Lump Platts 62% China Spot Source: Rio Tinto tonne of new installed capacity, spot prices generate a return on new investment of 28%. There is no scarcity of iron ore in the world and over time new investment will encourage supply and drive down prices. We are cautious on the potential for China to continue to consume ever increasing amounts of iron ore beyond Iron ore is an early cycle commodity as steel is used to build the heavy infrastructure like roads, buildings and bridges in the initial stages of a developing economy s move towards western world standards. China already consumes as much iron ore per person as the west and there is risk in assuming further growth. Negative real interest rates on cash deposits Oil versus US domestic gas price NYMEX WTI $/bbl (LHS) NYMEX Henry Hub $/mcf (RHS) 160 PRE 2005 HISTORICAL SPREAD AVG. SPREAD FORWARD SPREAD 16 1:1 Btu ratio 1.5:1 Btu ratio 7:1 Btu ratio Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Jan-16 Jan-18 0 Source: Chesapeake Energy All in costs for US gas producers (Mcfe) $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 Average: $5.62 UPL CHK DVN CRZO EQT FST NBL PQ HK APA COG NFX ROSE RRC QEP AREX BBG GMXR KWK CLR EOG GEOI PXD APC GDP WRES WLL VQ CXO SM BRY SFY PETD OAS Source: Ultra Petroleum encourage speculative investment in other asset classes like real estate. This weak underpinning calls into question the long term viability of the investment driven economic growth model. Metallurgical coal prices also depend heavily on global steel demand. Coal stocks have been hard-pressed by weakening metallurgical coal prices due to increased Australian supply and slower steel production demand. The more normal lack of flood disturbance to Australian metallurgical coal production pushed prices to US$225 per tonne in third quarter 2012 from a flood affected peak of US$330 per tonne in the second quarter of The third quarter settlement is up slightly from the second quarter's US$ per tonne due to strikes at BHP s Queensland mines impacting supply, rather than any meaningful pick-up in demand. Energy: Negligible growth in oil production, despite prices well over US$100 per barrel, supports the peak oil theory. Constrained supply against the backdrop of 2.5% compound annual growth in global primary energy consumption is compelling. Explosive growth in US shale gas resources and the resulting decade low US domestic gas price is cause for concern for energy producers. Could additional supply even reach far enough to impact the attractive prices Australian LNG producers receive in key Asian markets? The US has vast unconventional gas resources and the revolutionary technology and service companies to produce them. Growth in shale gas production is staggering, but not at any price. A weak natural gas price encourages utilities to switch from coal to gas where possible. This is having a minor impact on the Pacific thermal coal export market with some US coal finding its way to export. It exacerbates demand weakness at a time when Australian supply is improving following extreme weather in 2010 and But low prices encourage a rational response from producers. The number of shale gas drill rigs in the US is being cut with best of breed producers requiring a gas price of US$2.70 per thousand cubic feet of gas for cash break even. The US based Morningstar energy team estimates the long term marginal cost of shale gas production to be around US$6.50 per thousand cubic feet, roughly triple current prices. Henry Hub gas prices near US$2 are simply unsustainable. Add in depreciation, compression and shipping costs and gas from the US probably can't reach Asia for less than US$12. US domestic gas prices above US$6 will make US shale

10 10 BHP Billiton BHP Rio Tinto RIO Woodside Petroleum WPL $ /04/12 (YMW14) $ /04/12 (YMW14) $ /05/12 (YMW16) High High gas to LNG a marginal prospect. We don t expect meaningful shale gas to LNG exports from the US before 2020 and even then restricted to swing exports to Asia. The US market may only require a relatively small global export capacity to operate as a relief valve in times of anaemic domestic prices. China is potentially a more serious threat than the US. If gas can be produced in country, the cost of compression and shipping is avoided, replaced by a pipeline. Pipelines have high up front capital costs but very low operating costs. Chinese shale won't need to be as cheap as the US to take away some of the growth potential for Australian suppliers. Chinese shale gas will be used internally, unlikely to compete with Australian exports to traditional markets in Japan, Korea and Taiwan. The potential Chinese shale gas threat to LNG is in its infancy and is unlikely to displace LNG import growth this decade. China faces difficulties commercialising shale gas. Reserves need to be proved up, technology successfully imported and pipelines lain. reform on Chinese domestic gas is needed to unleash the power of supply and demand and for Chinese shale gas to emerge as a source of meaningful supply. Another touted cause for concern for growing LNG suppliers is capital cost particularly in Australia. From the mid 1980s to the completion of a fifth LNG train in 2008, the North West Shelf joint venture (NWS/JV) spent US$19 billion building capacity to 16.3 million tonnes per annum (Mtpa). That equates to a retrospectively modest US$1,165 per annual tonne of LNG nominal or US$1,650 in today's dollars. Fast forward to 2012 and Woodside's (WPL) 90% owned 4.3Mtpa Pluto project commissions 11% over budget at US$13 billion, or US$3,020 per annual tonne. In nominal terms this is a 150% increase on the NWS/JV's 25 year average capacity cost. Adjusting for inflation it's an 85% increase. Pluto is yet to build additional trains to leverage existing infrastructure with the capital intensity of subsequent trains at just 40 45% of the first. That may mean cost comparison with NWS/JV is closer to 30% higher for Pluto after adjusting for inflation. That 30% real cost escalation might not sound scary but appears to be accelerating. Chevron's massive three train 15Mtpa Gorgon project at last count was expected to cost US$45 billion. That's 80% more than the NWS/JV in real terms. And the company's two train 8.9Mtpa Wheatstone project at US$29 billion is 95% higher. It's not inconceivable the real cost of building LNG capacity in the near to medium term will be double that experienced by the NWS/JV pioneers, of course far higher again in nominal terms. This puts anyone with operating LNG capacity at an extreme advantage to the less advanced players. s will need to be permanently higher to incentivise new supply. It also suggests deals, takeovers, mergers and joint ventures to extract cost savings are likely in the space. Moat Comment Commodity prices can be extremely volatile so investors should stick to miners with sustainable competitive advantages low costs and long life and the ability to generate good returns in almost any metal price environment. This is particularly relevant for miners most leveraged to the Chinese fixed asset investment boom, such as iron ore and metallurgical coal. Our preference in the mining sphere remains with BHP Billiton and Rio Tinto. Both produce a range of commodities, BHP differentiated by its full suite of conventional energy products. Both can benefit from rallies in any of their product lines though Rio Tinto is particularly leveraged to iron ore. World class asset bases mean they are among the few miners which generate returns above their cost of capital throughout the commodity cycle. Revenues derive predominantly from resources in the safe havens of Australia, North America and Europe. BHP Billiton and Rio Tinto have limited pricing power over most products except iron ore, where along with Vale, they control 75% of the seaborne market. Minimal pricing power is aggravated by volatility and cyclicality in commodities. However, we assign narrow economic moats to each given their large, low cost and irreplaceable operations. The lack of comparable mega deposits and increasingly prohibitive capital costs pose formidable barriers to entry. Woodside is the only Australian listed company currently producing LNG in quantity. It is also the most LNG infrastructure-rich. That makes it a prime target in an environment of high capital costs. Previous CEO Don Voelte's decision to press the envelope on infrastructure spend prematurely in many eyes looks increasingly inspired. It is also a potentially very tasty morsel. At a market capitalisation of just US$26 billion (enterprise value US$30 billion) and over 7Mtpa of installed equity LNG capacity, why bother building new capacity? Acquiring producing assets avoids construction risk and delivers cash generating assets immediately. We believe Woodside Petroleum has a narrow moat because of world-class, large, long-life, low-cost, and expandable gas assets off the Western Australian coast. K

11 Huntleys Your Money Weekly 28 June Financials Banks remain attractive. Yield supports selective AREITs and Infrastructure Figure 2: Major Bank Dividends Per Half Year 1H08 2H08 1H09 2H09 1H10 2H10 1H11 2H11 200cps 160cps 120cps 1H12 FY11 Payout ratio of 64% FY11 Payout ratio of 73% FY11 Payout ratio of 70% FY11 Payout ratio of 71% Financials, Insurance, Property and Infrastructure David Ellis Tony Sherlock Adrian Atkins Ravi Reddy Michael Higgins ANZ Bank ANZ Commonwealth Bank CBA National Aust. Bank NAB Westpac WBC $ /06/12 (YMW21) $51.70 Accumulate /05/12 (YMW20) Low $ /05/12 (YMW19) $ /05/12 (YMW19) Low Moderate earnings growth support major bank dividend outlook 33Weak equity markets pressure wealth management earnings 33Lower interest rates increase appeal of property and infrastructure yields 33Expect pressure on regulated utilities earnings and distributions We again reach a very interesting point in the road. We are positive on the major banks and have been for a considerable time. On the one hand, the banks are producing solid profits and attractive dividends. But the global macro outlook looks decidedly worse, and negativity reigns. The major banks remain very profitable despite weak credit growth, higher funding costs and a softening property market. Revenue continues to grow, non-interest income is solid, costs are under control, profit margins remain attractive and dividend payout ratios are not under pressure. Figure 1 demonstrates the solid and consistent growth in total revenues of the four major banks since late 2007/early 2008, overlaid with total net profits before bad debts and tax (core or underlying earnings). Underlying earnings continue to increase and operating profit margins remain solid around 55% (core earnings divided by revenue). Return on equity for the Australian banks stands out and we expect these returns will be maintained despite higher capital and tougher regulatory oversight. Figure 1: Major Australian Banks Total Revenue v Core Earnings Total Revenue ($bn) (LHS) Operating Margins steady around 55% Core Earnings ($bn) (RHS) H08 2H08 1H09 2H09 1H10 2H10 1H11 2H11 1H Source: Company Accounts/Morningstar Note: Core earnings are net profits before tax and bad debts cps 40cps 0cps ANZ CBA NAB WBC Source: Company Accounts/Morningstar Credit growth drives revenue growth, and looking forward, we see only moderate growth at best. We argue the major banks (and the RBA) are in effect controlling system credit growth and are content with growth around 3 4%. Banks are tightening loan standards to slow credit supply it is increasingly difficult to obtain finance for both the consumer and business sectors. It looks like the major banks and the RBA are trying to engineer a soft landing in house prices, which is a difficult task and one that could go off the rails if the economy stalls, confidence collapses, unemployment skyrockets and house prices fall precipitously, but this is not our base case. The banks need increasing amounts of customer deposits to fund loan growth, to satisfy new, tougher Basel III funding rules and, most importantly, to reduce reliance on volatile wholesale funding. But the banks have to pay up to attract and hold the deposits. Attracting expensive but increasingly important customer deposits will likely result in short-term pressure on net interest margins. Traditionally, banks adjust lending rates to recoup higher funding costs, but with weak credit growth, any increase in interest rates could further damage demand for loans. Despite declining interest rates the trend to lower credit growth could run for several years. We expect further interest rate falls in second half 2012 with major banks likely to pass on only about two thirds of any RBA cut to the benchmark cash rate. Over time the banks will recoup more expensive funding costs through higher interest rates charged on loans and adjust rates offered on customer deposits, but still broadly in step with RBA policy changes. The narrow moats we assign to the four majors, ANZ Bank (ANZ), Commonwealth Bank (CBA), National Australia Bank (NAB) and Westpac Bank (WBC), are not under pressure

12 12 QBE Insurance QBE AMP Limited AMP BT Investment Mgmt BTT Westfield WDC CFS Retail Property Trust CFX $ /04/12 (YMW13) $ /05/12 (YMW18) 5.60 $1.74 Accumulate /06/12 (YMW21) 2.00 $ /05/12 (YMW18) 9.45 $1.89 Reduce /05/12 (YMW20) 1.70 and are sufficient to make us believe excess returns can be sustained for the long term. The four major banks have narrow moats due to cost advantages, efficient scale, dominant positions and pricing power in Australia s highly regulated banking oligopoly. There is no question the banks are strong financially and dividends are not under threat in the short term. We argue there is good upside to dividend payouts as capital increases beyond minimum requirements, even in uncertain times. CBA remains our preferred bank due to its high ROE, market-leading retail banking position, lower risk profile and leading technology. CBA's total shareholder return (TSR) has exceeded major bank peers and the S&P/ASX 200 Accumulation Index over the previous four years. WBC and ANZ follow in our pick list. NAB carries the highest risk but is also the cheapest and offers the greatest upside potential. QBE Insurance s (QBE) narrow-moat rating is based on the combination of a diversified product range, extensive geographical presence and an overarching risk management culture. Diversification reduces the overall risk profile, spreading exposures by product and geography. ASX Limited s (ASX) narrow economic moat is derived from its near monopoly of the highly regulated Australian securities market for both physical (known as the cash market) securities and derivatives, predominately futures and option contracts. Wealth management outlook Major changes in global and domestic market conditions continue to plague the outlook for earnings and investor confidence. Global political and economic turmoil overshadows underlying fundamentals, increasing volatility and exerting downward pressure on valuations. Earnings leverage to equity markets is direct but this linkage works both ways down and up. Our narrow-moat wealth managers include AMP Limited (AMP), BT Investment Management (BTT), Platinum Asset Management (PTM) and Perpetual Limited (PPT). Wealth management businesses generate strong cash flows and debt is either non-existent or under control. Deeply discounted capital raisings are not needed or expected, as balance sheets are strong despite slowing earnings. We remain upbeat on the industry s above-average growth outlook despite near-term market volatility. Long-term growth is supported by demographic trends and the highly regulated, compulsory superannuation regime delivering an increasingly large pool of retirement savings. The competitive advantages behind AMP s narrow moat are the size of its distribution footprint, the low-cost manufacturing platform that derived from superior scale, and one of Australia s oldest and most-respected heritage brands. AMP boasts the largest, most diverse financial advisor force in Australia and New Zealand. BTT operates a strong and well-respected brand, backed by majority owner Westpac, and benefits from the extensive distribution networks and market-leading investment platforms operated by Westpac s wealth business, BT Financial Group. Platinum s competitive advantage is derived from its strong brand and reputation in the retail investor market as Australia s leading specialist manager for international equities. The asset manager benefits from an impressive long-term investment track record that underpins funds under management (FUM). Perpetual s brand is widely known and respected by retail investors and financial planners, mainly for a long-term track record of outperformance in Australian equities. The goodwill towards the company continues to underpin FUM and is underwriting expansion into private wealth management. The best value in the sector is UK-based global fund manager Henderson Group (HGG), annuities specialist Challenger Financial (CGF) and the large and diversified wealth manager AMP. BTT and IOOF ings (IFL) also offer appeal, sitting in our Accumulate zone. But at present, the near-term outlook for equities is poor and our forecasts suffer from lower FUM and further margin pressure. In the medium term, we remain positive on the sector as we expect equity markets to recover and confidence to improve, boosting earnings and valuations. Property outlook Ultra-low long-term interest rates in most of the Western world are driving investor interest in real estate investment trusts (REITs). Demand from institutional investors for the stable and relatively low-risk income streams offered by higher-quality and conservatively geared REITs is a key factor in the significant outperformance of the Australian listed property sector, which is up 11% since end December 2011, as compared to no appreciation for the broader S&P/ASX 200. With global and local

13 Huntleys Your Money Weekly 28 June Westfield Retail Trust WRT Dexus Property DXS BWP Trust BWP SP AusNet SPN APA Group APA $ /06/12 (YMW22) 2.65 $ /06/12 (YMW21) 0.94 $ /04/12 (YMW13) Low $1.02 Accumulate /05/12 (YMW18) Low 1.15 $ /03/12 (YMW08) 4.75 interest rates likely to stay low over the medium term, the significant distribution yield premium over bonds provides material support for AREIT valuations in coming years, particularly those with highly defensive rental income. We view the larger retail REITs of Westfield Retail Trust (WRT) and CFS Retail Property Trust (CFX) as having narrow moats, as many of their larger malls enjoy regional monopolies, with supermarkets and other anchor stores and established transport routes bringing in a steady stream of shoppers. These attributes and ongoing redevelopment also provide a disincentive for new competition. Notwithstanding, WRT and CFX have a negative moat trend, reflecting the risk of escalating sales leakage to online competitors and ongoing consumer de-leveraging. We are more positive on Westfield Group (WDC), to which we ascribe a stable moat outlook due to the increased use of third-party capital to fund growth from development initiatives. Our preferred retail exposure is Charter Hall Retail (CRQ), due to its low specialty occupancy costs, which present scope for solid rental growth, combined with its low exposure to discretionary retail, with the portfolio focussed on grocery-anchored neighbourhood and sub-regional shopping centres. Given the backdrop of economic uncertainty, our preferred exposures in the property sectors are those with better quality tenants, high occupancy, longer lease terms, conservative gearing and the lowest re-letting risk. The narrow-moat stocks that best meet these criteria are BWP Trust (BWP) and Dexus Property (DXS). Despite no moat, ALE Property (LEP) also qualifies. In general, most AREITs substantially reduced risks following the GFC and should outperform the broader stockmarket during soft economic conditions. We consider DXS and BWP to have narrow moats, reflecting relatively secure income streams from good quality properties underpinned by longer lease terms and higher-quality tenants. DXS s large office portfolio also benefits from barriers to entry due to limited sites on which to construct competing offices. Additionally, office tenants have a variety of switching costs including relocation expenses. Infrastructure and Utilities outlook Like AREITs, infrastructure stock prices performed very well over the past year on a flight to safety and search for yield as official interest rates fell. Overall, we expect solid earnings growth to continue in FY13, while stock prices are unlikely to rise strongly from current elevated levels unless we get US-style ultra-low interest rates while our economy remains solid. The most stable infrastructure stocks are regulated utilities but, as shown in our recent special report (22 June 2012), profits and distributions will likely fall at regulatory resets over the next few years due to lower long-term government bond yields, a key determinant of allowed returns on equity. We have negative or neutral recommendations on most regulated utilities. Best value in the sub-sector is SP Ausnet (SPN), which sits just inside our Accumulate zone. SPN s narrow moat is derived from its regulated monopoly infrastructure assets providing secure and growing earnings combined with a strong balance sheet and conservative management. We continue to like the outlook for gas transmitters APA Group (APA) and Hastings Diversified Utilities Fund (HDF) due to robust growth in gas use/export and limited regulation allowing superior returns. We have recommendations on both after strong stock price rallies. If APA s takeover of HDF succeeds, it would form an immense network owning the majority of gas transmission pipelines across the country. Limited regulation, scale and a superior skills base help APA capitalise on robust gas demand growth, and generate competitive advantages that warrant a narrow moat. Toll roads are marginally sensitive to economic downturns, with truck volumes related to economic activity and car volumes influenced by employment. Airports are a little more economically sensitive, with tourism and business conditions impacting passenger numbers. While less stable than other infrastructure types toll roads and airports are far more defensive than the broader stockmarket. We have recommendations on Sydney Airport (SYD) and Australian Infrastructure Fund (AIX) and a Reduce on Transurban (TCL). K

14 14 Consumer & Industrials Safe havens Staples, Healthcare, Telecommunications Consumer, Healthcare, Industrials, Tech & Telecom Peter Rae James Cooper Tim Montague-Jones Ross MacMillan Nachi Moghe Peter Warnes Michael Wu Nathan Zaia Woolworths WOW Wesfarmers WES CSL CSL $38.70 Under Review /03/12 (YMW08) Cochlear COH $26.52 Accumulate /06/12 (YMW23) Low Wide $29.20 Accumulate /05/12 (YMW20) $ /02/12 (YMW05) High The outlook for consumer cyclicals continues to deteriorate with the likelihood of more downgrades and equity raisings. 33Healthcare and telecommunications offer strong defensive characteristics, but are not looking cheap after strong share price performance. 33The resources capital expenditure boom sets the stage for further short-term strength in mining services earnings, but watch for any signs of a slowdown. Consumer The weak outlook for consumer-related stocks has not changed and pressure on the sector has intensified in recent weeks. Daily headlines on the European financial crisis, weak equity markets and fears of job losses all contribute to ongoing weakness in consumer sentiment. The headwinds of structural change have increased with the relentless shift to online activity posing significant challenges for media companies and discretionary retailers. The pressure on earnings and financial positions has seen profit downgrades and highly dilutive equity raisings, with further raisings likely. In retail profit downgrades and weaker than expected quarterly sales continue to grab the headlines as retailers experience yet softer than expected conditions. We see little prospect of a short-term change in outlook and our preference is to seek value among moat companies in the consumer staples sector. Our preferred stocks are Metcash (MTS), Woolworths (WOW) and Wesfarmers (WES). In media a series of profit downgrades across the sector reveals the continuation of revenue weakness as adverting budgets are cut in response to weaker than expected trading conditions. The structural shift to online is also causing significant pain resulting in major business restructuring and associated costs particularly in print media. We recently downgraded our FY13 outlook for Print, TV and Radio on a weak advertising outlook. We continue to look for value in the domestic online classifieds channel which include Seek (SEK), carsales (CRZ) and REA Group (REA). While these stocks have strong market positions we do not assign them with a moat rating given the speed at which market conditions can change in the online space. Healthcare Healthcare stocks remain largely immune to weakness in consumer sentiment. But massive fiscal imbalances in the Western world could pose a risk to offshore earnings if government spending cuts impact re-imbursement of products that Australian companies sell overseas. The majority of companies we cover should be relatively insulated given they sell products with compelling cost-benefit profiles. At the right price, our favoured stocks remain moat companies CSL (CSL), Cochlear (COH), Ramsay Health Care (RHC) and ResMed (RMD). Telecommunications In the traditional telco business, mobile and wireless remains the key growth driver. Telstra s (TLS) competitive advantage is its superior mobile network. We expect momentum in mobile subscriber growth to continue but at a slower pace. A telco needs to balance subscriber market share, the quality of its subscriber mix and profitability. With the recovery of market share over the past year, we believe Telstra has achieved the right balance in its subscriber base and the focus is back on margins, hence the reduction in handset subsidies late last year. Rollout of the Long Term Evolution (LTE) or 4G networks continues but limited by spectrum availability. Optus acquisition of Vividwireless will strengthen network capacity. Optus LTE network is operating in the Newcastle area and tests are currently underway in Sydney, ahead of a full scale launch in Mobile revenue growth will be driven by the explosion in data. In the fixed line market, rollout of the NBN is gaining pace with the network expected to reach 450,000 households by July Competition will intensify and we expect smaller telcos such as iinet (IIN) and TPG Telecom (TPM) to benefit from the rollout. We retain a preference for TLS given its narrow moat and sustainable high dividend yield but at current prices our recommendation is. Industrials In broad terms the outlook for companies across most of the industrial sub-sectors is weak. Stocks in the manufacturing, transport, housing and building related segments are exposed to the weak conditions in the non-resources sectors of the economy. These sectors are hurt by a flow on from

15 Huntleys Your Money Weekly 28 June Ramsay Health Care RHC ResMed RMD Telstra TLS Brambles BXB Coca-Cola Amatil CCL $ /03/12 (YMW08) $ /05/12 (YMW18) None 2.95 $ /04/12 (YMW14) 3.85 $6.15 Accumulate /06/12 (YMW21) 7.50 $ /06/12 (YMW22) Low weak consumer spending, reduced construction activity and a strong A$. Lower interest rates should eventually stimulate demand for housing, but there are no real signs of this occurring at this stage. Mining services continues to do well with upgrades across the sector reflecting the buoyant resources conditions. While the short-term outlook remains positive and further upgrades are likely, major mining companies, BHP Billiton and Rio Tinto, signal they are re-considering plans to undertake some marginal mining and energy projects. This, combined with a potential peaking of capital expenditure over the next two to three years could see earnings peak for some of the smaller, less diversified mining services companies. We retain a preference for narrow moat firm Orica (ORI) which is leveraged to the expected strong growth in mining volumes. The building and construction industry is deeply cyclical and is closely aligned to interest rate cycles which determine the level of economic activity. Despite low interest rates here and in the US the residential segment of the industry, which consumes most building materials is subdued. Ultimately low interest rates will trigger a lift in activity but until consumer confidence and affordability improve conditions will remain challenging, but it could be argued we are at or close to the bottom of the cycle. The resources boom and a strong level of civil construction buoys demand for construction materials. As in most industries some are better placed than others. Of the traditional building material suppliers we favour narrow moat firm James Hardie (JHX) which is strongly leveraged to a recovery in the US housing market. Moat comments Blackmores (BKL) BKL s key competitive advantages are gained through brand awareness, ongoing product innovation and wide distribution channels which will take a new competitor some time to replicate. The strong brand and market position provide BKL with a narrow economic moat. Brambles (BXB) Brambles is the only truly global pallet pooler and while it is subject to local competition, rivalry is not high in most markets. Its key competitive advantage is provided by the network effect of core CHEP operation which gives it a narrow economic moat. Coca-Cola Amatil (CCL) Competitive advantages include the power of the global Coke brand, economies of scale including the promotional clout of Coca-Cola Atlanta, excellent distribution networks, and superior product and packaging innovation. Together these provide CCL with a narrow economic moat. Cochlear (COH) Cochlear's reputation for technological innovation and reliability in a highly specialised medical niche coupled with a strong intellectual property position constitute relatively strong competitive advantages and give it a narrow moat. High returns on invested capital for over a decade suggest few inroads by competitors, although a still immature, growing industry partly explains the high returns. Crown (CWN) Crown has a narrow economic moat. While its long life licences are not exclusive and the respective State governments could issue further licences, we believe a second casino in each state is unlikely to have a significant economic impact on Crown s assets. We believe the mature gaming market in Australia is unattractive for offshore casino operators. CSL (CSL) CSL has a narrow moat, largely a function of superior scale and technology. The company is vertically integrated utilising a hub and spoke model, a network of blood collection centres feed into centralised fractionation facilities. The scale and resultant lower cost of this international operation represents a significant competitive advantage. InvoCare (IVC) IVC s scale and reputation in a market where customers are naturally loyal deliver a narrow moat. Its marketing clout, a function of financial and operational scale, is also an important competitive advantage. It enables the company to segment the market with a variety of brands, from premium to value. This brand strength would materially constrain a new entrant s ability to win meaningful market share. James Hardie Industries (JHX) James Hardie s narrow moat derives from a blend of cost advantage and intangible assets. With the scale to constantly invest in product and process technologies competitors are kept at bay. As a result of proprietary product formulation and process technology, which are patented or held as

16 16 Crown CWN James Hardie JHX Leighton LEI Monadelphous MND Orica ORI $ /03/12 (YMW09) -High $ /05/12 (YMW19) 8.00 $ /06/12 (YMW23) High High $ /05/12 (YMW20) High High $24.43 Accumulate /05/12 (YMW17) trade secrets, the company is able to introduce new or refine existing products underpinning significant competitive advantage. Leighton ings (LEI) LEI has a narrow economic moat due to the company s market strength and lack of large scale competitors in the domestic and Indonesian contract open cut mining market. High capital costs to entry and a highly skilled workforce, ensures Leighton competes in mining service markets with limited competition but strong customer bargaining power. Metcash (MTS) Metcash dominates the Australian wholesale distribution of packaged groceries to the independent retailer. Its monopoly market position allows it to generate significant economies of scale and a cost advantage and is why we award it a Moat. Monadelphous (MND) MND has a narrow economic moat despite engineering and construction being a fragmented and cyclical industry. It has long established relationships with major mining and energy companies that have been leveraged into recurring maintenance and industrial services contract work. Orica (ORI) ORI has a narrow economic moat by virtue of its global explosives business. It is the leading global explosives company and benefits from strong technical expertise, global scale and high share of a consolidated market. Potential competitors are discouraged from building production plants due to the high costs and likelihood excess capacity within a particular region would lead to uneconomic returns. This market feature is known as efficient scale and is a powerful barrier to entry. Ramsay Health Care (RHC) Ramsay Health Care is a narrow moat business because of sustainable competitive advantage obtained through scale, allowing it to offer the lowest cost of quality healthcare services from private hospitals within Australia. RHC has historically delivered the highest industry profit margins when compared to its competitor, Healthscope, which is now owned by private equity. ResMed (RMD) RMD has dug a narrow economic moat around its business with superior development and marketing capabilities in sleep apnea devices. An ability to continually introduce novel products with greater comfort and effectiveness helped the company become a leader in the sleep apnea niche and generate returns well above cost of capital. Telecom New Zealand (TEL) Telecom s narrow economic moat derives from low operating costs and economic scale in mobile which offsets fixed-line headwinds. A higher proportion of fixed costs in a consolidated market discourages entry into the industry by would-be competitors. Telecom s competitive advantage in mobile is its XT network, a leading 3G network in New Zealand in both speed and coverage. Telstra (TLS) Telstra has a narrow moat rating based on its cost advantages. The infrastructure provides the most extensive coverage for fixed-line, mobile and broadband in the country which drives cash flow. Telstra is not the cheapest provider of telecommunications services but has the lowest cost structure resulting in EBITDA margins exceeding 40%. Trade Me Group (TME) Trade Me commands a very strong brand equity considering that it is one of the most popular online brands in New Zealand. The firm s auction business is the classic example of a network effect, where the value of the network grows as the people who use the network increases. This network effect creates significant barriers to entry rivals. Wesfarmers (WES) Wesfarmers diversified exposure to Australia s economy, a significant footprint across the Australian retail landscape and interests in the industrial, resources and agricultural sectors generates our narrow economic moat rating. Substantial buying power and the integration of distribution centres with those of major suppliers underpins a low cost operation. Woolworths (WOW) Woolworths significant footprint across Australia s retail landscape and the operating leverage gained from an integrated and streamlined supply chain generate a wide economic moat. Intimidating relative buying power and the integration of its extensive distribution network with those of the major suppliers underpins a low cost advantage. We view Woolworths as having both a network effect and a low-cost provider status. K