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 Berkshire Hathaway: Put down the pistols – the game of Russian Roulette is over

When we last reported on our attendance at the Berkshire Hathaway (“BRK”) Annual Meeting in 2013, our answer to the – ‘What happens when Warren goes’ question – was, there will be an immediate hit to the share price but over the ensuing year or so, the underlying value of BRK would assert itself.  No need to sell. 

Our answer this year is more assertive – have no concerns. The BRK pipeline gushes such a volume of operating earnings from such diverse sources operated by so many qualified and proven business CEO’s that BRK will roll on and on without him.  The Board-approved senior manager will take over as CEO of the operating businesses and the two youthful CIO’s will continue with the investments.

The scorecard (in USD)

Note: The S&P 500 numbers are pre-tax whereas the Berkshire numbers are after-tax.

The lead up

The BRK Annual Report (attached) is released on the last day of February each year, ahead of the Annual Meeting held in Omaha, Nebraska, on the first Saturday in May.  For this 50^th year “since present management took over”, it includes two additional pieces – the views of the Executive Chairman, Warren Buffett (pages 24 – 38) and the Vice Chairman, Charlie Munger (pages 39 – 43) on what has happened at BRK in the last 50 years and what each expects in the next 50 years.

Mistakes are admitted, reasons for success are listed, today’s foundations of BRK are described and the predictions for a successful future are clear and unequivocal. For Buffet:

            “…despite our conservatism, I think we will be able every [his emphasis] year to build the underlying per-share earnings power of Berkshire”.

For Munger predicting whether “abnormally good results would continue” post Buffett:

            “The answer is yes.  Berkshire has in place in its subsidiaries much business momentum grounded on durable competitive advantage.”

The whole report is good reading; these separate pieces are highly recommended. It has been said of Buffett that in addition to his investment prowess, he may be the best investment teacher and writer we have seen.  And witty.  About one mistake Buffett made: “I became the dog who caught the car”.  And insightful.  Munger says of Buffett: he “often displayed almost inhuman patience”.

The Annual Meeting – what is it?

Buffett was born (in 1930) in Omaha, Nebraska – established 1854, the start of the great trails West, think fur trading, Missouri River, Indian wars – the Mid-West.  He was mostly raised there, and post his education, has lived there and made Omaha BRK’s headquarters (340,499 employees, 26 at HQ).

The AGM weekend has grown over 50 years from nothing to an estimated 40,000 attendees this year.

The city fills with visitors wearing the shareholder credentials around their necks.  Americans, Australians, Germans, Indians and Chinese (in approximate order of arrival over the years).

Underneath the arena, most BRK businesses have stands either showing off their activities or selling their wares.

A daggy but amusing short film is shown at 8.30 am featuring investee company ads, various actors and sports stars, Buffett and Munger in different guises, all the company CEO’s and every year, the now famous clip of a younger and nervous Buffett fronting the Congressional Inquiry into the wrongdoings of Salomon Brothers in which he said he had made clear to Salomon staff:

            “Lose money and I will be understanding; lose us one shred of reputation and I will be ruthless”

The audience squashes in, the Board (including Bill Gates) sits at the front of the audience, and at 9.30am Munger and Buffett take the stage to answer random and unseen questions from 9.30 am – noon and 1.00 pm - 3.30 pm, posed by a panel of 3 journalists, a separate panel of 3 analysts and shareholders from 12 ‘stations’, themselves selected on the day.

So, planes and cars converging on Omaha, 40,000 people descending on the convention centre, all seated by 8.30 am and mostly, they remain until 3.30 pm.

Why go?

It’s a bit like Croatian-Australians travelling to Moree once a year to bathe in the hot mineral waters coming up from the Great Artesian Basin!  It is cleansing and refreshing. 

Their views are sobering.  Depending on your frame of mind, what they say is comforting.  A couple of wise people pick problems apart and solve them.  They are invariably optimistic.  There are home truths.  The reasons for investing in BRK are obvious.  There are a lot of laughs.

 What did they say?

 A great deal over 5 hours.  VGI Partners has produced a 23 page Q&A summary which we can provide or you can search on Google for coverage.  What follows are headlines and bullet points, taken from contemporaneous notes with occasional jet lag intrusions.

Universal remarks

On how to install a culture: From the top, by consistent behaviour; it has to be lived; rewarded when displayed (and punished when not); it’s a grain of sand thing; a child sees what  you do and how those above behave; it takes a long time.  CM: we were dissatisfied with what we knew.  We always wanted to learn and learning made it work.

On “SIFI’s” – Systemically Important Financial Institutions – and criticism of BRK not being included: BRK has 20% of revenue from financial operations compared to insurance companies with over 85%.  CM: there is still too much risk in the system.  Paulsen, Bernanke, Draghi got the job done because they were believed.  Capital ratios of 11.5% won’t be enough.

Brands vs Retailers and private labels: retailers have always fought the brands.  Heinz ketchup has 60% share and Coke sold record volumes again this year.  Costco and Walmart are tough.  Great brands will do well and so will great retailers.

On value investing: we have made a lot from other people’s mistakes and greed.  Especially in 1973 and 1974 – cheapest stocks ever.  That sort of volatility makes no sense.  It’s an easy game if you can control yourself.  CM: no-one buys a farm for next week’s profit.  Make a valuation decision and walk away.

Indicators of stock markets valuation

You have used total Market Capitalisation/GDP as a guide.  It is 125% at present, about the same level as 1999: we are living in an interest rate environment we thought was impossible.  Corporate profits are worth more when Treasuries are at 1% than when they are at 5%.  At normal rates, these prices look high; if we continue at these levels, they look pretty cheap.

Global remarks

On China per CM: Nothing is more important than future cooperation with China.  Crazy not to collaborate and increase trade.  For the collective safety and benefit of the world.

On USD: The US Dollar is likely to be the world’s reserve currency 50 years from now.

On good fortune: in spite of various global threats, the system is great and each generation is doing better.  The luckiest person in history is still today’s baby.  CM: I have lived in the most ideal era for any person ever.

BRK business(es)

Using “Berkshire” in the names of subsidiaries: We have no great brand plan.  The real estate agents bought from Prudential had to shed the Prudential name.  We will yank it if not used properly.

Future of Berkshire Energy faced with renewables and “distributed energy” (i.e. stored): Best defence is to have lowest cost energy.  CM: We will use renewables because fossil fuels will expire.  They are not a threat more an opportunity and a huge benefit to humanity.  Wind and solar relies on tax credits because the market can’t yet do it alone.

On QE and the lack of inflation: We have both been wrong on our inflation predictions.  Still can’t see how we cannot have it.  BRK will do better than most in most environments.  We can act.  We don’t need to rely on anyone else.  We have got US$60bn in cash.  We’d rather have US$20bn having made a US$40bn acquisition. CM: (on current environment) we just swim and let the tide take care of itself.  If you make too many pronouncements you eventually think you know something.

Could the CEO be the CIO as well: we don’t want someone with no operating experience to be CEO.   I am better at investment because I did operating as well. CM: every year our owned and operated businesses are becoming more important than our investments.

Humour/Homespun/Wisdom (mostly from CM and is not always immediately clear)

On working in a modern law firm: It’s like being in a pie eating contest: when you win you get to eat more.

On using so little leverage per CM: We could have used leverage. But we would have sweated at night – you’d be crazy to do that.  Per WB: he means over a financial thing!

On reputation: Get the best you can.  It’s a wise investment.  Behave well – I can’t think of anything more important.  WB: Gianni Agnelli said: ‘When you get old, you have the reputation you deserve’.  You can fool people early on.

On marriage and partners: Change yourself don’t try and change your spouse.  The best marriage partner is someone with low expectations.

On character: Trustworthiness is more important than brains.  We have specialised in meeting dysfunctional people with IQ’s of 160.  Salomon gave us a head start on that.

On an elderly shareholder failing to get the lowest premium from (BRK owned) Geico: If an older person ends up paying more it may be unfair but is a good trade-off.

What makes them tick (especially as investors)

WB: I had exceptional focus, great teachers, the right emotional qualities and I enjoy what I do.  It is enormously fun.  It is hard enough to be interesting but not impossible.  From age 7 – 19, I liked it but had no guidance.  Then I met Ben Graham and got a philosophy and was able to inject my energy in a focussed way.

CM: I got the idea from my family that my main duty was to become rational.  As much as possible.  I got good at that.  Confucius had the same idea.  BRK is a temple of rationality.  To see it the way it is.  It is dishonourable not to remove ignorance.

Conclusion – key takeaways

1. Succession is resolved;
2. The US and China must befriend each other; and
3. This may have been Charlie’s last meeting?

Over 10 years and 4 meetings, the topic of succession has evolved from ultra-sensitive, to a discussion point, to concrete steps put in place, to resolved.  Bill Gates and others on the Board are believed to have forced Buffett to address this and it is now done.  Almost to the point of being ‘ho-hum’ at the meeting.  Investments are down to less than 1/3 of the total market cap and almost all earnings are from operating businesses. Buffett will be replaced by one of his two leading company CEO’s and the two CIO’s have been in place for some years now.

The China sentiment seems obvious.

Charlie T Munger spoke more at this meeting than at all the previous meeting combined.  Was it his swansong?

 Postscript

According to Davis Investors who have invested in BRK for years, BRK is good value at present.  At USD220,000 per A Share or USD146.00 per B Share, we estimate BRK is trading at a P/E of 15x and approximately 1.5x Book Value.  We know that BRK will buy back its shares at 1.2x Book (it happened once) and we agree with Davis that 2x Book is overvalued.  We are buyers for long term holders.

PlayfairTan

May, 2015

December 23^rd 2014

2014 – It’s not what it seems

As the year draws to a close, and being mindful that we’re not quite out of the woods yet, we can’t help but get slightly ahead of ourselves and look over our shoulders at 2014. It’s been an eventful year: volatility returned to markets; the US’s all-important quantitative easing programme wound up; and commodity prices have plunged, taking the Australian dollar with them. As if that wasn’t enough, Ebola in West Africa, and the Ukrainian crisis as well as the surging Middle Eastern ISIS movement ensured that geopolitical risk was rife. With plenty of gloomy headlines, one could be forgiven for thinking that 2014 hasn’t been a great year.

Things are, however, not always what they seem. A couple of days before Christmas, all major markets, in local currency terms, are in positive territory. The S&P 500, a broad measure of US equities, is trading at an all-time high and is more than three times its March 2009 trough. Fuelled by aggressive monetary policy, Japan has accompanied the US into double-digit-return territory and despite its well-publicised economic woes, Europe boasts healthy mid-single-digit numbers for the year-to-date. Though falling commodity prices has been a significant headwind for domestic equities, the ASX 200’s 4% total return beats inflation and preserves capital. A-REITs, up more than 25% for the year, have been a silver lining. Add to this a rally in global bonds and the scene in the rear view mirror looks even rosier.

We continue to bolster our client’s investment line-up in a patient and gradual manner. As part of this ongoing effort, we strive for judiciously-diversified portfolios. Diversification is, after all, the oldest and most effective trick in the portfolio construction book. It’s a valuable tool that allows us to spread risk not just across asset classes but also across investments and currencies. Bringing a high-quality unhedged global listed property strategy into the mix during 2014 bolstered diversification on all three of these fronts. Other noteworthy changes included the performance-enhancing switch between two international equity funds and an impending switch between strategies offered by a long-held Alternatives manager that continues to impress.

Meanwhile, the power of currency diversification was on display in the latter half of 2014 –  as the ASX 200 tumbled from a six-year high, a fall in the Australian Dollar meant that currency gains from unhedged international growth assets offset Australian equity losses, effectively buffering portfolios.

Diversification wasn’t our only tool this year. Corporate activity amongst Australian equities allowed us to take advantage of market opportunities as they presented themselves. A share purchase plan, offered be a well-known ASX20 stock offered a compelling discount to market value. Reallocation, following a restructure, from an Australian-focussed retail REIT to its demerged international business, proved to be particularly fruitful. More recently, participation in the highly-sought-after privatisation of Australia’s largest health insurer, the largest IPO in a number of years, added further value.

Of course we won’t get all of our calls right, try as we may. For example, a long-held provider of engineering and professional services is down almost 30% for the year. The swift and unexpected slide in the oil price, accompanied by falling commodity prices, has been a double-whammy for the company. While this loss has been less than ideal, we take comfort in the firm’s strong balance sheet and steady cash flow. Despite shorter term headwinds, we believe the company is well-placed to benefit from long-term growth in global hydrocarbons and so we haven’t wavered over our recommendation. Building positions has been another vexed and trying matter. Some stocks, such as those in the Healthcare sector, are just too expensive to buy so we clench our jaws and remain patient.

We’ve spent considerable time during 2014 scanning the landscape for prospective investment opportunities. As strong advocates of active management, our ultimate goal is to unearth high-quality active strategies that can deliver favourable returns, protect capital on the downside and blend well with our existing roster of investments. Along the way, we have, at the very least, learned something new and, at the very best, unearthed a few worthwhile opportunities to pursue further in 2015. In January, we will, as we have in the past, publish and send our clients the most recent list of these investments for perusal.

As we have seen this year, there can be a clear disconnect between economic/political realities and investment market performance. On the horizon, there will surely be another market downturn, heightened geopolitical risk, and another global health scare. Sensational headlines, whether overly positive or negative, can lead to irrational decision-making. For us, that means not tacking left or right, regardless of how strong the winds of fear or greed blow, but instead staying on course to achieve our client’s investment objectives.

We will be in touch with each of our clients in the New Year to provide a more detailed performance piece, outlining which assets classes and underlying investments have contributed and detracted from calendar year returns. At the end of November, the recommended portfolio had achieved returns just below 10% and as things stand, December will add to that, pushing the calendar year’s returns into double-digit territory. A very pleasing outcome given the year we have had.

As always, we look forward to our next client meeting, where we get the opportunity to discuss portfolios in greater depth. Until then, we hope we have given each of you a sense of what to expect from the year that’s (almost) passed.

Our best regards and Merry Christmas,

PlayfairTan

Darren Cunneen          Matthew Playfair         Francis Tan      Kate Alden

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26 August, 2014

Financial System Inquiry

Second Round Submissions

By Email

Dear Panel,

The Responsibility of Money

We enclose our submission to the current round of the Financial System Inquiry ("FSI").

PlayfairTan is a boutique investment advisory firm, providing advice to wealthy individuals and families. We operate under our own Australian Financial Services Licence ("AFSL") and have accumulated years of experience in large financial services organisations.

As participants, we continue to be dismayed by the lack of true professionalism in the industry.

There are multiple factors that contribute to this and many are highlighted in the FSI Interim Report ("Interim Report"). They include:

• lack of structural integrity in financial services organisations;
• lack of standardised training or registration requirements;
• lack of a single statutory/membership organisation with standard-setting powers; and
• lack of competition in the industry – as the Interim Report notes, there are only 15% of firms which are independently owned.

Often, institution-owned firms are focused on "distribution" dressed up as advice. A phrase such as "share of wallet" is a commonly used term that exposes in three simple words the primary modus operandi of some organisations.

Our submission is based on our engagement with clients, past experience as employees, and now proprietors of a unique financial advisory firm. Our primary focus is the wealth management and financial advice sections of the FSI (sections 2 and 6).

We applaud the FSI’s focus on efficiency, stability and fairness of the system. In drafting our response, we found ourselves repeatedly drawn to three "R" words: responsibility, respect and reciprocity. They can be applied across different stakeholders from legislators to consumers of financial services (and everyone in between). These simple principles can help frame any of the issues to give greater clarity in deciding the way forward.

Section 2: Competition – wealth management (pg 2-37)

The Inquiry welcomes stakeholder views on competition issues in the broader wealth management sector.

As the Inquiry has noted, there is no clear definition of wealth management. The range of services that wealth management can encapsulate include: funds management, superannuation, insurance, stockbroking and financial planning. In addition, there are also a range of ancillary services that may include debt management, estate or intergenerational and philanthropy advice. Often, the motivator for many firms is to grow their assets under advice. Firms seek to outdo each other by amassing an ever bigger footprint. The only existential reason is to become bigger and more profitable. One way of achieving this is to secure more channels of distribution. As a business proposition, this is not necessarily unreasonable. However, our view is that the wealth management industry must have a higher standard than most: ultimately, we are dealing with someone else’s money. The outcome and impact of the industry’s conduct has an immediate or otherwise long term repercussion for its end customers, typically a private individual or family group. It is our collective duty to discharge our obligations ethically and responsibly.

There are three main routes to achieving the type of growth that the industry is accustomed to: organically, by acquisition or by increasing their [sources] of margins. The first is difficult to achieve, it requires focus, dedication, tenacity and patience. In a world where short-termism dominates corporate thinking, organic growth is simply not enough. Acquisitions and the ever more vertically integrated organisations are two ways to generate more revenue and margins by wealth management firms.

A concentration of players in any industry is not healthy. It can breed complacency, reduce the quality of outcome and increase cost for consumers. There is a need to ensure a healthy level of competition in the wealth management industry to ensure the best possible consumer outcome. The industry has focused on delivering quantitative outcomes for itself for too long when the core focus should be the delivery of quality outcomes for its customers. The only yardstick in this frame of competition is the reference to assets or funds under advice, easily observed amongst the major players.

A vertically integrated organisation has the ability to disguise the quality of its output. It is not possible to align internal sales target strategies that are maintained for the sole benefit of the house, such as revenue share, transfer pricing, hidden intra-organisation commissions or other forms of quantitative scorecard, to concurrently produce the best customer outcome. The murkiness and potential lack of transparency can only turn competition into a race to the bottom and not outcomes with a focus on quality. It breeds a sales driven culture and not an advice driven culture. We believe the Inquiry must address the systemic weakness inherent in

these vertically integrated structures and contemplate the reorganisation or breaking up of these structures.

The wealth management industry must learn to respect its role as adviser, facilitator and custodian of someone-else’s money. Clients are therefore not simply economic units, regulatory and compliance requirements are not just checklists.

We believe that the industry is at an inflexion point where competition must return. Smaller players like PlayfairTan will emerge in different parts of the wealth management client value chain. We are more focused, more customer-oriented, smarter and better at what we do. We will lead the industry and we welcome healthy competition. To ensure a level playing field, competition must be maintained through various policy areas, including strong regulatory oversight, encouraging new players from related industries or foreign players into the market, incentives for small players to start up, reducing red tape and cost for wealth management businesses.

Section 6: Consumer outcome

Financial advice (pg 3-63 to 3-73)

The provision of financial advice imposes an obligation on the advice giver to take due care and act in the best interests of the advice recipient. Our obligation as advisers should always be for our clients first - this should be the case even without regulatory oversight. A person who is part of the distribution / sales force of the same organisation that originates or designs the end financial product is not an advice giver but a product sales person or an information provider. This is a simple definition. The distinction needs to be clear and does not need to be controversial: when a customer walks into life company A or bank B, the customer expects to be served product A from life company A or product B from bank B. It should be made clear that the service provided is a product service and not advice. Removing the word "advice" from the wording of "general advice" will go a long way in clarifying what actually constitutes advice. It will also serve to highlight the weight of responsibility associated with advice.

The word "advice" connotes a level of personalisation and tailoring to a person’s circumstances. It also implies a degree of independence and impartiality: when one seeks advice from another person, it is rare for that person to want to rely on another person’s biased advice. Independence both from a structural and advice givers perspective should be built into the equation when advice is sought, irrespective of the advice giver’s position. It must therefore follow that independence in advice must not only be reinforced, it must also be clearly delineated. Non independent advice (if there is such a thing) should be separately defined. As we have noted previously, vertically integrated organisations simply cannot produce an advice culture that aligns their corporate objectives with customer needs. The only way forward is a separation of advice culture away from a sales culture embedded in vertically integrated organisations, and a removal of any hidden, internal incentives to promote sales.

As the Inquiry has already indicated, quality of advice varies. This will always be the case but it is possible to improve the overall standard of the industry. The starting position must be the introduction of a higher education standard beyond the minimum. A university degree does not make a person more competent or ethical but it does demonstrate a base level of competency and capacity. Similar to other professions like accounting, law or medicine, a degree is one way of demonstrating a person’s aptitude. This is highly relevant in the understanding of our ever changing financial, investment and legislative environment. The Inquiry may also wish to consider post tertiary requirements, similar to the professional year in chartered accountancy or College of Law in NSW. An academic qualification is far from ensuring the provision of good advice but we believe it brings it closer. We would welcome forms of national exams, specific training and centralised registers.

To achieve a high level of standard, advice must be separated from product distribution. A centralised professional standards board in advice, tasked with standard setting, registration and enforcement, will ensure oversight and confidence of the financial advice industry as a profession. Similar to the Law Society, this body may be tasked with both representative and regulatory roles. It will also have a role in highlighting ethical issues faced by the industry. Whilst there are many representative bodies in the wealth management industry, it lacks a

peak financial advisory body that can define and lead the industry with little influence from vested interests.

We do not believe that adding the phrase "restricted" to aligned groups would improve the outcome of financial advice without the broader structural changes. The more logical approach is for all advice to be independent, together with the other changes suggested in our submission.

There are costs associated with the provision of advice regardless of whether it is provided face to face, by phone or online. There also appears to be a general view that advice is good for consumers, yet consumers are not prepared to pay for it. This should not the reason to impede the necessary structural reforms that the industry needs. Like other industries, the wealth management industry should be allowed to innovate, adapt, compete and educate clients in order to overcome this perspective. What regulation can do is to provide the necessary framework to ensure transparency, accountability and independence of the industry.

Other Issues

Section 3: Funding

Impact investment and social impact bonds (pg 2-75)

We welcome any clarification that may be provided to superannuation and philanthropic trustees on impact investments.

Section 4: Superannuation

Direct leverage in superannuation (pg 2-117)

We believe that "the evidence that suggests borrowing in superannuation is often associated with poor financial advice" presents two separate and distinct issues. The first issue relates to leverage in superannuation, the second being poor financial advice. The second issue is addressed separately in the following section.

We are supporters of providing individuals with choices and the ability to take charge of their retirement savings, whether through a public offer or self managed superannuation fund.

However, we also agree with the Inquiry’s view that "leverage should not be a core focus of SMSFs… and is inconsistent with Australia’s retirement income policy"… that "the general prohibition of direct leverage on superannuation should be restored on a prospective basis". In addition, we suggest that existing leverage positions must be unwound within a reasonable window.

A commonly used but flawed argument in support of leverage in superannuation is that it is the trustee/members money and therefore they can invest in how they see fit. We believe for the following reasons, they should not be allowed:

- Integrity of the retirement system: As the Inquiry rightly points out, leverage can potentially introduce systemic vulnerabilities.

- Object of superannuation: The broad object is to provide a stable platform to assist with funding of a members retirement. Leverage introduces a different level of risk that we believe is unnecessary.

- Reciprocity: Superannuation is already a concessionally taxed environment. There are ample opportunities for leveraged to apply elsewhere other than this important nest egg. In return for these tax concessions trustees/members should expected to follow a set of rules and guidelines.

Self managed superannuation funds (pg 2-126)

We believe that providing individuals with choices in the management of their retirement funds will empower and benefit them in the long term. The growth of self managed superannuation funds is a net positive for Australia.

Prospective trustees/members have the obligation to consider for themselves the suitability of using a self managed superannuation fund. The issues may include the cost of operation, trustee obligations, investment strategy and members’ profile. A reasonable expectation is that a person in this position will seek financial advice from a qualified person as part of their decision process and this decision ultimately rests with the individual. As individual circumstances are different, it is neither possible nor reasonable to regulate the establishment of self managed superannuation funds. Whilst advice can be encouraged, it cannot be imposed.

It is a privilege of the finance industry to be involved in advising and dealing with other people’s money. That privilege comes with significant responsibilities that must be discharged honestly and with integrity.

Please do not hesitate to contact us if you wish to discuss any of the matters raised in our submission.

Yours faithfully

PlayfairTan

Sometimes in life, it is necessary to say the same thing over and over before it is heard. In our
experience, usually about the time you think you have repeated yourself one time too many is the
time you will be heard!

So it is with the repeated warnings Francis has been sounding about current day hybrids. We saw another flurry of
hybrid issuance in recent weeks: ANZ on 2nd July and Westpac on 10th July, both offered long and loud through the retail
distribution networks of their own organisations as well as the assisting investment banks. Both issues wore the new style
tag: “compliant with Basel III requirements”.

Yesterday, the Australian Securities & Exchange Commission (ASIC) released its paper on hybrids. In summary, the
paper contains a number of health warnings about hybrids in general, but recent issues in particular. ASIC is concerned
that hybrids are mislabelled as safe, debt instruments when they in fact carry equity risk and, the yield which is ‘sold’ as
attractive, does not adequately compensate investors for the risk. Some $18 billion invested in hybrids in recent years,
with virtually no institutional or professional participation, seems to have prompted ASIC to heed Francis’ warnings!
But, having said all that, don’t be thinking we don’t think there are still opportunities in the hybrid sector. Principally
the opportunity to acquire the discarded older vintages.

The ANZ Capital Note (ANZPD) was a $1bn, Tier one capital issue. It has a ten year maturity period, callable after eight
years. The yield margin was struck at 3.4% over 180 bank bills (total distribution including franking of 6% per annum).
The Westpac Subordinated Notes II (WBCHB) was a $750m, Tier two capital issue. It also has a ten year maturity but a
much earlier call date after five years. As a higher Tier credit, the yield margin was offered at 2.3-2.45% over 90 day bank
bills (total distribution of between 4.9%-5.05%).

We first wrote about the newer style hybrids around this time last year. To comply with the Basel III framework, these
new hybrids often contain two triggers that can both result in the conversion of the hybrid into equity. The first, known
as a “capital trigger event” only exists in Tier one hybrids and therefore in ANZPD but not WBCHB. The second is
known as a “non-viability trigger”. In the case of the capital trigger event, it is defined and requires the conversion from
hybrid to equity in the event that there is a breach of the bank’s Tier 1 capital ratio at 5.125%. The non-viability trigger,
simply put, is an option given to the banking regulator, APRA, which has the ability to request conversion of these hybrids.
The likelihood of triggering is low and the non-viability trigger in particular is often being viewed as a second, or last
line of defence from a public policy perspective. We are concerned, however, that there is no defined threshold and the
conservative view (or institutional view or professional investor view) is that it is an option with no exercise price.
The purpose of your interest rate securities portfolio is to get more yield and to provide some cushion against equity risks.
The inclusion of such triggers make these hybrids more equity like than their older cousins. We do not believe investors
are being compensated for granting options in the form of non-viability triggers. Whilst at face value, the possibility of a
trigger is low, the impact, if a conversion occurs, is high. As the older style bank hybrids mature, there may come a time
(from about 2017-18) when investors cannot avoid such exposures. In the meantime, we believe that older style bank
hybrids continue to be more attractive due to:

• there being almost no yield difference. What is publicly traded today only differs by 0.10% - 0.20%
  (for example, WBCPC against ANZPD); and
• the old style hybrids have shorter maturity profiles without this non-viability trigger.

We continue to look for opportunities in the interest rate security space and always remain conscious of the risk and return
trade off. As always please do not hesitate to contact us if you wish to discuss.
We take some comfort but little satisfaction from ASIC’s paper noting how easily and freely ‘retail’ investors were
encouraged to tip out older style hybrids and purchase the new ones – ka-chink, ka-chink for those sales forces.

Playfair Tan | 22 August, 2013

Before we get accused of sitting like a rabbit in a spotlight, we wanted to update you on one of the
big issues getting a large amount of attention at present – Emerging Markets.

The rabbit spotlight reference relates to the choice of issues at present: the Quantitative Easing roar is deafening
(referred to as Chairman Bernanke’s “big bang moment”); the Chinese credit crisis; Australia: it’s leadership,
outlook and the AUD; China’s overcapacity; and Banking regulations and capital reserves, to mention a few.

We are clear-ish on each of these but did want to single out Emerging Markets to unpick what is happening
and re-state our case which is over time, to have an investment stance in favour of investing in faster growing
and ultimately higher returning Emerging Markets.

For somewhat insular North Americans and Europeans, investing in Indonesia, Brazil, China, Turkey, and
India etc. is relatively new. Investment in Emerging Markets at this point in history invariably comes down
to “flows” – money flowing in and money flowing out. We have observed over the years (and our Investment
Managers have confirmed) that it is not really the performance of Taiwan Semi-conductor, ICBC, Hankook
Tyres or Brazil Foods etc. which dictates short term performance – it is the Developed Market investment
flows. If international investors take fright, money flows out; if animal spirits build up, money flows in.
And performance of Emerging Markets follows in the short term.

So when as now, flows are out, prices are falling, discounts to expected fair value are widening, currencies
are falling – our ears begin to prick and our interest grows. If we can invest with proven experts – Comgest
(at it for 28 years), Allard (18 years) and PIMCO (for Emerging Market debt) – who want companies not
geographies, we will benefit from Emerging Market investment, in spite of the headlines.

Emerging Market Fund Outflows

Investment funds dedicated to Emerging Markets have posted record monthly outflows in June. Data from
the Emerging Markets Portfolio Fund Research (EPFR) Global shows that on a monthly basis, dedicated
emerging market equity funds suffered US$19.86 billion in fund outflows, outstripping the previous record set
in January 2008, when US $18.7 billion left the sector. Emerging debt funds have also experienced outflows of
over US $6 billion in the month of June.

Reasons for Fund Outflows

(1). Fears over the U.S. cutting back QE. Fund outflows have coincided with hints by the US Federal Reserve
in May that economic recovery may allow it to start unwinding stimulus, with the selloff gathering pace in June
with concerns over China’s growth. Ben Bernanke’s “big bang moment” in June confirmed the May Fed hints.
Much of the money printed since 2009 has leaked into areas offering yield or growth, including Emerging
Markets. Hot, short term money which flows out, all flows back.

PlayfairTan in Australian Financial Review

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