Value in the eye of the beholder - Legg Mason...VALUE, IN THE EYE OF THE BEHOLDER Legg Mason Martin...

VALUE, IN THE EYE OF THE BEHOLDER

Legg Mason Martin Currie Select Opportunities Fund

JUL 2018

ABOUT LEGG MASON

At Legg Mason, our proven investment solutions across a full suite of equity, fixed income and multi-asset funds are purposefully designed to meet your clients' future needs. With our range of investment affiliates providing in-depth expertise, we enable you to actively respond to changes in your clients' plans or circumstances.

Wide valuation spreads havehistorically preceded strongalpha for value strategies. Reece BirtlesChief Investment Officer, Martin Currie Australia

REECE BIRTLES

Chief Investment Officer,Martin Currie Australia

The past few years have seen strong performance for momentum and growth strategies - but poor outcomes for some with a value bias.

Is the value spread now, at last, widening? How you can capitalise depends on your perspective.

Reece Birtles explains how the Legg Mason Martin Currie Select Opportunities Fund has navigated the tough environment and is in a strong position to capture future opportunities.

ACTIVE VIEWPOINT

02

Active Viewpoint - Value, in the eye of the beholder

WHY HAS THE VALUE STYLE STRUGGLED?

We have witnessed strong world earnings-per-share (EPS) growth since June 2016, extending the post-global financial crisis (GFC) run to nearly 10 years of expansion.

Given the persistence of the economic cycle, momentum strategy performance has been exceptionally strong.

MSCI World EPS and momentum

700 60

50

40

30 (%)

20

10

0

550

600

650

500

450

400

350

300

250

200Jan 02 Jan 05 Jan 08 Jan 11 Jan 14 Jan 17

MSCI World EPS and momentum

MSCI Momentum/MSCI World (rhs)**

MSCI World EPS*

Past performance is not a guide to future returns. Source: Martin Currie Australia, FactSet; as at 30 June 2018. *Rebased to long term average P/E for the market (17x). **Cumulative returns in US$.

The strength of momentum has also driven unprecedented underperformance of value-based strategies globally for the last few years.

MSCI Value vs. MSCI World:

Rolling 10-year annualised return differential

2

0

3

1

(%)

(2)

(1)

Jan 85 Mar 89 May 93 Jul 97 Sep 01 Nov 05 Jan 10 Mar 14 May 18

MSCI Value vs. MSCI World: Rolling 10-year annualised return differential

Past performance is not a guide to future returns. Source: Martin Currie Australia, Factset; as at 30 June 2018. Returns in US$.

EPS GROWTH IS NOT THE PROBLEM

We had originally surmised that the main reason traditional value indices had performed poorly was that Value stocks have not shown great earnings growth compared with Growth or FANG (Facebook, Amazon, Netflix and Google's parent Alphabet stocks).

1Source: Martin Currie Australia, FactSet; as at 30 June 2018.

However, we were surprised to find that in the global market, since June 2016, earnings growth of Value (+14.8% p.a.) has in fact been stronger than that of Growth (+12.5% p.a.).1

MSCI World EPS by style

1,200

1,000

800

600

400

200

0Jul 98 Jul 01 Jul 04 Jul 07 Jul 10 Jul 13 Jul 16

1,400

MSCI World EPS by style

Value EPSGrowth EPS

Past performance is not a guide to future returns. Source: Martin Currie Australia, Factset; as at 30 June 2018.

IS NOW THE TIME FOR VALUE TO RECOVER?

In our research, we have found the recent strong returns of Growth strategies appear to have come not from earnings growth, but from a price-to-earnings (p/e) re-rating (18.7x to 20x) versus a de-rating of Value (from 14.3x to 13.1x).1

MSCI World P/E by style

20

10

0

(10)

(20)

(30)

(40)

Jul 98 Jul 01 Jul 04 Jul 07 Jul 10 Jul 13 Jul 16

30

40

50

MSCI World P/E by style

Growth ValueQuality

Past performance is not a guide to future returns. Source: Martin Currie Australia, Factset; as at 30 June 2018.

So, it looks like value stocks have been beaten up, despite their better EPS growth. Now may be the time to look for value opportunities.


IS THE GROWING VALUATION GAP ALL IT SEEMS?

By some measures, there is certainly evidence of a growing valuation spread – the gap between the cheapest and average-priced stocks in the market. Wide valuation spreads have historically preceded strong alpha for value strategies.

Most traditional Value indices (such as MSCI Value) are predominantly based on relatively naïve measures such as p/e or price to book (p/b). The divergence in p/e across investment styles that we have already mentioned has caused the valuation spread based on this measure to widen significantly.

Dispersions of p/b, another common indicator of valuation opportunity, have also widened notably for the Australian market.

S&P/ASX 200 Constituent Price to Book

Standard deviation

3.4

3.6

3.8

3.2

3.0

2.8

2.6

2.4

2.2

2.0Jan 11 Jan 13 Jan 16 Jan 18

Average

S&P/ASX 200 Constituent Price to Book

Past performance is not a guide to future returns. Source: Martin Currie Australia, FactSet; as at 30 June 2018.

However, a note of caution: other measures, which use current earnings/cash flow based metrics and rely less on a mean reversion assumption, are still showing far narrower dispersions.

While we don't have an Australian equivalent, this is well described by the valuation analysis of Empirical Research Partners on the US market which uses cash flow methods.

This shows a much lower valuation spread, and as such, less value opportunities available in the market than shown by p/e or p/b measures.

US valuation spreads: expected return of the top quintile compared to the average

2

0

3

1

Sta

ndar

d de

viat

ions

(2)

(1)

Jan 52 Jan 67 Jan 82 Jan 97 Jan 12

4

US valuation spreads: expected return of the topquintile compared to the average

Wide disparities

Narrow disparities

Past performance is not a guide to future returns. Source: Empirical Research Partners Analysis, National Bureau of Economic Research; as at 31 May 2018.

While we agree Empirical Research Partners has acomprehensive quantitative valuation model to assesscompanies in the US and across the globe, we believeboth naïve and quant measures miss a layer offundamental insight required to truly understand thelevel of opportunity.

MARTIN CURRIE LOOKS DEEPER FOR VALUE

Martin Currie Australia's investment team of 17conducts fundamental, forward looking risk adjustedanalysis on the broad Australian market consideringcashflow, quality, growth, cyclicality, and environmental, social and governance (ESG) risks.

This fundamental research, combined with 24 years of proprietary data, puts us in a great position to consider valuation opportunities across the Australian market.

In our ongoing analysis, we compare the valuation ofthe 90th percentile stock (representing the cheapeststocks) versus the median but also the 80th percentile(the next cheapest) versus the median based on our inhouse Valuations.

Martin Currie valuation spreads

80th percentile – median

75

65

55

45

(%)

35

25

15

5Jan 99 Jan 04 Jan 09 Jan 14

90th percentile – median

MCA valuation spreads

Past performance is not a guide to future returns. Source: Martin Currie Australia; as at 30 June 2018.

03

04

In the preceding chart you can see that, in the yearspre-GFC, there was less dispersion between the 90th and 80th percentile stocks.

Following the GFC, these value spreads have been much wider generally and also relative to each other. This was as a result of greater uncertainty about world growth drivers.

However, since 2009, these spreads had narrowed significantly, and in February 2017 reached their lowest post-GFC levels.

It is only recently that the spread for cheapest stocks has begun to really look cheap again. However you can see that this hasn't spread to the next cheapest stocks yet.

FOCUSING ON THE FUNDAMENTALS – A BETTER WAY TO FIND VALUE

So our analysis supports the thesis of good and poor valuation opportunities discussed earlier.

Despite the better outcomes that p/e and p/b measures do indicate, and the lower opportunities shown by quant measures, we do see that valuation spreads have somewhat widened, but only at the extremes.

So, if value spreads, by our measures, are in fact generally still low – and only in certain pockets – is our Value approach compromised? In a word, no.

We believe the combination of our collective analysis of the market environment and our multi lensed investment process (Valuation, Quality, Direction and Sustainable Dividend) places us in a unique position to assess the potential reward versus risk on offer of individual stocks, broad factors and the market regardless of the prevailing conditions.

For example, valuation spreads approached their lows in early 2017, we viewed the risk/reward skew of holding lower Quality/deeper Valuation names as inadequate, and we moved the portfolio towards higher Quality companies with stronger earnings Direction characteristics that also offered superior risk adjusted value opportunity.

IS IT STILL VALUE THEN?

Notably, our approach to risk-adjusted value lead to our Barra Value exposure (similar to p/b) going negative over 2017 and into 2018.

This was not a break in process or philosophy. On the contrary, it was due to the consistent application of our Valuation, Quality, Direction process, considering the potential reward versus risk on offer at both the stock and factor level, that took us away from naively cheap stocks (such as the banks) in 2017.

Risk exposures

0.3

Sta

ndar

d de

viat

ions

0.5

0.1

(0.3)

(0.1)

Aug 06 Aug 08 Aug 10 Aug 12 Aug 16Aug 14

0.7

MSCI Barra Value Valuation (Martin Currie)

Risk exposures

Past performance is not a guide to future returns. Source: Martin Currie Australia, MSCI Barra; as at 30 June 2018. Data shown for a representative Value Equity account for illustrative purposes only.

Holistically, you can see in the chart below that as Valuation has narrowed for the portfolio, we have been able to improve the portfolio’s Quality and Direction characteristics, ensuring strong expected return characteristics of the portfolio.

Risk exposures based on Martin Currie research lenses

0.5

0.3

0.1

(0.1)

(0.3)

(0.5)

(0.7)

0.7

Risk exposures based on MCA research lenses

Sta

ndar

d de

viat

ions

Direction QualityValuation

Aug 06 Aug 08 Aug 10 Aug 12 Aug 16Aug 14

Past performance is not a guide to future returns. Source: Martin Currie Australia; as at 30 June 2018.Data shown for a representative Value Equity account for illustrative purposes only.


We believe the combination of our collective analysis of the market environment and our multi lensed investment process (Valuation, Quality, Direction and Sustainable Dividend) places us in a unique position to assess the potential reward versus risk on offer of individual stocks.

POSITIONING THE FUND FOR THE OPPORTUNITIES

The Legg Mason Martin Currie Select Opportunities Fund is currently overweight stocks in consumer, non-bank financials and energy sectors, and holding higher-than-average Quality exposures.

Below, we highlight some of the key holdings2 in the portfolio that we believe are being undervalued by the market and demonstrate our multi-lensed investment approach and outlook.

JB Hi-Fi is a world-leading retailer with high sales productivity and low cost-of-doing-business ratios.

The retailer is well-positioned against Amazon’s arrival with its improved online and delivery options. It is producing strong above-market EPS growth, yet is trading at a 20% discount to the market p/e multiple.

Woolworths There is a saying that should ring true for Woolworths: ‘when the elephants are fighting, the ants die first’. It will be the small independents that will suffer in any price wars, potentially with Amazon.

But the interesting point from discussions with Woolworths’ management is the plans for big data. It is now one of the biggest data owners in the country, with transaction data on baskets, line items and economic activity allowing the company to track customer behaviour and target individual promotions. Just 18 months ago it did not employ any software engineers, but now has a big team.

Financial services company IOOF has demonstrated itself as a preferred home for financial planners and has significant opportunities from platform optimisation including the integration synergies of the ANZ Wealth business. We think there will continue to be growing demand for financial advice and IOOF continues to prove its worth as an efficient, cash-generative company exposed to the trend.

Energy stocks have underperformed the market for 10 years, impacted by deflationary forces, lower bond yields, falling oil prices, and the perception that there is a glut of liquified natural gas (LNG).

With oil prices now regaining ground towards incentive cost, as well as strong demand growth and a likely shortage of LNG beyond 2020, energy companies such as Woodside Petroleum are well-positioned with new projects to deliver growth into this demand window.

Jim PowerResearch Analyst

Matt DavisonSenior Research Analyst

Michael SlackHead of Research

2The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.

Our Select Opportunities Fund iscurrently overweight stocks inconsumer, non-bank financials andenergy sectors, and holding higher- than-average Quality exposures.


05

06


PERFORMANCE SUPPORTED BY PROCESS

Our investment approach won’t deliver the same outcomes at all points in the cycle, but it certainly has helped us to navigate the choppy conditions we have seen for Value investors over the last three years.

Cumulative performance relative to S&P/ASX 200

CY 2015+0.0% alpha

CY 2016+8.2% alpha

CY 2017+5.2% alpha

(9.1%) alpha +6.0% alpha (6.2%) alpha

YTD 2018+0.5% alpha

(7.6%) alpha

1.20

1.10

1.00

0.90

Dec 14 Jun 15 Dec 15 Dec 16Jun 16 Jun 17 Dec 17 Jun 18

Inde

x (1

.0 =

1 Ja

n 20

15)

0.80

Legg Mason Martin Currie Select Opportunities FundMSCI Australia Value Index

Past performance is not a guide to future returns. Source: Morningstar, Legg Mason; as at 30 June 2018. Data based on net of fees performance in A$.

Our approach has also helped provide our clients around 200 basis points more alpha over the last three and five years relative to the next best value manager.

Morningstar Equity Australia Large Value category Top 10

managers: three yearsMorningstar Equity Australia Large Value category Top 10 managers: three years

13.7

11.7

11.1

11.0

10.7

10.1

10.1

10.1

9.6

9.5

9.0

5.9

LMMC Select Opportunities Fund

Dimensional Australian Value Trust

Dimensional Australian Core Equity

NAM Tyndall WS Plus Australian Share

Nikko AM Australian Share

Strategic Australian Equity

Nikko AM Australian Share Value

Investors Mutual Concentrated Aus

Nikko AM Australian Share Income

Lazard Select Australian Equity

S&P/ASX 200

Median manager

Top 10 managers: five years

13.4

11.5

11.2

11.2

10.9

10.9

10.9

10.9

10.8

10.8

10.0

8.3


Nikko AM Australian Share W

Perpetual W Share Plus L/S


AMP Capital W Australian Equity Value



Perpetual Wholesale Ethical SRI



S&P/ASX 200

Median manager


Morningstar Equity Australia Large Value category Top 10 managers: three years

13.7

11.7

11.1

11.0

10.7

10.1

10.1

10.1

9.6

9.5

9.0

5.9




NAM Tyndall WS Plus Australian Share

Nikko AM Australian Share

Strategic Australian Equity




Lazard Select Australian Equity

S&P/ASX 200

Median manager


13.4

11.5

11.2

11.2

10.9

10.9

10.9

10.9

10.8

10.8

10.0

8.3


Nikko AM Australian Share W

Perpetual W Share Plus L/S


AMP Capital W Australian Equity Value



Perpetual Wholesale Ethical SRI



S&P/ASX 200

Median manager

Past performance is not a guide to future returns. Source: Martin Currie Australia Morningstar Direct. Ranked in the first quartile in its peer group among 88 (3yr) & 81 (5yr) funds respectively within Morningstar Equity Australia Large Value category as at 30 June 2018. Based on net of fees performance data in A$.

As valuation spreads continue to widen, new opportunities are opening for the portfolio.

Our multi-lensed investment approach of Valuation, Quality, Direction and Sustainable Dividend places us in a strong position to navigate this environment.

07

Past performance is not a reliable indicator of future performance. Legg Mason Asset Management Australia Ltd (ABN 76 004 835 849 AFSL 240827) is part of the Global Legg Mason Inc. group.

Any reference to ‘Legg Mason Australia’ or ‘Martin Currie Australia’ is a reference to Legg Mason Asset Management Australia Limited. ‘Martin Currie Australia’ is a division within Legg Mason Asset Management Australia Limited. Legg Mason Australia is the responsible entity of the Legg Mason Martin Currie Select Opportunities Fund (ARSN 122 100 207)(Fund). Martin Currie Australia is the fund manager of the Fund. Before making an investment decision you should read the Product Disclosure Statement (PDS) for the Fund carefully and you need to consider, with or without the assistance of a financial advisor, whether such an investment is appropriate in light of your particular investment needs, objectives and financial circumstances. The PDS is available and can be obtained by contacting Legg Mason Australia on 1800 679 541 or at www.leggmason.com.au. This product has not been prepared to take into account the investment objectives, financial objectives or particular needs of anyparticular person. Neither Legg Mason Australia, nor any of its related parties guarantees any performance or the return of capital invested. Past performance is not necessarily indicative of future performance. Investments are subject to risks, including, but not limited to, possible delays in payments and loss of income or capital invested. These opinions are subject to change without notice and do not constitute investment advice or recommendation.

The information contained in this article has been compiled with considerable care to ensure its accuracy. But no representation or warranty, express or implied, is made to its accuracy or completeness. Some of the information provided in this document has been compiled using data from a representative account. This account has been chosen on the basis it is an existing account managed by Martin Currie, within the strategy referred to in this document. Representative accounts for each strategy have been chosen on the basis that they are the longest running account for the strategy. This data has been provided as an illustration only, the figures should not be relied upon as an indication of future performance.

© 2018 Morningstar, Inc. All rights reserved. The Morningstar Rating is an assessment of a fund’s past performance – based on both return and risk – which shows how similar investments compare with their competitors. A high rating alone is insufficient basis for an investment decision. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser.

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Value in the eye of the beholder - Legg Mason...VALUE, IN THE EYE OF THE BEHOLDER Legg Mason Martin...

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