Illuminate

December Quarter 2016

Foreword

Kelvin Boyd Chief Investment Officer

In our last edition of Illuminate, we discussed our view that bond yields were artificially low and were likely to rise which would impact upon financial markets. This has happened and been the primary influence on financial markets over the last quarter, with interest rate sensitive asset classes such as fixed interest, real estate investment trusts and infrastructure performing poorly. Despite this, equity markets have held up reasonably well as investors have switched to cyclical assets which have performed well. Looking ahead, we expect movements in global bond markets will continue to have a large bearing on the performance of financial markets over coming quarters. Whilst there have been many false endings to this multi decade bond market rally, there are signs that we have passed an inflection point and this has important ramifications for financial markets. This alone would create a volatile financial market environment, but before the end of the year we also have the US election, an expected increase in US official interest rates in December, as well as a number of potential geopolitical events (such as the Italian referendum). With valuations across most assets remaining elevated, an element of caution remains appropriate. On a lighter note, I have recently returned from 3 weeks travelling around Madagascar, a beautiful and challenging island, and have included in this publication some of the pictures that I took along the way. With respect to the two pictures on this page of the lemur and chameleon, we will be sending out a bottle of wine for the most entertaining caption that we receive for each picture. If th you would like to enter, just email through your suggestions by the 10 November to [email protected] with Madagascar in the subject line and make it clear which picture you are referring to and include your name in the email. The research team will be picking the winners based purely on what we found most entertaining (without knowing who they are sent in by as we will not see the original emails).

Contents

2

3

Outlook Scenarios

4

Strategy & Themes

6

Economics

8

Markets

10

Focus Topic

ILLUMINATE • DECEMBER QUARTER 2016

Outlook Scenarios What are our Outlook Scenarios? We live in a world of uncertainty and constant change. Rather than base our investment strategy upon a single outcome that may or may not be correct, we explore a range of different scenarios, assign probabilities to each occurring and examine the implications for our investment strategy under these potential alternative scenarios. The table below highlights what we consider to be the three most likely economic scenarios for the coming year.

MOST LIKELY

POTENTIAL ALTERNATIVES

Scenarios

MODEST GROWTH

MORE OPTIMISTIC

MORE PESSIMISTIC

The global economy continues to expand at a modest pace of around 3% with divergences across countries and regions and also across manufacturing and services industries



The global economy regains some momentum and the growth rate over the coming year comes in above the current modest expectations

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The global economy succumbs to its many headwinds and growth slows from already modest expectations to lower levels raising concerns of a global recession

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The leading economic indicators remain consistent with growth in the major global economies in line with our expectations



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The monetary stimulus being applied by governments has lost its effectiveness and any fiscal stimulus will take time to implement leaving downside risks in the short term

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Wage growth in the US is rising which will support consumer spending and the US economy, providing a key support for the global economy

With employment and wages continuing to rise in the US, consumer spending accelerates providing a boost to the economy which feeds through to global trade supporting an upturn in global economic growth



Global trade remains weak as excess capacity in manufacturing continues to impact on supply and prices



An adverse outcome in the Italian referendum in December leads to another euro crisis and economic downturn in the region



The Chinese property and credit bubble deflates dragging down the economy and impacting upon global growth



The probability of this outcome eventuating has remained fairly constant over the last quarter. Whilst we regard it as a lower probability, it is our second most likely scenario and one we closely monitor

Description



Reasons this outcome may occur



Growth across Europe and China has stabilised after earlier concerns and their forecast growth rates for next year look achievable

Likelihood



Governments will increase their spending to stimulate economic activity should the outlook start to deteriorate



Whilst there have been some ups and downs, the majority of the recent economic data has been consistent with ongoing modest growth in the global economy and this remains our core and most likely scenario







Governments abandon fiscal austerity and pursue spending policies designed to stimulate economic growth After years of caution and conservatism, consumers and businesses start to spend creating a virtuous circle of confidence and spending which lifts economic activity

We continue to regard this as the most unlikely scenario and it is not supported by recent global economic data

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Strategy & Themes Key themes influencing our investment strategy Inflation past the low point Last quarter we discussed our belief that most inflation measures had passed their low point and would begin accelerating over coming quarters. In the last few weeks we believe investor sentiment is aligning with our view and this is one of the factors impacting upon bond markets. In the US most inflation measures are turning upwards with the headline rate still comparatively low as it’s held back by energy and food prices. By the end of this year the energy price will be flat year on year and then begin to rise sharply in 2017 as it cycles the low point in the oil price earlier this year. We expect US headline inflation measures to continue to rise over coming quarters impacting upon bond markets and financial markets generally. We expect inflation readings in other regions and countries to also rise, but not to the same extent as in the US given that domestic factors also play a large part in inflation outcomes. Monetary policy losing its impact Last quarter we discussed that there was declining confidence in the ability of monetary policy including quantitative easing to stimulate economic growth and that the focus would likely shift to the potential for governments to use fiscal policy. If this occurred, then investors would question the commitment of the authorities to maintaining record low interest rates and bond yields. This has occurred and been a contributing factor in the poor performance of bond markets. Looking forward, we expect that governments will be more inclined to pursue fiscal policy, that is, increase government spending. Whilst the capacity for fiscal spending is far greater across the emerging economies given their lower levels of debt, we would not be surprised to see some of the major developed economies also pursue policies in this area. In particular, the Japanese authorities recently cleared the way for more aggressive policy in this area. This has two implications. Firstly, in the short term, it is negative for bond markets as investor’s sense that central bank support is waning. Secondly, if fiscal policy is pursued, it will likely change the composition of economic growth, so there will be winners and losers from an investment perspective. Elections and uncertainty Whilst the focus is currently on the US election in November, the next twelve months will also be particularly busy across Europe. With the surprise Brexit vote and support for populist parties continuing to rise across the region, there is a growing risk of an adverse outcome. If any of the populist parties were to be elected, it would pose a significant risk to the continuation of the euro given most have committed to holding referendums on continuing membership of the eurozone. In addition, Italy is holding a referendum on constitutional reform in December. Their prime minister has promised to resign if it is not passed, which could then result in an Italian election next year. As per the graphs, Italy has one of the highest levels of support for populist parties and is not known for its political stability. With Italy one of the largest and most important economies within Europe, the risk of a change of government and vote to exit from the euro needs to be watched closely as it could have significant political and economic implications for the region.

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ILLUMINATE • DECEMBER QUARTER 2016

Strategy & Themes ASSET CLASS

VIEW

REASONING 

Cash   Fixed Interest

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 Australian Shares

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International Shares



 Property

  

Infrastructure   Alternative Growth



The Reserve Bank has indicated in its recent commentaries that it is content with the official interest rate at its current level and we believe it is unlikely there will be any change before the end of this year Cash returns will continue to be modest, but offer security and liquidity which are of value in the current environment Government bonds have quickly reversed a large part of their gains over the previous six months We believe government bond yields will continue to trend higher creating a challenging investment environment. Corporate bonds offer relatively attractive returns in comparison and is our favoured area for investment Valuations across all sectors remain at the expensive end of their historical ranges. This limits the potential upside for returns unless we have a stronger than expected recovery in earnings, which we regard as unlikely Small companies continue to offer the best opportunities, but caution in the short term is also warranted given recent strong gains Global sharemarkets have fared reasonably well this year to post modest gains given the lacklustre earnings environment We see challenges in the near term given political risk, rising bond yields, subdued earnings and expensive valuations. That said, there are always opportunities given the much wider range of investment options The Australian listed property trust sector has fallen more than 14% from its July peak, but is still trading at a large premium to its underlying property values The asset class remains highly sensitive to changes in bond yields Whilst the capital risk has reduced due to the recent declines, we still regard the potential returns as unappealing We downgraded our view on the asset class last report due to expensive valuations and our view that rising bond yields could impact upon the performance and this has eventuated Whilst value has improved, we retain a cautious view primarily due to our expectation of ongoing volatility in bond markets We expect that the combination of expensive valuations and rising bond yields will result in a challenging and volatile environment for most traditional financial assets over coming quarters In this environment we continue to diversify return sources in the portfolio away from the traditional assets and favour a range of alternative growth investments

Understanding our asset class views for the next 3-12 months Attractive: The asset class is expected to provide returns in line with or above its historical returns or above the other asset classes

Neutral: The asset class is expected to provide returns commensurate with the perceived risks that may also be attractive relative to the other asset classes

Cautious: There are reasons such as higher than normal valuations or higher than usual perceived risks that suggest caution when investing

Negative: The asset class is expected to provide returns below its historical returns or below the other asset classes or the risks do not justify the anticipated returns

ILLUMINATE • DECEMBER QUARTER 2016

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Economics Key points 

Since our last report the economic data that has been released has generally been in line with expectations

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The growth rate for the global economy this year looks to be around 3%, similar to recent years

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Given the ongoing headwinds faced by the global economy, we expect that the outcome for 2017 will be similar to this year

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There continues to be plenty of risks, many of which have the potential to derail the outlook, so ongoing volatility is likely

The global economic data that has been released over the months since our last Illuminate report has been broadly as expected and thus we have not seen a significant change in expectations or any heightened concerns about the outlook. Given that ongoing vacillations in sentiment have been a feature of the last couple of years, the quietness of the last quarter was a welcome respite. In our last report we discussed the US version of the Economic Surprise Index and how it had shown a sharp improvement in the US economic data which had been released in the preceding months. The surprise index tracks how major economic data releases compare to consensus expectations. In the graph below we show the Economic Surprise Index over the last three months for the three largest economic countries / regions, being the US, Europe and China. An outcome of zero effectively means that the economic data is in line with expectations, whilst a positive number indicates that the economic data which is being released has generally been above expectations.

We will utilise this data to explain the outcomes over the last quarter and the potential implications for the outlook for each of these regions. The US economy was expected to improve over the September quarter after the weak start to the year, therefore it is a relief that the recent economic data has not disappointed. In the Citi Economic Surprise Index graph this is illustrated by the dark blue line, which for the last couple of months has generally been around zero indicating the economic data being published was consistent with expectations. We stated last quarter that the US economy would continue to show modest improvement and this is what has played out over the past few months. Current expectations are that the growth rate will have risen from the sub 1.5% annualised rates for the first half of the year to somewhere in the 2% to 2.5% range in the third quarter, a modest improvement but in the right direction. As there were no negative surprises last quarter, confidence in the outlook for the US economy has improved even though the outcome was modest. Therefore whilst the US Federal Reserve kept interest rates unchanged at its September meeting, expectations have firmed considerably that interest rates will be increased at the 15 December meeting once the November election is out of the way. This is also our expectation. Why does the US Federal Reserve want to increase interest rates when growth is subdued and inflation expectations remain low? There are three key reasons. Firstly, holding interest rates at such low levels is causing distortions and imbalances in the economy. Secondly, to stop inflation rising too quickly. Whilst inflation remains low, it is rising and we expect will surprise on the upside over the next couple of quarters. Finally, the Federal Reserve would like to have the capacity to reduce interest rates when the next economic downturn occurs. At the current low interest rate levels its ammunition is severely depleted. Whilst we agree interest rates should be increased and believe it will be positive for the economy in the short term (as it sends a positive signal to consumers and businesses about the health of the economy), the pace of interest rate increases will continue to be modest. So far we have had one increase in 2015 and likely one increase in 2016. Given our modest outlook for the US economy, we would not be surprised to see only one or two increases in 2017. This is based on the expectation that the authorities look through the short term upturn in inflation that we are anticipating rather than being spooked into additional interest rate increases.

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ILLUMINATE • DECEMBER QUARTER 2016

Within the Eurozone the economic data waxed and waned but ended the quarter on a positive and improving note (grey line in the Citi Economic Surprise Index graph) which has alleviated concerns over the near term outlook. The recent improvement in the economic data has in fact prompted speculation that the European Central Bank may end or reduce its asset purchase program in the first half of next year. At this stage we believe that the program will be extended with some adjustments, primarily because inflation expectations remain very subdued and the European Central Bank (ECB) will likely err on the side of caution. In September the ECB updated its Eurozone economic outlook and is now forecasting an expansion in the economy this year of 1.7% (previously 1.6%) and a similar rate of expansion of 1.6% in both 2017 and 2018 (previously 1.7% for both years). The good news is that any potential short term impact of the Brexit vote appears to have been well contained and short term expectations for economic growth in the Eurozone have stabilised. The bad news is that in the coming years growth is expected to remain relatively modest due to the ongoing headwinds of poor structural reform, deteriorating demographics, modest global economic growth and ongoing deleveraging. The ECB’s expectation that the Eurozone will grow at a moderate but steady pace appears reasonable and realistic, albeit we would agree that the risks are primarily to the downside. The final country listed on the Economic Surprise Index graph is China (light blue line). After a poor start to the quarter, the economic data has improved and was above expectations over the last month. The GDP data for the September quarter has been released and showed the economy grew at a yearly rate of 6.7%, the same as the previous two quarters. Whilst the recent Chinese economic data is consistent with stabilisation in the economy, we continue to have a cautious view moving forward for the following reasons. 

Much of the improvement in the economy since the start of the year has been short term stimulus driven. We expect this effect to wane over coming quarters.



Recent economic data shows ongoing weakness in some of the key areas of the economy, such as exports, that have historically been the main drivers of economic growth.



The authorities in the Tier 1 cities have again stepped in to ease speculation in housing markets and this will likely limit the output from this sector of

the economy and also restrict the demand for commodities. 

Whilst economic growth has been slowing over recent years, debt levels have been rising rapidly. It’s unlikely that debt can continue to support growth in the economy, particularly as we expect the banks will be hampered in their lending going forward from rising bad debts and credit constraints.

For these reasons, whilst sentiment towards the Chinese economy is generally positive at present, we are more circumspect and believe that the Government’s 6.5% medium term target is a best case rather than base scenario for 2017. A deterioration in the Chinese economy remains one of the potential risks to our core economic scenario for the year ahead. A worse than expected outcome for China would also have implications for the Australian economy. Whilst the local economy surprised on the upside compared to our expectations this year, we believe the risks are to the downside next year. In the graph below you can see that the yearly growth rate in the Australian economy has accelerated over the last four quarters, topping out at 3.3% in the June quarter. Looking forward, we expect the growth rates will step back down and end next year in the low 2% range.

Our belief the Chinese economy may not perform as well as most expect is one of the reasons for our more modest views on the outlook for the Australian economy. One of the other reasons is that residential property construction has peaked and will ease over the coming year. The strength in this sector of the economy over the last couple of years has been an important offset to the weakness in mining investment. In addition, we expect property prices will stall and this will have a flow on effect for consumer confidence and spending. Overall we are forecasting a growth rate for the global economy of around 3% for 2017, similar to this year and last. There are ongoing risks, but we believe our modest expectations contain a buffer for some outcomes more adverse than currently expected.

ILLUMINATE • DECEMBER QUARTER 2016

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Markets Key Points 

A sell off in government bonds has been the dominant influence on financial markets over recent months resulting in poor performance from a range of interest rate sensitive assets and investments



We believe that an inflection point has been passed and that bond yields will trend higher over coming quarters. Interest rate sensitive assets and investments will likely continue to struggle in the short term



We have positioned the portfolios for this eventuality, but much depends on how disorderly the movements in bond markets become and its influence on other financial markets

In our last issue of Illuminate our primary topic of conversation was the record low in government bond yields and why we didn’t believe this was sustainable. In turn we expected any reversal in the direction of bond yields would impact upon financial markets and we were particularly wary of ‘safe haven’ interest rate sensitive investments and assets. Accordingly we downgraded our view on infrastructure to cautious and retained our negative view towards government bonds and listed property. This discussion has proven to be rather timely, as a sharp upward movement in long term bond yields has been the primary influence on financial markets over recent months. The graph below shows the movements in the Australian 10-year government bond yield over the last year and highlighted on the far right is the reversal we have seen in recent months. Even after this increase the yield is still well below the levels of six or twelve months ago.

In fact, if we take a look at the long term movements in the direction of Australian 10-year bond yields (on the following graph which covers a period of 50 years), the most recent movements are almost indeterminable.

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Australian government bond yields have been trending lower since the early 80’s and over this period there have been many periods where bond yields have risen sharply in the short term, but then reversed course and continued to trend lower over time. Given this long term trend and the many false dawns before, why do we believe we have passed an inflection point and bond yields will now trend higher? There are three key reasons and a couple of these have come into play over recent months. Firstly, it is the actions of governments and government authorities which have been primarily responsible for the record low bond yields as they pursued policies to stimulate economic activity. We believe that these policies are losing their effectiveness and this view is gaining traction amongst investors and governments. Accordingly, we expect governments will shift their focus to fiscal policy and their support for bond markets will wane. Secondly, we believe that inflation is past its low point and it has also been on a long downward trend. As outlined last quarter and elsewhere in this document, we expect inflation to surprise on the upside over coming quarters. Finally, these policies have harmed the profitability of banks and impeded the workings of the financial system. Banks generally borrow short term and lend long term, making profits on the margin between the two. But with long term rates subdued, they have been reluctant to lend thus the policies have to some extent backfired and not resulted in increasing lending. This is a key reason that financial companies have performed so poorly over recent years. Why is the direction of bond yields so important? Long term bond yields have a significant influence on financial markets as they are the reference point from which other assets are valued. This is why long duration assets, basically any investment whose valuation or performance is very sensitive to movements in long term bond yields, have performed exceptionally

ILLUMINATE • DECEMBER QUARTER 2016

well over recent years. Therefore if this trend is going to reverse, this will have important ramifications for the performance of the various asset classes. An example will help illustrate this point. Below is a graph that shows the performance of the Australian real estate investment trust (A-REIT) index for the last twelve months. This asset class has been one of the strongest performers over recent years as it offered reliable earnings and a high distribution of income. As bond yields trended lower, REITs have been in heavy demand as a high income alternative. At its peak in July the price of these trusts was trading at a 40% premium to the value of the underlying properties, the only time it had been higher was just prior to the global financial crisis. We have been avoiding this asset class as we believed the risks to capital were very high if there was any change in the direction of bond yields. This has now started to play out and you can see in the graph that since July the value of this asset class has declined by more than 14%. Even at these levels the premium to the value of the underlying assets is still above what we regard as acceptable and we see further downside risk, particularly if bond yields trend higher as we expect. Not surprisingly, our view remains negative. A-REIT Index performance last 12 months

focussed on corporate bonds rather than government bonds, thus they will be less impacted by these events. Our view on the fixed interest asset class remains cautious. We are not outright negative on the entire asset class as we expect to achieve reasonable returns on corporate bonds. Infrastructure: The asset class has held up better than REITs, but performance has been modestly negative over recent months. Last quarter we downgraded our view to cautious as we expected some near term volatility. Our long term view on the asset class remains positive and if we do see further weakness in performance in the short term we would use this to establish further positions in the asset class if the opportunity presents. Shares – Interest rate sensitive: The implications for sharemarkets are mixed. There are some sectors, such as consumer staples, which have performed strongly over recent years as they were viewed as bond proxies. These sectors are likely to come under pressure in the near term. In addition, companies that offer reliable growth have been in strong demand and the valuations on some of these companies have reached historically very high levels. These types of companies we also expect to struggle, purely because of the influence of higher bond yields on their valuation. The overall implications for sharemarkets we expect to be slightly negative and this is one of the reasons why we are continuing with our cautious view on both global and Australian shares. Alternatives

If bond yields continue to trend higher, then the investments that have been the best performers over the last five years are likely to be much more challenged. Apart from REITs, the other assets classes or sectors which we believe warrant caution in this environment are as follows: Government bonds: The return an investor receives on a bond in the short term is a combination of income and any movements in the capital value. If bond yields are rising, this means that the capital value of the bond is falling. If yields rise too sharply in a short period of time, such as has occurred over the last month, then the capital loss will be greater than the income and the total return will be negative. Not surprisingly, the Australian Fixed Interest has had a negative return over recent months. We have been wary of this risk and the majority of the fixed investments that are held in portfolios are

The different types of alternative investments have different return sources and risks thus the implications are mixed and investment specific. The managed futures strategies which invest in financial market trends have been caught out in the short term by the sharp reversal in the performance of bond markets. This has caused them to have negative short term performance. However these strategies can adapt as trends change, thus they can change their position towards bond markets if the trend becomes upwards. Other strategies such as market neutral are by their design less impacted by general market or macro moves with their performance primarily determined by company specific factors. This is one of the reasons we have a positive view on them in the short to medium term. Overall we expect a challenging environment across financial markets through to the end of this year. This is a result of the influence of rising bond yields, as well as a range of other potential risks over this period.

ILLUMINATE • DECEMBER QUARTER 2016

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Focus Topic – Investing in smaller companies Key Points 

Small companies have historically provided investors with higher returns with only modestly higher levels of volatility

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Investing in small companies is attractive because of the prospect for higher returns, the additional diversification and the greater opportunities for active managers to add value

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There are different ways to gain access to small companies with the risk tolerance of the investor being a major factor in determining the best option

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In a low return environment, smaller companies are one option to generate stronger investment returns, however after recent strong gains valuations are no longer cheap which makes stock selection vital for generating returns

Over the last few years whilst many of the traditional Australian ‘blue chip’ stalwart companies such as the major banks and Woolworths have struggled, smaller companies have provided investors with more attractive returns. This is not unique to Australia, in most regions around the world smaller companies have provided higher returns for investors. This is illustrated in the graph below from Lazard Investment management, which shows the performance of the MSCI World Small Cap Index compared to the performance of the MSCI World Index over the fifteen years to the end of 2015. Each blue dot on the graph represents a monthly rolling five year period and if the dot is above the grey sloped line, it means that the small company index has outperformed the broad company index. Over this fifteen year period small companies have performed better than large companies 95% of the time. This is a very strong hit rate and includes the global financial crisis, one of the worst ever periods for equity markets. Comparison of five year rolling returns of small companies compared to large companies (2001-2015)

companies has been similar to the volatility of the returns of the Australian sharemarket. This is illustrated in the table below, which shows the data for the ten years to the end of April 2016. Historical returns and volatility (10 years to 30 Apr 2016)

You may note in the above table that the Australian small company index has been more volatile and provided lower returns. This is because this period covers the collapse in small resource companies which impacted upon the performance of the index and highlights the importance of diversification. If this influence was to be excluded, the outcome would be similar to what has been seen globally.

What is a small company? Companies are categorised according to how large they are based on their market capitalisation. It is calculated by multiplying the share price of a company by the total number of shares that have been issued. In Australia the following categorisations usually apply: Large: The largest 50 companies by market capitalisation that are listed on the Australian Securities Exchange (ASX). Mid-Cap: Refers to companies that are ranked from size 50 to 100 in terms of market capitalisation on the ASX. Small: Usually refers to companies that are outside of the top 100, but are still large enough to be included in the broader market indices such as the S&P/ASX 300 Index. Microcap: Smaller companies with a market capitalisation generally less than $250 million and may not be included in any of the major indices. Whittle & Skok regard small companies as being any company that is outside of the top 100.

What are the attractions of investing in small companies?

Whilst the volatility of those returns has been higher, it is only marginally so and in fact the volatility of global small

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In addition to the potential for higher long term returns, there are two key attractions of investing in smaller companies which are the greater ability for active managers to add value and the additional diversification that they can provide.

ILLUMINATE • DECEMBER QUARTER 2016

Ability for active managers to add value

Diversification

Whilst there are ongoing debates about the ability of active managers to add value in many of the asset classes, there is virtually no argument for smaller companies.

The small company sectors of sharemarkets are usually more diversified and provide exposure to a wider range of industries and opportunities. For example, in Australia the broad market indices are dominated by finance and resource companies and this tends to dictate the overall market performance, whereas the smaller company index is more diversified and performance is influenced by company specific factors.

The graph below shows the value that the top quartile of global small and large cap managers have added compared to their respective benchmarks over various periods for the last ten years. Whilst the top large managers (orange bars) have struggled to add value on a consistent basis, the small company managers (blue bars) have added solid value over every time period. Value added by top quartile equity managers

How can you invest in smaller companies? When building a portfolio there are three ways an investor can gain exposure to smaller companies: 





Why is this the case? Generally it’s because the market for small companies is inefficient. Large companies have extensive stockbroker coverage and the ability to gain unique insights and opportunities to add value can be limited. In contrast, many small companies have limited or no research which can create an inefficient market and allow active managers who conduct their own due diligence to identify mispriced attractive investment opportunities. This is illustrated in the graph below, which by market capitalisation category shows the average number of analysts publishing research on a company (blue bar) and the percentage of the companies in that category who do not have any coverage (orange bars). Small companies have much less coverage and some 35% of global small companies do not have any analysts publishing research on them. Stockbroker analyst coverage of companies

By investing in a broad share fund that includes smaller companies as part of its overall portfolio. The exposure to small companies will rise and fall depending on the opportunities that the manager can identify. By investing in a small company fund. There are various funds that target the different small company categories and have different return and risk profiles. By investing directly in individual companies.

The most appropriate method is ultimately dictated by the risk tolerance of the investor. For cautious investors we normally only have an indirect exposure via the broad share funds. For more aggressive investors, we will adopt the higher risk strategies if we believe there are attractive opportunities.

What is the current Whittle & Skok view on investing in smaller companies? In a low growth economic environment sharemarket returns are likely to be modest and investing in small companies is one option for enhancing the prospective long term returns of a portfolio. Given the attractive characteristics of the sector we generally have a favourable view towards investing in small companies and they are represented in all portfolios. However, after the strong returns over recent years, the sector no longer is valued at a discount. Historically smaller companies have been cheaper than large companies, but currently they are valued similarly. This does not mean there are no attractive investment opportunities, it just means they are harder to identify and the risks are higher given the more expensive valuations. We expect the returns from investing in small companies will be more modest than recent years with a greater focus on stock selection required to generate attractive returns. The long term arguments for investing in small companies remain compelling, but in the short term some caution is warranted.

ILLUMINATE • DECEMBER QUARTER 2016

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Additional Information This Illuminate publication has been prepared by the Research Department of Whittle & Skok Financial Services Pty Ltd and is distributed exclusively to clients investing in our Tailored Portfolio Solutions. Any queries or requests for further information relating to articles that appear in this document should be addressed to your adviser.

Disclaimer This document has been prepared by Whittle & Skok Financial Services Pty Ltd (Whittle & Skok). It is not an offer or invitation for subscription or purchase of securities or a recommendation with respect to any security. Information in this document should not be considered advice and does not take into account the investment objectives, financial situation and particular needs of an investor. Before making an investment any investor should consider whether such an investment is appropriate to their needs, objectives and circumstances and consult with an investment adviser if necessary. Past performance is not a reliable indication of future performance. Whittle & Skok has prepared this document based on information available to it. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information, opinions and conclusions contained in this report. To the maximum extent permitted by law, neither Whittle & Skok, its directors, employees or agents, nor any person accepts any liability, including, without limitation, any liability arising from fault or negligence on the part of any of them or any other person, for any loss arising from the use of this report or its contents or otherwise arising in connection with it. This document may contain forward looking statements that are subject to a range of risk factors and uncertainties. Whilst the statements are considered to be based on reasonable assumptions, the statements themselves and the assumptions upon which they are based may be affected by a range of circumstances which could cause actual results to differ significantly from the results expressed or implied in these forward looking statements..

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