CFS Wholesale Equity Income (FSF0961AU) Report & Performance

The Fund returned -12.0% net of fees excluding franking, and it is disappointing that the Fund lagged the benchmark in a falling market by 90 basis points. Market conditions were very turbulent throughout the quarter and overall the attractive income the Fund generated from the sale of call options was not sufficient enough to offset the effect of negative stock selection.

The outcome of negative stock selection has not been the result of the Fund holding more growth than value names as the Fund is currently positioned quite neutral across these styles. Rather, our holdings in ‘value cyclical’ stocks impacted performance as they were disproportionately impacted by investor $5,000 $10,000 $15,000 $20,000 $25,000 $30,000 2008 2011 2014 2017 2020 Fund (excluding franking) Benchmark -25.0 -20.0 -15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 Jun-19 Sep-19 Dec-19 Mar-20 Jun-20 Sep-20 Dec-20 Mar-21 Jun-21 Sep-21 Dec-21 Mar-22 Jun-22 Fund (excluding franking) Benchmark Cash 7.31% Equity Strategy 92.69% First Sentier Wholesale Equity Income Fund 30 June 2022 concerns about a downturn in economic activity. We remain focused on delivering through the cycle risk adjusted returns and we believe the market has overlooked the ability of these companies to deliver positive earnings growth, with operating conditions still remaining favourable. While a slowdown may occur we believe the extent to which investors have priced in a downturn may be excessive. For example, detracting from performance over the quarter were positions in building materials companies CSR Limited (CSR) and James Hardie (JHX) as the market focused on the impact of rising rates on building activity. While new starts for US single family houses has declined in recent months, underlying demand for building products from JHX is more closely related to the repair and remodel market, which historically has proved more resilient in market downturns. Further, the record levels of homeowner equity and shortage of housing inventory is also supportive of underlying demand. Meanwhile, CSR has a significant backlog of work with elongated construction times due to labour shortages, construction delays and supply chain shortages that provides a robust pipeline translating into a high degree of visibility of earnings into FY23 and FY24.

The position in EML Payments (EML) detracted from performance over the quarter as they provided a disappointing third quarter trading update where the company downgraded EBITDA by 8% and the subsequent share price reaction of -39% on the day far outweighed the actual downgrade. The majority of the downgrade can be attributed to a remediation program with the Central Bank of Ireland (CBI), where the CBI took a more conservative stance than expected and prevented new programs from being approved. This resulted in EML missing establishment fees for new programs in their European General Purpose Reloadable Business. We have undertaken extensive work on the situation surrounding the CBI and it appears that the regulatory issues are industry wide and not specific to EML. The remediation plan is expected to finish on 30 June 2022 with external sign off, after which time we think the business will return to normal operations. While the additional costs to the business are disappointing, it does not change the central investment thesis, and each of the points of the downgrade are understandable as short term in nature.

The Fund returned 1.4% net of fees excluding franking for the March quarter, underperforming the benchmark. Moves in the market were volatile over the quarter with equity markets experiencing a sharp pullback in January before bouncing back in February only for investor sentiment to be zapped by Russia’s invasion of Ukraine. Once the market settled, March saw an extraordinary rally with the best monthly return since November 2020. Buy-write strategies generally underperform in strongly rising markets as the option overlay, which provides a cushion in falling markets, can act to cap the upside in strongly rising markets particularly during short time frames. While the Fund acted to provide a cushion during the market declines, the subsequent short sharp rallies led the Fund to lag the market. Over the quarter, the Fund benefitted from its positions in iron ore miners BHP and Rio Tinto as iron ore prices rose higher. Iron ore prices have been boosted by expectations that China will increase stimulus spending in order to lift economic activity, in combination with supply concerns as heavy rain in south east brazil forced producers to stop production and as the war in Ukraine disrupts supply from the region. The Fund also benefitted from its nil position in Wesfarmers (WES) as supply chain issues, wage inflation and higher input costs drove concerns about near term margin compression.

The Fund returned 6.6% after fees for the June quarter capturing 77.3% of the markets performance. Given the significant rally we have seen in the equity market over the last couple of months, we are pleased with the Fund’s capture for the quarter. Buy-write strategies generally underperform strong rising markets particularly during short time frames, as was the case in the last quarter. The ability of the Fund to provide a significant cushion in falling markets, as evidenced in March 2020, provides the longer term outcomes of good, more consistent, equity market returns delivered with lower volatility and attractive income over the full market.

Over the quarter our positioning in the consumer discretionary sector was beneficial as companies gained traction fuelled by cashed up consumers and pent up demand. Aristocrat leisure (ALL) contributed to performance, as the company continues to benefit from the recovery in US casino revenues that are now close to pre-covid levels and are focused on continuing to drive the profitability of their digital capability. Dominos (DMP) also outperformed as they continue to deliver earnings benefiting from their successful global store roll out and a covid-19 tailwind of contactless fast food. Over the quarter they announced the acquisition of Domino’s Taiwan which will further expand their reach into Asia and provide the opportunity to improve profitability by applying their proven marketing strategies and technological intellectual property.

Our underweight position in Afterpay (APT) detracted from performance as technology stocks rebounded, spurred by a moderation in inflationary fears. Investors reacted positively to the announcement of a roll out an affiliate program in the US to merchants such as Amazon, CVA, Dell and Sephora as they seek to expand their offering and compete for market share in the BNPL space. Our position in a2M milk (A2M) also detracted from performance as the turnaround in their inventory challenges is taking longer than expected. Conditions remained challenged in the diagou channel as supply chains are constrained and they face growing competition from domestic Chinese brands

The Fund returned 3.6% after fees for the March Quarter, capturing 81% of the markets performance during the rising market. The buy-write strategy used by the Fund typically results in underperforming the market during rising markets because the sold call options detract from performance as they limit the upside. This outcome is consistent with delivering the lower volatility objectives of the strategy. The capture of a significant proportion of the upside in a strong market quarter was mainly driven by the options component of the strategy rather than contribution from stock selection. Stock selection was negative in January but rebounded strongly in February and March, and had a roughly neutral impact to performance over the full quarter. Stocks exposed to offshore earnings were particularly weak in the early part of the quarter as the US dollar weakened

The Fund returned 9.7% after fees for the December quarter, representing a 70% of the strong rising market performance during the quarter. Buy-write funds typically underperform during strongly rising markets, particularly if the market appreciation occurs over a short period of time as was the case during the December quarter. However, it is important to understand how this impact is managed through the course of the market cycle. Earlier in the year when markets were significantly weak, the strategy provided a strong capital preservation outcome, falling significantly less than the broader market. This means that the starting point for the market recovery was from a much higher base for the Fund compared to the market, which provides an offset to some of the return lag during the strong rising markets.

Over the quarter the Fund’s position in Webjet (WEB) added to performance overall despite the volatile share price. WEB represents the Fund’s most significant exposure to the travel thematic. Most travel stocks globally are currently still loss making ahead of a return to more normalised travel conditions, which will not occur until wholesale vaccinations occur globally. While there was another covid-19 outbreak in December, overall travel stocks still performed well over the quarter on news of vaccines being rolled out by several countries. Bluescope Steel (BSL) also performed strongly over the month; as economies reopen the demand for steel has led to increased steel spreads which directly benefit the profitability of BSL. At the same time, the Australian government’s stimulus packages have benefited the domestic building cycle, leading to the company providing a positive update on the Australian business.

Offsetting the strong performance was the Fund’s position in A2 Milk (A2M) which was an initial beneficiary of the stay-at-home and pantry stocking theme; as China emerged earliest from shutdowns this theme unwounded and left A2M with an excess of inventory in its sales channel. This resulted in consecutive downgrades. It will take time for these distribution channels to stabilise but its core brand remains strong as evidenced by the strong performance of its Chinese label products.

Overall the portfolio has performed well in such a strong quarter in capturing a significant proportion of the upside.

The Fund had a very strong quarter returning 2.4% against the S&P/ASX 100 Accumulation index which fell -0.8%. This strong performance is a result of the combination of strong stock selection and also the result of call option premiums that were earned. While the market was volatile over the quarter, the end result of the market ending relatively flat meant that the Fund was able to earn premium with only a small amount of forgone upside. This contributed positively to the Fund performance.

While international travel stocks have remained volatile with fears of a second wave in Europe and the ongoing uncertainty around a vaccine, Australian travel stocks have fared better. In particular Corporate Travel Management (CTD) has performed strongly over the quarter. In its annual result it reported a much better outcome than expected with higher revenues especially in the US, resulting from their larger exposure to government and essential travel. This higher revenue meant that they had much lower cash burn than expected, resulting in a stronger financial position. A large proportion of corporate travel is also domestic in nature, and the market looked to examples such as New Zealand where domestic travel recovered to pre-covid levels very quickly once the virus was kept under control. Corporate Travel also took the opportunity to raise capital to acquire competitor Travel and Transport to expand its US footprint. The acquisition makes sense both strategically and financially.

The Fund also benefitted from the position in James Hardie (JHX). Even before covid the company had been successful in expanding market share and increasing margins through its ‘LEAN’ program. As covid emerged, the company was able to quickly adapt and prepare for different potential scenarios. The US housing market rebounded strongly from lockdowns, driven by historically low interest rates and a stronger than expected economy; James Hardie benefitted from this strong recovery and led to a very strong first quarter result (James Hardie reports using a March year-end).

The biggest detractor for the Fund was A2 Milk (A2M). Initially benefitting when covid first impacted China in January through to April as the Chinese consumer rushed to stock up their pantries, over the last quarter A2M has been impacted by a combination of these trends reversing as China recovers the quickest from covid outbreaks, while its Australian sales that are mainly driven by its daigou distribution channel has been interrupted primarily by the Melbourne lockdown. This combination of factors led to the company downgrading in September, after it initially held guidance in its August annual result. This lead to the stock underperforming for the quarter.