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Chester High Conviction FundQuarterly Thoughts | January 2021

Total returns

Quarter in review

We learnt an interesting fact over summer. Watching a Netflix documentary on WWII we discovered that during the Blitzkrieg of 1940, when German forces stormed through France and took Paris in little more than a week, one of the key ingredients to their success was a drug called Pervitin. Which was actually Crystal Meth or Ice. It ensured the Panzer drivers and night bombers were wide awake and relentlessly driving forward destroying everything in their path. Not having to sleep or rest for 3 days was very productive for surprising the enemy.

We mention this, as we’re not sure that some parts of the equity market aren’t also taking Pervitin. The relentless march higher of many growth stocks in our mind is very hard to reconcile with anything fundamental, but is purely supported by ongoing stimulus and liquidity flows into passive ETFs. We understand that much like 1999, the powerful construction of the “narrative” or story telling around a concept stock is bringing a new cohort of investors (20-30 year old retail investors) that have wonderful anecdotes of success with options and leverage. Tesla is this generation’s poster child for speculation. Perhaps this time is different? We keep reading Charles Dow’s very timely quote above.

Having said that, every cycle is different, and at no time in history have investors been faced with the prisoners dilemma we are all faced with in 2021. Invest in theoretically riskless assets (cash or sovereign bonds) and receive no return, or invest in riskier assets (equities). We expect the world to look different in 2021 (as does everyone), while the COVID-19 pandemic rages through Europe and the US, the prospects of vaccines being rolled out quickly over the next 6 months has seen a renewed interest in the prospects of a cyclical recovery. This prospect has been combined with the Democratic control of Congress in the US, which is expected to enable increased deficit spending through 2021. The sheer enormity of the increase in money supply through 2020, combined with more aggressive stimulus in 2021 from the Biden administration, suggests there will be a strong prospect of the continuation of the weaker USD, which augurs well for commodities, emerging markets and asset prices more broadly. This appears to be now very much the consensus line of thinking. That doesn’t make it wrong. This has only inflamed the debate (which to our mind is overly simplistic) between “value” and “growth”, whereby growth has been a long term structural winner as bond yields have fallen, effectively since the GFC. So the debate remains around the prospects for 2021. Is this the year where “value” finally outperforms as the money supply growth creates inflationary forces that sees bond yields rise?This high level view (2020 has been dominated by macro influences) we can only hope, makes way for more stock specific outcomes in 2021, whereby we remain heavily focused on owning a portfolio of stocks that remain compelling on a bottom up cash flow basis. We suspect our style bias of cash flow analysis will stand the portfolio in good stead into the new year, particularly if valuations actually matter again.While we still see a range of outcomes over the next 12 months, markets enjoy certainty, which is what a Biden administration will provide, combined with Janet Yellen (former Fed Chairperson) being appointed as the Treasury Secretary, that all but ensures monetary policy and fiscal policy will be intertwined.

Risk vs RewardAt the risk of repetition, risk management remains vital over the next 12 months, while facing inevitable corrections and higher volatility that we suspect becomes “the norm”. The risk of not being invested to a large extent is outlined above, while we remain acutely aware of the economic challenges ahead of us and the dislocation to large chunks of society. For us, risk management means appropriate portfolio construction to attempt to mitigate downside risk, while also exploring opportunities for capital and income growth. It requires very focused views on the stock specific risk of each holding. In that context, we focus heavily on the operating (earnings) risk, financial (balance sheet) risk and corporate governance (management alignment, labour force, reputational damage) risk of each stock in isolation. So portfolio construction takes on a very important role over the coming 12 month period. We also look at the prospect for a change in market leadership over the coming 12-18 months, which would be led by inflation expectations. Given the current dispersion between high quality growth (high ROE) names and some more capital intensive industries that have seen some impact from COVID-19, we tend to err on the side of looking at outperformance from this point coming from unloved sectors and stocks, as opposed to the winners of the past 5 years.

At 31 December 2020 1 mth % 3 mths % 6 mths % 1 yr % 2 yr % p.a 3 yrs % p.a.Incep. % p.a.

(27 Apr 2017)

Chester High Conviction Fund (after fees) 1.9 16.1 23.0 16.5 18.4 8.3 13.1

S&P/ASX 300 Accumulation Index 1.3 13.8 13.7 1.7 12.2 7.1 7.3

Outperformance (after all fees) +0.6 +2.3 +9.3 +14.7 +6.2 +1.2 +5.8

“There is always a disposition in people’s minds to think that existing conditions will be permanent. When the market is down and dull, it is hard to make people believe that this is the prelude to a period of activity and advance. When the prices are up and the country is prosperous, it is always said that while preceding booms have not lasted, there are circumstances connected with this one which make it unlike its predecessors and give assurance of permanency. The one fact pertaining to all conditions is that they will change.” Charles H. Dow, 1900

* The inception date of the Chester High Conviction Fund was April 26th, 2017. The NAV at December 31st, 2020 was 1.4903


So the key question is how (and in what shape) inflation appears? The most obvious answer at this juncture is being manifested through a lower USD, which provides a very strong backdrop for commodity prices (both hard and soft commodities). This looks to be feeding into higher PPI (the purchasing price index for manufacturers) as we sit here today. We believe the sheer size of the increase in money supply by directly targeting individuals, which potentially feeds through to higher CPI (consumer prices). The Fed is acutely aware of the deflationary forces bought about by forced lockdowns, hence the view held by many (including us) that the Fed (and in fact all central banks) will let economies accelerate and over shoot to the upside before starting to talk about the prospect of normalising monetary policy. The money supply side is undisputed, the confidence of consumers to increase the velocity of money is the missing ingredient.

We retain a view that gold holds a very useful place in portfolio construction. Historically gold equities have demonstrated non-correlated characteristics with other equity sectors, albeit not as much through 2020. Given our base case that fiscal deficits remain in place for a longer period of time than necessary (forever) the tailwind for gold, as a direct beneficiary of fiat currency debasement, leading into what is likely to end up as an inflationary outcome, suggests the backdrop for gold remains favorable for the foreseeable future. Although this thinking is never linear.

So what are we focusing on?

Our broad themes for portfolio construction remain consistent, albeit we have been cognisant around the strength in the AUD (or weakness in the USD) which has been a strong tailwind for Australian listed stocks with offshore earnings. This trend (weaker AUD) has been persistent for the past 7 years, leading to the strong outperformance of the basket of offshore earners. While each company needs to be assessed on individual merits, as a basket we have reduced our exposure to this cohort of stocks. In broad terms we have increased our exposure to the Australian domestic economy as one of the better placed geographies to manage the reopening of its economy.

We retain a strong focus on relatively predictable cash flows in industries that appear less likely to be disrupted. Essential services are still prevalent in our portfolio, Woolworths (WOW) and CSL remain two of our larger holdings based on this certainty of cash flows. We have also placed more emphasis on industry leaders as we emerge from the lockdown period, whereby recapitalised balance sheets on certain stocks will ensure a far stronger industry position over the next 2-3 years than they have had previously. We categorise Qube Holdings (QUB), Aristocrat Leisure (ALL) and Ramsay Healthcare (RHC) in this category. We have also had a relatively meaningful allocation to companies that we consider to have strategic assets, whereby in a world of less global trade, these assets are increasingly relevant for the supply of raw materials. Lynas Corp (LYC) and to a lesser extent Synlait Milk (SM1), are in this camp.

Considerable time over the past 6 months has also been spent looking for companies that have been severely punished through COVID as their cash flows have significantly reduced. Based on the expectation that second half of 2021 brings with it vaccinations and better management of social distancing measures, many of these companies have been materially undervalued on the assumption that these cash flows will normalise over the next 12-18 months (back to FY19 levels). We would classify Sky City (SKC), United Malt Group (UMG) and Lend Lease (LLC) in this category. Gold, as previously mentioned, remains a significant holding, with OceanaGold (OGC) our preferred name on valuation grounds, albeit requiring some patience over the next 6 months.

The Portfolio

The CHCF posted a 16.1% gain in the December quarter, relative to the 13.8% increase in the ASX300 Accumulation Index. The strategy had a pleasing 12 month period, whereby we navigated the severe drawdown in March relatively well, while finding enough strong opportunities to participate in the market recovery. While past performance is not a reliable indicator of future returns, we remain of the view that we have a significant portion of our fund (read frustrating positions) that haven’t meaningfully participated in the market recovery. We are optimistic (a fund manager’s best skill) there is several key holdings that are well positioned for strong periods over 2021. We wrote up Aussie Broadband (ABB) in our most recent quarterly, which delivered strong returns from its IPO price of AUD1.00. We remain of the view that ABB has a meaningful revenue growth period ahead of it backed by strong cash delivery. Mineral Resources (MIN) has a long history of delivering returns for shareholders through a mining services business (servicing commodity producers), while it also operates its own commodity businesses in iron ore and lithium, where in the right cycle, very strong cash flows are generated. We are currently in one of those cycles, while the market has started to factor in the range of growth opportunities that MIN has in front of it over the coming 2-3 years.

Comet Ridge (COI) has been a very poor investment, which in hindsight was allocating capital to a project too early. We have always allocated a small portion of the fund’s capital to emerging companies, whereby we were taken with the strategic location of COI’s asset base in the Bowen Basin in Queensland. COI owns 40% of the Mahalo gas field in a JV structure with Santos (30%) and APLNG (30%). We remain of the view that East Coast gas growth projects are being materially undervalued as the decline in existing fields will need to be addressed in the next 2 years. Mahalo will potentially play a role in filling the Australian gas production shortfall. Synlait Milk (SM1) has also been a frustrating investment thus far, as issues with inventory management at its major customer (A2 Milk) has seen its capital spend over the past 3 years not yet achieve any significant returns to shareholders. The announcement of a major multi-national customer at its Pokeno facility and a capital raise to repair its balance sheet should set SM1 up for the next leg of growth over the next 2 -3 years, while an improvement in A2s infant formula sales will be very welcome.

Top 3 Holdings Portfolio Breakdown Top 3 Portfolio Attribution Bottom 3 Portfolio AttributionWoolworths Ltd Industrials 19.7% Aussie Broadband Pty Ltd Comet Ridge LtdDowner EDI Materials 14.0% Lynas Rare Earths Ltd Synlait Milk LtdQube Logistics Consumer Staples 12.4% Mineral Resources Ltd Aurelia Metals Ltd


Same Strategy - Accumulated performance

Note this graph is representative only of the combination of the same Portfolio Manager running the same strategy, and would only represent actual returns for unit holders that invested money at inception of SGH Australia Plus, withdrew those funds at the end of February 2017 and then invested all those initial funds again at inception of the Chester High Conviction Fund in April 2017. Note, this depicts returns after fees.

FY14 (%)# FY15 (%) FY16 (%) FY17 (%)* FY18 (%) FY19 (%) FY20 (%) FY21 (%) Since Incep-tion (%) p.a.

Same Strategy (after MER) +11.2 +24.5 +17.4 +11.2 +28.3 -6.4 +3.9 +23.0 +15.6

S&P/ASX 300 Accumulation Index +7.8 +5.6 +0.9 +9.1 +13.2 +11.4 -7.7 +13.7 +7.5

Value added (after MER) +3.5 +18.9 +16.4 +2.1 +15.1 -17.8 +11.6 +9.3 +8.1

Accumulated Performance by Financial Year - Same Strategy

# The inception date of SGH Australia Plus was the 8th of October, 2013, where Rob Tucker was the sole Portfolio Manager, until his departure on February 28th, 2017.* The inception date of the Chester High Conviction Fund was April 26th, 2017, hence FY17 reflects 8 months of SGH Australia Plus and 2 months of the CHCF.

We note this is a statement of fact of the performance achieved by the fund during the time which Rob Tucker was the sole Portfolio Manager making active decisions on the SGH Australia Plus portfolio. We note performance is the record of the firm not the individual however past performance has been constructed from publicly available unit price data. Past performance is not necessarily indicative of future performance and should not be relied upon in making investment decisions.

High Active ShareFor active managers to outperform long term, the fund has to be truly different from the benchmark. This strategy has had an active share of over 80% since inception

Mid Cap BiasBroadly speaking, we find more interesting growth opportunities outside the large cap universe. For funds to perform well over an extended period, exposure to mid caps and small caps is essential

Back Owners of CapitalAllocating capital to management teams that think like owners is more likely to ensure longer term suc-cess. Alignment of interests is crucial. Managers must take a long term view.

Concentration in few ideasWhile a portfolio can be appropriately diversified with approx 20 stocks, our mid cap bias has seen the strategy average around 33-35 stocks since inception

Own our decisionsAs a team, Chester has worked together for over 9 years, we each know our role and the strengths and weaknesses of each employee. We are proud of the culture we have built.

Keep it simple Ultimately, we allocate capital to sectors and companies that we understand

Focus on InsightsDo we have a different view than the prevailing wisdom of the market? Backing ourselves in unloved or undiscovered stories has been the most consistent alpha generation of this strategy

Cash Flow Growth We seek to invest alongside companies that either generate predictable cash flows in high quality industry positions, or determine an appropriate margin of safety where valuation support is paramount

The Chester High Conviction Fund philosophy - building a strong track record with these key principles

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High conviction strategy ASX300 Accum Index

177.8%

66.0%

15.6% CAGR

7.5% CAGR


What are we thinking about?

1. The ramifications of the Blue Wave - how blue is it?

The long anticipated “Blue wave” was confirmed in early January with the Democratic victories in 2 Georgia senate elections. Effectively this ties the senate at 50-50 between Republicans and Democrats while Vice President Harris will have the deciding vote, ensuring the Democrats now control both the house of representatives and the senate. While existing senate rules require much legislation to obtain 60 senate votes to pass, any budget measures only require a majority. Hence the widespread expectation for continued stimulus in 2021. This is expected to come in the form of an increase in stimulus cheques to USD2000, student loan relief of USD500bn-1.0tn, enhanced prospects for an infrastructure bill of up to USD3.0tn and a US auto plan (in some form of cash for clunkers program to accelerate the move to EVs), which would all be partly funded by an increase in corporate taxes from 21% to 28%, but we do think that expectations for the Democrats to have everything their own way are misplaced.

2. Consensus trades of 2021

We always try to understand where the consensus thinking is, as this helps us assess how we view the world relative to others. As we start 2021, it is very consensus to view the next 12 months as being bullish for equities (and we don’t disagree) in large part thanks to the unprecedented stimulus provided in 2020. The decline (or weaker) USD is also a consensus trade as US deficit spending is only growing to fund the programs outlined above. This lower USD view is very positive for commodities and emerging markets, which again, are very consensus views, while the rotation inspired by this trend is from long duration growth names into more cyclically exposed sectors. We don’t disagree with any of this and we have been positioning steadily over the past 6 months for a more cyclical recovery into 2021. But while mindful of agreeing with consensus too much, we do think this trade has really only taken flight since the US election and the announcement of the vaccine roll out in November, which suggests to us, this trend persists for more than just 8 weeks.

3. Position sizing

We like the terminology of portfolio position sizing as never being right. Any stock in the portfolio is either too big (the stock is going down), or too small (the stock is going up). We do think about this more than we probably should as it can really determine the performance of the overall portfolio. We discuss this more on page 10.

4. Exploration trends - an amazing year in Australia

2020 actually heralded some amazing success with the drill bit in Australia with the two best performing stocks on the ASX, De Grey Mining (+1890%) and Chalice Mining (+1633%) finding world class deposits in Western Australia. Combine this success with the favourable backdrop outlined above for the commodity cycle and it appears we are in the early stages of a bull market in exploration. We look in more detail what this means on page 9.

5. Contrarian ideas - winners and losers from 2020

Everyone’s favorite exercise at the start of the calendar year is to screen for the most successful stories or the most unloved companies from the year before. Often it comes down to what style suits your personality, momentum or contrarian investing. While momentum investing has been wildly successful over the past 10 years, we do believe that 2021 may herald in a more value oriented style, suiting mean reversion. Our preferred capital allocation framework is towards unloved or undiscovered stocks, hence our style is more suited to taking on a contrarian style. We outline the winners and losers from 2020, and highlight several “losers” from our portfolio in 2020 where we think the prospects look far stronger in 2021.

6. What to do with the Australian Banks

The largest sector of the Australian economy has seen a large reversal of fortunes in 2020. From the prospect of significant impairment charges in the middle of COVID in May/June where large provisions were taken, to the relief rally in the 4th quarter after Josh Frydenberg released the most market friendly budget in Australian history in October. Trading below book value, the margin of safety was the key reason for the relief rally. The key question is, what do we do now? Our thoughts are on page 13.

7. Does money supply lead to inflation?

Really this remains the key question of 2021. The only certainty this year is the increased spending in the first half of 2021 to combat further lockdowns which almost ensures a synchronised global recovery in the second half of 2021. We look at some of the key charts on page 14.

8. What does this mean for growth vs value

This debate is overly simplistic in our mind. Stocks can be both value and deliver strong earnings growth over a 2-3 year cycle, but this thesis is heavily tied to how interest rates respond to central bank stimulus and if in fact the acceleration of the cycle brings a halt to the equity bull market which has been predicated on interest rates remaining effectively zero bound for the foreseeable future. An inflation scare would be the major catalyst for both an ongoing rotation of style (towards value). The debate for us is most often centred around the lifecycle of the industry and the sustainability of the business model.


Stock selection - Woolworths

Description Operating Australia’s largest supermarket network (~1,050 stores) and accounting for ~35% of the domestic food retail segment Woolworths (WOW) requires little introduction as one of the most trusted Australian brands. Representing around two-thirds of group profit (EBIT) in recent years WOW’s food segment is complimented by its operations in Liquor (Endeavour Drinks), New Zealand supermarkets, Big W and Hotels (ALH Group). It had been anticipated that WOW would progress the shareholder approved demerger of its Liquor and Hotels segments toward completion in 2020. Not surprisingly, this transaction was delayed given the disruption caused to the group’s Hotels operations in particular and completion is once more being targeted in 2021, most likely the second half of the calendar year.

Quality WOW’s greatest strength remains its leading market positions in its key Australian food and liquor segments. Representing about 85% of group sales and EBIT in a normal (ex-Covid) operating environment this incumbency positions WOW to maintain industry leading margins whilst limiting the opportunities for competitors to take market share if management execute well. For current CEO Brad Banducci the scars of poor decision making and a failure to adequately balance the interests of all stakeholders (including customers, suppliers, shareholders and staff) remain front of mind having assumed the CEO role as the group was seeking to extricate itself from the disastrous Masters hardware venture. So too, the lessons of the early part of the decade when WOW’s aggressive pursuit of profits saw it lose considerable market share to the previously struggling Coles (COL) while also providing an opening for Aldi to successfully enter the Australian market. Over the past 5 years Banducci has made good progress in terms of both restoring the confidence of Australian shoppers and regaining lost sales momentum. While these efforts have required some additional investment that has impacted margins it looks likely that WOW will enjoy a more favourable operating environment in the coming years with more rational competitors. Restored balance sheet strength post the sale of their fuel business in FY19 also supports further investment in their supply chain and eCommerce capabilities.

Valuation Our assessed value for WOW is currently AUD 46.50 before any adjustments for the demerged Endeavour Group and potential capital structure changes. While the impacts of COVID-19 (higher sales and incremental COVID-19 associated costs) are expected to persist through the current financial year current expectations are that F22 and beyond should more closely resemble normal operating conditions for WOW. Amongst the key operating assumptions underpinning this valuation are supermarket sales growth to average 4% over the next 3 years with EBIT margins to expand toward 5.7% by F23 (5.3% in F20) as margins improve in the online channel and recently increased wages (new EA implemented in F20) are cycled and legacy distribution centre costs roll off.

Insight Despite the sales tailwinds enjoyed by WOW’s supermarket and liquor businesses in particular in 2020, the combination of higher costs servicing these sales, together with the challenges faced by the group’s hotel business saw the stock only modestly outperform the ASX300 for the calendar year, and quite materially underperform its closest listed peers COL (+22% total return) and Metcash (+31%). We consider the strong possibility that this underperformance is reversed in 2021.Woolworths in the last 6 months in particular has begun to materially outperform COL in the online supermarket channel. Despite a larger sales number in the prior corresponding period Woolworth’s 100% online sales growth in the 1st quarter of F21 comfortably outpaced the 57% growth achieved by COL. Whilst in the short term these online sales are being achieved at a lower EBIT margin than traditional in-store sales, it’s anticipated that stronger online penetration should enable Woolworths to continue to outpace COL sales growth (and therefore gain market share) and also begin to benefit from increased scale in the online channel. While COL have stated a reluctance to commit too much capital to their online sales capabilities in the near term (ahead of the anticipated commencement of operations with eComm partner Ocado in F23) Woolworths have shown a greater preparedness to invest in technology and online capability. This has the potential to deliver WOW a key sales advantage in the coming years.The potential recovery of the WOW hotels business in 2021 (subject to various COVID-19 scenarios/vaccines) and ultimate completion of the Endeavour Group demerger is another potential catalyst for Woolworths this year. Despite the anticipated one-off costs of completing the demerger (~$270m) the benefits of each business having its own operating and investment agenda makes strong sense. Removing the hotels portfolio from the WOW business should ensure any ESG overhang is removed for investors, while the strong cash flows of the WOW liquor business should support a clear growth agenda for the newly formed Endeavour Group.

Chart 3Chart 2

Source: Jefferies Research Source: Woolworths Ltd

WOW has superior online capability than Coles 2021 could be transformative for the group


Chester High Conviction Fund top ten holdings as at January 2021

FY1 FY2 FY21 Yield FY22 Yield FY1 FY2 FY 1 ROE FY 2 ROE FY1 FY2 FY21 PER FY22 PERSales Growth Sales Growth DPS Growth DPS Growth EPS GROWTH EPS GROWTH

Atlas Arteria -27.5% 24.6% 2.5 4.9 nm 95.6% 2.28 9.58 -54.8% 324.0% 84.5 20.0

Aussie Broadband nm 37.7% 0.0 0.0 nm nm nm 27.70 nm nm 1055.0 30.1

CSL Limited 8.7% 7.7% 1.0 1.1 3.8% 11.0% 31.20 29.05 6.4% 10.8% 44.4 40.1

Downer 0.2% 3.9% 2.8 4.4 11.4% 53.0% 8.64 9.89 41.1% 19.4% 14.8 12.4

Mineral Resources 52.8% 5.9% 4.6 3.8 122.3% -19.4% 29.80 20.70 114.9% -20.6% 9.3 11.8

News Corp -4.9% 2.4% 1.1 1.1 6.0% 4.1% 2.23 3.45 nm 57.7% nm 35.9

OceanaGold -24.4% 64.3% 0.1 0.9 nm nm nm 8.31 nm nm nm 7.8

Qube Logistics 8.8% 8.1% 1.7 1.9 -2.0% 10.0% 3.69 4.47 -3.0% 25.0% 45.5 36.4

Westpac -3.4% 0.4% 4.5 5.7 nm 26.3% 7.50 7.99 nm 9.9% 14.2 12.9

Woolworths 4.3% 1.5% 2.7 3.0 12.3% 10.6% 19.43 19.56 12.0% 9.7% 27.1 24.7

Source: Chester Asset Management, Bloomberg consensus data as of January 7th, 2021. Note stocks are listed in alphabetical order

We have listed here our top ten holdings at the end of December 2020. Naturally we find that our stock weights can change over the course ofa quarter or year. We broadly hold positions between 1% and 6% depending on our conviction level on the stock and the market capitalisation.Our conviction level is dictated by the broad art of combining 1/ the appropriate valuation of the stock, with 2/ our assessment of the qualityof the assets and management team, overlayed by 3/ our expectation (or insight/edge) of the earnings direction. I.e. Do we think the market ismispricing earnings? For our thesis to hold, we require at least 2 of these 3 factors to be validated for the investment case.To explain that in more detail we have used a slide from our presentation material (chart 5). Most of the stocks currently held in the top tenholdings are classified as “Predictables” (Healthcare, Consumer Staples, Communication Services or Infrastructure) while Mineral Resources is the only cyclical as a top ten holding. We have defined DOW as a predictable business driven by the change in strategy that leaves the core business as more predictable than DOW has been historically. The focus of the fund has been very much on essential services with relative cash flow certainty in this unique economic climate we find ourselves in, while we have been selectively adding more cyclical names over the past quarter.When we are allocating capital to those sectors that are more predictable in nature, our primary focus is the quality of the industry position they hold and relative cash flow certainty. We determine this by asking ourselves 7 questions around pricing power, barriers to entry, threat of disruption, etc. We also ask a range of questions around the management incentive structure and track record. Once we decide that a company is well positioned, we then seek at least one other “thesis” to hold true. For predictable companies, we need to be convinced around the quality first, and then valuation or edge. For cyclical or defensive (gold) companies, we need to have a high degree of confidence in the valuation support first (as by definition, we cannot be sure of how predictable the cash flows are). We then seek a degree of conviction around the management team and whether we have a unique insight (“edge”) to those particular assets. Thus for the cyclical or gold stocks, it is primarily a valuation driven decision first.

Chart 5

Source: Chester Asset Management

Chart 4


Portfolio construction


We have always broken down our portfolio construction into threecategories as outlined on chart 6. We think of most sectors inthe predictables bucket - healthcare, consumer staples, defence,infrastructure, etc as, in general, able to offer relatively predictablecash flow profiles from the industry structure they operate in. Weare the first to admit this is a relatively primitive exercise giventhat many stocks have very different cash flow characteristics thatmay be categorised in several ways. For example, gaming or morespecifically casinos have historically been relatively predictable cashflow generators, but COVID has derailed many of these formerly“predictable” sectors. We focus heavily on the industry structureand competitive advantages of each company when assessing theinvestment thesis for “predictable” stocks.We use the word “relatively” predictable, as sectors that are genuinelycyclical in nature (energy, commodities, retail, etc) there is always lesscertainty over the longevity of a cash flow cycle and sustainability ofmargins, hence given the uncertainty, we tend to desire much bettervaluation support in cyclical sectors.The “defensive” sleeve is comprised of positions that are historicallyuncorrelated to the ASX300. We classify gold equities with this lens,as a historical study of large equity market drawdowns highlights how well gold holds up in extremely volatile markets. Cash is often a residual position, while the fund does have the ability to own small positions in ETFs that are negatively correlated to the ASX300.Chart 7 illustrates how these “sleeves” have looked over the past 7years. On average, the allocation to predictable companieshas been 60-70%, while cyclicals have averaged around 15% (10-25%)and defensives ranging from 10-25%. We have tended to hold an increased defensive position over the past 2 years, while in the last quarter have added incrementally to our cyclical position with the backdrop of a cyclical recovery that appears underwritten by central banks.The history of the strategy has been successful in delivering alpha,outside FY19, in which the fund was (in hindsight) too cyclical leadinginto the end of 2018, and then far too defensive during the first part of2019.

Chart 8 has been pulled directly from the Morningstar database oflarge cap Australian Equity strategies, whereby it highlights the strongtrack record relative to its peer group (ranked 6/342 funds over 1year, and 31/319 over 3 years). While this is pleasing, the portfolioconstruction as described above, we think creates a differentiatedproduct to our peer group. Largely because we use the defensivesleeve, our drawdown has been lower than the index and the peergroup, which also shows in the beta of the strategy (0.9 vs peers at0.99). This effectively means the fund demonstrates less volatility thanthe peer group, which is also shown by the standard deviation (17.23 vs18.16).

But what it also highlights is the lower level of correlation (R-squared)to the index, which shows this strategy is only 86.65% correlated to theindex, relative to the peer group correlation of 94.37%. The portfoliois designed this way deliberately, which we think becomes even moreimportant over the next 12 months with increasingly volatile markets,thus ensuring some focus on capital protection (although it is a longonly product) is paramount to the way we invest.Hence the fund (to this point, and past performance is no guaranteeof future performance), has been able to demonstrate higher returnsthan many of its peers, for significantly lower beta (or volatility) andcorrelation. Thus, it has achieved its objective, while being a verydifferent offering than most other Australian equity funds.

Chart 7


Chart 6How we categorise sectors by cash flow type

Chart 8

Portfolio construction over the past 7 years

The Chester High Conviction Fund is different to its peers

Source: Morningstar database of Australian large cap strategies, Jan 2021


Position Sizing

The idea of this is to illustrate how we build portfolio positions and how we manage them as an active fund. We have used ALS Limited (ALQ) as our example, largely because it’s relatively flattering to our process over the past 2 years. When we try to build portfolio positions we aim to blend the fine art of valuation discount, the quality of the industry structure and management team and the research we undertake that may lead to having a unique insight into a particular stock. ALQ provides analytical testing services globally across 3 key segments being Life Sciences (Environmental Services ~70%, Food ~20% and Pharma ~10%), Industrials and Commodities. The Commodities division represented ~50% of FY20 earnings (pre corporate costs). This division consists of Geochemistry, Metallurgy, Inspection and Coal with the majority of earnings (Geochem and Met) predominantly exploration driven. We view the earnings stream in 2 parts, Life Sciences being very predictable in nature, while the commodities division is clearly cyclical. We have discussed on the following page why we have a heightened conviction around ALQ’s earnings over the outlook for the commodities division in the coming years, based on the exploration cycle.

Broadly speaking, we tend to work in 2% increments for our portfolio, while for several smaller companies, 1% can be an appropriate weight. Again, this is the broad art of position sizing. We actually held Xero for almost 3 years, enjoying a share price gain from AUD20 to over AUD100 when we exited XRO on valuation grounds. The attribution of XRO in the portfolio has obviously been strong, but unfortunately the portfolio weight was only ever a 1-2% position given our concerns around the valuation (which are even stronger at AUD150/share).Hence the comment that portfolio positions have two sizes. Too big and too small. For us XRO was always too small.

The other broad comments we make around position sizing is incorporating other factors such as liquidity. This is how much a share trades on a daily basis and its market cap, while sometimes these can be mutually exclusive - that is, some small caps can trade with large daily liquidity while some large caps only trade in low volumes. The volatility of a stock (what we term as the beta, whereby more cyclical stocks, or stocks with higher leverage trade in wider ranges and are often held with lower portfolio weights) is also an important variable for portfolio sizing.

The other key aspect when building a portfolio, which is often missed with illustrations like this one, is how this individual position blends with the other stocks in the portfolio. That is, how much exposure do you want to different industries or sectors. Given our fund is highly benchmark unaware, we tend to stick to the formula that has worked well for us over 7 years, which is shown on page 7. This is the art of having enough exposure to the sectors you want, while attempting to minimise the volatility of the fund. Our gold position is used as a tool to lower volatility while being of the view that there remains strong tailwinds to the gold thesis over the next 2-3 years.

Back to ALQ, to us it remains a very well managed company with between 15-25% market share globally in the services it offers, with a corporate history traced back to 1863. Fundamentally, we see ALQ valued between AUD8.50-10.00, depending on a range of variables (including the appropriate WACC and margin assumptions for a renewed commodity cycle over the coming years). For Chester, we first established a 4% position over 5-6 weeks in July-August 2019 based on a large discount to valuation for a very strong global franchise. The entry price was in the low AUD7.00 range. As ALQ reached our valuation and breached it in late 2019 and early 2020, we initially reduced the position to a 2% weight, and then exited the last of our holdings at the end of February 2020, with an average exit price in the low AUD9.00 range. Once we were of the view that the global stimulus packages would provide a tailwind to ALQ’s commodity business given the strength of the gold market, we re-initiated a 2% position in the high AUD6.00 range in early July 2020. While currently trading slightly above our target price, the analysis shown on page 9 highlights that we see strong likelihood of further earnings upgrades over the next 18 months, hence we remain comfortable with our position.


Chart 9

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ALS Limited CHCF trading history


An exploration super cycle?This is an extract of a livewire piece Chester published in January. The link can be found here. https://www.livewiremarkets.com/wires/return-of-the-explorerWhy we could be at the start of an exploration upcycle:

1/ Recent exploration success stories. CHN (+1633%) and DEG (+1890%) were the two best performing ASX stocks of 2020. Success breeds confidence and also FOMO as investors dream of what could be the next big name to hit the billboards. The recent increase in junior capital raisings is testament to this. 2/ Commodity price strength. In a year that contained a global pandemic it was almost amazing to see a host of commodities deliver record price growth. Gold +25%, Copper 26%, Iron Ore +72%. Chart 11 is an approximate representation of global exploration spend by commodity, strength in these 3 provides the ability (via FCF) and confidence (via management and investor capital allocations) to invest in the drill bit. 3/ Historic underspend. Wood Mackenzie has suggested the gold industry alone must invest USD54bn by 2025 on greenfield projects and mine restarts just to maintain production at current levels. 4/ New age of electrification. The electrification of the global transportation fleet and increased demand for energy storage provides a strong backdrop for investing in new supply of commodities like copper, nickel, lithium, cobalt, rare earths, etc. 5/ Globally co-ordinated fiscal stimulus targeting infrastructure. Governments globally have spent over USD10trn since the onset of the COVID-19 pandemic. S&P’s latest 2020 estimate is USD8,700m in expenditure, ~11% below 2019 levels. If accurate it would actually represent a material upgrade to the 29% decline projected in April 2020. Early indications have S&P Global projecting 2021 growth at ~20%, which we expect would be 2H weighted. Hence the upcycle may have already begun. But what might it look like past 2021? We believe the average of the 2 most recent up cycles (2002-2008) and (2009-2012) provide the best guide to what this potential upcycle may look like. We have averaged these two periods which form our base case of global exploration spend in coming years. I.e., Chester’s base case is a 4-year bull cycle in exploration peaking in 2024 at ~USD20bn.

There is five ways to gain exposure to this thematic.1/ Pure greenfield opportunities – very high risk without the appropriate skills2/ Pure play explorers that have made discoveries – resource delineation and development plays.3/ Established producers with underappreciated exploration upside 4/ Pure play service companies. 5/ Service companies with some exploration exposure

ALS Limited (ALQ) is the largest and most liquid way to play a potential bull market in exploration. ALQ provides analytical testing services globally across 3 key segments being Life Sciences (Environmental Services ~70%, Food ~20% and Pharma ~10%), Industrials and Commodities. Given the topic of this paper below we have only focused on the (cyclical) Commodities division which represented ~50% of FY20 earnings (pre corporate costs). This division consists of Geochemistry, Metallurgy, Inspection and Coal with the majority of earnings (Geochem and Met) predominantly exploration driven. Summarised below are the division’s results since 2009. Although ALQ’s Commodities division is more than just non-ferrous exploration we have compared results with S&P Global data to calculate ~ALQ market share since 2010. Our work (refer to full article) estimates ALQ’s revenue has averaged ~4.5% (pretty consistently) of global exploration spend over the past 5 years. If we are in an exploration upcycle, we see opportunity for upgrades to FY23 revenue and margins. We have shown only to FY23 as data is only really available to then but as discussed in the article, based on our assumed cycle for exploration this Jaws would continue / expand into FY24 and FY25. Note we see it reasonable in an upcycle margins would materially expand, based on: mix benefits - higher proportion of more profitable greenfield (including juniors) exploration; operating leverage – high degree of fixed costs in operating labs; and price rises.


Chart 10

Source: Imdex AGM presentation 2020

An approximate split of exploration spend by commodity

Global exploration spend

Chart 11

Chart 12

ALS potential for large upgrades to consensus

Source: Chester Asset Management, Iress


Explorers - Some of the most exciting ASX resource delineation plays

Resource Delineation / Development Plays

Finding existing discoveries that are progressing through the resource delineation phase is far less risky than swinging at pure greenfield explorers but anyone who has invested in this end of the curve or watched the movie Gold will understand there are unique risks in doing so. We have outlined above what we deem to be some of the most interesting discoveries listed on the ASX. As shown on chart 13, these companies are across a range of commodities over a range of geographies.

It is quite an art to capture the value of the de-risking phase while trying to avoid the pre start-up ‘orphan period’. We find chart 14 extremely useful in summarising the lifecycle of a mineral discovery. As outlined, capturing the speculation phase can be rewarding as can the pre production period, hence we have historically invested in this part of the market - very selectively.


Chart 13Explorers / Resource Delineation and Development Plays

Company Play Commodity/s Comments Catalyst/s

Adriatic (ADT) Vares, Bosnia & Herzegovina

Silver, Zinc, Gold, Lead, Copper

With an NPV8 of USD1,040m for capex of USD173m the Vares (Rupice and Veovaca) 'silver' project in Bosnia and Herzegovina shapes as an exciting development. There is also potential for further upside at Kizevak & Sastavci (Ag, Zn, Pb, Au) in Serbia.

Rupice Exploitation Permit Q1 2021. Vares DFS Q3 2021. Kizevak &

Sastavci resource Q2 2021

Alkane (ALK) Boda and Tomingley, NSW Gold + Copper

Although it could be argued this is an established producer with 50kozpa of gold production at Tomingley Gold Operations (TGO) the significant Boda Gold + Copper Porphyry prospect which is drawing analogues with NCM's Cadia mine shapes as the largest driver of value within the company. Roswell and San Antonio resource delineation at TGO which takes resource there close to 2Moz are also key.

Boda drilling ongoing with further assay results expected Feb 2021. San

Antonio Assays Jan 2021

American Pacific Borates (ABR)

Fort Cady, SC USA Boric Acid + SOP Hosting an NPV8 of USD1,368m from its DFS, as a low cost boric acid and SOP producer the Fort Cady project in

Southern California shapes as an extremely interesting and scalable project. Notably borates play into a number of growth narratives: food security, EVs, renewables, etc. and the market is somewhat of a (RIO dominated) duopoly.

Phase 1A first production Q3 2021

Atrum Coal (ATU) Elan, Southern Alberta Canada Coking Coal Large hard coking coal resource in thick, shallow coal seams, with favourable properties in a tier 1 proven low cost

mining jurisdiction. USD1,395m NPV9 based on updated scoping study work.PFS, June Qtr 2021

Auteco (AUT) Pickle Crow, Ontario Canada Gold Hosting an inferred resource of 1Moz at 11.3g/t with multiple new hits and zones identified outside of the resource area

as well as cross-over in some of the same team members sees AUT shape as the 'Canadian Bellevue'.

Accelerate drilling at Pickle Crow Q1 2021, resource update 1H 2021

Bellevue (BGL) Bellevue, WA Gold Hosting an indicated resource of 1Moz at 11.4g/t and total resource (inc inferred) of 2.4Moz at 10g/t shapes as a high grade undeveloped deposit in WA. Location near existing infrastructure provides for a potential low capital intensive development. Exploration now focused on resource growth across multiple lodes with 4 to 5 rigs currently on site.

Underground drilling results Q1 2021. Feasibility studies 1H 2021

Chalice (CHN) Julimar, WA Polymetallic (Ni, Cu, Pd, Pt, Au, etc)

Julimar marks Australia's first major palladium discovery in what is one of the most exciting exploration plays in Australia over the last 10 years. Many features make this discovery extraordinary: the grades and drill results to date at Gonneville, the combination of strategic Nickel-Copper-platinum (PGE) elements, ~26km long intrusive complex, the fact its near surface, the location (~70km NE of Perth), etc. A backlog of assay results and 6 drill rigs drilling make for an exciting period of newsflow for the company.

Ongoing drill results, Maiden resource estimate Q2/Q3 2021, Scoping Study

Q4 2021?

DeGrey (DEG) Mallina, WA Gold Mallina in the Pilbara already hosted a mineral resource of 37.4Mt at 1.8g/t for 2.2Moz but that excluded Hemi where results to date suggest an overall resource size multiples of this. The refractory nature of the gold however introduces an element of complexity and requires consideration in assessment of project economics.

Ongoing Hemi drilling 2021, Regional RC drilling results 1H 2021, Hemi

maiden resource mid 2021

Hastings (HAS) Yangibana, WA Rare EarthsHosting high contents of Neodymium and Praseodymium (42%) in rare earth oxides (REO) vs 21% for LYC provides for a very attractive basket price however the complexity in establishing and ramping up a separated rare earth supply chain should not be underestimated.

Updated resource Q1 2021, updated project economics Q1 2021

Ioneer (INR) Rhyolite Ridge, NV USA Lithium + Boric Acid

Although the flow sheet isn't as well establish as the spodumene players the Rhyolite Ridge project ticks a number of boxes: BFS NPV of USD1.27bn, positioned at the lower end of the LCE cost curve (if boric acid treated as a by-product credit), located in Nevada USA (close to Tesla), long mine life, with scalability subject to permitting. Furthermore The existing resource is open to the North, East and South providing for additional optionality.

Lithium offtake agreements 1H 2021, financing including strategic

partnership/s thereafter

Legend (LEG) Rockford, WA NickelVery early days but the intersection of massive nickel-copper sulphides in RKDD034 adds to the existing sulphide discoveries at Mawson.

Phase 1 metallurgical testing of Mawson Feb 2021

Mincor (MCR) Kambalda, WA Nickel Well funded, capital lite nickel play (16ktpa of concentrate) given processing and sales agreements with BHP Nickel West. Existing DFS Pre tax NPV7 of AUD305m however doesn’t include Cassini upside (18m at 5% Ni) or Long.

Cassini North drill results Q1 2021, Golden Mile drilling results Q2 2021, first nickel concentrate Q1 2022

Musgrave (MGV) Cue, WA Gold Hosting a high grade mineral resource already of 659koz gold including [email protected]/t at Break of Day makes MGV's Cue project one of interest. Notably Break of Day's high grade section starts only 3m below surface and would require low stripping to exploit. Management see the potential for lode repetitions in the South.

Ongoing drill results 1H2021, update resource Q3 2021, development

studies Q4 2021

Ora Banda (OBM) Davyhurst, WA Gold Outside of ALK, OBM is the most advanced of this list with Davyhurst scheduled to commence production this quarter in what will be targeting 80kozpa over 5+ years at AUD1,566/oz from 6 key deposits. We believe this is just the base for the project with strong potential for the resource and mine life to expand from definition drilling programs.

First gold pour Q1 CY2021, drilling results ongoing

Piedmont (PLL) Piedmont, NC USA Lithium PLL's integrated spodumene to hydroxide project is: lowest quartile, strategically located in the US, has a base case

NPV of USD1.1bn and has a spodumene offtake agreement with Tesla. Although current resource is 14Mt @1.1% Li2O indicated with a further 14Mt inferred we see potential for this to expand with PLL's current 5 rig drill program.

Resource update Q1 2021, lithium hydroxide offtake Q2 2021, Concentrator DFS mid 2021

Sheffield (SFX) Thunderbird, WA Mineral SandsWe point out that there are a number of undeveloped mineral sands projects that are interesting in their own right (STA, IMA, NMT) but we include SFX in this table given the recent investment by Yansteel of AUD130m for 50% of the project enables it to progress to Phase 1. Thunderbird is targeted as a large long life zircon, ilmenite producer to feed into declining global supply of Mineral Sands. The original BFS of the project had gross NPV8 of AUD980m

Updated BFS Q1 2021, project financing Q2 2021, FID Q2 2021

Stavely Minerals (SVY) Stavely Arc, VIC Copper + Gold

Similar to the established producers table we had to have a copper explorer because it really is one of the most interesting commodities on a medium to long term view with few high quality projects in the pipeline. There aren't too many companies reporting hits like SMD050 32m at 5.9% Cu, 1g/t Au and 58g/t Ag and SMD087 87m @ 1.74% Cu, 0.6g/t Au and 20g/t Ag. The Cayley lode suggests SVY could be in the early discovery stages of a new copper province

Mineral resource drill-out of shallow Cayley Lode 2021, scoping study on

Phase 1 Open Pit Mid 2021

Chart 14 The lifecycle of a mineral discovery


Winners and Losers of 2020 from the ASX200 Universe

This type of analysis is always rolled out at the start of a calendar year, it’s very simple to do, and generally tells you very little about a potentialinvestment. Broadly speaking we would prefer to have stocks at 52 week highs as opposed to 52 week lows, but having several underperformers in the portfolio often indicates better times are ahead (hopefully). We note that from this exercise at the start of 2020, many of the top performers in 2019 were also top performers in 2020. But there has certainly been a shift towards several mining stocks (given the strength in iron ore and lithium) and several gold stocks did well as did several consumer staples. The one sector that surprised us during the year was the broad strength in consumer discretionary names, given the stimulus packages available to households and SME’s. In hindsight, it is a sector we haven’t allocated capital to particularly well.

It has also been relatively challenging being a contrarian over the past few years, as there has been no sign of any real mean reversion on a sector basis, although there are always individual stocks that have a stronger year the year following a very poor year. So what do we glean out of the above tables? Given our process lends itself to a contrarian bent, we look for underperforming stocks that we can rationalise as to why they have performed poorly and finding evidence of why we think they can perform better in the period ahead. But the real reason for this exercise is to screen for new ideas, or even old ones that haven’t worked out as yet. We hold several of the worst performed stocks in 2020 that were all bought at various stages throughout the course of the year. We see reason for valuations to support shares prices in these cases, whereby we see very compelling risk reward equations over the next 2 years from where these stocks are trading today.

Downer (DOW) - trading on just 12.1x FY22 PER, as the business transforms towards its core business of urban services, it will generate meaningful free cash flow with far less capital intensity that the legacy business. We think as the market grows confidence in the relatively predictable nature of the business, the PE multiple can trade higher, given the 4.5% dividend yield will look compelling, as does a business that is geared towards infrastructure spending in Australia.

Lend Lease (LLC) - as the world recovers from the COVID lockdowns, LLC’s business model of developing urban projects in gateway cities around the world will continue to recover. The development pipeline has grown from AUD40bn to AUD110bn over the past 3 years, which sets LLC up for a period of very strong growth over the next 3 years. All while trading on an FY22 PER of 12.9x and a 3.6% dividend yield.

Austal (ASB) - ASB is a shipbuilder that wins large contracts, predominantly from Governments both in the US and Australia. It is currently trading on 10.5x FY22 PER as a AUD900m mkt cap company that will have over AUD300m in cash in February, so an EV (Enterprise Value) of just AUD600m. While tenders for new ship contracts can be lumpy, we think you can make a case for ASB to be valued at today’s share price just from the maintenance business alone, which generated AUD30m in EBIT in FY20 and will grow. The current share price factors in no new contracts, which we believe materially undervalues ASB’s long term track record as a successful builder, with the US Navy determined to increase their fleet size.

Aurizon (AZJ) - AZJ could be the most disliked stock in Australia, as it happens to be a logistics provider to the coal industry, which has become a very unpleasant phrase. The break down of coal transport is roughly 2/3rds coking coal (used for steel making) and 1/3rd thermal coal (used for coal fired power generation). The market doesn’t seem interested in distinguishing between these very different end markets. Besides that, roughly 50% of its EBIT is generated by an infrastructure return of operating a railway network which effectively a regulated utility, but again the market is very disinterested. Trading on 13.4x FY22 PER with a 7.4% dividend yield. It’s just too cheap.

Source: Chester Asset Management, TSR is Total Shareholder Return

Chart 15


The value/growth debate

We have spent a lot of time thinking through the ramifications of the value/growth debate, although we do find it overly simplistic. The most successful investment style over the past 7-10 years has been one of growth and momentum, which has been fueled by ever lower interest rates, providing an enormous tailwind to companies perceived to be higher quality and those deemed to be a “disruptor”. But if you have had a true value bias, it has been a relatively lean period. The underlying principles of value investing is effectively buying shares which are stakes in actual businesses, with the focus on true worth as opposed to price and the use of fundamentals (cash flows) to calculate intrinsic value. Investing in companies when there is a wide divergence between the price at which something is offered and the deemed valuation is the true definition of value investing.Thus the categorisation of value stocks is simply those that have the lowest multiples (PE ratios) or highest dividend yields. Value is a function of cash flows, growth and risk, and any intrinsic valuation model that does not explicitly forecast cash flows or adjust for risk is lacking core elements. Price is determined by demand and supply, and moved by mood and momentum, and you price an asset by looking at how the market is pricing comparable or similar assets. Many pure value investors seem to view discounted cash flow valuation as a speculative exercise, and instead pin their analysis on comparing on pricing multiples (PE, Price to book, etc.). After all, there should be no disagreement that the value of a business comes from its future cash flows, and the uncertainty you feel about those cash flows, hence discounting future cash flows at an appropriate rate.

But most of the debate centres around the lifecycle function of an industry structure, which is where we struggle with the theoretical value/growth debate. A growth stock can still reflect strong value (or a margin of safety) while just because a stock is cheap (on a PER basis) doesn’t mean it can never grow its cash flows. What we have struggled with over the past 5 years is the notion that many stocks in the young growth or high growth stages (as illustrated above) have been rewarded with what we view as disproportionate share prices for what in many cases are still unproven business models. It has never been more acceptable for a public company to lose money in pursuit of a large prize in the future, which clearly challenges the notion of any valuation margin of safety. We have seen the winner takes all notion of certain industries (think Amazon) where developing and scaling businesses has never been easier, thus the willingness of early stage investors to back “disruptors” has also reached unprecedented scale. We wrote a piece in 2019 around how we try to protect the portfolio from disruption risk asking ourselves seven key questions around business sustainability, which largely revolve around barriers to entry and pricing power. We feel while there is certainly an argument for many businesses to be valued in a sustainable manner (long term cash flows) many businesses lack the visibility in what those industries will look like in 3 years time. For many tech companies that promote Saas (software as a service) business models, we actually remain relatively cynical as to these companies’ ability to generate any meaningful recurring revenues before they are themselves disrupted, given the low capital intensity of tech start ups. Hence by and large, we have been very selective with the tech businesses we’ve owned over the past 5 years, simply as many of them haven’t passed our sustainability criteria, or been remotely close to offering a valuation margin of safety.We do believe to be a good equity investor you have to be wired as an optimist as the notion of taking a 3-5 year view on forecasting cash flows with any certainty is fraught with danger and a strong belief in the industry or management team’s ability to execute on their chosen strategy is required. The economic value of a sustainable moat across a technology platform has never been valued more richly. This is what we call the “intangible” value of a tech platform. These tech based businesses are both more vulnerable to disruption (from start ups) and more dominant in today’s world, which makes investing in this part of the market both hugely rewarding, but very susceptible to change at the same time. This is not to say we aren’t curious about new business models and potential “disruptors” because we are, but for us the goal at the end of the day is to try and figure out what the cash flows that a company can generate are worth, and buy them at a discount to that. The portfolio has also been designed to invest along the lifecycle spectrum, as observing and discovering early stage ventures can be very rewarding, if the business model stacks up.

Source: Aswath Damodaran

Chart 16


Australian Banks - what do we do now?

We have shown the key metrics that we assess when looking at the bank sector above. Given banks remain a material part of the ASX300 Index, it is essential to have a view. As a benchmark unaware strategy, it is highly unlikely that we would ever take an overweight position in the bank sector (which by definition, would mean allocating over 20% of the fund to banks). We have long held a cautious stance on the Australian banks for three relatively simple reasons. 1/ Net interest margins continue to be under pressure from the lower RBA cash rate (the spread between deposits and mortgage rates is being squeezed as deposits can’t go any lower, but variable mortgage rates can). 2/ We haven’t had a significant bad debt cycle since 2008 (chart 19 below). The stimulus packages announced in 2020 all but saved both the Australian economy and the banking system. 3/ A slow erosion of profit centres of the banking system from “fintechs” or non bank lenders. Credit cards, personal lending, auto finance, etc. are all being dis-intermediated by new entrants and new technology.We then take into consideration the significant discount to book value that the banks were trading on at the start of the 4th quarter, whereby all (ex CBA) major banks were trading on 0.7x book value, which was at historical lows. Hence, every stock has a price that drives a margin of safety to the investment thesis.What changed in October was the extremely supportive budget deficit the government delivered. This budget removed much of the downside risk to unemployment and hence significantly reduced the risk of a large spike in impairments. Given what has transpired in the 4th quarter, Australia has exited 2020 in strong shape, with house prices accelerating and renewed optimism for strong credit growth in 2021. As a result of this, banks have seen a very strong period of share price performance, which has largely been on the back of the prospect of materially higher dividends in 2021 than we would have thought 3 months ago. So what now?Banks are no longer cheap in the traditional sense, but still offer a large gap between the dividend yield and term deposits (chart 18). Our concern over the medium term remains the prospect for increased bad debt charges, particularly when the stimulus packages roll off and mortgage holidays cease. Structurally banks remain challenged with the issues we outlined above and hence we need a very strong margin of safety to consider them as a sector to allocate capital to.


Chart 17

Source: Goldman Sachs research Source: Goldman Sachs research

2020 2021 2022 2020 2021 2022 2020 2021 2022 2020 2021 2022

Share Price 24.68 24.68 24.68 85.11 85.11 85.11 24.02 24.02 24.02 21.60 21.60 21.60

Shares (m) - YE underlying 2,872 2,847 2,830 1,770 1,772 1,749 3,068 3,292 3,270 3,595 3,637 3,631

P/B 1.16 1.10 1.07 2.09 1.94 1.83 1.23 1.26 1.23 1.14 1.11 1.08

ROE 6.20% 8.20% 8.57% 10.58% 10.04% 10.68% 6.47% 8.80% 9.10% 3.83% 7.63% 7.60%

P/E 19.13 13.92 13.41 20.72 20.23 18.40 20.19 14.80 13.90 29.79 14.59 14.24

ROA 0.37% 0.50% 0.49% 0.74% 0.73% 0.78% 0.51% 0.61% 0.62% 0.29% 0.60% 0.59%

Yield 2.43% 4.55% 5.05% 3.50% 3.63% 4.13% 2.50% 4.44% 4.95% 1.44% 4.27% 4.63%

Grossed Up Yield 3.47% 6.50% 7.22% 5.00% 5.19% 5.90% 3.57% 6.34% 7.08% 2.05% 6.11% 6.61%

Loan growth 0.3% 2.2% 3.1% 2.7% 3.1% 3.0% 0.1% 2.1% 3.1% -0.9% 0.9% 2.5%

Net Interest Margin 1.62% 1.51% 1.47% 2.03% 1.95% 1.92% 1.78% 1.69% 1.64% 2.09% 1.96% 1.88%

Housing as a % of Total Loans 53% 70% 58% 71%

Business as a % of Total Loans 45% 28% 40% 27%

Credit Cards/ Personal as a % of Total Loans 2% 2% 2% 2%

Trading Income as % of Income 10.7% 4.0% 6.7% 4.5%

Wealth Management as % of earnings 1.02% 0.00% 4.41%

Offshore Earnings as % of earnings 20.5% 9.8% 16.3% 14.8%

Cost to Income Ratio 52.9% 48.5% 48.0% 45.9% 46.1% 45.5% 52.4% 45.6% 45.3% 61.6% 52.9% 52.1%

Pre Provision Operating Profit (PPOP) 8,369 9,041 9,007 13,293 12,556 12,933 8,912 9,265 9,464 10,299 9,373 9,330

Growth -16.0% 8.0% -0.4% -1.3% -5.5% 3.0% 8.6% 4.0% 2.1% -10.0% -9.0% -0.5%

Impairment Charges 2,738 1,638 1,333 2,518 1,893 1,441 1,969 1,551 1,155 3,178 1,479 1,269

Loans Past 90 Days due 3,844 5,600 5,314 3,348 6,614 6,694 4,255 7,060 7,323 8,532 9,153 9,398

Annualised Provision Charges to GLA - Specific 0.20% 0.31% 0.26% 0.18% 0.14% 0.13% 0.12% 0.32% 0.20% 0.05% 0.05% 0.07%

Annualised Provision Charges to GLA - Collective 0.14% 0.01% 0.01% 0.27% 0.16% 0.13% 0.35% 0.00% 0.03% 0.41% 0.21% 0.13%

Cash Net Profit (AUDm) 3,758 5,209 5,351 7,495 7,476 8,123 3,710 5,417 5,737 2,608 5,388 5,504

Cash EPS (AUD/share) - diluted 1.29 1.77 1.84 4.11 4.21 4.62 1.19 1.62 1.73 0.73 1.48 1.52

EPS growth -41.1% 37.5% 3.8% -13.3% 2.4% 9.9% -36.2% 36.4% 6.5% -62.9% 104.1% 2.5%

Dividends 0.60 1.12 1.25 2.98 3.09 3.52 0.60 1.07 1.19 0.31 0.92 1.00

Dividend Growth -62.5% 87.2% 11.0% -30.9% 3.8% 13.7% -63.9% 77.8% 11.6% -82.2% 197.8% 8.3%

Core Equity Tier 1 Capital 11.3% 11.2% 11.1% 11.9% 12.7% 12.0% 11.5% 11.8% 11.8% 11.1% 11.4% 11.2%

Total Tier 1 Capital 13.7% 13.8% 13.7% 13.9% 14.8% 14.4% 13.2% 13.4% 13.3% 13.1% 13.5% 13.3%

Housing Market share 14.4% 25% 15% 22%

Business Market share 15% 15% 22% 16%

Personal Market share 14% 27% 9% 16%

Deposits Market share 14% 25% 16% 20%

Loan to Deposit Ratio 91% 111% 109% 118%

Item

ANZ CBA NAB WBC

Banks yields are attractive relative to term deposits But it has been stimulus that saved bad debtsChart 18 Chart 19


How does inflation occur, what does it mean?There are a myriad of charts we could use here, but they all point to the same issue. The unprecedented money supply embarked upon by the US (and every other nation) in combating the economic cost of the pandemic has ramifications through 2021 and beyond. Central banks are very focused on getting unemployment lower, and thus will be happy to let economies overshoot to get confidence restored. The obvious medium term risk to this is a massive spike in asset prices, in which in many corners, we are already witnessing.Hence we view the set up for 2021 as very different from 2020. Commodities are a clear beneficiary from fiscal stimulus - and expectations of a globally synchronised recovery as all the northern hemisphere accelerates out the COVID induced lockdowns in the 2nd and 3rd quarters of 2021. We can see the relationship between commodities and the US 10yr on chart 21 below. It appears logical that the US 10yr yield continues higher. But whether it be Australian house prices, Bitcoin, commodities or stock markets, the outcome of this monetary policy is to increase asset prices. The prospect of inflationary forces though changes the type of sectors that will prosper. Hence we believe the leadership of the market will be very different over the next 2-3 years than it has been over the past 4-5 years. Clearly our focus remains on individual stocks, but the likelihood of a valuation based market with higher interest rates looks to us at least, the most probable scenario in the next 1-2 years.

Source: Jefferies Research

Chart 20

Source: JP Morgan

Commodities and interest rates diverging

US M2 growth - has provided enormous tailwinds

Chart 21

Chart 23Does inflation finally tip this relationship over?

Source: Jefferies research

Freight costs going up

Chart 24

Low rates and fiscal stimulus = Aust house prices up

Source: DoublelineSource: Macquarie Research

Chart 22


Charts that make you go hmmm...It’s actually just a way for us to not have to write as much. We comeacross many charts over the course of our readings and being relativelyvisual, subscribe to the notion that a picture can tell 1000 words.Much of our thinking is framed by “lines that move up or down” so we willstart showing a select range of charts that we have come across...withouthaving to explain them!

Source: Bianco Research

Chart 25

Source: JP Morgan

Are we reaching the end of the USD as a reserve currency?

This is not rational

Chart 26

Chart 27

Is Bitcoin going to infinity?

Source: Rosenberg Research

High Quality firms still extremely expensive

Is 2020 like 2000? Interest rates are the key difference

Source: Corey Wang, Bernstein Research, April 2000

Source: Goldman Sachs

Chart 28

Chart 29


Our executive summary

Equities All else being equal, equities remain attractively valued relative to bonds. The prisoners dilemma we all face is how to generate low risk returns in a world where the risk free rate is effectively zero. This conundrum has caused several pockets of significant speculation in various asset classes, which we think will give rise to higher volatility through 2021.

By and large we prefer to be contrarian with our investments which has been remarkably difficult over the past 5 years. Our most successful ideas have either been somewhat unloved or undiscovered stories. This may be famous last words, but we can’t see the recent trend of technology outperformance continuing throughout 2021, refer to chart 25 on page 15. The valuations are simply fanciful in many cases. The prospect of structurally higher inflation led by money supply and a weaker USD, which is supportive for commodity prices lends itself to the view that a rotation in style continues throughout 2021.

But by and large, our focus remains on:Essential services - WOW, CSL, ASB, ALX, ABBIndustry leaders - ALL, QUB, RHCStrategic assets - AZJ, LYC, CNU, SM1Economic recovery focused stocks - SKC, UMG, WBC, DOWGold - OGC, SAR, AMI

There is the prospect of a more conciliatory tone between the US and China as President Biden is faced with what appears to be the significant task of moderating the US political climate and attempting to heal the rift between the two major parties. We do see the appointment of Janet Yellen as the Treasury secretary as a signal that under this government, monetary policy and fiscal policy will be intertwined. This possibly assists in removing any policy errors as the US attempts to restart their economy in the second half of 2021.

Having said that, we are genuinely excited by many of the stocks in the portfolio today, where we can justify materially higherprices over the next 12 months. As we have demonstrated over the past 7 years with this strategy, the returns we generate dodeviate significantly from the benchmark, where we are proud of the track record of the strategy, delivered with lower volatility than the ASX300.

Gold Gold effectively has a dual purpose. As a store of safety in uncertain times, which we have just witnessed, and as a store of value when inflation occurs, which hasn’t occurred yet, but appears inevitable with the increase in the money supply. It has proven highly successful in outperforming when equity markets fall through the course of history and hence remains a valuable allocation to the portfolio construction.We spend much of our time analysing gold equities which are selected primarily on valuation grounds first, and then an assessment of the quality of the resources and cost of extraction. Clearly management competency and a track record of delivery is also an important variable.

Government spending and bond yields

The enormous increase in deficit spending across the globe to ensure the unemployed workforce can pay bills has left (and will leave) most central banks with an insurmountable debt burden. There is no longer any pretense of any political party anywhere to try to repay these debt burdens the future generations are faced with. Interest rates simply cannot rise with the amount of debt issuance by central banks, and it appears we are more likely to see negative interest rates in the US, than higher interest rates in the foreseeable future.With this backdrop, the only way interest rates ever rise is with significant inflation, as the only way the debt burden to societygets repaid, is through asset reflation, or in some cases, debt forgiveness.Central Banks (led by Japan) have had no other playbook since the GFC, and will continue to issue new bonds to finance thedeficit spending of governments, and the debt burden. Since Alan Greenspan, Fed governors have always issued a “put” on the stock market with new easing policies, which in the next downturn, eventually becomes yield curve control, and ultimately direct equity purchases, if needed.

Currencies Our track record of predicting currency movements is very poor, but we offer the following thoughts.Given the level of deficit spending in the US relative to Europe, and the relative success in getting the economies reopened safely, it appears the US dollar may be entering a period of underperformance (relative to the EUR), which is helpful for emerging economies that are faced with high USD loans. It also augurs well for commodities that are priced in USD. This has played out to a large degree in the second half of 2020, but we see reason why these trends persist through much of 2021.Generally speaking, we were surprised with the strength of the AUD through the worst of the pandemic, but point to both the interest rate differential in Australia and the strength of our terms of trade (iron ore exports) that suggests the AUD remains higher than we originally anticipated, which acts as a headwind for AUD denominated offshore earners in 2021.

Risks The outlook remains more optimistic as we enter 2021, with the prospect of a globally synchronised recovery post vaccine roll out in the second half of the year. Still, the complete reliance of asset markets on stimulus packages and government spending combined with historically low interest rates means heightened risks of policy error. Combined with pockets of speculative frenzy, there is always reason to remain vigilant on the portfolio. If 2020 has taught us anything, anability to be nimble and change our assessment of the likely outcomes is critical to not only protecting capital, but identifyingopportunities when they arise.


Past performance is not a reliable indicator of future performance. The total return performance figures quoted are historical, calculated using end-of-month mid prices and do not allow for the effects of income tax or inflation. Total returns assume the reinvestment of all distributions. The performance is quoted net of all fees and expenses. The indices do not incur these costs. This information is provided for general comparative purposes. Positive returns, which the Chester High Conviction Fund (the Fund) is designed to provide, are different regarding risk and investment profile to index returns. A performance fee of 15.0% is payable quarterly on any excess performance (after deducting the management fee) above the benchmark, S&P/ASX Small Ordinaries Accumulation Index. A performance fee is only payable where the unit price is higher than when the last performance fee was paid. This document is for general information purposes only and does not take into account the specific investment objectives, financial situation or particular needs of any specific reader. As such, before acting on any information contained in this article, readers should consider the appropriateness of the information to their needs. This may involve seeking advice from a qualified financial adviser. Copia Investment Partners Ltd (AFSL 229316, ABN 22 092 872 056) (Copia) is the issuer of the Chester High Conviction Fund (ARSN 620 091 858). A current PDS is available from Copia located at Level 25, 360 Collins Street, Melbourne Vic 3000, by visiting chesteram.com.au or by calling 1800 442 129 (free call). A person should consider the PDS before deciding whether to acquire or continue to hold an interest in the Fund. Any opinions or recommendation contained in this document are subject to change without notice and Copia is under no obligation to update or keep any information contained in this document current.

1800 442 129 | client [email protected] | copiapartners.com.auCONTACT COPIA

chesteram.com.au

John Clothier General Manager, Distribution 0408 488 549 | [email protected] Mason Director, Institutional Business 0412 137 424 | [email protected] Papakonstantinos Distribution Manager 0439 207 869 | [email protected] Roberts Distribution Manager 0438 297 616 | [email protected] Fernandez Distribution Manager 0414 604 772 | [email protected] Harris Distribution Manager 0429 982 159 | [email protected]

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