Annual Letter 2013

Dear Unitholders,

Our fund generated a satisfactory return during the year, but underperformed both Australian and world share markets as you can see in the following table.

To 30 June 2013	STAR	All Ords	MSCI ($A)
1 year	18.82%	20.67%	31.26%
3 years (%pa)	23.80%	7.96%	9.85%
5 years (%pa)	14.41%	2.19%	3.95%
Since inception on 1 Nov 2003 (%pa)	9.67%	8.42%	4.33%

There are several reasons for this underperformance. First, we had an average of 9% of the fund in cash during the year. Second, deep value funds (which I perceive this fund to be) often underperform in strongly rising markets, but tend to do better (relative to the market) in weak markets. Our relative performance has tended to follow that pattern. The biggest cause of the fund’s underperformance was Australian timber producer RuralAus, which reduced the fund’s value by about 7% during the year. RuralAus has been substantially restructured this year and I am now optimistic about its prospects.

I am pleased to report that the fund is up about 14% since 30 June, and as a result, the fund has achieved its long term goal of generating a net return of over 10%pa. As well as outperforming most indices and most other funds, we have also had less volatility than the Australian share index.

Welcome to Nigel Burgess

The most significant change at Samuel Terry during the year was the appointment of Nigel Burgess as a non-executive director in November 2012. Nigel and I have known each other professionally for over 25 years, and we worked together in London in the late 1990’s. We have worked closely together on investments for the last few years and Nigel found several of the fund’s more successful investments, including Challenger Kenedix, Nexus Bonds and Lion Selection. Nigel is also a large unit holder in the Fund. He has already added a lot of value to the fund. I hope and expect that he will become more involved in the company over time.

GFC wreckage

In recent years, we have spent a lot of time looking at, and investing in securities that were damaged (often severely damaged) by the Global Financial Crisis, or GFC, of 2008-2009. As part of this process, we bought distressed debt in companies like CIT and Timbercorp. We bought shares in companies that had borrowed far too much, but had solid underlying assets, like Keybridge Capital, Ingenia Communities and Infigen Energy.  

We bought shares in two of the world’s finest banks, Goldman Sachs and Macquarie, at less than their net tangible asset (“NTA”) value. I was particularly excited to have made those purchases because both banks have cultures and franchises which mean they are likely to earn high returns on equity for many years to come. Both have significantly de-risked their balance sheets compared to the pre-GFC era. During the year, Macquarie shares rose to almost twice NTA value, causing us to sell our shares. About 7% of the fund remains in Goldman Sachs, which continues to trade at only a modest premium to NTA.

We suspect that the period during which one could find real bargains in the GFC wreckage is drawing to a close, but even so, we are still finding occasional bargains in the rubble. A recent example is our purchase of shares in Galileo Japan Trust, a near-bankrupt property owner we helped to resuscitate on attractive terms.

Diversification

It is arguable that we could and should have devoted even more time and money to GFC wreckage in recent years. We deliberately ignored some opportunities because we wanted to retain some exposure to higher quality, safer companies like Microsoft and Centuria Capital as a form of diversification. Having the majority of the fund in cash, or in securities backed by net cash on the issuer’s balance sheet helps us to sleep soundly, as does the lack of debt in the fund itself.

Because we do not have the ability to accurately predict economic and market conditions, we aim to diversify in a way that can be expected to do reasonably well across the widest possible number of potential scenarios. This requires that our strategy is able to overcome not only occasional bear markets and dislocations, but all of the other hurdles that are endemic to active investment management. The list includes bad luck, bad timing, and occasional mistakes in judgment. Most importantly, any truly robust long-term investing strategy must be built to survive the worst possible scenarios the market can throw at us and allow us to live to play another day. If we do this, we are unlikely to be the best performers in any given year, but we do have a good chance of continuing to generate satisfactory overall returns.

Liquidations – and our decision to temporarily close the fund to new subscriptions

Partly as a consequence of our fossicking in GFC wreckage, and partly because I have long had a penchant for investing in debt and equity in liquidation, about a quarter of the fund is invested in securities that are in a form of liquidation. Many investors shy away from such securities, but we believe we can generate good returns from them, especially the more illiquid and complex liquidations where few other investors compete against us.  If bought correctly, such securities can offer high returns, with modest downside risk, as these companies all have solid balance sheets.

The following table lists our securities in some form of liquidation at 30 June 2013:

NAME	fund Weighting	Price[1]	NAV per share[2]	Discount to NAV
Asset Resolution Ltd[3]	5.54%	0.01	0.02	50.0%
BAO Trust	5.37%	0.061	0.110	44.5%
Hamilton Securities	1.26%	0.30	0.95	68.5%
Kangaroo Island Plantations	8.06%	2.00	12.03	83.4%
Keybridge Capital	8.94%	0.14	0.190	26.3%
TOTAL	29.16%

The NAV numbers are based on public information, but are inherently very imprecise. They are not predictions and we caution against reliance on these numbers.  We have included them to illustrate our view that the reported value of our fund understates the actual value of our assets. The key point to note is that all of these securities are, in some form or other, liquidations, where the gap between the share price and the underlying value is likely to close as the underlying assets are liquidated and the proceeds returned to shareholders. While timing is uncertain, we expect most of these liquidations to be complete within the next year or two.

This wide gap between underlying value and stated value was the reason we temporarily closed the fund to new subscriptions in August 2013. As fund managers, we’d love to grow the business by welcoming new investors, but we found it too difficult to price the above holdings in a manner that is fair to both existing and incoming investors.

We do not know when the fund will re-open to new subscriptions, but do not expect the closure to last a long time. This decision does not affect your rights to withdraw some or all of your capital from the fund.

Outlook for the fund

The end of the “easy” pickings from the GFC wreckage, and the strong performance of world share markets in recent years are making it increasingly difficult for us to find attractive investments.

As a result of global money printing, high-quality bond yields are so low that such bonds have been transformed into “return-free risk”. For the same reason, high-yield debt (one of my traditional hunting grounds) is now priced at unattractive levels, reflecting the desire by many investors for “yield”, and their apparent willingness to ignore risk.

Fund managers globally seem to be keener to chase performance by taking risks, and the investment banks and other promoters are, as always, ready and waiting with over-priced IPOs to satisfy that demand.

Despite the stronger markets, we remain optimistic about the fund’s outlook and thank you for your support.

Yours sincerely,

Fred Woollard

31 October 2013

LIST OF HOLDINGS AT 30 JUNE 2 2013
Air Change International Ltd	0.59%
Asset Resolution Ltd	5.54%
BAO Trust (prev Brookfield Aust Opps Fund)	5.37%
Calliden Group	5.74%
Centuria Capital Ltd	9.76%
Commstrat Ltd	0.21%
Esperance Minerals Ltd	0.37%
Greenvale Mining NL	0.74%
Hamilton Securities Ltd	1.34%
Infigen Energy	4.53%
Ingenia Communities	4.90%
ITL Ltd	4.35%
Keybridge Capital Ltd	8.94%
Macarthur Cook Property Securities	2.05%
Nexus Energy 8.5% notes due Jan 17	1.35%
Premium Income Fund	0.77%
RuralAus Investments	8.06%
Saracen Mineral Holdings	3.27%
TFS Corporation	2.64%
TOTAL AUSTRALIAN SECURITIES	70.50%
Astro Japan Property Group	4.26%
CIT Group	4.35%
Goldman Sachs	7.05%
Macquarie Atlas Roads	8.43%
TOTAL OVERSEAS SECURITIES	24.09%
Cash	5.41%

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[1] This is the price at which the securities are valued in the fund’s accounts.

[2] This is the net Asset Value per share as per the underlying companies’ published accounts at 30 June 2013.

[3] Asset Resolution claims to have NAV of 3.6 cents per share, but we think that is far too optimistic.