Platinum Asset Management

PCL Cumulative Performance Of NAV (Pre-Tax) And Share Price Versus MSCI World Accumulation Index
We have found the last quarter very difficult and as a result, the fund declined 3.5%, falling below the 1% gained for the MSCI World Accumulation Index. Apart from the markets continuing to focus on momentum plays, several stocks in our portfolio took a pounding: in particular Novell and Showboat in the US, and Olivetti in Italy. The July sell-off in Wall Street was accompanied by weakness in Europe. This principally stemmed from a weakness of the US dollar which raised concerns about the European economic recovery. The "lead balloons" will be discussed later, but before doing so we would like to reiterate that as a manager seeking anomalies in the pricing of businesses, there are times when our return will lag the field for reasons of underestimating turnaround times, paying too little heed to fashion and so forth.

Intra-market volatility is also characteristic of present conditions where individual shares can be unexpectedly hammered. By way of illustration, IBM was trading at around US$90 at the beginning of the quarter having retraced from an earlier high of US$125 in March. Faced with this type of price action, it is very easy for a manager to become dispirited. Our response is to retest our views and reappraise our profit projections and if everything is on track, stay with our position or even add to it. This we did with IBM and concluded that it is one of the cheapest, moderately cyclical stocks within our universe, with little value being attributed to its extraordinary breadth of activities, its emerging high growth service stream and encouragingly agile embrace of the internet. The share price has subsequently recovered by 35%.

There is much hype of a corporate renaissance in the US, with particular excitement surrounding the internet and consumer "growth" companies. We thought it instructive to consider the facts and present them to you. It appears that, contrary to opinions that have become accepted wisdom in the current bull market, this cycle is little different to any other. The spectacular earnings gains of the nineties, which have captured the imagination of investors, should be viewed in terms of a longer history. These gains were off a low base and have been fuelled by a weak dollar and a significant decline in finance costs.

	1986-95	1926-95	Current
Compound Annual Growth Rates	%	%	%

Sales	6.4	-
Operating Profits	7.1	-
Pre-Tax Profits	5.4	-
Earnings Per Share	4.2	6.3
Cash Flow Per Share	4.5	-
Net Asset Value Per Share	0.3	5.3
Industrial Index (S&P 400)	11.4	6.4
Profitability (Averages)
Return on Average Capital Employed	19.3	-	21.9
Return on Average Equity	16.6	12.4	22.7
Operating Margin	9.9	-	11.3
10 year Bond Rate	7.6	6.5 *	6.7
Inflation	3.5	3.2	2.9
* (1950-95) Valuation (Averages)

	x	x	x
Price/Earnings Ratio	19.6	12.9	22.5
Price/Cash Earnings Ratio	9.2	-	11.5
Price/Net Asset Value	3.2	1.7	5.0
Enterprise Value/Sales	1.1	-	1.5

It should be noted that the growth rates shown are trend values. Owing to current high profitability, ten year "point-to-point" earnings growth rates are noticeably higher. All growth rates include the effects of inflation.

The table illustrates the moderate growth in earnings and net asset values over time and the current high level of profitability (evidenced by high margins and returns on equity). Paradoxically, valuations (which encapsulate future expectations) are also high in an historical context.

Our research revealed other interesting features of the past decade. The companies comprising the S&P 400 Industrial Index have sales of $3.2trn, employ 16 million people, and have a market capitalisation of $4.2trn, about 60% of GDP. While many of these large US companies have been restructuring, the number of employees has actually increased by over one million during the period. Working capital, at 21% of sales, is in line with the historical average and notwithstanding the popularity of share buy-backs, shares outstanding have increased by 14%. Net indebtedness has risen, both as a percentage of equity (now 83%) and in relation to sales. Signs of improved efficiency is evidenced by higher sales to net fixed assets which have risen from 2.2 to 2.7 times and sales per employee have grown by 6% compound.

While it is recognised that statistics only give an outline of trends, we would venture some conclusions. In aggregate, nothing much appears to have changed. The US is currently at a high point in profitability (possibly at a peak) and the normal cyclical downturn should be expected in due course. Although some analysts continue to be optimistic, there is increasing evidence of slowing earnings momentum. Rolling figures for the last four quarters show virtually no earnings growth. Most expectations are for a reacceleration in the next six months. This should not be treated as a foregone conclusion.

Not all markets are extended. Many of the tiger markets of Asia have been declining with the downturn in global trade and in Europe, France and Italy are barely higher than four years ago.

Let us return to those companies which cost us money. The woes of Olivetti and the machinations of the board of directors have been well covered in the newspapers. As analysts, we were particularly disappointed in the first half results and the blow-out of debt. However, partly offsetting these negatives is the extraordinarily strong showing of the 42% controlled Omnitel mobile phone business. To date it has signed up 560,000 connections (versus a budgeted 350,000 for the whole of 1996). From our earlier writing on the company, you will be aware that the true attraction of the company is its mobile phone business. Importantly, pre-emptive rights among the other shareholders in Omnitel should protect this asset from being removed disadvantageously from the Olivetti group. Providing Omnitel continues to grow (and note that the success to date has been achieved with very little buying of connections), this asset alone is worth nearly twice the current Olivetti share price of 530 lira. In addition, there is value in the traditional parts of the company. To provide for an adequate margin for error, we have valued the PC business, which has 4.3% of the European market, as having a negative worth of 250 lira per share. The facilities management and systems integration business we think is worth around 900 lira per share, while the Lexicon printer business may be worth 250 lira per share. Offsetting these positives is debt which could amount to 600 lira per share at year end. This leaves us with a value of over 2x the current share price. In case you feel we are playing yesterdays' game of break-up values, consider the recent evidence of further consolidation within the European telecommunications industry. BT paid $1.7bn for 25% of Cofira which controls one of three mobile operators in France. The forces at work, namely institutional pressure, and industrial and financial logic, all point to major changes being made to Olivetti within 6-12 months. Experience suggests that there is a level of uncertainty and embarrassment attaching to Olivetti that is normally associated with a major bottom in terms of the share price.

Of the two US stocks which have been very weak, Novell has proved in retrospect to be a poor investment decision. We placed too much faith on its vast user base and under-estimated the resistance of users to upgrade to Netware 4.1 in the face of intranets and Microsoft's NT offering which bundles many of Netware's functions. We are gradually selling down this holding.

The share price of Showboat crumbled with the sharp retracement of the gambling sector in the US but is still above our entry cost and we are cautiously adding to this position. From our perspective, the essence of the Showboat story is its ownership of the management rights to the Sydney Harbour Casino. As the sole facility within 350kms of Sydney, Showboat is endowed with a unique asset. Trading to date at the temporary site has been disappointing but this can be largely attributed to the cramped nature of the present temporary accommodation. Once the A$1bn casino complex, with its 500 hotel rooms and apartments, 2 theatres and 2,500 parking spaces, opens in December 1997, the story should change appreciably. We estimate that Showboats' annual profits from the management contract alone should be worth close to US$15mn (US$0.90 per share).

In the meantime, the company continues to earn relatively steady cash flows from its principal casino in Atlantic City, loses a small amount in Nevada and is due to open its Chicago East property in June 1997. With a market capitalisation of US$365mn, this makes it a very interesting takeover target to probity-approved bidders. However, this is not fundamental to our owning the shares as there are considerable barriers to a takeover, including family control, a poison pill defence mechanism and probity consideration.

On currencies, we are hedged out of the Yen and hard European currencies into Australian dollars.

Turning to the portfolio, we can dissect it along the traditional geographic lines or in terms of our investment categories. As you may appreciate from our earlier commentary on the S&P index, we pay close attention to historic relationships and patterns in an attempt to avoid the deafening thunder of near term events.

To find underpriced stocks we are looking for anomalies. Over 40% of the portfolio comprises large, well known companies with superior underlying business characteristics which for transient reasons are being valued at less than the market average or for less than their historic valuations. (The best measure we have of superior businesses is that they display above average profitability and earnings growth over an extended period). Half of those are global in scope with strong brands and average to above average growth prospects and include the likes of IBM, Nestlé, Fuji Photo Film and Canon. The other half have similar characteristics but have more of a national orientation and include Yokogawa, the Japanese Coke bottlers, Tabacalera, Souza Cruz and the Brazilian banks. 15% of the portfolio comprises companies going through restructurings and these include Alcatel, BNP, Lagardere, Lyonnaise des Eaux, Daimler Benz and Olivetti. There is then the group with long gestation but large price appreciation potential which includes the Korean banks, Showboat, Zeigler and some of the emerging market holdings, and these make up 16% of the portfolio. Lastly there is 5% in cyclical, shipping and commodity producing companies, and 3% on the sell list.

Investment Outlook
Though we continue to have difficulty finding companies that make attractive investment sense, the underlying environment is positive for financial assets. Inflation, even in countries that have bad records and who have seen large depreciation in their currencies in the last four years, are experiencing unusual price stability. Liquidity remains plentiful as European central banks stay highly accommodative in the face of their governments' pursuit of Maastricht imposed austerity, while the Japanese continue to price money at close to zero interest cost. Amidst this financial boom, the liquidity has been concentrated on the two asset classes of stocks and bonds to the almost complete exclusion of property. However, the first signs of leakage into the property market are becoming apparent. In the year to August, median house prices in the US have risen by 6% and the UK has also seen a gradual recovery in housing prices. The lack of pricing flexibility, which is a function of the removal of trade barriers, slow growth and a changed buyer psychology, is a dark spot for corporate earnings. This accounts for the very high valuations that are being placed on companies with perceived growth potential. Even so, the growing evidence that the recovery is gaining momentum in Europe and Japan should ensure that well chosen stocks in these markets will give good returns.

There are also interesting investment opportunities in some markets in South East Asia which are well below their peaks of 1993. Further, it is of note that while the yields on Brady bonds have declined significantly relative to US Treasury's, this has not been matched by a corresponding appreciation in some stockmarkets. This is causing us to focus on countries such as Brazil.

This idyllic world of low inflation, continuing growth in Asia and the US, plus recovery in the stubborn economies of Europe and Japan, combined with limited absorption of liquidity by real economic activity, is about as good as it gets. We continue to search for stocks where the opportunities are less apparent.