Markets
We have found the last quarter very difficult and as a result, the fund declined 0.8%, falling below the 3.5% 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 "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 over 40% to US$130.

There is much enthusiasm about a corporate renaissance in the US, with particular excitement surrounding the internet and consumer "growth" companies. Having spent some time analysing company performance, we can find no factors that have permanently lifted corporate profitability. The strong earnings gains of the nineties, which have captured the imagination of investors, can be attributed to three main causes; wages have trailed inflation; interest costs have declined; and a weak dollar has benefited export profits and the translation of multi-national earnings.

If one examines the S&P Industrial Index over an extended period, say from 1926-95, some surprising statistics arise. The compound increase in earnings over this time was 6.3% pa, which compares with inflation averaging 3.2% pa. At the same time, the return earned by company's on shareholder's funds averaged 12.4% pa, whereas the yield on a ten year government bond since 1950 has averaged 6.5%. Dull as you may find some of these statistics, the important point is that the present return on shareholder's funds is almost twice that of the last 69 years, even though inflation and the yield on the government bond are in line with the historic average (6.7% and 3.0% respectively).

As noted above, we can not identify any factors that have permanently lifted the profitability of companies and hence believe that 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 low single digit growth. Most expectations are for a reacceleration in the next six months. This should not be treated as a foregone conclusion. We believe earnings are going to fall short of expectations and hence continue to hedge our US share exposure.

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.

Disposition Of Asset

Region	31 October 1996	31 July 1996
Japan	24%	31%
Other Asia	7%	8%
Australia	1%	1%
Western Europe	26%	21%
North America	9%	10%
South America	9%	7%
Total Invested	76%	78%
Cash & Equivalents	24%	22%
TOTAL	100%	100%

Top Ten Holdings (as at 31 October 1996)

Stock	Country	Industry	% Holding
Fuji Photo Film	Japan	Photographic Products	4.4%
IBM	USA	Information Technology	4.0%
Lagardere	France	Media/Defence	3.7%
Sekisui House	Japan	Housing	3.4%
Canon	Japan	Office Equipment	3.3%
Matsushita Electric	Japan	Consumer Electronics	3.1%
Yamanouchi Pharm.	Japan	Pharmaceutical	2.3%
Daimler Benz	Germany	Auto Manufacturer	2.1%
Delta Airlines	USA	Airlines	1.8%
Nestlé	Switzerland	Food Manufacturer	1.8%
TOTAL			29.9%

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. 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 twice the current Olivetti share price of 450 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 continuing jockeying for position that is evident in the European telecommunications industry. BT recently paid $1.7bn for 25% of a company which controls one of the 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 dull but this can be largely attributed to the cramped nature of the present 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.

Turning to the portfolio, it can be dissected along 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. Some 42% 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. 10% 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 11% of the portfolio. Lastly there is 7% in cyclical, shipping and commodity producing companies, and 2.2% 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.

KERR NEILSON

Managing Director - Platinum Asset Management

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