ELEVATION CAPITAL - SECOND QUARTER REPORT

Dear Fellow Unitholders,

After several quarters of strong stock market returns, sentiment based mainly on macroeconomic concerns saw global markets sell off aggressively during the second quarter. Sovereign debt concerns which started in Greece spread east and west. The concerns centre around the debt burden of certain European Union nations and Japan at present, with many asking when the tide will turn on a seemingly profligate US as well. Despite its own particular issues, the New Zealand economy is in an enviable position when one looks solely at Government debt burdens versus the aforementioned Government fiscal positions. However, this did not spare the NZSX from the global sell-off with the NZX 50 declining -9.05% during the quarter. [This compares to the S&P 500 -11.4%, FTSE 100 -13.43%, Nikkei -15.40%, Hang Seng -5.2%, ASX 200 -11.61%]

The Multi Strategy Fund and Value Fund suffered significantly smaller declines, compared to the indices, reflecting the benefits of holding a portfolio of stocks that are asset rich / well financed. Also, positive developments within some portfolio companies with regard to industry consolidation, and our preference for maintaining a cash position within the Fund/s enabled us to purchase securities during the sell-off.

 
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There has been a significant flow of funds into the perceived “safety” of bonds versus “risky” equities. (See table below on US Bond / Equity Fund inflows from Lipper FMI) – while data in NZ is harder to source it is reasonable to assume that investors here also currently prefer bonds over equities). In my opinion, such investors are putting themselves into a position of significant risk if interest rates rise as is reasonable to expect in the next 12 – 24 months. This is also a function of the very short time horizons that investors now seem to hold (as evidenced by heightened volatility in markets). For example, in the US, there seems to be very little concern about bond yields versus long term inflation rates from investors. It seems to me that retail investors by seeking the perceived safety of bonds enmass have not given due consideration to the unintended consequences of “group think” which is clearly evident based on fund flows.

 
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To provide further illustration of the preference for bonds vs. stocks at present, US 10 year Treasuries currently yield 2.98% as at the close of business 28 July 2010 (US Time). This compares to the current dividend yields on a selection of US / Global Blue Chips: McDonalds ~3.1%, Johnson & Johnson ~3.4%, Heinz ~3.8% and Royal Dutch Shell ~5.9%.

In New Zealand, 10 year Government Bonds currently yield 5.37%. By way of comparison, even a basket of New Zealand retail stocks yield significantly more than this providing investors with +~6.25% NET in the case of The Warehouse or Briscoes and Hallenstein Glasson’s, offering a NET yield of +~7% (based on GSJBW forecasts). What’s more, both Briscoes and Hallenstein Glasson have substantial net cash positions which provides a “margin of safety” that is not always present for equity market investors.

I also remain firm in my convictions that the world economy is not about to grind to a halt. I do agree that governments globally (with exceptions in the Asia Pacific region) have too much debt and there is a risk of currency debasement. But if one switches to corporations globally they continue to hold / generate significant cash and are trading at low multiples and attractive dividend yields (which seem sustainable). If one uses history as a guide it shows that -- (i) it is always a good time to invest when no one else wants to – or as Buffett says “you pay a very high price in the stockmarket for a cheery consensus” – from where I am sitting there does not seem to be much “cheer” around at present; (ii) well financed, asset rich (both in terms of brands and physical assets) companies have proven themselves adept at outpacing inflation over time and (iii) high quality companies will continue to maintain a competitive advantage which will drive market share growth at the expense of smaller / weaker players. This will translate into earnings / dividend growth and in time higher stock prices.

For those investors willing to depart from the crowd and take a truly longer term view – I believe that this will prove an opportune time to have been an “equity market” investor versus a “bond market” investor.

Our Fund/s continue to hold a unique portfolio of undervalued assets / franchises around the globe. Furthermore, within New Zealand (by far our largest geographical exposure) several investments look set to enter a transformative stage which may result in a re-rating of their valuations in our portfolio. Based on these facts, I (personally) continue to purchase units in our Fund/s as my circumstances permit.

 
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Within the Multi Strategy Fund, we were a little more active in the second quarter than more recent times with participation in several rights issues / placements and other investment realisations allowing us to redeploy capital into a total of 17 new investments (see portfolio listed above / commentary below) -- many of these we have invested in previously or have been researching over some period of time.

The investment realisations during the quarter are detailed below:

 
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The portfolio expanded within the following strategies / into the following stocks during the quarter:

  1. Event Driven: India Equities Fund and Van Eyk Three Pillars are both companies listed on the ASX that have announced plans to liquidate and are therefore best described as arbitrage positions for the Fund. Celsius Income Fund in New Zealand is also an arbitrage position for the Fund. Terra Nova Royalty is splitting into a royalty company listed on the NYSE and a cement manufacturer listed in Germany. We plan to sell the cement company and hold onto the royalty company as we believe it to be undervalued on an intrinsic value basis. Fosters Group in Australia is undertaking a demerger. We bought the stock after the initial announcement as “demergers” have been a lucrative area for the Fund historically (eg. PBL/Crown). Furthermore, with Fosters free from the shackles of a value destructive wine business it is increasingly likely it will both improve its own operational performance (which should be EPS / DPS positive) but may also see it become an attractive acquisition target for global brewers such as -- SAB Miller, Asahi etc.

  2. Opportunistic: We acquired positions in the following stocks for a variety of individual reasons – but mostly because they were offered at attractive valuations for the Fund during the recent sell-off (some of the holdings we have owned before in the Fund): Arden Group (US), BP plc (UK), Guyenne et Gascogne (France), Just Water (NZ), National Western Life Insurance (US), Nestlé (Switzerland), Pfizer (US), PrimeAg (Australia), Royal Dutch Shell (UK), Shimano (Japan), Syms Corp (US), Wakefield Healthcare (NZ).

 
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At the beginning of the quarter CBS Canterbury, Southern Cross Building Society and Marac announced that they had signed a memorandum of understanding to explore a merger to create a NZ owned and NZX listed bank. As many of you are aware, industry consolidation was a primary driver of our initial investments in both CBS Canterbury and Southern Cross Building Society. I recently attended the 135th AGM of CBS Canterbury on 20 July 2010 in Ashburton where the merger timetable was outlined as follows:

  • Mid / Late August – Merger terms will be announced;

  • Mid / Late November – SGM will be held by CBS Canterbury to vote on the proposal.

Independent appraisal reports can be expected to be released well in advance of the SGM.

According to the Chairman of CBS Canterbury, the merger discussions are proceeding to plan and there remains a willingness on all sides to see a transaction complete as the parties believe this to be in the best interests of all shareholders / depositors and that they have a unique opportunity to create another NZ-owned bank.

I agree with these thoughts and while it will take time to realise the full potential of our investment we see this as a significant step to closing what I see as a large discount between the current values at which we carry Southern Cross in our books, as well as what the NZAX market suggests CBS is worth versus the merged entity which will attract significantly more investor and broker attention when it is listed on the main board of the stock exchange (NZSX).

 
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The Value Fund added five new positions during the second quarter – Arden Group (US), BP plc (UK), Groupe Bruxelles Lambert (Belgium), Genting (Malaysia), Sofina (Belgium).

We also took the opportunity to add to a number of existing positions within the portfolio as markets sold off. As a consequence cash levels declined from 31.20% to 22.67%.

[Please also note the following name changes within the portfolio: MMC Contrarian is now called Clearview Wealth Limited and Aruze Corp is now called Universal Entertainment.]

The Value Fund had one investment realisation during the quarter:

 
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Arden Group

On 7 August 2007, I first wrote to investors in the Multi Strategy Fund about Arden Group the owner / operator of 18 Gelson’s supermarkets in the greater Los Angeles area. Gelson’s is “the first class cabin” of grocery stores – e.g. you don’t unload the trolley at the check-out – they do it for you. Supermarket sites are now very hard to come by, especially in LA. The company owns 3 of their 18 sites. These are in the books at historical cost, together with neighbouring car parks. The leased supermarkets all have 18 year lease terms so there is value in them to another operator like Whole Foods in the future. Bernard Briskin owns ~57% of the Company and he is ~85 years old, with no family in the business (that we are aware of). The Company has a net cash position and a history of paying special dividends.

 
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Arden is a conservatively financed / asset rich company and is currently valued at well below sector wide earnings multiples. How does this happen ? Quite simply because it is a small capitalisation stock by US standards with a market capitalisation of only ~US$ 300mln. Therefore, it is largely overlooked by brokers/stock market analysts. This affords investors like ourselves the opportunity to uncover attractive long term investments (like Arden Group) which are in plain sight.

Closing Remarks

While our portfolio businesses across the world continue to grow in intrinsic value, the same cannot be said for New Zealand as an economic unit in my opinion.

In this past week, we have seen Bright Foods from China purchase 51% of Synlait, Olam from Singapore (a major shareholder in local company Open Country Dairy) has bid for NZ Farming Systems Uruguay (a NZ Company essentially selling its farming technology to South America), and more recently it is my understanding that a Japanese company purchased the former NZX listed – Cedenco Foods. While I am not suggesting that any of these companies would be appropriate investments for Elevation Capital’s Funds it is disappointing to continually see assets trade away to foreigners. This is occurring because New Zealand does not have a savings base of its own to invest in such entities. We are highly dependent on offshore capital. Our latest international position figures from the RBNZ provide a simplistic yet revealing picture as to our true economic position in my opinion:

 
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While the Government sector debt burden is growing it remains at a very low level when compared to other nations around the world at present.

However, the same cannot be said for private sector debt which now totals 117% of GDP. We can see quite clearly the New Zealand economy is in the process of deleveraging with debt levels down from NZ$ 236bln in March 2009 to NZ$ 219bln in March 2010. The key concern remains the fact that this large debt burden has increasingly in the last 5 – 10 years been funded by foreigners. Clearly, this external debt position leaves us vulnerable. It also highlights the need for greater domestic savings in my opinion. We have a scheme in KiwiSaver that could quickly be made compulsory -- Andrew Harmos (Chairman of the NZX and a Director of Elevation Capital Management Limited) has publicly suggested we start as low as 0.5% to “ease” people into it -- I agree that a low level for a period of time so as to establish both habit and prove to people the power of compounding makes sound economic and political sense.

However, such decisions require both economic vision and leadership -- I certainly hope for the sake of my children that this begins to appear sooner rather than later otherwise their business cards will only ever say XYZ (NZ) Limited a division of XYZ Inc. or XYZ plc.

I am equally worried we are losing a generation of investors at exactly the time that they can find great value in equity markets both domestically and internationally. The Government is taking the necessary steps to try and restore investor confidence via regulation but this is only one part of what in my view needs to be a multi faceted approach. Equally important is financial literacy, it is with some irony that in New Zealand the Retirement Commission is in charge of financial literacy. That is not to say they are not doing the best with the resources they have, but if our Government/s were really serious about beginning to address the savings gap that we very clearly have then in my opinion they would look to establish a separate entity with its primary responsibility to develop a program to attempt to deal with this very clear deficiency within our current education process/system over time.

Despite my somewhat gloomy closing remarks, these are the times to sow the seeds of fruitful long term investments.

Thank you for your continued support and interest.

Yours sincerely,

Christopher Swasbrook
Elevation Capital Management Limited