©2017 Morningstar, Inc. All rights reserved.

Daniel Needham, CFA

President & Chief Investment Officer

Valuation Driven Asset Allocation

Outline

Valuation-driven asset allocation

Historic valuation analysis

Asset allocation process

Case study – a full investment cycle

Investment opportunities

Current positioning

Key takeaways and questions

33

Valuation-driven asset allocationThe origins of valuation-driven asset allocation

“The whole idea of basing the value upon current earnings seems inherently absurd, since we know that current earnings are constantly changing. […] A conservative valuation of a stock issue must bear a reasonable relation to the average earnings […] which should cover a period of not less than five years, and preferably seven to ten years.”

is what you get

”“ Price is what you pay; value

Warren Buffett, 2008 Letter to Shareholders of Berkshire Hathaway Inc.

Graham and Dodd,1934, Security Analysis (p. 452)“

”34

Valuation-driven asset allocationThe origins of valuation-driven asset allocation

Source: Shiller, Morningstar, Inc. Monthly, as of Dec, 31,2016. For Illustrative purposes only.

0

5

10

15

20

25

30

35

40

45

50

1881 1886 1891 1896 1901 1906 1911 1916 1921 1926 1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 2016

CAPE Price E10 Ratio

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Valuation-driven asset allocationU.S. CAPE and 10-year real returns

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

Q1 Q2 Q3 Q4 Q5

10-y

ear A

nnua

lised

Rea

l Ret

urn

(189

1 to

201

6)

CAPE Quintiles

36

Source: Shiller, Morningstar Investment Management. For illustrative purposes only.

Valuation-driven asset allocationPrice to fair value drives returns and losses

Source: Morningstar. For Illustrative purposes only.

VALUE

TIME

MARGIN OF SAFETY

FAIR VALUEPRICE(MR MARKET)

GREATER POTENTIALFOR RETURNS

LOWER POTENTIALFOR RETURNS

LOWER POTENTIALFOR LOSSES

GREATER POTENTIALFOR LOSSES

37

Historical valuation analysisEmpirical evidence – developed countries shares

gSetup

/Valuation Measure: Cyclically-Adjusted Price-Earnings Ratio (CAPE: 5-Year Average Earnings)

/Universe: 23 Developed Countries - Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, United Kingdom, USA

/3 Equal-Weighted Portfolios: High (Most Attractive), Medium, and Low (Least Attractive)

/Update Frequency: Monthly

/Timeframe: 01/1975 – 03/2016

38

Historical valuation analysisDeveloped countries shares (01.1975-03.2016): Growth of $1

$55.0

$18.9

$14.7

$0.5

$1.0

$2.0

$4.0

$8.0

$16.0

$32.0

$64.0

$128.0

1974

1975

1976

1977

1977

1978

1979

1980

1980

1981

1982

1983

1983

1984

1985

1986

1986

1987

1988

1989

1989

1990

1991

1992

1992

1993

1994

1995

1995

1996

1997

1998

1998

1999

2000

2001

2001

2002

2003

2004

2004

2005

2006

2007

2007

2008

2009

2010

2010

2011

2012

2013

2013

2014

2015

2016

High Medium Low

Source: MSCI, IMF, Morningstar Investment Management. Past performance does not guarantee future results.

39

Historical valuation analysisEmpirical evidence – bond markets

gSetup

/Valuation Measure: Current Interest Rate minus 5-Year Average Interest Rate

/Universe: 15 Long-Term Bond Markets - Australia, Austria, Belgium, Canada, Euro Area, Germany, Ireland, Italy, Japan, Netherlands, New Zealand, South Africa, Switzerland, UK, US

/3 Equal-Weighted Portfolios: High (Most Attractive), Medium, and Low (Least Attractive)

/Update Frequency: Monthly

/Timeframe: 01/1975 – 11/2015

40

Historical valuation analysisLong-term bonds (01.1975-11.2015): Growth of $1

$16.35

$7.58

$4.37

$0.5

$1.0

$2.0

$4.0

$8.0

$16.0

$32.0

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

High Medium Low

Source: IMF, Morningstar Investment Management. Past performance does not guarantee future results.

41

Historical valuation analysisEmpirical evidence – currency markets

gSetup

/Valuation Measure: 5-Year Change in Real PPP Exchange Rate

/Universe: 13 Currency Pairs vs USD - Australia, Canada, France (1975-1998), Germany/Euro, Italy (1975-1998), Japan, New Zealand, Norway, Singapore, Spain, Sweden, Switzerland, UK

/3 Equal-Weighted Portfolios: High (Most Attractive), Medium, and Low (Least Attractive)

/Update Frequency: Monthly

/Timeframe: 01/1975 – 3/2016

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Historical valuation analysis13 currencies (01.1975-03.2016): Growth of $1

$1.72

$0.87

$0.66

$0.0

$0.5

$1.0

$1.5

$2.0

$2.5

1974

1975

1976

1976

1977

1978

1978

1979

1980

1980

1981

1982

1982

1983

1984

1984

1985

1986

1986

1987

1988

1988

1989

1990

1990

1991

1992

1992

1993

1994

1994

1995

1996

1996

1997

1998

1998

1999

2000

2000

2001

2002

2002

2003

2004

2004

2005

2006

2006

2007

2008

2008

2009

2010

2010

2011

2012

2012

2013

2014

2014

2015

High Medium Low

Source: MSCI, IMF, Morningstar Investment Management. Past performance does not guarantee future results.

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Asset allocation processOur valuation framework

VALUATION-IMPLIED RETURN

EQUITY

PROPERTY

BONDS

CURRENCY

DividendsBuybacks

Rent

CouponsInterest

FCF GrowthEarnings Growth

Income Growth

Defaults

Inflation

Price/Fair ValueP/CF, P/E

Price/NTA

Yield Spread

Real FX Rate

CASH FLOW YIELD CASH FLOW GROWTH CHANGE IN VALUATION+ +=

Interest Rate Differential

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Depth and quality of our resourcesAsset allocation process

Our fundamental approach to investing helps to form our best thinking about capital markets research and asset classes.

Morningstar’s Investment Management group includes Morningstar Investment Management LLC, a registered investment adviser and subsidiary of Morningstar, Inc., and Morningstar Investment Services LLC, a registered investment adviser and subsidiary Morningstar Investment Management LLC. Globally, other affiliates or subsidiaries of Morningstar, Inc. can provide consulting or investment advisory services in Europe, Africa, Asia, and Australia.

Our fundamental, valuation-driven approach to investing starts with data and analysis from Morningstar, Inc. This judgement-driven approach helps to form our best thinking about asset classes and fund managers.

Our investment professionals collaborate with our global research team to uncover attractive investments around the world.

InvestmentProfessionals

Manager ResearchAnalysts

Equity & CreditAnalysts

110

121203

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Asset allocation processGlobal asset class teams

Asset Allocation

Philip StraehlHead of Capital Markets & Asset Allocation, Americas

Tanguy de LauzonHead of Capital Markets & Asset Allocation, EMEA

James FootHead of Capital Markets & Asset Allocation, Asia-Pac

Global Asset Class Teams

Equity, AmericasMarta Norton

Equity, EMEAClemence Dachicourt

Equity, Asia-PacBryce Anderson

Global SectorsPhilip Straehl

Emerging MarketsNimalan Govender

REITS/InfrastructureBianca Rose

Capital Markets & Asset AllocationRegional Leads

Paul ArnoldCarrie ScherkenbachMichael JuettnerMike StoutNabil SalemRob Miehm

Simon MolicaRichard WhitehallDaniel Vaughn

Vesna PeroskaJoel GrosvenorAndrew Jayne

Dan McNeelaJared WattsRob CaldwellSteve TagarovMatthias Palowski

Cyrique BourbonKyle Cox

Brian HuckstepBryan Platz

Fixed Income, AmericasDario Castagna

Fixed Income, EMEAMark Preskett

Fixed Income, Asia-PacBrad Bugg

GS/Global CreditTanguy de Lauzon

Emerging Market DebtEd Fane

CurrencyJames Foot

Hong ChenJohn McLaughlinJosh CharneyMichelle WardMike KeaveneyShekryar KhanHui Min Chang

Enrico BolzoniEmma Morgan

Ameya HattangadiJames Nairn

Olufemi MadaMarina JelesovaDanielle Rusznyak

John ShelbourneRicky WilliamsonMichael Kruger

Lucian MarinescuMatthew Wu

Equity

Fixed Income

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Asset allocation process

For illustrative purposes only. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive results.

Building multi-asset portfolios

47

Case studyA-REITS were very compelling directly after the GFC …however this has been largely played out

How do we respond to changes in valuation?

BALANCE SHEET

2007 2010 2016

Highly Leveraged

Low Quality

Borrowed

Overweight

Positive

Expensive

Unattractive

Recapitalisation/Divestments

Higher Quality

Sustainable

Underweight

Extremely Poor

Cheap!

Attractive

Increasing Leverage

Quality beginningto deteriorate

Becoming stretched

Overweight

Positive

Expensive

Less Attractive

EARNINGS

PAYOUT

MARKET POSITIONING

MARKET SENTIMENT

VALUATION

YIELD

AREITS

48

Case studyA-REITS – a valuation-driven opportunity that has undergone a full investment cycle

Source: Morningstar Investment Management.

49

$-

$1,000

$2,000

$3,000

$4,000

0.0%

5.0%

10.0%

15.0%

20.0%

AREITs Weight in Portfolio (RHS)

Growth of $1000 in ASX300 Property

Position Increased as AREITs Identified as

UndervaluedStrong Positive

Performance Seen by Sector

Position Tapered Off as Asset Class Approaches

Fair Value

Investment opportunitiesAsset allocation in a low return world

Source: Morningstar Investment Management. As at 31/08/2016. For illustrative purposes only.

U.S. Equity Now

U.S. Aggregate Bonds Now

Cash Now

U.S. Equity Fair Return

U.S. Aggregate Bonds Fair Return

Cash Fair Return

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

-16% -14% -12% -10% -8% -6% -4% -2% 0%

Valu

atio

n-Im

plie

d Re

turn

(USD

)

Valuation Conditional Drawdown

Normal

Now

50

Equity and Bond Discount Rates have been in a secular decline, decreasing prospective returns

Investment opportunitiesEquity vs. bond discount rates

Source: MSCI, IMF, Barclays Capital, Morningstar Investment Management. Past performance does not guarantee future results.

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%De

c-74

Oct-7

5

Aug-

76

Jun-

77

Apr-7

8

Feb-

79

Dec-

79

Oct-8

0

Aug-

81

Jun-

82

Apr-8

3

Feb-

84

Dec-

84

Oct-8

5

Aug-

86

Jun-

87

Apr-8

8

Feb-

89

Dec-

89

Oct-9

0

Aug-

91

Jun-

92

Apr-9

3

Feb-

94

Dec-

94

Oct-9

5

Aug-

96

Jun-

97

Apr-9

8

Feb-

99

Dec-

99

Oct-0

0

Aug-

01

Jun-

02

Apr-0

3

Feb-

04

Dec-

04

Oct-0

5

Aug-

06

Jun-

07

Apr-0

8

Feb-

09

Dec-

09

Oct-1

0

Aug-

11

Jun-

12

Apr-1

3

Feb-

14

Dec-

14

Oct-1

5

E Yield (CAPE)

Nom. Interest Rate + IG Credit Spread (OAS)

51

Investment opportunitiesFinding opportunities in fixed income

Source: Morningstar Investment Management. As at 31/08/2016. For illustrative purposes only.

U.S. Equity

U.S. Aggregate BondsU.S. Treasury Bonds

Intl. Treasury

U.S. Inflation-linked Bonds

U.S. Credit

U.S. Corporate High Yield

Cash

Hard Currency Emerging Market Debt

Local Currency Emerging Market Debt

0%

1%

2%

3%

4%

5%

6%

7%

-18% -16% -14% -12% -10% -8% -6% -4% -2% 0%

Valu

atio

n-Im

plie

d Re

turn

(USD

)

Valuation Conditional Drawdown

More Attractive

Less Attractive

52

Investment opportunitiesPockets of opportunity outside traditional developed market bonds

Source: Reuters, Morningstar Investment Management. As of 31/08/2016.

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

2011 2012 2013 2014 2015 2016

Emerging Markets Local Currency | 10-year yield

Brazil Mexico Poland South Africa Indonesia Malaysia

53

U.S. Equity

Europe ex UK Equity

Pacific ex Japan Equity

United Kingdom Equity

Emerging Markets Equity

Europe, Australasia and Far East

U.S. Aggregate Bonds Cash

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

-20% -18% -16% -14% -12% -10% -8% -6% -4% -2% 0%

Valu

atio

n-Im

plie

d Re

turn

(USD

)

Valuation Conditional Drawdown

Investment opportunitiesFinding opportunities in equities

Source: Morningstar Investment Management. As at 31/08/2016. For illustrative purposes only.

More Attractive

54

Less Attractive

Investment opportunitiesDiverging U.S. and international valuations (CAPE)

0.0

5.0

10.0

15.0

20.0

25.0

30.0

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

USA EAFE EM

Source: MSCI, IMF, Morningstar Investment Management. For Illustrative purposes only. Past performance does not guarantee future results.

55

Investment opportunitiesEmerging markets have been very unpopular

Source: BofA Merrill Lynch Global Fund Manager Survey. For illustrative purposes only.

56

Current investment opportunity setAustralia – key asset classes: valuation implied returns (real, local currency)

Source: MSCI, Morningstar Investment Management. As of 31/12/2016. For illustrative purposes only.

6.7%

5.9%

4.8%

3.5%3.0% 2.9%

2.2% 2.2% 2.2%

1.4% 1.1% 0.9% 0.9% 0.9%0.2% 0.1% 0.0%

-0.1%-0.6%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

Kore

a Eq

uitie

s

Taiw

an E

quiti

es

EM E

quiti

es

UK E

quiti

es

Euro

pe E

quiti

es

EM D

ebt -

Loc

al C

cy

EM D

ebt -

Har

d Cc

y

Aus

List

ed P

rope

rty

Japa

n Eq

uitie

s

Infra

stru

ctur

e

US H

igh

Yiel

d

US E

quiti

es

Aus

Infla

tion

Link

ed B

onds

Aus

Equi

ties

Glob

al L

iste

d Pr

oper

ty

US G

ovt B

onds

Aus

Govt

Bon

ds

AUD

Cash

Glob

al A

gg B

onds

Valu

atio

n Im

plie

d Re

turn

(Loc

al C

urre

ncy)

57

Investment opportunitiesHigh conviction investment positions of different vintages

2010 2012 2014 2016

↑ Increase A-REITS↑ Increase Global Credit

+ Initiate Japanese Equities↑ Increase Unhedged Currency – position for falling AUD

↓ Decrease AU Equities↓ Decrease US Equities↑ Increase EU Equities↑ Increase Japanese Equities

↑ Increase Currency Hedging↑ Increase EM Equities+ Initiate EU Energy

+ Initiate EM Debt↓ Decrease EU Equities↓ Decrease AREITS

+ Initiate Global Quality Strategy+ Initiate European Utilities↓ Decrease Global Credit

↑ Increase EU Equities+ Initiate EU Financials+ Initiate US HY Credit↑ Increase Inflation-Linked Bonds↑ Increase EM Debt (LC)↓ Decrease Listed Property↓ Decrease Global Infrastructure

2011 2013 2015

58

Current positioningMorningstar Growth Real Return Fund asset allocations

Source: Morningstar Investment Management. As at 31 December 2016.

Other Developed Equities6.9%

US Equities3.9%

European Equities13.1%

Japanese Equities8.8%

Emerging Market Equities8.2%

Australian Equities7.9%

Global REITs0.9%

Global Infrastructure1.6%

International Bonds1.5%

Emerging Market Debt6.0%

US High Yield1.4%

Inflation Linked Bonds3.8%

Australian Bonds4.1%

Alternatives11.0%

Cash & Currency21.0%

Holdings for Morningstar Growth Real Return Fund Fund as at Dec-16

59

Key takeaways and questions

O Valuation-driven asset allocation is a long-term investment strategy that has the ability to generate significant returns across stocks, bonds, and currencies

O Conversely, an analysis of historical data suggests that holding assets that are overvalued can lead to significant underperformance

O Morningstar’s global investment capabilities, put us in a unique position to identify and harness potential investment opportunities across the globe

O Iterative approach to building multi-asset portfolios, driven by valuations, fundamentals research and a willingness to be different, focused on maximising reward for risk

O Despite lower prospective returns across most major asset classes, we try to find select opportunities in international assets while maintaining defensive aggregate positioning

O Our multi-asset portfolios are biased towards Emerging Markets, Japanese & European equities, and away from developed world government bonds (towards cash, emerging market debt and credit)

60

Important information

This document is issued by Morningstar Investment Management Australia Limited (ABN 54 071 808 501, AFS Licence No. 228986) (‘Morningstar’). Morningstar is the Responsible Entity and issuer of interests in the Morningstar investment funds referred to in this report.

© Copyright of this document is owned by Morningstar and any related bodies corporate that are involved in the document’s creation. As such the document, or any part of it, should not be copied, reproduced, scanned or embodied in any other document or distributed to another party without the prior written consent of Morningstar. The information provided is for general use only.

In compiling this document, Morningstar has relied on information and data supplied by third parties including information providers (such as Standard and Poor’s, MSCI, Barclays, FTSE). Whilst all reasonable care has been taken to ensure the accuracy of information provided, neither Morningstar nor its third parties accept responsibility for any inaccuracy or for investment decisions or any other actions taken by any person on the basis or context of the information included.

Past performance is not a reliable indicator of future performance. Morningstar does not guarantee the performance of any investment or the return of capital. Morningstar warns that (a) Morningstar has not considered any individual person’s objectives, financial situation or particular needs, and (b) individuals should seek advice and consider whether the advice is appropriate in light of their goals, objectives and current situation. Before making any decision about whether to invest in a financial product, individuals should obtain and consider the disclosure document. For a copy of the relevant disclosure document, please contact our Adviser Distribution Team on 02 9276 4550.

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