One of the most useful measurements investors and advisors can use when assessing a manager's past performance is up capture and down capture ratios. These measurements can tell a lot about how a manager has a generated their performance and can indicate whether they are a suitable investment for your portfolios. Up and down capture ratios also are a great indicator of whether a fund is delivering on its philosophy and process.

The up capture ratio shows the percentage of market gains the fund has captured in the months that the market provided positive returns. The higher the up capture ratio the better the manager has done when the market has been doing well. Ultimately, you should expect a long only fund to have an up capture ratio of greater than 100% indicating that the fund performed better than the market in the months the market was positive.

As you would expect the down capture ratio shows the percentage of market losses the fund captured during the months when the market lost money. The lower the down capture the better the fund has performed when markets are down. You would expect a long/short fund to have a down capture ratio significantly lower than 100%, indicating that the fund has protected against the downside.

Isolating up and down capture data provides interesting insights into how active funds have delivered returns over the past 3 and 5 years.

Isolating Global Equity Funds including Long Only and Long/Short Funds over 3 years, to the end of May 2021, the market was positive for 23 months and negative for 13 months:

• The best performer in the peer group had the highest up capture (151%) and the 5^th lowest down capture (57%).
• The 14 funds in the top quintile for performance were all 1^st and 2^nd quintile for up capture and 1^st, 2^nd or 3^rd quintile for down capture.
• As expected, long/short funds had a lower average up capture ratio of 82%. But surprisingly they produced an average down capture of 86%. Of the 17 funds in the long/short peer group, 6 funds had a down capture of greater than 100% and didn't protect on the downside.

Looking at a 5-year time horizon where the market was up for 37 months and down for 23 months:

• The best performer in the peer group had the 2^nd highest up capture (148%) and the 6^th lowest down capture (70%).
• Long only funds proved that they can protect against down markets. The average down capture for long only funds was 87% and only 8 of the 43 funds in the peer group had a down capture greater than 100%.

Having a strong understanding of how a fund performs during different market cycles provides investors and advisors with broader insight into how a fund might fit into a portfolio and provides a unique benchmarking tool to allow them to assess that managers performance.

Detailed information on Up and Down Capture Ratios for over 600 actively managed funds can be accessed via Australian Fund Monitors.

In recent engagements with our investors, the topic that has come up most frequently is fears of higher inflation.

Concerns on inflation are valid. We have essentially had an entire generation of consumers never having had to live through a high-inflation period. Historically, inflation peaked in the early '80s in the US, meaning that a person would have to be in their mid-to-late 40's (at the very least) to even remember it, and more likely in their 60's to have felt the experience of seeing their purchasing power erode at double-digit rates year-over-year. As such, the risk of inflation is top of mind for us as an investment team, and has been since last year.

We think a number of topics around the potential effects of inflation (both near term and long term) on the Fund are worth highlighting, not the least of which is what we as your investment team are doing about it.

Firstly, we distinguish between what could be called 'transitory' inflation (which is affecting near-term sentiment and making news headlines on an almost-daily basis) and potential 'structural' inflation (i.e. where prices go up, and then keep going higher).

If we go back 15 months to when the COVID outbreak began to materially impact economic data, demand for goods and services were artificially depressed, as many consumers were confined to their homes for long periods of time. What we are seeing now is that the reopening of the global economy and the related pent-up demand for goods and services (i.e. the demand-side of the inflation equation) has to an extent overwhelmed the pace at which the supply-side can respond and normalise by producing/delivering a sufficient quantity of goods/services. This demand/supply imbalance has resulted in temporarily higher inflation as there are relatively more people chasing the same (or fewer) amount of goods and services. We expect that as supply chains work through the disconnections (typically it takes several months to ramp up production capacity) and the imbalances normalise, this type of 'demand-pull' inflation will moderate. At present, the combination of 'demand-pull' inflation and a relatively weak comparative base for the period March to July 2020 is pushing up the reported inflation numbers, which is what you are seeing in the headlines on a day-to-day basis.

More of our focus as an investment team is spent on whether or not these temporary inflation trends can become more structural in nature. By way of example, in May, McDonalds in the US announced that they would be increasing the wages of over 36,000 workers by 10% over the next several months. Similarly, Amazon is offering $1000 sign-on bonuses to new employees at starting salaries higher than minimum wage rates (and what would likely have been the going hourly rate otherwise). To us, these are indicators that the labour shortages in the US may manifest in structurally higher wages in time. Given the strong demand levels for goods and services in the near-term, we would expect them to get passed through to the end consumer in higher prices. Essentially, once McDonalds has increased staff wages, we would expect wages to remain at those levels and not to revert lower. The risk here is that this type of wage increase leads to an upwards adjustment in the cost of production/services, leading to cost-push inflation. This dynamic could lead to inflation taking a step-change higher and not be merely 'transitory' in nature (though in time it could be offset by greater automation). As you might suspect, we are watching developments on the wage front closely.

Actions taken in the Fund

Importantly, while the nature of inflation (transitory or structural) and the rate of inflationary increases remain uncertain at present, we have worked to position the Fund to take advantage of this current environment. We have invested in businesses with strong balance sheets and considerable pricing power. By and large, our businesses have utilized the past year to remove costs from their operations without sacrificing the capacity to service their customers. We expect this will translate into sustainably higher margins over the medium term, a point that seems to be ignored by the broader market at present (which seems fixated on the inflation print from now to December 2021). Given the nature of the unique products they sell/services they deliver and their strong market position, our businesses are using the current inflationary environment to not only pass on rising input costs, but in many instances raise prices above inflation. In short, these businesses prefer to operate in the current environment where demand for their goods is strong and they can more easily pass on price increases. We expect this inflationary period to be a tailwind for the businesses in the Fund.

However, business fundamentals are often not reflected in the market (at least, in the short run). Should the inflationary outlook result in central banks globally raising interest rates materially, this will likely negatively impact valuations across all asset classes (equities, bonds & property) as the 'risk-free' rate of return (achieved through owning a government bond or placing money on deposit) will move higher, meaning investors' will reassess how much risk they need to take to generate a specific level of return. Stated more simply, if interest rates are 0% (and inflation remains contained), you'd pay up a lot more for a business that can grow earnings at 15% p.a. for the next five years than if interest rates were 5% and inflation at 4%, (at which point you might well consider having some money on cash deposit). If inflation REALLY takes off, prices might need to come down quite a bit for a period of time. Stocks at the hyper-growth end of the market (think very, very expensive tech names with no demonstrable cash flows) will be disproportionately hurt in such a scenario, which is why we have reduced our overall tech weight since September 2020.

One common theme shared by our businesses is that they are run by management teams who have a demonstrated ability to allocate capital wisely; combined with the fact that they understand how to generate shareholder value (return on capital > cost of capital) the same way we do, they are very sensitive to the acquisition price paid. We believe owning a portfolio of cashed-up businesses with good capital allocators, strong cash flows and little debt is exactly what one would want to do in such a scenario, as it would give CEO's such as Mark Leonard (Constellation), Messrs. Buffet and Munger (Berkshire), the Mendelson family (HEICO), etc. the opportunity to finally deploy their balance sheets in a meaningful way. Seen in this light, we would argue our ability to actively back superior capital allocators places us at an advantage to the major indices (& the ETFs that track them) through such a period, as our businesses have the ability to 'create' value in a shareholder friendly manner (whereas our opinion of the capital allocation skills of the average business in the index is not nearly as benign.)

There is a school of thought that says commodities and commodity producers are a good inflation hedge. This may work for a period of time, but in the long run, doesn't actually hold true. To quote from the 1983 letter to Berkshire Hathaway shareholders (written just as inflation was subsiding):

Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom - long on tradition, short on wisdom - held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn't work that way. Asset-heavy businesses generally earn low rates of return - rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment - yet its franchises have endured. During inflation, Goodwill [intangibles] is the gift that keeps giving.

The whole piece written by Mr. Buffett on the type of business to own during periods of inflation is worth reading, though it is quite lengthy. (Those readers who are interested can find it here: https://www.berkshirehathaway.com/letters/1983.html - simply search for the phrase 'Goodwill and its Amortization: The Rules and The Realities' to skip to the relevant part.)

We are grateful for the interactions we have and feedback we receive from our investors. We view ourselves as a long-term partner rather than simply a fund manager, and would encourage any investor (or prospective investor) to reach out to us with any questions. As an investment team, we are committed to responding personally (and promptly) to these kinds of queries.

While the uncertainties around inflation in the near term persist, we believe the Fund is well positioned to capitalise on a range of outcomes that may unfold in future.