QUARTERLY REPORT

INVESTMENT MANAGER'S REPORT

AS AT 31 DECEMBER 1995

Investment Markets
The big driver for equity markets in the last six months has been the continuing fall in the yield of government bonds in all major industrialised countries. The surprise since the start of the calendar year was the unusually weak tendency of consumer prices, with earlier forecasts of a rise in inflation proving to be wrong. This and the prospect of moderate economic growth caused investors to take a positive view for equities and resulted in a 6.0% rise in a weighted basket of world equity markets (the MSCI Index) from July through to December. The US was by far the strongest market with only France and Germany among major markets showing declines.

Our performance has lagged behind the MSCI with a rise of 1.3%, principally because of our misreading of the US market. Not only did we have a relatively small exposure but many of our American stocks which had served us so well in the first half of the year ran out of steam and in some cases retraced part of their gains. Exacerbating the position was our short position on the S&P500 index to the full extent of our US exposure. With the market having risen by 9.3% this cost the company some 2.8%. Clearly not an attractive outcome but incurred in an attempt to remove market risk from part of our portfolio.

While investors have good reason to be disappointed with the performance, the realities of our investment style are that we will often diverge significantly from the MSCI. In a year where the world's very strong businesses saw their premium ratings move to spectacular new highs, our neglect/value approach was unlikely to match the performance of the MSCI. 1995 was fascinating in that it provided a good example of how a boom can feed upon itself to push markets above trend. If we take the US market, for example, the year began with valuations looking uninteresting. As the market went up (having begun its run in August 1994), we saw perceptions and beliefs being transformed into apparent market realities. This was accompanied by extravagant articles proclaiming the resurgence of US industry with a notable cover story late in the year titled "Champs", Fortune magazine explained that the respective CEOs of General Electric Co. and The Coca-Cola Co. each created US$50bn of shareholder wealth almost single handedly. In the story, the underlying bull market was ignored in the measurement of so-called "market value added", a method which essentially relies upon the change in the stock market capitalisation of the company to assess management's contribution.

The danger of the apparently self-confirming trend in a market is that somewhere it is required to face the more fundamental reality of the laws of economics. Clearly 1995 was a joyous year for momentum players; not so for those trying to buy companies on attractive valuations. Recent weak price action on Wall Street lends support to our somewhat jaded view of valuations and reinforces the benefits of having some portfolio insurance (ie. we remain short the S&P500 index).

Portfolio Changes
The big change in the portfolio has been the aggressive acquisition of companies in Japan as shown in the table below. Other significant changes were the continued sell down in North and Latin America and the acquisition of new holdings in Continental Europe.

Disposition of Assets

Region	31 December 1995	30 June 1995
Japan	24.5%	10.0%
Other Asia	9.8%	10.7%
Australia	3.5%	4.4%
Western Europe	22.4%	19.1%
Eastern Europe and Russia	2.4%	2.8%
North America	26.0%	30.7%
South America	6.8%	9.5%
Africa	0.5%	1.0%
Total Invested	95.9%	88.2%

The emphasis of our purchases in Japan has swung away from the exporting companies towards those that will benefit from the recovery in the domestic economy and its gradual deregulation. These range from the likes of Sekisui House, which is Japan's premier builder of free-standing houses, to Yokogawa (the country's second largest industrial controls company) which will benefit from the recovery in domestic capital expenditure.

In the US, we have used the retracement in the price of IBM to add to our position and have recently acquired Novell which is a company engaged in networking communication technology. We sold the call options over the Airline stocks and added two new holdings in the oil service sector.

The reduction in exposure to Latin America largely stems from the removal of resource related companies from the portfolio.

New holdings in Europe include Lagardere and Lyonnaise des Eaux in France (the former is engaged in media and defence and the latter is the world's leading water treatment and distribution company).

Holdings in Italy have been complimented by the addition of Olivetti and ENI. Olivetti's principal attraction is its participation in the second mobile phone operator in Italy, while ENI is the recently privatised oil and gas producer and distributor.

Top Ten Holdings (as at 31 December 1995)

Stock	Country	Industry	% Holding
Fuji Photo Film	Japan	Photographic Equipment	5.4%
IBM	US	Technology	4.7%
Delta Airlines	US	Airlines	4.2%
Olivetti	Italy	Computers	3.9%
Novell	US	Technology	3.5%
American Airlines	US	Airlines	3.4%
Sekisui House	Japan	Home Building	3.1%
Canon	Japan	Electrical Equipment	3.0%
Yamanouchi Pharm.	Japan	Pharmaceutical	2.9%
Matsushita Electric	Japan	Electrical Equipment	2.8%
Total			36.9%

The Investment Outlook
When examining the composition of our portfolio, we are pleased by the fact that many of our new acquisitions were made at prices well below the peaks of the last 2-3 years. These companies are available at attractive prices and have prospects for good earnings growth over the next few years. Their host stock markets have generally been weak since December 1993 which is in sharp contrast with the US which has been in an unremitting bull market.

The present case for the US stock market is that companies are benefiting from having taken the necessarily difficult decisions regarding restructuring and are now benefiting from their clear focus and technical prowess. With American information technology companies clearly having global leadership, this adds weight to the idea that the US is enjoying an economic renaissance.

We have great respect for the remarkable change in the American business and political environment but point to the record level of profitability evident among listed companies. The main source of this profit growth has been stagnant wages (often bartered in exchange for job security - with its interesting implications in an economic downturn) and the weak dollar. Neither of these conditions is likely to be permanent. To the extent that the US truly has gained competitive advantage against other industrialised countries, so this should continue to be expressed in an improvement in its trade account and ultimately in an appreciation of the relative value of the US dollar. So it is not so much a question of contradicting the evident resurgence in corporate America, but more a question of its sustainability and its valuation implications.

We are unable to identify factors which have resulted in a once-and-for-all lift in US corporate profitability. It is interesting to note for example, that companies continue to aggressively buy back their own stock (under the guise of shareholder value enhancement). This may be sensible in some cases but it suggests that as a group, companies comprising the S&P500 index are finding it difficult to invest their capital at a rate of return equivalent to their published ROE's (around 20%) and that at the margin, the next best thing is to buy back shares which will probably give a trend return of some 12%. This raises questions about the investment return at the margin and the inherent growth rate of these companies. So-called reengineering of businesses has clearly benefited profitability in the short term but to suppose that none of these benefits will be competed away would be unusual. The overall indebtedness of S&P companies has remained at 66% notwithstanding record profits and lower working capital needs.

Events such as a stronger dollar and the availability of new capacity can be expected to bear down on these returns in due course. However, we may be underestimating the magnitude and force behind this lift in corporate profitability, and thus the return to trend may be slow in coming. Nevertheless so long as the stocks we pick perform as well as the Index, we believe the insurance policy (ie. the short on the S&P index) is worth having.

By contrast, Continental Europe is seen as being hampered by an inflexible social structure and the concomitant difficulties companies still face in adjusting to "globalisation". Adding to their woes in the short term, is the desire by EU Governments to curtail spending to meet the Maastricht criteria. This has contributed to slowing economic activity at a time of intense competition and accompanying weak pricing power.

However, with the realisation that growth is more at risk than price stability, Central Banks will induce further falls in interest rates. This combined with weaker exchange rates should help provide economic growth and stimulate corporate profits.

Turning to Japan, although we have seen some significant price appreciation in the exporting companies, we believe they still have further potential. This will stem from very strong profit growth and a more clinical appraisal of the appropriate valuations for these companies. We find that there is a poor correlation between company's inherent profitability and growth and their market ratings (valuation). We believe this stems from historic distortions in the Japanese financial system, but as these are gradually whittled away, so these valuations should realign themselves. It is partly due to this concept that we have become excited by companies serving the domestic Japanese market. As deregulation becomes more prevalent, companies which hitherto enjoyed undue protection should gradually fade and provide opportunities for those who were previously subsidising them.

Looking at some of the older themes, they are largely intact. Shipping continues to unfold gradually with freight rates having risen sharply over the second half of the year. The negative though is that this has interrupted scrapping of old tonnage and in addition, new technology in oil discovery and drilling has enhanced the flow of oil from existing fields and from new discoveries which are geographically close to big users (thereby reducing the need for water borne tonnage). Nevertheless, consumption growth in Asia and the inevitability of old vessels being scrapped supports the theme.

The price of newsprint has been even better than we could have hoped and yet the market is looking through the current boom to a period of softer demand. One of our Canadian producers, Quno, is presently subject to a bid at a price above our entry level, yet less than we would have anticipated.

The American airline theme is unfolding well. The industry is starting to make good profits notwithstanding healthy competition and the continuing emergence of new carriers. However, as predicted, the bulk of the industry, in terms of available seat miles, is reluctant to add capacity and is paying close attention to yield. We see no reason to downgrade our earlier high earnings expectations.

Our investment in Russia has recovered fractionally but is generally somnolent. The resident consultant we have hired reports that there are many signs of reform taking root and segments of the economy are starting to behave in a manner with which we would be familiar. However, at this early stage of capitalism, all its worst characteristics are being amply displayed with the naked greed of directors taking precedence over the interests of ordinary workers and shareholders. Hence it seems as though equity investment in Russia will unfold rather like in Brazil some years back. There is plenty of promise but enormous "taxes" will be exacted in the intervening period.

We remain of the view that the US currency will appreciate against the core European currencies and the Japanese Yen, hence assets in those currencies have been hedged into US dollars. As we believe the Australian dollar will keep pace with the US dollar, we have hedged 70% of the company's assets into Australian dollars.

Olivetti
Olivetti, the Italian computer and more recently telecommunications services company is a business which has been through a nightmare since the heady days of the late 1980s. Transformed by Mr Carlo De Benedetti from a sleepy typewriter business in the late 1970s, into a successful PC and software operation in the mid-1980s, it subsequently succumbed to the intense competition from the likes of Compaq in the 90's. To try to meet this competition, the company has had several reorganisation attempts which have seen its workforce halve.

The business of course comprises more than simply PCs. A valuable alliance with Canon of Japan is the basis of Olivetti's profitable ink-jet technology business (printers and faxes in particular); and a significant investment in the early part of the 1990s gave the company a solid business in providing desktop and networking services throughout Europe.

The profile of the company was altered significantly in 1994 when it won the right to operate the second (after the state run monopoly Telecom Italia) GSM mobile phone licence in consortium with AirTouch and Bell Atlantic of the US, and Mannesman. The cost of the licence fee plus the necessary infrastructural work will involve a total investment of L2,850 billion (A$2.4 billion). Though part of this investment will be spread over the next few years, to finance its 40% share Olivetti had a rights issue late in 1995. The supply of new stock and the announcement of further write offs put the shares under intense pressure and it was at this time that we added to our position.

To encourage investors to subscribe to the rights issue, Olivetti revealed a restructuring plan which differs from those of earlier years in that it includes specific financial targets for each business division rather than just qualitative strategies to improve performance. Within its original business, the key swing variable will be the losses incurred by the PC division. Not only does the plan outline how Olivetti intends to break even in this business (by outsourcing production to Asia so that they are only assembling and branding, by cutting the staff by a further 30% in the division, and by completely overhauling the distribution strategy), but the company has stated its intention to close the operation down if it makes further losses in 1996. We suspect this business will continue to struggle to break-even, and that the more likely outcome during 1996 is some sort of alliance with a more healthy PC manufacturer. With Olivetti Lexicon (ink jet products) continuing to make healthy profits, and the services and systems businesses in profits (though not yet satisfactory), the traditional Olivetti business should be in overall profit. Once this happens, the exciting potential of the GSM operation will be allowed to shine through and become the focus for the stockmarket's attention.

After a couple of months testing, Omnitel launched the network in December and although it has less geographic coverage than Telecom Italia Mobile (TIM), it signed up over 50,000 subscribers in its first three weeks of operation, thus achieving a 40% GSM market share for that period.

We think there are three things working in Omnitel's favour in its battle against the entrenched provider TIM. Firstly AirTouch and Mannesman bring with them the highly successful strategies they learned when they were in a similar position competing with Deutsche Telecom. Secondly, the average Italian expresses great dissatisfaction with the existing provider and indeed, seemingly every government entity and is longing to be able to express this with action. Thirdly, having met the management of Omnitel, we are convinced that they are not underestimating the task ahead of them if they are to win their target share of 40% of the market.

The way it looks is that the traditional business may make around L230 billion in net profits in 1996, the first year of the turnaround, putting the shares on 17 times prospective earnings. Omnitel itself will only start making a contribution in 1998 - capital costs and start up expenses are heavy until there is a sufficient number of users to cover the fixed costs. We have therefore acquired a company at a valuation slightly above the market average and yet with a controlling interest in one of two GSM mobile licences in the fifth largest economy in the world. The business characteristics of mobile phones in Italy have to date proved breathtaking.

We are not out of the woods yet, with the risks being the possibility of a price war in mobile charges and worse than expected performance from the traditional business. On this point we draw comfort from the significant management changes at the helm of the PC business, and it is our judgement that the stock price at the moment pays very little for the full potential of Omnitel.