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Fund Manager Focus - September 2016

Davy - Dublin

Davy Asset Management is part of the Davy Group, one of Ireland's leading financial services firms, providing wealth management, asset management, capital markets and financial advisory services, to domestic and international clients for 90 years. The Davy Group has assets under management of €14 billion+ ($15.45bn). Its subsidiary Davy Asset Management manages over €3.8 billion ($4.2bn) on behalf of clients across equity, fixed income, multimanager and alternative investment strategies.

Chantal Brennan is the Chief Investment Officer of Davy Asset Management. She has over 20 years of investment experience managing Global and European equity portfolios, raising assets and developing investment teams. Previously, Chantal was the Managing Director responsible for AIG's global small and mid-capitalisation equities businesses and a member of various investment committees. In 2010, AIG sold its third- party asset management business which became PineBridge Investments where she was a partner. She received a Master's of Science in Investment and Treasury from Dublin City University, a Masters of Arts and a Bachelors of Arts in Economics from University College Dublin.

Can you give me a brief overview of the asset management industry in Dublin and where Davy fits in?

"It is dominated by large global index managers such as State Street as well as some boutique managers such as Davy Asset Management. All of the other players are owned by large global or Italian banks, Davy Asset Management is wholly owned by management and staff."

What proportion of AUM are in equities?

"Equities represent more than 30% of our assets under management. All our strategies are global equities."

Asset Class: 30 June 2016

Your investment style is both value and growth oriented with a quality overlay - can you elaborate?

"We believe companies that are long-term winners exhibit common identifiable characteristics which we refer to as QUALITY pillars. We believe the market systematically misprices companies demonstrating these characteristics and an investment process focused on identifying QUALITY companies, at an appropriate valuation, will deliver superior performance for our clients over the long term.

Our conviction regarding QUALITY is supported by our own extensive back-testing. The results of our back- testing has proven that high-QUALITY companies, as per our definition, outperformed both low-QUALITY companies and the broader market consistently over time."

You run a number of different strategies - can you elaborate on your investment style for each strategy?

Average holding period?

"Usually around 30% which translates into a 3 years or longer average holding period. Sometimes this can be even longer."

Do you have a target price when you buy a stock?

"Yes, we utilize our proprietary valuation model to assess the value of a security. We forecast 5 years of earnings and cash flows. We also forecast a best and worst case scenario to give a range around our base case. The aim of our valuation process is to establish an absolute valuation for a stock and a realistic best and worst case scenario.

The output from the forecasts is used in two separate valuation models; a discounted cash flow model and an exit multiple based model.

For each stock we calculate a quality score (Q-Score) which is based on a series of 31 fundamental questions that each Fund Manager must answer about the stock they are analysing. The higher the Q score, the higher the quality. We incorporate the Q-Score directly into the Cost of Equity that we use to value the company. A company with a lower Q-Score will have a penalty attached to their cost of equity. This ensures that our valuation reflects the risk of the stock relative to others in the portfolio or research universe."

Do you have any market cap cut off restrictions on stocks?

"The Davy Discovery fund which focuses on small and mid-cap equities has a minimum market cap threshold of $200 million and can hold stocks up to $15 billion.

The large cap strategies focus on stocks with market caps above $10 billion."

Any sectors/themes you don't favour?

"A Quality orientated philosophy tends to perform across the market cycle because businesses with higher returns, growing margins and lower leverage tend to have share prices which are less volatile as their businesses are less affected by the economic cycle. This phenomenon is based on our experience and has been confirmed by the back testing of our proprietary four factor Quality model.

We expect a global small and mid-capitalization strategy to perform in the early to mid-stages of a business cycle but performance may moderate towards the later stages of the cycle as growth moderates and earnings come under pressure. We focus on investing in Quality businesses as we wish to moderate the effects of this. When an economy slips into recession, liquidity and earnings growth tends to dry up and low quality stocks such as turnaround situations, low margin cyclicals and/ or asset plays perform. As we don't invest in these types of businesses we would expect our performance to lag the market in the short term."

Does a company need to pay a dividend?

"It depends on the strategy. Not all growth orientated small and mid-cap companies have dividends as they tend to be focused on growing their businesses whereas in the case of more mature large cap stocks we prefer them to pay dividends as it demonstrates good capital discipline."

What's your view on share buy backs?

"Positive, as it demonstrates good capital discipline but you need to ensure the firm is not increasing leverage in order to do so."

Do you have any ethical constraints?

"Only our strategies where it is appropriate have ethical constraints but all of our strategies have an environmental and social governance rank within our investment universe."

Do you vote your proxy of foreign holdings?

"Yes, but only in certain appropriate cases."

Typical size of a US and European holding? European position?

"Active position sizes range from 1% to 3.5%, depending on their volatility or expected risk-return characteristics. Depending on the size of the fund, positions can be between €500,000 and €2 million in the case of the Davy Discovery Fund.

Examples of our largest US and European equity holdings in our global small and mid cap equity strategy are MSCI, Xylem, Ulta Salon and Panera Bread while in Europe it's Teleperformance, Micro Focus, Playtech, DCC, Alten."

Cadence is a recent addition to the portfolio, can you explain why you bought the stock?

"Cadence is a leading provider of EDA and semiconductor IP. It is #2 provider of EDA software globally. The EDA industry is oligopolistic with >80% of the market in the hands of three companies and Cadence has a 26% share. The firm has double digit operating margins and returns and these returns should continue given key secular trends - mobility, cloud computing and the internet of things. ~90% of Cadence's revenues are recurring. The business is debt free. Accretive acquisitions have enabled Cadence to grow market share and its revenues at a faster pace than its competitors in the last five years."

Henry Schein is another recent addition - discuss.

"Henry Schein is the world's largest distributor of medical products and value added services to office based health care practitioners. It operates in dental, medical and animal health and has a global market share of 20 - 25%. The healthcare products distribution industry is worth ~$45 billion globally. The businesses of Henry Schein carry next to no product risk or 'patient cliffs', even in adverse economic climates the company has generated top and bottom line growth. Margins are on an improving trend due to improvements in the SG&A line as a result of scaling and integration of recent acquisitions. It generates significant levels of free cash flow and plans to allocate ~$400 million to share repurchases and $200 - 300 million to M&A. Management's ability to balance short term profitability and cash flow with medium and long term priorities has for decades delivered consistent financial results."

Sika is a recent European addition to the portfolio - discuss.

"Sika is a market leader in construction chemicals and #4 in the adhesive and sealants sector. In spite of its leadership position the firm has outgrown all peers in recent years and this is expected to continue. Revenue is above the sector average and margins have been improving since 2012. This trend looks set to continue as the company exploits economies of scale, pricing power and favorable raw material costs. It has a strong balance sheet with a net cash position. We also like the capable management coupled with capital discipline."

Do you have to meet management before you buy a stock?

"Yes. We gather fundamental company information through direct company contacts, analyst meetings, sector conferences and official company filings. We would seek to meet with all company managements within a 12 month cycle.

As a team, we attend over 400 company meetings per year."

How do you prefer to meet management? 1/1 in your offices, at conferences, at HQs, in groups?

"We interact with portfolio companies at least once a year, if not quarterly. We always have company contact before investing in its stock; meetings take place at our offices or via site visits to the company. If time is a constraint, we will conduct a conference call."

How is the changing regulation around corporate access affecting you?

"Given the introduction of MIFID II, we decided to separate our commission into execution and research. This has resulted in a more concentrated list of execution and research counterparties. We allocate commissions on a quarterly basis depending on the relevance of it towards making our investments decisions."

Why should corporates target Davy Asset Management?

"Davy is a long-term, low turnover investor which operates a consistent investment style. It's also a 'relatively' new investment firm with an experienced fundamental research driven investment team."

How has BREXIT impacted you?

"Although, the collapse of the pound post BREXIT was a positive for UK large capitalisation stocks whose revenues are generated internationally; 75% overseas, the effects in the UK small and mid-capitalisation space has been more acute. Our UK holdings have less than 4% of their revenues coming from the UK and we are already seeing earnings upgrades happening for those stocks in our portfolios, we have used this volatility as a buying opportunity.

In the aftermath of BREXIT, many of our funds have experienced a strong rebound in July, in fact we had recovered most of our drawdown within 6 business days. We are relatively defensively positioned, focused on preserving capital by investing in securities with good earnings visibility which we believe have the ability to withstand periods of market volatility. This is the cornerstone of our Quality investment philosophy."

This article also appeared in IR Magazine.

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