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Repositioned for emerging opportunities

Fidelity Emerging Markets 8 August 2022 Review
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Fidelity Emerging Markets

Repositioned for emerging opportunities

Investment companies
Emerging markets equity

12 August 2022

Price Ord.

612p

Market cap

£558m

AUM

£868m

NAV*

698.7p

Discount to NAV

12.4%

*Including income. At 4 August 2021.

Yield

2.1%

Ordinary shares in issue

91.1m

Code

FEML

Primary exchange

LSE

AIC sector

Global Emerging Markets

Benchmark

MSCI Emerging Markets (EM) Index

52-week high/low*

905.0p

596.5p

988.4p

690.7p

*Including income.

Gearing/cash

Gross market gearing*

40.5%

*At 30 June 2022 (from the company’s factsheet).

Fund objective

Launched in July 1989, Genesis Emerging Markets was one of the first emerging markets (EM) funds in the UK. Managed by Fidelity from 4 October 2021 (and renamed Fidelity Emerging Markets), it seeks long-term capital appreciation through investing in securities and financial instruments, providing exposure to emerging markets companies. Performance is benchmarked against the MSCI Emerging Markets Index.

Bull points

Enhanced investment powers with measured risk approach.

Substantial Fidelity resource, including local presence in emerging markets.

The proactive board is committed to promoting the interests of the fund’s shareholders and to narrowing the discount.

Bear points

The EM asset class can be more vulnerable to periods of risk aversion.

Due to the quality growth and large-cap bias, FEML might lag value-focused peers when value stocks are leading the market.

Employing shorts and use of derivatives may not suit all investors.

Analyst

Victoria Chernykh

+44 (0)20 3077 5700

Fidelity Emerging Markets is a research client of Edison Investment Research Limited

Fidelity Emerging Markets (FEML) was transferred to Fidelity in October 2021. FEML mirrors the FAST EM Fund (FAST, £178m AUM at 30 June 2022), which has achieved a strong track record over the past 10 years, outperforming the MSCI Emerging Markets Index (MSCI EM Index) under lead fund manager, Nick Price. Russia’s invasion of Ukraine in February 2022, concerns about inflation and the outlook for global growth have shaken riskier assets and the MSCI EM Index is down 8.1% year to date (in GBP to end July). While FEML was not immune to the setback, Fidelity’s comprehensive team of 45 analysts, together with manager Nick Price and co-portfolio manager Chris Tennant, can react to market shocks efficiently, while identifying and investing in the widest range of attractively valued, high-quality EM growth opportunities.

FAST* has outperformed the benchmark** over the past 10 years

Source: Refinitiv (returns in sterling to 31 July 2022). Note: *Fidelity FAST EM fund, ISIN LU0688696094, launched by FEML’s lead portfolio manager Nick Price in 2011, is used as a model portfolio for FEML and illustrates the same long/short strategy that Fidelity applies to FEML. **MSCI EM Index.

Why invest in FEML

Relative to long-only strategies, FEML can build a higher gross long exposure by using short positions (subject to strict limits, see our initiation report), to extend the long book and with the aim of offering greater scope for outperformance. Since its launch, FAST has consistently achieved higher risk-adjusted returns compared to sector peers and the benchmark (see page 4). FEML differentiates itself by the types of business in which the fund invests, targeting companies with robust fundamentals and consistent returns at a reasonable price.

The analyst’s view

The unprecedented event of Russia, a meaningful EM, becoming uninvestible has had a negative impact on FEML’s recent performance relative to peers, but the managers acted swiftly to deal with the issue. In 2021 FEML had a conviction overweight position in selective Russian stocks (c 18% country weight). Given rising geopolitical tensions in late 2021, the team took steps to reduce exposure to Russia by employing a country hedge. The aggregate Russia weight of the fund was 0.06% (net exposure at 31 March 2022). These efforts are ongoing and FEML will not invest in Russia in the foreseeable future. The advantages of FEML's closed-ended structure are starting to emerge, as highlighted by its recent outperformance relative to the open-ended FAST.

The managers’ view: Manoeuvring in an inflationary environment

As financial markets turned south at the start of the year, Price and Tennant continued to focus on finding attractive companies to invest in. The managers believe that inflation will persist for some years to come, resulting in higher commodity prices. They expect prices to remain high for many reasons, including deglobalisation, underinvestment, the move to renewables, an escalating ‘climate crisis’, energy and food security issues and the potential for stock piling. The managers differentiate between inflation in developed markets (DM) and EM economies. They note that in EMs inflation is generally lower than in most DMs. They expect that while DM governments will increase rates to respond to inflationary pressures, overall rates cannot remain high given that many economies have unsustainably high debt/GDP ratios. What sets EM apart is that inflation has been tackled early and proactively, giving central banks scope to manoeuvre.

While FEML’s country and sector positioning are the result of a bottom-up stock-picking approach, a number of themes have emerged. In the managers’ view, China will remain volatile but the direction of the Chinese market is looking more positive, supported by lower valuations and less focus on platform regulations, while stimulus is likely to come given the rising unemployment rate. FEML’s overweight positions in the materials and semiconductor sectors are driven by the green agenda and multi-year underinvestment in the former. For the latter, strong fundamentals and long-term structural demand underpin the manager’s conviction, given that technological advancement continually requires greater processing power and memory.

Current portfolio positioning

At 30 June 2022, the portfolio’s 164 holdings included 93 long and 71 short positions (including short positions in the MSCI EM Index (7.2%) and the MSCI India Index (2.7%)). As described in our initiation report, Fidelity’s team can build a higher gross long exposure as part of its long/short strategy, while its net exposure is targeted to be a neutral c 100–110%.

We present FEML’s geographical split in Exhibit 1. Fidelity’s high conviction approach results in significant concentration in the top three countries: China, India and Taiwan (c 56% and c 62% if we include Hong Kong). While Hong Kong is overweight, India and Taiwan are underweight the MSCI EM Index.

Exhibit 1: Portfolio breakdown by geography

Country

Portfolio weight

Benchmark*

Active weight vs benchmark*

China

35.3

35.2

0.1

India

10.7

12.7

(2.0)

Taiwan

9.5

14.5

(5.0)

Brazil

7.6

4.9

2.7

South Africa

7.2

3.5

3.7

Hong Kong

6.4

0.1

6.2

Korea (South)

4.9

11.2

(6.4)

Canada

4.2

0.0

4.2

United Arab Emirates

3.4

1.3

2.1

Kazakhstan

3.3

0.0

3.3

Other countries

5.5

16.6

(11.0)

Index shorts/unclassified

-7.2

0.0

 

Cash

8.3

N/A

 

Other

0.9

0.0

 

Total

100.0

100.0

Source: Fidelity International, Edison Investment Research. Note: At 30 June 2022. *MSCI EM Index.

Exhibit 2 illustrates FEML’s portfolio by sectors. Combined, the cyclical information technology (24.8%), financials (22.1%), materials (14.0%) and industrials (12.3%) sectors represent 73.2% of the portfolio, giving it a cyclical tilt, albeit the focus on owning quality stocks is prevalent across all sectors. Since taking over the management of the portfolio in October 2021, the team has materially reduced the fund’s exposure to the consumer discretionary sector (12.6% and underweight the benchmark 2.2pp) due to concerns about the cost of living. Communication services is the largest sector underweight position relative to the benchmark of 7.3pp (at 30 June 2022) as the team is finding better investment opportunities elsewhere.

Expecting a stronger inflationary backdrop, the managers used this freed up cash to increase the exposure to commodities. The managers believe commodity prices will remain high, particularly energy commodity prices, which will lead to higher prices in general. In addition, issues such as deglobalisation, food and energy needs, will facilitate and accelerate the move to renewable energy sources.

Exhibit 2: Portfolio breakdown by sector

Industry

Portfolio weight

Benchmark*

Active weight vs benchmark*

Information technology

24.8

19.2

5.6

Financials

22.1

21.2

0.9

Materials

14.0

8.4

5.6

Consumer discretionary

12.6

14.9

(2.2)

Industrials

12.3

5.6

6.6

Consumer staples

8.9

6.1

2.8

Communication services

3.3

10.6

(7.3)

Energy

2.0

5.0

(2.9)

Real estate

1.5

2.1

(0.6)

Healthcare

0.2

4.0

(3.7)

Utilities

(1.1)

2.9

(4.0)

Cash

8.3

0.0

 

Gearing/short positions

(9.9)

 

 

Other

0.9

 

 

Total

100.0

100.0

 

Source: Fidelity International, Edison Investment Research. Note: At 30 June 2022. *MSCI EM Index.

Exhibit 3 lists FEML’s top 10 overweight positions versus the benchmark (at 30 June 2022). As the table illustrates, the active weight of the top 10 overweight stocks versus the benchmark is 39.3%.

Exhibit 3: Top 10 overweight positions (as at 30 June 2022)

Company

Country

Sector

Fund (%)

Index* (%)

Difference (%)

HDFC Bank

India

Financials

6.6

0.0

6.6

AIA Group

Hong Kong

Financials

5.3

0.0

5.3

China Mengniu Dairy

China

Consumer staples

4.8

0.2

4.6

Zhejiang sanhua

China

Industrials

4.2

0.0

4.2

First Quantum Minerals

Canada

Materials

3.6

0.0

3.6

Kaspi

Kazakhstan

Financials

3.3

0.0

3.3

Keichow moutai

China

Consumer Staples

3.5

0.4

3.1

Beijing Oriental Yuhong Waterproof Technology

China

Materials

3.00

0.0

3.0

Infosys

India

Information technology

3.9

1.0

2.9

SK Hynix

South Korea

Information technology

3.3

0.6

2.7

Top 10 (% of portfolio)

41.5

2.2

39.3

Source: Fidelity International, Edison Investment Research. Note: *MSCI EM Index.

The section below presents examples of the team’s active sector exposures and stock picks.

Examples of differentiated positioning

FEML’s commodities positioning reflects the ‘all cap, go-anywhere’ approach and with holdings in a wide range of commodities, including copper miners (First Quantum, Grupo Mexico) it remains an area of high conviction, given the increase in renewable energy and scarcity of commodities’ supply. Nevertheless, the overall exposure to commodities is benchmark neutral.

After the outbreak of the war in Ukraine the materials sector was used to balance the portfolio in the absence of energy ideas. However, gold has subsequently been reduced given the market’s expectations that interest rates will continue to rise.

In energy, the managers added positions, such as Africa Oil (Canadian listed with assets in Kenya and Ethiopia), alongside two European multinational integrated oil, gas and petrochemical companies. Under-researched opportunities such as tin (Alphamin) and mineral sands (Kenmare) are reflected in the portfolio.

The strategy has higher exposure to Chinese real estate (long China Overseas Land). The portfolio managers believe that the demise of Evergrande and the consolidation of the sector will see a healthier industry structure going forward; conservatively run, well capitalised developers will benefit. The managers believe that the company can, if it chooses to, short highly leveraged sub-scale developers that will not be able to refinance their debt.

The managers believe that India remains attractive on a highly selective basis; however, the additional investment powers, such as the use of shorts and derivatives, allow for an index hedge to actively manage the country weighting.

Alibaba is another example of a company, where the managers have growing conviction. The stock price has been on a downward trajectory. The team says that prolonged lockdowns will result in lower revenues, but it is attractively valued with no value ascribed to its cloud business segment. The team also believes that the stock is currently at the peak of uncertainty and it expects the downward share price trend to reverse.

Higher market volatility offers the opportunity to generate income by writing options. Examples include Alibaba, HDFC Bank and KE Holdings.

Performance: Looking beyond the short-term

Genesis’s emerging markets team had been running the company since its launch in July 1989 until Fidelity took over, effective 4 October 2021. Therefore, FEML’s historical performance until the start of October 2021 is attributable to Genesis (GSS). We have included the performance track record of FAST, launched by the current fund manager, Nick Price, in 2011. As we show in Exhibit 4, FAST outperformed the MSCI EM Index and Genesis’s strategy, which was applied to FEML historically on a net asset value (NAV) total return basis over one, three, five and 10 years.

More recently, FEML’s NAV has outperformed FAST over one, three and six months, benefiting from its closed-end structure, though it underperformed versus the MSCI EM Index during these three periods.

The bulk of underperformance year-to-date and shorter periods (c 84%) is attributable directly to its Russia exposure and there is also some secondary impact from this exposure. There was a 10% country hedge on Russia but it did not mitigate all the losses as the position was c 18% in absolute terms.

The other notable detractor from the fund's short-term performance was the technology sector for a number of reasons, the first being market rotation. Technology was regarded as more expensive and as the market has rotated more into value, growth technology stocks have sold off sharply. Technology hardware within consumer electronics businesses were hit by inflation fears and weakening consumer confidence. Korean and Taiwanese technology portfolio stocks, including Samsung, MediaTek, SK Hynix and TSMC – all had a negative effect on the performance. With regards to TSMC, for example, the team notes that the business has been hit by fears of a reduction in consumer spending, supply chain disruption and the collapse of crypto currency, yet the balance sheet remains robust. TSMC has continued to deliver operationally, but the stock price is down c 14% year to date (in sterling to end-July).

Exhibit 4: Share price and NAV total return performance, absolute and relative to indices (%)

 

One month

Three months

Six months

One year

Three years

Five years

10 years

GSS (FEML since 4 October 2021) equity

(2.6)

(6.1)

(21.5)

(29.3)

(17.7)

(2.7)

33.6

GSS (FEML since 4 October 2021) NAV

(2.5)

(6.3)

(20.2)

(25.2)

(17.8)

(3.1)

43.2

FAST

(2.8)

(7.3)

(22.1)

(23.8)

(3.6)

5.0

146.4

MSCI Emerging Markets

(0.4)

(3.3)

(7.4)

(8.3)

4.5

15.7

76.6

Price relative to MSCI Emerging Markets

(2.3)

(2.9)

(15.2)

(22.9)

(21.2)

(15.9)

(24.4)

NAV relative to MSCI Emerging Markets

(2.2)

(3.1)

(13.8)

(18.4)

(21.3)

(16.2)

(18.9)

Price relative to FAST

0.2

1.3

0.8

(7.3)

(14.7)

(7.4)

(45.8)

NAV relative to FAST

0.3

1.1

2.4

(1.8)

(14.7)

(7.8)

(41.9)

Source: Refinitiv, Edison Investment Research. Note: Data to 31 July 2022. Geometric calculation.

FEML's Q222 performance was also negative due to the underperformance of the long book although this was mitigated to an extent by the short book and some yield enhancement. For example, the short book benefited from its position in an ecommerce platform in the Europe, Middle East and Asia region, which underperformed after it posted weaker Q1 results. Brazilian shorts also contributed as investors withdrew from Brazilian equities against a backdrop of risk aversion. Locally, new social measures to alleviate inflation led to increasing concerns of fiscal risk. The sell-off was exacerbated by domestic outflows from equities to bonds given high interest rates.

The areas that did well during the first two quarters of 2022, thus mitigating some of the underperformance until recently, include the fund’s exposure to copper, Brazil and the Middle East, such as UAE fertiliser company Fertiglobe, which benefited from increased demand as international fertiliser buyers switched from Russian suppliers.

Peer group comparison

Exhibit 5 shows what we believe are the five most relevant peers to FEML from the AIC Emerging Markets sector. Note the company’s performance to end-October 2021 was principally due to Genesis, as Fidelity took over the company at the start of October 2021. We also show FAST’s superior performance over FEML (Genesis run) and the sector average over one, three, five and since Fidelity took over FEML on 4 October 2021.

Exhibit 5: FEML’s peer group at 31 July 2022*

% unless stated

Market
cap £m

NAV TR
1 year

NAV TR
3 year

NAV TR
5 year

Discount (cum-fair)

Ongoing charge

Perf. fee

Net gearing

Dividend yield (%)

Fidelity Emerging Markets

557.5

(23.7)

(24.1)

(16.6)

(12.4)

1.0

No

100

2.1

ScotGems

41.5

(8.1)

(7.8)

(12.7)

(8.1)

1.5

No

92

1.8

Fundsmith Emerging Markets

306.3

(10.8)

(7.9)

5.0

(14.0)

1.3

No

101

0.2

JPMorgan Emerging Markets

1,246.5

(12.9)

(11.8)

8.4

(9.5)

0.9

No

97

1.3

JPMorgan Global Emerging Mkts Income

359.2

(10.8)

(4.7)

7.9

(12.3)

1.0

No

108

4.2

Templeton Emerging Markets

1,735.7

(13.5)

(15.7)

(1.2)

(11.1)

1.0

No

100

2.6

Sector average (six companies)

707.5

(13.3)

(12.0)

(1.6)

(11.2)

1.1

99

2.0

FEML rank in peer group

3

6

6

6

4

4

3

3

Source: Morningstar, Refinitiv, Edison Investment Research. Note: *Performance in GBP to 31 July 2022 based on cum-fair NAV. TR = total return. Net gearing is total assets less cash and equivalents as a percentage of net assets (100 = ungeared).

While the performance since Fidelity took over FEML has been disappointing, this is attributable principally to the two factors discussed in detail above: the exposure to Russia up to February 2022 and the exposure to the technology sector. The portfolio managers have adjusted both exposures.

Valuation: Wider discount could present an opportunity

FEML is currently trading at a 12.4% discount to its cum-income NAV. As shown in Exhibit 6, the discount narrowed during Q421, following Fidelity’s takeover of the company, when the market digested and began viewing Fidelity’s appointment as positive.

Exhibit 6: Discount to NAV (including income) over one year (%)

Source: Refinitiv, Edison Investment Research

The discount widened sharply at the start of the war in Ukraine and while it has since narrowed and stabilised, the company’s NAV is still trading on a wider discount than at the end of calendar 2021. The current discount is also wider that the one- and three-year averages of 10.9% and 10.7% respectively. The current discount differential may present investors with an entry opportunity, as the fund’s performance stabilises under Fidelity’s tenure.

Fund profile: Capital growth and smart risk management

On 1 July 2021 FEML’s board announced the appointment of Fidelity as the company’s manager. The previous manager was Genesis Investment Management (Genesis), which launched the company in July 1989.

FEML aims to achieve long-term capital growth from an actively managed portfolio made up primarily of securities and financial instruments providing exposure to EM companies, both listed and unlisted. The lead portfolio manager, Nick Price, supported by the co-portfolio manager, Chris Tennant, employs an actively managed global growth equity strategy with additional investment tools, enhancing the long-only approach. These include a series of complementary strategies, relaxing the typical constraints of traditional long-only strategies to generate enhanced risk-adjusted returns. At least 80% of the company’s total assets (measured at the time of investment) are exposed to EM companies. The managers aim to maintain a diversified portfolio of a minimum of 75 holdings (comprising a mixture of long and short exposures) in companies listed in or operating across at least 15 countries. Gearing is permitted either through borrowing of up to 10% of NAV and/or by entering into derivative positions (both long and short), which have the effect of gearing, to enhance performance.

The appointment of Fidelity took effect on 4 October 2021, following shareholder approval at the extraordinary general meeting (EGM) on 1 October.

The board undertook a review of investment management arrangements, looking to:

gain access to a top performing EM strategy with a proven long-term track record, as the Genesis team’s relative performance had weakened over the past few years;

find a well-recognised investment management brand in the closed-ended retail, as well as institutional space, as Genesis is primarily focused on institutional investors; and

reduce fees.

We summarise the benefits for the company’s shareholders listed in the board’s announcement on 1 July 2021:

Access to Fidelity International's top-performing EM strategy.

Reduction in management fee: a reduction from the existing 0.9% to 0.6% of NAV.

Nine-month fee waiver from Fidelity.

Fidelity’s brand recognition and increased marketing focus: access to an award-winning investment company manager with extensive marketing capabilities led by a dedicated marketing team.

Ongoing discount control: a commitment to both a performance-triggered tender offer in 2026 and the introduction of a continuation vote for the company to be held every five years.

Given extremely high commonality, FAST is used to illustrate FEML’s investment strategy.

The following differentiate FEML from FAST:

FEML has more flexibility in its investment mandate, such as the ability to invest in unlisted stocks. It is likely to have slightly different portfolio weightings because of its liquidity profile. However, these are very marginal.

There are no retail share classes for FAST and it is not marketed to retail investors in the UK or overseas. Fidelity looks to market FEML to both institutional and retail investors.

The team

The company is managed by Nick Price and Chris Tennant, with the support of Fidelity’s wider EM portfolio management team and 45 (as at 31 October 2021) equity research analysts responsible for the coverage of emerging market stocks. Both managers also tap into the expertise of the EM debt team at Fidelity.

Price designed the approach applied to FEML. Having launched FAST, he has developed, managed and grown the strategy for more than a decade. He has 24 years’ investment experience and has been with Fidelity since 1998. The co-portfolio manager, Chris Tennant, is an emerging market specialist with 10 years’ investment experience, all with Fidelity. Chris started his career as an analyst across various sectors before progressing to a portfolio management role in 2019.

Strong long-term track record of FEML’s strategy, based on FAST

The strategy has outperformed the MSCI EM Index since launch in October 2011 (Exhibit 7). Exhibit 8 illustrates that FEML’s strategy’s higher gross exposure increases active money; Fidelity believes that the increased exposure provides the strategy a greater opportunity to outperform going forward.

Exhibit 7: Long-term track record of FAST (gross of fees*), in £ terms

Exhibit 8: Potentially greater scope for outperformance of strategy with higher exposure for FEML*

Source: Refinitiv, Bloomberg, Edison Investment Research as at 30 June 2022. Note: *Fidelity FAST EM Fund, launched in 2011. The green colour represents long and grey short exposure. **Performance since FAST's launch on 31 October 2011.

Exhibit 7: Long-term track record of FAST (gross of fees*), in £ terms

Exhibit 8: Potentially greater scope for outperformance of strategy with higher exposure for FEML*

Source: Refinitiv, Bloomberg, Edison Investment Research as at 30 June 2022. Note: *Fidelity FAST EM Fund, launched in 2011. The green colour represents long and grey short exposure. **Performance since FAST's launch on 31 October 2011.

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Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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Australia

Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Crown Wealth Group Pty Ltd who holds an Australian Financial Services Licence (Number: 494274). This research is issued in Australia by Edison AU and any access to it, is intended only for "wholesale clients" within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.

New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

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United States

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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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