Thursday, 18 April 2019 14:28

Roadsigns to Recession

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Mark Draper (GEM Capital) wrote this article for the Australian Financial Review and was published during the month of April 2019.

 

With the graphs of leading Australian economic indicators taking on the shape of a waterfall, investors would be wise to dust off the play book about how to invest in a recession.  While not in recession yet, we are likely to know in the next few months whether Australia will enter recession, and it depends on whether some indicators, that we examine here, can change direction.

Many investors have not seen an Australian recession during their investing life, with the last one taking place in 1990/1991.  During that recession the economy shrank by almost 2%, employment reduced by just over 3% and the unemployment rate moved into double digits.  Business failure rates increased along with bank bad debts, and two of Australia’s major banks were in financial stress with share price falls of at least 30%.

At the epicentre of the current downturn is the residential property market.  Property values have been heading south, rapidly, particularly in the eastern states.  The further and faster property prices fall, the greater the probability of recession.  The IMF believes the downturn is worse than previously thought.  This is one of the few times that property prices have fallen without the RBA raising rates or from rising unemployment.

The second key indicator is housing credit growth.  Housing credit growth is currently below the level seen during GFC and below the level witnessed during the 1991 recession.  Credit approvals are falling, particularly in the second half of 2018.  This reflects tightening of lending standards by banks, but also that Australian consumers may have reached their capacity to take on new debt.  Investors need to ask what will alter this environment.  Previous episodes of weak demand for credit have been met with cuts to official interest rates, but with rates currently at 1.5%, the RBA does not have much ammunition to fire.

Building approvals are collapsing.  While there is currently enough work from buildings currently in progress to keep tradesman busy, building approvals point to a more troubling future.

Falling property values can create a wealth effect where consumers feel less wealthy and as a result defer purchasing decisions.  This can be seen in new car sales figures and 2018 saw its worst annual result since 2014.  This is against a backdrop of strong population growth during that time.

The weakening economic outlook is unfolding during an election campaign that the ALP are favoured to win.  The ALP is proposing to significantly increase the overall tax levied, (ie franking credit changes, CGT and negative gearing changes) which is likely to suck further money out of the economy and act as an additional handbrake.

If Australia were to enter recession, there are several investment sectors where investors should tread carefully.

Given that 60% of the Australian economy revolves around consumer spending, discretionary retailers are most at risk to a consumer under pressure.  Caution should also be taken with the price paid for food retailers who may also come under pressure as consumers seek to lower their expenses during a downturn.  The recent Woolworths profit result shows the food retailers are already operating in a very difficult retail environment.

Travel is another sector at risk as consumers in a downturn could turn their focus away from discretionary leisure spending.  Businesses too could replace interstate travel with more teleconferences in tighter economic times.

Banks are obvious investments to suffer in an economic downturn as demand for credit weakens and bad debts rise.

Property investments with a focus on property development profits should also be scrutinised.

The currency could be one of the few safe havens as the Australian dollar most likely depreciates during recession.  Beneficiaries of a weaker currency are those Australian companies who earn income from overseas or unhedged International investments.  Australian exporters who have not hedged currency can also benefit from a lower Australian dollar.

Investors should pay attention to the next few months of leading economic indicators to determine whether Australia is likely to break the 27 year recession drought, and position their investments accordingly.  

Thursday, 18 April 2019 14:23

Montgomerys' Best of the Best Report - April 2019

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Montgomery Investments have recently produced their 'Best of the Best Report' for April 2019.

 

In this edition, they cover:

1. The recent company reporting season - opportunities for investors

2. Sydney Airport - is the runway for growth likely to continue?

3. Their view on Challenger

 

To download the report - please click on the image below.

 

April 2019 Best of Best image

Thursday, 18 April 2019 14:15

Major Parties' Tax and Super policies

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thinking aboutThe federal election has been called for May 18 and both major parties have outlined their superannuation and tax policies. With the federal election only weeks away many of our clients have been asking what the major political parties’ policies are that may impact their SMSF, individual taxation circumstances or personal investments. 

 
LIBERAL-NATIONAL COALITION

Superannuation

  • Australians aged 65 and 66 will be able to make voluntary superannuation contributions without needing to work a minimum amount. Previously, this was only available to individuals below 65.

  • Extending access to the bring-forward arrangements (the ability to make three years of post-tax contributions in a single year) to individuals aged 65 and 66.

  • Increasing the age limit for individuals to receive spouse contributions from 69 to 74.

  • Reducing red-tape for how SMSFs claim tax deductions for earnings on assets supporting superannuation pensions.

  • Delaying the implementation of SuperStream (electronic rollovers for SMSFs and superannuation funds) until March 2021 to allow for greater usability.

Taxation

  • From 2018-19 taxpayers earning between $48,000 and $90,000 will receive $1,080 as a low and middle income tax offset. Individuals earning below $37,000 will receive a base amount of $255 with the offset increasing at a rate of 7.5 cents per dollar for those earning $37,000-$48,000 to a maximum offset of $1,080.

  • Stage 1 tax cuts: From July 1 2018, increasing the top threshold of the 32.5% tax bracket from $87,000 to $90,000.

  • Stage 2 tax cuts: From 1 July 2022, increasing the top threshold of the 19% personal income tax bracket from $41,000, to $45,000.

  • Stage 3 tax cuts: From 1 July 2024, reducing the 32.5% marginal tax rate to 30% which applies from $120,000 to $200,000. The 37% tax bracket will be abolished.

AUSTRALIAN LABOR PARTY

Superannuation

  • Disallowing refunds of excess franking credits from 1 July 2019 – this would mean SMSF members in pension phase no longer receive refunds for the franking credits they receive for their Australian share investments.

  • Banning new limited recourse borrowing arrangements.

  • Reducing the post-tax contributions cap to $75,000 per year down from $100,000.

  • Ending the ability to make catch-up concessional contributions for unused cap amounts in the previous five years.

  • Ending the ability for individuals to make personal superannuation tax deductible contributions unless less than 10% of their income is from salaries.

  • Lowering the higher income 30% super contribution tax threshold from $250,000 to $200,000.

Taxation

  • Labor supports the stage 1 tax cuts and will match the $1,080 low and middle income tax offset. From 1 July 2018, individuals earning below $37,000, will get a $350 a year tax offset, with this amount increasing for those earning between $37,000- $48,000 to the maximum $1,080 offset.

  • Introduce a 30% tax rate for discretionary trust distributions to people over the age of 18.

  • Will limit negative gearing to newly built housing from January 1 2020. (Existing investments are grandfathered under the current law).

  • Reduce the capital gains tax discount for assets that are held longer than 12 months from the current 50% to 25%. (Existing investments are grandfathered under the current law).

  • Limit the deductions for the cost of managing tax affairs to $3,000.

Sunday, 31 March 2019 07:58

Investors Guide to the Federal Election

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The next Federal election will be held during May 2019.

It is difficult to remember an election that potentially has so many impacts on investors.  Mark Draper wrote this article for the Australian Financial Review which was published during the month of March 2019.

As if worrying about potential changes to franking credits and capital gains tax discounts weren’t enough, there are a myriad of other potential changes that investors need to think about should Australia have a change of Government at the next Federal election, as is widely anticipated.

Normally politics doesn’t usually need to feature prominently with investment decisions, but we suspect that this Federal election will bring politics to the top of mind for investors.

Here we examine some of the sectors that are likely to be impacted by the election.

Nathan Bell, (senior portfolio manager Intelligent Investor) says “If Labor reduce the CGT discount to 25%, that could drastically reduce demand for investment properties, which has already collapsed due to falling property prices and tighter lending.

This would be very bad news for the banks (and mortgage brokers and other lenders), which need to increase the size of their loan books to grow earnings.”  The banks could also face a higher bank levy from either side of politics as a politically acceptable way of funding election promises, particularly following the Royal Commission.

The ALP has proposed a cap of 2% on private health insurance premium increases. Matt Williams (portfolio manager Airlie Funds Management) is of the view that the insurers are already preparing for the introduction of this policy and that the question investors must ask is whether the health insurers, or the hospitals will have the upper hand in negotiating prices.  Who has the upper hand will determine whether the insurers can operate under this policy without a hit to their bottom line.  He points out that insurers are already looking to reduce claims and keep people out of hospitals with a focus on greater recovery at home and other alternatives. The recent profit result from Medibank Private showed very tight cost control.

Williams is also surprised that neither party as yet has committed to policy to write down the value of the NBN, thereby potentially reducing the price that NBN wholesalers, and by extension consumers, pay for their internet access.  He believes it is likely that the next term of Government write down the value of the NBN.  Such a write down would be broadly positive for the Telco sector as it could lead to higher margins for Telcos, which have struggled to generate a reasonable return from re-selling NBN.  This is unless the price reductions were ‘competed away’ in a highly competitive environment.

Nathan Bell is also concerned about the effects of policy changes to consumer behaviour.  He says “Labor's main policies all act as a tax on consumers. We've already got a recession on a per capita basis, so these policy changes will reduce spending. Non-discretionary retailers, including Woolworths and Coles, recently reported weak earnings growth. These policies could see growth evaporate altogether. People will find ways to cut their spending by buying more discounted groceries; shopping less often; buying more generic brands; and avoiding small treats.  Imagine what that then means for discretionary retailers, such as Harvey Norman and JB HiFi.” 

The Coalitions’ energy policy has ensured that the share prices of Australia’s energy retailers have been heavily discounted on the concerns of electricity prices being capped or companies broken up.  

Bill Shorten late last year also contributed to the uncertainty in energy policy suggesting the ALP will redirect east coast gas, earmarked for export, to the domestic market, if certain price levels (which weren’t disclosed) were reached.  Australia’s gas producers have export contracts to deliver gas that usually spans decades.  Investors are right to be concerned if a Government considered mandating that export contracts be put at risk in order to fulfil domestic demand.  Williams believes that this uncertainty is creating opportunities to buy energy companies that are cheap as a result.

It’s hard to be definitive about how to position investments for the Federal election at this stage, given that both major parties haven’t really put many cards on the table.  What ends up being legislated is often not necessarily what is promised during an election campaign, so investors need to ensure they don’t over react too..  

One thing however is certain, populist politics and business bashing is with us for the moment, and is likely to have material ramifications for investors.  Investors must respond by paying more attention than usual to this years’ Federal election.

Friday, 01 March 2019 17:47

Knowing when to sell

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Mark Draper (GEM Capital) writes a monthly column for the Australian Financial Review.  In his January 2019 article he outlines some of the triggers investors should look for that provide clues for when to sell.

 

7 flags to tell you ‘it’s time to sell’

The days of the ‘buy and hold’ strategy has long been a ‘dinosaur’ and probably always was. Regular changes to technology, regulation, consumer tastes not to mention competitors can turn today’s hero investments into tomorrows dogs. 

Successful investing involves not only buying assets for a reasonable price, but also knowing when to sell.

The term ‘red flag’ is referred to by professional investors as events that take place that act as an early warning signal to sell.

Here are 7 red flags to help investors sell before ‘it hits the fan’:

  1. When directors sell shares in their own company, particularly when more than one director sells in a short period of time, investors should be nervous.  History is littered with examples of director selling followed by dramatic falls in share prices.  In August 2016 the CEO and Chairman of Bellamys both sold a combined total of 365,000 shares at around $14.50 per share.  In June 2018 two directors of Kogan sold 6,000,000 shares at $7 per share. The share price charts below tell the rest of the story.  INSERT Bellamy’s and Kogan charts (attached PDF’s)
  2. Crowded trades takes place when consensus opinion on an investment is universally positive which usually coincides with excessive valuation.  The ‘investment that can not lose’, verbalised by cab drivers and instant experts at barbecues  is usually a place to avoid.  Crowded trades could also be referred to as fads.

Who can forget the mantra in 2007/2008 about peak oil theory, when the oil price was around $150 per barrel.  Investing in energy was a one way bet according to common beliefs of the day, providing an excellent example of the crowded trade.  Oil today of course trades today at around $60 per barrel.  

  1. Poor behaviour from management which include directors/management using company assets for private use, related party transactions such as the company renting premises from directors and excessive management remuneration.
  2. A google search of Nepotism reveals “the practice among those with power or influence of favouring relatives or friends, especially by giving them jobs”.  Whether employing a relative or friend of management, or the company expanding into an unrelated business, so that a relative can run it, rarely results in getting the best person for the job.
  3. Most investors appreciate that a company’s share price follows the earnings.  Earnings should follow cash flow, so when earnings rise without a corresponding rise in cash flow, investors should beware.
  4. My father always said to me ‘everything comes from the top’, and how true this is with respect to investing.  Changes to management can play a big role in share holder returns.  A Financial Services executive employed to run a healthcare company?  A Milkman running a Childcare company?  True situations that didn’t end well for shareholders.  Investors should consider the background and experience of new management that is appointed to satisfy themselves that they are fit for the role.
  5. Valuation is the ultimate red flag. Buy low and sell high sounds simple but the only way an investor can do this is to first hold a view of what an asset is worth.  While this seems elementary, I continue to be surprised by investor behaviour which clearly demonstrates no regard for valuation.

Let us pay tribute to the poor souls who invested in Cisco Systems at the height of the dot.com bubble paying well in excess of 100 times earnings.    Almost 20 years later, the share price is still not back to its level at the peak of the dot.com boom.

And there were many examples of this behaviour in Australian technology stocks in the dot.com boom that didn’t even have a price earnings ratio due to the fact that the company’s didn’t have any earnings to show.  Crypto currency is possibly the most recent example of investors chasing returns from an asset without regard for intrinsic value.

7 flags to help investors keep from trouble.  As the great Kenny Rogers song said, “you gotta know when to hold ‘em, know when to fold em’, know when to walk away and know when to run.  Happy investing!

Livewire recently interviewed arguably two of Australia's best Global Investors.  They are Andrew Clifford (CEO Platinum Asset Management) and Hamish Douglass (CEO Magellan Financial Group).

The interview discusses their current views on the financial landscape and is a must see for investors.

 

Mark Draper (GEM Capital) writes a monthly column for the Australian Financial Review.  This article outlines the generational opportunity that is before investors in the doubling of the Chinese middle class in the next 5 years.  It was published during February 2019.

 

The growth in Chinese middle class is one of the strongest demographic opportunity for investors in a generation.  Most investors however, including the Global indices, have little in the way of exposure to this theme.

Chinese middle class is forecast to double from around 300 million to 600 million people in the next 5 years.  While the definition of middle class varies widely, it is commonly characterised to include those but the poorest 20% and the wealthiest 20%.  It is natural as more people enter the middle class they will have more disposable income to spend on discretionary purchases.  Buying cars, property, healthcare, mobile phones and a change of diet are all examples of the opportunities that exist for investors from this demographic trend. 

Vihari Ross, Head of Research at Magellan Financial Group points to coffee consumption in China as a long term opportunity. Those with even modest discretionary income can afford this ritual.  Chinese annual coffee consumption is less than 1 cup per year per capita, versus the US consumption of around 300 cups per year per capita.  

Growth in Chinese coffee consumption is one of the key drivers behind Magellan’s investment into Starbucks according to Ross. There are currently 3,400 Starbucks stores currently in China,  the company is forecast to open 600 new stores in China each year for the next 5 years, which equates to annual growth of 15%.  With a pre-tax return of 85% on investment from these stores the investment case seems compelling.

Source: Magellan Financial Group

Andrew Clifford, CEO Platinum Asset Management says “China is the world’s largest physical market – not just for iron ore and copper but everything imaginable:  aeroplanes, autos, mobile phones, semiconductors, running shoes and luxury handbags.  Indeed, it is hard to imagine a physical market for which China is not the largest customer.”

Source: Platinum Asset Management

With growing car ownership in China, comes the need for insurance.  This helps explain Platinum’s investment into Ping An Insurance Group, the number 1 global insurance company on the 2018 Forbes Global 2000 list.  Ping An, which trades on a price earnings multiple of around 11 is growing rapidly and boasts a technology-first mindset.  Its Fintech capabilities are world class and its health business and life insurance businesses are also booming.  Needless to say, there are very few listed companies in Australia trading on a price earnings multiple of 11 that are growing their earnings.

To help put further perspective on what the next 5 years might look like for Chinese middle class, we look back 5 years. Dinner party conversations will be enriched by wheeling out some of these Chinese growth statistics.  In 2014 there were 25 million motor vehicles sold in China and in 2018 the number was 28 million.  Chinese box office revenue in 2014 was $5bn and in 2018 it took in $9bn. There were 640 million internet users in 2014 and in 2018 there were more than 800 million.  109 million overseas visitors entered China and in 2018 the number of tourists was over 150 million.  14 billion express post parcels were delivered in 2014 and in 2018 parcel delivery grew to over 50 billion parcels.  32 million Chinese passengers flew domestically every month in 2014, rising to around 50 million passengers per month in 2018.  (statistics courtesy of Platinum Asset Management)

To cope with the surge in air travel, China plans to build over 70 new civil airports by 2020 to make the total 260. That’s up from 175 in 2010.  The opportunity for inbound tourism into Australia is enormous (and bolsters the investment case for Sydney Airport).

The numbers are phenomenal and difficult to grasp for many Australians.  More importantly, investors who base the majority of their investments domestically are ignoring this generational tailwind.

Clearly there will be peaks and troughs in the Chinese economy, although it is still growing at around 6% per year, good by Western measures.  Just the growth of the Chinese economy each year is larger than the entire Australian economy.

Investors would be wise to look through the short term economic cycles and embrace the extraordinary opportunity that is before them.

Tuesday, 11 December 2018 13:34

AMP - two bagger or falling knife?

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Mark Draper wrote this article which appeared in the Australian Financial Review during the month of December 2018.

After spending the last 20 years despising AMP and selling any shares we ever came into contact with, it is interesting that we find ourselves potentially interested in buying AMP shares now that they are trading at an all time low.

Every investor dreams about picking the turnaround story that doubles in value.  Is AMP a two bagger or a falling knife?

It’s hard to find much in the way of positive news flow around AMP at present, which is normally a good place for investors to start as it can imply most investors have already headed for the exits.  The recent sale of AMP’s life insurance division was the last instalment of poorly received news with some in the market labelling it a ‘fire sale’ or ‘AMPutation’.

After the sale of AMP’s Life businesses, consensus earnings estimates are around 25 cents per share according to Skaffold software, which puts AMP on a current price earnings multiple of 10.

Skaffold which models intrinsic value based on assumptions of future cash flows currently has the share price trading at a small discount to intrinsic value.  

Source: Skaffold

What is often overlooked by investors is that AMP still has 3 key divisions, which are Wealth Management (platforms and advisers), AMP Capital (funds management) and AMP Bank.

AMP Capital has assets under management of $192.4bn, with around two thirds of this coming from their internal channels such as AMP aligned financial advisers.  This division is currently in fund outflow.  The key question for investors is whether AMP can regain the trust of investors and stem fund outflows, or whether fund outflows are permanent?  

AMP Bank has a lending book of around $20bn and the loan book saw a small decline for the first time since 2015.  This division carries the same risks of the other retail banks in the event of potential for bad debts.

Nathan Bell, portfolio manager at Intelligent Investor says “within a few years after the recent AMP Life disposal and the sale of its New Zealand wealth management business slated for next year, AMP could have around $1.5bn of capital that could either be returned to share holders or reinvested to grow earnings. Incoming CEO De Ferrari (who starts on 1st Dec 2018) needs to increase the company's return on equity to 15% to earn all his bonuses, so theoretically investing the money would increase earnings by $225m, which in turn could see earnings per share move closer to 30 cents per share”.

Bell then suggests that if AMP was subsequently re-rated to 15 times earnings, assuming no deterioration or improvement from other divisions, the share price could be $4.50 (15 X 30 cents per share earnings). The dividend yield for investors with an entry price of $2.50 would also be attractive under this scenario according to Bell. 

The problem with finding investments that can produce such a high return at the tail end of a bull market is that these opportunities often come with ‘warts’, and AMP’s business units are under immense pressure, which is why Bell is eager to hear De Ferrari's strategy. There are also suggestions De Ferrari will renegotiate his contract, as his bonus targets will be very difficult to achieve following the board's widely condemned deal announced recently to sell its AMP Life business.

It is always useful to understand how senior management is incentivised and the incoming CEO receives a large incentive if the share price reaches $5.25.

Matt Williams, Airlie Funds Management is watching AMP closely but has rarely invested in the company over his career. He cites a revolving door of management and a business with high fixed costs that is not really a leader in any of its market segments as reasons to be cautious.  Airlie have recently met with AMP management but remain on the sideline at this stage.

Risks for AMP include De Ferrari not being able to restore the company’s reputation, continued fund outflows, financial market downturn which decreases fee revenue from funds under management, bad debts from the banking division not to mention the outcome from the Royal Commission with respect to vertical integration among other issues.

The best investment decisions are often the ones which make investors feel the most uncomfortable and on that count AMP rates highly, given the uncertainties.  The strategy from the incoming CEO is the next piece of the puzzle for investors to help determine whether AMP is a turnaround in the making or a falling knife.

Thursday, 08 November 2018 11:56

Why Buffett likes Apple

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Mark Draper writes a monthly column for the Australian Financial Review - this article was published in September 2018

 

Apple has not only featured in the media for its latest range of iPhones and Watches, but also because it is Warren Buffett’s largest investment.

Warren Buffett owns around 5% of Apple shares (via Berkshire Hathaway) which recently became the first company to crack the US $1 trillion market capitalisation level.  ($AUD 1,400,000,000,000)  To put this in perspective, the market capitalisation of the entire ASX200 is only about 25% higher than that of Apple alone. 

Even though technology is the one of fastest growing sectors globally, local investors are starved of IT opportunities in the ASX200 with technology comprising less than 4% of the index. Local investors with a focus on the domestic market may be missing out on Buffett’s wisdom.

Composition of the ASX 200

Buffett does not have a natural leaning toward technology manufacturers but at his recent annual meeting described Apple as a “very, very special product, which has an enormously widespread ecosystem, and the product is extremely sticky”.  So what is behind the investment case for Apple?

The best place to start is to ask, how many of your friends and family own an iPhone?

The iPhone is important to Apple as its sales represent around 60% of revenue, but what has changed in the last 5 years is the composition of iPhone sales.  Magellan Asset Management estimate that in 2012 around 45% of iPhone sales were to new users.  In 5 years this changed so that only 20% of iPhone sales are to new users, with 80% being sold as replacement handsets to existing users.

For investors, this means more consistent earnings in the form of recurring earnings, rather than one off handset sales.  Magellan portfolio manager, Chris Wheldon describes the iPhone sales figures “as a subscription that Apple users are willing to pay every 2- 3 years, to remain in the Apple ecosystem”.

While revenue from iPhone sales YTD to 30th June 2018 is up an impressive 15%, what is more impressive according to Wheldon is the growth in the ‘Services’ business which is up 27% YTD.  The Services business comprises of revenue from digital content and services including the App Store, Apple Music, iCloud, Apple Care and Apple Pay.  Apple Music is now the most popular paid streaming service in the United States. 

The Services business was the second largest division within Apple contributing over $27bn in revenue for the 9 months to 30th June 2018, which represents almost 15% of total revenue.

The Services business is largely recurring in nature and its strength relies on the number of Apple devices connected to the ‘ecosystem’.  Earlier this year, Apple CEO Tim Cook stated in January 2018 that its active installed base of devices had reached 1.3bn, which includes iPhone, iPad, Mac and Apple Watches. 

The ‘Wearables’ division which includes products like Airpods and Apple Watch is also growing strongly.  In the last quarter of 2017, for the first time, Apple shipped more Apple watches than the entire Swiss Watch Industry, making Apple the largest watch maker in the world.

Wheldon believes the market may not yet fully appreciate the quantum and growth in the Services and Wearables businesses which could account for 35% of the total business in the future.

The technology bears would point to the high valuations of the dot.com boom at the turn of the century.  To this end it is interesting to note that Apple currently trades on a forward looking 2019 price earnings ratio of around 16 (less if adjusted for cash holding), which for a business whose earnings are growing at a double digit rate does not seem excessive.

Investors can invest in Apple through many avenues, either by owning it directly or via listed invested companies/trusts from leading managers including Magellan, Platinum and Montgomery Investments.  Some ETF’s also provide an entry point to technology companies.

Using technology is second nature in our everyday lives, so why wouldn’t investors make it second nature to their investment strategy as Warren Buffett has done?

Thursday, 08 November 2018 11:35

Bank Reporting Season scorecoard FY 2018

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Article written by Hugh Dive - Atlas Funds Management and reproduced with permission from Hugh

On Monday this week, Westpac ruled off the 2018 financial year profit results for the Australian banks. In the words of Queen Elizabeth, 2018 could only be described as an annus horribilis for Australian banks and their investors. The CEO of one major bank lost his job, the revelations of the Financial Services Royal Commission resulted in remediation provisions and a spike in legal fees (which should see new sports cars and houses at Palm Beach for sections of the legal community this Christmas), fines were levied and credit growth slowed. An environment of fear has weighed on bank share prices.

There are common themes emerging from the banks in the 2018 reporting season. We will differentiate between the major trading banks and hand out our reporting season awards to the financial intermediaries that grease the wheels of Australian capitalism.

Bank reporting season scorecard October 2018

Click to enlarge

Scaling back the empire

The main theme from 2018 was the breaking down of the allfinanz model that the banks built up carefully over the past 30 years. Allfinanz or bancassurance refers to the business model where one financial organisation combines banking, insurance and financial services such as financial planning to provide a financial supermarket for their customers. This is based on the somewhat false assumption that the bank’s employees can efficiently cross-sell different financial products to their existing customers at a lower cost than if this was done by separate financial institutions. It creates some of the conflicts of interest that have been on display at the Royal Commission.

Over the past year, the Commonwealth Bank sold its life insurance business to AIA and the asset management business a week ago to Mitsubishi UFJ for a very solid price. Similarly, ANZ exited both its wealth management and life insurance businesses. NAB also announced plans to sell MLC by 2019. Additionally, Westpac has reduced its stake in BT Investment Management (now renamed as the Pendal Group). These moves acknowledge that creating vertically-integrated financial supermarkets was a mistake. If adverse rulings are made on vertical integration in the Royal Commission’s Final Report, most of the banks will have already made moves to simplify their businesses, so shareholders won’t be exposed to significant ‘fire sales’ of assets by motivated sellers.

Profit growth hit by remediation

Across the sector, profit growth was subdued in 2018 as the banks grappled with slowing credit growth, the application of tighter lending standards, customer remediation and legal costs. The table above looks at the growth in cash earnings inclusive of these costs. Whilst many companies encourage investors to look through these charges, ultimately these are real costs that impact the profits available to shareholders, and in aggregate the four banks have set aside $1.3 billion to cover customer remediation.

Westpac reported the strongest cash earnings by cost control, very low bad debts and a lower level of customer remediation charges. NAB brought up the rear due to both $755 million in restructuring costs and $435 million in customer remediation charges.

Bad debts stay low

A big feature of the 2018 results for the banks has been the ongoing decline in bad debts. Falling bad debts boost bank profitability, as loans are priced assuming that a certain percentage of borrowers will be unable to repay. Additionally, declining bad debt charges year on year creates the impression of profit growth even in a situation where a bank writes the same amount of loans at the same margin. Bad debts fell further in 2018, as some previously stressed or non-performing loans were paid off or returned to making interest payments. The main factors causing this fall has been the low unemployment rate and a near absence of major corporate collapses over the past 12 months.

Westpac and Commonwealth Bank both get the gold stars with very small impairment charges courtesy of their higher weight to housing loans in their loan book. Historically home loans have attracted the lowest level of defaults.

Shareholder returns hold as dividends steady

Across the sector, dividend growth has essentially stopped, with Commonwealth Bank providing the only increase, two cents, over 2017. In an environment where loan growth is slowing, provisions rising and the management teams regularly appearing either in front of the Royal Commission or before our political masters in Canberra, it would be imprudent for the banks to raise dividends.

In 2018, dividends were maintained across the banks, which was a surprise in the case of NAB. It paid $1.98 in dividends on diluted cash earnings per share of only $2.02, a very high payout ratio and not a sustainable situation given that the bank’s capital ratio is below the APRA target of 10.5%.

Looking ahead, dividend growth is likely to be subdued in 2019, as the banks digest the outcome from the Royal Commission. ANZ and Commonwealth Bank shareholders can expect capital returns in the form of share buy-backs to offset the dilution from asset sales. In 2018, ANZ bought back $1.9 billion of its own stock, with an additional $1.1 billion due over the next six months. The major Australian banks in aggregate are currently sitting on a grossed-up yield (including franking credits) of 9.4%, an attractive alternative to term deposits.

Interest margins

The banks’ net interest margins [(Interest Received – Interest Paid) divided by Average Invested Assets] in aggregate declined in 2018, reflecting higher wholesale funding costs and borrowers switching from interest only (which attracts a higher rate) to principal and interest mortgages. This switching was done in response to regulator concerns about an overheated residential property market, and in particular the growth in interest-only loans to property investors. Looking ahead to 2019, margins should recover courtesy of a rate rise of around 0.15% announced in mid-September. All the banks put through a similar rate rise with the exception of NAB, and it will be interesting to see whether NAB increases its market share as a result of this or follows suit at a later date.

Total returns including share prices

All the banks have delivered negative absolute returns, also trailing the S&P/ASX200 which eked out a small gain of 0.24%. The uncertainty around the outcomes from the Royal Commission, rising compliance costs and slowing credit growth has weighed on their share prices. Westpac has been the worst-performing bank, mainly due to concerns about lending standards in the $400 billion mortgage book, though we are yet to see any adverse evidence in the form of rising bad debts.

– No star given –

Our overall view of the future

It is hard to be a bank investor at the moment and some fund managers are advocating avoiding them all together.

We view that at current prices, investors are being paid an attractive dividend yield to own solid businesses that have a long history of finding ways to grow earnings and navigate political minefields. Looking at the wider Australian market, the banks look relatively cheap, are well capitalised and unlike other income stocks such as Telstra, should have little difficulty maintaining their high fully-franked dividends. Additionally, the share prices of ANZ and Commonwealth Bank will see the benefit of share buy-backs, as the proceeds from the sales of non-core assets are received. The key bank overweight positions in the Maxim Atlas Core Equity Portfolio are Westpac, ANZ and Macquarie Bank.

Hugh Dive is Chief Investment Officer of Atlas Funds Management. This article is for general information only and does not consider the circumstances of any investor