Author: Hugh Dive

In times of war, investors shouldn’t sell first and ask questions later

Here’s what to watch both in the Middle East and the Russia-Ukraine conflict.

The last four years have been very eventful for bank shareholders, with each year bringing a new set of worries predicted to bring the banks to their knees. 2020 saw an emergency capital raising from NAB (some of which was used to pay the dividend) and Westpac missing their first dividend since the banking crisis of 1893, as experts forecasted 30% declines in house prices and 12% unemployment! Then, 2021 saw the banks grappling with zero interest rates and APRA warning management teams about the systems issues they may face from zero or negative market interest rates expected to come in 2022. In 2022 and 2023, the concerns have switched to the impact of a 4.25% rise in the cash rate on bad debts and the looming fixed interest rate cliff that would see retail sales and house prices plummet.

In this piece, we will look at the themes in approximately 900 pages of financial results released over November, including Commonwealth Banks 2023 full-year results from August and the regional banks awarding gold stars based on performance over the past six months. This piece originally appeared in Firstlinks

Lower Net Interest Margins

Net interest margins are always a major topic during the November banks reporting season, with most investors going straight to the slide on margin movements in the immense Investor Discussion Pack (in the case of ANZ, it was page 29 of the 157 pack). Banks earn a net interest margin [(Interest Received – Interest Paid) divided by Average Invested Assets) by lending out funds at a higher interest rate than by borrowing these funds from depositors or wholesale money markets.

During the peak COVID-19 period, when the cash rate was at 0.1%, interest margin pressure was on the lending side of the book, with banks trying to write as many loans as possible. The banks were willing to cut margins to gain market share by offering competitive interest rates and cash-back offers, with some exceeding $10,000! Today, this pressure has moved to the deposit side of the book, with consumers benefiting from higher interest rates on bank deposits and term deposits. Banks are now being forced to offer competitive deposit rates as consumers look to move their money to those who are most willing to offer better rates.

The November reporting season saw net interest margins decrease for all banks. The banks more heavily exposed to mortgages (CBA and Westpac) traditionally have higher margins than the business banks (NAB and ANZ), which face competition from international banks when lending to large corporates. Commonwealth Bank posted the highest net interest margin in June, with 2.07%. However, due to CBA closing their books on 30^th June, we may see this number compress with the more recent deposit competition.

Low Bad Debts

From May 2022, Australia’s official cash rate climbed from 0.10% to 4.35% across 13 different rate hikes. Every time we had a cash rate increase, investors were worried and questioned how it would impact consumers? Are bad debts going to rise sharply? Do house prices collapse? What we have seen over the last year is that employment in Australia has remained remarkably robust in a tight labour marketplace. This has seen consumers being able to reallocate funds from discretionary or non-necessity spending to being able to fund their home loans.

Bad debts have remained low in 2023, with all banks reporting negligible loan losses; ANZ and Macquarie reported the lowest level, with loan losses of 0.01%. To put this in context, since the implosion in 1991, banks grappled with interest rates of 18% and considerable losses to colourful entrepreneurs such as Bond, Skase, et al. Since then, loan losses have averaged around 0.3% of outstanding loans, and the banks price loans assuming losses of this magnitude.

The level of loan losses is important for investors as high loan losses reduce profits and, thus, dividends and erode a bank’s capital base. Conversely, the very low losses in 2023 have translated into record dividends and billion-dollar share buybacks.

Bad debts have remained low in 2023, with all banks reporting negligible loan losses; ANZ and Macquarie reported the lowest level, with loan losses of 0.01%.

Building Offset Account Balances

What we have seen over the last year is that employment in Australia has remained remarkably robust in a tight labour marketplace. This has seen consumers being able to reallocate funds from discretionary or non-necessity spending to being able to fund their home loans.

Something that we have seen over the past few years is consumers allocate more towards their home loans through offset accounts. As you can see in the chart below, balances in offset accounts have ballooned, meaning banks are forgoing some interest income in exchange for more secure clients and lower bad debts. We were surprised to see that despite rising interest rates, offset account balances have risen rather than fallen, with $5 billion added since March 2023, with a total of $214 billion currently sitting in the offset accounts of the big four banks.

Show me the Money

While the big Australian banks are sometimes viewed as boring compared with the biotech or IT themes du jour, what is exciting is their ability to deliver profits in a range of market conditions. In 2023, the banks generated $32.7 billion in net profits after tax. This saw the big four banks’ dividends per share increase by an average of 15% per share, with all banks except for NAB now paying out higher dividends than they did pre-Covid 19. The star among the banks was ANZ, which raised dividends per share by 20%!

Well Capitalised

Capital ratio is the minimum capital requirement that financial institutions in Australia must maintain to weather the potential loan losses. The bank regulator, the Australian Prudential Regulation Authority (APRA), has mandated that banks hold a minimum of 10.5% of capital against their loans, significantly higher than the 5% requirement pre-GFC. Requiring banks to hold high levels of capital is not done to protect bank investors but rather to avoid the spectre of taxpayers having to bail out banks. In 2008, US taxpayers were forced to support Citigroup, Goldman Sachs and Bank of America, and British taxpayers dipping into their pockets to stop RBS, Northern Rock and Lloyds Bank going under. The Australian banks were better placed in 2008 and did not require explicit injections of government funds; the optics of bankers in three-thousand-dollar Armani suits asking for taxpayer assistance is not good.

In 2023, the Australian banks are all very well capitalised and have seen their capital build. This allows the banks to return capital to shareholders through on-market buybacks. During the bank reporting season, Macquarie announced a $2 billion dollar on-market buyback, Westpac announced a $1.5 billion share buyback, CBA announced a $1 billion share buyback, and NAB announced they had a remaining $1.2 billion share buyback. For investors, this not only supports the share price in coming months but reduces the amount of shares outstanding to divide next year’s profits by!

Expenses

Australia’s banks operate in a competitive oligopoly, largely selling an undifferentiated product (loans) where their competitors have a similar cost of production (capital from depositors and wholesale capital markets). Consequently, other banks swiftly match moves to gain a higher market share and increase profits by discounting loans. However, banks can grow profits by reducing their expense base, which expands yearly.

Containing expense growth has proved challenging for the banks, with low unemployment contributing to wage growth and the need to hire more compliance staff after the 2018 Banking Royal Commission. Additionally, compliance teams have grown in response to the Commonwealth Bank and Westpac getting hit with hefty penalties from AUSTRAC for not complying with the Anti-Money Laundering and Counter-Terrorism Financing Act 2006.

Wage growth was the major contributor for all the banks this year, accounting for more than half of the growth in expenses. Due to the persistent higher-than-normal levels of inflation experienced over the last year, banks were forced to increase wages for staff after increasing headcount from last year. Atlas still believes that rationalising the branch network will be the easiest way for the banks to grow earnings over the next few years.

An important measure when looking at a bank result is how the jaw ratio changed, which is the difference between the growth of operating income and operating expenses. This is a very important measure for banks due to the large size of their loan books. A small move in the jaws can move hundreds of millions of dollars in profits. Westpac wins the gold star for expense control, cutting costs by 1% whilst growing operating income by 8%.

The Vampire Kangaroo – Macquarie

After two sensational years driven by high volatility in energy and oil prices due to supply shocks from weather and geopolitical events, Macquarie’s first-half profit was down 39%, cycling off a strong first half last year. After two sensational years driven by high volatility in energy and oil prices due to supply shocks from weather and geopolitical events, Macquarie’s first-half profit was down due to a decision not to IPO assets into an unfriendly market (see below table).

The first half of last year was a great time for renewable companies following lots of hype around the transition to renewable energy, allowing Macquarie to get top dollar and even above book prices for these assets. This year, though, has seen a very different environment, with the market sceptical of risky IPOs in a risk-off environment.  Macquarie has moved some of these assets into a specific Green Energy Fund, creating lower short-term earnings but longer-term profits.

Outside of the market-facing business, the banking and financial services business has been outperforming, with the home loan portfolio growing by 6% to $114 billion and deposits growing to $131 billion. This is a great outcome for the bank, taking market share away from the big four banks while maintaining a strong net interest margin.

The Regional Banks

There are 4,236 commercial banks in the United States, with many small regional banks, a very different structure to Australia. This is a relic of historic US banking laws that prohibited interstate banking and limited the ability of banks to operate branches outside their state. While many of these regulations were repealed in the 1990s, they favoured the existence of many small local banks and in 2023, left the big 4 (JP Morgan, Bank of America, Citibank, and Wells Fargo) with a combined market share as measured by total assets of only 23%. Conversely, in Australia, there are 95 banks, with the big four banks having a market share in 2023 of 73%! The two listed regional banks, Bank of Queensland and Bendigo Bank, have a market share of around 2% each.

As we can see in the bank matrix at the top, the Australian regional banks did not win a single star across the board. This is due to having a higher capital cost than the big banks, as wholesale funders require higher coupons on their bonds to offset their higher risks. Additionally, the regional banks have limited access to the large pools of corporate transaction account balances that have historically paid minimal interest rates. To be competitive against the lending products from the major banks, the regional banks need to accept a lower net interest margin across their loan book, leading to lower returns on equity.

Our Take

Overall, we are happy with the financial results in November from the banks owned by the Atlas Australian Equity Portfolio. The three main overweight positions, Commonwealth Bank, ANZ, and Westpac, all increased their dividends, which is a crucial signal indicating improving prospects and board confidence in the outlook.

All banks showed solid net interest margins, low bad debts, and good cost control. Profit growth is likely to be tough to find on the ASX over the next few years, with earnings for resources and consumer discretionary likely to retreat; however, Australia’s major banks look to be placed in a good position in current turbulent markets and have cleaner loan books and a greater margin of safety than they had going into the turbulent times of 2007/08.

• October was a weak month, with global markets continuing to fall for the third month in a row, driven by expectations of more rate rises to combat the stickier-than-expected inflation. There was nowhere to hide in global markets, with the S&P 500 down -2.2%, the NASDAQ down -2.8%, and the ASX200 down -4%.
• The Atlas High Income Property Fund pulled back by -5.6% despite several companies in the Fund reporting robust quarterly earnings. Indeed, the two toll roads held in the Fund reported quarterly profits on record average traffic and inbuilt inflation-linked toll escalators.
• Concerns of higher inflation and rising geopolitical tensions have dominated the last three months quarter, with many trusts having share prices below what they were during the middle of lockdowns in mid-2020 when they faced an uncertain future and were having trouble collecting rents. Conversely, in October 2023, many generated profits higher than pre-CV19 levels and enjoyed close to full occupancy. Early November has seen a sharp recovery, with October’s losses recovered in the first few days of trading.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2024.

In October each year, listed Australian companies with a June financial year end host their annual general meetings (AGMs). Fund managers rarely attend these events as they are designed to allow retail investors to pose questions to company management and vote on directors and the company’s remuneration report. Institutional investors do not vote in person but rather by instruction to the custodians holding their fund’s shares. They would have met with company management in August when they released their financial results.  

In this week’s piece, we will look at the quarterly trading updates given by a range of Australian companies to try and piece together what is going on in the Australian economy. While the broad-based fall in share prices since mid-September suggests that companies are struggling, the quarterly updates showed robust trading conditions for many Australian companies.

Normally, we don’t pay much attention to AGM’s and the trading updates given by management are usually very similar to the conditions the company was facing in August.

However, this October has seen greater interest in company updates at the AGMs due to the sharply changing economic conditions. Over the last 18 months, the average mortgage rate has increased from 2.14% to 6%, along with cheap fixed-rate mortgages converting into higher variable rates dubbed the “fixed rate cliff” by the media. This should have seen cratering retail sales in 2023 and significant falls in house prices, neither of which have occurred. Additionally, increases in inflation of the same period have posed challenges for many companies.

Consequently, Atlas has been looking closely at management presentations over the past two weeks at company AGMs. While some companies are exhibiting signs of weakness, the October updates showed that many Australian companies are navigating the changing environment quite well.

Retail Mixed

The non-discretionary grocers had a good start to their years, with Woolworths and Coles posting sales growth of over 5% for the first quarter. The grocers both mentioned that food inflation is moderating in late 2023 to between 2-3%, with the prices for some items such as fruit, vegetable and packaged meat now falling. Higher interest rates have seen shoppers trading down to cheaper home brand items, which deliver a higher profit margin, with Woolworths citing an 8% increase in home brand sales. Liquor retailer Endeavour saw modest sales growth at BWS and Dan Murphy’s of 1.8% and, like the grocers, experienced value-conscious customers trading down to mainstream beer and lower priced rosé and pre-mixed drinks.

JB Hi-Fi’s first quarter was much better than expected, with Australian sales falling -1.4%, cycling off a very strong first quarter last year. Conversely, electrical goods rival Harvey Norman saw Australian sales falling by -14% but announced a surprise $440 million on market buy-back as a salve for investors. Atlas’ calculations indicate that the company will be borrowing to buy back their shares, an aggressive move from an already highly geared company in a market with rising interest rates and weakening retail sales. JB Hi-Fi appears to be benefiting from their lower cost business model, which has seen them take market share off Harvey Norman.

Wesfarmers produced a fantastic first-quarter result, demonstrating that consumers are still willing to spend money and trade down to lower-cost products across their offerings. We see that Bunnings and Kmart, the lowest-cost operators across the hardware and discount department store markets, will continue to benefit and take market share over the short-medium term.

Miners facing cost inflation

The iron ore producers had in-line first quarters and are continuing to benefit from higher iron ore prices but will face headwinds over the coming months and years. BHP, Rio Tinto, and Fortescue are all facing inflationary problems, with higher oil prices set to be higher for longer and ongoing labour costs, which will increase production costs. We remain cautious towards the iron ore producers due to concerns about the sustainability of iron ore prices above US$100/t in the face of a slump in Chinese residential construction and a government plan to cap steel production at 1 billion tons per annum.

Energy powering ahead

Woodside Energy had a solid quarter, with production up +8% to 48 million barrels of oil. The company also announced that they had started producing at a new field in the Gulf of Mexico, which was six months ahead of expectations which saw full-year guidance being upgraded. Woodside has little exposure to a weakening Australian consumer, selling energy into a global market primarily via long-term off-take agreements to utilities in Japan, China and Korea. Stronger energy prices in the latter part of 2023 and a weaker Australian dollar are setting Woodside up for a strong finish to the year. Similarly, oil refiner and petrol retailer Ampol released a stellar quarterly update in October, showing that profits were up +65% on the previous quarter. The company continues to benefit from higher fuel sales, strong margins from refining crude and, surprisingly, an increase in convenience retail sales. We had expected a big fall in convenience retail sales for Ampol due to higher petrol prices, but motorists are still buying Gatorades, Mars bars and Guzman y Gomez burritos after filling up!

Toll Roads Stronger than Ever

After the Ampol quarterly that showed Australian fuel sales were up +11%, it was not a great surprise to see the toll road operators report strong traffic numbers in October. Transurban reported record quarterly average daily traffic across their network with 2.5 million trips per day, with traffic up +3% on the prior period. Similarly, Atlas Arteria saw traffic up +2.3% in the past quarter, mainly in their French assets, with revenue up a healthy 6.1%. Due to the impact of quarterly escalators on their inflation-linked tolls and long-term fixed-rate debt, higher traffic will see expanding profit margins.

Healthcare robust, but weight loss Fears Dominate

The past quarter has been tough for investors in healthcare stocks, with the dominant theme being concerns that GLP-1 weight-loss drugs will impact demand for a range of therapies treating sleep apnea, cardiovascular diseases and kidney damage. Indeed, these weight loss drugs have even impacted the share prices of pathology testing companies under the assumption that a potentially slimmer society will result in fewer oncology, fertility, gastrointestinal and respiratory tests.

Resmed has seen its share price hit the hardest, losing a third of its market capitalisation due to the view that slimmer patients will see diminished demand for sleep apnea devices. While this may occur in the future, Resmed’s quarterly update showed revenue of +16% and profits up +9%. Similarly, CSL’s share price has been under pressure due to the unproven potential of the GLP-1 weight-loss drugs on the company’s kidney disease treatments, despite dialysis comprising a small part of company earnings. At their annual capital markets day in October, CSL revealed that the company was trading strongly and confirmed guidance for profit growth in 2024 between 13-17%.

Out Take

Global equity markets have fallen by close to 10% over the last three months, and at the close of October 2023, many companies on the ASX200 are trading near or even below the lows of March 2020 despite having better business operations and higher profits in 2023. Toll road operators Transurban and Atlas Arteria are trading at a 25% discount to their pre-COVID share price despite higher traffic volumes and toll prices. Similarly, healthcare companies Sonic Healthcare and CSL both have share prices below January 2020 despite having higher earnings per share and servicing more customers worldwide. While some companies will struggle in an environment where money is no longer free or falter due to higher geopolitical tensions, for many companies, these factors will have limited to no impact on corporate profits and distributions to their shareholders.

“In the short run, the market is a voting machine, but in the long run, it is a weighing machine” – Warren Buffett.

• September was a weak month, with global bond yields rising to Global Financial Crisis levels driven by macroeconomic concerns around higher interest rates and oil prices. This saw global stock markets uniformly fall between -3% and -5%. There were also few places to hide in Australia Listed Property, which fell -9% on concerns for rising interest rates reducing profitability for property and infrastructure assets.
• The Atlas High Income Property Fund pulled back by -6.2%, a fall based on global macroeconomic fears rather than any specific issues with the companies held in the Fund. In aggregate, the companies held in the Fund have an average occupancy rate of 99%, with lower gearing, lower interest costs and a longer tenor of debt than the wider Australia Listed Property index. Despite this, the companies held by the fund trade at an average discount to net assets of -19%, with this net asset value backed up by actual transactions in the direct property market.
• The Fund declared a quarterly distribution of $0.027 per unit for the September Quarter. The distribution was paid to investors earlier this week.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2024.