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The last 12 months have been very kind to equity investors, with the ASX trending upwards throughout the year. The ASX finished +17% ahead of where it ended 2020 and all its sectors posted a positive gain except for tech stocks. More importantly for the psyches of bruised investors, there were no significant corrections throughout the year; this despite falling iron ore prices throughout the year, new lockdowns in Eastern Australia, and the emergence of the Omicron variant late in 2021. Indeed, the August reporting season saw a record $40 billion in dividends declared by Australian companies, beating the previous record of $28 billion set in August 2019. After periods of good fortune, which saw the share prices of many companies surge ahead of valuations, it is natural to look at those companies with share prices marked down. Several companies are inevitably out of favour every January but will see their share prices rebound strongly by December.

In this first weekly piece of 2022, we will look at the “dogs” of the ASX in 2021, see how 2020 Dogs performed, consider some predictions for 2022, and review of Atlas’ forecasts from January 2021 (see Dogs of the ASX 2020)

Dogs of the Dow

Michael O’Higgins popularised a systematic strategy of investing in underperforming companies named “Dogs of the Dow” in his 1991 book “Beating the Dow.” This approach draws on the same investment principles as deep value and contrarian investors. O’Higgins advocated buying the ten worst-performing stocks over the past 12 months from the Dow Jones Industrial Average (DJIA) at the beginning of the year, but restricting the stocks selected to those that are still paying a dividend. Restricting the investment universe to a large capitalisation index like the DJIA or ASX 100 improves the chance that the unloved company may have the financial strength or understanding capital providers (such as existing shareholders and banks) that can provide additional capital to allow the company to recover over time. The thought process behind requiring a company to pay a dividend is that its business model is unlikely to be permanently broken if it is still paying a distribution. A company’s directors are unlikely to authorise a dividend if insolvency is imminent. The strategy then holds these ten stocks over the calendar year and sells them at the end of December. The process then restarts, buying the ten worst performers from the year that has just finished.

Retail investors have an advantage

One of the reasons this strategy persists is that institutional fund managers often report their portfolios’ contents to asset consultants as part of their annual reviews. This process incentivises fund managers to sell the “dogs” in their portfolio towards the end of the year as part of “window dressing” their portfolio before being evaluated.

For example, in early 2021 fund managers with Treasury Wine in their portfolios would have faced some stern questioning from asset consultants about why they owned the troubled winemaker. Treasury was expected to face an unpleasant couple of years due to a 220% tariff that China was now applying to imported Penfolds Grange. Treasury Wine shares returned +35% (including dividends) over 2021. The winemaker has been able both to redirect some Chinese sales to other Asian countries and also to make Penfolds branded wine in both China and California in a move to circumvent the putative tariffs imposed on Australian wine. While this strategy is yet to replace the lost higher-margin sales to China, it has improved sentiment towards the company.

Here retail investors can have an advantage over institutional investors. Their lack of scrutiny from asset consultants allows them the flexibility to pick up companies whose share prices have been under pressure late in the year that could see a rebound when the selling pressure stops in January and February. Furthermore, retail investors can afford to take a longer-term view on the investment merits of a particular company that may have hit a speed bump.

Over the past year, the Dogs from 2020 returned +7%, underperforming the ASX 200 index’s return of 17% in a year of above-average returns for the ASX. Continued underperformance from AGL Energy and IAG was too much to outweigh the gains of Treasury Wine and QBE Insurance to allow an equally weighted portfolio of the Dogs from 2020 to outperform a surging ASX in 2021. 

The common theme in the reversal of performance for the two stars of the 2020 Dogs – QBE Insurance and Treasury Wine – were improvements in the company-specific issue weighing on the share price. QBE Insurance had a very solid 2021 benefiting from premium rate increases, cost reductions and sound underwriting. Furthermore, the insurer will benefit from rising interest rates.

Three energy companies appear on the list of the 2020 Dogs: Oil Search, Origin and Woodside. On average they returned only returned +8% in 2021. This return was a surprise in a year where the oil price rallied +60%, as energy companies’ share prices are usually closely correlated with the price of oil. Atlas attribute this disconnect to uncertainty around major corporate acquisitions conducted in 2021 for Oil Search (merger with Santos) and Woodside (merger with BHP Petroleum), as well as oil companies being screened out by ESG algorithms. Ultimately the share prices of these companies will revert to the market price of oil and LNG.

Predictions from January 2020

When we went through this exercise in January 2021, looking at which of the Dogs of 2020 would shine in 2021, Atlas saw that the pain would continue for Qantas and Treasury Wine. This was due to these companies’ inability to reverse the issue that caused their share price decline in 2020, namely travel restrictions and Chinese tariffs. Here we were correct with Qantas but wrong on Treasury Wine as we dismissed the strategy of making Californian Penfolds and using Chinese grapes to rebuild sales in China.

In the case of QBE Insurance and IAG, we underestimated the extent of rising premiums and increasing interest rates while we expected increases in premiums. Fortunately, Atlas owns QBE Insurance in the portfolio which outperformed IAG by +39% due to IAG’s higher claims and some self-inflicted wounds around not changing clauses in their business interruption insurance.

In January 2021 Atlas predicted that oil would recover in 2021, precipitating a strong recovery in the energy companies that appeared on the list of the Dogs from 2020. This prediction proved correct, with oil recovering from an average of US$42/barrel in 2020 to US$70/barrel throughout 2021. Atlas’ forecasts that the energy stocks would rebound in 2021 and that Woodside would outperform were less accurate. While this is disappointing, we are unwilling to admit defeat, with Woodside expected to report 2021 net profits in February 2022 in the region of US$1.1 billion – a significant increase over 2020 net profits of US$447 million. As discussed above, Atlas believes that the lack of positive momentum on Woodside’s share price in 2021 has less to do with rising earnings and dividends and more to do with concerns around the merger with BHP Petroleum. The merger will see BHP shareholders issued with Woodside shares and will turn Woodside into one of the largest global energy companies.

Unloved Mutts from 2021 in Need of a Good Home in 2022

Historically, finding the fallen angel amongst the worst performers seems to work best where the underperformance is due to stock-specific problems rather than macroeconomic issues beyond a company’s control. Macroeconomic issues beyond a company’s control include AGL facing falling wholesale electricity prices, or A2 Milk facing regulatory issues in China and falling e-commerce sales. Additionally, where the underperformance is due to a company-specific problem, the company in question may receive a takeover offer from a suitor who believes they can snap up the company cheaply and then fix its issues.  

Unlike previous years, the list of the bottom ten performing stocks in the ASX 100 is not concentrated in a few sectors. Rather, this year’s list is populated by companies whose woes were linked to company-specific issues, typically indicating rich pickings for the coming year. Looking at the two financial companies on the above list, it is hard to pick Magellan as a candidate for a bounce-back, as the company’s issues in late 2021 are likely to intensify in 2022. AMP has been a serial inclusion since 2018 on the annual Dogs of the ASX 100, with its share price falling from $5 to $1. AMP could, however, see a takeover offer in 2022, though potential suitors have walked away in the past.

After agreeing to a takeover in mid-2021, AfterPay’s share price is tethered to Block’s (née Square) share price in the NYSE. As we have no unique insight into Square’s global merchant payments activities and are alarmed at its price-earnings ratio of 156x, it is tough to pick AfterPay as the sharp recovery candidate in 2022.

For 2022 we are picking Orica and Lend Lease as the candidates for a strong rebound in 2022. Orica’s falls in 2021 was attributed to decreasing thermal coal volumes which resulted in reduced demand for explosives. However, in 2022 the outlook for coal looks robust, particularly in light of major exporter Indonesia banning coal exports in January 2022. This move by the Indonesian government is being made to divert coal to domestic power producers and will be beneficial for Australian coal miners and hence Orica. Lend Lease looks like an attractive takeover candidate in 2022, with an attractive $110bn global development pipeline, and because it currently trades on a cheap multiple. Additionally, Lend Lease is a more palatable and cleaner acquisition target since exiting its volatile engineering business.

This piece was originally published on Livewire Dogs of the ASX in 2021

Fund managers say inflation, COVID-19 will be important in 2022

One of the biggest challenges for investors in 2022 will be higher interest rates as central banks move to combat rising inflation. Futures markets are pricing in two hikes by the Federal Reserve in 2022 and at least three rate rises by the Reserve Bank of Australia.

• Atlas High Income Property Fund had a steady month in November gaining +1.1%, as global markets were buffeted by the emergence of the Omicron variant of Covid-19 and a slowing Chinese property market.
• Unlike in early 2020, concerns about lockdowns to contain the new Covid-19 did not see panic selling of companies owning hard assets due to more certainty around earnings and the view that real assets provide a hedge against inflation. The Fund is primarily exposed to asset classes that saw minimal to no impact from lockdowns in 2020, which gives us confidence that distributions will be maintained in the unlikely event that the Omicron variant results in further restrictions.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2022

CSL shares dip below $300 as it confirms M&A talks

On Friday, the stock fell $7.63 to $297.69 each – their lowest close since late October. The Swiss drugmaker’s shares shot up more than 20 per cent on the Swiss Stock Exchange overnight forcing Vifor to issue a statement telling investors “it systematically reviews options that can strengthen its market position and/or accelerate the growth of the company both organically and through partnerships and acquisitions”.

Midway through 2020, the prevailing view was that 2021 was going to be a challenging year for the banks, which were expected to face an unemployment rate above 10%, a 20% fall in house prices and significant declines in lending as the economy was expected to be beset by large company collapses. This scenario would have seen the banks eat through their carefully hoarded capital reserves and probably encouraged by a nervous APRA to issue more equity at deeply discounted prices.

The November 2021 reporting season proved these forecasts incorrect, with bank dividends increasing sharply, loan loss provisions taken in 2020 written back, all banks conducting share buybacks and demand for business and home loans robust. In this piece, we will look at the themes in the approximately 800 pages of financial results released over the past two weeks, including Commonwealth Banks 1^st Quarter 2022 Update, awarding gold stars based on performance over the past six months.

Recovering from the Pandemic

The key feature of the November results for the banking sector was the continued recovery in the financial health of corporate and household Australia despite Sydney and Melbourne experiencing months of lockdowns during 2021. Instead of seeing a steep increase in unemployment and falling house prices, thus increasing bad debts for the banks, the unemployment rate has declined from a peak of 7.5% in June 2020 to 5.2% in October 2021. Robust employment combined with low interest rates has seen house prices surge over the past year. CoreLogic Home Property Value Index increased by 20.6% over the twelve months ending in October, led by Sydney houses and apartments that gained 25.2%.

This vast improvement in the outlook saw Westpac, ANZ and NAB continue to write back provisions taken against expected Covid-19 losses, with CBA and Macquarie only recording minimal loan losses. The discrepancy between loan losses is due to the different times that the various banks report their results. NAB, Westpac and ANZ all have September financial year ends, which saw their management teams estimate their expected losses from Covid-19 in May 2020. At this time, bank management teams were facing a bleak and uncertain outlook and consequently made provisions of approximately $2 billion each for expected losses. Additionally, NAB raised $3.5 billion from its shareholders. As Commonwealth Bank has a June year-end, their management team had the advantage of observing a recovering economy and the impact of $311 billion in Australian government stimulus measures.

The below chart shows banking sector bad debts over the past 40 years. In 2021 the combination of increases in employment, sharply rising house prices and record low interest rates has seen bad debts fall significantly.  The recovery from Covid-19 has proved to be faster than the GFC, and nothing like the decade it took the banks to recover from the 1991/92 recession.

Give me my Money Back

Excess capital and share buybacks have been a feature of the recently concluded results season, a theme that would have been unfathomable 18 months ago. All banks have a core Tier 1 capital ratio well above the Australian Prudential Regulation Authority’s (APRA) ‘unquestionably strong’ benchmark of 10.5%, aided by asset sales in wealth management, Covid-19 provisions, as well as low to no dividend payments. This resulted in the banking sector remaining well capitalised, with the capital building as the expected loan losses from Covid-19 have not eventuated.  The second half of 2021 has seen the four major banks buy back $13.5 billion worth of their own shares, with CBA ($6 billion) and Westpac ($3.5 billion) buying back their shares off-market due to a higher level of franking credits which can be paid directly to investors in an off-market transaction. Nab ($2.5 billion) and ANZ ($1.5 billion) have been gradually buying back shares on the ASX,  due to their lower level of excess franking credits stemming from these two banks offshore adventures, which limited the amount of tax paid in Australia.

The rationale for buying back shares is couched around neutralising the impact of lost earnings from divested insurance and wealth management businesses. However, reducing the share count will make it easier for bank management teams to hit the return on equity targets (ROE) as the equity divisor is reduced.  Nab, ANZ and Westpac all have similar levels of Tier 1 capital post their capital management initiatives, with CBA’s current lower level of capital reflecting both a large buyback in 2021 and not taking large loan loss provisions in 2020. As APRA appear content with allowing CBA to have a lower level of excess capital, investors in the other three banks can probably expect further share buybacks in 2022 if economic conditions remain benign.

Gold Star

Falling Net Interest Margins

Net interest margins were a major topic during the November banks reporting season, with the share prices of CBA and Westpac both falling after reporting declining margins. Banks earn a net interest margin [(Interest Received – Interest Paid) divided by Average Invested Assets] by lending out funds at a higher rate than borrowing these funds either from depositors or on the wholesale money markets.

When the prevailing cash rate is 6%, it is much easier for a bank to maintain a profit margin of 2% than when the cash rate is 0.1%.  Falling interest rates reduce the benefits banks get from the billions of dollars held in zero or near-zero interest transaction accounts that can be lent out profitably. However, this cheap source of funding continues to benefit the banks. In their result, Westpac revealed that as of September 2021, the bank held $282 billion on accounts earning less than 0.25% and a further $126 billion paying interest between 0.26% and 0.49%.

The November 2021 reporting season saw net interest margins compress for Westpac and Commonwealth Bank as they competed to take market share off the two Melbourne-based banks. In a competitive market for loans,  Westpac and CBA were able to grow their loan book by offering cheaper rates, though this comes at a cost. ANZ’s margin was broadly stable though this came at the expense of lost market share as the bank struggled to process the elevated level of home loans over the past six months. 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. Westpac posted the highest net interest margin in November with 1.98%. However, this declined over the past six months due to growing market share and borrowers concerned about rising rates shifting to lower margin fixed-rate loans and the bank continuing to reduce its exposure to interest-only loans and loans to investors. While this looks concerning, Westpac’s lower margins will be offset by the growth in its loan book.

Gold Star

Expenses

Containing growth in expenses has proved challenging for the banks, with low unemployment contributing to wage growth combined with the need to hire more compliance staff after the 2018 Banking Royal Commission. Additionally, compliance teams have grown in response to  Commonwealth Bank and Westpac getting hit with hefty penalties from AUSTRAC for not complying with Anti-Money Laundering and Counter-Terrorism Financing Act 2006.  In the recently concluded results season, Westpac surprised the market after growing expenses by 8%, mainly due to the bank hiring 3,000 new staff to set up new financial crime and complaints handling procedures and meet other regulatory obligations.

While there was minimal discussion around cutting expenses by closing branches, Atlas sees that rationalising the branch network will be the easiest way for banks to grow earnings. On average, the significant banks each have over 1,000 branches around Australia. They have experienced a decline in usage of these branches over the past decade, as most bank transactions are now conducted either online or via smartphones.  In November, NAB reported processing 1,300 digital transactions for every in-person transaction conducted at a bank. Westpac said that it had closed 98 branches over the past year, which should show benefits in coming years. The gold star goes to ANZ, who kept expenses unchanged at $7.4 billion despite higher revenue.

Gold Star

Dividends

As can be seen in the first table all banks sharply increased their dividends in the most recently completed reporting season. However, for all banks, there was an element of catching up for reduced payments to shareholders in 2020 after APRA placed a cap limiting dividends to 50% of earnings.  ANZ increased their semi-annual dividend by 66% to 72 cents, though this is still 10% below their pre-Covid 19 levels. Macquarie wins the gold star, increasing their dividend by 100%, but what is more important for investors is that the $2.72 paid to investors is ahead of the $2.50 per share paid to investors in November 2019.  As a global investment bank, Macquarie Bank has enjoyed a good pandemic, growing earnings in 2020 and 2021, profiting from market volatility.

Gold Star

Our Take

Investing in Australian banks is one of the major questions facing institutional and retail investors alike, with the banks comprising 25% of the ASX 200.  We expect the banks to deliver around 5-10% earnings growth over the coming year as earnings continue to recover from the hit from the pandemic. However, growth will be muted by lower credit growth, normalising bad debts and reduced earnings support from provision write-backs. However, if investors examine the wider Australian market, the banks look relatively cheap and are well capitalised. Unlike other income stocks such as Telstra, they should have little difficulty maintaining their high, fully franked dividends.

Additionally, their share prices are likely to see support over the next 12 months from share buybacks. Looking further ahead, Australia’s banks have historically performed well in an environment of rising interest rates. They have seen expanding profit margins by being swift to increase interest rates on loans but slower to increase the rate paid on term deposits and transaction accounts.

This piece originally was published in FirstLinks: Bank results scorecard: who deserves the gold stars?