The little Aussie Battler under pressure

In the press, large movements in the Australian dollar are often erroneously presented in the press as a vote of confidence in Australia as a nation or the management (or mismanagement) of our elected leaders. A falling Australian dollar is often viewed as a negative event, raising the cost of online purchases, imported cars and overseas travel.

Over the last year, we have seen the AUD fall 8% vs the USD, continuing the volatility in the AUD that we have seen over the past decade since the AUD peaked at 1.10 vs USD in 2011. Over 2018 we had seen the AUD slide downwards from a peak of 0.81 in January to 0.725 as uncertainties over the leadership of the country have increased. Political instability is likely to continue to weigh on the AUD in the short to medium term, as over the next year Australia faces a National election and a likely change in government to a party that has few business or investor-friendly policies.

In this week’s piece we are going to look at currencies, the AUD and in particular the winners and losers from currency movements.

 

Fixed Rates

For much of the last 200 years currencies have been fixed either against another stronger currency or commodity such as gold. For example, following the second war the Bretton Woods agreement pegged currencies against the USD, which was fixed to gold at the rate of US$35 per ounce.

When a country has a fixed currency and faces adverse economic conditions, their treasury inevitably uses the nation’s stock of foreign currency reserves to prop up a faltering exchange rate. The outflow of foreign currency reserves occurs as investors seek to exit and sell the county’s currency which is viewed as overpriced based on the changing economic circumstances or market sentiment.  A great example of this occurred in Russia in 2008, which saw Russia chew through US$200 billion in carefully hoarded foreign currency reserves in a futile attempt to defend the value of the rouble before eventually devaluing the exchange rate.

Additionally, fixed rates can attract the attention of speculators that may look to profit from a forced reset in the exchange rate, where the rate is perceived to be fixed at a rate higher than the currency’s fundamentals. For example, in 1992 the GBP was set at a rate of 2.7 DM to the GBP as part of the European Rate Mechanism, fundamentally this over-valued the GBP as it the UK’s inflation rate was three times that of Germany’s. Speculators famously led by George Soros shorted the GBP, after spending large amounts of foreign currency reserves defending the GBP and raising interest rates from 10 to 12%, the GBP was ultimately devalued, netting Soros’ fund a profit of GBP1 billion.

Floating Rates

In the 1970s as a result of inflation induced by spending in on the Vietnam war, the US abandoned fixing the USD to gold and allowed the USD to float freely in line with market demand. The free float of the USD eventually forced other major currencies to follow suit, with the AUD switching to a floating rate in 1983.

By allowing its currency to float freely, a country loses the ability to control its exchange rate, but it gains control of its monetary system. Before 2000 (when the Greek Drachma was fixed to the €), the current Greek debt situation would have arguably been much less painful to the Greek economy. The current Greek debt crisis would have seen the Drachma being sold down heavily, thus making summer holidays on the Aegean and Greek olive oil much cheaper than similar products offered by Italy or France.

History of the AUD

In 1983 when the Hawke government came into power, one of their first decisions was devalued the AUD by 10% and float the Australian dollar, assuming that this action would cause the AUD to fall and improve our international competitiveness and stimulate the export sector. Before 1983, the value of the AUD was set each day by the Reserve Bank of Australia (RBA) and the Federal Government and either directly pegged to the foreign currencies such as the GBP or USD or pegged to a trade-weighted basket of currencies.

Corporations had to apply to the RBA to buy foreign currencies to buy imported goods or make investments offshore, with the RBA selling the company USD or GBP in exchange for their AUD at the official fixed rate.

Two floors of the RBA Building in Martin Place were occupied by Exchange Control staff whose job was to make it hard and discouraged for Australian businesses and investors wanting to invest offshore. While this sounds archaic, this level bureaucratic obstruction may have prevented BHP US shale gas debacle or Wesfarmers UK hardware expedition, both of which resulted in significant transfers of wealth from Australian shareholders to companies domiciled in the US and the UK.

 

 

 

Since floating in 1983 the AUD/USD has averaged 76c. However, the AUD was in a downward trajectory from 1983 to 2002. This was broadly due to Australia’s higher relative inflation rate. The strength in the AUD over the past ten years has been a result of China’s industrialisation and its unprecedented associated explosion in demand for Australian minerals since China’s integration into the global economy after joining the World Trade Organisation in 2001. More recently the interest rate differential between Australia and the US and Europe has boosted the AUD; though rate cuts since 2011 and higher US rates have closed this gap. In the medium term, we would expect the AUD to move towards fair value based on purchasing power parity, which we estimate, is approximately US$0.66.

WINNERS

The companies that are likely to benefit from a weaker AUD fall into four categories;

  1. Import substitution:  Companies that produce something in Australia and compete with the now more expensive imports such as steel (BlueScope), fertiliser (Incitec Pivot) or tourism (Crown).
  2. Exporters: Companies that have production costs such as wages in Australian dollars but sell a commodity globally like iron ore that is priced in USD (Rio Tinto) or Grange Hermitage wine (Treasury Group). Here a falling AUD translates into higher revenue for the same quantity of goods sold.
  3. Companies with inflation linked-pricing: When a falling AUD results in inflation, companies like Transurban should see an expanding profit margin. Here their road tolls will increase with inflation, while a proportion of these companies’ costs remain fixed, thus resulting in higher profits.
  4. Offshore Operations: The falling AUD also benefits companies with substantial offshore operations such as CSL, Atlas Arteria and Unibal-Rodamco-Westfield, as their USD or Euro denominated earnings are worth more when translated back into AUD for Australian investors.

Losers

The companies that are likely to hurt from a weaker AUD fall into three categories;

  1. Resellers: The companies that are typically hurt by a falling AUD are those that buy goods offshore for resale to Australian consumers such as retailers Myer and JB Hi-Fi.  Here Australian consumers wages are not impacted by a fall in the currency, but a new iPhone or LED TV’s cost has gone up.
  2. Users of foreign content in their production process: Similarly, a falling AUD presents a challenge for companies like Qantas and Seven West Media that earn revenue in AUD from domestic consumers, but have significant USD-denominated costs such as aviation gas or television series produced in the USA.
  3. Unhedged borrowers of offshore debt:  Further, companies that have significant un-hedged USD borrowings such as Boral will see their interest costs increase, especially if the company does not have USD earnings to service their debt. This situation occurred in 2010 and required Boral to raise $490 million to keep the company within their debt covenants.

Our Take

We expect the AUD to continue to trend down towards 66c in-line with purchasing power parity, diminishing interest rate differentials between Australian and other Western economies and expected further falls in commodity prices. Accordingly, we have structured the portfolio to benefit from a falling AUD. One additional benefit in having a strong bias towards companies with earnings offshore is that the variability of domestic political decisions and the uncertainty brought on the turnover in leadership will have less of an impact on profits and dividends.

Big versus Small Company Investing

Over the past twelve months, small companies (as measured by the ASX’s Small Ordinaries) have returned 22%, outperforming large caps (ASX Top 100) by almost 10%. This has led to numerous articles in the financial press claiming that small is beautiful and that investors should look beyond large Australian companies to add growth and excitement to their portfolios.

In this week’s piece, we are going to look at the reasons behind this performance discrepancy on the ASX, and why investors tend to get compensated for investing in small capitalisation companies.

Large capitalisation companies are defined as those in the Top 100 companies listed on the ASX. They tend to be large household names such as NAB, Woolworths or Harvey Norman. Currently the smallest large-cap company – measured by market capitalisation (shares outstanding multiplied by price) – is CSR with a market capitalisation of $2.1 billion which has been listed on the ASX since 1962. Conversely, companies classified as small caps are generally newer companies seeking to grow earnings by developing a new mine, product or technology. An example is Afterpay Touch that was first listed last June. Often small companies grow at such a rate that they become classified as large companies like A2M Milk. However, this also works in the other direction in the case of declining companies like Myer.

Life is harder for smaller companies

At first glance, one would think that smaller companies on average should underperform large companies, as company size confers stability and a range of advantages. In other words, small companies have limited financial resources and fewer avenues to access the capital markets. These characteristics entail commercial disadvantages, for example, Westpac can easily raise capital from a number of sources quickly, whereas a small company may only be able to tap existing shareholders. Additionally, small companies generally face a higher cost of debt with a shorter tenor, as only large companies are able to sell 10-year bonds to the US Private Placement market. Larger companies can therefore negotiate more forcefully over interest rates with the domestic banks.

Additionally, smaller companies often have weaker competitive advantages than many large Australian companies that operate in cosy domestic oligopolies, where the incentive is mainly to maximise profits by managing the political environment to maintain the status quo. Arguably however the competitive advantages conferred by operating in domestic oligopolies can lead to destructive offshore acquisitions designed to deliver growth that may be elusive domestically, where the company is constrained by regulation or the actions of competitors protecting their market share. A recent example of this can be seen in Wesfarmers’ hardware acquisition in the UK and BHP’s foray into US shale gas.

Small companies outperform

Despite these challenges, since the 1980s a number of studies have shown that small-cap equities have historically outperformed large-cap equities on a risk-adjusted basis over the longer term. The most famous study of this phenomenon was done by Nobel laureates Fama and French[1] who looked at monthly returns between July 1926 and February 2012 in the US stock market. They found that during that time, small-cap stocks also delivered a cumulative excess return of 253% relative to large-company stocks. In their view, the outperformance of small caps over large caps was due to an element of risk unique to small companies; that is, investors are compensated for undertaking additional risk inherent to investing in companies with higher risk

As a former small-cap fund manager, my observation is that some of this outperformance can also be attributed to market inefficiency and not just compensation for additional risk. Inevitably smaller companies are less well understood by the overall market. They will be less subject to analyst coverage from the investment banks, which could increase the risk of mispricing. For example, there are 16 analysts working at large investment banks publishing research on BHP, all seeking to uncover new information or angles on this company currently worth $112 billion. Conversely, most small companies struggle to receive minimal – if any – coverage from stockbrokers.

The last twelve months in Australia

Over the last twelve months, small capitalisation companies listed on the ASX have outperformed their larger cousins by close to 10% on average, a significant gap. The largest 100 companies on the ASX have returned 13% including dividends, a pretty good return by historical standards. However, amongst these companies there is a significant variance in returns.

Amongst the large caps the top performing companies were CSL (56%), Santos (+88%), ResMed (+59%), and Macquarie (+48%), ably assisted by mining heavyweights BHP (+39%) and Rio (+25%).  Whilst these are all great returns for investors the average return has been dragged down by Telstra (-26%), AMP (-29%), and Fortescue (-19%) as well as fallen angels Ramsay (-18%) and Harvey Norman (-15%). However, the real story behind the underperformance of large capitalisation stocks is the banking sector that has essentially done nothing over the past year: Westpac (-2%), NAB (0%), ANZ (+3%) and CBA (-7%). These four stocks represent close to a quarter of the ASX – though if we measured this four weeks ago the results would have been worse!

Whilst the returns over the last year from large companies such as CSL and Santos were impressive, they look quite pedestrian when compared with the star small-cap companies such as Afterpay Touch (+361%), Beach Energy (+186%), Appen (+161%), WiseTech Global (+113%), and A2M milk (+130%). The common theme amongst these is investors paying for early-stage IT or growth companies that benefit from leveraging exciting technologies or are M&A candidates for bigger companies.

The small cap index also has a large weighting to mining services and small mining companies that were on their knees in early 2016 but given their operating leverage have benefited from rising commodity prices in 2017 and 2018 courtesy of a Chinese stimulus plan. Still, investing in small companies is not without risks, as when things go wrong for a smaller company often the consequences are more extreme than for a larger more established company. Over the past year Retail Food Group (-89%), BlueSky (-74%), Isentia (-55%) and Myer (-32%) have caused a degree of pain for small cap investors, as well as former market darlings Ainsworth Game Tech (-53%), Vocus (-29%), Class Super (-26%) and Amaysim (-41%).

The last ten years

Over the past 10 years the large caps have actually outperformed the small caps by 30%, however we recognise that a big factor in this performance is related to the time frame used. As you can see from the below chart, the market crash during the GFC hit the smaller companies much harder than their larger cousins, with the small companies falling on average -48% in 2008 compared with the still very painful -29% fall for the Top 100 companies. When the economy falters, smaller companies have a greater risk of going into administration. Given the number of small companies listed on the ASX exposed to mining or mining services, share price falls are magnified when the downturn in the economy is accompanied by a fall in commodity prices as it was in 2008.

Additionally, after a recovery in 2009, the above chart shows that the small capitalisation index was unchanged until early 2017. Over this same period the large caps did well, particularly in the period 2012 -2015. This occurred as the large cap financials benefited from the removal of competition and falling rates globally, whilst the mining stocks bounced back courtesy of higher commodity prices from a range of Chinese stimulus plans.

[1] Fama, Eugene F & French, Kenneth R, 1992. ” The Cross-Section of Expected Stock Returns,” Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.

 

Our Take

Since March 2009, the ASX has risen close to 60% and in our opinion, there is a range of companies on the ASX that are priced on the assumption that benign conditions will continue indefinitely. Towards the latter stages of any sustained bull market in equities, it is prudent for investors to have a close look at what they have in their portfolio. We would be disinclined to own small cap companies that rely on benign debt and equity markets to finance their growth or are “concept stocks” still proving up their business model. Whilst many of the larger companies might not have the “blue sky” growth prospects of some of the stellar small caps of the past year mentioned above, they do however have business models that have been tested during trying market conditions. With the ASX small companies index trading on 21x forward earnings one could think that you are paying quite a lot for this growth with a minimal margin of safety.

Losing money overseas

In the travel sections of newspapers there frequently appear articles with titles such as Top 7 Overseas Travel Scams (and How to Avoid Them). However, Atlas see the biggest cause of Australians losing money overseas is not pickpockets, dodgy taxi drivers, or pre-damaged jet skis, but rather ill-conceived offshore acquisitions by Australian corporates.

Last Friday the latest of these came to an end with Wesfarmers exiting their UK Hardware operations. Over the two and a half years of ownership, this adventure cost Wesfarmers shareholders A$1.7 billion. What is worse is that for shareholders of Wesfarmers, booking the loss and selling these operations for one pound is a good outcome as it avoids significant closure costs. At Atlas, based on bitter experience we are very sceptical about offshore acquisition strategies embarked on by Australian corporates. In this week’s piece, we are going to look at offshore expansion by Australian companies.

 

 

 

 

 

 

 

 

Why Australian companies expand offshore

The main reason expounded by Australian corporates for offshore expansion is to gain access to larger pools of potential customers for the purpose of driving earnings growth. In many industries, Australian companies operate in oligopolies or are constrained by government regulators such as the ACCC (Australian Competition & Consumer Commission) from growing rapidly through either price competition or acquiring competitors.

In the banking or grocery industries, neither Westpac nor Woolworths are able to take market share from competitors by dropping prices, as their competitors will immediately match their moves. Similarly, a move by Westpac to acquire the smaller Bank of Queensland would have difficulty getting approval from the ACCC.

Other reasons touted for global expansion are access to new technologies and diversification, since business or regulatory conditions in certain foreign markets may not be correlated with those in Australia. For example, Sonic Healthcare is not likely to face simultaneous fee pressures in their pathology businesses in the USA, Australia and Germany. Where management teams are under pressure and incentivised to grow earnings each year, it is understandable that they could be seduced by an investment banker in a two-thousand-dollar suit selling dreams of global expansion.

We will now go on to examine some of the mistaken assumptions that motivate international expansions.

Wrong move 1: We are dominant in Australia, so we will dominate the world

We see that this is the most common mistaken assumption made by Australian corporates venturing offshore. Arguably this was the rationale motivating Wesfarmers when they purchased the number two player in the UK hardware market in 2016. In Australia, Bunnings dominates the $48-billion hardware sector and earns an EBIT margin of 14%, whereas Bunnings’ equivalent in the UK – Kingfisher – has an EBIT margin of 7% in a more competitive and crowded market. Firstly, Australian entrants will often face higher levels of competition in new markets. Furthermore, a successful strategy in Australia will not necessarily resonate with foreign consumers. In the case of Bunnings UK, large BBQs and cheap power tools that sell in Sydney were a surprise to UK shoppers entering a Homebase store in the UK looking for Laura Ashley homewares.

Other examples of this factor can be seen in IAG’s entry into the UK general insurance market after buying the country’s eighth largest motor insurer. Ultimately this adventure cost shareholders $1.3 billion, as IAG found the UK insurance market far more competitive than Australia where IAG, Suncorp and QBE have a 70% market share.  In a similar vein, NAB in the late 1980s and 1990s acquired banks in Northern England, Ireland and the USA, based on the strategy that their dominance in Australia would translate into other parts of the English-speaking world. Ultimately NAB was unable to run the dispersed set of financial services businesses from Melbourne and this adventure cost shareholders billions, though it would have been costlier had NAB not sold their Irish banks to Denmark’s largest bank just prior to the GFC.

However, it would be disingenuous not to mention that foreign companies also make this same mistake in buying domestic assets at high prices off canny Australians. Japan’s Kirin Breweries and UK’s SAB Miller have written off portions of the Lion Nathan and Fosters brewing assets, as sales of iconic Australian beers such as Tooheys and Victoria Bitter have declined with drinkers turning to smaller craft beers.

Wrong move 2: Let’s try something new

This version of an offshore misstep generally occurs when an Australian corporate with excess cash is presented with an opportunity to grow earnings by investing in a new technology in a foreign market. Typically, this involves buying assets from local players who typically have a better grasp on what the assets are actually worth. A great example of “Let’s try something new” has been BHP’s investments in US onshore shale gas in 2011 and 2012. BHP acquired assets of US$4.75 billion from Chesapeake, and US$15 billion for Petrohawk. BHP at the time was flush with cash due to a surging iron ore price. However, extracting shale gas in the US is more of a small scale modular process compared with BHP’s massive iron-ore and offshore LNG projects. Furthermore, BHP’s purchase was made at peak oil prices. In 2018 BHP is in the process of extricating themselves from these acquisitions, having already written off US$13 billion of this investment.

 Wrong move 3: Sort of similar to something we already do

This acquisition mistake is a close cousin of “let’s try something new” in that the acquisition is made in an area close to the company’s core area of competency and presented to investors as a low-risk form of offshore expansion.  Fletcher Building’s purchase of the Cincinnati-based Formica in 2007 for US$ 700 million from private equity was touted as a logical extension to the company’s decorative surface laminates business. In hindsight, this acquisition was made at the peak of the US housing construction cycle for a business that faced ongoing production issues due to site consolidation.

Slater+ Gordon’s acquisition of Qunidell’s professional services division in 2015 for A$1.2 billion also falls into the category of “Sort of similar to something we already do”. Whilst this infamous acquisition made Slater+Gordon the number one personal injury law firm in the UK, it also added claims management companies, insurers and insurance brokers – businesses somewhat adjacent to the company’s core litigation practice. Arguably this move helped contribute to equity holders losing 99% of the value of their investment in the company as it both burdened the company with too much debt and bought a business without undertaking sufficient due diligence.

Shortly after the purchase of Quindell, the UK government announced plans to limit the proceeds from personal injury claims and Quindell came under investigation for accounting practices that inflated earnings. See Jonathan Shapiro’s fine analysis of this transaction in Sowing the seeds of Slater & Gordon’s market demise.

No discussion of poor acquisitions would be complete without including Rio Tinto’s 2007 acquisition of Canada’s Alcan for US$38 billion, which manages to put tick most boxes of a poor offshore expansion. This acquisition arguably was made to fend off a takeover from BHP and led to Rio acquiring smelters in exotic places such as Iceland (“Sort of similar to something we already do”) and engineered products and packaging (“let’s try something new”). Ultimately US$30 billion of this acquisition was written off and resulted in a highly dilutive equity issue in 2009.

Offshore acquisitions that worked

It would be wrong to claim that all offshore acquisitions end in tears for Australian investors. A number of Australian companies have made major offshore acquisitions that have driven earnings growth for a number of years and propelled the company into a major global player in their industry. Amcor has leveraged a range of successful acquisitions to become one of the largest manufacturers of flexible packaging and rigid plastics, ironically making their most successful acquisition from Rio Tinto.

Similarly, CSL made major acquisitions in 2000 and 2004 in Switzerland and Germany and is now the largest global producer of blood plasma-derived medicines. Computershare has grown through acquisition to become one of the largest global share registry businesses, successfully buying and improving the profitability of various global banks’ unwanted registry businesses.  Sonic Healthcare has made 50 acquisitions over the past 20 years in Europe and the US. Sonic’s shareholders have enjoyed rising profits due to doctors requesting greater numbers of tests per patient and being able to run higher volumes through their increasingly automated labs.

The common theme through these successful offshore expansions is that the Australian companies have focused on a particular niche where the Australian company has some form of comparative advantage. This is very different from buying foreign banks, where the Australian company brings no intellectual capital or technology to the table, only capital!

Our take

Wesfarmers’ adventure into the UK hardware market is unlikely to be the end of Australian corporates making poor foreign acquisitions. Management teams are incentivised to grow earnings, and acquisitions are presented as a quick way to achieve this goal. Atlas is very wary of companies announcing major offshore acquisitions as for every successful acquisition there seem to be several that end in tears. The common theme is one of excessively optimistic due diligence which underestimated the level of competition in the new foreign markets and the difficulty in managing diverse global businesses from a head office in Sydney or Melbourne.

The most (and the least) profitable companies on the ASX200

In early May the major Australian banks collectively reported profits for their last six months of A$15.3 billion dollars. This resulted in some media commentary about banks being too profitable, especially as three of the banks reported in the middle of the Royal Commission into the financial services industry, which had highlighted examples of inappropriate financial advice and problems issues with lending standards.

Whilst large corporations generate large profits in dollar terms, what is often ignored in much of the debate on corporate profitability is that these profits have to be shared amongst millions of individual shareholders.

For example, collectively the banks made $15.3 billion, however, divided by 10.8 billion bank shares outstanding this crude measure equates to a mere $1.42 per share. In this piece we are going to look at different measures of corporate profitability for large Australian listed companies, looking beyond the billion dollar headline figure.

Different Measures of Profitability

As a fund manager, the $4.25 billion of cash profit generated by Westpac over the past six months does not mean very much. As an investor, I am most concerned with the underlying earnings per share (EPS), which is what the owner of a single share of the company receives from the profit generated in a particular year. In Westpac’s case, their cash earnings per share compared with the first half of 2017 grew 4.3% to $1.25 – nice growth but not particularly exciting.

We also look at growth in EPS, as often a company’s profits can grow substantially when they make an acquisition. However, if that acquisition is funded by issuing a large number of additional shares, profit per share might not actually grow. Conversely, a company’s profits may be down, but if this is due to the selling of a non-core division it could be a good result for shareholders. For example, earlier this month ANZ Bank reported a 16% decline in cash profits due to the sale of their Asian retail banking businesses. As the proceeds from the sales were used to buy back ANZ Bank shares, their earnings per share actually gained 4%. Additionally, at a company level, we also look at measures such as returns and profit margins, which can be better measures of how efficient a company’s management team is in generating their annual profits. Furthermore, these measures allow the investor to compare different companies in similar industries.

Return on Capital Employed

Return on Capital Employed (ROCE) looks at the profit generated both by the capital that the equity holders have contributed to establish the business, as well as the debt taken on to support the business’ activities.

ROCE is calculated by dividing a company’s profit before interest and taxes by the shareholders’ equity plus debt. The investment by shareholders includes both original share capital from the IPO plus retained earnings.

Retained earnings are the profits kept by the company in excess of dividends and are used to fund capital expenditure either to maintain or to grow the company. Companies with high ROCE typically require little in the way of equity to keep the business running and little need to borrow from their bankers.

The above chart shows the top and bottom companies in the ASX as ranked by ROCE. The top ROCE earners include:

  • a milk company (A2M),
  • three fund managers (Magellan, Perpetual and Pendal),
  • a healthcare company (Cochlear), as well as
  • an internet services companies (REA and Carsales).

The common factor in these businesses is minimal ongoing capital expenditure to run the company.

Bringing up the rear are a range of capital-heavy businesses that require both large amounts of initial capital to start the business and regular capital expenditure to maintain the quality of their assets and finance their ongoing activities. This subset includes a gain handler (Graincorp), logistics (Qube), retailer (Myer), healthcare companies (Healthscope and Primary), and an energy company (Santos). Typically when looking at this measure, miners, steelmakers, wineries and Qantas are prominently featured amongst the lowest returning businesses as they are operating in capital-hungry industries. However, in 2018 these three industries are currently enjoying cyclically strong earnings.

Profit margin

Profit margin is calculated by dividing operating profits by revenues. It measures the percentage of each dollar received by a company that results in profit to shareholders. Here we have used earnings before interest, taxes and depreciation as it allows us to compare companies across different industries with different capital structures, and this margin is for the six months ending December 2017.

Typically low margin businesses operate in highly competitive mature industries. The absolute profit margin is not always what investors should look at when analysing a company’s results, but rather a change in this margin. A rising profit margin may indicate a company enjoying operating leverage as profits are growing at a faster rate than costs. Conversely, a declining profit margin could indicate stress and might point to large future declines in profits.

From the above chart, the highest profit margins are generated by companies that are fund managers enjoying the operating leverage mentioned above (Platinum and Magellan), monopolies (ASX), internet businesses (REA), or energy companies (Woodside and Oilsearch).

The energy companies enjoy a high-profit margin, as once the large offshore LNG trains are built these assets have a low marginal cost of production per barrel of oil. Obviously, this metric does not account for the tens of billions in capital required to build these giant projects. BHP features in this list courtesy of the 60% profit margin that the Big Australian earns from digging up iron ore in the Pilbara when iron ore prices are around US$70 per tonne. Low profit margin companies characteristically receive large revenues but operate in intensely competitive industries such as petrol retailing (Caltex), grocery retailing (Metcash, Woolworths and Wesfarmers), department store (Myer), and construction (Lend Lease).

Companies with low profit margins are obviously forced to concentrate closely on preventing their profit margins from slipping, as a small change in their margins is likely to have a significant impact on the profit available for distribution to shareholders. For example Metcash’s food distribution business runs on a very slim profit margin, such that when the business faced declining margins in 2014 they were forced to cut their dividend, which was not reinstated until 2017. For this reason, we monitor the net interest margins of the banks very closely

Our take

While the banks and the large miners (BHP and RIO) generate large absolute profits resulting in headlines around the billions of dollars they earn, they are generally not among the most profitable large listed Australian companies in terms of profit margins and returns on assets. Over the last six months, Commonwealth Bank’s 48,900 employees produced a $4.7 billion profit, but this represented a return on assets of 1.03% and a profit or net interest margin of only 2.16% on a loan book of $962 billion. When looking at companies to include in the Maxim Atlas Core Australian Equity Portfolio, the indicators of earnings power that we look at is not the headline number, but rather its return on capital or equity and changes in profit margins.

Sticky fingers in many pies

The business of wealth management has been put under the microscope over the past month with the Royal Commission into the financial services industry. In March, the Commission focused on misdeeds in consumer lending and for the next two weeks in April it will be concerned with transgressions around financial advice.

The Royal Commission has highlighted the extent to which the major financials are involved in the business of managing Australia’s investments. Consequently, this week we are going to have a closer look at the funds management landscape in Australia. In particular we will examine the degree of vertical integration by the largest players of this industry that looks after A$3.4 trillion of investments for Australians.

Influence of the Major Institutions

The wealth management businesses of Australia’s major financial institutions (Commonwealth Bank, NAB, ANZ Bank, Westpac, Macquarie Bank and AMP) include funds management, life insurance and general insurance, investment administration platforms, and financial advice. The wealth management business is attractive for the banks, not only due to the government mandated growth that comes from rising compulsory superannuation contributions, but also because wealth management earnings carry a low capital charge. This appeal only increased with the $19 billion of capital raised in 2015 to meet Australian Prudential Regulation Authority’s (APRA) tougher stance on bank capital adequacy.

Whilst this might not be the most exciting of topics, changes to capital requirements have two important effects: they make funds management earnings more attractive to the banks, and also increase the cost of lending to business and home buyers. When a bank makes a standard home loan with a ~70% loan to value ratio (LVR), the Australian Prudential Regulation Authority (APRA) requires that the bank hold approximately $2 in capital for every $100 lent. This rises to $5 for every $100 in the case of a loan to a business that incurs a higher risk weighting. Mathematically, when a bank is required to quarantine more capital to conduct activities, their return on equity (ROE) declines. This decline may not seem very significant, but in an environment in which the Australian banks are facing higher capital requirements from regulators globally, earnings from wealth management are very attractive as they can boost the bank’s return on equity. Additionally, participating in the government mandated growing superannuation pool is seen as attractive to the major banks, since growing superannuation balances are expected to have a limited correlation with the credit cycle and demand for loans.

Vertical Integration: Clipping the Ticket at every stage

Over the last twenty years the major financial institutions either bought, or have organically created at great expense, a financial supermarket. This was based on the Allfinanz or bancassurance model, that assumed the banks could efficiently deliver banking, insurance and funds management through their existing networks, with employed tellers and financial advisors cross-selling “home brand” financial products. Aspirations to this model enticed the Commonwealth Bank to acquire Colonial in 2000, National Australia Bank to buy MLC, and Westpac to purchase BT and Rothschild Wealth Management. Additionally, by buying downstream financial advice groups, the major financial institutions acquired a distribution network for the financial products they manufacture such as managed funds, loans and life insurance.

In essence, the wealth management industry comprises a value chain of advice (financial advisers), portfolio administration (platforms) and manufacturing (funds management). The major financial institutions have captured a dominant market share in all three links in the wealth management chain via acquisitions and IT expenditure. As shown in the below chart on the right, the four major banks plus AMP and IOOF have financial relationships with just under 50% of the financial planners in Australia. Their market share had been increasing with acquisitions (such as Count, acquired by CBA in 2011 for example) and heightened compliance requirements that tend to favour the large institutions over smaller practices. However, over the past two years we have seen a swing away from this trend with the number of independent financial advisers growing. One of the potential outcomes from the current Royal Commission is that investors will become increasingly aware of the conflicts of interest inherent in the vertical integration of wealth management, and management and will shift towards using independent financial advisers.

The major financial institutions have also been very successful in capturing a large share in the business of actually managing the money. The above chart on the left demonstrates the dominance that the large institutions enjoy in “manufacturing” the investment products, or funds for sale to retail investors. Currently the major banks plus AMP manage almost 80% of the retail funds under management, though this may change shortly with CBA looking at listing its funds management arm Colonial First State via an IPO. Westpac’s share of funds management is declining as the bank continues to reduce its ownership position in BT Investment Management.
Finally, investment platforms are the “middle man” in the process, connecting the fund manager to the adviser by providing administration services and tax reporting for a client’s portfolio of managed funds, shares and cash. Platforms generally charge around 0.3-0.6% of funds under management annually. Whilst running platforms might not sound like a very glamorous business, it has been a lucrative area for the major financial institutions, which by virtue of their IT expenditure have been able to capture over 85% of this market. However, like financial advice, the dominance that the major financial institutions have enjoyed on the platforms is being eroded by smaller more nimble platforms such as Hub24 (1. see below note), Netwealth and OneVue. These platforms have been very successful in capturing market share from the big banks due to a combination of accessibility and the flow of financial advisers leaving the major financial institutions.

Not all good news

At first glance, vertical integration sounds like a solid way for banks to supplement banking profits in an environment of relatively anemic credit growth, rising capital requirements and government mandated superannuation flows. However, the events of the past few weeks demonstrate that the ownership of wealth management businesses by the banks do pose some risks.

Aside from the volatility in investment returns, wealth management businesses have delivered adverse headlines that could impact on an institution’s core banking business. Over the past few weeks we have seen financial services CEOs face the Royal Commission due to allegedly fraudulent behaviour and bad financial advice from the banks financial planners. Indeed, we have also seen the Treasurer flag the possibility of gaol time for bankers!

In 2017 Commonwealth Bank spent $437 million in advertising to build its banking brand. While AMP does not disclose in its annual accounts what it spends annually on marketing, we would be surprised if it was less than $100 million. One would have to imagine that a portion of the goodwill that this spend generates has been dissipated by headlines detailing malfeasance in these institutions’ financial planning, platforms and insurance divisions. The management teams at the major financial institutions must be concerned that unethical behaviour observed in the wealth management businesses should not spill over to damage their core banking brands that generate the bulk of their profits.

1. Disclosure: in April Atlas in partnership with Maxim Private have launched the Maxim Atlas Core Australian Equity Portfolio on the Hub24 platform.

Our Take

The major financial players have not built these vertically integrated wealth platforms (comprising advice, investment accounting and funds management) to see large amounts of value being “leaked’’ to service providers outside the network. This naturally creates strong incentives to recommend the house products over independent providers, or to favour house products over external products with similar or even slightly superior characteristics. As an investor in the major banks, we would prefer that they keep as much of the value in-house to boost payments to shareholders, however as an independent boutique investment firm, we also have a strong personal incentive to see the vertical integration model break down and for clients to seek out independent financial advisors.

Whatever the composition of the market, of utmost importance is that all financial service providers adhere to rigorous codes of ethical conduct, such as that of the CFA Institute as the unethical behaviour revealed by the Royal Commission damages public trust in the financial industry as a whole.