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Banks Reporting Season Scorecard May 2018

The last few months have been tough for shareholders in the major Australian financial services companies, who have seen their share prices drift lower throughout March and April. Evidence of misconduct presented at the Royal Commission on Financial Services has fed market fears that bank profitability will be diminished in the future. However, over the past ten days, the major banks have reported their profit results for the past six months, showing the market how their underlying businesses are performing and how the management teams plan to address the issues raised at the Royal Commission.

In this piece, we are going to look at the common themes emerging from the banks in the May reporting season. We will differentiate between the different banks and hand out our reporting season awards to the financial intermediaries that grease the wheels of Australian capitalism.

Simplification

The main new theme to emerge from this reporting season was that banks are looking to reduce their footprint on the Australian financial services landscape, by divesting businesses that are deemed to be non-core. This results season was characterised by complexity arising from either announcements of new significant moves, or that were complicated by sales made in 2017.

In May Commonwealth Bank announced plans to spin off their wealth management business Colonial First State, which followed the sale of the life insurance business in 2017. ANZ’s result was complicated by the sale of both their wealth management and life insurance businesses in 2017. NAB also announced plans to sell MLC wealth management by 2019. Additionally, Westpac continued to reduce its stake in BT Investment Management (now renamed as the Pendal Group). These moves can be seen as acknowledging that the costly exercise of creating vertically integrated financial supermarkets was a mistake. Whilst some of these moves to sell these carefully constructed divisions may be attributed to the events of the Royal Commission, some of these sales were consummated well before the titans of Australian finance faced the harsh light of the witness stand.

 

Profit growth

Across the sector profit growth was roughly in-line with the credit growth in the overall Australian economy. Westpac reported the strongest cash earnings growth across the banks courtesy of keeping costs under control, very low bad debts, and the sound performance of their core domestic businesses. NAB brought up the rear in May due to the combination of weaker revenue and elevated costs even when the restructuring charges are excluded.

 

 

Gold Star

Bad debts

One of the biggest drivers of earnings growth over the last few years 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 and that the outstanding loan amount is greater than the collateral eventually recovered. Bad debts fell further in 2018, as some previously stressed or non-performing loans were paid off or returned to making interest payments. This resulted primarily from a buoyant East Coast property market and higher commodity prices. Further, at the big end of town there were no major corporate collapses over the past six months which kept corporate bad debts low.

Westpac gets the gold star with a very small impairment charge courtesy of their higher weight to housing loans in their loan book. Historically home loans attract the lowest level of defaults.

 

 

Gold Star

Shareholder Returns

Across the sector dividend growth has essentially stopped, with CBA providing the only increase of 1 cent over 2017. With relatively benign profit growth a bank can either increase dividends to shareholders or retain profits to build capital (thereby protecting banks against financial shocks) – but not both. In the recent set of results, the banks have held dividends steady to boost their Tier 1 capital ratios to get close to the APRA mandate of a core tier 1 ratio of 10.5%.

Looking ahead, there may be some capacity to increase dividends as the rebuild of bank capital to APRA’s standards is largely complete. ANZ shareholders can expect capital returns in the form of further on-market share buy-backs as the proceeds from the sale of their wealth management and insurance businesses are received. The major Australian banks in aggregate are currently sitting on a grossed-up yield (including franking credits) of 8.9%.

Gold Star

Interest Margins

The banks’ net interest margins [(Interest Received – Interest Paid) divided by Average Invested Assets] in aggregate increased slightly in 2018, despite the imposition of the major bank levy. This was attributed to lower funding costs and repricing of existing loans onto higher rates. In response to regulator concerns about an overheated residential property market – and in particular the growth in interest-only loans to property investors – the banks have repriced these loans higher than those repaying both principal and interest. For example, Westpac currently charges 6.3% on an interest-only loan to an investor, which contrasts to the 4.44% being charged to owner-occupiers paying both principal and interest. This has had the impact of boosting banks’ net interest margins, though these gains will tail off as borrowers switch to principal and interest loans.

One of the key things we looked at closely during this results season was the impact of the May 2017 Major Bank Levy on the various banks’ margins. It was apparent from looking at the numbers that this levy was passed on both to borrowers in the form of higher rates, and to depositors by offering lower rates on term deposits.

 

 

Gold Star – Australian banking oligopoly

 

Total Returns

In 2018 all the banks have delivered negative absolute returns, while also trailing the ASX 200 which has gained 2%. The uncertainty around the outcomes from the Royal Commission, rising compliance costs, and slowing credit growth has weighed on their share prices. CBA has been the worst performing bank as it has seen its CEO ushered to the door, faced fines for not complying with anti-money laundering laws, and has faced uncertainty around the potential impact of changes implemented based on recommendations from the Royal Commission.

No stars given

Our Take

How to approach investing in the Australian banks is one of the major questions facing both institutional and retail investors alike. We expect the banks to deliver around 3-5% earnings growth as they face low credit growth, increased regulatory scrutiny, and the sale of some of their insurance and wealth management divisions. However, if investors examine the wider Australian market the banks look relatively cheap, are well capitalised, and unlike other income stocks such as Telstra should have little difficulty in maintaining their high fully franked dividends. Additionally, their share prices are likely to see support over the next 12 months from share buybacks, as the proceeds from the sales of non-core assets come through.  The key bank overweight positions in the Maxim Atlas Core Equity Portfolio are Westpac, ANZ and Macquarie Bank.

Short selling harder than you think!

Over the past week short selling has been a hot topic in the financial press after a noted US-based short seller released a very negative piece about listed fund manager Blue Sky Alternative Investments (BLA). This caused BLA’s share price to fall 50%, wiping $440 million from Blue Sky’s market cap. Short sellers are frequently derided as vultures, rumour mongers or un-Australian. However, in practice, shorting stocks is a difficult, stressful and lonely way to make money in the market, which is predominately skewed towards good news and wearers of rose-tinted glasses.

In this week’s piece we are not going to look at the merits of Blue Sky as an investment, but rather at the mechanics and issues around short selling equities. We see that much of the coverage on short selling over the past ten days reveals that many of those who hold strident opinions on short selling have only a limited understanding of how it actually works in practice.

Step one:  find a company with bad characteristics and a catalyst

In traditional long only investing the goal is to own good quality companies with honest management teams, clean balance sheets and solid future prospects. By contrast, when selecting a stock to short sell the desirable characteristics include companies with low or negative growth, high and increasing debt levels, a weak business model, over-valuation by a market, and possessing a shaky management team. However, a critical factor is the requirement for a catalyst; over-valuation or high debt in itself is rarely enough. In Blue Sky’s case it was the negative report from Glaucus. As very few investors have the luxury of lobbing a damming report from the sidelines and outside the regulation of ASIC and the ASX, we would look for events such as a potentially bad acquisition (preferably off-shore), heavy directors selling, or corporate turnover at management level.

Step two: Find the stock to borrow

Short sellers will then borrow stock from a stockbroker and sell it. They are essentially betting that the price of the target company will decline before they have to replace the borrowed shares by buying the stock back. This is often the step that is ignored in the financial press when talking about shorting a company’s stock, as it is wrongly assumed that investors can borrow stock to reflect their negative view on a company.

When borrowing shares to short sell an investor has to look closely at both the rate per annum that they are required to pay to borrow the stock, and where the owner is located geographically. The rate reflects supply and demand, and for most stocks is currently 0.5% per annum. For stocks where the shorting demand may be higher than the supply (such as Fortescue) the rate may be 15% or higher. In the case of small capitalisation or tightly held companies such as Blackmores, the short seller may be unable to borrow stock and thus cannot short sell.

In the case of Blue Sky, when we looked a week ago there was no stock available to be borrowed and the current short-sold position only represents 3 million shares, or 3.8% of the register. In a small and tightly held company such as Blue Sky most holders would not lend out their stock for short selling as to do so they would be providing short sellers with the ammunition to bet against their long position.  For example, BigUN – which is currently suspended on the ASX in February due to accounting irregularities – only had 500k of their outstanding shares lent out to short sellers, which is a mere 0.3% of the register. In the lead up to BigUN’s suspension as its share price was falling, the demand to short this stock would have been intense, but there would have been no stock available to be borrowed.

Step three: Dividends and Corporate Actions

The short seller is required both to return the shares to the owner when requested, and also to pass on any dividends paid. We also strongly prefer to borrow stock from foreign owners such as large index funds like Vanguard or State Street, as if you borrow stock from a domestic owner and a dividend is paid, short sellers are required to compensate the original owner for both the dividend and any associated franking credits.

What happens if the stock goes up?

If the short stock rises sharply, the lender will be required to give their broker additional collateral, or the broker will require the short seller to close out the short sale transaction before the planned timeframe.  A series of urgent requests to wire cash to your margin account to cover a short-sold stock that is rising sharply will test the mettle of even the most hardened short seller. In contrast, a long only position in a falling company can mentally be filed in one’s bottom drawer until it eventually comes good (or goes into administration).

This gives rise to the skewed payoff ratio from short selling, where the maximum gain is known (the stock falls to zero), but the maximum loss is theoretically infinite.

The Market can remain wrong longer than you can remain solvent

It would be wrong to view that short selling risky stocks is a smooth path to outperformance. Keynes, the father of modern macroeconomics, once famously said that “markets can remain irrational a lot longer than you and I can remain solvent’’. This quote particularly resonated with me after an unprofitable short selling of Fortescue prior to the GFC due to concerns about the over-valuation and debt situation of the company.

This trade was put on at $50 per share late 2007 and then was closed out at $70 four months later as the price continued to rise with no signs of slowing momentum. It was very painful to lose 29% in a short stretch of time; however, Fortescue peaked at $120 in June 2008 before falling back to $20 in December 2008. Whilst our investment thesis was ultimately correct, we were unable to handle the pain of a steeply rising stock and the associated unrealised losses and increasing margin calls.

Short squeeze

A “short squeeze” occurs when a heavily shorted stock rises sharply, forcing sellers to close out their position by buying back stock, thus causing further upward price momentum. Often when the market appears to overreact to a small piece of positive news, this is a short squeeze and it is similar to too many people trying to fit through a door.

For example, if JB-Hi Fi (currently 17% of the register have been “borrowed” by short-sellers anticipating that the price will go down) or Domino’s Pizza (18% of short) were to receive a takeover bid, the price would escalate sharply as short sellers look to cover their positions. A nightmare scenario would be a contested bidding war if you are short. In December 2017 we saw a short squeeze in Westfield when a bid from Unibail-Rodamco came through. However, unlike Dominos or JB Hi-Fi, the percentage of the property trust’s outstanding shares that we sold short was not a large amount, though we did see a spike in the share price that reflected the short sellers buying back stock to exit their positions.

Our Take

While short selling is often criticised and retains a negative connotation in a securities industry that is inherently biased towards optimism, we see that it serves a valid role in financial markets. Short sellers provide an alternative view and can aid both liquidity and price discovery in stock markets. In coming years – with MiFID II (new European regulations on stockbrokers) reducing the incentives for the investment banks to put out negative research and the decreasing value placed on sell side research – shorting will provide an alternative view. 80% of calls are buy or hold!

Investors should not look at situations like Blue Sky, BigUn or Slater and Gordon and view that it is an easy way to make money, nor that it is unfairly ganging up on a company. Even very experienced and adept short sellers such as Glaucus have made mistakes. For example, its shorts on Japanese trading house Itochu would have cost the fund manager substantially, with the price up +43% since they released their report in mid 2016.

Neither the Atlas High Income Property Fund nor the Maxim Atlas Core Australian Equity Portfolio currently employ shorting as an investment strategy. However, the author has previously managed a long short fund and has some understanding on short-selling as an investment strategy.

Monthly Newsletter March 2018

  • In March the listed property sector was effectively unchanged, a solid outcome in a month when the ASX200 declined by -3.8% and equity markets globally fell between -2% and -4% on concerns about a potential Trump trade war and rising tariffs.
  • The Atlas Fund declined slightly by -0.24% in a month were Listed Property effectively sat on the sidelines and ignored market volatility.
  • We see that after the pull back in early 2018, the listed property market is offering investors some interesting opportunities with a range of trusts offering stable distribution yields between 6% and 7% and are trading at discounts to their net tangible assets. In this environment we would expect management teams to be looking at initiating on-market share buy-backs.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2018.

Splitting up with Coles, 1+1=3?

On Friday morning Wesfarmers announced that they are looking to demerge its Coles division to create a new ASX top 30 company, with leading positions in supermarkets and liquor. This move was very well received by the market, with Wesfarmers stock finishing up $2.60 or +6.3% on Friday, and over the weekend we have seen analysts upgrade their price targets for Wesfarmers.

The stated aim of this action is to reposition the Wesfarmers portfolio into businesses with higher growth prospects. Given Coles’ size and the concentrated market structure of the Australian grocery industry, Coles is likely only to grow at a rate similar to Australian GDP. In this week’s piece we are going to look at the Wesfarmers deal, and in particular at the rationale behind spinning out assets to form a new company.  Typically, CEOs are incentivised grow rather than shrink the size of the businesses they manage.

The Deal

Wesfarmers are proposing to demerge Coles into a stand-alone ASX Top 30 company, and existing shareholders will then own shares in both Wesfarmers and Coles. Shareholders will get a chance to vote on this action later this year with the deal expected to close in FY2019. The new company will consist of Coles and Liquorland, and Wesfarmers will retain a 20% stake in the newly-listed Coles as well as Bunnings, Kmart, Target, Officeworks, Flybuys, and the industrial and chemical companies. Critically, management expect that the distribution of Coles shares to WES shareholders will likely qualify for demerger tax relief.

Why are management doing this?

Coles operates in the highly competitive domestic food and liquor business and going forward their growth will essentially track Australian GDP growth. Currently Coles holds 33% market share of Australian supermarket spend and 16% of retail alcohol sales. Realistically it would be very hard for Coles to increase their market share meaningfully in either of these categories without provoking an immediate reaction from competitors Woolworths and Aldi. Fundamentally Coles is a stable, low growth mature business.

People more cynical than us might look at remuneration conditions for senior management in the Wesfarmers Annual Report and notice that a large portion of the CEO’s bonus is tied to delivering a high RoC (return on capital) and note that removing Coles could make it easier to hit those targets. For example, in the last six months, Coles delivered a RoC of 9%, whereas Bunnings Australia had a RoC of 47%! However, these bonus conditions may be adjusted to reflect the split.

1+1 = 3 ?

Prior to Friday’s announcement Wesfarmers had traded on a lower price earnings (PE) multiple that Woolworths, so spinning off Coles is expected to deliver a valuation uplift to shareholders. Assuming Coles trades on the same multiple as Woolworths the new company would be worth $22 billion. Prior to the announcement using an EV/EBIT (Enterprise Value divided by Earnings before interest and tax) multiple, the implied value of Coles was $18.5 billion. The uplift to shareholders from the announcement can be seen in the $2.9 billion lift in Wesfarmers’ market capitalisation on Friday.

The ignored child gets a new lease on life

The most common reason cited for a company demerging or “spinning off” a division into a separately listed vehicle is that the previously unloved division will now be run by management totally focused on it. The theory goes that as a result of this increased love and focus and not having to compete with other larger divisions for management attention and capital, the demerged division begins to prosper. Furthermore, management at the parent company benefit, as the more attractive “core” business is now re-rated upwards by the market and valued on a higher multiple. The sum of the two parts becomes greater than the original whole. We see this as one of the motives behind Wesfarmers spinning off Coles.

Recent examples of this type of strategy can be seen in Orica’s 2010 spin off of their paint division Dulux, Woolworths spin-off in 2012 of a portfolio of shopping centres into Shopping Centres Australasia Property Group, and BHP’s spin off of S32 in 2015. These three spin-offs have proved to be very successful with Dulux giving shareholders a total return of +251% vs Orica’s loss of -2%. Similarly Shopping Centres has returned +89% since it was spun out of Woolworths in 2012, against a total return to Woolworths shareholders of 12%. In May 2015 BHP demerged S32 to separate the core iron ore, oil, copper and coal assets primarily located in Australia, Chile and the US from the smaller aluminium, Columbian nickel, South African manganese, silver, and South African coal assets. Since listing, S32 has returned +50% to shareholders vs BHP’s gain of +9%.

From meeting with the new management teams of the above companies post their demergers, it was clear to me that they exhibited a great deal of pride in the results of their own smaller companies and relished controlling their own destiny outside the larger parent. Furthermore, as stand-alone companies both Dulux and S32 were able to make decisions to grow their businesses, moves that probably would not have been approved if they were still competing for capital with BHP’s and Orica’s much larger Australian mining and global mining services.

Getting rid of a problem

Whilst the above more recent spin-offs have all outperformed their parents, there have been situations where a company demerges less desirable businesses that they see might hold back the core business in the future.

BHP has previously spun off divisions in the past that they viewed as less desirable. In 2000 BHP demerged their long steel division (Arrium née Onesteel), and in 2002 their flat steel division BlueScope Steel. This was motivated by the view – which proved to be correct – that greater returns could be made from digging ore out of the ground and directly shipping it to China, rather than in manufacturing commodity steel in Australia. Furthermore, BHP was able to “spin off” the industrial relations headaches that are present in the heavily unionised steel manufacturing sector. Whilst BlueScope is currently performing well after some near-death experiences in 2011 and 2012, BHP’s long steel business Arrium went into administration in 2016.

Similarly, Amcor’s demerger of its paper low growth business PaperlinX in 2000 removed a significant management headache for the global packaging company, as the growth in electronic communications and data storage has caused a structural decline in the paper business.

Our take

Whilst the above suggests that spin-offs can unlock hidden value for shareholders, there are potential downsides. Running two separately listed companies results in Wesfarmers shareholders bearing additional costs of maintaining two separate listings on the ASX , such as two separate boards and management teams. The most consistent winners from spin-offs are the investment banks. BHP paid US$115M in fees to create South32 and the investment banks would be expected to earn similar fees from Wesfarmers.