Following on from a previous article – Australian Banks: The death of a 25 year bull market – last week, this week we highlight an article from Sam Ferraro on APRA and the impact their macro-prudential changes will have on the banks. While the article is slightly more technical, it may be one of the more important reads on the banks this year.
– Evidente –
APRA’s quest for an unquestionably strong financial system continues Penned April 6, 2017
It has been a good week for APRA and the RBA. Their announcements surrounding the expansion of the use of macro-prudential policy tools and warnings around slow growth in rents and the outlook for property prices have had the initial desired effect of maximum media coverage. They would hope that lenders and potential property investors are getting the message.
The head of APRA yesterday, further weighed in on the debate surrounding banks’ loss absorbing capital buffers. Mr Wayne Byres had already bought into the key recommendation from the Financial System Inquiry (FSI) that Australia’s financial system should be unquestionably strong due to the fact that Australia has historically been a net importer of financial capital, and the high concentration of residential mortgages on banks’ loan books. To that end, the FSI suggested that Australia’s banks’ capital positions should be in the top quartile globally. APRA hasn’t committed to this hard edged quantitative aspiration or target and it is at their discretion which capital ratios they focus on.
In mid-2016, APRA lifted the risk weights used by banks with internal risk based models (ie. larger banks) by 50%, from 17% to 25%. In yesterday’s speech however, Mr Byres took a more glass half empty approach by drawing attention to the fact that Australia’s banks had indeed lifted their risk weighted capital ratios since the financial crisis, but their leverage ratios had remained little changed during this time. The leverage ratio, the ratio of total assets funded by shareholders’ equity, has increased marginally to around 6.5% from 6% in 2007 (see chart).
The Tier 1 capital ratio – which represents the ratio of shareholders’ equity to total risk weighted assets – has increased to 12% from 8% over the past decade (see chart). Risk weighted assets assign lower risk weights to loans that are considered less risky (eg. residential mortgages) and higher risk weights to more risky loans such as commercial lending. The key implication is that a bank must therefore must use more shareholders’ equity to fund a commercial loan than a residential mortgage.
Because housing loans attract low risk weights, growth in risk weighted assets has been slower than growth in total assets as banks have lifted the share of residential mortgages in their loan books (see chart). A cynical interpretation is that the banks have gamed the risk weights; a more generous interpretation is that a lift in mortgage lending has helped to offset the persistently weak demand for corporate lending since the crisis.
Against this backdrop, Mr Byers announced that it would release an issues paper later this year, outlining a road-map on how it intends to further strengthen banks’ loss absorbing capital ratios, and hinted at the prospect of a further lift in the risk weight for residential mortgages used by the larger banks.
The key development in Evidente’s view is the focus on the leverage ratio. APRA has left itself plenty of flexibility at this stage, and I am not suggesting that that APRA intends to target a desired leverage ratio. But as a guide only, we undertake a global comparison of leverage ratios and a sensitivity analysis. At present, the leverage ratios for the Australian majors range from 6% to 6.5%, which puts them below the median of the largest 100 developed market banks by over 100 basis points (see chart).
Assuming that the sector’s assets remain unchanged from current levels, the majors would need to top up their shareholders equity base by 18% or $40 billion to reach the global median of 7.6%. To get to the top quartile would require an additional $70 billion or a 30% more equity. These are large numbers and I suspect for this reason, APRA won’t be imposing a hard edged target on the leverage ratio.
Finally, it is not just possible but likely that the path to stronger capital positions will involve some contraction of assets. This has already been evolving, with annual asset growth in the sector turning negative for the first time in over two decades recently (see chart). ANZ and NAB have been seeking to ‘shrink to greatness’ by shedding low return international businesses, and Evidente expects this process to continue with ANZ and CBA looking to sell their wealth management businesses.
Evidente is an independent financial consulting firm managed by Sam Ferraro that delivers innovative financial advice to wholesale investors, including active long only funds, hedge funds, pension funds, and sovereign wealth funds, in Australia and globally. Drawing on academic research in asset pricing, behavioural finance and portfolio construction, Evidente provides wholesale investors with commercial solutions to stock selection and asset allocation decisions across equities and other asset classes.
Sam writes as a freelance journalist for The Age, Sydney Morning Herald and Australian Financial Review, was a member of the advisory board of API Capital, teaches business finance and international finance courses to undergraduates at RMIT, and most importantly Sam is a well respected source of information and friend of TAMIM.
We take a look at accessing IPO’s and Capital raisings. Small investors tend to be locked out of these raisings. In most instances, this is not an issue as the quality of the capital raisings tend to be poor. However, in the case of a strong IPO, you can benefit from a relationship with an investment manager who provides access to these IPO’s and Capital raisings.
Summary:
Gaining access to the best IPOs and Capital Raisings appears to remain the preserve of institutional and high net worth individuals at present. Whilst this plays to our advantage at TAMIM Asset Management we would like to see the market playing field level over time to allow fairer access to retail investors. However, in the meantime we continue to take advantage of opportunities to access the highest quality IPOs and Capital Raisings within the ASX smaller companies universe. In this article we discuss the ins and outs of gaining access to stock.
Not all IPOs and Capital Raisings are created equal…
IPOs and Capital Raisings are a sensitive subject for many retail investors who often view them as “closed doors” for smaller investors. And of course the more a door appears closed, the more it is natural for human psychology to want it to be opened.
However, we believe this way of thinking warrants caution since not all IPOs and Capital Raisings are created equal. In our opinion the vast majority should be avoided due to their lack of track record and evidence of sustainable moats, and their often unproven business models. We have previously written about our high quality shopping list, and we find the majority of IPO and Capital Raising opportunities fail to meet our criteria of a high quality investment.
We recently saw a cautionary tale when it comes to IPOs, as covered on The Lazy Dog blog.
STOCK EXAMPLE: Zenitas (ASX:ZNT) is a good example of a recent Capital Raising which ticks all our high quality boxes. ZNT now operates from 54 locations throughout Australia, employing 700+ health professionals, providing services across allied health, home care and primary care; making it a significant player in the community healthcare in the Australian market. Community healthcare is expected to benefit from supportive government policy, as community-based health services represent a cost effective solution compared to high cost hospital care. We like ZNT as it is in a sector supported by strong tailwinds and encouraging thematics, it is priced on an undemanding multiple, has multiple and credible pathways to grow, and is run by an experienced management team. That said, the business still has work to do prove itself to the market, and to build out its model. As it does, there is ample room for the share price to re-rate.
Once you have identified the right ones – how to gain access?
We have generally found that competition is intense for stock if an IPO or Capital Raising does indeed tick all our high quality boxes. In small Capital Raisings that are in high demand, it is often the case that the stock available is bid for multiple times over by institutional and sophisticated investors, before retail investors are even offered an opportunity. As a result, it can be very challenging for retail investors to pick up stock in these cases. Conversely, it is often easier for retail investors to pick up stock in the lower quality IPOs we are aiming to avoid.
At this point it is worth mentioning that the IPO market largely remains under the control of the larger brokers who still generate very high fees for handling IPOs. So the main route to IPO or Capital Raising stock supply is through the broking community.
For smaller investors this means leveraging existing broker relationships, and showing yourself as a potential longer term client for that broker rather than an “IPO flipper”. If an IPO is in hot demand brokers will be very focused on the clients they believe will help build their business longer term rather than short term focused traders.
This is one of the areas where it is a major advantage to be invested through a long term focused smaller companies investment manager since these funds tend to move to the front of the queue for the reasons mentioned.
STOCK EXAMPLE: In the above mentioned example of Zenitas (ASX:ZNT), there was no public float or ability for retail investors to participate. And even sophisticated investors had their bids substantially scaled. However, we were able to use our existing relationship with the company through our long term shareholding in BGD Corporation to secure a strong allocation.
What is being done about it by the ASX?
The short answer is the ASX are doing nothing about this. They recently released a consultation paper on listing rules reform, which made it clear they don’t intend to address the fair participation in IPO issue at all. This effectively means the IPO (and Capital Raising) markets will remain the preserve of bankers, brokers and high net wealth individuals, at least in the short term.
Alternative strategy to gain access to IPOs: Onmarket Bookbuilds
It is positive to see the emergence of onmarket bookbuilds, a relatively new business model which aims to provide IPO access to retail investors. At present, this type of business is generally the secondary IPO broker behind a traditional primary broker so is generally only contributing a relatively small portion of the IPO fund raisings it in involved in. However, the key point is that this business is providing IPO access to retail investors who were previously locked out of the market, which is a clear step in the right direction.
We hope these bookbuilding models succeed in building their business longer term as their success will lead to greater access to the higher quality IPOs which remain largely inaccessible for retail investors at present. And hopefully other alternative access points for retail investors will emerge in the coming years.
Conclusion:
We rarely participate in IPOs and generally only participate in the highest quality Capital Raising opportunities. However, fair access to stock is a debate which will rage on. We believe a move towards fairer access to stock for retail investors is likely longer term despite the ASX’s recent lack of reform action.
Robert Swift takes a look at the sideshow that is North Korea. We do not believe that North Korea impacts global economic fundamentals and that any short term dips that it may create in markets are good opportunities for us to purchase assets we would like to hold over the long term.
North Korea – “Buy on the cannons; sell on the trumpets” Robert Swift
The saying was attributed to Nathan Rothschild from 1810 when Europe was plagued by periodic outbreaks of war which obviously needed financing, and which might end in change of government or, catastrophically, an invasion by foreign power and confiscation of assets. The anticipation of this turmoil led to falls in bond and equity prices which offered an opportunity to invest at cheaper prices. Fortunes are typically made by buying on dips when others panic.
Source: Wall Street Journal
With all eyes on North Korea and growing tension in the region is this such a time? Is the current selling, particularly in Asia, offering a chance to repeat Rothschild’s success?
It is hard to argue that equities are in ‘bargain basement’ territory – or at least that USA equities are. Over the last several years they have risen substantially and depending on the definition of the earnings number you use trade between 18 and 22 x next year’s earnings.
Source: Thomson Reuters Datastream
On the other hand earnings volatility has been reduced and is likely to remain low, and it is unlikely that 10 year Treasury Note yields, from which we can estimate the fair price of equities, will go much above 3%. (They are currently just over 2%) Both of these help underpin USA equities at current levels and make selling frenzies attractive entry points.
So while not bargain basement they aren’t a bubble either. Looking at the average PE is misleading anyway in such a diverse universe of stocks. It’s a bit like saying “if I put my head in the oven and my feet in the fridge, then on average I’m comfortable”. It’s nonsense. Focus on stocks and try to pick those whose prospects are strong but whose share prices have fallen to where PE multiples are reasonable.
How can we be so sanguine?
North Korea is a side show and has done this shakedown before. Once it gets paid out then tensions ease.
Trump might refuse to payout on such a shakedown, unlike past Presidents, and make bellicose gestures, but he has shown more restraint than expected.
This tension gives him a chance to backtrack on his ‘abandonment of the region’ which should do wonders for its long term prosperity and stability.
We can tell you from our connections in the USA that there is so much firepower trained on North Korea that it will be cinders in a second should it do something stupid. They aren’t stupid. Part of the opportunity to ramp up tension was created by the political corruption scandal currently engulfing the South and a perceived subsequent political vacuum. Clever stuff by the North in one respect?
A much more interesting line of conjecture is what should you do as investors if North Korea re-engages with the South as East and West Germany did in 1990. We won’t do that here but can suggest unification would cost South Korea a lot more than it cost West Germany. Japan would also need to reconsider its source of unofficial cheap labour.
In what should you invest?
Meanwhile back in the real world, certain USA financials we like have mostly reported good earnings and indicate stability ahead. JP Morgan beat (carefully massaged) expectations and with plenty of risk capital buffers is now starting to reduce risky loans.
Another financial stock we like, AFLAC, trades on a PE multiple of 11.5 and grows slowly but steadily in the USA and Japan by selling policies to supplement health and medical care and loss of income protection.
Part of our investment thesis for USA financials is that they are not the beasts of 2002 – 2008 and have much more control over what loans are being made, and are much more closely supervised. If anything, the problem is in hitting growth targets which was the root cause of the Wells Fargo accounts fabrication scandal? The next crisis won’t be caused by financial stocks.
Directly in the ‘firing line’ in Asia is another cheap financial stock Sumitomo Mitsui Financial Group which trades on a PE of just over 9x. It has fallen about 10% in the last month and represents an attractive entry point now. Those of you who have been to our seminars or read anything we publish will know that Japan is not the economic basket case that the conventional wisdom would have you believe. The economy won’t implode and there is lots of innovation.
Now is not the time to reduce equity risk. If you are heavily invested in Australian equities then try to become more diversified. Be wary of the financial sector here which although not badly managed represents a single exposure to residential real estate. More legislation is likely which will reduce the potential for growth of that loan book and then where is the growth going to come from? Not overseas where NAB and ANZ have conspicuously failed and are now withdrawing, nor from investment banking. It won’t take much of a PE derating to make the franked dividends look a forlorn reason to own so much of the Australian financial sector.
This week Guy Carson takes a look at the Australian banking sector, how it generates profit, how this has operated historically and what the outlook is going forward. Guy argues that the tailwinds aiding bank profitability over the last 25 years may be coming to an end.
Australian Banks: The death of a 25 year bull market
Guy Carson
In the early days of May, ANZ, Westpac and NAB will all report their first half results. Short-termism will grip the market and the focus will be on whether earnings from the October to March period are above or below expectations. This will undoubtedly swing share prices a few percent in the appropriate direction and as a result lead to under or out performance for fund managers relative to the Australian index. Now if I was a betting man, I would probably say the odds are in favour of a “beat”. This is based on the evidence from CBA’s recent result that showed an easing of credit conditions in the corporate sector combined with the APRA data showing the banks continue to grow their investor mortgage book (at least until last month). However, when investing it is the not the last six months that will determine your success or failure. It is important to take a longer term view of the companies and the economic drivers that will drive the performance over coming years.
In order to understand this, we have a look at two areas:
A bottom up analysis of how the banks have performed over the last 25 years.
A top down analysis of what the drivers have been that have led to that performance and how likely they are to continue.
Bottom up analysis – How the banks have performed
The banks are mainstays in most Australian equity investor’s portfolios and with good reason. They have been remarkable investments. Commonwealth Bank listed in 1991 at $5.40 per share. The price currently sits at around $85 and the company has paid plenty of dividends along the way. Dividends for the Big Four banks are a major attraction and have grown fairly consistently over recent history with one minor hiccup in 2009.
Source: Company filings, Thomson Reuters
By any measure an investment in CBA has been incredibly successful. To understand why it has been it’s worth stepping back and looking at how a bank makes money. This can be broadly defined as follows:
Raise capital to support business.
Borrow funds (liabilities) typically at a ratio of up to 20 times capital.
Lend borrowed funds to borrowers (assets).
The interest earned less interest paid creates the interest margin (net interest).
Charge fees (non-interest income).
Non-interest costs divided by net interest plus non-interest income is the cost to income ratio.
Provisions for potential and possible problem loans are charged against the profit.
Profit after provisions divided by capital gives return on equity.
Any objective analysis of the above for the Big Four banks over recent history suggests they have done a good job. Starting with point number 3 above, all of the Big Four have used their balance sheet to good effect and grown their loan book significantly. The below chart looks at total loans (chart is in billions).
Source: Company filings, Thomson Reuters
The four banks as a whole have grown their loan books from $242bn in 1990 to almost $2.5tn today. That is a 10 fold increase with CBA leading the way going from last to first.
So they have had no problems growing their book. Moving onto point 4 and the Net Interest Margin (NIM) which has gone the other way.
Source: Company filings, Thomson Reuters
Net Interest Margins have fallen from around 3.5% in the mid-1990s to 2% today. Now there are a lot of explanations for why this has happened but one of the key ones in our opinion is technology. Technology has brought down the cost to income ratio for banks by allowing them to work more efficiently with less staff concentration. The below chart shows this with cost to income ratios dropping from above 60% in the early 1990s to around 40% today.
Source: The Australian, CLSA
The lower cost to income ratios have allowed the banks to reduce their NIM and maintain profitability. Return on Equity (ROE) for the last 20 years has been consistently in the mid to high teens. You would be hard pressed to find this consistency in any other banking system around the world.
Source: Thomson Reuters
All in all, this track record is impressive and as a result the shares have been great investments. Although one aspect of the above chart does give some slight concern for the future and this is the dip in the ROEs over the last year driven by regulatory changes. We’ll cover this in the next section.
Top Down analysis – What has driven this performance and will it continue?
From the above analysis, one might come to the conclusion that Australian has a strong banking system that has been well run in recent history. However it is important to realise that banks are highly leveraged cyclical companies, when the economic tailwinds are behind them it is easy to look good. When things turn, the real test will begin. This is a point that many Australian fund managers seem to have forgotten in recent times due to the long term success of the domestic banks.
In order to understand why the banks have been so successful in recent times it’s important to examine the economic drivers behind the performance. This begins with a trip back to the 1980’s which saw a significant amount of deregulation for banks and the beginning of the Basel capital requirements. This decade saw the beginning of a debt supercycle globally which imploded in many developed countries in 2007. Prior to 1980, the global standard for banks was a leverage ratio of 7x, this has changed dramatically since. Just prior to the Global Financial Crisis, leverage in the European Banking system stood at 40x, in the US it stood around 30x and in Australia it stood at over 20x. Australia joined the rest of the world in “gearing up”.
The original Basel accord in 1988 looked at minimum capital levels and the risk weightings of different types of loans. For residential mortgages, risk weights were set at 50%, hence banks had to carry half as much equity against them and could in effect leverage their balance sheet twice as much. This helped kickstart a boom in Australia.
Adding to this was a falling interest rate environment. Interest rates over the last 27 years have gone from 17.5% to 1.5%. Amazingly over that period, Australia has barely been through a tightening cycle.
Source: RBA
Basel 2 in 2007 has added a further tailwind with the banks effectively allowed to set their risk weights through their internal risk models. The banks moved to a 17% risk weighting for residential mortgages. Given an 8% minimum tier one capital ratio from APRA, this allowed banks to leverage their equity 83x. A 17% risk weight means they only have to hold 17% of the 8% minimum capital requirement. In other words for $1 of equity, a bank could lend out a staggering $83 in residential mortgages.
The impact of lower interest rates and favourable risk weightings has meant that our banks have in effect become rather large building societies. Australian banks have a disproportionate amount in residential mortgages when compared with international peers.
Source: AFR, Variant Perception
In becoming building societies the banks have driven household debt up. Australia now sits in 2nd place globally with regards to household debt to GDP.
Source: Bank of International Settlements
Comparing our journey to some other significant countries, you can see one major difference. In the period post 2007, all of these other nations have been through “deleveraging cycles” and household debt at some point has fallen (with the exception of Canada, an economy similar to Australia with a large exposure to the resource sector and commodity markets). Australian households never deleveraged and have in fact taken on more debt. Household debt has risen from 40% of GDP back in 1990 to 123% today.
Source: Bank of International Settlements
The problem for banks now is that the two key drivers that lead to this growth in the mortgage book and household debt are either exhausted or reversing.
Interest rates are sufficiently close to zero that further scope for lending growth from rate cuts is limited. It also suggests that the capacity of households to take on more debt is limited. Hence for the banks it will be a struggle to grow their loan books.
After a long period of supportive regulatory changes, the tailwinds have reversed. APRA moved back in 2015 to shift the risk weighting associated with residential mortgages from 17% to 25%. This means that the banks have to hold more equity against their current loan books (they can now only leverage their equity a meagre 50x as opposed to 83x). The impact of this was that slight drop in ROE seen above. APRA now has indicated there are further changes to risk weightings coming and these set to be announced “around the middle of the year”.
Conclusions:
Investing is all about probabilities. The value of a share is the sum of its future cashflows. The future however is unknown. Therefore, when establishing what a company is worth or how much certain shares will return we need to look at a range of circumstances to understand the potential upside and downside scenarios.
For the banks, we know that loan growth going forward will be constrained. The best scenario is a likely flat lining of the household debt to GDP ratio over the coming years. In that instance, earnings will grow at roughly the level of nominal GDP which has averaged 3.3% over the last 5 years. Add to that a dividend yield of around 5% and some franking and you get a return of around 10%, a perfectly reasonable outcome for a low interest rate environment. The problem is this is the best expected outcome (outside of a surge in GDP growth that seems unlikely), and it doesn’t even include the likelihood of higher capital requirements from APRA.
What about the other side of the equation? Well, high household debt doesn’t cause a problem on its own but it does make our economy and our banks vulnerable to a shock. The last time we had a shock two of the Big Four recorded significant losses. In fact, Westpac managed to destroy 23% of their equity in one year. A loss that large will lead to a significant rerating in the Price to Book multiple meaning the loss for shareholders would be considerably more than the 23%.
Source: Company filings, Thomson Reuters
So what could lead to a potential shock? There are three potential catalysts:
Higher Interest Rates. There is a very low probability of interest rate rises anytime soon and in our opinion there is a very low probability of any meaningful tightening cycle in Australia over the next decade. The RBA is effectively hamstrung by the high level of household debt, a problem which they have largely brought on themselves. Although we have to note, a consequence of the stricter capital limits and the rising rates of the US Federal Reserve has led to “out of cycle” rate hikes from Australian banks.
Higher unemployment. Recent job numbers have shown a deterioration in the employment picture most notably in Queensland and Western Australia (something we wrote about in our 2017 Outlook). We do expect this to cause some problems for the banks over the coming 12-18 months.
Low wage growth. Low wage growth makes it more difficult to service debt and currently wage growth in this country is at a record low.
Ultimately, when we assess the outlook for banks we arrive at a conclusion that asymmetric risks exist with limited upside but significant downside. When we look for companies to invest in we want the opposite, limited downside with large potential upside. As a result we continue to avoid the banks, believing that the 25 year bull market has come to an end. The only question that remains for us is whether this bull market ends with a bang or a whimper.
Robert Swift presents 4 short videos on the impact of the withdrawal from Zero Interest Rate Policies on financial stocks, infrastructure, geographic segments and asset allocation. As global central backs commence the process of normalising rates we will see the investment landscape change, Robert provides his thoughts on how best to navigate global investment markets.
