Making sense of the banking sector Airlie Funds Management March 2025

How long will the extraordinary rally continue? The banking sector enjoyed an extraordinary rally in 2024, with the Big Four Banks delivering an average TSR of 33%. As recently as February, Commonwealth Bank (CBA), for instance, enjoyed a price to earnings multiple of 26x- a 60% premium to its historical average. This raises an important question: are these valuations justified for a sector that has not grown its overall earnings per share over the last 10 years? To look at this in another way, you can see in the chart below that the collective earnings of the Big Four are only today back to where they were in 2018. Yet if we add up the cumulative share prices of the banks, you're paying $233 in total for all four banks versus $157 in 2018 for the same level of earnings. And this is after the recent share price rout; at the banks' peak in February, you would have paid a cumulative $276 for these earnings. Are banks really making more money? The net interest margin story At its core, banking profitability hinges largely on a single key metric: Net Interest Margin (NIM). This is the difference between what a bank earns on loans and what it pays on deposits. The higher the margin, the more profitable the bank. However, over the past few decades, this margin has been steadily shrinking. This decline has been driven by three key structural changes in the industry: Mortgage brokers Over the past decade, the share of mortgage broker-originated loans has surged from ~50% to 75%, significantly squeezing bank margins. Banks pay the broker a large upfront commission of ~0.65% of the loan value ($6.5k for every $1m lent) and a trailing commission of 0.15% per year. Moreover, because brokers focus on securing the lowest possible rate for customers, mortgages have become increasingly price-driven, reducing banks' ability to charge more favourable rates. Since brokers earn their largest commission when writing a new loan, they have an incentive to refinance customers regularly, which further erodes bank margins. The Commonwealth Bank estimates that the broker channel is 20-30% less profitable than a loan originated through a bank's proprietary channel.  Entrance of Macquarie Over the last decade, Macquarie Group has entered the banking sector, employing a digital, broker-led model where it can operate a lean model without the tech debt and branch costs of its traditional competitors. The company has successfully grown its share to ~5% and its ease of use has made it popular with brokers. Unlike the major banks, Macquarie doesn't need to maintain a constant presence in the mortgage market. It has entered when risk and pricing are attractive and exited when margins tighten, making it a highly agile competitor. This dynamic prevents periods of excess profitability for the Big Four, as Macquarie re-enters the market whenever rates become too favourable for banks. Exit from broader business lines In the past, banks operated in higher-margin businesses such as wealth management and insurance. While these divisions may have distracted them from mortgage competition, they also provided additional profitability. With banks now exiting these areas, mortgage lending has become their primary battleground, intensifying competition and further pressuring margins. Bad debts are low but can this last? One of the biggest risks for any bank is loan defaults, which result in bad debt expenses; that is, the losses banks take when borrowers can't repay their loans. Historically, Australian banks have averaged bad debt expenses of ~0.15% to 0.20% of gross loans and acceptances. In FY24, this figure was just 0.08% - about half the long-term average. While this looks like a positive for bank earnings, the key question is: is this sustainable? Why are bad debts so low right now? There are three key reasons bad debt expenses remain unusually low: Favourable economic conditions. Strong employment and rising house prices mean most borrowers can still meet their repayments. Even if someone loses their job, they can often sell their home at a premium, allowing the bank to recover the loan without taking a loss. Covid-era provisions act as a buffer. During the pandemic, banks set aside large provisions for expected loan losses that never fully materialised. These reserves have been gradually released, reducing reported bad debt expenses in recent years. Shift towards lower-risk lending. Some argue that historical bad debt levels aren't as relevant today because banks now focus more on residential mortgages rather than riskier business lending, which traditionally had higher default rates. The real risk: Are banks underestimating future loan losses? While bad debts are currently low, history suggests this won't last forever. Since current bank earnings are inflated by unusually low bad debt expenses, it's reasonable to assume: Future earnings may be overstated at today's valuations. A normalisation of bad debts could reduce bank profitability more than expected. Bottom line? The current low levels of bad debts make bank earnings look better than they likely are in the long run, suggesting investors should be cautious about assuming today's profits are sustainable. To pick on ANZ as an example - and we chose ANZ because it has the lowest level of provisioning for bad debts - if the bad debts expense were to normalise to ~0.20% of gross loans and acceptances (the pre-covid FY16-19 average) from 0.05% in FY24, its EPS would have been ~13% lower.   Expenses One area where banks could justify a higher valuation is through improved efficiency. However, the track record here is mixed. While banks have closed physical branches and pushed digital banking, these savings have been offset by rising IT spending, cybersecurity costs and regulatory compliance. Additionally, employee expenses account for ~70% of a bank's cost base and wage pressures remain high. The net result? Banking cost bases have proven resilient, making it difficult for them to structurally improve profitability through expense reduction. Since FY16, bank expenses have grown at ~1.7% p.a. compared to income growth of just 0.9% p.a.   This means that despite cost-cutting efforts, banks struggle to convert these savings into higher profits because any efficiency gains are competed away in lower prices for customers. As a result, cost-cutting alone is unlikely to drive meaningful margin expansion at the sector level. Over time cost efficiencies (lower cost-to-income (CTI) ratio) have been reinvested back in the customer   Source: JP Morgan Are bank valuations justified? The 2024 banking rally may suggest a thriving sector but the fundamentals tell a different story: Net interest margins remain under pressure as mortgage brokers dominate the market and Macquarie intensifies competition. Bad debt expenses are at historic lows but history suggests they will normalise over time, reducing earnings. Cost-cutting has failed to translate into sustained profitability, with banks reinvesting savings into lower prices to stay competitive. Volume growth will remain moderate, given Australia has one of the highest household debt-to-GDP ratios globally. Given these challenges, the current high bank valuations appear disconnected from long-term earnings potential. By Jack McNally, Investment Analyst Funds operated by this manager: Airlie Australian Share Fund, Airlie Small Companies Fund Important Information:  This material has been delivered to you by Magellan Asset Management Limited ABN 31 120 593 946 AFS Licence No. 304 301 trading as Airlie Funds Management ('Airlie') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation.  This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should obtain and consider the relevant Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') and consider obtaining professional investment advice tailored to your specific circumstances before making a decision about whether to acquire, or continue to hold, the relevant financial product. A copy of the relevant PDS and TMD relating to an Airlie financial product or service may be obtained by calling +61 2 9235 4760 or by visiting www.airliefundsmanagement.com.au. Past performance is not necessarily indicative of future results and no person guarantees the future performance of any financial product or service, the amount or timing of any return from it, that asset allocations will be met, that it will be able to implement its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of an Airlie financial product or service may differ materially from those reflected or contemplated in such forward-looking statements. This material may include data, research and other information from third party sources. Airlie makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material. Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of Airlie. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon. No representation or warranty is made with respect to the accuracy or completeness of any of the information contained in this material. Airlie will not be responsible or liable for any losses arising from your use or reliance upon any part of the information contained in this material. Any third party trademarks contained herein are the property of their respective owners and Airlie claims no ownership in, nor any affiliation with, such trademarks.   Any third party trademarks that appear in this material are used for information purposes and only to identify the company names or brands of their respective owners. No affiliation, sponsorship or endorsement should be inferred from the use of these trademarks.  This material and the information contained within it may not be reproduced, or disclosed, in whole or in part, without the prior written consent of Airlie.

[Current Manager Report if available]

Starting Points Matter Airlie Funds Management January 2025

Understanding the three components of shareholder returns. I learned a valuable lesson in July 2022, the last year the S&P/ASX 200 index posted a negative return, that starting points matter. I had gone on leave to have my second child in December 2021 as markets were making all-time highs, the cash rate was on the floor (and the RBA was promising to keep it there for years) and a raft of IPOs were hitting the ASX. When I returned six months later, it was like returning to a different planet: the S&P/ASX 200 had fallen 12%, the Fed and the RBA were aggressively raising rates, and what was most notable to me was the absolute consensus bearishness that had taken hold. Things were bad, and they were only going to get worse. This bearish view had become so dominant that we actually chose the title 'Beware the Dominant Narrative' for our national roadshow that year, suggesting the fundamentals facing most Australian companies weren't actually that terrible. If we take that starting point of July 2022, the S&P/ASX 200 has gone on to return 38% inclusive of dividends, an impressive return over two-and-a-half years. What is interesting about this strong return is that, in my view, it was a function of the starting point. In any year, your total shareholder return as an investor is driven by three components: earnings growth (how much did earnings per share change by?), dividends, and the change in the price/ earnings (P/E) multiple. It is this last component I find the most interesting: how much are investors willing to pay, on average, for a particular earnings stream? If we look at these three components at an index level, as in the chart above, the P/E multiple is the best guide we have to the 'psychology' of the market: when market participants feel bearish, as they did in CY22, the market P/E contracts. Despite delivering 18% earnings growth, the S&P/ASX 200 return was flat because of this sizeable de-rate. When market participants feel things are improving, the P/E expands. As you can see in the chart above, the bulk of the 38% index return generated in the last two-and-a-half years has come from the P/E re-rating rather than earnings growth. In fact, over the last two years, earnings have declined 11%, while the P/E has re-rated by 27%. Whether or not this is sustainable is anyone's guess, albeit I would speculate that actual earnings growth is going to be needed for further returns from here. If we do get a rate cut or two in 2025, such earnings growth should be achievable, although it is interesting that our market has rerated over 2024 in line with the US, which enjoyed 100bp of rate cuts over the year, despite the lack of falling interest rates in our own economy. So now we have a new starting point, 1 January 2025, and it's a very different one. The average P/E multiple of the S&P/ASX 200 has re-rated from 12.7x in July 2022 to 17.7x today. In particular, the re-rating in the Big Four banks, which collectively drove almost 40% of the return of the ASX over the last two years, has rendered the 24% of the S&P/ASX 200 index, which they represent as overvalued, in our view, considering their anaemic profit growth outlook. Does this mean it's a bad time to invest? Not necessarily. We are big believers in the age-old saying, "It's time in the market, not timing the market" that drives long-term wealth creation in investing in equities. That said, we are tilting the portfolio towards businesses where the starting point reflects depressed, rather than elevated, expectations. A number of these investments are positions we established in 2024: BlueScope, IDP Education, IGO, The Lottery Corporation - all businesses where expectations are muted. Others are positions we've added to as share prices have fallen: Ampol on weak refining margins and production issues, BHP as Chinese stimulus disappoints, CSL as the Vifor acquisition has fallen short of expectations. What these businesses have in common are strong balance sheets and good management teams, as well as the ability to generate good returns through the cycle. In an expensive market, we believe positioning the portfolio towards businesses with strong financial characteristics and somewhat "beaten up" valuations should prove a good starting point for decent long-term returns. By Emma Fisher, Deputy Head of Australian Equities & Portfolio Manager Funds operated by this manager: Airlie Australian Share Fund, Airlie Small Companies Fund Important Information:  This material has been delivered to you by Magellan Asset Management Limited ABN 31 120 593 946 AFS Licence No. 304 301 trading as Airlie Funds Management ('Airlie') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation.  This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should obtain and consider the relevant Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') and consider obtaining professional investment advice tailored to your specific circumstances before making a decision about whether to acquire, or continue to hold, the relevant financial product. A copy of the relevant PDS and TMD relating to an Airlie financial product or service may be obtained by calling +61 2 9235 4760 or by visiting www.airliefundsmanagement.com.au. Past performance is not necessarily indicative of future results and no person guarantees the future performance of any financial product or service, the amount or timing of any return from it, that asset allocations will be met, that it will be able to implement its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of an Airlie financial product or service may differ materially from those reflected or contemplated in such forward-looking statements. This material may include data, research and other information from third party sources. Airlie makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material. Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of Airlie. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon. No representation or warranty is made with respect to the accuracy or completeness of any of the information contained in this material. Airlie will not be responsible or liable for any losses arising from your use or reliance upon any part of the information contained in this material. Any third party trademarks contained herein are the property of their respective owners and Airlie claims no ownership in, nor any affiliation with, such trademarks.   Any third party trademarks that appear in this material are used for information purposes and only to identify the company names or brands of their respective owners. No affiliation, sponsorship or endorsement should be inferred from the use of these trademarks.  This material and the information contained within it may not be reproduced, or disclosed, in whole or in part, without the prior written consent of Airlie.