Own the bank not a bank deposit

Roger Montgomery, Montgomery Investment Management

22 February 2021

After 37 years of declining interest rates that have fuelled asset price increases but laid waste to lower-risk income streams, it is perhaps surprising that now should be the time to be discussing dividends. But dividends are back in the spotlight, in no small part due to pronouncements by central bankers including the US Federal Reserve's Jerome Powell and the Reserve Bank of Australia's Phillip Lowe that low short-term rates are here to stay, perhaps for years.

The search for higher income and yields

The desire to deliver income in a low yield and low growth world is, we believe, driving a surge in corporate merger and acquisition activity. And the buyers aren't just trade operators but also large pension and superannuation funds looking to enhance income returns to their clients, investors and members.

Evidence of this demand is reflected in mutterings by the NSW Government that they are considering selling the revenue stream from gambling taxes (to also plug the hole left by changes to stamp duty), and in Telstra's idea to spin off its cell towers.

We recently wrote about this thesis, translating the search for income and higher yields by pension and super funds into the purchase of securities in companies with boring but stable annuity-style income streams. Included in the list of small cap candidates are REITS such as National Storage REIT and retirement and caravan park owner Ingenia Communities Group, as well as companies where we believe reliable annuity income streams are being developed such as Macquarie Telecom and Uniti Group.

Will the banks return higher dividends?

The banks are also back in the spotlight with a meaningful rebound possibly underway in the prospects of higher dividends. Prior to the global pandemic, bank dividends amounted to A$24 billion in 2019, representing almost a third of all of the dividends and franking credits paid by companies listed on the Australian share market.

While vaccination programs are still underway and COVID mutations may yet keep company boards on edge, stronger balance sheets, a recovery in the economy and particularly real estate prices should give the banks leeway to increase their payout ratios.

Any upside from the 0.1 per cent cash rate?

One upside from the decline in cash rates by the RBA to 0.1 per cent at the same time consumers cannot travel overseas, is that they are reassessing the suitability of their homes and borrowing to renovate or upgrade.

The pile of non-performing home loans is defrosting, repayments have recommenced, and home loan credit growth is being fuelled by refinancing and house upgraders and sea and tree changers thanks to technology and the work from home trend COVID spurred. ANZ CEO Shayne Elliott recently noted 92 per cent of customers who had deferred mortgage repayments had returned to repayments.

Changes to lending and borrowing

At the same time, the government's management of the economy has meant job losses have been less acute than expected and consequently the number of frozen home loans is thawing. Fewer underperforming loans will also help bank confidence in the future.

Also favouring a more generous dividend payment policy for the banks, are changes in posture by legislators and regulators. Late last year, the Australian Prudential Regulation Authority (APRA) cancelled its previous ruling that prevented banks from paying dividends in excess of fifty per cent of profits. Bank boards now have control of the payout ratio.

And around the same time the Federal Government indicated it would relax the rules surrounding responsible lending.

These changes are occurring at the same time consumers, having been banned from travelling overseas, and therefore from spending A$42 billion per year there, now have more firepower to spend locally or accumulate savings. Indeed according to the banks, bank customers have been building cash deposits at a record rate despite returns falling to close to zero.

With more of the onus around the risk of borrowing being born by the consumer/borrower, and with consumers flush with cash, the endemic fear of lending hitherto held by the banks is lifting and that means a return to credit growth along with confidence in paying higher dividends.

The shift in confidence should not be underestimated. It was only six or nine months ago that some of the major banks' economists were predicting economic Armageddon and property price falls of up to a third.

Commonwealth Bank results

Earlier this week the Commonwealth Bank of Australia  announced its half year results. After delivering a cash net profit which fell 10.8 per cent to $3.9 billion in the six months ended December 31, the bank announced a fully franked $1.50 dividend to be paid on March 30. The dividend exceeded expectations $1.45 a share and while it was 25 per cent down on the first-half dividend last year of $2 per share, this interim dividend was 53 per cent higher than the second half's 98¢ a share.

As an aside, the bank pointed to the economy returning to good health. It recorded strong growth in residential housing and business lending, along with deposits.

For years bank dividends were sacrosanct and surveys of retiree self-managed superannuation portfolios revealed heavy weightings to the banks. In an environment of plunging yields elsewhere bank dividends became indispensable. With the threat of the COVID-19 pandemic now dissipating, with bank forecasts for a property calamity turning 180 degrees and with business confidence returning tentatively, bank credit growth should cease slowing at the same time Net Interest margins could cease narrowing. Consequently, we believe bank dividends may once again be the lure that sees bank share prices improve.

And sturdier bank share prices are both directly and indirectly good for shareholders. Keep in mind, they make more attractive, and less dilutive, future capital raisings improving bank capital management flexibility.

At Montgomery, we don't expect the banks will immediately return to the payout ratios of old, but the main obstacles to increasing payout ratios have been removed and that makes banks prospects and shares a vastly more attractive proposition compared to term deposits than they were before.

Macquarie Bank's result

Elsewhere Macquarie Bank, this week, delivered a surprise profit upgrade at its operational briefing, highlighting very strong trading conditions in 3Q21.

While the trading businesses benefitted from market volatility, the bank also highlighted ongoing growth opportunities (infrastructure, commodities, renewables and retail banking) and a focus on Asset Management and Macquarie Capital.

Importantly, management flagged the FY21 result is expected to be only slightly down on FY20's NPAT of A$2,731 million. If "slightly down" means circa 2.5 per cent below FY20, it implies A$2,660 million for FY21), which is 22 per cent above the previous consensus estimates of circa A$2,180 million.  This resulting in big upgrades by analysts for FY21 and FY22 and possibly puts the stock on a PE of less than 18x FY22 estimated NPAT.

Funds operated by this manager:

Montgomery Small Companies Fund, The Montgomery Fund, Montgomery (Private) Fund

The Australian February 2021 Reporting Season

Arminius Capital

28 February 2021

Twice a year we summarise the half-year and full-year results of the companies in the ALCE portfolio. Most of the companies in the portfolio reported strong earnings recoveries in the December half-year, and dividend payouts were higher than our forecasts. This suggests that company boards - who by definition are in possession of inside information - believe not only that the worst is past us, but also that earnings will continue on a strong upwards trajectory.

Ampol's result for the year to 31 December 2020 was slightly better than expected. Net profit was down 38% to $212m before inventory losses. The final dividend was cut from 51c to 23c, making 48c fully franked for the year. Australian petrol volumes were down 17% year-on-year, but in the December half sales were recovering along with the economy. Shop sales were up 7% on a like-for-like basis. Nonetheless, strong cash flow enabled Ampol to halve its net debt to $434m, equivalent to 18% of equity. The retail network will be completely re-branded from Caltex to Ampol by end-2022. At present, it is likely that Ampol will close the loss-making Lytton refinery unless the Federal Government improves its proposed support package.

At end-January Bluescope had pre-released its unaudited figures for the half-year, and the official result was in line with the pre-release. Recovering housing demand in Australia and automotive and housing demand in the US lifted demand for BlueScope's flat steel products, propelling underlying earnings before interest and tax (EBIT) to $531m from $302m in the December 2019 half. The final dividend was unchanged at 6% unfranked. Management indicated that, for the key Australian and US steel businesses, the June half was likely to be better than the December half, putting underlying group EBIT in the range $750m to $830m.

BlueScope is actively improving the sustainability of its operations and reducing carbon emissions, but the commercial viability of "green steel" is probably a decade away. A further complication is that BlueScope's Port Kembla steel mill faces an uncertain future after 2025. The only blast furnace operating there (No. 5) will reach the end of its economic life between 2026 and 2030. BlueScope may have to spend up to $800m re-lining the No. 6 blast furnace, which has been mothballed since 2011. In addition, the Illawarra coal mines may not be viable in the long run, because falling Chinese, Japanese and Korean demand will lower coal prices, while new mines and expansions are constrained by their impact on Sydney's water catchment areas. Shutdown of the Illawarra mines would force BlueScope to spend an extra $100m per year to import coal. On the positive side, BlueScope can afford the necessary capex because it has strong cash flow and zero net debt.

BWP Trust, which is the landlord of most Bunnings stores, reported a solid result for the December half year. Like-for-like rents rose 2.0% year-on-year, and 99.0% of rent due was collected. The weighted average cap rate for the portfolio improved from 6.08% to 5.84%, which is still well above the yields on recent transactions for Bunnings stores. The portfolio value rose by $87m and NTA increased from 304c to 320c. Gearing declined slightly to 17.8%. The December half distribution was unchanged at 9.02c, and management re-affirmed that the level of the FY21 distribution was expected to be similar to FY20. Disappointed investors marked the share price down.

Property group Charter Hall reported a 43% fall in operating earnings after tax to $129m (27.8c per share), but raised distributions 6% to 18.6c per share. (For property stocks, operating earnings are a better measure of underlying profitability than statutory profit, which includes changes in property values.) Operating cash flow was only 70% of operating earnings, because of changes in working capital and differences between tax expensed and tax paid. Charter Hall increased its funds under management by $3.6bn net to $46bn. The group has zero net debt and $5.3bn in undrawn facilities, so it is likely to make more acquisitions this year. Management upgraded its guidance for FY21 operating earnings from 53c to 55c per share.

As expected, Coles reported a strong result, with sales up 8% and earnings before interest and tax (EBIT) up 12%. The interim dividend was lifted 10% to 33c, in line with the group's policy of paying out 80% to 90% of earnings. Operating cash flow was extremely strong at $1.7bn, equivalent to 120% of reported profit, and the group's cash holdings exceeded its borrowings.

Management indicated that supermarket sales could "moderate significantly or even decline" in the current half and in FY22 as pandemic-driven demand returned to normal levels, i.e., as the pig moved through the python. The end of government support schemes could trigger a decline in consumer demand. They also warned that reduced immigration would create a headwind for longer-term sales growth. These remarks frightened investors, who marked the share price down 10%, even though other retail CEOs made similar comments.

But Coles is not going back to the way business used to be. The group has taken advantage of the pandemic to improve its quality, convenience and fulfilment of its online offer, e.g. the Ocado automation program and the Coles Plus subscription membership. Management noted that omni-channel customers spend twice as much as store-only customers,

Real estate website Domain reported 3.6% higher EBITDA despite a 5.5% fall in revenues. (We have used the company's "like-for-like" figures.) Management attributed the improvement to the cost reduction program, but noted that costs would rise by 5% to 10% in the current half. Volumes and revenues improved in the key residential segment, especially in NSW. The commercial market remains very weak in all three East Coast capitals. Operating cash flow was unusually low in the December half, but management attributed the weakness to temporary factors and said that cash flow had subsequently returned to normal. Net debt of $112m was equivalent to only 12% of equity.

Industrial supplier GUD Holdings reported a 17.6% increase in net profit after tax to $31m (34.5cps). The dividend was maintained at 25c fully franked. A strong recovery in demand for cars lifted revenue by 10.7% to $251m, although exports were still hampered by COVID-19. Operating cash flow improved from $26m to $40m, even though, as management noted, the company was still bearing substantial costs related to COVID-19. Net debt is a modest $118m. Management suggested, with several provisos, that FY21 earnings before interest and tax would be $95-100m, implying a second half very similar to the first. The GUD share price has now returned to its pre-pandemic level.

Lend Lease beat market expectations with a 26% fall in core operating profit after tax to $205m. Development EBITDA fell 10%, investment EBITDA almost halved, but construction EBITDA rose 3%. The unfranked dividend of 15c was half of the December 2019 half-year, but much better than the 3.3c of the June half-year. Net debt rose from $0.8bn at June 2020 to $1.8bn at December 2020, but this is a positive sign because it reflects greater development activity hence more profits in future. CEO Steve McCann will hand over to Asia regional head Tony Lombardo in June.

Property group Mirvac reported a disappointing result, and the share price is now below NTA of 258c. Operating profit after tax of $276m was better than the June half number of $250m, but well below the $352m achieved in the December 2019 half. Earnings from office and industrial property held up well, but earnings from residential dropped to $76m, compared with $146m in the December 2019 half and $79m in the June 2020 half. The balance sheet remains strong, with gearing of 21.4% and $1.3bn in cash and undrawn lending facilities. The half year distribution was only 4.8c, compared to 6.1c in the December 2019 half. Management indicated that the FY21 distribution was expected to be 9.6c to 9.8c. The market had been hoping for a rapid return to the days of 12c distributions, so the share price has been marked down.

Media group Nine Entertainment saw first-half NPAT rise 79% to $182m, compared to the December 2019 half. Revenue slipped only 2% because large rises in digital revenue almost offset the declines in print and radio revenues. The interim dividend was unchanged at 5c fully franked, indicating the board's renewed confidence after the FY20 final had been cut to 2c. Strong operating cash flow allowed Nine to slash debt from $291m at June 2020 to $150m by December 2020.

The CEO stated that the pandemic lockdowns had accelerated Nine's transition to digital and allowed the group to bring forward its strategic plan. For the June 2021 half, free-to-air advertising markets have recovered to their pre-coronavirus levels, while digital audiences and subscriptions have re-based to higher levels and are continuing to grow.

Heath insurer NIB reported a 15.9% rise in net profit after tax to $66m, partly because of a $25m provision release related to COVID-19 claims liability. In the core business of Australian residents' health insurance, policyholder numbers increased, the lapse rate declined, and the net margin improved. The interim dividend was unchanged at 10c fully franked, and far above the 4c dividend for the June 2020 half-year. Gearing of 26.7% is below the policy target of 30%. Management warned that claims outlook remained uncertain, with no clear pattern in the catch-up of previously deferred treatment and ongoing COVID-19 implications.

Scrap metal dealer Sims (SGM) is enjoying a very good recovery. Even though sales revenue fell 9.5% and volumes fell 3.7% (compared to the Dec 2019 half), the company returned to profitability. Net profit after tax moved from a $91m loss to a $53m profit (26.3cps), and the dividend was doubled from 6c to 12c fully franked. Sims lifted operating cash flow from negative $34m to positive $149m, so that its cash holdings rose by $55m to $165m. Management attributed the improvement to a cost reduction program, better control of margins, and higher prices for ferrous and non-ferrous scrap. No guidance was offered for FY21 profits, but the market has concluded that recent strength in scrap prices justifies a higher share price for Sims.

Insurance broker Steadfast continued its record of steady growth, despite the pandemic. Underlying net profit after tax rose 19.3% to $60.4m. Insurance broking continued to benefit from premium increases by insurers, with no loss of volume, while insurance underwriting continued to benefit from market share gains as well as premium increases. The interim dividend was lifted from 3.6c to 4.4c fully franked. Steadfast completed $121m of earnings-accretive acquisitions in the December half, while keeping debt still within the target range. Management re-affirmed its guidance for FY21: underlying NPAT of $120m to $127m, and underlying diluted EPS growth of 10% to 15%.

Diversified property group Stockland is still a long way from full recovery. Funds from operations (FFO) rose only 0.4% to $350m or 16.2c per unit. Net rental collections from the property portfolio reached 90%, compared with only 61% for the June 2020 half. Higher foot traffic and better sales have improved the expected credit loss from 16% of billings at June 2020 to only 3% at December 2020. Stockland's residential development business is back to normal, with sales and enquiries picking up strongly in the current half. The interim distribution fell from 13.5c to 11.3c, which was at least better than the 10.6c paid for June 2020. Gearing of 24.2% is in the middle of the target range of 20% to 30%, and weighted average debt maturity is a comfortable 5.6 years. Management indicated that FY21 FFO would be 32.5c to 33.1c, with a payout ratio of 75% or better.

Retail conglomerate Wesfarmers announced a 23% rise in net profit to $1.39bn and a 17% lift in the interim dividend to 88c as its Bunnings, Officeworks and KMart businesses prospered during the pandemic. Bunnings was the strongest performer with a 28% increase in sales, and it provided 62% of group EBIT. Operating cash flow was strong at 102% of net profit before depreciation and amortization. In the wake of the Coles selldown, Wesfarmers has net cash of $817m. The company plans to spend more than $1.0bn on its lithium project, but management said that a capital return was possible once the COVID-19 risks had passed.

Engineering contractor Worley had already signalled at end-January that profits for the December half-year would be down because collapsing end-market demand had forced the deferral of many of its contracted projects, particularly in the Americas. For the December 2020 half-year, revenue dropped 25% from $6.0bn to $4.5bn, and underlying earnings before interest, tax and amortisation plunged from $365m to $207m. Management emphasized that long-term contracts remained in place and that project cancellations had been minimal. In addition, many contracts scheduled to be awarded in the December half had been delayed. Gearing of 22% is well below the target range of 25% to 35%. The interim dividend was unchanged at 25c unfranked, which suggests that the board is confident of a rapid rebound. Management expressed optimism for a better second half, but did not offer any firm numbers.

Funds operated by this manager:

Arminius Capital ALPS Fund, Arminius Capital GMMA Fund

Damen Purcell, COO of Australian Fund Monitors, speaks with Jonathan Wu, Executive Director at Premium China Funds Management.

Premium China was started their first fund in 2005 and have grown to offer 4 actively managed specialist Asian equity and fixed-income funds to both Australian and New Zealand investors. Their Premium Asia fund, which was started in 2009 has returned 12.97% per annum since inception outperforming the Asia Pacific Ex Japan benchmark by over 8% per annum.

Funds operated by manager: Premium Asia Fund, Premium Asia Income Fund, Premium Asia Property Fund, Premium China Fund

Australian Fund Monitors' CEO, Chris Gosselin, speaks with Charlie Aitken from AIM Investment Management about the AIM Global High Conviction Fund's recent and long-term performance.

The AIM Global High Conviction Fund is a long-only fund that invests in a high conviction portfolio of global stocks. The Fund has achieved a down-capture ratio since inception in July 2015 of 81.83%, highlighting its capacity to outperform when market's fall. The Fund has outperformed the Index in 7 out of 10 of the Index's worst months since the Fund's inception, further emphasising its strength in negative markets.

Damen Purcell, COO of Australian Fund Monitors, speaks with Richard Ivers from Prime Value Asset Management about the Prime Value Emerging Opportunities Fund.

Since inception in October 2015, the Fund has returned 14.86% p.a. against the Index's annualised return over the same period of +9.64%. The Fund's Sortino ratio (since inception) of 1.27 vs the Index's 0.74, in conjunction with the Fund's down-capture ratio (since inception) of 45.74%, highlights its capacity to significantly outperform in falling markets.

Funds operated by manager: Prime Value Emerging Opportunities Fund, Prime Value Equity Income (Imputation) Fund - Class A, Prime Value Growth Fund - Class A, Prime Value Opportunities Fund

The Bond Market: The Tail Wagging the Dog?

Aitken Investment Management

11 March 2021

US political strategist James Carville once remarked, "I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. Now I would like to come back as the bond market. You can intimidate everybody!" This witticism was vividly bought to life in February.

The ongoing progress made in administering vaccines more widely has raised the prospect of considerable levels of pent-up demand being unleashed as the global economy re-opens in the second half of 2021. Combined with ample amounts of monetary and fiscal stimulus - and assurances by governments and major central banks that policy will remain accommodative for several years - the outlook for an increasingly robust economic recovery over the next 18 months is taking shape. Alongside the prospect of this stronger economic recovery is the fear that permanently higher levels of inflation - benign for a long period of time - could be unleashed.

In our recent investor webinar, we specifically addressed the issue of inflationary risks in some detail (which you can watch by clicking here). We anticipated the potential for an inflation-led market wobble during the first half of 2021 as reported year-on-year inflation cycles the disinflationary period of March to July 2020. The volatility experienced in February may be the first sign markets are beginning to price in the implications of potentially higher levels of inflation.

Should inflation run hotter than the Federal Reserve is comfortable with - meaningfully above 3% year-over-year for a sustained period of time - the risk of interest rates needing to be increased to cool down the economy would be materially higher than markets assume today. 

To illustrate why higher bond yields could negatively impact valuation, imagine that you invest in an asset that will produce $1 in cash flow in year one, growing thereafter at 3% every year into perpetuity. How much should you pay for this asset? The answer depends to a significant degree on your discount rate, which is determined by the prevailing interest rate offered on long-dated government bonds.

In the chart below - adapted from our aforementioned webinar - we illustrate that as the discount rate rises, the fair value (or justified price) of a stock declines. Higher interest rates, all else equal, leads to lower valuations.

At present, our central case is that inflation will increase in 2021, but will then trend back down towards 2% over time. However, despite the fact that we believe there is a high likelihood of an inflation overshoot this year, it is an open question whether the current market positioning and structure is sufficiently robust to absorb rates moving sharply higher. On the evidence offered in February, there are potentially quite a few pockets of the market where higher discount rates will have a materially negative impact on valuations - in particular for highly leveraged investors. We remain cognizant of this risk and have taken appropriate steps to protect the capital in the Fund. In anticipation of a potential increase in discount rates, the Fund had already reduced its exposure to technology businesses with long duration cash flows, selling out of Apple, Netflix and Salesforce.com.

Funds operated by this manager:

AIM Global High Conviction Fund

Finding hidden value in volatile markets

Against a backdrop of heightened economic uncertainty and ever-falling interest rates, Australian investors have flocked to "quality": paying higher multiples across the board for the highest returning, fastest growing businesses. The challenge, in this environment, is to satisfy the desire to invest in quality businesses, without overpaying for them.

In this webinar with Airlie Australian Share Fund portfolio managers, Matt Williams and Emma Fisher, they explore their investment framework for finding underappreciated quality or hidden value in businesses, and how to invest sensibly when markets swing so quickly between fear and euphoria. They also dissect the latest interim results season and what it means for their portfolios.

Damen Purcell, COO of Australian Fund Monitors, speaks with Jonathan Wu, Executive Director at Premium China Funds Management.

Premium China was started their first fund in 2005 and have grown to offer 4 actively managed specialist Asian equity and fixed-income funds to both Australian and New Zealand investors. Their Premium Asia fund, which was started in 2009 has returned 12.97% per annum since inception outperforming the Asia Pacific Ex Japan benchmark by over 8% per annum.

Funds operated by manager: Premium Asia Fund, Premium Asia Income Fund, Premium Asia Property Fund, Premium China Fund