The royal commission opens Pandora’s Box
As the royal commission into the financial services industry leaves a path of destruction and humiliation in its wake, much change lies ahead.
In case we had forgotten the importance of incentives, the royal commission is providing a salutary reminder. Across the spectrum of banking, financial advice, and mortgage broking, the industry has been found sorely lacking on the basics of looking after the customer, and possessing acceptable moral standards. Incentives to lend more money and charge more fees were somewhat more powerful than those aimed at improving customer wellbeing.
The industry has more regulators and regulation than almost any other and the commission will undoubtedly trigger calls for more. It needs additional regulation like Donald Trump needs additional Twitter accounts. Complexity, excessive regulation and perverted incentives are all contributing to the problem; however, calls for simpler, lightly regulated, market-driven businesses with sensible incentives, remain notably absent. As the government has now conceded its opposition to the royal commission was ill-judged, further investigation and a more extensive time frame seem likely. I’ll go out on limb and suggest the findings won’t be dominated by happy customers receiving excellent quality service at well below what they expected to pay. Given the valuations of major banks, AMP and many other intermediaries have faded markedly relative to other businesses over recent months and now trade at earnings multiples well below industrial counterparts. Whether they offer appealing investment opportunities depends significantly on the extent to which a more challenging operating environment for Australian financial businesses crimps profitability. Significant profit growth from current elevated levels seems a pipe dream.
Despite this outlook, valuation gaps between those businesses with perceived strong prospects and those with a more challenging outlook continue to stretch well beyond historic norms. For context, ANZ finished April at an almost identical equity market value to CSL, about $77bn. Current year earnings for ANZ (with the half year result just reported) are expected to be around $7bn. Forecasts for CSL are for profit a little above $2bn (US$1.65bn). Revenue for CSL is approximately the same as ANZ’s profit before tax. CSL is a wonderful company; however, it is already a large and extremely profitable player in the plasma fractionation industry charging very high prices for its products, and its profit needs to triple to match ANZ. We agree totally with a far more positive profit trajectory for CSL; however, we cannot bridge the valuation gap between the two companies on assumptions we see as realistic. Profit momentum rather than valuation levels remains the totally dominant driver of stock prices. History tells us this has not always been the way of things.
To put it bluntly, our expectations are that profits for most of the Australian financial sector should and will go backwards. Like much of the world, the past couple of decades in Australia has been characterised by booming asset prices fuelled by somnambulant central bankers and a complicit banking industry. While the behaviour of certain elements of the industry deserves to be vilified, the incentives start with government policy. Both the asset and liability side of the country’s balance sheet have been exploding for more than two decades. Capital gains tax discounts, superannuation tax breaks, negative gearing and ever lower interest rates have been blatantly favouring asset price speculation over wage and salary income. Behaviour has followed incentives. That growing both sides of the balance sheet in unison cannot grow the net wealth of the country should be obvious but remains lost on government. Having not yet moved on from cash accounting where asset sales and one-offs are treated as income, this is no surprise.
In forming our view on sustainable financial sector profits we have a significant conundrum. Shrinking a bloated balance sheet is tough. Bank profit growth has come almost solely from maintaining a relatively stable NIM (net interest margin, or the equivalent of price for a bank) on an exploding deposit and loan base. Volume, not price, has been the driver. The same is true for financial planning, platforms and asset management. Price has been flat to down, volume (asset prices) up and up. However, as money is the lifeblood of the modern economy, shrinking its volume without disastrous flow-on impacts to the rest of the economy is almost without precedent. Even mild attempts to reduce leverage, such as recently announced efforts to limit borrowing to six times income (a still ludicrously high level) run the risk of triggering a credit crunch that cascades into falling asset prices and a viscous leverage spiral. None of this has yet started. Housing credit growth is still running north of 5% and debt-to-income levels are therefore still rising. We expect efforts to reduce balance sheet size to err on the side of extreme caution. As a result, revenues in the banking system should not fall precipitously. System bad debts can only rise from here, with the extent totally dependent on whether asset prices can retain some stability. Penalties, levies and assorted other mechanisms to augment government coffers and deflect blame for their role are certain to be an ongoing feature. Nevertheless, as the veins and arteries which pump blood around a financialised economy, best interests will not be served by inducing a heart attack. Our best guess: sustainable bank profits are likely to be some 25% below current levels when normalised bad debts and an educated guess at penalties are taken into account. This would take earnings multiples from apparently very cheap current levels back to the mid to high teens. This would, however, still leave them as fairly attractively valued and far more appealing than large segments of the equity market which trade at multiples well above this, without rosier long-term prospects and without the benefit of the domestic tax payments which mean a significant proportion of cashflow is not lost to foreign tax departments.
Despite more significant short-term share price falls, our views on the prospects for AMP are more circumspect. The value proposition offered to customers — the basis for any company being worth something — is less clear. High prices and a bloated cost structure for poor service is not a great starting point. It may be possible to turn around; however, it will be challenging. While Netwealth and HUB24 continue to price the transition of large amounts of platform revenue from incumbent banks and AMP, we believe the bigger issue will be the sustainability of the currently high levels of revenue attached to platform account administration. Incentives again play a powerful role. Platforms are a useful productivity and business management tool for financial planners, yet fees are paid by the end customer. As in countless other sectors, spending other people’s money often means searching for the lower price and best value becomes a secondary objective. In no way do we believe this reflects a far greater prevalence of dishonesty within the financial services sector. This is statistically unlikely. It is merely the incentive. REA does the same with real estate agents, insurance companies do the same with insurance brokers, drug companies do the same with doctors. Current financial services outrage may well be mimicked across a few other industries should royal commission popularity get on a roll.
The model of wealth creation we seek to employ in our investment process relies on the addition of net tangible assets plus dividends through hard work and organic growth to sustainably grow value. Dissuading merger and acquisition activity at levels well above book value also plays a significant part. The poor behaviour induced by misguided incentives and cheap money remains broadly evident across the equity market. Businesses such as QBE Insurance, AMP, BHP Billiton and Fletcher Building continue the process of trying to repair the drawn out damage of woefully misguided acquisition strategies. Others such as Downer and Boral appear to be accelerating the timeframe between the party and the hangover as cracks have already appeared in the Spotless and Headwaters acquisitions, respectively. The likes of Corporate Travel Group and Wistech Global continue to garner support for aggressive acquisition strategies that we believe will presage future disasters. The contrast evident with successful organic growth strategies such as Fortescue Metals, Cochlear, earlier stage models such as Xero and the strong recovery in businesses like Computershare and Rio Tinto as organic growth strategies replace those of years past, leave us in no doubt as to the right path. Bond and corporate debt markets, which have backed up as artificial stimulus, shows at least some sign of retreating and to us seems to offer some scope to shift rewards away from rampant speculation and towards hard-earned profits. We’d expect the exceptionally wide gulf which has opened up between the ludicrous values attached to perceptions of high growth and the far more pedestrian levels accorded to the more mundane but sustainable businesses, to close in the process.
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