Japan

Japan’s Nikkei fell on Monday from the impact of losses in US shares, mainly in response to reported slower earnings. The Nikkei fell 0.8% to below its 25 day moving average for the first time in two weeks. In the US, the S&P 500 and Nasdaq experienced their largest fall since March on Friday, lowering US Treasury yields. Nonetheless investors should not be concerned about the Fed raising rates in the short term however it does seem probable in September or next year. (More about the Fed rate hike in our next posts).

Globally, the second half of 2015 started slowly. Activity in China’s factory sector fell in July at the fastest rate in over a year, and manufacturing in the Eurozone was slower than expected. The global downturn would have reined in investor attitude to risk and contributed to the fall in the Nikkei, in particular, the price of financial stocks should attribute their decline to this.

Nonetheless, the Japanese market should sustain outperformance in the global market given expectations for stronger company profits due this week and strengthening economy. Its push for renewal all indicates Japanese equities are worth investing in today. Unlike the US stockmarket, which accounts for a disproportionate number of tech firms whose fortunes are irrelevant to the nation’s consumption behaviour, Japan’s weight in the MSCI World Index has fallen to reflect its economic weight. (In 1989 it contributed 17% of global GDP while representing 44% of the MSCI World Index, which leads to a distorted portfolio).

Government and shareholder actions have facilitated such investor interest in Japanese equities. The proxy advisor Institutional Shareholder Services advised voting against director reappointments if return on equity has been less than 5% for five years. The Abe government’s corporate governance regulations have discouraged large passive positions in other organisations, which used to be a common means of supporting their peers. Instead effective capital management is now implemented as shareholdings in other corporations must be justified.

These structural shifts mostly affect the financials sector. Due to greater capital efficiency even when growth in earnings is slow, share prices should rise. High end manufacturers and a growth in domestic and inbound tourism are other sectors with potential for stronger results. With this positive sentiment however, Japan’s demographic profile may be a red flag to watch: population is forecast to fall by 17% by 2040 with 20% of that population expected to be over 75.

References:

Australian Financial Review, Sydney Morning Herald

The Housing Bubble, Currency and Interest Rates

The Australian real estate bubble has peaked on Friday, and the median house price reached the 1million mark. What has been interesting is the relationship between our currency, the housing bubble, and interest rates.

The RBA this month had kept the cash rate at 2%, however the rise in interest rates for housing investors by ANZ and CBA will mean they could cut the cash rate again, given slower loan growth. This is particularly interesting as it against logic – as the interest rates rise, the cash rate is expected to fall. Banks are attempting to improve margins and return on equity as regulators impose lower leverage. ANZ last Thursday had raised the variable interest rate for property investors by 0.27 percentage points. CBA did so by that exact amount in less than 24 hours later.

It should have been expected that eligibility criteria for investor loans are tightening, though understandably it is the timing and magnitude of the pricing action last week that is the biggest surprise to the market. This is because banks historically are constrained from adjusting variable mortgage rates outside of the cash rate moves.

Nonetheless the banks’ choice to raise rates shouldn’t be controversial as the recommendation of the financial system inquiry that led to APRA’s decision to increase housing risk weights to a minimum of 25% from July next year was to change the competitive landscape between the majors and smaller banks. The rise in mortgage rates by the major banks can facilitate this.

Banks are showing willingness to reprice mortgage rates with limited downside risk. This should be good news for bank shareholders and the central bank. Major banks are expected to reprice all housing loans by between 0.55-0.65 percentage points which would maintain group return on equity that otherwise would be lost from APRA’s decision last Monday to increase housing risk weights to minimum 25% from July next year. For bank shareholders, the repricing is positive as net interest margins are key drivers of bank profit. They are fattened up after being squeezed in recent years from competition.

Another positive outcome that comes out of this is that despite it being contradictory, the ability of banks to increase rates without the RBA increasing the cash rate means the RBA can focus on depreciating the Australian dollar. Otherwise, the RBA would be torn between two goals: low Aussie dollar and to slow the property price bubble, of which would cause low rate financial stability concerns.  

However investor lending approvals are still 22% higher than in 2014 and more than 50% of new home loan approvals are being used for investment purposes.

Also, because the banks are already growing investor lending at around 10 per cent, their ability to attract customers from one another is severely limited, as new customers will push them over the 10% speed limit. So if peers do not follow ANZ’s lead, they will likely gain more share and once again exceed the 10% cap. This means the ability for better market share for smaller banks has been curtailed by these caps set by APRA. (The consequence of being over 10% is more capital and the increase in margins will only cover the increase in required teir 1 capital.)

Investor Advantage

The bank repricing gives flexibility to the RBA to cut the cash rate up to 75 basis points to weaken the dollar without affecting the housing bubble. This is positive for stocks with offshore earnings, and leads to a lower Australian 10 year bond price. Westpac and regional banks are also worthy stocks to hold given their overweight position to investment lending.

ANZ’s repricing of its domestic variable rate investor lending book will increase cash earnings by 2%. However to offset the valuation impact of this additional $13 billion to $24 billion of common equity tier 1 capital, the major banks would need to increase their margins by 12 to 22 basis points. CBA earnings should increase by 2-3%, and if the others follow suit: NAB 1-2% and Westpac 3-4%. Combined profits of the big 4 banks could improve by $800 million. For regional banks the returns would be even larger: Bendigo and Adelaide bank 4-5%, Bank of Queensland 5-7%. Interest rates therefore are expected to continue on the upward trend. 

Sources:

Australian Financial Review, SMH, Reuters

Growth Portfolio: Healthcare (NAN, CSL, SOM, JHC)

Nanosonics

Valuation

Market Price: $1.78

Current Value ~ $2

Future Value FY1: ~ $2.20

Future Value FY2: ~ $2.40

Business

Nanosonics Ltd was founded in 2001 and has headquarters in Sydney, Australia. Offices extend to USA and Europe. They operate in the healthcare sector focusing on development of innovative technology for infection control purposes. This technology can be applied for a range of industries.

Analysis

A new study conducted by Nanosonics concluded that the medical field should strongly consider the results of their research, hence inferring increased demand for Nanosonic products and revenues. The soaring share price increased in May this year following the announcement that of a new study which showed their Trophon ® EPR, their ultrasound high level disinfection system, was unique in its ability to kill natural infectious high risk HPV given normal conditions. High risk HPV accounts for 5% of all cancers. This caused a share price rise of 12% to finish at $1.72. Considering their previous high was at $2.02, there is high room for growth, especially given that Nanosonics operates to serve a niche market who are likely to have inelastic demand for such healthcare products, thus has high probability to prompt a re-pricing. This is likely as it has proven to be more effective than standard routine disinfections and wipes in use in hospitals and clinics nowadays. With a current market share of 30% in Australia and with rising sales, the company can easily achieve offshore profits as well. Industry numbers imply the market for ultrasound systems that Nanosonics offers is worth $US4.5 billion and the company already has locked in an exclusive distribution agreement with GE in the USA. In FY14, sales reached $24 million, and sales are expected to increase to $39.4million in FY16, which facilitates profits. Drops in profits can be attributed to development of other products (increase in CAPEX) though this should only hinder profitability in the short term.

CSL

Valuation

Market Price: $93

Current Value: $93

Future Value FY1: $97

Future Value FY2: $109

Business

CSL is an Australian pharmaceuticals company. In Australia, bioCSL manufactures and in-licenses, markets and distributes vaccines with particular focus on vaccines for the prevention and treatment of serious disease. CSL Behring Australia supports all aspects of the process from the collection and testing of donated plasma through to the production of a range of plasma-derived products. CSL Behring is the chosen national fractionator of Australia, New Zealand, Hong Kong, Malaysia, Singapore and Taiwan. In October 2014, CSL announced it would acquire Novartis’ influenza vaccine business to integrate with BioCSL’s current influenza business.

Analysis

In the first half of FY15, revenues increased 8% to US$2.74 billion. The segment which generated the highest revenues was CSL Behring (87%), whose revenues improved by 8% due to strong sales demand from Hizentra and Privigen in China’s hospitals, but competitive pressures reduced prices across their products. This competition came from European companies looking to increase their $US denominated sales. However, due to economies of scale in global networks (more than 65 laboratories in USA and Germany) and strict licensing requirements for collection and testing of plasma, there are high barriers for new entrants. CSL, Baxter and Grifols dominate the market and together add up to 85% of market share supply. This sustains industry profits. bioCSL accounted for 10% of revenues, which increased by 15% due to flu season in the northern hemisphere. CSL IP revenue decreased from the previous FY by 8% due to cuts in royalty payments from the HPV vaccine, though it only accounted for 3% of total group earnings.  Overall, this meant net profits rose by 7% to US$692 billion, and profit margins expanded to 31%. However it should be noted that the previous period included a class action settlement worth US$39 million. This helped boost their interim dividend by 9% to $US0.58 Approximately 8% of revenues are allocated to R and D, ensuring sustainable future growth. Historically speaking in the past ten years, R and D has been successful in developing 17 product approvals and registrations.  Their resulting patents ensure that competitors do not replicate their innovation for years, boosting pricing power due to relatively inelastic demand.  Their acquisitions have also achieved leverage and scale. They have managed to generate high amounts of capital, which is impressive given $2300 million worth of equity reductions from FY10-14 from buying back shares. Net return on equity rose in the corresponding period from 18 to 58%. They have moderate gearing, with a 42% debt to equity ratio. Gearing is supported by steady growth in operating earnings hence the interest coverage ratio of 32. Their $950 million share buyback split over FY15 further demonstrates a strong balance sheet with high potential for earnings growth.  However, there are short term pressures in trading conditions in their market which will impact net income. Management downgraded net income growth expectations by 2%. In the long term their therapies, offshore expansion into Asian emerging markets and the aging population in advanced economies (correlated with increased healthcare expenditure) will drive profits.

Key Risks

The main risk is if there is a material change in competitor supply which would affect the market’s equilibrium supply demand curve and hence product prices given their monopolistic nature. Whilst their plasma products are not discretionary, cyclical conditions are worsening globally which prompts governments to reduce their budget expenditure on the healthcare sector, which limits the company’s pricing power. Regulatory changes regarding product quality and/or safety likewise impacts reputation and hence sales.

JHC

Valuation

Market Price: $2.60

Current Value: $2.65

Future Value FY1: $2.68

Future Value FY2: $2.69

Business

Japara Healthcare Limited (JHC) is one of the residential aged care operators of healthcare services in Australia, with 3,391 places across 39 facilities located in Victoria, New South Wales, South Australia and Tasmania. Currently, JHC operates in Residential Aged Care sector, a sub-sector of the aged care industry. The Company operates through an aged care organization, ACSAG and Japara Retirement living.

Analysis

JHC is one of Australia’s leading aged care operators, meaning increased demand for aged care services compliments their growth strategy. Naturally this would also introduce threat of new entrants and competitive pressures, however the government’s controlled expansion of aged care residential facilities, licensing requirements and high compliance costs create barriers to entry, and supports already established and reputable monopolies. JHC aims to use brownfield and metropolitan greenfield projects to increase capacity. This means they are also in prime position to make acquisitions to enhance their portfolio from 3131 places to approximately 5000, as the aged care sector is very fragmented- the leaders account for only 10% of market share. Their Whelan acquisition increased places by 27%, and total occupancy was 94.4%, a percentage increase from FY14. Further growth strategies could increase their debt ratios however in Jan 2015 JHC had repaid all debt with $95 million available in loan facilities to fund growth. Moreover, JHC has proven to be effective in cost efficiency gains as well as revenue increases- average EBITDA per bed count increased by $21,761, a 15% boost from FY14, which increased EBITDA by 28% to $26 million.

Key Risks

Earnings are exposed to regulatory changes, as the government subsidises approximately 70% of operating revenues. Aged Care Funding Instrument is the main source of funding and is based on residents’ income and necessary care level. Fee regulation therefore decreases JHC’s pricing power, and JHC must continue to ensure costs are managed accordingly to sustain margins. Nevertheless, management estimates an increase of 80,000 aged care places by 2022, increasing sector investment by $25 billion.

SomnoMed

Valuation

Market Price: $2.90

Current Value ~ $3.30

Future Value FY1: ~ $3.30

Future Value FY2: ~ $3.35

Business

SomnoMed is a sleep organisation based in Sydney which designs and manufactures a premium range of oral appliances for sleep breathing disorders such as sleep apnoea. They are a market leader in their Continous Open Airway Therapy products and have recently expanded business to Europe and US whilst expanding product range. 45% of revenue is sourced from the US and 45% is from Europe.  

Analysis

The share price drop which followed a May announcement was due to an announcement that SomnoMed’s sales were lower than expectations, meaning their final volumes were between 50000 to 55000 units. However, this would still mean their YoY growth is 17%, and revenues are still expected to increase more than 25% in FY15. Over the next year the company will begin to include its digital record transmission product into its portfolio, which offers a positive share price catalyst amongst rising international sales and demand. Its recent release of Herbst Advance commences sales in September, and will account for more than half of existing Herbst sales. Product portfolio growth is both for upscale market as well as the lower end market. For instance, Fusion is an upmarket product which will replace Flex over the next 2 years. Innovation drives constant earnings growth. Air and Air+ have a December launchdate and targets lower end markets which is an effective strategy given that this accounts for almost a third of their total market. It will still maintain similar margins. Such catalysts increase long term growth rate to 30%.

Quantopian Algorithmic Trading Strategy: Portfolio allocation, Sell high, Buy low

This below algorithm should trade with the portfolio in the earlier post. In this situation we have $1 000 000 invested and no single stock has more than $350 000 invested in it. This is a trading guard as it would otherwise indicate a riskier portfolio. There is also a trailing stop at 20%. Our target is to have rather equal weights in all the stocks, and sell when it hits a maximum and go long when it reaches minimum. The maximum and minimum is determined by refreshing once a day to find the highest/lowest price in the last 7 trading days.

def initialize(context):
    set_benchmark(context.stocks)
    context.stocks = symbols(‘ANZ’, ‘MFG’, ‘NAB’,‘MFG’, ‘NAB’, ‘WBC’, ‘PNC’, ‘FLT’, ‘AGI’, ‘NCK’, ‘TRS’, ‘DSH’, ‘SOL’, ‘TLS’, ‘CCP’, ‘WOW’, ‘S32’, ‘JHC’, ‘CSL', 'NAN', 'SOM', 'SMX', 'SMA', 'MYOB', 'EPD', 'MLB')
    context.bet_amount = 1000000
    context.long = 0
    set_max_position_size(max_notional = 350000)

    context.stop_price = 0

    context.stop_pct = 0.2

 
def handle_data(context, data):

    set_trailing_stop(context, data)

         if data[context.stock].price < context.stop_price:

               order_target(context.stock, 0)

               context.stop_price = 0

    record(price=data[context.stock].price, stop=context.stop_price)

    order_target_percent(context.stocks[0], .05)
    order_target_percent(context.stocks[1], .05)
    order_target_percent(context.stocks[2], .05)
    order_target_percent(context.stocks[3], .05)
    order_target_percent(context.stocks[4], .05)
    order_target_percent(context.stocks[5], .05)
    order_target_percent(context.stocks[6], .05)
    order_target_percent(context.stocks[7], .10)
    order_target_percent(context.stocks[8], .10)
    order_target_percent(context.stocks[9], .05)
    order_target_percent(context.stocks[10], .05)
    order_target_percent(context.stocks[11], .05)
    order_target_percent(context.stocks[13], .05)
    order_target_percent(context.stocks[14], .05)
    order_target_percent(context.stocks[15], .05)
    order_target_percent(context.stocks[16], .05)
    order_target_percent(context.stocks[17], .05)
    order_target_percent(context.stocks[18], .05)

    pv = float(context.portfolio.portfolio_value)
    portfolio_allocations = []
    for stock in context.stocks:
        pos = context.portfolio.positions[stock]
        portfolio_allocations.append(
            pos.last_sale_price * pos.amount / pv * 100
        )

    record(perc_stock_0=portfolio_allocations[0],
        perc_stock_1=portfolio_allocations[1],
        perc_stock_2=portfolio_allocations[2],
        perc_stock_3=portfolio_allocations[3],
        perc_stock_4=portfolio_allocations[4],
        perc_stock_5=portfolio_allocations[5],
        perc_stock_6=portfolio_allocations[6],
        perc_stock_7=portfolio_allocations[7],
        perc_stock_8=portfolio_allocations[8],
        perc_stock_9=portfolio_allocations[9],
        perc_stock_10=portfolio_allocations[10],
        perc_stock_11=portfolio_allocations[11],
        perc_stock_12=portfolio_allocations[12],
        perc_stock_13=portfolio_allocations[13],
        perc_stock_14=portfolio_allocations[14],
        perc_stock_15=portfolio_allocations[15],
        perc_stock_16=portfolio_allocations[16],
        perc_stock_17=portfolio_allocations[17],
        perc_stock_18=portfolio_allocations[18])

def set_trailing_stop(context, data):

    if context.portfolio.positions[context.stock].amount:

        price = data[context.stock].price

        context.stop_price = max(context.stop_price, context.stop_pct * price)

def handle_data(context, data):
    rval = minmax(data)
    if rval is None:
        return
    maximums, minimums = rval
    for stock in context.stocks:
        current_max = maximums[stock]
        current_min = minimums[stock]
        current_price = data[stock].price
        current_position = context.portfolio.positions[stock]
        order_direction = calculate_direction(stock, current_min, current_max, current_price, current_position)
        order_amount = calculate_order_amount(context, stock, order_direction, current_price)
    order(stock, order_amount)

def calculate_direction(stock, current_min, current_max, current_price, current_position):
    if current_max is not None and current_position.amount <= 0 and current_price >= current_max:
        return -1
    elif current_min is not None and current_position.amount >= 0 and current_price <= current_min:
        return 1
    else
        return 0

def calculate_order_amount(context, stock, signal_val, current_price):
    current_amount = context.portfolio.positions[stock].amount
    abs_order_amount = int(context.bet_amount / current_price)
    if signal_val == -1:
        return (-1 * abs_order_amount) – current_amount
    elif signal_val == 1:
        return (1 * abs_order_amount) – current_amount
    else:
        return 0

@batch_transform(refresh_period = 1, window_length = 7)
def minmax(datapanel):
    prices_df = datapanel[‘price’]
    min_price = prices_df.min()
    max_price = prices_df.max()
    if min_price is not None and max_price is not None:
        return (max_price, min_price)
    else:
        return None

Growth Portfolio: Financials (PNC, ANZ, MFG, NAB, WBC)

Pioneer Credit

Valuation

Market Price: $1.73

Current Value ~ $2

Future Value FY1: ~ $2.25

Future Value FY2: ~ $2.30

Business

Pioneer is an Australian financial services provider, specialising in acquiring and servicing unsecured retail debt portfolios. Customers are in financial difficulty, mainly due to major life events such as unemployment, marriage breakdowns or significant health issues. PNC's debt purchases focus predominantly on credit card and personal loan accounts that are usually more than 180 days overdue.

Analysis

A positive catalyst based on their recent announcement that Pioneer Credit had signed a forward flow agreement with a major bank failed to be impounded into the stock price. By securing the forward flow agreement, the company has fulfilled customer acquisition expectations that supported its FY15 forecast outlined in their IPO prospectus. As a result of this agreement, Pioneer has agreements locked with three of the Big 4 Australian banks as well as a variety of smaller lending institutions This will support long term sustainable earnings growth as debt purchases increase. Forward flow agreements from debt sellers as well as its unique business model will drive profits over the next few years, particularly as its funding is established and ease of strategy execution. The fact the announcement failed to be supported in share price rises is surprising given the fact their share price dropped from $2 in March to a low of $1.45 in May. Analyst forecasts also expect EPS to be 14.6cents, making a PE multiple of 15.4 based on their 12 month price target of $2.25. Such expectations are in line with Managing Director’s confirmation that they were on track to achieve a net profit of $6.6 million this financial year. Because it will deliver EPS growth of 36.6% in FY15, it has high room for growth as it is trading at a high discount to its target.

Key Risks

Based on historical performance, 85% of debt purchased by PNC was from one financial group. If this client’s forward flow agreement were gone, supply of debt and hence earnings growth would drastically reduce. However, its new clients provide effective diversification and reduce risk. Nevertheless, availability of debt to purchase for its portfolio is highly dependent on the bank’s potential and agreement to sell to PNC, hence the need for forward flow agreements. This risk is increased due to increased competition which would pressure margins. Fortunately PNC has indicated its strategy includes broadening its product and service offerings. The increase in CAPEX would spur long term performance. However, investments would come at higher costs in the future given heavier regulations and higher compliance costs in the regulatory environment. There is limited information regarding implications of company strategy, for instance, limited understanding of whether their asset purchases which increase market share would hamper future performance.

ANZ

Valuation

Market Price: $32.25

Current Value ~ $37

Future Value FY1: ~ $36

Future Value FY2: ~ $38

Business

Australia and New Zealand Banking Group operates in Banking and Financial services and serves approximately 10 million global customers on retail, business and corporate clientele levels. The company operates in 33 countries across Asia Pacific, Europe, Dubai, USA and Asia. Australian operations make up the largest part of ANZ's business, dominating with commercial and retail banking lines. Operations extend across the Asia Pacific, Europe, Dubai, USA and Asia. Their strategy involves growing its Asian Pacific operational presence until 25-30% of earnings are sourced from the non-core APEA region by 2017.

Analysis

In the first half of financial year 15, cash profits rose by 5% and statutory profits rose by 3%. Flexible and accommodating credit conditions are highlighted through ANZ’s record low 0.19% loan impairment relative to total loans. Provisions likewise dropped below their 25-year average to 0.47% of assets. However in the long term earnings will suffer once such provisions and bad debts revert back to historical means. These expenses cannot fall much further, indicating banks have reached their peak of cyclical profitability. Their peak was strengthened by the favorable economic climate and strong property prices. Concerns over bubbles imply increased regulatory capital requirements, especially as the average financial leverage for Australian banks is relatively high compared to international banks at 17x. ANZ’s financial leverage ratio sits lower at 16.5x.  However, its Tier 1 Common Equity ratio (which ensures banks have a buffer to access funding in financial crises) has decreased by 0.1% to 8.7% of risk-weighted assets, 0.2% below its 9% goal. NAB and Westpac have already increased their ratio due to anticipation of APRA’s increased capital regulations.  Reports indicate Australian banks must boost their capital ratios by an average of 1.4% to be on par with the top global quartile with regards to capital. Regulatory changes combined with a slowdown in economic growth and rising interest margin pressures from competitive forces means ANZ must outperform in their operations. They are experiencing increased market share from their expansion in the Asia Pacific, where deposits and loans are growing. ANZ reaps benefits from large market cap and reputation in the wholesale deposit and funding markets and its operations in Australia’s secure socio-legal environment, as it ensures raising funds at cost effective prices. Its super regional strategy has so far been effective as profits from Asia Pacific represent 25% of total group earnings, and international and institutional banking (IIB) profits are increasing. Interim dividends were 4% higher than the first half of financial year 14 at $0.86.

Key risks

ANZ has experienced slow progress in their super regional strategy in creating an Asia Pacific connected bank. They are effectively diversifying group earnings by capitalizing on the international shift in focus on Asian emerging economies, though key risks include increased competition from global banks, slowing of Asia’s economic growth (compounded by Chinese equity market bubble and crash) and returns have rarely historically been over the cost of capital. Lesser provisions also increases risk in an economic downturn, especially as reversion in impairment depends on cyclical economic factors such as low unemployment and interest rates which maintain quality credit conditions. Such reductions in boosting earnings cannot be sustainable meaning operational revenues must grow and the company must drive cost efficiencies in their regional strategy. However it is unlikely there will be rate hikes over the next FY.

MFG:

Valuation

Market Price: $17.40

Current Value ~ $19

Future Value FY1: ~ $17

Future Value FY2: ~ $22

Business

Magellan Financial Group is a Sydney based specialist investment management business. Their asset management business line offers global equities and infrastructure investment funds for high net worth, retail and institutional investors in Australia and New Zealand.

Analysis

Their performance fee revenue of $33 million is a substantial increase of 1623% from last FY results, which drove revenues to increase by 91% to $128 million. This boosted NPAT margins to $77 million, up by 115%. Considering only 35% of total funds in management is subject to performance fees, there is room to build on this revenue growth. Funds in asset management increased from $23.4 to $31.6 billion due to growth in US (accounts for 25%) and UK (accounts for 49%) institutional clients. Australia accounts for 16%. Future growth is determined by the performance of funds in management, though based on 3 and 5-year historical performance, Magellan funds performed in the top quartile relative to competitors. Leverage also rises as there is a higher ratio of fixed costs relative to variable, and there is limited capital in their operational model. This will spur profit margins. Retail investors reap higher margins in management fees, though retail investors only account for 27%. Magellan Global Equities (MGE) is essentially a duplicate of their main retail fund though offers a catalyst in terms of extending retail distribution over fund platforms used by investment advisors, enabling self-investors convenient access to funds. Positively, growth in their distribution team will ensure higher retail sales, helped by the increase in net assets by 113% to $74 million. Moreover, they have been increasing self-managed super funds to international shares, which have appealed to clients. In Australia the minimum legislative requirement on super is set to rise from 9.5% to 12% by 2019. Their successful operations in London where over 90 clients have provided funds can easily be replicated in the US with its new management team. Their recent platform integration with AMP and Westpac for funds management will strengthen Magellan’s relations and reputation with investment advisors in Australia. However, 54% of funds are invested internationally without hedging against exposure to depreciation. Presently record low interest rates from quantitative easing in Europe, Asian and Americas from slowing economic growth spur net inflows for stocks due to the relatively lower returns in fixed income such as bonds and cash. Their business is likely to expand with such inflows in the long term as it is widely expected such rates will stay low.

Key Risks

The key risk involves effects on performance from stability in global equity markets and interest rates. In FY15 there has been increased allocations towards the cash asset type (weighted average of 11% compared to post GFC weighted average of 4%) due to recent global market instability and worries over interest rates. Performance risk is emphasised for Magellan due to relatively higher institutional mandates, which encompass a higher number of retail clients who will withdraw funds in times of poor investment returns. Currently, fund managers typicaly allocate 30% of self managed super fund capital to international shares, however Magellan has less than 0.5% in this asset type. Whilst this mitigates risk of global instability, it must increase substantially to ensure sufficient retirement capital.

NAB

Valuation

Market Price: $33.78

Current Value ~ $36

Future Value FY1: ~ $36

Future Value FY2: ~ $39

Business

National Australia Bank (NAB) is one of the four largest financial institutions in Australia in terms of market capitalisation and customers. They operate in Banking and Financial services. Their provision of products and services is mainly for Australian customers though their operations extend to Asia, UK, US and New Zealand. The group has multiple brands to market various products to different segments. Globally, their corporate business falls under National Australia Bank. In Australia, brands include NAB and UBank for banking, MLC for wealth management and insurance.

Analysis

NAB also reaps benefits from large market cap and reputation in the wholesale deposit and funding markets and its operations in Australia’s secure socio-legal environment, as it ensures raising funds at cost effective prices. Like all banks, it has reached the peak of cyclical profitability due to historically low bad debts expense (loan impairment charges at 0.18% of loans and provisions are 0.39% of assets, much lower than historical average) and the high likelihood of increased capital requirements and competitive pressures. Increased bad debts and provisions is strongly correlated with decreased returns. As bad debts cannot feasibly decrease further, the focus is on banking income to increase dividends and satisfy shareholder expectations, given its final 99c dividend was unchanged from prior FY. Interest margins are under pressure, with a group contraction of 1 basis point from FY14 due to lower earnings from assets, however NAB offset this by increasing statutory profits by 20.4% and cash earnings increased by 5.4% compared to the previous first half of FY14. 14% of earnings increase was attributed to loan impairments expense, though NAB’s main banking business in Australia increased cash earnings by 4%, largely driven by revenue growth from increased lending to households and businesses. Moreover, NAB combats regulatory risk by providing $5.5bn capital via a 2 for 25 pro rata accelerated renounceable entitlement offer to UK franchises to guard against losses, as they are exposed to macro trends in the UK, particularly with regards to commercial property. This means shareholders will have the right to purchase 2 shares for every 25 they own at $28.50 each. As expected with rights issues, EPS is falls by 4.5% and Return on Equity falls by 1.4%. If losses from compliance to regulations extend beyond the minimum required by the UK’s Prudential Regulatory Authority, the proportionate amount of increase will boost NAB’s CET1 ratio. This implies higher regulatory capital allocations pressures profit margins though reduces risk, supporting the relatively low required returns for the Australian Big 4 banks. NAB’s latest CET1 ratio is 8.87%, an increase from last FY though shows potential for improvement from the rights issue, particularly as its target range is 8.75%-9.25%. Increases in the CET1 ratio will also be driven by NAB’s divestment of underperforming British subsidiary Clydesdale, exit of its Great Western stake and UK commercial real estate. Its demerged asset of 70-80% of Clydesdale to shareholders, sold via IPO to institutional clients will list on the LSE, allowing increased focus on profitable segments such as Australian banking and wealth management lines.  Risk reduction is good news as Australian banks have high leverage relative to international banks, with NAB at 19.5x leverage (Australian mean 17x).

Key Risks

NAB has a large 33% sector exposure to emerging recovery in business lending. Previous key drivers of banking credit growth and real estate investor loans is likely to hit its peak due to the upcoming stricter regulatory environment. With low interest rates and the Australian dollar set to hit US65c, there will be less pressure in the business sectors of the economy and hence boost business lending. As common across the banking sector, there will be a reversion of impairment and provisions, though slow credit growth means this risk is not a large one. Impairment risks are further offset through low corporate leverage, attractive asset prices due to sustained low interest rates and global liquidity and minimal exposure to the slowdown in the mining sector in Australia.

WBC

Valuation

Market Price: $34

Current Value ~ $34

Future Value FY1: ~ $35

Future Value FY2: ~ $37

Business

WBC is one of the Big 4 Australian banks that provides financial services. Westpac has Australia’s largest branch network in terms of branches and ATMs. It is the second largest Australian bank by assets, and second largest bank in NZ.  Global finance capitals also host its offices including London, New York, Singapore and HK.

Analysis

Westpac’s strengths include its strong domestic network, conservative lending amounts, high liquidity and scale as well as strong interest margins. It is also reaching the peak of cyclical earnings given low interest rates and record low bad debts and provisions. Strong credit conditions meant impairment charges were only 0.11% of loans, and provisions accounted for 0.45% of total assets, much lower than historical means. Low interest rates will continue to ensure credit quality and credit growth in the medium term. However, banks are leveraged to cyclical conditions, which will remain subdued. The risk of unexpected downturns where unemployment increases and businesses fail, particularly in key cities such as Sydney and Melbourne (majority of home loans on the Big 4’s balance sheets), is unlikely. Its leverage is at 16.1x, which is lower than Australia’s mean of 17x. Westpac mitigates future regulatory risk where there will be increased capital requirements- the company will use an underwritten dividend reinvestment plan at 1.5% discount to raise approximately $2 billion of capital to shift its CET1 ratio towards the higher end of their target spectrum. Their CET1 ratio is recently at 8.76%, lower compared to FY14. Its recent financial results for first half FY15 was below expectations by 12%- profit remained flat with only a 2% increase in cash earnings. There was also a methodology change relating to adjusting a derivative valuation, which decreased non-interest income by 4%. Net interest revenues increased 5% due to a 3% increase in interest earning assets and their interest margin holding at 2.01%. Household debt being over 150% of disposable incomes means credit does not hold expansion potential. However, their 60% investment in BY Investment Management offers a catalyst based on growth in superannuation funds.