More to come from diversified financials

A lot is written about the four major banks in Australia. They do make up a large part of the All Ordinaries Index and, it could be argued, are closely tied to the Australian residential property sector.

Roughly 70% of all the major bank lending is on Australian residential property, and 70% of those loans are variable interest rate loans. Commentators domestically, and internationally, have varying opinions on residential property valuations and the consequent valuations of our four major banks.

Rather than focus on this part of the financial services market, I am focussing on what can loosely be described as ‘diversified financials’. This sector comprises companies such as domestic and overseas fund managers, domestic and overseas investment banks, superannuation specialists, trust companies and businesses of this nature.

The superannuation phenomenon in Australia is well understood and the current 9.25% compulsory contribution to employee superannuation, creating a form of ‘forced retirement savings’ as well as the systematic investment of those savings into appreciating assets, has created the fourth-largest superannuation pool in the world. This will soon to be the third-largest superannuation pool of funds in the world, at more than $1.7 trillion.

These funds need to be individually managed (self-managed superannuation funds) or collectively managed (managed funds, institutional funds, union funds, industry body funds), involving asset allocation decisions, asset class decisions, accounting, auditing, compliance and the many various skillsets required to manage and grow this very large national asset.

How can Australian investors get access to this diversified financials sector of the market, and is it a compelling area of investment from a sectoral and a valuation point of view? Interestingly enough, diversified financials is structurally a very compelling sector to invest in, for the reasons outlined above but also from a valuation and cyclical point of view.

As structurally attractive as this sector has been to invest in, the relatively recent global financial crisis has caused investors to shy away from diversified financials. This ‘shying away’ from sectors that have suffered a period of underperformance is known as the ‘recent phenomenon’ bias. People use the most recent set of events as the basis on which to predict what will happen in the future.

As history tells us, what happened in our most recent history is probably likely to happen again at some point in the future, but very rarely occurs in the immediate future. This is because the collective mindset, or general knowledge about these events, is fresh in people’s minds and we are unlikely to make the same mistake twice. It is far more likely that we will make a new mistake this time around!

The mistake we are more likely to make is to stay away from ‘out of favour’ diversified financial services companies with strong structural and compelling reasons for growth, due to recent memories about the GFC.

Two out of favour stocks in the diversified financials space are Henderson Group (HGG) and Macquarie Bank (MQG).

HGG was a spin-off from AMP many years ago and is a global fund manager with around $120 billion of funds under management. The company is dual listed in London and Australia. Management has been diligently building up the business and deliberately moved away from building ‘commoditised’ products into ‘value-added’ absolute return funds. In addition, management and the board have made acquisitions into ‘out of favour’ assets with excellent timing and these assets are now bearing fruit. Furthermore, global stock markets are in a period of recovery and, as such, HGG is benefitting from this global recovery. The majority of HGG revenue is from overseas and since the GFC most major stockmarkets in the world have recovered and some are even reaching new highs (this is certainly not the case in Australia where our markets trade at around 5,500 currently, a long way from our 2007 highs of around 6,800).

Macquarie Bank is another ‘out of favour’ stock. I see MQG as being in the early stages of a significant earnings recovery and ultimately a valuation rerating. Significantly, 68% of MQG revenue comes from offshore which, as outlined above, is experiencing significant recovery. Global levels of mergers and acquisitions activity are on the rise as are trade sales, Initial Public Offerings, placements, rights issues and general business expansion. All of these trends bode well for an earnings recovery, particularly in the ‘human capital’ parts of the business which tends to experience the most cyclical earnings cycle within the business.

I remain committed to the diversified financial services sector as an investment thesis, and while it has delivered significant profits to date I feel that the secular and cyclical nature of these stocks indicates that there is more to come.

Karl Siegling is a Portfolio Manager at Cadence Capital. To find out more about Cadence Capital Limited visit www.cadencecapital.com.au

The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.