ANZ Banking Group's full-year profit offered a great insight into the challenge facing all Australian banks last week. Since 2007 ANZ's equity capital base has swollen by about $11 billion as it looks to comply with new regulatory capital requirements.
Shares were issued when the stockmarket was battling the effects of the global financial crisis.
The challenge now is to generate an adequate return to new and old shareholders on that expanded capital base.
In full-year 2012, ANZ's return on equity on its preferred measure of earnings fell from 16.2 per cent in 2011 to 15.6 per cent.
The result was noticeable for its headcount cuts and a reduction in collective provision balances for bad debts. Neither line item can be relied on to continue to grow profits sustainably. Looked at another way, if ANZ backs out the cost of capital from its earnings and assumes an across-the-cycle level of bad debts then it generated just a 1 per cent increase in so-called economic profit in 2012 to $2.54 billion.
This economic profit calculation is not just an academic number it is used to calculate the variable component of executives' remuneration.
Thankfully, it looks like the strengthening of ANZ's capital base is all but complete for the foreseeable future. It says it is now well placed to comply with the Basel 3 regulatory capital requirements being implemented from January 2013. ANZ chief executive Mike Smith was arguing last week that the result was a good one given the trading environment and the bank's continued rollout of its Asian footprint.
Or, as the chairman of another listed financial services company noted last week, "flat" is the new up.
But when constructing a balanced portfolio professional investors typically look to financial services stocks to offer leverage to an uptick in economic activity.
The question is do banking stocks continue to offer the same leverage they once did now they are regulated like utilities. ANZ's share count has increased by more than 44 per cent since September 2007. That's a lot more shares to which dividends have to be paid.
Fortunately, there are many companies in the financial services sectors that have been able to keep their equity issuance to a minimum during a period of depressed share prices. According to Capital IQ, there are more than 20 companies that have not grown their share count by more than 10 per cent over the past five years.
These include Challenger Financial, ASX Ltd, Treasury Group, Perpetual, Mortgage Choice, The Trust Company and Platinum Asset Management.
With the exception of Challenger these companies can be considered relatively capital-light businesses. This means they might prove to be shareholder friendly in improving economic conditions.
In itself, subdued share issuance does not necessarily point to good prospects for existing shareholders but at least it means a company is better placed to reward long-standing (and, in many cases, long-suffering) shareholders than it would have been had it needed to shore up its balance sheet during the GFC. Of late, investors have been looking to increase exposures to some of these companies.
Shares in home loan broker Mortgage Choice and fund manager Perpetual have both risen about 30 per cent since the start of June. In recent periods both companies have suffered at the hands of depressed revenues and relatively high fixed-cost bases.
Mortgage Choice recently told shareholders that despite investments in new businesses, it expected to achieve similar cash profit in 2013 as in 2012 and maintain its dividend at 2012 levels.
On consensus numbers MOC is trading at about 11.5 times FY2013 expected earnings and is offering a prospective yield of about 7.5 per cent. It will benefit from any bounce in housing credit growth from multi-decade lows plus an expansion of its footprint, including a move into financial planning.
On consensus numbers Perpetual is by no means cheap relative to peers, trading at 17 times expected FY2013 earnings and a prospective yield of below 5 per cent. But what it does offer is the ultimate in leverage to any continued equity market rebound plus the possibility of becoming the target of a bank wanting to beef up its brand presence in the wealth-management sector.