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.
Frequently Asked Questions about this Article…
What did ANZ's full-year profit say about the challenges facing Australian banks?
ANZ’s full-year result highlighted a key challenge: since 2007 its equity capital base has swollen by about $11 billion as the bank issued shares to meet stronger regulatory capital requirements. That larger capital base makes it harder to generate the same returns for shareholders — ANZ’s preferred return on equity fell from 16.2% in 2011 to 15.6% in 2012, and its economic profit rose only about 1% to $2.54 billion.
How will Basel III regulatory capital rules affect banks like ANZ?
The article notes ANZ has largely completed the strengthening of its capital base and says it is well placed to comply with the Basel III regulatory capital requirements being implemented from January 2013. Stronger capital means banks should meet new rules, but it can dilute returns unless earnings grow to cover the higher cost of capital.
Do banking stocks still offer leverage to economic growth now they’re regulated like utilities?
The piece raises that exact question: tougher regulation and increased equity issuance (ANZ’s share count rose more than 44% since September 2007) reduce the pure leverage banks once offered. In other words, heavily regulated banks can behave more like utilities, making them less responsive to an economic uptick than they were previously.
Which financial services companies have avoided large share issuance and why does that matter for investors?
According to Capital IQ cited in the article, more than 20 financial-services companies have not grown their share count by more than 10% over the past five years. Examples named include Challenger Financial, ASX Ltd, Treasury Group, Perpetual, Mortgage Choice, The Trust Company and Platinum Asset Management. Limited share issuance matters because it leaves companies better placed to reward long-standing shareholders (for example via dividends) than firms that raised equity during the GFC.
Why might capital-light financial services businesses be attractive to everyday investors?
The article explains that many of the companies that kept equity issuance low are relatively capital-light (with the exception of Challenger). Capital-light businesses generally need less new equity to fund growth, so they may be more shareholder-friendly and able to benefit quickly from improving economic conditions.
What’s the recent performance and outlook for Mortgage Choice shares?
Mortgage Choice shares have risen about 30% since the start of June. The company said it expects to achieve similar cash profit in 2013 as in 2012 and to maintain its dividend at 2012 levels. On consensus numbers the stock trades at about 11.5 times expected FY2013 earnings and offers a prospective yield of roughly 7.5%. Mortgage Choice stands to benefit from any bounce in housing credit growth and from expanding into financial planning.
How is Perpetual priced and what investment case does the article make for it?
Perpetual has also risen around 30% since early June. On consensus figures it trades at about 17 times expected FY2013 earnings with a prospective yield below 5%. The article suggests Perpetual offers strong leverage to any continued equity-market rebound and could be an acquisition target for a bank looking to bolster its wealth-management presence.
What practical factors should everyday investors check when looking for opportunities in the financial services sector?
Based on the article, investors should look at a company’s history of share issuance, capital intensity (capital-light vs capital-heavy), return on equity and economic-profit trends, dividend policy and prospective yield, exposure to housing credit or equity-market rebounds, and how well the firm meets regulatory capital rules like Basel III — all of which affect shareholder returns.
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