Working Macquarie's human capital harder

Back in the heady days before the global financial crisis, Macquarie Group Limited’ a (MQG) share price nearly reached $100.

Then, in the bad old days of the GFC, the MQG share price fell to $15. Investors often say they like to buy stocks that are cheap and sell stocks that are expensive – very rational. The other theory of investing is that stocks get expensive when everybody ‘loves’ them, and they get cheap when everybody ‘hates’ them. This second statement is based on emotion. It is possible that these two theories can be reconciled when we accept that, due to emotion, stocks can get both cheap and expensive.

MQG is currently trading at around $43 and at the 2013 annual general meeting gave investors guidance on the short-term outlook for the 2014 financial year. The annual results presentation, titled ‘Short term outlook’, contains an interesting net profit contribution table outlining the six operating groups’ historical net profit ranges as well as guidance for the financial year 2014.

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Contained in this table are two stand-out operating groups: Macquarie Securities and Macquarie Capital. These operating groups stand out as they are both loosely termed ‘Human Capital’ groups and are both performing at the bottom of their historical net profit contribution.

In fact, Macquarie Securities actually lost money in the financial year 2013. The ‘Human Capital’ groups are those groups that earn a living through the use of human endeavour rather than the use of capital. ‘Human Capital’ divisions within financial services companies are highly cyclical and dependent on the wider economy as well as the level of economic activity, takeover activity, capital raisings and volume of securities trading on stock exchanges. These areas within Macquarie typically do not tie up much capital but have a fixed and variable cost component (largely wages) which needs to be met.

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These two Human Capital divisions can have a very big swing factor on the overall profit of MQG, and in many ways hold the key to strong earnings per share growth for Macquarie in the short to medium term. Both divisions are trading at the bottom of their historical ranges and offer a high leverage effect on net profit. Were they to earn historically high profits, they would add an additional $2.6 billion of profit.

I am not advocating that the ‘Human Capital’ divisions of MQG are about to earn $2.6 billion of profits but merely pointing out that to suggest these operating groups may go from making very little contribution to a healthier profit contribution is not outside the realms of possibility. To suggest that these divisions may return to making a profit is, in my opinion, a good risk-adjusted investment.

Should these divisions return to good levels of profitability, this will go a long way to restoring MQG’s return on equity, which is currently 9%. The other four divisions, including the high-profile Macquarie Funds Division, offer annuity style income, which underpins the strength of the group. Macquarie is also making inroads into the mortgage and home loan market, with a domestic mortgage portfolio of $11.8 billion, which has the potential to be a major contributor over time. Macquarie generates over 60% of its earnings from offshore and management has highlighted that a 10% fall in the Australian dollar would boost profit by 6%.

MQG is one of a handful of ASX-listed large capitalisation companies forecast to deliver double-digit earnings growth over the near term, and I believe the stock has potential for valuation expansion in addition to earnings  growth.

MQG is the second-largest position within the Cadence Capital Limited (CDM) portfolio. My team started adding a 1% position to our portfolio at $22 and have been adding to the position as the share price has recovered. I hope that MQG really starts to work that ‘human capital’ and our investment in MQG continues to grow.

Karl Siegling is portfolio manager at Cadence Capital Limited.