A misunderstood gem at a material discount
In a video filmed with Livewire this time last year, we believed stock prices had been moved more by macro events than by individual outlooks, resulting in fertile ground for stock pickers. One such stock was Macquarie Group (ASX: MQG). Since then, the stock has risen by 35%, and Livewire has asked us to review our thesis, where we see it going forward, and to nominate a misunderstood gem we’re seeing in the market today.
The silver lining in the silver doughnut
Macquarie has enjoyed consistent strong earnings upgrades in the last 12 months which has seen the share price outperform. On top of improved earnings there has also been a re-rating of the stock, i.e. the PE ratio has gone up, as the market has become more comfortable with the sustainability and relative stability of their earnings. Typically the market will pay more for earnings they feel they can predict more accurately. This has been driven by the transformation of Macquarie into more of a stable asset management business than the volatile capital markets facing businesses such as investment banking. It is also helped by the large diversified earnings base they now enjoy. Demand for infrastructure assets and management of those assets continues at pace globally and strong performance fees from these funds were a key contributor in FY18. A balance sheet pregnant with unrealised asset gains continues to allow earnings growth to both beat and persist longer than the market expects. These equity investments are diverse including energy assets such as recently sold Quadrant, right through to technology companies like PEXA and Nuix. Increased market volatility and activity levels have also contributed more than expected.
“A balance sheet pregnant with unrealised asset gains continues to allow earnings growth to both beat and persist longer than the market expects”
A change in CEO
An announced change in CEO in July was a little surprising in its timing but not surprising that the appointment was internal, or indeed who that person was. Shemara Wikramanayake is a Macquarie veteran and both well known to the market and very well regarded. The well planned succession is seen as business as usual. Nicholas Moore is leaving the company with a lot of juice still in the tank (and on the balance sheet). Changes to the US tax rate were a positive surprise in the year and will contribute to earnings growth in FY19.
“Shemara Wikramanayake is a Macquarie veteran and both well known to the market and very well regarded”
We continue to have a positive view of Macquarie over the next year, especially relative to other financials. Recent company updates suggest they continue to perform ahead of expectations and we believe their guidance for the full year remains quite conservative. The market struggles to move too far away from their “broadly in line guidance”, despite 1H19 update suggesting they have already overcome their biggest hurdle of large performance fees from the prior year (and that is before booking some decent sized asset realisations which will be in the 2H).
AUM growth, market activity levels and asset realisations all look set to beat expectations. With the majority of earnings now being sourced offshore, the falling A$ will provide another meaningful tailwind, added to the US tax change benefit. Earnings upgrades will likely continue. Macquarie’s balance sheet also continues to be very strong allowing excess capital to be deployed into business growth opportunities or to be returned to shareholders if they don’t arise (we expect the capital to be deployed rather than returned). We think the re-rating of Macquarie is also likely to continue to play out as the market gets more comfort around the stability and repeatability of earnings, as each result passes. In a sector plagued by negative Royal Commission sentiment and low earnings growth in Australia, Macquarie stands out with strong earnings growth, upside earnings surprise potential and majority of earnings from offshore.
“In a sector plagued by negative Royal Commission sentiment and low earnings growth in Australia, Macquarie stands out with strong earnings growth, upside earnings surprise potential and majority of earnings from offshore”
A misunderstood gem we’re seeing today
Looking for other companies that have their own earnings cycle going on, we think Suncorp continues to be misunderstood. While investors are often distracted by peripheral issues when it comes to Suncorp, ultimately earnings will be driven by improving insurance margins. These, in turn, will be driven by:
- An improving pricing environment in both commercial and personal lines insurance
- Taking costs out of the business; both operating and claims.
We are now into the second year of stronger commercial premium rates and motor pricing in particular in personal lines has been strong. It takes up to two years for a premium rate rise to flow through to the bottom line for an insurance company, i.e. it takes a year to put the price through your whole book and a further year for the price rise to be ‘earnt’. Suncorp’s business improvement program still has 12 months to run and is ahead of schedule.
Suncorp already has a cost advantage over their major peer (IAG), especially in motor claims given their SMART repairer network and this is contributing to improved margins as premium rates go up. Having recently sold their Life Insurance business, Suncorp will also be returning capital to shareholders before year end (including a share consolidation), and that follows on from a special dividend at the last result. We like that the positive insurance cycle in Australia is operating independently of other global cycles, and unaffected by trade wars. Suncorp is priced at a material discount to its largest peer, IAG.
Author: Andrew Martin, Portfolio Manager