Read the previous week’s Investment matters.
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The Market
Challenger Group (CGF)
This week, we return to discussing our core Australian Shares sub-portfolio and a recent new addition: Challenger Group Limited (CGF).
In part, this is a reacquaintance of sorts with a previously well-held position in a business that historically had a chequered history of execution.
Over the past decade, Challenger has provided regular opportunities for profitable trades when its price is excessively discounted. Today the combination of strong fundamentals, improving execution, regulatory tailwinds and a cheap price will prove another such opportunity.
Source:
In today’s note, we outline some of the opportunities that Challenger will have to grow its retirement income products.
The company enters clients’ Australian Shares sub-portfolios at a moderate weight, and we anticipate the position could grow, especially as the overall market continues to move to higher levels.
What does Challenger do?
Challenger operates two core investment businesses: an APRA-regulated Life Insurance division and a fiduciary Funds Management division.
Challenger Life Company Limited (Challenger Life) is Australia’s largest provider of annuities. This business focuses on the retirement phase of investors. As the population ages and with the concentration of wealth amongst baby boomers, we think this business is strategically well-positioned for the near and medium term.
What is an annuity?
An annuity is a financial product that provides a regular and guaranteed income stream over a specified period or for the rest of an investor’s life. Essentially, it’s a contract between the investor and an insurance company whereby the investor makes a lump-sum payment or series of payments (premiums). In return, the investor receives a series of regular payments that begin immediately or at some future.
A discounted valuation
Despite improving profitability and consistent EPS growth in recent years, Challenger has failed to capture investor attention and has suffered a sizeable de-rating.
The stock trades on a forward price-earnings multiple of close to 10x earnings, around half the PE of CBA, despite having superior forward earnings growth projections by market consensus.
Challenger Prospective Price Earnings multiple
Source : UBS, Factset
This leaves the stock trading at a significant discount of ~40% to the broader ASX200 PE multiple, itself the low end of the historical range for which the stock has traded in the past 20 years.
CGF 12-month prospective Price Earnings multiple versus that of the ASX200
Source : Barrenjoey
The relatively cheap price compared to both the market and the history of prices the market has paid for Challenger is despite the improving returns of equity (ROE), as shown below.
CGF Prospective Price to Book and Return on Equity
Source : UBS, Factset
Higher ROE the result of management’s improved execution
The company has been putting together an impressive recent track record of operational performance, with consistent improvements in earnings.
Source : Company reports
And, importantly, returns generated on shareholders’ capital have been improving and are well above cost of capital.
Source : Company reports
The improvement in returns has been driven, in part, by an increased focus on cost efficiency, but without cutting into ‘muscle’ and capability.
So too, management has also taken the opportunity to take meaningful writedowns of its property investment portfolios (average 20.5% across its commercial property holdings) in a manner that many listed-REITS have failed to do.
The previous reticence of management and the Board to write down the value of such investments had been a factor in First Samuel avoiding the company since 2020. Coming to terms with the need to rebase these values, sets the business up well for future growth opportunities.
Outlook and opportunities – Favourable backdrop for their key annuity products
The popularity of annuities, which currently account for just 3.5% of assets held in pension accounts, could be set for a big boost with the Federal Government, superannuation funds and annuity providers all looking to introduce more appealing products to ensure more successful retirements.
The main superannuation regulators – the Australian Prudential Regulation Authority and the Australian Securities and Investments Commission – wrote to funds in June asking them to introduce better retirement income products.
Annuities could fit the bill, as long as they are less complex and more appealing so that they can offer retirees guaranteed income for a set number of years or for life.
APRA ringing in the changes
That opportunity could be arriving this year with the prudential regulator APRA recently outlining in a new corporate plan that it will “support life insurers to increase the availability of retirement products for retirees” this financial year.
Part of that will be to examining what is working in offshore markets to see whether it could be applied to Australia.
That could include some relaxation of the capital requirements for annuity providers, to allow for greater flexibility.
At the moment, Australian requirements for annuity providers are seen as too onerous compared to established markets in the US and Europe.
More flexible capital rules may be in the offing
In simple terms, assets are marked to market while the liabilities, which include the present value of future payments, are valued using risk free rates plus an allowance for illiquidity.
Nobody wants to see a situation in which any annuity providers go broke, given their important function in providing a safe and reliable form of retirement income. But under the current rules the test is seen as too “tight” compared to offshore rules.
If a larger allowance could be made for illiquidity, it would allow annuity providers to offer more appealing products that might increase the popularity of annuities.
Changes to the capital requirements would also take some of the volatility out of annuity underwriters’ business operations, which could lead to more attractive returns for customers and shareholders, and potentially a bigger and more competitive annuities sector.
We view Challenger (ASX: CGF) a the most obvious beneficiary of any relaxation in the capital rules around annuities.
Other opportunities – Several, including partnering with large superannuation funds
Annuities distribution
The superannuation industry has been effectively focussed on delivering wealth creation opportunities for retirement, but industry participants acknowledge that the drawdown and post-retirement phase of the cycle is not given due consideration.
We anticipate that Challenger can be a successful participant as a manufacturer of quality post-retirement products for large investment platforms such as Netwealth but also providing product for clients of the large industry superannuation funds.
The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.