Read the previous week’s Investment matters.
Background
This is the third in a series of stocktakes provided to clients as we approach the end of the financial year. Let’s remind readers of the background for the series.
In the weekly Investment Matters, we often discuss the themes crucial to building Australian Equity sub-portfolios. Themes that have received the most attention in recent years include population-led growth, energy transition, companies ripe for takeover, and structural tailwinds.
In this four-week series of Investment Matters, we will look a layer down: the individual security positions. These updates on portfolio companies we might call a year-end stocktake. So to speak. In each company update, we will note:
- What are the opportunities?
- What is the investment proposition, and how has it changed?
- What has been the progress in the past twelve months?
- How does the company fit in the sub-portfolio both thematically and in terms of the sub-portfolio’s construction?
The portfolio construction angle helps explain why we are at the high end of the number of securities positions we typically anticipate having in our standard Australian Equities sub-portfolio.
The market
Following the marketing creates risks
Our contention is that the combination of a non-representative benchmark ASX300 index and an Australian economy in transition means that simply following the market in its current form creates higher portfolio risks than necessary.
Year-end stocktake: Part three
Part Three of the year-end stocktake will outline our exposure to non-bank financial stocks and several technology and medical device companies our clients own.
Sector exposure: Non-bank financials
A notable economic change for the past century has been the ongoing financialisation of people’s lives. The quantum of debt and the breadth of the population in debt continued to expand, especially since banking deregulation. With higher debt, longer lives, and higher asset prices, insurance needs grew faster than the economy. Activities once not insured became insured.
Everyday banking in Australia was once about first home buyers, new business formation for the middle-aged, and corporate banking. Changes to global bank regulation gradually made the humble household mortgage the simplest way for Australia’s banks to make the highest returns. Australian banks slowly vacated other forms of lending, squeezed small businesses and credit card holders, and deemphasised personal finance.
40 years later, simplistic regulation and opportunistic politicians reducing taxes on property speculation have transformed our Big 4 banks into mere building societies, far from the institutions that should be helping grow the economy.
Along with insurance, the giant Australian banks missed the opportunities to grow additional financial services, especially investment banking. Banks often left areas such as business banking, invoice financing, and FX markets behind, allowing new businesses such as Judo or EarlyPay to emerge. One area the large banks took advantage of was superannuation products, but even these have been subsequently sold.
The result is a range of listed and unlisted non-bank financial companies that we can invest in. Several of these companies, including QBE and Macquarie Group, have also taken the opportunity to grow internationally.
In combination, 30 per cent of the ASX300 by market weight are financial services companies, but it is dominated by almost 20 per cent concentrated in the Big 4 banks. Building a portfolio from scratch, one designed to deliver strong risk-adjusted returns that track the wealth of an economy, you would certainly not concentrate anywhere near 20 per cent of its holdings in building societies.
Part of the reason for avoiding such a portfolio is the inherent leverage in a banking system. When an economy weakens, a bank is likely to risk exhausting its capital as it incurs bad debts. For this reason, historically, banks in Australia and internationally, trade at a discount on the prices paid for other listed companies.
Today, Australia’s Big 4 banks no longer trade at a discount to the broader market, as shown in the chart below. They trade at prices that the best market analysts consider to be a 70 per cent premium to comparable global banks.
Figure #1: Australian Banks Sector PE Relative to the ASX200 (%)
We note that subsequent to the previous peak in the 2013-4, this represented the beginning of a period of significant underperformance. Banks underperformed the market by approximately 25% between December 2013 and December 2018.
Interestingly, as shown in the next chart, banks are more expensive than the market over the past 13 years and much more expensive than they have ever been compared to their own history.
The figure below shows the current PE price relative to earnings for the sector. Note that even in 2013, before the multi-year underperformance period outlined above, the banks were not anywhere near as expensive as they are today (16.6x PE vs 14.5%).
This is why we continue to lighten our position in Australian banks.
Figure #2: Australia Banks – expensive and getting more expensive in June 2024
So, what is currently driving prices higher? We noted that even in the past three months, a period in which global banks have underperformed, banks in Australia have continued to outperform.
The Australian market is inefficient in terms of pricing bank stocks.
Half the shares of our major banks, especially CBA, are held in very sticky, tax-effective holdings of older households, whether held in personal names or superannuation. With franked dividends and embedded capital gains tax to avoid, the incentive to sell for these owners is low regardless of the risk and regardless of the return.
It is possible that in the short-term at least the large retail investor base is distorting price discovery, while technical factors around index weighting add to the price squeeze. Passive money, exchange-traded funds and some industry super funds buy bank shares at up to 50% higher concentration than professional investors to maintain index exposure.
Similarly, global investors looking for liquid exposure to non-China Asian equities are finding the largest Australian companies, including the banks, a viable short-term option.
Are there other reasons Australian banks would be so expensive today compared to their history, the rest of the market and the rest of the world? To the contrary.
- The last time the bank sector was as expensive, the same four banks generated a significantly higher ROE (return on equity, a measure of how profitable a bank is based on the value of its capital base).
- In addition, today, the ROE for the sector is contracting, and earnings per share, despite buybacks, is declining. In terms of near-term performance, expected earnings per share, even in the coming 12 months, are being revised lower. Lower profit but higher share prices?
With fewer banks, what should we own?
We have chosen to invest in areas of the non-bank financial sector, including business banking, global and domestic insurance, invoice financing, and insurance.
The table below shows our positions in the financial sector. During the year, we also owned ANZ Bank. Note that the overall exposure to financials is approximately 18 per cent of the portfolio, with only 3.5 per cent in NAB amongst the Big 4 banks.
Macquarie Group, which we extensively wrote about previously in Investment Matters, is the largest financial company outside the Big 4. As an investment bank with a global focus, it has different growth drivers than traditional banking. However, it has increasingly generated value competing with the less technology-savvy Big 4 in some traditional markets.
| Financial Sector | Per cent of Australian Equities sub-portfolio | Index Concentration ASX300 | Core features |
| Large Banks | 24.00% | ||
| Macquarie Group | 4.50% | Global investment | |
| NAB | 3.50% | Home loans/business | |
| Non-bank financials | 6.00% | ||
| QBE | 3.60% | Global insurance exposure | |
| Judo | 2.25% | Emerging Aust Lender | |
| Steadfast | 2.25% | Domestic Insurance | |
| EarlyPay | 2.00% | Invoice Financing | |
| Total Financials | 18.10% | 30.00% |
Conservative clients will also have benefited from a slightly larger position in Australian banks and the ownership of another insurance company, IAG.
The performance of our non-bank financials has been pleasing, as noted in the table below.
| Portfolio Positions | FY-24 YTD Average return |
| Macquarie Group | +19.3% |
| NAB | +44.3% |
| QBE | +14.4% |
| Judo Capital | +32.4% |
| Steadfast – part-year | +12.7% |
| EarlyPay | -13.2% |
| ANZ – part year | +11.0% |
| Sector performance | |
| Financials (XFKAI) | +28.0% |
| ‘ – exc. Big 4 banks | +17.7% |
As part of the stocktake, we will provide an update on Judo Capital, EarlyPay, and Steadfast Group. We have previously written about the positive recent results from Macquarie Group and QBE. As noted earlier, the share price performance of ANZ and NAB has outstripped the underlying strength of the businesses and the prospects for the broader economy.
Steadfast Group
Steadfast (SDF) is Australasia’s largest general insurance broker network and underwriting agency group, with general insurance brokerages across Australia, Asia and Europe. The group also provides complementary businesses, including Steadfast Technologies, Steadfast Business Solutions, Steadfast Re and others.
Steadfast was a new position in client accounts in November 2023 and has been a strong performer, albeit somewhat volatile, ranging from $5.40 to above $6.10. Despite the price volatility, we have been consistently pleased with the business’s operating performance, company presentations, and associated financial updates.
The company’s new opportunities in the US market appear measured and well-researched. Our research into the opportunities the US represents is highly supportive of the direction in which the company is proceeding.
Judo Capital
JDO was founded in 2015 by a group of experienced corporate banking executives to service a clear gap in Australian small and medium enterprise banking. JDO opened its first office in Melbourne in September 2016, officially launched in March 2018, and was granted a full APRA licence in April 2019. The company listed on the ASX in November 2021 at $2.10.
We began buying a position in the company in October 2023 when the price was lower than $1. This was an adequate discount from the original overpriced IPO and a fair reflection of the business’s underlying risks and operating climate.
Judo is currently subscale, and its balance sheet is still too small compared to its underlying cost base. However, current growth rates and the manner in which the company is growing are giving the market increasing confidence in both its likely trajectory for its balance sheet and the quality of the loans it will have written to grow to such a level.
On the funding side, we have also been pleased with the cost of funding achieved and the sources of funding it anticipates funding its growth from.
Current macro uncertainty regarding a credit cycle exists, but it is more than adequately included in its circa $1.30 share price. Unlike the major banks, it does not trade at a significant premium to its book value.
EarlyPay
EarlyPay is well known to clients, and discussed extensively in Investment Matters. After a particularly weak FY23, the company has implemented a range of measures designed to improve profitability and better use its shareholder capital.
The upcoming results in August will be the first time the company can demonstrate its short-term success to a sceptical market and shareholder base. At current price levels, the stock is heavily discounted for the uncertainty regarding its underlying operations. We believe that this discount is excessive, and when assessed along with the strategic value of its assets, the stock is materially undervalued.
Only demonstrable operational success will either close the discount or see the company attract a suitor at higher prices.
Sector Exposure: Technology
Technology is much smaller in the ASX market than in other markets, including the US. This is partly due to extensive competition from foreign-listed competitors in the Australian market and partly due to a range of takeovers over the past decade. We are pleased to get most of our clients’ exposure to technology companies through our exposure to large and mid-cap US companies.
The limited supply of Australian-listed technology companies tended to make ASX-listed companies quite expensive compared to global peers.
Currently, we have three listed technology exposures in our Equities Portfolio, two of which are medical device companies. Some clients will have also benefited from exposure to DUG Technology during the past 18 months.
| FY-24 return | Portfolio weight | |
| Seek Limited | -4% | 2.70% |
| Impedimed | -60% | 0.40% |
| Nanosonics | -40% | 1.40% |
| Technology Index (XTX) | 29% |
Seek
SEEK’s principal activities consist of online matching of hirers and candidates with career opportunities and other related services. In Australia, its main website, Seek.com.au, is a staple for job-seekers and firms of all sizes.
SEEK also has an economic interest in the SEEK Growth Fund (the Fund), a unit trust holding investments in a portfolio of high-growth investments in the human capital management industry. According to the company, the fund’s value is $2.3bn.
Seek was a new position in client portfolios following their result in August 2023. We are attracted to Seek for several reasons, including
- The company is the most reasonably valued technology name, with the strongest brand value
- The company has a cost base and recent software investment profile that is higher than that of its peers. Now in place, it provides the business the capability to leverage revenue growth into profits at a faster rate.
- The company’s management has a set of medium-term profit aims that are both realistic and aggressive.
The opportunity to invest in Seek shares at a reasonable price is partly due to the market’s concerns about short-term weakness in the number of job advertisements. The market has high-quality insight into this data, with statistical measures highlighting movements in the short-term demand for listing open employment positions.
However, we like to look through cycles to find long-term value; cycles come and go. Seek’s range of services for employers and employees continues to grow in Australia and other countries.
As the quality and value created by SEEK’s services grow, so does the price firms are willing to pay for these services. SEEK’s so-called “yield” per customer continues to rise; even in a softer year, we expect yield growth of 10%.
The company’s long-run value is its ability to drive yield growth, establish and grow market share, and continue to invest in a margin-accretive manner. The next two years will be critical in determining the rate of possible profit growth. If successful, the price growth from current share prices levels will be considerable.
Impedimed
Impedimed Limited (IPD) develops and markets bioimpedance spectroscopy (BIS) equipment for medical applications. Its lead application is L-Dex, a BIS technology for monitoring early-stage lymphoedema, a debilitating complication of cancer treatment.
First Samuel built a small position in the stock following the inclusion of bioimpedance monitoring in the US National Comprehensive Cancer Network (NCCN) Clinical Practice Guidelines in Oncology. Inclusion was a major win for ImpediMed in 2023, leading to a reassessment of the future value of the company’s product sales.
Since its inclusion, the number of US health insurance providers now offering reimbursement for Impedimed services has continued to grow. Reimbursement in the US healthcare system is the key to increased clinical adoption.
By late 2023, over half of the USA had >40% coverage (by patients) for bioimpedance spectroscopy (BIS) for subclinical lymphoedema assessment, providing a good base on which to grow.
However, FY24 was a disappointing year for the company. Following disruptive management and board changes that were not required, the company’s new team poorly executed its new plans in 2024. The stock market increasingly lost faith with execution, and when combined with tax loss selling in recent months the stock price has been very weak.
We still believe that the ultimate value of the Impedimed assets is a significant multiple of the current share price. The company will need sales success in FY25 or, at minimum, establish a viable plan for future execution. If not, industry competitors will purchase the asset, given their better capacity to grow sales. Based on our analysis, either outcome would be value-adding.
Nanosonics
Nanosonics has been the most disappointing position in clients’ portfolios in FY24.
The company’s share price rose 50 per cent in FY23. The market was excited about the development of its new CORIS product, and the company was benefiting from strong product sales and growing recurring consumables revenue.
The market reasonably saw a combination of strength in the core business and near-term upside from CORIS deployment. Through FY24, both legs of confidence were challenged.
In the core business, Nanosonics’ previous success in generating high levels of market penetration (>60%) created questions about future growth and whether the business is likely to grow as quickly as possible. Our research suggests that this growth is maintainable and that new customer capital sales are only one leg of this growth and ultimately not the most important. Consumable sales generate much higher margins, and replacement sales for existing machines, which have lower sales costs, each provide significant cash flow and profit growth going forward.
It will take another year of successful sales to prove this momentum is valuable to the market.
The second hit the company took was the ongoing delays in registering the CORIS product. Finally, in June 2024, Nanosonics announced the publication of positive results in the Journal of Hospital Infection, the first published data regarding their long-awaited endoscope channel cleaning device, CORIS.
The publication highlighted CORIS’s capability to offer the only solution to address bioburden, particularly in small endoscope channels, which otherwise go uncleaned. This is exactly the same type of result the company had for its first product, Trophon, and it enabled the development of a $1bn business. Given that the regulatory approval will be completed this calendar year, market investors will likely factor in the value for CORIS at levels similar to those we initially expected. Almost no value is currently attached to COIRS at the current share price.
The combination of CORIS upside and value in the underlying business provides confidence for the position going forward.
Summary
This week’s Investment Matters provides an overview of our below-index concentration in the Big 4 banks and the range of non-bank financial assets we own.
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.