It’s not possible – or at a minimum exceptionally rare – to be able to buy a good company at a good price in a good market. Investors have to be prepared to sacrifice one of these ingredients. Our strong preference is to forgo the latter. In Australian Finance Group Limited, we see just such a position.
Courtesy of the Banking Royal Commission, investors are fleeing Australian Finance Group Limited (AFG) under the misconception that the mortgage broking industry is terminal.
Commission caused indiscriminate selling
Notwithstanding ‘headline indiscretions’, our analysis indicates that on the whole, the industry provides an important service to tens of thousands of consumers every year and delivers superior outcomes to the direct banking channel in terms of interest rate, conditions and cost to the consumer.
And indeed by late February, the importance of mortgage brokers seemed to be well understood, with AFG’s share price reaching $1.95 ($1.83 adjusted for the 12c special dividend). By late May however, the price had declined to around the $1.30 level, despite any negative updates. So what has gone wrong?
In our reading of the situation, the round 1 hearings at the Royal Commission were somewhat hijacked by the big 4 banks who were effectively able to deflect much of the attention onto the role of brokers. This was never the original focus of the hearings, yet the banks were able to successfully divert much of the attention away from themselves, and in doing so also make the case for the reduction in mortgage broker commissions! A win-win for the banks at the expense of AFG and the like.
However, what was lost on many investors, is that the mortgage broking industry had only recently undergone detailed regulatory reviews from both ASIC and the ACCC. And whilst these reviews recommended some minor tweaks to the remuneration structure, they both recognised the importance of the industry in terms of competition and pricing. In short, they re-affirmed the criticality of the mortgage broking function.
Be greedy when others are fearful
At the current level, AFG’s investment arithmetic has it priced for failure. Assuming the traditional seasonal split between the 1st half and 2nd half, of 52%:48%, our model generates underlying EPS of 12.9c per share, or a PER of 10x earnings for the 2018 financial year. For a company that has been growing underlying profits at >10% per annum for many years, this is simply too cheap.
Further, AFG still has net cash on the balance sheet and has stated that the payout ratio will remain on (or around) 80% of underlying (ie cash) profits. Our model puts this on a yield of at 7.93%, or 11.33% including franking credits. This has grown every year since listing, and hence we expect further growth over the coming years.
The market is clearly in a ‘quality bubble’ at present and companies such as AFG require patient capital from patient investors. And we are certainly happy to be patient, whilst we are getting paid 11.33% per annum!
how will they grow their profits and dividends if the housing market comes off the boil for a few years ?
A good question and one that highlights a lot of the misconceptions around this company. Firstly its worth noting that despite fluctuations in housing prices, actual total credit growth has only been negative once in the past 2 decades. But even if credit growth was to turn negative There are at least (4) ways that AFG can continue to grow profits: 1. Increasing the share of their higher margin white label and even higher margin securitisation products 2. Push into SME lending where they have a fraction of the market compared to mortgages 3. Adviser growth ; since listing this has increased from 2200 to 2900; the BRC has added even further pressure on lenders (banks) to ensure that they have the highest level of compliance; banks prefer to deal with large aggregators such as AFG as they have the best internal controls; more advisers will be driven towards larger aggregators and AFG is the largest 4. AFG is actively working on FINTECH and as the largest player they have the largest IT budget; early days but they are not asleep.