It would be understandable if investors with large holdings in the four major commercial banks spent much of their time reviewing the recent mixed earnings results and negative newsflow from the Royal Commission. However, the vast amount of negative media and analyst coverage makes it tempting to spend too much time on a sector likely to pay only flat dividends and deliver minimal capital growth over the year ahead. Investors also need to understand the opportunities and risks elsewhere in the banking and financial services sector.
One such stock for the watchlist is Macquarie Group. In contrast to the major banks, this name continues to benefit from a seven-year earnings upgrade cycle which recently pushed the share price to a record high of $115. Over this period the stock has appreciated fivefold. The question for value investors now is whether there is further upside, and if so what price to pay.
After such a strong rally, the shares have already priced in most of the upside from the currently favourable operating environment for this diversified global group, whose businesses span asset management, corporate and asset finance, banking and financial services, commodities, global equities, mergers and acquisitions. The forward price-earnings ratio is over 14 times, already five per cent above the five-year average and 20 per cent above the post-GFC average. The stock trades on 2.2 times equity per share, the highest since the GFC and fairly reflecting the return on equity in 2018 of 16.8 per cent.
So it is a little difficult to see a bullish case at current prices around $114, particularly when rising global bond yields and central bank tightening will eventually dampen the financial markets and banking sectors on which Macquarie’s earnings depend. The world is heading, slowly, into a late-cycle global macro environment with higher volatility and slower rates of asset price appreciation. Over time this will reduce growth in Macquarie’s underlying revenue and increase reliance on lumpy items like asset sales, and the earnings upgrade cycle will fade. If world inflation, particularly in the US given its tight labour market, consistently surprises on the upside in 2018 and US 10-year Treasury yields spike above four per cent then a sustained ‘risk-off’ environment would arrive sooner rather than later. In this bearish case Macquarie shares could be worth less than $80.
However this is not our base case, which sees US 10-year Treasury yields of 3.25-3.50 per cent a year from now – not greatly higher than 3.10 per cent currently. The more likely problem is a sharp fall in performance fees for Macquarie in fiscal 2019 after the very strong contribution of $595 million in 2018, mainly the first half. With fewer performance fees likely in 2019 Macquarie will rely more heavily on proprietary investment gains and capital markets activity to drive its revenue that year. Total revenue could be flat, so further operating leverage (revenue growing faster than costs) and a lower tax rate are likely to be required for earnings growth in 2019.
If this outlook, perhaps combined with temporary market jitters over rising interest rates and earnings disappointments, were to push the stock down to $109 investors could pencil in a 15 per cent return to our $120 base case valuation for 2019 plus the $5.60 of dividends the market expects over the year ahead. The dividends are 45 per cent franked.
A share price dip would be an opportunity worth considering, as the downside risks to consensus earnings over 2019-20 are low and performance fees could rebound in 2020. Many of Macquarie’s unlisted infrastructure funds were launched in the years following the financial crisis and bought assets well below today’s valuations. As these funds mature and the assets are realised, total performance fees are likely to rebase above their historical average of around 0.50 per cent of funds under management.
Certainly Macquarie has revenue and cost levers not available to the four major commercial banks, where revenue growth is slowing as the mortgage lending super cycle unwinds. Material cost reductions at the four majors are painful, as we have seen, and more difficult given the intense public and political scrutiny of banks. The major banks have already achieved substantial gains in cost efficiency over the last 20 years, whereas Macquarie’s cost-to-income ratio ranged between 70 and 85 per cent over this period and was still at 68 per cent in 2018. As it did in 2018, Macquarie should be able to grow revenue faster than costs over 2019-20, reducing the ratio further, provided financial markets remain favourable. Assets under management continue to grow and Macquarie is leveraged to segments with global and structural growth, like infrastructure and energy including renewables, where it has a long record and expertise. The global leverage is important given the Australian economy is lagging the world economy’s acceleration.
Macquarie has some $4 billion of surplus regulatory capital. This creates optionality, for example execution of the $1 billion buyback would add to the upside by increasing return on equity.
Clime Group owns shares in MQG.