At an investor day in Sydney last month, newly-appointed CEO of Challenger (ASX: CGF), Richard Howes, announced something that any new CEO would rather not. Howes announced that he was abandoning the 18 per cent pre-tax Group normalised return-on-equity (ROE) target that had been held by the company for the last 15 years. The market did not take kindly to this news, wiping off 16 per cent of Challenger’s market capitalisation over the subsequent 24 hours.
But it is worth digging into this change made by Challenger’s management team more deeply. You see, Howes did not simply abandon the prior 18 per cent ROE target; he instead replaced it with a formulaic target that incorporates the RBA cash rate. That is, Challenger now targets a Group normalised ROE of the RBA cash rate plus 14 per cent, pre-tax. Said another way, if the RBA cash rate is high, for example at 5.25 per cent in 2004 when Challenger’s original 18 per cent ROE target was set, then Challenger’s new ROE target would be 19.25 per cent. Whereas, if the RBA cash rate is relatively low, for example at 1.00 per cent today, then Challenger’s new ROE target is 15.00 per cent.
Given the nature of Challenger’s business, this new formulaic structure for the ROE target of the business is reasonable. After all, the earnings generated by Challenger’s life business – which drives the vast majority of the company’s total earnings – is derived from two broad components: (i) the interest earned on the shareholder capital that is required by regulators to be held; and (ii) the spreads, or risk premia, that can be harvested by the company on its book of life business. In a low interest rate world, the former will obviously be lower – and sometimes the latter too.
Of course, lower earnings are generally considered to be a bad thing by investors, all else being equal. But all else is not equal. You see, if earnings are lower only because interest rates are lower, then it also implies that an investor’s opportunity cost is also lower. This is a concept in finance theory that basically compares the ROE that is generated by a business to an investor’s best alternative return that could be generated by taking the same degree of systematic risk. This opportunity cost is often referred to as the “cost of equity” in the industry jargon.
Here is how to think about it. If Challenger’s cost of equity is, say 10.5 per cent, and it generates an ROE of, say, 14 per cent, then it has created value. If it generates an ROE of 10.5 per cent, then it has neither created nor destroyed value. And if it generates an ROE of less than 10.5 per cent, then it has destroyed valued.
When Challenger announced a lower ROE target, the stock price reaction arguably implied that the reduction in ROE was not accompanied by a commensurate reduction in the firm’s cost of equity. This cannot be true. The company’s cost of equity must be lower as the RBA cash rate falls. And a lower cost of equity, said another way, equates to a higher fair price-to-earnings multiple, all else equal.
At Challenger’s investor day in Sydney, Richard Howes categorically stated that he believes the business will generate an ROE well above the company’s cost of equity. And here is where the finance theory gets really interesting. If a business can generate the same excess return over and above its cost of equity under all conditions, then this business should actually be more valuable in a world in which the cost of equity is lower, notwithstanding the lower company earnings. Food for thought.
Great insight. I’m a big fan of Challenger for the long term.
Have you increased your holding in Challenger post the Investor day last month Andrew ?
Yes Michael, our global funds bought more shares after the Investor day.