Quality financials outside the big 4

When you look at the ASX 300 Industrial Index, over 50% is dominated by financials and real estate so investors need to be cautious. The financials can be quite leveraged companies, where earnings quality can often be an issue, and a lot of those companies are tied to the property markets. Not necessarily a natural default for the retail investor. So, quality becomes a key filter on these types of stocks. At Investors Mutual, we invest our money in the financial sector in companies like Steadfast and Clydesdale.

Steadfast Group (ASX:SDF)

We've invested in Steadfast across our portfolios and added to our position on any recent weaknesses. Steadfast is a company that came out of IPO in 2013. It's a very defensive business. They run the biggest distribution network for commercial SME insurance at the small to mid- end of the market. Basically, they're the biggest insurance broker and underwriting agency in Australasia. It's very defensive because insurance is compulsory for an SME if they ever want to get a bank loan, and they tend to get 95% customer retention in the network. This represents enviable recurring earnings for any business.

Further to that, they are able to make low risk acquisitions in their network of brokers and other businesses they know. They've also gained market share by virtue of their superior service. We've seen the number of brokers in the network grow by about 50% since 2013, and we've also seen Steadfast capture a greater share of market premium, while at the same time, growing earnings through acquisition. They've delivered 10-15% earnings growth consistently since IPO, and if anything, the conditions for this business are better now.

Clydesdale Bank (ASX:CYB)

Another company which IML holds across a lot of our portfolios is Clydesdale Bank. It was interesting when NAB spun out Clydesdale bank two years ago. On the one hand we were quite encouraging as NAB management were divesting in an underperforming business. On the other hand, we were quite happy to start buying Clydedale on market after they listed because it got a lot more focus under a much stronger management team. They floated it as a de-risk business with some indemnities in place for the issues around conduct that a lot of the UK Banks are now facing. They also have a much lower proportion of commercial lending. In fact, the business is 75% retail and 25% SME of which the majority is quite heavily collateralised. And it's 90% deposit funded, putting it at an advantage against a lot of banks in the UK.

Additionally, there's a lot of easy wins for Clydesdale management in terms of stripping costs. In fact, they've made a lot of progress on their target towards a 15% cut to their cost base. Moreover, they've been operating under much more onerous capital requirements than other banks in the UK, which, could see them releasing 75 cents of capital sometime in the near future. And the lending in their book is a stark contrast to the Australian banks. Clydesdale’s mortgage lending is only up to three times income at the inception of the loan.

We really struggle to find anything at that sort of multiple in Australia. I'd highlight this as a real contrast to the index, which is dominated by the major banks who tend to trade on a high multiple, and certainly don't have those potential levers to pull to grow earnings.

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While the information contained in this article has been prepared with all reasonable care, Investors Mutual Limited (AFSL 229988) accepts no responsibility or liability for any errors, omissions or misstatements however caused. This information is not personal advice. This advice is general in nature and has been prepared without taking account of your objectives, financial situation or needs. The fact that shares in a particular company may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock.