Firstly, it would be a mistake to confuse issues in emerging markets as a fundamental problem for developed markets. My personal view is the recent selling we have seen in developed markets, most notably the USA, UK, Japan and Australia, driven by those investors with large emerging market losses, is a buying opportunity in the right developed market equities.
Improvements in the developed economies
If anything, developed market economic data continues to improve. Global growth is being revised up, led by developed countries, while emerging market currencies are having their legs chopped off by a combination of the FED’s QE tapering and increased political risk at a country-specific level. So my point is – keep focused on developed market opportunities in an emerging market led correction.
On that point, this week we again saw UK GDP grow. UK GDP rose 0.7% to an annualised rate of 2.9% in the fourth quarter. The aggressive monetary policy of the Bank of England, under new governor Canadian Mark Carney, is working to spur increased cyclical activity and, particularly, home building.
I remain much more bullish on the UK than Europe. Europe to me is an almost impossible fix, with one currency and 27 bond markets, let alone North versus South cultural issues. The UK is an easier fix due to the fact it controls its own monetary and fiscal policy destiny. You can clearly see the UK is recovering more strongly than Europe, and I continue to want to add UK exposure to portfolios.
In an Australian equities context, that is not that easy to do. In the ASX top 20, the only real UK exposure is via the National Australia Bank (NAB), where the stock remains discounted to its domestic peers due to legacy UK banking exposure issues.
While NAB shares have done very well for us in the last 12 months (50% total return), it’s worth noting they are basically the same share price they were 10 years ago. I call it NAB’s “lost decade” but I think that lost decade is ending and NAB is heading back to a domestic peer group P/E multiple. It’s worth noting CBA is up 150% in the same period.
10 long years in NAB
While NAB has made some well documented strategic stuff ups over that “lost decade”, it is fair to say, under chairman Michael Chaney and CEO Cameron Clyne, the company has become far less accident-prone. The issue of the last five years hasn’t been one they initiated. It was one they inherited in terms of UK Banking exposure, which they continue to manage down.
However, we now believe the recovering UK economy and strengthening UK banking system, combined with the strong GBP/AUD cross rate (.5294p), allows NAB to, once and for all, divest these legacy UK businesses.
On our analysis, we believe deconsolidating NAB’s UK operations and normalising the leverage ratio would increase ROE from 14.5% to 16.1% (comparable to WBC that should lead to better risk-adjusted pricing) and release $2.9 billion (123c per NAB share) in surplus capital in the process. It would also lead to NAB’s cost of group equity falling below 10%, in line with its peers.
The incremental benefits are significant and summarised below:
- Net interest margin (NIM) rises 0.04% to 2.06% by moving to more productive interest-earning assets.
- Other income as a percentage of average assets 0.1% to 0.7%.
- Cost to income ratio -3% to 41% largely as a result of better quality revenues.
- Bad and doubtful debts (BDD) charge as a percentage of gross lending assets (GLA) improving from 0.37% to 0.26%.
- Return on assets (ROA) 0.1% to 0.8% by moving to more productive assets in general.
- Return on equity (ROE) 2.7% to 17.2% (trending towards 18.4%).
Allowing for a leverage ratio closer to the sector average (dropping from 20x to 17x) and provisioning as a final UK deconsolidation step, NAB’s de-risked and normalised ROA and ROE would be 0.9% and 16.1% respectively, approaching those of WBC. All else being equal, this should then lead to a cost of equity and prospective price to book multiple (PB) similar to that of Westpac (i.e. one that is commensurate with a near identical risk profile).
In addition, around $2.9 billlion in surplus CET1 (Common Equity Tier 1) capital of 123c per NAB share would be released following the sale of the UK and UK CRE (commercial real estate). This assumption is based on 8.5% of 2013 risk-weighted assets currently supporting the two UK businesses.
A helpful comparison
Many of you would have made good returns following our positive Suncorp (SUN) view over the last few years. The SUN experience is the playbook for NAB.
Using SUN as the relevant benchmark, we believe it’s only a matter of time before the NAB UK commercial real estate (CRE) portfolio is reduced to a manageable balance that should lead to enhanced price re-rating potential for NAB group equity.
In the comparisons below, figure 1 highlights SUN’s progress in executing its banking review, ring-fencing the non-core portfolio, and sticking to the runoff game plan. The sequence of events has clearly improved the market perception of SUN’s risk profile as highlighted by a lower cost of equity since 2009 (10% now and lower than the major banks), rising core business ROE to around 15% and payments of 15c and 20c in special dividends in the last two years, as surplus capital was returned to shareholders.
Figure 2 suggests NAB’s UK CRE runoff has started off positively at a quicker pace (relative to SUN). Assuming the scenario where no action is taken to divest the UK, or the good bank, re-rating of NAB as per SUN’s experience and based on the current trend could occur as early as in Q +10 (i.e. 3q 2015) following 75% portfolio runoff. This would, in addition, be supported by strong valuations from a recovering UK economy.
Source: Bell Potter
Source: Bell Potter
Either way, via full scale UK divestment, or by runoff of the UK CRE book, NAB will be re-rated to a domestic peer group multiple over the years ahead.
The good news is, in the interim, NAB offers a 6.00% fully franked yield, or 8.57% grossed up. To me, this means NAB is a self-funding call option on what we write above eventuating. We get paid 8.57% grossed up annually to hold NAB, yet we can also look forward to $4.00 per share of re-rating and potentially also special dividends as capital is released from the UK.
Interestingly, on our FY14 forecasts, NAB offers the best earnings per share (EPS) growth in the Big Four Australian sector at 8%, yet remains on the cheapest price to book ratio and highest dividend yield, due to the legacy UK issues.
Source: Bell Potter
NAB remains a core member of my high conviction buy portfolio. It is exactly the style of stock that should be added to portfolios during pullbacks triggered by emerging market issues.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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