Ann: Challenger expands strategic relationship with MS&AD, page-13

"Have you had a chance to firm up your thinking on CGF since the HY result @madamswer ?"

@thunderhead1,

Apologies for the tardy response; I've been away from HC for a bit.

The Challenger situation has gone from being a pretty straightforward investment proposition 4 or 5 years ago, to a quite tricky one today.

The one aspect of the company that has not changed, in my mind, is the strong underlying demand for its products. The macro-demand story is unchanged: Australians are ageing in greater numbers and increasingly desire certainty around the income they are wanting to receive during their retirement years. Added to this, from a regulatory standpoint, governments on all sides also want retirees to be insulated from the vagaries of market forces (capital preservation and security, dividends, interest rates).

So, the macro tailwinds have a near perfect score and have remained that way for many years (which, I suspect, is why most people are initially attracted to CGF as an investment).

So that part is still pretty straightforward: strong structural growth (~11%pa CAGR, on average) in product sales for CGF. And don't forget that CGF is the industry leader by far: it has the most recognisable brand, a proven risk management framework and a highly scale-able platform.

But, as we all know, Sales is just one part the profit equation; the other is Margin.

And the part that I failed to properly appreciate from about 18 months ago, in terms of Margin, was twofold:

1. what was going to happen to the margin on Cash Operating Earnings (COE), and
2. how enduring and long-lasting that COE margin impact would be.

Because what changed over the past two years was the interest rate regime (impacting cash rates as well as corporate and government bonds, and therefore just about every fixed income security in existence), which went from low, to super, ultra-low... where it has remained.

And, more importantly, where it looks like it will continue to remain for some time to come... several years, in all likelihood, and possibly even more than a decade based on some of the structural global economic issues currently in place.

How this low interest rate world impacts CGF - and this is what I had vaguely suspected, but the mistake I made was in thinking that it was merely a temporary phenomenon - is that there is effectively less "wiggle" room (between the yield that CGF can offer its clients on the annuities it sells and the yield that it is able to garner on its investment portfolio).

Put another way, when interest rates are high, there is more room for CGF to "manoeuvre" in order to maximise the interest rate spread it earns; when interest rates are compressed, so too is the scope for CGF to optimise the spread on what it earns on the capital it invests over what it pays to its clients in terms of annuity payments. I thought this would be the case, but it turned out being more pronounced than I had anticipated.

And, as I said, it hasn't just been a temporary thing; it now appears to be of a somewhat permanent nature.

So, in a nutshell, that is my thinking about the road that brought us to this point for the stock; that point being a stalling in earnings growth (this year, normalised Profit Before Tax will be largely unchanged on FY2018's $547m, compared to the preceding 5-Year CAGR in Pre-Tax Profit of 9% pa), combined with a ~40% crunch in the share price over the past 18 months.

The result of this is a high-quality company (albeit a complex one) that has de-rated from a P/E multiple in excess of 20x, to somewhere around 13x today. (And over that time, the average valuation multiples of the broader market have probably gone up by one or two P/E points, I sense, so relative to the market, CGF's valuation multiples have probably almost halved!)

In hindsight, >20 times was too expensive (I note that, over its listed history, CGF's P/E multiple has varied significantly - from 25x in early 2000s, to around 15x/16x in the years leading up to the GFC, down to single-digits during and for several years after the GFC, rising consistently into the high teens from 2015/6 and peaking again at around 20 times in 2017).

By the same token, 13x P/E seems to me to be too cheap, effectively pricing in a degree of earnings risk.

Intuitively, CGF - with the mix of its positives (market dominance, brand resonance, and demographic and regulatory tailwinds) and negatives (business complexity and hard-to-forecast earnings) - "feels" to me to be a business somewhat more resilient and attractive than justifying a mere 13x P/E (a ~20% or 25% discount to the broader market).

I think earnings have been re-based (I think so), and the growth trajectory can resume assuming capital market conditions are not volatile (noting that, given the margin compression, the rate of growth might only be modest over the next 12 to 18 months).

Accordingly, I have been opportunistically adding modestly to my holdings every time the stock price weakens for no obvious reason.

But I have to say, because the forecast risks are not low, it is not a high conviction investment for me, meaning I will confine my CGF holding to a maximum of 3% or 4% of my invest-able capital.

If, by this time next year, the business demonstrates resumed traction, it will be a higher conviction investment. Sure, the valuation might be higher, by it won't be the first time I've deemed something to be an even better investment, on a risk-adjusted basis, at a higher price.

Hope that gives you some colour on my somewhat imprecise thinking on this stock in terms of its current investment appeal.

..