As a followup to my previous posts on this thread, and for those who found that analysis useful, this is to confirm that I have in the end decided to become a IOOF shareholder. To mitigate my concerns about some of the risks inherent to the Company’s earnings, I have also put in place a hedging overlay.
My rationale for buying, and its implementation, have been as follows:
1) As previously observed, IOOF’s earnings are inherently leveraged to the mark-to-market value of FUMAS; therefore, on a constant-asset basis, the IFL stock is akin to an in-the-money call option on that market value. In particular the operational leverage is approximately 4-to-1, i.e. a 1% drop in the market value of FUMAS translates, everything else being the same, into a 4% drop in earnings.
2) In addition to that, i.e. on a non-constant-asset basis, IOOF benefits from structural fund inflows as well as from acquisitions (where Management have so far demonstrated a respectable track record of shareholder value creation). This benefit is only partially offset by secular compression on margins (specifically, on the percentage fees charged by IOOF on FUMAS).
3) In terms of current valuation multiples, and depending on the assumptions on the future earnings contribution from the ANZWM acquisition, IFL is trading at a 2-year forward PE in the range of 10.7-11.7x; while such multiples look optically attractive, relative to the stability of the underlying business and its structural tailwinds, it has to be kept in mind that they are a direct function of the current market-implied level of FUMAS, and that some of the components of FUMAS (most notably International Equities) are currently trading at valuations that are arguably well above “mid cycle”.
4) Therefore, the question I asked myself was: “if I could somehow lock in the level of the components of FUMAS that I see as being most overvalued, would I see the current PE multiple as providing me enough margin of safety against the residual risks?” The residual risks (as far as I can see) being mostly a) possible changes in the regulatory landscape, and b) Possible failure in successfully integrating the ANZWM business, I determined that my answer to this question was “yes”. It then became a matter of how to hedge out the undesirable components of FUMAS.
As per the 2017 Annual Report, the breakdown of FUMAS by asset class was as follows:
International Listed Equities: 22.9%
Australian Listed Equities: 22.8%
Fixed Income: 20.9%
Property and Infrastructure: 13.3%
Cash: 12.4%
Unlisted Equities: 4.0%
Hedge Funds, Commodities and Other Assets: 3.7%
While I do not see any of these categories as being outright “cheap” (by historical standards), the only one I am definitely uncomfortable being indirectly “long” at its present valuation levels is International Listed Equities (which is typically dominated by US equities). Furthermore, because the weights listed above are reflective of market prices as of roughly a year ago, I estimate the current weight of International Listed Equities to be higher, probably around 25.0% (as a result of market price movements alone).
Given that the leverage to FUMAS is roughly 4-to-1, it follows that, to neutralise the exposure to International Listed Equities, the hedge ratio needs to be in the order of 4 * 25.0% = 100.0%; because the S&P500 index can be used as a good proxy for International Equities, and because there are liquid 3x leveraged inverse ETFs linked to the S&P500, the hedge ratio using such a hedging product becomes 100.0% / 3 = 33.3%.
Therefore, I have between yesterday and today allocated 4.5% of my investable capital to IFL shares, and 1.5% of it to 3x leveraged inverse S&P500 ETFs (adding to my existing short-S&P500 position). Taking into account that the expense ratio of the ETF is 0.90% pa, and taking the mid point of the IFL forward PE range as a reference, the expected earnings yield of this hedged package then becomes (1/11.2*4.5% - 0.90%*1.5%)/(4.5%+1.5%) = 6.5%, which looks to me like an appropriate reward for the risk taken. Note that this is a conservative yield estimate, because the ETF component of the package (while subject to market risk and to a bit of time decay) can be unwound and stripped out as cash at any time.
Finally, for the sake of completeness, I have decided to keep the call options I purchased three weeks ago, as they provide me (at their current residual market value) with some very cheap extra leverage to the upside. Plus, holding them has allowed me to do more due diligence and buy the underlying shares at a better price, without the risk of missing out.
To conclude, this post merely represents a followup to my previous analysis of IOOF for those who found it interesting. By way of disclaimer, I am not suggesting that anyone on this forum should follow my example in terms of implementation strategy, especially when it comes to using ETFs and option contracts.
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