Take the time to read the excerpt from a Charlie Aitken note on...

Take the time to read the excerpt from a Charlie Aitken note on ANZ. Well worth it for ANZ holders and potential buyers.

"Backsolving"

My view remains that you need to start with the prevailing share price and then attempt to "backsolve" the earnings and dividend outcome the market is currently discounting in that share price and consider whether than outcome is realistic or too pessimistic (and by what margin). This is far from a perfect science but is the best approach to the current trading mess.

There is no doubt that consensus analyst forecasts for financials are in "la la land". There is no doubt consensus analyst forecasts must come down but the good news is that the market, due to the efficient work of hedge funds, is far more efficient than the consensus analyst forecasts. The market, as reflected in the huge share price falls, is already discounting aggressively lower earnings from financials this year and next. In fact it appears, in certain stock prices, to be discounting a macro-economic (bad debt/ net interest margin scenario) that is far more pessimistic than the likely outcome.

Today we are going to start at the top of the stock alphabet to do a "backsolving" test case on ANZ.


ANZ; working backwards from today share price

For the sake of simplicity and given the high chance that the share price is 5% higher or lower than the ANZ share price as I write now, I will use an ANZ share price of $20.10 for my backsolving test case.

My current “base case” scenario for ANZ is a valuation and price target of $26.10 based off 2007-08 earnings per share (EPS) of $2.14. I am making the assumption that the "right" P/E for ANZ is 12 times earnings. My current base case EPS forecasts already assumes that bad debts as a percentage of risk weighted assets is 0.36%, while net interest margins decline by 14 basis points.

As you can see in the two graphs below, to justify a $20.10 ANZ “valuation” I would have to be forecasting EPS of $1.65. That would require a 22% downgrade to my estimates and would have to be driven by the combination of another 15 basis point decline in net interest margins and bad debts as a percentage of risk-weighted assets rising by another 25 basis points.





You would have to have a very, very, very bearish view of the Australian and Asian economies, the broader health of the Australian household and corporate Australia, to believe that ANZ would take another 25 basis point hit of bad debts as a percentage of risk-weighted assets. You would also have to believe that wholesale funding issues are a permanent feature of credit markets to subscribe to net interest margins blowing out another 15 basis points.

ANZ was criticised, even by yours truly, for being underexposed to funds management over the past five years. However, being underweight funds management is actually a big advantage of ANZ at the moment as it won't be cum the scale of earnings downgrades of its heavily exposed peers. The only downgrades to ANZ in my view will come from a combination of bad debts and worsening net interest margins. My view is that the scenario the market is currently pricing into ANZ shares is too aggressively pessimistic, and not the likely outcome.

What if we are at the high point of leveraged blow ups (both individuals and corporates)? When I look through the ASX 200 I find it hard to identify the next large-cap corporate "implosion" when looking at interest cover, net debt to equity, and business structure. There is every chance the market is discounting further high-profile domestic corporate "implosions" that may well not be coming.

Let’s assume we are too optimistic in assuming the market will pay 12 times for ANZ's earnings and they actually pay 10 times. Ten times $2.14 still gets you to a share price ($21.40) above today’s with the added bonus of a prospective dividend yield of 6.6%. The point I am getting to is that even assuming lower multiples are paid for ANZ, you can still see the stock trading above today's share price and paying you "better than cash" when franking credits are added on.

However, if I am right and the market in the second half of this year regains some sort of normality in sentiment terms and again pays closer to 12 times for Australian major bank earnings then ANZ shares will be around our base case valuation of $26, which would be a 30% return from today's prices before dividend yield is taken into account. On a risk-reward basis that is a risk worth taking.


nANZ share price totally driven by CDS swap rate sentiment




The "inverse" correlation between ANZ shares and ANZ credit default swaps since June 2007 is almost 1. It's the perfect inverse correlation. Now, many of you will think the falling ANZ share price drove the credit default swap (CDS) rate up. It was a case of chicken and egg. However, I understand that the hedge fund community have been watching the CDS rate and then trading in ANZ shares. I think the CDS swap rate is the chicken and the share price the egg; not vice versa.

There's even a conspiracy theory out there that some believe that involves certain parties manipulating CDS swap rates higher while actively shorting the underlying equity. If you can manipulate the CDS you can make people worry about the financial health of the underlying equity. In the current environment you could even conceivably bring a company down by manipulating their CDS. It's not hard to create a crisis of confidence manipulating CDS because CDS is one way of measuring the supposed likelihood of "credit default risk" of a given company.

In my personal view, the "risk" of ANZ "defaulting" is nowhere near the increase that is reflected in the CDS rate increase since June and there is some chance that the CDS is being mischievously manipulated by shorters of the underlying ANZ stock. I am not saying I believe that; I am saying there is a chance it is happening.

The clear point of the graph is, however, that there is a perfect inverse correlation between the ANZ share price and the CDS rate. If there is even the slightest decline in the ANZ CDS rate you will see a corresponding rally in ANZ shares. It would be unwise to underestimate just how sharp that rally in ANZ shares could be considering the huge recent turnover in the stock, a high percentage of which must have been physical shorting.


Group punishment

While all financials are currently being punished for a lack of transparency and the sins of a few, in my view ANZ has been ahead of the curve in terms of transparency and most likely even a touch conservative (in a good way) in its provisioning (Charles Goode is an extremely conservative chairman, which is good).

New chief executive Mike Smith has come in with a new broom and brought into question some of ANZ's more aggressive corporate exposure, as new CEOs tend to do: clear the decks and potentially give yourself the chance to write back some of the provisioning in the future. My Asian banking contacts all seem to regard Mike Smith as a very capable guy worth backing with ANZ's differentiated strategy of Asian expansion.

You will look back on this period and say, ‘I bought ANZ shares at less than 10 times earnings on a 6% dividend yield the week Bear Stearns blew up’. ANZ has 80% of its wholesale funding complete for this year and is in the best funding position of all the major Australian banks.

The simple fact remains that our "backsolving" work on ANZ suggests ANZ shares are currently discounting an earnings scenario that is simply too pessimistic. The net interest margin decline and bad debts as a percentage of risk-weighted assets increase required would have to be a direct consequence of a domestic disaster economic scenario I simply don't see occurring.

On that basis, I believe ANZ is low-risk buying at current prices. Yes, I think the real investing risk at these prices is low. The upside risk outweighs the downside risk and dividend yield alone makes buying ANZ self-funding at current levels. In my opinion, the first bank to buy is ANZ and the best approach to take advantage of huge options market volatility is to buy ANZ and write some short to medium-dated call options. In my view it's the perfect time to employ a buy/write strategy in ANZ.

There comes a time when you have to draw a line in the sand. That line in the sand is ANZ at $20. While the first reaction of markets is to treat all stocks as guilty, the reality is that when stability returns the secondary reaction of markets is to consider who are actually net winners in terms of permanent, profitable, market share gains now that some of their competitors have fallen. ANZ will clearly be considered a winner when the market starts considering the real long-term winners of all this. Close your eyes and buy a few ANZ while it is being treated like a third-tier financial institution.