Tell me about this businessWe've already covered this company...

Tell me about this business

We've already covered this company once, as I will summarise later, but I thought now might be a good time to go over things again. For now however, and to the benefit of our new readers, we'll begin from the top.

Genworth Australia began its life as the government owned Housing Loans Insurance Corporation in 1965. Throughout the life of this company it has been Australia’s leading provider of Lenders Mortgage Insurance. In 1997 the government, as they are prone to do, spun off this profitable company to GE where its name was changed to GE Mortgage Insurance Co.

Of course, anyone that is familiar with the GE empire building that went on in the go-go years of finance knows that this didn’t end well for GE. As such this little Australian operation was sold to Genworth Financial, a Fortune 500 United States insurance company, which is itself in the process of change as it is being purchased by China Oceanwide. The unit that GE sold to Genworth Financial was then rebranded to Genworth Mortgage Insurance Australia.

What in the hell is LMI?

Lenders Mortgage Insurance, otherwise known as LMI, is an insurance product purchased by a bank and paid for by the borrower. The bank normally only takes out this policy when the borrower can’t come up with the 20% deposit on a house purchase. In theory, if the borrower defaults on the loan and the bank repossesses the house to sell it, this insurance product covers the gap between the sale price achieved and the amount owing.

The insidious part of these contracts is that they often include a section that allows the LMI issuer, say Genworth in this example, to go after the borrowers, even after they have lost their house, in order to recoup the money they had to pay the bank.

So how much of the company is on the ASX?

In 2014 the parent company decided they wanted to cash out on 40% of the company and they sold shares at an IPO on the Australian Stock Exchange. Since this listing Genworth (ASX:GMA) has sought to pay out dividends and return capital through share buybacks. At all times in the last 3 years the parent company has ensured it maintains a 52% ownership stake.

If all else fails you, which would be at least partly understandable at times as we will see later, it is relieving to know that the US based parent company has maintained a large stake in the company and has not simply walked away. Of further interest is Andrea Waters, a new appointee to the board, who has spent the better part of $103k picking up shares in Genworth since she arrived. This is basically the after tax amount of her board fee which shows a decent level of confidence in the future of the business.

In addition to Andrea Waters there appears to be a board culture of buying into the Genworth business. Christine Patton ($14k), David Foster ($20k), Duncan West ($174k), and Ian MacDonald ($75k) have all bought shares this year. It is too obvious to say but bears pointing out; those on the inside of the business clearly have the best view of the business’ prospects and here it appears as if they have voted with their wallets.

Tell me what they are earning

The insurance business is a great business to be in, until it isn’t, but we will get to that later. Just imagine this, you get paid your insurance premiums up front and this is exactly when the loans you have insured are performing at their best. I mean, come on, who the hell doesn't pay their mortgage within the first year of getting it?! As risky as our banks have proven themselves to be, and God knows I’m not a huge fan of theirs anyway, they simply don't lend to people that fail to repay their home loans months after taking them out.

Genworth earns their keep in a few ways. Firstly, they receive the Gross Written Premium when they agree to an insurance contract over a loan which is secured by a house. Wow, try saying that sentence without sounding like an investment banker! Anyway, they take that money and invest it so that the earnings plus the capital can pay for any future claims. Each year as the loans mature and, thanks to rising housing prices and people paying off their loans, become less risky (as judged by the loan to value ratio) Genworth ‘earns’ their premiums and that amount becomes revenue to the business. It is the management's assessment of tail risk (the risk that things at the margins of the bell curve hit you between the eyes) that altered the balance between unearned and earned premiums. We will touch on how well run Genworth is in a moment but with the onset of the coronavirus pandemic Genworth management have taken the prudent course of placing greater likelihoods to future losses on some of their older insurance contracts. This has directly, negatively, impacted the largely accounting driven income statement. That is why you will see, if you look, an infinite price to earnings ratio (P/E) on the shares. The earnings reported in the half year (and not fully clawed back by the third quarter results) have the company sporting a loss of $90m, compared to a profit of $88m the year prior.

The thing is, you need to take this information within the greater context, which the yearly and half yearly reports can provide, along with not living under a rock for any part of the last 6 months. So the management team at Genworth have written down their estimate of future conversion of unearned premiums for fear that they will need to cover a lot of bank insurance policies. This fear was, rationally, driven by the expanding crisis that is the coronavirus pandemic that saw a large number of people working from home or simply not working at all. This decline in employment and the knock on effects to consumption played out on their Excel spreadsheets as a decline in house prices that would lead to foreclosures, banks being caught short and them enforcing the lenders mortgage insurance contracts to make the banks whole again. This would, predictably, have a negative impact on Genworth (to put it mildly). As a precaution Genworth, in the first quarter, wrote down the future value of their unearned premiums by $181m. This, along with a pandemic induced panic on global asset markets, were the main drivers on the income statement for the reported loss Genworth is still sporting.

But it is here that we need to place the details on the income statement into a more well rounded context. This is where it is helpful to take a look at the cash flow statement. I’m a huge fan of cash flow statements. Afterpay shareholders just pretend they don’t exist. If they did, they’d have to own the fact their moonshot company just doesn’t make an operating profit and that would lead to a not insignificant amount of cognitive dissonance… Probably the best way to start is to walk through the basics of a cash flow statement. There are three major headings in this statement; operating, investing, and financing activities. Operating activities refers to the day to day operations of the business. How much, in dollar terms, does the business bring in and from that number you subtract how much it cost you to provide that service. What you are left with is, hopefully, a cash profit from the business before you factor in the other two parts. The next section is investing activities. This portion of the cash flow statement is concerned with the purchase of equipment to run the business and the buying and selling of investment assets. The third and final portion is the financing activities. This is where the business records the actual dollars put into the business (by issuing new shares) or sent out through share buy-backs, dividends and the payment of leases. When they are all put together you get a great picture of the actual cash moving in and out of the business and you can gauge, in cold hard cash terms, how things are going. This brings us back to Genworth, the company that is, on paper, losing money.

If we take a look at the operational activities of Genworth we can see that they earned $291m in premiums and interest in the half year to June 30. After we take away their operational costs we are left with $74m of net cash. That’s a net return of 25.4%. Not too bad at all. Now because Genworth is an insurer and they are heavily regulated they need to carry a large amount of investment assets to cover the possibility of future claims. As I’m sure you already know, short term assets like treasury notes and short term government bonds provide a large amount of liquidity and security of capital (although the security is related to their highly liquid markets in conjunction with their credit rating). It is because of the safety and liquidity that Genworth predominantly loads up on these assets. This drives a large dollar value of turnover on the Genworth investing activities cash flow statement. What we saw in the first half year was the purchase of $1.84b and the sale of $1.79b in assets. The end results was the financing activities saw the company spend $47m more than it earned. Lastly, and potentially your favourite, is the financing activities. Here we can see the final dividend that was paid out to shareholders on the 19th of March. With that $31m payment along with the lease payments the final total was that Genworth consumed $6.2m of their $87.2m in cash over the first 6 months to June 30. This does not look like a business in poor health and that fact was further confirmed with the release of the third quarter results. These showed that their net earned premium had increased to $80m while they wrote $7.8b in new insurance, an increase of 22% on the year prior.

In the financial year to date Genworth have written insurance policies covering $21.3 billion dollars worth of mortgages, a 12.8% increase on the year prior. I look forward to seeing how this significant increase shows up on the cash flow statement, and eventually the balance sheet, over the next few years.

Yeah, but do they actually have any assets to back it up?

Fortunately for all involved, this industry is heavily regulated by APRA or the Australian Prudential Regulation Authority. APRA tells companies that sell LMI how much capital they need to have on hand at any time to cover any expected worst case losses.

In addition to this Genworth carries a large amount of assets on their books so as to help earnings. One of the major downsides of having these assets callable at short notice to potentially pay out claims is that they tend to be invested mostly in short term bonds that, on average and according the third quarter release, earn around 1.2%.

The real upside is just how large these holdings are. As of the last half year statement Genworth held net tangible assets (no accounting tricks here) of $1.39 billion. That’s roughly $3.37 per share in net assets (Net Tangible Assets or NTA) for a company that trades at $2.12 a share. At this point you are buying a money making firm with a well run management team for roughly 63 cents on the dollar.

So what does Genworth do with all that cash?

Put simply, they pay dividends and buy-back their own shares. Or at least that’s what they used to do until coronavirus entered our everyday lexicon. For now it appears that Genworth are restocking the cupboard to ensure they don’t run out of cash if there is a long winter. I know, corny analogy. Nonetheless, in writing down future earnings and stockpiling cash and investments on the balance sheet Genworth is looking out for their long term survival. I know it isn’t much fun not being paid a return but for those who have picked up a mid panic bargain at $1.22, you are now laughing even without the cash payments.

When more normal times return, both buy-backs and dividends will ensure there is a steady cash and capital return to the investor. We will touch later on what this return looked like for investors who have held Genworth over the last 2 years but it is instructive to point this out; management have made direct reference to ensuring they do not hold excessive amounts of capital on their books and that they still have $255m in additional capital, above and beyond, the board’s Prescribed Capital Amount (PCA). This PCA is also set above the mandated level of capital cover as if to prove that prudence and cash will be king if the proverbial ever hits the fan. To give you a reference to base that $255m in excess capital on; the last full year at Genworth saw the payment of $330m in buy-backs and dividends. If you factor in the likelihood that Genworth will have a pile of not insignificant net cash flow from their operating activities this places them in a good spot.

So how do share buybacks work then?

A share buyback is where the company goes out into the market and purchases their own shares. They then cancel these shares out and strike them from the register. Here is an example of what a share buyback might do for a company.

Say Genworth has 100 shares and earns a profit of $100. It therefore has earnings per share (EPS) of $1. The investing public considers Genworth good value currently at a 10 times earnings multiple. That means the shares should trade at $10 i.e. $1 of earnings multiplied by 10. This is the P/E or Price to Earnings ratio.

Now Genworth goes out into the market and buys 10 of its own shares and immediately cancels them. Next year when it goes to report its $100 profit it only has 90 shares to spread them between. This means the EPS is now $1.11. If the investing market still sees good value in Genworth at 10 times earnings (P/E of 10) then the shares will trade at $11.11. This is now a gain of 11.11% for the shareholders that held onto their shares.

What are the risks?

This all depends on whether you think it is a risk or not but… you are unlikely to see a dividend this year. Yes, I know I’ve basically shown you, up to this point, that the company is making money but hopefully you’ve also picked up how cautious the management team are. Ultimately this will be to their and your benefit but I wouldn’t expect to see any dividend payments in the near future.

The real microscopic elephant in the room here is the coronavirus and how this will impact our economy moving forward. If you are afraid of risk and avoid hearing hard truths, this is probably a bad time to point out that we have never had a coronavirus vaccine. It could be that all of our attempts will prove to be futile and we will have to live with under the auspices of governmental health control for a lot longer. More optimistically a vaccine could, in fact, be discovered but the ramp up in production would still see us dealing with this virus well into next year. At that point we will have to make very honest and open assessments on where we are and where we are headed as an economy. If the jobless rate increases on a second countrywide lockdown and this drives a positive feedback loop (where one action drives another and another in turn with ‘positive’ not connoting the impact) then it would be reasonable to assume a lowering of house prices. This would, sadly, eventually show up on the Genworth books as paid insurance claims and lower their asset base as well as profitability.

Another risk we, as house and investment property loving Australians, must be aware of is the household debt levels. With current figures putting this at 200% on household income we can’t ignore the fact that, as a country, we are very highly leveraged. While interest rates stay down and employment stays up we are all good. If either of those figures are reversed in a major way then we begin to have our feet put to the flames. This is not a moralistic or judgement made on debt either by the way, it’s just math. If we assume (always a dicing proposition but bear with me) that the market for housing in Australia, which makes up the lion's share of debt anyway, is split equally three ways into renting, mortgage, and fully paid we can see why that 200% figure should concern. You see, renters (logically and on average) don’t have mortgages so they make up a very small amount of the 200%. People who have paid off their home, by definition, don’t have a mortgage and so also make up a small part of the 200%. That leaves our mortgage holding brethren. If 33% of the population holds a debt equivalent to 200% of household income the total debt load of those households is… large. Now I know that is a dramatic oversimplification of the problem but it is illustrative that the people Genworth are insuring are also the most highly leveraged in our society.

For the short term at least we need to see that immigration, long the driver of economic growth in Australia, will be anemic. The demand hundreds of thousands of new arrivals places on our real estate can’t be overstated as upon arrival each of them will need somewhere to live. Eventually they will join the throngs of people buying units, houses and eventually (perhaps) investment properties. With those people simply not arriving this year and potentially next year, the demand side through immigration should slide and that may have an impact on housing prices.

Let's get right down to it. If the housing market crashes and the banks that took out those insurance claims come knocking, Genworth will need to pay out a huge amount of money. This is probably a good time to point out that Genworth currently has $307 billion in mortgages that it has to cover. This is a really big potential tail risk but, to this point, it is one they have been rewarded for covering. This risk is made even more precarious when you consider that the only people that take out LMI are those that already were at some risk of leading to a loss for the bank; hence the banks’ insistence on getting the policy.

Make me feel better, what are the upsides?

Here’s the thing though; not everyone is cut out to run an insurance company. You need to have the right mix of caution and daring. Too daring and you price the insurance too low, get loads of business and when the risk comes back to haunt you all of a sudden you are getting bailed out by the government. Oh, sorry, that was the story of AIG, another insurance company I’m sure you are well aware of and, if you aren’t, just pick up any book about the GFC and they will feature. If you are too cautious you end up with the opposite problem. You are forever jumping at shadows, seeing risk where others see adventure (my partner says this is me to a t so perhaps I’m best used outside of the insurance industry). This sort of thinking just drives up the insurance premium you demand which drives away business. You invest in only cash which crushes your earnings profile and, eventually, your business closes for good.

The great news about Genworth is that they have a senior leadership team who have, over a long period of time, proven to be dependable and reliable stewards of your shareholder capital and have deftly walked the line between those two camps. The first quarter provisioning of $181m against future earnings if further proof of management's use of prudence in the face of uncertainty. This write down was related to older book years and if the property market, once again, turns the corner this money flows back onto the balance sheet to further bloat the coffers.

The most overwhelmingly positive upside for investors however must sit with the troika of the federal and state governments, the reserve bank of Australia, and the regulator APRA and their willingness to prop up the housing market. To be quite clear from the outset, what I am writing is not a judgement on any one political party, ideology, or economic rationale; this is as close to a statement of facts as possible. How we got to this point and the rights or wrongs of it are a far more detailed conversation that another format is better at exploring. With that said, it has to be noted that the biggest and most powerful players in the land are trying to support housing prices. State and federal governments have enacted first home buyer grants, superannuation access schemes, stamp duty concessions, and more in the direct or indirect hope of stimulating housing prices. These policies are in addition to multi-government long concessions for capital gains taxes on principal places of residence, capital gains tax concessions on assets held over 12 months, negative gearing tax advantages, and the avoidance of using the asset value of a principal place of residence in the assessment of aged pension entitlements.

The reserve bank has cut the cash rate to 0.10%. What is the cash rate is probably a fair question to ask though. The cash rate is the rate at which the RBA lends to authorised deposit taking institutions. This sets the absolute, rock bottom, risk free rate of return. Why is that? The simple answer is that the RBA can not go broke as they can simply ‘print’ more money. Hence, whatever they set as the risk free cash rate, becomes by default the lowest rate of return upon which all other asset returns are based. This impacts on the investment markets by readjusted all other returns. When the cash rate is 7% and your bright young investment banker has determined she needs a 5% return above the risk free rate on equities, the target for her equity fund becomes 12%. Simplistically, if that difference of 5% remains, the total return target on equities now becomes 5.10%. And, just like bonds, the capital price of those assets is readjusted up (provided expected earnings remain constant).

In addition to the slashing of the cash rate, the RBA has also waded into the bond buying business in a very real way. They have committed to buying $100b in bonds at $5b per week in order to drive down the 3 year rate of interest. The theory goes that this will reduce the cost of capital for businesses (either directly or through bank intermediation) and that these new, low, rates will encourage more spending. Sounds like a great supply side solution for a demand side problem but again, I’m not taking sides.

Lastly you have APRA. Ah, APRA; the most toothless regulator from what is a bunch of basically useless regulators (looking at you ASIC). After the wild ride that was the banking royal commission ended in all round red faces and many mea culpas to correct the wrongs of the past we saw, no less than a year later, a full winding back of consumer lending protections. No longer would we look towards a model of caveat venditor (let the seller beware) but rather shift to a full blown caveat emptor (let the buyer beware) and be still the bleeding hearts please.

So the government/pseudo government led troika policies of house buying grants, transaction cost reductions, credit cost reductions and regulatory oversight and scrutiny reductions should see an uptick in housing construction and purchasing. The hope is that this goes part, if not all, of the way to filling the gap left by the lack of overseas migration. If this purchasing feeds into a series of price rises, all the better. Any decent (or actual) rise in housing prices actually feeds into the GMA profit story really nicely as the insurance payouts are dramatically reduced. This leaves Genworth with additional capital on hand to service the needs of the remaining questionable customer loans. In addition to this we see, as mentioned earlier, that as the insurance contracts mature and often become less risky, GMA is taking ‘unearned’ premiums and recognising them as ‘earned’ premiums that are flowing directly onto the income statement. Just the idea that in trying to save the banks, the government and all other governmental bodies (plus the RBA) are actually bailing out Genworth and allowing them to, potentially, pay out large dividends and make reasonable sized buy-backs is astonishing. As ever though, you need to play the system to your own advantage wherever possible.

The prospect of a second wave has many people seriously considering the size of their homes. This isn't unreasonable given a significant portion of the country felt the walls closing in while in lockdown. The good news for Genworth out of this is Australians are buying bigger houses. Bigger houses, unsurprisingly, cost more. Combined with all of the other factors driving up prices just leads to even more business for Genworth as more and more buyers, in a rising market, struggle to put together the 20% deposit plus costs.

Ultimately, your main concern should be focused on the delinquency rate of the portfolio. After all, it’s only the loans that go bad that you have to pay for and, thankfully, this often isn’t the case until after the first full year. For your records the current rate of delinquencies across Genworth's entire portfolio is 0.62%.

A full 44% of the loans that Genworth has insurance over are from 2011 and before. Now, unless you live in Perth (sorry guys) it is highly likely that the properties underlying those loans have appreciated and so currently present an extremely small risk to the bank that loaned the money and hence to Genworth which would cover any potential sales proceeds gap. In fact, Genworth has reported that this cohort of loans has a delinquency rate of 0.55%.

The next thing in Genworth's favour is that they have contracts with reinsurers to take on $800 million worth of losses should they occur. This makes up a full 31% of the expected greatest loss for any one year that has been calculated by APRA. That year, in case you are interested, is the 2013 vintage and the total maximum loss is estimated to be $2.6b.

An important note is that Genworth has committed to paying out between 50 and 80% of net profits after tax (NPAT) as dividends. They have also proved willing to invest money in on-market share buybacks. Both of these methods, in different ways, put money in shareholders pockets. Although, as we touched on earlier, we should expect this payout ratio to be waived this year there will come a time when the excess capital and earnings will need to be shifted off their balance sheet and onto yours.

Lastly, Genworth is run with a very limited amount of debt. Currently, as of the half year report, debt makes up 14.2% of the company structure. This is sort of like having a $200,000 home (sorry again Perth) and owing $28,470 on it. Not ideal, but certainly not a deal breaker.

You recommended this to me on the 10th of December, 2018. What has happened since then?

In the closing stages of 2018 I did suggest that Genworth looked like a solid bet. They had a lot of capital on hand, the market was concerned about housing prices and something just didn’t sit right with me. It’s cliche to rely on being greedy when others are fearful but it wasn’t even as direct as that. Once you adjust your perspective and realise that many arms of the government will act in the long term interests of home owners and buyers, you begin to see things differently. That larger scope allows you to look through smaller, episodic, moments of panic. With a Genworth recommendation at $2.20 (including $19.95 in brokerage fees) things have really only looked up from that point on. The tailwinds were a management team looking to lighten the balance sheet that was far more secure than even prudent safety dictated. What followed was a round of share buy-backs that took 79,837,198 shares off the register and saw a grossed up payout of 42.06%. Now, yes, that share price today sits lower than the original purchase price but the total return is still 38.9% for an annualised return of 18.65%.

Of course at one point during the deepest part of panic the shares fell to $1.22. This, at the time, would have left us with a 4.99% total return. That obviously would have been less than stellar. Looked at another way however is this; what a time to buy. Of course, this report would have been much more beneficial to your long term wealth had it been written just prior to that $1.22 low. But, of course and as usual, I missed it and you're left once again reading a report that's probably worth what you paid for it.

What should I do?

This is the really interesting part. If you believe that there won’t be a housing crash and that banks will continue to lend (what else do they do anyway?!) then this company presents a great way to cash in. You’ll eventually collect a stunning dividend, benefit from share buybacks and look like a genius when the market calms down and realises that this company shouldn’t be trading at $2.14!

If however things go sideways, delinquencies pile up, the banks stop lending or people stop buying then you might find your investment fairly underwater.

This investment could be the ultimate litmus test for avid property investors. If you genuinely believe the market is headed up from here (I’m just so sorry Perth!) then this is the investment you make to reap massive rewards.

If you aren’t invested in residential real estate but still think the market falls are over, then this is a very cheap way to get into the action and potentially earn handsome rewards for doing so.

For either one of these options you will prove to everyone that you have nerves of steel and I will forever respect your double down conviction.

On a scale of 1 to 10 for risk, you’ll always be a 23 to me.