Why I’ve changed my mind on CGF, and some thoughts on sell discipline

For what it’s worth, I’ve sold out of my entire CGF holding today. As I’ve posted extensively about this Company over the past 18 months, here’s the reasoning behind my course of action, for those who are interested.

Original investment thesis vs current set of fundamentals

My original investment rationale for CGF can be found in the following post from September 2018:

https://hotcopper.com.au/posts/35690033/single

Whether it was explicitly stated or not, the main underlying assumptions that analysis relied upon were:

1) The sustainability of the then-prevailing annual Annuity Sales levels.

2) Life Cash Earnings growth being broadly in line with Life Book Growth; or, in other words, Life Cash Earnings margins being sustainable.

3) Life Cash Earnings being uncorrelated with Equity market behaviour.

As this set of assumptions has turned out to be a poor modelling of reality, I have spent some time trying to identify the causes of discrepancy, and whether such causes are likely to be temporary or permanent.

1, Sustainability of Annuity Sales): I had originally assumed that 4.00bnA$ pa of Annuity Sales (in line with FY17 and FY18) would be a sustainable level for the foreseeable future; that looked to me like a reasonably conservative assumption, given that annuities captured only about 5% of the annual switch between the accumulation and the retirement phase in the Australian superannuation system, and with the prospect of the CIPR framework (requiring superannuation funds to offer lifetime income streams) being implemented by 2022. But, the actual FY19 Annuity Sales figure ended up being as low as 3.54bnA$ (-11.5% vs FY18), and its current run rate is merely 3.37bnA$ (-15.8% vs FY18). The reasons for this decline can be summarised as follows.

1a) Disruption in the Financial Advice distribution channel (through which the quasi-totality of Challenger’s annuity products is sold to end customers in Australia), mainly as a consequence of the Financial Services Royal Commission. While it seems reasonable to assume that this situation will eventually stabilise, there appears to be vast consensus on the fact that the number of practicing financial advisers in Australia will drop significantly over the next few years. It is presently unclear how efficiently the Company can find alternative marketing routes to customers, and how long this process is going to take.

1b) New Age Pension means test rules in Australia, effectively disincentivising the purchase of high-capital-access Lifetime annuities; these products (such as the Challenger “Liquid Lifetime” options), which give annuitants the flexibility to receive up to 100% of their invested capital as a lump sum for up to 15 years, in exchange for a lower regular income, appear to be the most popular format of Lifetime income stream in Australia. This regulatory change is the likely cause behind the sharp drop in Challenger’s Lifetime Sales in 1H20, the first quarter after implementation of the new rules; while it is still unclear whether Lifetime Sales will recover from this lower level, the change in the means test rules has a permanent nature. Importantly, though, Lifetime annuity products with low or no access to capital are far less penalised by the new rules, so it is a matter of whether and how quickly the latter can gain traction as alternative retirement income tools; a more extensive discussion of this topic can be found in the links below.

https://hotcopper.com.au/posts/41206914/single

https://hotcopper.com.au/posts/41226429/single

1c) Steep (and unprecedented) negative differential between A$ and US$ bond yields, causing a collapse in Japanese Annuity sales. While this effect has been subsequently offset by a US$-denominated reinsurance deal being reached with MS&AD in Japan, it remains to be seen how the corresponding margins are going to be affected. In terms of how long the negative yield differential is likely to persist for, I personally have no strong view; but, as the Japanese retail market is renowned for its focus on “positive carry”, I see it unlikely that A$-denominated products will regain any meaningful traction there until they can offer a yield pick-up vis-a-vis their US$-denominated equivalents. In other words, I the negative yield differential needs to fully reverse, not just shrink.

2, Sustainability of Life Cash Earnings margins): A good way of visualising the recent trajectory of operating margins in Challenger’s Annuity business is by looking at page 20 of the FY19 Analyst Pack (see picture below).

The Product Cash Margin is essentially the annual dollar return from investing Annuity (and GIR/IndexPlus) proceeds into the Life Investment Portfolio, net of the running cost of servicing those liabilities; the Investment Yield on Shareholders’ Funds, on the other hand, can be roughly thought of as the annual dollar return from the excess of the Life Investment Portfolio over the aggregate Life (Annuity and GIR/IndexPlus) Book.

If we express these returns as a percentage of the Average Life Book (for the Product Cash Margin) and of the Average Excess Life Investment Portfolio (for the Investment Yield on Shareholders’ Funds), the following figures are obtained:

The reasons for the decline in Cash margins and Investment Yield margins can be summarised as follows.

2a) The compression in both government bond yields and risk premia (credit spreads and dividend yield spreads), that has occurred over the past couple of years and has intensified during FY19, has caused a squeeze in Product Cash Margins, as there is now a lot less room to extract a positive differential between asset yields and liability (annuity) yields.

2b) Whenever assets and liabilities are not duration-matched, e.g. when the proceeds from long-term fixed-rate annuities are invested into assets with a shorter average life, the re-investment at maturity of those assets at lower yields has an additional negative effect on the Product Cash Margin, as the rate paid on the corresponding annuity liabilities remains unchanged (or increases with CPI).

2c) In addition to damaging product margins, asset yield compression also reduces (self-evidently) the benefit from re-investing Retained Earnings from the business back into the Life Investment Portfolio.

As a further point of consideration, annuities in general arguably become a harder sell, in an ultra-low-yield environment, because retirees either feel that they would be locking in the all-time lows, or simply need a higher yield to support their lifestyle in retirement, even if that means staying/getting invested into riskier assets; however rational this mindset may be, it is relatively widespread. This obviously affects annuity sales, but it can contribute to squeezing product margins too, as providers feel under pressure to keep offering annuity rates that are not too unattractive in absolute terms, despite falling asset yields.

Forming a view as to whether the extraordinary asset yield compression we have witnessed over the past year is likely to be temporary or permanent would require a separate and lengthy discussion, which goes beyond the scope of this post. Nonetheless, as a long-time proponent of negative real yields as a likely endgame for the global economy, I will just say that there is a plethora of structural forces currently at play (debt dynamics, ageing population, excess savings, credit supply/demand, wealth inequality, globalisation, accelerating automation of labour, etc.) that support the case for ultra-low asset yields representing the long-term trend (on an inflation-adjusted basis, at least). So, this is not a phenomenon I am personally prepared to “bet” against.

3, Lack of correlation between Life Cash Earnings and Markets): I had also assumed, in my original modelling, that projections of future Life Cash Earnings could be made pretty much irrespective of would happen in the global equity markets; after all, even if part of the Life Investment Portfolio consists of dividend-paying stocks, it should be irrelevant what the market price of those securities is, as long as the corresponding dividends are sustainable.

But, it so happens that 36.9% of the Life Equity Portfolio (or 4.5% of the whole Life Investment Portfolio) is invested into the so-called Absolute Return Funds, i.e. a collection of “systematic global macro” and “market-neutral long/short equity” funds, which pay periodic performance-dependent cash distributions. Those distributions are (unfortunately) incorporated in the Product Cash Margin and in the Investment Yield on Shareholders’ Funds; therefore Life Cash Earnings, too, are to some extent dependent on the performance of those funds. In particular, in 1H19, equity market volatility was blamed for the underperformance of Absolute Return Funds (so much for being market-neutral!), which resulted in a non-immaterial hit to Life Cash Earnings by -13m$ for the half year.

While I didn’t place much emphasis on the Funds Management side of the business, in my original investment thesis, it goes without saying that operating earnings in that division are leveraged to the underlying Assets Under Management, which in turn are largely a function of global equity market prices. Also, because the Life Equity Portfolio is invested with the Funds Management division itself, poor performance of those funds has a double-whammy effect on Challenger Group’s overall earnings.

Speaking of performance, it is worth pointing out that the Equity component of the Life Investment Portfolio has substantially underperformed the market over the past couple of years; in fact, the Equity portfolio lost money both in FY19 (-4.4% on average assets) and in FY18 (-5.1% on average assets), while the ASX200 was up +15.7% in total, over the same two-year period.

Before moving to the next section, an additional structural fragility I have identified in the Challenger business model is its heavy exposure to the Australian Property sector. This manifests itself both as direct Property investments (3.73bnA$, or 19.3% of the Life Investment Portfolio, on a pre-debt basis) and as Property-linked Fixed-Income securities (4.28bnA$, or 22.5% of the Life Investment Portfolio, consists of either RMBS/CMBS or debt securities issued by Commercial Real Estate companies).

While Management are obviously aware of this large sector exposure, and have been working towards reducing it over the recent past, they have also made it clear that any switch from Property (or Property-linked) investments to other forms of Fixed-Income securities would entail an erosion of Cash margins.

New Fair Value estimate, and when to sell

Having concluded that my original investment thesis for CGF hasn’t worked out the way I wanted, my view of “sell discipline” consists of:

a) Coming up with a new estimate of fair value, relative to the changed set of fundamentals.

b) Asking myself whether, if I didn’t own the stock, I would want to buy any amount of it at its current price.

c) Selling out completely, unless the current price compares favourably enough with (i.e. is sufficiently lower than) my updated estimate of Fair Value, that a new case for owning the shares can be made.

My original estimate of Fair Value for CGF (as per my September 2018 post attached above) was arrived at using a Discounted Cash Flow (DCF) approach, i.e. taking the Present Value of all future modelled EBIT outcomes (using a suitable pre-Tax Discount Rate) as an estimate for Challenger Group’s Fair Enterprise Value.

The rationale for using such an approach was that I saw CGF’s core Annuity business as being stable enough, and my own growth assumptions as being conservative enough, to justify projecting cash flows many years into the future with a sufficient degree of confidence.

As that assumed stability has been incontrovertibly challenged by facts, I no longer see that valuation approach as being adequate for CGF; therefore, while I am fully aware of its limitations, I will use a simple PE approach for my updated estimate of Fair Value.

That, as I see it, presents the prospective investor with interesting conundrum. Namely, how can asset yield compression be isolated, in the valuation process, given that it has opposite effects on the overall equity market valuation (in a positive way) and on the Company’s own earnings (in a negative way, as we have seen).

So, the way I have chosen to look at it is by starting from what I see as a fair “mid-cycle” market PE, i.e. where I think the ASX200 would be fairly valued in absence of asset yield compression; by looking at historical averages, a PE multiple of 15x does look like a sensible assumption to me.

Under the same assumption, i.e. no margin deterioration due to ultra-low yields, I then ask myself what premium/discount to market should be applied to CGF’s stock, given the structural characteristics of the business.

Based on i) the durability of the demand side (supported by ageing population tailwinds and on the low market penetration of annuities in Australia), and ii) Challenger’s position as market leader in the Australian annuity market, I would see a premium to market as being justified, before any further considerations are made.

But, because of iii) Challenger’s over-reliance on the Financial Advice distribution channel, currently under disruption from permanent regulatory changes, and iv) the new Age Pension means test rules representing a possible drag on the growth prospects for Lifetime products, given the preference for high-capital-access products in the Australian retail market, I see a definite possibility that the Company’s earnings may not have found a new base yet, and may also experience sub-par growth for some time once a new base is found.

The net effect of points i) to iv) above is that I wouldn’t currently value CGF at more than 15x their current NPAT, i.e. merely in line with a “mid-cycle” market PE, before asset yield compression is factored in.

The effect of asset yield compression on equity markets is to increase the Present Value of future earnings, thereby inflating the PE (or EV/EBITDA, EV/EBIT, etc) multiples used to value stocks; on the other end, as previously discussed, lower asset yields also have the effect of squeezing margins in Challenger’s annuity business.

So, having observed that the ASX200 is currently trading at an above-average PE multiple of ~17.5x, and that such a valuation is primarily driven by asset yield compression, given that the current rate of earnings growth is not above historical average, can we conclude that CGF should be valued at 17.5x NPAT too (i.e. in line with the prevailing market valuation, as if we were at “mid-cycle”)?

We could, actually, but only if the effect of yield compression were already fully discounted by the current level of earnings, and if the rate of future earnings growth, too, were in line with the broader market.

But, unfortunately, the current level of earnings is not yet fully reflective of “front-book” economics, because a large portion of the current Product Cash Margin is derived from annuity liabilities and investment assets that were entered into at a much higher level of yields; it is only once all the “legacy book” has rolled off that we will know exactly what Product Cash Margin is achievable and sustainable at the current level of asset yields. This slow convergence to front-book economics does of course affect Challenger’s future earnings growth too, all else being equal.

So, my personal conclusion is that we should ignore at what PE the ASX200 is trading, and keep valuing CGF at the “mid-cycle” multiple of 15x, i.e. at a discount to the current market.

Using the latest FY20 Normalised NPBT guidance of 500-550mA$, and the Tax rate guidance range of 28%-30%, the implied Fair Value range would then be between 15*500mA$*(1-30%)/611m = 8.59$/share and 15*550mA$*(1-28%)/611m = 9.72$/share.

What remains to be determined, though, is how representative of real operating earnings these “normalised” figures actually are. A 10-year history of Statutory vs Normalised NPAT results can help visualise that.

As shown in the table, the average ratio between Statutory NPAT and Normalised NPAT over the past decade has been 90.6%, with the last two financial years being even worse (FY19: 77.7%, FY18 79.4%) due to the stark underperformance of the Life Equity Portfolio.

Therefore, it seems reasonable to me that the previously calculated Fair Value range should be adjusted by this factor too; that translates into a new Fair Value range between 8.59$*90.6% = 7.78$ and 9.72$*90.6% = 8.81$.

As the current share price of 8.61$ is near the top of this range, my personal conclusion was that I would not buy any amount of Challenger shares, If I had to start a new investment portfolio from scratch today; based on this, I sold my entire CGF holding on market this morning.

For the sake of clarity, I am not suggesting that anyone here should sell their CGF shares; the purpose of this analysis is only to provide an updated subjective view of the Company, as well as a practical example of how I personally go about deciding when to exit an investment.

So, the idea is that those who have managed to read this post to the end might find it helpful from a methodological point of view, if nothing else.