Macquarie Inside a Strong Buy

a compilation of research on MACQUARIE GROUP | published DECEMBER 2011

Intelligent Investor PO Box Q744 Queen Vic. Bldg NSW 1230 T 02 8305 6000 F 02 9387 8674 [email protected] www.intelligentinvestor.com.au Intelligent Investor

Dear Intelligent Investor,

Nine years ago in a special report titled Macquarie Bank—A rare opportunity, we explained why Macquarie Bank was our third ever Strong Buy recommendation. From the initial upgrade at $20.39 on 18 Oct 2002, the share price eventually peaked at $98.64 in May 2007. Had we not missed the opportunity to sell, including dividends it would have been a ‘5-bagger’. As the GFC deepened the share price collapsed to $15.00 in March 2009 before rebounding to $58.80 in September 2009. It’s been a wild ride. More recently, with corporate deals drying up, volatile markets producing a climate of fear, the impending introduction of more onerous regulatory capital standards and the great deleveraging reducing demand for debt, investment banks are amongst this year’s worst performers on global sharemarkets. It’s an embarrassing fall from grace for a group heralded as masters of the universe during the boom. Macquarie’s return on equity has now fallen from well over 20% to single digits and, as I write, the share price is $22. Though profits and dividends will fall in 2012, a price-to-earnings ratio of 8, a 29% discount to net tangible assets of $31 and an unfranked dividend yield of 7.5%, the market expects that Macquarie is on its way out backwards. We’re not of that view. Macquarie’s balance sheet is in good shape, corporate activity will eventually increase (though not to pre-GFC levels) and large investments in recurring revenue divisions, including funds management and corporate leasing and lending, are starting to pay off. With its problems mostly temporary, the low share price means Macquarie Group is only our tenth-ever Strong Buy recommendation in 12 years. Before deciding to act on it, please take the time to read and consider the detailed research enclosed. It features seven full reviews, including an Investor’s College on portfolio allocation (replete with another recommendation), a three-part series explaining Macquarie’s business and the most recent research describing the current opportunity. There are two possible ways to read the report. From the front, with the most recent review first, or from the back, which will give you a chronological picture of how the opportunity has unfolded. There are no guarantees in investing, so please adhere to the portfolio limits and understand that in the short term at least, Macquarie’s share price may fall further. But if you’re prepared to accept the risk of owning an investment bank and want to add a high quality blue chip to a diversified portfolio at a very attractive price, we commend Macquarie to you.

Yours sincerely, CONTENTs page

Macquarie interim: Good, bad, ugly 3 Macquarie Pt 3: Inside a Strong Buy 5 Macquarie Pt 2: Inside a Strong Buy 7 Macquarie Pt 1: Inside a Strong Buy 9 Banking on Macquarie 12 Nathan Bell Weighing up Macquarie Group 14 Research Director Why Strong Buy doesn’t mean load up 16

2 Special report | Macquarie: Inside a Strong Buy

Nathan Bell, CFA | First published 3 Nov 2011

Macquarie interim: Good, bad, ugly

Macquarie’s trading profits have suffered. But good results elsewhere augur well for this leading buy recommendation. Key points Return on equity falling to more normal levels, With Goldman Sachs recently reporting only its second quarterly loss since listing in as predicted 1999, the writing was on the wall for Macquarie Group shareholders. Goldman’s revenue fell Trading businesses struggling but funds by a breathtaking 60%, as the European banking crisis wreaked havoc on financial markets. management going well So Macquarie’s 2012 first half results were never going to impress. The company’s Buyback adds shareholder value, sticking with Buy trading divisions were clobbered, with overall trading income falling 38% from what were already depressed levels. Compared to the same period last year, group operating income for the six months to 30 September was down 11% to $3,243m. Operating expenses were also down 11% to $2,828m but net profit dropped 24% to $305m. Plug in the numbers and that’s an annualised return on equity (ROE) of 5.7%. This paltry figure confirms the theses outlined on 19 Oct 11 in Macquarie Pt 2: Inside a Strong Buy. Macquarie’s ROE signifies this is now a normal, rather than an exceptional, banking business. With earnings per share falling 27% to 87 cents, the interim dividend was also cut, from 86 to 65 cents (unfranked, ex date 7 Nov). At current prices, Macquarie still yields 5.9% if the company can manage a 75—cent final dividend. That would be down from one dollar in 2011. The bad news continued in Macquarie’s three trading businesses (see Macquarie Pt 1: Inside a Strong Buy from 12 Oct 11 (Buy—$24.89)). Macquarie Securities suffered a loss of $19m, Macquarie Capital earned $5m and Fixed Income, Currencies and Commodities $6m. All up, a net loss of $8m was incurred from these three businesses.

Poor result MACQUARIE Group | MQG

While phones on the equity desks ceased to ring, depressing brokerage and commissions, Price at review $23.62 it was the upheaval on fixed income and currency markets, together with lower corporate Review date 03 Nov 2011 activity, that sealed the poor result. market cap. $7.9bn The value of Macquarie’s average advisory deals also halved, suggesting large companies 12 mth price range $20.24—­ $41.78 are unwilling to part with their record cash piles in light of the uncertain economic outlook. And finally, after 36 years with the company, deputy managing director and chief Business risk Med-High executive officer Richard Sheppard is retiring in December. He’ll be replaced by chief Share price risk Med-High financial officer Greg Ward. Ward knows the company inside out but it’s unnerving to see max. portfolio weighting 5% such an experienced executive depart in the midst of a rapid business expansion. Our View BUY That’s the bad and the ugly news. What about the good? Net profit for Macquarie Funds almost doubled to $410m, a combination of staff cuts and the US managed fund business Delaware contributing a full year’s profit. That’s increased our confidence that the low ball valuation estimate for this division of $4.8bn, laid out in Macquarie Pt 3: Inside a Strong Buy from 25 Oct 11 (Buy—$23.34), is quite conservative. Following several acquisitions, the Corporate and Asset Finance division produced a $358m net profit, up from $246m. As discussed on 12 Oct 11, this division, together with the Macquarie Funds business, could alone be worth more than Macquarie’s current market capitalisation. Macquarie has also taken baby steps to cut staff numbers, by far the company’s largest expense. However, chief executive Nicholas Moore faces a difficult balancing act between protecting profit margins and maintaining an incentivised global workforce, the company’s greatest asset. It won’t be easy.

3 Intelligent Investor

Subject to regulatory approval, Macquarie will also initiate an on-market share buyback for up to 10% of shares on issue. At current prices that would add plenty of value for shareholders without compromising the company’s strong financial position or its ability to meet new regulatory capital rules.

Table 1: MQG’s income statement key drivers

1H12 $Am 2H11$Am 1H11 $Am

net interest income 698 670 605

Fee and commission income 1,766 1,896 1,995 ntrac Trading income 374 762 606

Equity accounted gains/(losses) 49 94 85

Equity investment impairments (39) (77) (53)

Loan impairments (66) (51) (77)

Other income 461 675 405

Operating income before listed fund initiatives 3,243 3,969 3,566

Gains from listed fund initiatives —­­ 14 95

Total operating income 3,243 3,983 3,661

Total operating expenses (2,828) (3,208) (3,165)

Net profit before tax and minorities 415 775 496

Income tax expense (107) (197) (85)

Non-controlling interests (3) (25) (8)

Net profit after tax 305 553 403

Source: Table recreated from MQG Half year results, Sep 11 Still, without a rapid improvement in market sentiment, which seems some way off, Macquarie’s full year result will probably fall short of the $956m earned in 2011. That doesn’t change our view, though. After years of investment, Macquarie’s more predictable businesses are starting to bear fruit. And when markets finally settle, an upswing in the trading businesses should see earnings and dividends increase considerably. BUY. Note: The model Growth portfolio owns shares in Macquarie Group. Disclosure: The author, Nathan Bell, owns shares in Macquarie Group, as do other staff members.

4 Special report | Macquarie: Inside a Strong Buy

Nathan Bell, CFA | First published 25 Oct 2011

Part 3 Macquarie: Inside a Strong Buy

It’s a highly leveraged investment bank full of unknowns. So how on earth do you value it? Nathan Bell points the way. Key points Macquarie is priced for a poor outcome Macquarie Group manages $154bn of assets, excluding $306bn of funds under Even a pessimistic case undervalues the business management. It has 15,500 staff scattered across scores of countries. The company Returns from here could reach 20%p.a. over the doesn’t split out all of its assets and even if it did, we wouldn’t be able to analyse them all. next 4 years How does one value such a beast? Discounting the company’s cashflows—a traditional method—is problematic because these fluctuate with unpredictable markets. Historical comparisons are also unreliable. Macquarie’s 20%—plus returns on equity from the previous decade are history, literally (see Macquarie Pt 2: Inside a strong buy from 19 Oct 11). One could value each division separately. But then some divisions would be worth less outside the Macquarie empire. Also, reported results exclude a share of Macquarie’s $1.4bn of corporate costs, which includes salaries for the risk management boffins and accountants. How would one allocate these? There aren’t any direct comparisons with Macquarie, either. Those that have tried to copy the Macquarie model have invariably failed and it’s a model in transition anyway. There really is no perfect way. But if we try to measure potential returns through the cycle by estimating a long-run average return on equity, we’ll get close. We can get closer still by valuing Macquarie’s ‘hard’ assets and funds management business separately and then, to build in a margin for error, take a pessimistic approach to the entire valuation.

Three case scenario Table 1 is the modest recovery case, not exactly optimistic but better than the other MACQUARIE Group | MQG two. Whilst another credit crisis and large tangible asset write-offs are not part of this Price at review $23.34 scenario, a modest economic recovery and a return of sorts to corporate dealmaking are. Review date 25 Oct 2011 Under these circumstances, return on equity increases steadily from the 8% expected market cap. $7.7bn in 2012 to 12% by 2014 and 2015. We also assume Macquarie pays out 50% of its profits as dividends (the lower end of its 50% to 60% target) and that the share price in 2015 is 12 mth price range $20.24—­ $41.78 about 1.2 times ‘current’ net tangible assets, or ‘hard’ asset value. Business risk Med-High Remember that using a current net asset value is conservative because higher profits Share price risk Med-High would increase Macquarie’s net asset value over time, and potentially expand the multiple max. portfolio weighting 5% to around 1.4. Our View BUY We’re therefore assuming Macquarie would be trading at slightly above book value, or ‘soft’ asset value, which includes intangible assets such as goodwill (which has roughly doubled since 2009 after a flurry of acquisitions). Table 1: Modest recovery case Investment banks have historically traded for between two and three times book value. 2012 2013 2014 2015 mUlt. In the aftermath of the GFC, a multiple less than 1.5 is more appropriate (perhaps below ROE 8% 10% 12% 12% 1.2 one without a modest recovery). But even at $36.72 per share in 2015, Macquarie may well be underpriced if its strategy pays off and the global economy holds together. Net profit 955 1,193 1,432 1,432 Share price If this scenario plays out, it would deliver a total return (capital gains plus unfranked EPS 2.75 3.44 4.13 4.13 36.72 dividends) of 88%, or about 20% per year, at the end of which investors would still own DPS 1.38 1.72 2.06 2.06 Total Return a cheap stock. PER 8.5 6.8 5.7 5.7 88%

Still cheap The pessimistic case (see Table 2) assumes profits remain flat for three years, with return on equity producing higher profits in 2015. Macquarie’s share price in 2015 is equal to one times net tangible assets, meaning the stock would still be trading at a discount to book value. Total returns would be 56%, or 13% per year, a respectable result that still assumes no major disasters or regulatory surprises. 5 Intelligent Investor

In the case of a Japanese style deflation (see Table 3), return on equity, profits and Macquarie’s valuation would fall over time. A negative total return of 17% isn’t the very Table 2: Pessimistic case worst-case scenario, either. Capital raisings and other painful surprises are excluded. 2012 2013 2014 2015 mUlt. If you want to investigate how bad (or good) the various cases look under different ROE 8% 10% 12% 12% 1.2 scenarios, download this spreadsheet. You could also assign a probability to each scenario Net profit 955 955 955 1,193 Share price to produce a weighted average return.

EPS 2.75 2.75 2.75 3.44 30.60 For example, giving scenario one, two and three a probability of 65%, 20% and 15%, respectively, would produce an average weighted return of 66%, or about 15% per year DPS 1.38 1.38 1.38 1.72 Total Return (.65*.88+.20*.56+.15*—.17). PER 8.5 8.5 8.5 6.8 56% An alternative valuation As one last check, let’s take a different valuation methodology by adding Macquarie’s net tangible assets of $10.6bn to the value of its funds management business. Table 3: Japanese-style deflation These are typically valued as a percentage of funds under management or a multiple 2012 2013 2014 2015 mUlt. of profit. Actively managed retail equity funds, like those of Platinum Asset Management ROE 8% 6% 5% 5% 0.5 and Perpetual, produce higher and more reliable management fees, which is why they’re

Net profit 955 716 597 597 Share price more valuable. Currently, Platinum is trading at 14% of funds under management, while Perpetual is EPS 2.75 2.06 1.72 1.72 15.30 trading at 4%. Their respective price-to-earnings ratios are around 15. DPS 1.38 1.03 0.86 0.86 Total Return Macquarie’s funds are best valued as a multiple of profit because, following the PER 8.5 11.3 13.6 13.6 —17% $516m acquisition of US manager Delaware (see Chart 1), half its funds are fixed interest investments (Macquarie paid less than half of one percent of funds under management for this business), while the rest are a mixed bag including stocks and infrastructure. Using a multiple of eight times profit before tax, a conservative assumption if fund inflows eventually increase and Macquarie’s acquisition of Delaware pays dividends, that’s $4.8bn in total.

Strong recovery not required Assuming Macquarie is successful raising more funds in Australia and the US and markets recover, at a multiple of 10 or 12 current earnings, the value of this operation CHART 1: ASSETS under mgmt rests somewhere between $6.0bn and $7.2bn. Remember, Macquarie’s entire total market of $a308B value is currently only $8.1bn. $Ab Let’s be conservative and reduce Macquarie’s hard asset value by 30% from $10.6bn 350 326 to $7.4bn. Assuming the funds business is valued between $4.8bn and $6.0bn, then 310 308 300 Macquarie is worth somewhere between $35 and $39 per share. If the funds business is 250 232 243 valued closer to $8bn, then prices beyond $44 per share are quite possible. 197 200 This makes the point very nicely. At today’s price, we don’t need to bet on a strong 150 recovery in order to do well. The company could be hit by another banking crisis and new 100 regulatory capital rules may force a capital raising but this isn’t the most likely outcome. A 50 takeover bid is perhaps easier to imagine. 0 Part 2 (see next page) of this series discussed how Macquarie’s three acquisitions in Mar Mar Mar Mar Mar Jun ‘07 ‘08 ‘09 ‘10 ‘11 ‘11 its Corporate Finance division totalled around $3.5bn. Combine those with even a low Fixed income Direct infrastructure. Equities value for the company’s funds management division and Macquarie’s current market value Cash Direct real estate is easily reached. Currency Other Whilst competitors may be eyeing Macquarie’s assets, they’re going to have to pay a Source: ASX release, Sep 2011 princely price to get them. Company staff own a significant amount of the shares on issue. They won’t be giving it away. If a takeover does proceed, there’s a good chance it will be well above today’s price. Macquarie boasts a price-to-earnings ratio of 8.2 and an unfranked dividend yield of MQG recommendation guide 8.0%. With it trading well below hard asset value, there are several ways today’s buyer strong buy Below $22.00 can win. bUy Up to $26.00 Morningstar’s US fund manager of the decade, Bruce Berkowitz, has made an all-in bet on US financials. Forced to defend the poor results so far, he said ‘The financials are HOLD Above $30.00 priced for failure, and that’s how you want to buy them.’ We wholeheartedly agree. Macquarie offers a wide range of potential outcomes, but with the share price falling slightly since Macquarie Pt 2: Inside a strong buy from 19 Oct 11 (Buy—$24.20), it’s priced for failure when all the signs point in the other direction. BUY. Note: The model Growth portfolio owns shares in Macquarie Group. Disclosure: The author, Nathan Bell, owns shares in Macquarie Group and Platinum Asset Management, as do other staff members.

6 Special report | Macquarie: Inside a Strong Buy

Nathan Bell, CFA | First published 19 Oct 2011

Part 2 Macquarie: Inside a Strong Buy

Macquarie is radically changing its business strategy, buying new businesses and expanding offshore. But will it work? Nathan Bell investigates. Key points US expansion is risky The Financial Times put it best. An article on the investment banking industry, titled Lower leverage means lower returns on equity A sparser future, had this to say: Macquarie remains a Buy “Tough new rules, coupled with tightened regulatory scrutiny and increased mistrust on the part of investors, are driving radical changes in business models and behaviour. The masters of the financial universe are scrambling to find new ways of making money against a regulatory and economic backdrop that prevents them from placing the high-risk, high-reward bets of years gone by.” Macquarie is scrambling in its own particular way. In the first of this three part series we explained how the global financial crisis (GFC) undermined its strategy of using highly leveraged listed funds to generate huge fees. Macquarie has been compelled to adapt. The FT article provides a graph showing return on equity (ROE) for US and Eurozone banks for the period 2000 to 2010. If one had to choose a single yardstick against which banks could be measured, ROE would be it. The graph shows how, in the period leading up to the GFC, US banks enjoyed an extended period of ROE well over 15%. Macquarie did even better. In the seven years to 2007 it produced an average ROE of 24.3%, an incredible figure. Future returns won’t be anything like that. Investment banking is returning to its roots, and historical returns of less than 10% ROE. Why? Because banks themselves are being forced to adapt. The only question is how they’ll reinvent themselves. Macquarie’s approach has four planks; First, it wants to increase the amount of loans its MACQUARIE Group | MQG makes to its customers; Second, it aims to expand overseas through acquisition; Third, it has Price at review $24.20 a strategy of developing businesses with recurring revenues, such as funds management; And finally, it wants to use less leverage because the authorities will eventually compel it Review date 19 Oct 2011 to anyway. Let’s examine each plank in turn. market cap. $8bn While many banks have cut lending during the GFC, the interest Macquarie earns from 12 mth price range $20.24—­ $41.78 making loans has increased 56% since 2008. In a contrarian manner, Macquarie has made Business risk Med-High acquisitions in areas it knows well. Share price risk Med-High The Ford and GMAC motor vehicle leasing businesses were purchased for around $1bn max. portfolio weighting 5% each in 2009 and 2010 respectively. Also in 2010, Macquarie acquired a fleet of 44 aircraft from International Lease Finance Corporation at a cost of US$1.6bn. With a fleet of around Our View BUY 170 aircraft, the company is an old hand at complex cross-border aircraft leasing transactions. But unlike fee and commission-based businesses such as corporate advisory and CHART 1: DIVERSIFICATION INCOME stockbroking, making loans requires large licks of capital. Corporate loans are also riskier than mortgages, so capital requirements are more onerous, which in part explains why Operating income $Am high returns on equity are now highly unlikely. 1,800 1,600 Overseas acquisitions 1,400 Macquarie is also expanding overseas (see Chart 1), especially in the highly competitive 1,200 1,000 US investment banking market, dominated by a handful of Wall Street titans. In fact, J.P. 800 Morgan Chase, Bank of America, Citigroup, Goldman Sachs and HSBC account for 96% 600 of US derivatives activity. 400 Macquarie isn’t aiming to compete directly with them, at least not yet. Instead, it’s 200 taking on smaller, less well-financed investment banks. But the US isn’t Australia, where 0 Australia Asia Americas Europe, government and corporate connections are plentiful. Chart 2 (on the next page), shows M.East & Africa how deleveraging, fewer deals and intense competition, to say nothing of poor investments, 2H09 1H10 2H10 are producing lousy returns. This is far from an easy business. 1H11 2H11

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Expanding across Asia is no panacea, either, despite success including advising on the CHART 2: RETURN OF EQUITY (%) $22bn dual listing of the Agricultural Bank of China, the world’s largest initial public offer. The $Ab Wall Street titans are well established and better connected. And maintaining Macquarie’s 350 326 risk culture abroad will be more challenging. 310 308 300 It’s fair to say running a bunch of highly leveraged, locally listed satellite funds that 250 232 243 Macquarie could endlessly milk was a far easier and more profitable business than this. 200 197 150 Recurring revenues 100 Macquarie is making more progress in the shift towards generating more recurring 50 revenues. Chart 3 shows the recent change in the split between Macquarie’s annuity 0 Mar Mar Mar Mar Mar Jun (read: reliable) and transactional (read: volatile) revenue. ‘07 ‘08 ‘09 ‘10 ‘11 ‘11 Selling the listed fund operations removed a reliable source of fees that Macquarie is Fixed income Direct infrastructure. Equities trying to recoup by acquiring funds management businesses, for example, where rivals Cash Direct real estate Credit Suisse, UBS and Morgan Stanley are strong. Given current low valuations for fund Currency Other managers—Platinum Asset Management and Perpetual are both on our Buy list—and Source: ASX release, Sep 2011 the prospect of higher inflows (eventually), the timing is cute. The problem is that Macquarie’s reputation in funds management was tarnished by poor returns during the GFC. Investors haven’t forgotten Macquarie CountryWide (now Charter Hall Retail) and Macquarie Office (now Charter Hall Office), for example. Again, this change in direction isn’t yet conclusively successful.

Reducing leverage CHART 3: DIVERSIFIED INCOME With Macquarie’s net debt-to-equity ratio falling from 568% in 2008 to 263% in 12 mths to 31 Mar ‘10, $A7.0b 2011, the company’s objectives here are within view. The risk remains significant (this is an investment bank, after all) but assets aren’t valued at boom time prices and deposits have increased from $16bn to $35bn. Despite the deposit guarantee in Australia falling from $1m to $250,000, deposits are a reliable source of funding and reduce Macquarie’s dependence on short-term overseas wholesale funding (see Chart 4). That makes it a safer proposition. There are three key points to understand about Macquarie’s financial position. First, lower leverage means the days of 20% plus returns on equity are gone. Returns of 10% to 12% are more likely. The issue of valuation will be discussed in Part 3. Second, Macquarie’s $3bn of ‘surplus capital’ is a beautiful mirage. That tidy sum 12 mths to 31 Mar ‘11, $A7.6b will be used to meet higher capital watermarks when Basel III regulations are eventually introduced. APRA, the Australian banking regulator, may also introduce tougher rules of Mar ‘10 Mar ‘11 its own, penalising Macquarie compared with offshore rivals, many of which can borrow Lending, leasing and 27% 27% margin-related income at rock bottom interest rates. Instit. and retail cash equities 16% 16% Third, holding more capital will slow Macquarie’s growth. Whilst the company could Equity derivatives 8% 5% reinvest the proceeds from selling its $5.2bn investment portfolio, which includes stakes Fund management 17% 18% in listed property group Charter Hall, Sydney airport owner MAp Group and oil services M&A and advisory income 11% 11% Asset and equity investments 8% 9% company Miclyn Express Offshore, this is unlikely. Commodities, resources and 16% 14% foreign exchange CHART 4: FUNDED BALANCE SHEET REMAINS STRONG $Ab 31 Mar 2010 30 Sep 2010 31 Mar 2011 90 3% 6% 80 8% 10% 60 7% 9% 30% 70 31% 30% 50 17% 26% 17% 37% 17% 36% 40 9% 10% 9% 30 20 40% 36% 31% 30% 28% 33% 10 16% 7% 14% 7% 13% 6% $0 Funding Funded Funding Funded Funding Funded sources assets sources assets sources assets Funding sources Funded assets St wholesale issued paper Cash and liquid assets Other debt maturing in 12 mths Trading assets Deposits Loan assets < 1 year Debt maturing beyond 12 mths Loan assets > 1 year Equity Equity investments Value not represented

8 Special report | Macquarie: Inside a Strong Buy

Volatile profits Under former chief executive Alan Moss, Macquarie forged a reputation for under-promising and over-delivering. After emptying its hollow logs during the GFC, that’s largely impossible now. The results from this business are now far less predictable. Operating with less leverage is therefore entirely sensible. Although Macquarie’s financial position is sound, much capital will be tied up in lower return assets in order to meet new regulatory requirements. This is a handbrake on Macquarie’s return on equity, as it is for every other investment bank. The company’s push into the US is also risky. It may have been sensible buying assets at lower prices after the credit bust but growth in highly competitive western economies is likely to be slow for an extended period. Plenty of risks remain, which means the argument to buy ultimately comes down to price. With a 21% discount to net tangible assets of $30.60, the return on equity for today’s buyer is actually a more attractive 11%, especially if we’re at or near a low point in the earnings cycle. Even a slight hint that Macquarie’s strategy is paying off is likely to produce a much higher share price, which is the issue we’ll explore in the final part of this series. With a share price down 3% since Macquarie Pt 1: Inside a Strong Buy from 12 Oct 11 (Buy—$24.89), Macquarie remains a BUY. Note: The model Growth portfolio owns shares in Macquarie Group. Disclosure: The author, Nathan Bell, owns shares in Macquarie Group and Platinum Asset Management, while other staff members own shares in Macquarie Group, Platinum and MAp Group.

Nathan Bell, CFA | First published 19 Oct 2011

Part 1 Macquarie: Inside a Strong Buy

As one of only two recent strong buys, Macquarie deserves a full explanation. In the first of three parts, Nathan Bell lays out the groundwork. Key points Macquarie’s business has changed In 1969 merchant bank Hill Samuel Australia, now known as Macquarie Group, opened Discount to NTA offers more ways to win its doors. It had just three staff. The company now employs over 15,500 people in offices Downgraded to Buy around the globe. For almost 40 years, the company’s trajectory was resolutely up. In May 2008 the company that was once a very small business produced a very big net profit of $1.9bn. Its share price had peaked at $98.64 a year earlier, valuing the investment bank at $27bn. Everyone knows what happened next, not least the staff on Macquarie’s trading floor, visible from our new digs in Pitt St Sydney. In less than two years the widely imitated ‘Macquarie model’ was dead. The global financial crisis made light work of the company’s suite of highly leveraged listed funds. Most were either sold off or expensive management contracts were severed. The fee factory, at least as far as the famous satellites were concerned, became a cottage business. By 2011 net profit had fallen 50% from its peak. The share price has tumbled 75% from its all time high, including a 32% fall this year. Despite an 19% discount to net tangible assets (NTA) of $30.60 per share, a price-to- earnings ratio of 8.9 and a 7.4% unfranked dividend yield, the crowd has moved on. After polishing a diamond, the market has found a stone.

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Different business In Chaos amid the storm: the upgrades from 5 Aug 11 (Strong Buy—$22.97), Macquarie earned our strongest recommendation, just as it did nine years ago in a special report titled MACQUARIE Group | MQG Macquarie Bank-A rare opportunity. Price at review $24.89 But whilst the share price has returned to levels reached at the time of that report, this

Review date 12 Oct 2011 is now a vastly different business. The $1.8bn profit in 2008 was an anomaly. Profits aren’t likely to quickly rebound, either, stuck at around $1bn as they are. But as we’ll discover, for market cap. $8.3bn today’s buyer to do well they don’t need to. 12 mth price range $20.24—­ $41.78 In this, the first of a three-part series, we’ll analyse Macquarie’s six profit centres. Part Business risk Med-High 2 explores the company’s current strategy and financial position whilst Part 3 examines Share price risk Med-High the issue of valuation and lays out a road map, a series of waypoints the company needs max. portfolio weighting 5% to pass in order for this investment to work out well.

Our View BUY Let’s start with Macquarie’s equities business. Macquarie Securities ‘Esoteric and sometimes dangerous activities are this group’s specialty’ is how we described Macquarie’s cyclical equities division in 2002. Nothing much has changed. CHART 1: AUSTRALIAN equity Combining stockbroking services with risky trading strategies, this operation enables market volatility Macquarie to sell complicated products to other large investors.

60 3.0 Although expanding overseas has helped offset the fall in brokerage and commissions, costs have increased at a time when trading income has fallen. Low volatility (see Chart 50 2.5 1) and lower demand for complex leveraged products (funny, that) have reduced trading 2.0 40 opportunities, as has an absence of investment banking deals (see Chart 3). 1.5 30 Around a third of the company’s profits are tied to equity markets, much of that through 1.0 the equities division. No wonder group profits have tumbled from $1.2bn in 2008 to $175m 20 0.5 in 2011. With such variable profits this division could be worth anywhere between $1bn 10 0 and $3bn, or more in a bull market. Jun Dec Jun Dec Jun Dec ‘08 ‘08 ’09 ’09 ’10 ’10 S&P/ASX 200 VIX (LHS) Fixed income, commodities & currencies (FICC) All Ords Index - Daily change (%, RHS) This division’s name belies its purpose. FICC is a giant, legalised gambling den, financed Source: ASX market announcement, Jan 11 largely with other people’s money. Allegations that traders ride on the coattails of their client’s transactions aren’t as important to this operation as the big bets on economic announcements, such as changes in official interest rates. This is a business of grand profits and great holes. CHART 2: ASSETS under mgmt Macquarie made hay during the wild fluctuations in bond yields throughout 2009. of $310bn But with staff numbers increasing from 611 in 2008 to 980 in 2011 during a time of flat

$Ab profits, either trading profits need to increase or staff numbers will fall. Comparisons are 340 difficult but Macquarie’s average profit per employee appears to lag many of its major rivals. 330 Helped by acquisitions, profits have been steady since 2008. The FICC division could be worth between $2bn and $4bn. 320 (9.6) 6.7 (6.8) 21.0 (26.7) 310 Macquarie Funds 325.7 309.8 300 Macquarie is possibly Australia’s largest fund manager with more than $300bn of Mar 10 A B C D E Mar 11 funds under management (see Chart 2). The acquisition of US funds manager Delaware A. CMT/CMA conversion B. Asset acquisitions for $516m in 2010 added $151bn of mostly fixed income portfolios, although the average C. Asset disposals fee margin is lower than for stock portfolios. D. Net inflows and equity movements 1 E. FX (impact of strengthening AUD) Funds management hasn’t been Macquarie’s strong suit but it does help replace 1Includes the impact of net inflows/outflows and the management fees that were lost when the company’s listed funds (Macquarie movements in AUM driven by changes in listed equity prices Infrastructure Group, Macquarie Airports (now MAp Group) and Macquarie CountryWide Source: Macquarie Group presentation, Sep 11 (now Charter Hall Retail), for example) were sold. A rough estimate suggests this division may be worth between $4bn and $6bn.

Corporate and Asset Finance The corporate lending division specialises in constructing complex loans and leases. Take the book of tax-driven loans for cross-border aircraft leasing for example. It’s incredibly complex, demanding and lucrative work, which is why it’s potentially worth $2bn alone. With the GMAC and Ford motor vehicle leasing businesses each valued at $1bn when they were acquired in 2009 and 2010 respectively, a valuation of this division could easily exceed $4bn. In fact, the Macquarie Funds and Corporate and Asset Finance divisions are potentially worth more than Macquarie’s current market value of $7bn, implying today’s buyer is getting 10 the remaining divisions thrown in for free. Special report | Macquarie: Inside a Strong Buy

Banking and Financial Services This division is a mini-AMP, delivering financial services to individuals and small businesses. Last year, on revenues of $1.5bn it produced a $275m profit before tax, or 22% of Macquarie’s total profit in a year when other divisions suffered enormously. Net interest income increased from 29% of total revenue in 2008 to 46% in 2011, as Macquarie’s former cash management trust was converted to bank deposits (and therefore brought on to the balance sheet). We’ll explain that further in Part 2 but having more deposits has helped Macquarie’s financial position at a time when it was strained. A rough estimate of the value of this business would place it somewhere between $1.5bn and $3.0bn.

Macquarie Capital During the credit boom Macquarie’s investment banking division produced vast swathes of cash advising on mergers and acquisitions, recapitalisations, rights issues, restructuring CHART 31 debt and raising capital for governments and companies. Global M&A completed Chart 3 shows how the flood has become a famine. Macquarie has also lost market $USb share, a potential sign that there’s a ‘brain drain’ effect. The company’s smartest employees 5,000 may be leaving for its competitors. 4,000 The colossal $3.3bn profit recorded in 2008 was, to a large extent, a function of the 3,000 fees gouged from its former suite of listed satellite funds, all loaded to the gills with debt. 2,000 Related party deals used to make up 50% of revenue. Now it’s more like 15%, a figure 1,000 that contains the story of the decline of the Macquarie model. 0 FY08 FY09 FY10 FY11 1Q12 Jul–Aug With US rival Goldman Sachs widely tipped to report a loss for the quarter ending 30 2011 September, Macquarie’s profits could fall further. In the event they fall to, say, $100m, a M&A completed 5 year quarterly average conservative valuation might suggest this business is still worth $1bn, though this is arguably the most difficult division to value. Interestingly, Macquarie’s current share price implies Global IPOs and secondary issues this division will never make another dollar of profit, an implausible scenario in our view $USb given the relationships Macquarie has forged over four decades. 1,000 800 Having sold most of its listed funds and their lucrative management contracts, and with 600 around a third of Macquarie’s profits tied to equity markets, the demise of the Macquarie 400 model has been exacerbated by a deep cyclical downturn. 200 As we’ll explain in Part 2, Macquarie is now a typical investment bank. Profits will be more 0 FY08 FY09 FY10 FY11 1Q12 Jul–Aug cyclical and, because it relies more heavily on lending its own money, it’s more risky, too. 2011 Secondary offering IPO Best opportunity 5 year quarterly average We have reduced the prices in the recommendation guide to reflect a drawn-out global 1 Source: Thomson Reuters, data based on completed transactions. FY data based on year ended 31 Mar economic recovery. Although two divisions alone are worth more than Macquarie’s current Source: Macquarie Group presentation, Sep 11 market value, we are downgrading a notch to BUY following an 8% increase in the share price since 9 Sep 11 (Strong Buy—$23.20). Parts 2 and 3 of this series will tease out the case. Macquarie Group is one of the best opportunities we’ve found in years. If you haven’t yet taken advantage of it, what follows will offer you all the information you need to do so. If you have, it may well reassure you that you’ve made the right decision or perhaps convince you to buy a little more (but please note the portfolio limit). Note: The model Growth portfolio owns shares in Macquarie Group. Disclosure: The author, Nathan Bell, owns shares in Macquarie Group, while other staff members own shares in Macquarie Group and MAp Group.

11 Intelligent Investor

Nathan Bell, CFA | First published 28 Apr 2011

Banking on Macquarie

Trading at book value and boasting a 5.3% dividend yield, this is not the time to Key points write off Macquarie Group, argues Nathan Bell. Risky strategy Share price compensating for risks Macquarie Group was once celebrated for under promising and over delivering. Now it does almost the opposite, a view recently reinforced when chief executive (CEO) Nicholas Portfolio limit remains 4% Moore revealed several profit downgrades and unveiled a risky new strategy. Since hitting $58.80 in September 2009—Macquarie’s shares peaked at $98.64 in May 2007—the investment bank’s share price has fallen 40%. Members that haven’t yet acted on past recommendations, most recently on 13 Apr 11 (Long Term Buy—$34.62), are now getting another chance, and another advocation, to do so. Macquarie Group, perhaps now at the low point in the earnings cycle, is an Australian success story sporting a 5.3% dividend yield. It also happens to be highly leveraged with above-average risks. In fact, it’s a very different beast to the fee machine that won acclaim before the global financial crisis (see Good riddance to the ‘Macquarie Model’ in issue 277). If you’re to follow this recommendation, it’s vital you understand that difference.

Macquarie loses its spots Dubbed the millionaire factory, the company gained notoriety through its listed infrastructure model. It acquired assets, often using ’other people’s money’, geared them up and flipped them into a fund like Macquarie Infrastructure Group and Macquarie Airports (now MAp Group). MACQUARIE Group LIMITED | MQG Every step of the way, it collected fees, some would argue rapaciously so. The profits Price at review $34.87 were breathtaking (see Chart 1). Eventually, one-dimensional imitators like Babcock & Review date 28 Apr 2011 Brown, Allco and Rubicon copied the model but with much less success; all collapsed market cap. $11.6bn during the GFC.

12 mth price range $20.24—­ $41.78 Macquarie survived but the halcyon days of returns on equity (ROE) above 20% are over. Last year, Macquarie’s ROE was barely 10%, and will fall in 2011. Higher capital Business risk Med-High requirements and lower sharemarket activity have shattered profitability to the point where Share price risk Med-High Macquarie has become what most thought it would never be: a regular investment bank. max. portfolio weighting 5% The death of the Macquarie model has required a new strategy, which is—drum roll Our View LONG TERM BUY please—offshore, acquisition—led expansion, primarily in the US. Of late, Macquarie has paid US$516m for fund manager Delaware Investments and US$1.2bn for an aircraft leasing portfolio from AIG. More than half of its workforce now resides overseas. Not only do such deals require Macquarie to contribute more of its own capital than was CHART 1: Average return on the case in the past, they place the company up against the major global investment banks. shareholders equity (%) That’s no bad thing, you might imagine, given the monumental greed and incompetence 30 that firms like Goldman Sachs displayed before and during the GFC.

25 But these firms have enormous political and regulatory influence. If Macquarie ever became a threat, a few discreet phone calls could easily bring this strategy undone. 20 There are other problems, too. Because the company is so much larger than it was 15 five years ago, it needs big deals to move the profit needle. But it’s not the nimble,

10 entrepreneurial and fast-growing company it once was, which may reduce the chances of actually securing such deals. 5 Macquarie’s culture has also changed. The need to balance the opposing demands of 0 staff and investors remains but it’s getting harder to attract and retain talented staff, the ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 lynchpin of an investment banking business. Bonuses are lower, working for Macquarie Source: Macquarie Group 2010 annual report abroad doesn’t carry the cache that it does in Australia, and rivals are making superior offers to senior staff. Anecdotally, there are reports of a brain drain.

12 Special report | Macquarie: Inside a Strong Buy

Bull case That, then, is the bear case. What of the bulls? First, Macquarie is a company that thrives and profits from activity. Yes, there’s a chance we’re in a ‘new normal’ of permanently lower dealmaking but even Japan’s 20-year Table 1: Bull vs Bear case depression produced several bull markets. BULL BEAR Second, as discussed in Macquarie transformed by crisis (see issue 295), the bank is in Market activity will rebound Expanding overseas a relatively strong financial position. In a downturn, that offers investors some protection. Strong risk management culture Risky acquisitions More importantly, it affords Macquarie the chance to purchase smaller players at cheap Strong financial position Brain drain prices and pinch clients from rivals. These are no small advantages. Third, Macquarie retains a strong risk management culture. It deserves credit for Experienced management Large size largely avoiding markets that brought much larger rivals, like AIG and Lehman Brothers, Undervalued share price Culture changing undone. It’s getting harder to maintain this culture as the company grows, but it remains a foundation stone. Fourth, don’t underestimate Nicholas Moore. After joining in 1986, he was a major architect of Macquarie’s success and understands this business inside out. There are also a couple of seasoned internal candidates that could capably fill his shoes.

Table 2: Key financials Portfolio Point Year to 30 June 2007 2008 2009 2010 2011F We recommend limiting your portfolio Revenue ($m) 7,181 8,248 5,526 6,638 7,670 exposure to no more than 10% in bank stocks. And no more than 15% in other financials such Net profit ($m) 1,463 1,803 871 1,050 945 as insurance companies and fund managers, Earnings per share ($) 5.92 6.71 3.10 3.20 2.70 for a total of 25%. The more conservative you are, the lower these numbers should be. PER (x) 5.9 5.2 11.3 10.9 12.9

Dividend per share ($) 3.15 3.45 1.82 1.86 1.86

Franking (%) 100 100 76 0 0

Yield (%) 8.99 9.8 5.2 5.3 5.3

Fifth, and this is something already touched on, current return on equity (see Chart 1) needs improving. A cyclical upswing will help greatly and recent acquisitions are yet to bear fruit. But what offers great confidence is the fact that Macquarie is sticking to markets it knows well (such as funds management and energy trading). It’s also employing a counter-cyclical approach of buying during tough times, which is what shrewd management should do. A lower Aussie dollar would help profitability, although it would also increase the price of US acquisition targets. Finally, Macquarie’s current share price embodies very low expectations. Investors now see this company as somewhat of a yield play, which is why the company is currently valued merely at book value. That reflects the challenges that lie ahead, and the company’s Macquarie’s ‘new’ business much larger size. model will produce lower returns But with a 5.3% dividend yield, investors don’t need much in the way of capital gains and be more exposed to broader to do well. That Australia and Asia are currently flavour of the month with foreign investors financial conditions. But if its could also make Macquarie a takeover target. acquisitions pay off, and it can win deals considered too small Potential returns outweigh the risks for the likes of Goldman Sachs, In summary, Macquarie’s ‘new’ business model will produce lower returns and be more then Macquarie will be a far more exposed to broader financial conditions. But if its acquisitions pay off, and it can win deals profitable enterprise. considered too small for the likes of Goldman Sachs, then Macquarie will be a far more profitable enterprise. If it can regain its mojo, a share price well above $50 is within reach. But if Macquarie fails abroad—as so many Australian companies have before it—then we’ll see the obligatory write-downs and sale of ‘non-core’ assets and the naysayers will have been proven right. Peter Lynch said that you should ‘never invest in any idea you cannot illustrate with a crayon’. That rules out Macquarie. And, as Macquarie is highly leveraged to the global economy, conservative (and short term) investors should steer clear. But for patient, risk-tolerant investors, Macquarie is a LONG TERM BUY for up to 4% of a well-diversified portfolio subject to the caveats laid out in the Portfolio Point. Disclosure: Staff have interests in Macquarie Group, but they don’t include the author, Nathan Bell.

13 Intelligent Investor

Greg Hoffman | First published 31 Jun 2009 Weighing up Macquarie Group

The group’s recent annual meeting raised a number of small red flags, but they Key points must be weighed against the broader outlook and current share price, which is Financial market recovery good for profits not particularly demanding. Has raised enough capital Emotions typically run high at Macquarie Group’s annual meetings and this week’s Sticking with Hold event proved no exception. The spectrum was wide, from messages of congratulations on the company avoiding the fate of the likes of Babcock & Brown and Bear Stearns, to tough questions surrounding the disastrous BrisConnections float, the proposed internalisation of Macquarie Airports’ management and auditor PricewaterhouseCoopers. Despite the headlines and side-issues, those with an eye for value should remain focused on the key question; is the current downturn inhibiting Macquarie’s long-term earnings power or enhancing it? Macquarie has, in the past, turned downturns to its advantage in two main ways. Firstly, the group has made opportunistic acquisitions, such as BT’s Australian operations in 1999 and ING’s Asian assets in 2004. That’s a trend which has continued this time around with the acquisitions of Orion Securities and Constellation Energy in North America, for example. Secondly, in previous downturns Macquarie has selectively built its staff numbers as competitors shrank or went bust. This time around things are different. As you can see in Chart 1, Macquarie has taken the knife to its own staff (indeed, Intelligent Investor is seeing resumes from former Macquarie staff flow our way). This could be a sign of a healthy culling of underperformers, using the downturn as an excuse. Alternatively, it might indicate that Macquarie has now evolved beyond its former MACQUARIE Group | MQG niche positioning and is now behaving more like its larger competitors in this regard. In any

Price at review $43.70 case, we note the departure from past form. And sometimes it pays to note the small things. At the meeting, several small things irked us. Chief executive officer Nicholas Moore Review date 31 Jul 2009 knows better than anyone that banking is a game of confidence (and sometimes market cap. $12.4bn overconfidence, as Malcolm Gladwell explained in The New Yorker recently). 12 mth price range $20.24—­ $41.78 In his confident—almost breezy—presentation to the annual meeting, Moore emphasised Business risk Med-High that Macquarie had some $30bn in cash ‘on board’ at 31 March. While this was a Share price risk Med-High ‘truthful’ statement, it led to an inaccurate impression in the minds of some shareholders max. portfolio weighting 5% (for more on the difference between truth and accuracy, see Gareth Brown’s classic review CFS Gandel spins a web of truth, see issue 192). Our View HOLD For example, one shareholder asked why Macquarie wasn’t standing by with its cash hoard to take up the US$5bn worth of preferred stock Goldman Sachs issued to Warren Buffett’s Berkshire Hathaway last year. The fact is that while Macquarie may have had $30bn in cash and liquid assets on the asset side of its balance sheet at 31 March, that money wasn’t freely available for distribution to shareholders or investment in Goldman Sachs. It was offset by liabilities of matching maturity. It’s one thing to show that Macquarie has a well matched balance sheet (something few banks can boast); it’s another to allow an impression to take root that the company CHART 1: Macquarie staff numbers has tens of billions in idle financial capacity.

15,000 A couple of the charts used by Moore also bear examining. Slide 34 for example is, once again, truthful but not particularly accurate. At a glance, 12,000 the chart (above) seems to show Macquarie consistently outperforming the MSCI World

9,000 Diversified Financials Index since April. Closer inspection reveals that the chart is not drawn with a common base; the MSCI index line begins at approximately 29.5 while the 6,000 Macquarie line begins at around 36.

3,000 Although Macquarie did end up outperforming by the end of the period (returning approximately 55% against the index’s 42%), it was behind for much of the time until 0 June; which would have made for a less impressive—less confidence-inspiring—picture. Australia International And the chart on slide 45 was just plain laughable (and, funnily enough, reproduced by our national broadsheet). The chart (see below) plotted net profit since 1999 and included a super-imposed upward sloping ‘trend line’ replete with an arrow head jutting out,

14 Special report | Macquarie: Inside a Strong Buy

optimistically, into the future. But it’s plain to see that the ‘trend line’ chops the heads clean off the previous four years’ profit results. CHART 2: Global financials Aside from the highlighted 10-year annual compound growth rate of net profit of 18% continued to rebound being substantially lower than last year (placing its implied predictive value into question), 60 it is less impressive when expressed in terms of what really matters to shareholders; the 10-year annual compound growth rate in earnings per share was a more modest 11.8%. 50 And, for completeness and accuracy, we’ve set out the compound growth rates in earnings and dividends per share over a range of periods in Table 1. 40 The point of this analysis is not to place a negative slant on everything, but to balance up the ledger after such a one-sided presentation by management. Macquarie has made 30 mis-steps and shareholders deserve a frank account. The fear for long-term shareholders is that Warren Buffett’s admonishment 0 Apr 09 May 09 Jun 09 Jul 09 (in his Owner’s Manual to Berkshire Hathaway shareholders) may prove prescient in Macquarie Group regard to Macquarie: ‘The CEO who misleads others in public may eventually mislead MSCI World Diversified Financials Index himself in private.’ Source: Bloomberg, data current to 27 Jul 09 Valuation The reasons why book value is our preferred valuation yardstick for this business were laid out in our recommendation upgrade of 14 Mar 08 (Buy—$46.25), Throwing the book at Macquarie. We also presented two potential future scenarios Table 1: Growth in perspective in that review, which history has rendered optimistic. But the basic financial model eps dps can still provide a useful rough guide, though it doesn’t take into account the effect of any capital raisings (which are almost certain to occur over the coming years). 3-year —8.2% —4.9% Table 2 updates the figures for the current situation and the prospects for the next few years. 5-year 5.8% 8.7% For the model’s opening book value, we’ve made an estimate, taking the recent capital 10-year 11. 8 % 10 . 5 % raising into account. We’ve then made an estimate for the coming year’s profit (which we think is likely to be hampered by further writedowns) before projecting out further on the basis of the business achieving an average return on equity of 15%.

Table 2: What the future may hold (Scenario 1) CHART 3: net profit after tax 2010(F) 2011(F) 2012(F) 2013(F) 2014(F) attributable to ordinary equityholders Book value ($/shr) 32.51 33.38 35.88 38.52 41.29

Return on equity (%) 8.4 15.0 15.0 15.0 15.0 1,800 1,600 Earnings per share ($) 2.72 5.01 5.38 5.78 6.19 1,400 Payout ratio (%) 68.0 49.9 51.1 51.9 53.3 1,200 Dividend ($/shr) 1.85 2.50 2.75 3.00 3.30 1,000 800 Closing book ($/shr) 33.38 35.88 38.52 41.29 44.19 600 PER (x) 16.2 8.8 8.2 7.6 7.1 400 Dividend yield (%) 4.2 5.7 6.2 6.8 7.5 200 Such assumptions would have seemed overly cautious a year ago, but 2010 is likely to ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 Growth: 428% be Macquarie’s second year in a row of sub-10% return on equity. Yet it’s reasonable to Ten year compound annual growth rate: 18% expect that by 2011 Macquarie will be taking full advantage of its recent acquisitions and, probably, somewhat higher levels of activity in financial markets. Table 3 shows a more sedate future, where return on equity rebounds to 12% and then flatlines at that level. Such a scenario is possible in a world of lower leverage, higher funding costs and higher bad debts. From today’s share price, the scenario in Table 3 would likely result in lacklustre, though not disastrous returns. More attractive returns would result from the scenario painted in Table 2. Though if the world becomes mired in a broad economic malaise, there is the potential for substantially worse outcomes. The general return of optimism and Nicholas Moore’s confident performance at the annual meeting have combined to push the share price up 20% since 2 Jun 09 (Hold—$36.65). We remain braced for further writedowns on Macquarie’s listed and unlisted investments but there now seems little doubt the group will survive following a $1.2bn capital infusion from shareholders in May. In March, despite the protestations of a confident Nicholas Moore, we were convinced that Macquarie needed much more capital. If it had been forced into a raising when its share price was below $20, the result would have been serious dilution to intrinsic value

15 Intelligent Investor

per share. But Moore’s poker face paid off and he was able to raise capital during the market recovery—and lots of it.

Table 3: What the future may hold (Scenario 2) 2010(F) 2011(F) 2012(F) 2013(F) 2014(F)

Book value ($/shr) 32.51 33.38 35.38 37.43 39.52

Return on equity (%) 8.4 12.0 12.0 12.0 12.0

Earnings per share ($) 2.72 4.01 4.25 4.49 4.74

Payout ratio (%) 68.0 49.9 51.8 53.4 54.8

Dividend ($/shr) 1.85 2.00 2.20 2.40 2.60

Closing book ($/shr) 33.38 35.88 37.43 39.52 41.66

PER (x) 16.2 11.0 10.4 9.8 9.3

Dividend yield (%) 4.2 4.5 5.0 5.4 5.9 More broadly, the continuing recovery in financial markets is good news for Macquarie as it clips the ticket when activity increases. All things considered, we view Macquarie’s current share price as somewhat on the happy side of fair value. HOLD. *You can make your own assumptions and consider the outcomes using an accompanying spreadsheet in the special reports section of the website (under the ‘Stocks’ tab). Disclosure: The author, Greg Hoffman, owns shares in Macquarie Group, as do other staff members.

John Addis | First published 12 Sep 2011

Why Strong Buy doesn’t mean load up

QBE Insurance and Macquarie Bank are incredible opportunities. So why do we Key points recommend you allocate only a few percent of your portfolio to them? Stock picking and portfolio allocation are distinct tasks but both are central to successful investing Share ‘Your goal as an investor should simply be to purchase, at a rational price, a part interest price compensating for risks in an easily-understandable business whose earnings are virtually certain to be materially A cheaper stock doesn’t always deserve a higher weighting higher five, ten and twenty years from now. Over time, you will find only a few companies Stick to recommended portfolio limits and consider that meet these standards—so when you see one that qualifies, you should buy a meaningful recommendations in this light amount of stock.’—Warren Buffett, 1996 letter to shareholders. QBE Insurance and Macquarie Group’s renowned brands, attractive economics and fine management make them excellent businesses. Both face short term difficulties but future earnings are likely to be substantially higher than today’s. Trading at very attractive prices, they’re both Strong Buy recommendations and two of our best investment ideas ever. If you were to follow Buffett’s advice, you’d be buying them with every skerrick of available capital—with ‘your ears pinned back’, as they say. We’re not recommending that at all. Instead, we suggest you restrict QBE and Macquarie to just 7% and 5% of your portfolio respectively. How one reconciles our strongest recommendation with a modest portfolio limit is the subject of this Investor’s College. Successful investors have two essential tasks. The first is to identify underpriced stocks, something in which Intelligent Investor assists you. The more positive—or stronger—our recommendation, the cheaper we believe a stock to be priced. For example, a stock with a Buy recommendation is cheaper than a stock assigned a Long Term Buy, and a Strong Buy suggests a stock is cheaper still.

16 Special report | Macquarie: Inside a Strong Buy

Portfolio weightings The second task is to assemble those stocks into a portfolio that’s appropriately structured according to your investing goals and risk profile. Our recommended maximum portfolio Portfolio Point weightings should be central to this task. As well as portfolio limits on individual stocks, There’s clearly a relationship between the two. Overpriced stocks shouldn’t be in your we recommend limiting your total portfolio exposure to banks to no more than 10% and portfolio at all whilst mildly underpriced stocks might have small weightings. Everything else no more than another 15% in other financials being equal, it makes sense for extremely underpriced stocks to have higher weightings. such as insurance companies and fund But of course, everything isn’t equal. Consider Woolworths: Save a zombie apocalypse, managers. Your total financial services sector it’s virtually certain to continue to make vast profits selling groceries. If it became sufficiently portfolio limit should be no more than 25%. The more conservative you are, the lower cheap we’d have little hesitation recommending it for up to 10% of your portfolio. these numbers should be. Insurers, on the other hand, are prone to high impact shocks; the September 11 terrorist attacks are perhaps the best example. Another such event would result in large claims and perhaps a capital raising. It’s a slim but real risk for QBE Insurance; the type of risk that Woolies simply doesn’t face. CHART 1: WOW-NARROW RANGE Much the same argument applies to Macquarie Bank. It’s highly leveraged; one rogue trader could lose billions and, as a business far more complex than a simple food retailer, High more can go wrong. Macquarie Group’s share price fall from its all-time high of $98.64 to its current price of $21.90 suggests as much. Charts 1 and 2 offer a visual representation of this point. The more skewed the graph is to the right (showing a higher weighted probability of a good outcome), the cheaper the Probability stock is and the more positive the recommendation will be. That’s why Macquarie and QBE carry Strong Buy recommendations and Woolworths only a Long Term Buy. The wider the spread of possible outcomes, the greater the risk of a poor one, and Low the lower the portfolio limits should be. Macquarie and QBE’s portfolio weightings should Bad outcome Good be low while Woolies’ tighter range of potential outcomes and greater certainty permits a higher weighting, assuming the price is right. So, whilst Macquarie and QBE are very cheap, these aren’t businesses about which one can be ‘virtually certain’ things will work out well. The portfolio limits offer an insurance CHART 2: QBE­, MQG-A LONG TAIL policy in the event that they don’t. High Conviction indication A strong recommendation with a relatively low portfolio limit—as is the case with QBE and Macquarie Bank—indicates a very cheap stock in an inherently risky industry. A strong recommendation with a relatively high portfolio limit indicates a far higher level of conviction, Probability implying a cheap stock in a more stable and predictable industry. The lesson is to use the two in combination, not isolation. If you’re still not convinced, revisit our 2010 Analyst Interview videos, in particular Low those with Gareth Brown, Nathan Bell and Greg Hoffman. Listen to what they consider Bad outcome Good their biggest investing mistakes. It wasn’t that they were fully invested in 2007; It wasn’t that they didn’t buy more RHG or Flight Centre during the GFC; it was overconfidence. Each allocated too much money to what seemed like very cheap stocks that didn’t work out. What to know more? By sticking to portfolio limits and separating your stock picking and portfolio allocation decisions, you can avoid these costly mistakes. If you’re after more portfolio advice, we recommend reading our special report Note: The model Growth portfolio owns shares in Macquarie Group and QBE, while Building and managing a portfolio, which the Income portfolio owns shares in QBE. delves into these ideas in much greater depth. Disclosure: Staff members own shares in Flight Centre, QBE Insurance and Macquarie Bank.

Important information Intelligent Investor PERFORMANCE Past performance isn’t a reliable indicator of future results. Our performance figures are hypothetical and come from the recommendations made by The Intelligent Investor. Transaction costs haven’t been included. We encourage you to think of investing as a long- PO Box Q744 term pursuit, as stocks can fall and you can lose money on the stockmarket. To read our performance report, go to www.intelligentinvestor.com.au. Queen Vic. Bldg NSW 1230 WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation T 1800 620 414 | F (02) 9387 8674 or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all people. [email protected] DISCLAIMER This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of www.intelligentinvestor.com.au its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation. COPYRIGHT© The Intelligent Investor Publishing Pty Ltd 2011. Intelligent Investor and associated websites and publications are published by The Intelligent Investor Publishing Pty Ltd ABN 12 108 915 233 (AFSL No. 282288). PO Box Q744 Queen Victoria Building NSW 1230. Ph: (02) 8305 6000, Fax: (02) 9387 8674. DISCLOSURE As at 1 December 2011, in-house staff of Intelligent Investor held the following listed securities or managed investment schemes: ABP, ALL, ALZ, ARP, AWC, AWE, AZZ, BBG, BCC, BER, CBA, CIF, CMIPC, CND, COH, CPU, CRC, CSL, CUE, EBT, ELDPA, FGL, FLT, HVN, IAG, IDT, IFL, IFM, IVC, KRM, KRS, LMC, MAP, MAU, MCE, MFF, MLB, MQG, MTS, NABHA, NBL, NWS, PGA, PTM, QBE, QTI, RCU, RNY, ROC, SDI, SFC, SGN, SGT, SHL, SKI, SRV, TAP, TGP, TLS, TRG, TRU, TWE, TWO, UXC, VMS, WBC, WDC, WES, WHG and WRT. This is not a recommendation. PRICES CORRECT AS AT 1 December 2011 DATE OF PUBLICATION 1 December 2011

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