I. Sector Landscape and Outlook 

The Banking and Insurance Sector is broadly classified under Financial Services. The sector covers banks, non-banking financial corporations, and life and non-life insurance activities. Australia enjoys being one of the largest contestable funds under management country, valued at about $1.3 trillion. Gross Value added (GVA) rose 2.7% in December 2020 quarter, with 17 of 19 industries posted an increase. Financial and Insurance Services grew by 0.4% in the quarter ended December 2020, while it had surged 2.9% on a YoY basis. The financial sector growth reflects an increase in deposit balances by households, rise in housing loan driven by housing market activity over the second half of 2020, among other factors.

Figure 1. 5-Year Trend Showing GDP Growth vs Financial Services:

Data Source: Australian Bureau of Statistics, Chart Created by Kalkine Group

On 3 November 2020, the Reserve Bank of Australia decreased the official cash rate to 0.1%, following a 25 bps cut on 19 March 2020, to benefit loan takers, and priority sectors, including the housing sector. As a base case, the Central Bank predicts Gross Domestic Product (GDP) to grow ~6% by June 2021 and a further 4% in 2022.

Wholesale debt costs and retail and wholesale deposit rates decreased to historically low levels led by a decline in the cash rate. As a result, banks have started funding from deposits, which increased substantially over 2020. Excluding equity, approximately two-thirds of the major banks' funding came from deposits. This also resulted in the fall of overall debt funding costs by a similar amount to the cash rate.

Figure 2. Change in Cash Rate to Cash Market Transaction: At All-Time Low Levels

Data Source: The Reserve Bank of Australia, Chart Created by Kalkine Group

Cash rates provided substantial liquidity to banks

The cash market is a short credit for overnight unsecured loan facilities between banks. The rate applicable to these loans is the cash rate set by RBA, which is an important financial benchmark for cash requirements for banks to cover their statutory obligations set by RBA. As per Figure 3, it is evident that there is a significant fall in volume for cash transactions within banks. As per RBA, till 23 March 2021, the average quarterly cash transaction has come down to $11,320 million in Q1CY2021 from the pre-COVID level of $76,229 million in Q1CY2020. However, there was a marginal jump in average quarterly cash transaction of $16,727 million in Q4CY2020. This trend indicates that the requirement for cash by the banks was low during post-COVID duration versus pre-COVID level, due to a change in cash rates.

Figure 3. Trend in Volume of Cash Market Transaction: Indicating Sufficient Liquidity with Banks to Cover Loans demand

Data Source: Reserve Bank of Australia, Chart Created by Kalkine Group

Stimulus to Small Businesses in Australia

With a marginal recovery in broader sectors, the conditions for small businesses in Australia have also improved in the second half of 2020. Contrary to the early stages of the pandemic, the government has floated multiple policies to support the provision of credit to small businesses. However, these loan supports were being provided with tight security and for short terms. As per the survey conducted by The Australian Bureau of Statistics in February 2021, approximately a quarter (in August 2020 the share was approximately two-thirds) of small businesses stated that economic uncertainty is driving the need for capital expenditure. The Government allotted a $15 billion Structured Finance Support Fund for the enhancement of private sector investments in debt issued by smaller banks and non-banks.

The Australian Prudential Regulation Authority (APRA) has published the December 2020 quarter Authorised Deposit-taking Institution (ADI) performance and the quarterly Authorised Deposit-taking Institution property exposures publications. The quarterly ADI performance includes financial performance, financial position, capital adequacy, asset quality, liquidity, and key financial performance ratios.

Figure 4: Key Statistics on ADIs for December 2020 versus December 2019

Data Source: Australian Prudential Regulation Authority, Table Created by Kalkine Group

Australia has an established, well-regulated, and highly competitive insurance sector. It caters through three verticals – Life insurance, Health insurance, and General Insurance by industry leader including brokers (AON, Marsh, Willis, JLT), underwriters (Allianz, BUPA, Zurich, AMP, AXA, Tower, MetLife) and reinsurers (General Re, Munich Re and Swiss Re)

The life insurance business is in the turbulence phase

As per the report by APRA for companies in life insurance, for December ending FY21, total revenue dropped phenomenally by 68.9% to $13.3 billion versus $42.7 billion in 2019 as a result of the market volatility impacts of COVID-19. This led to an investment loss of $2.3 billion for FY20 vs. $24.6 billion profit for FY19. Return on net assets was reported at (0.4%) vs. (1.2%) in the corresponding period last year. The industry Prescribed Capital Amount coverage ratio (PCA) increased from 1.66x to 1.80x in 2019 led by adding of capital for the new capital framework that came into effect on 1 October 2020 and the fall in the asset risk charge due to de-risking of investment portfolios.

Data Source: Australian Prudential Regulation Authority, Chart Created by Kalkine Group

Index Performance:

The ASX 200 Banks (Industry Group) Index generated a 1-year return of ~52.36% as compared to ~35.86% by the ASX 200 Index. Strong reach in credit requirements, favourable lending practices, supporting RBA monetary policies and government stimulus are some of the drivers that helped to post sector gains.

Figure 6: The ASX Banks (Industry Group) outperformed ASX 200 Index by whooping ~16.50% in one year period:

Source: Refinitiv (Thomson Reuters) as on the close of 25 March 2021

Key Risks and Challenges:

Effective risk management is a crucial element in the Banking industry to achieve its strategic objectives and meeting its policy responsibilities. The first and foremost risk is the rising complexity in matching regulatory frameworks. Banks are open to an array of macro and microeconomic risks, which includes trade tensions, political upbeat, falling customer confidence in the financial system, increased cyber risks, operational risk, exchange risk, financial instrument portfolio risk, interest rate risk, and much more. Any economic disruption from COVID-19 gets worse or lasts longer than government expectation, will impact the economic recovery in 2021

Figure 7. Key Risks in the Banking and Insurance Industry:

Outlook:

The government of Australia has decided to purchase $100 billion of government bonds with maturities of ~5 to 10 years. Further, it has also decided to purchase an additional $100 billion of government bonds when the existing bond purchase program is completed in mid-April 2021 at the same rate. The government announced its Term Funding Facility (TFF) on 19 March 2020, and an increase and extension of the TFF were announced on 1 September 2020. The Reserve Bank injected additional liquidity into the financial system through its daily market operations. These decisions support the economy through the normal transmission mechanisms of monetary policy, including lower borrowing costs, a lower exchange rate than otherwise, and higher asset prices. In its central scenario, the central bank predicts GDP to grow by ~6% by June 2021 and by a further 4% in 2022.

II. Investment theme and stocks under discussion (IAG, KSL, BEN, QBE)

After understanding the sector, let us now look at four companies listed on the ASX. The price potential of the companies under discussion has been analysed based on the ‘Price/Book Value’ method.

1. ASX: IAG (Insurance Australia Group Limited)

(Recommendation: Buy, Potential Upside: Low Double Digit, Mcap: A$11.93 Billion)

IAG is a general insurance company with operations in Australia, New Zealand, and Asia. It provides a personal and commercial insurance product, primarily motor vehicle and home insurance.

Valuation

Our illustrative valuation model suggests that stock has a potential upside of 26.89% on 25 March 2021. We believe that the stock might trade at a premium as compared to its peer median Price/Book Value (NTM Trading multiple) given the resilient business performance and strong capitalization. The company able to increase rates in its long-tail products and achieved favourable performance in all loan segments. For the said purposes, we have taken peers such as Credit Corp Group Ltd. (ASX: CCP), AUB Group Ltd. (ASX: AUB), Pendal Group Ltd. (ASX: PDL). The stock delivered annualized dividend yield of 3.54%.

2. ASX: KSL (Kina Securities Limited)

(Recommendation: Speculative Buy, Potential Upside: Low Double Digit, Mcap: A$271.50 Million)

KSL, a Papua New Guinea-based company provides share brokerage, fund administration, investment management services, asset financing services.

Valuation

Our illustrative valuation model suggests that stock has a potential upside of 30.18% on 25 March 2021. We believe that the stock might trade at a discount as compared to its peer median Price/Book Value (NTM Trading multiple) citing the severe deterioration in asset quality following the acquisition of ANZ’s retail and SME business. Although the company is actively investing in risk mitigation strategies, but the upside is capped due to high portion of non-performing assets in total advances. For the said purposes, we have taken peers such as Pacific Current Group Ltd. (ASX: PAC), Bendigo and Adelaide Bank Ltd. (ASX: BEN), Humm Group Ltd. (ASX: HUM). The stock delivered annualized dividend yield of 8.99%.

3. ASX: BEN (Bendigo and Adelaide Bank Limited)

 (Recommendation: Hold, Potential Upside: Low Double Digit, Mcap: A$5.10 Billion)

BEN is a provider of banking and financial services, such as retail banking, mortgage distribution, business banking and commercial finance, treasury, and foreign exchange services.

Valuation

Our illustrative valuation model suggests that stock has a potential upside of 16.85% on 25 March 2021. We believe that the stock might trade at a premium as compared to its peer average Price/Book Value (NTM Trading multiple) citing the key investment risks as the company’s investment income is correlated to monetary policy announcement by the Reserve Bank of Australia. Declining bond yields have a direct impact on profitability. For the said purposes, we have taken peers such as Bank of Queensland Ltd. (ASX: BOQ), Suncorp Group Ltd. (ASX: SUN), Australia and New Zealand Banking Group Ltd. (ASX: ANZ). The stock delivered annualized dividend yield of 2.90%.

4. ASX: QBE (QBE Insurance Group Limited)

(Recommendation: Hold, Potential Upside: Low Double Digit, Mcap: A$14.22 Billion)

QBE is engaged in the underwriting of general insurance and reinsurance risks and manages Lloyd’s syndicates and investments. 

Valuation

Our illustrative valuation model suggests that stock has a potential upside of 17.00% on 25 March 2021. We believe that the stock might trade at a slight discount as compared to its peer median Price/Book Value (NTM Trading multiple) citing the impact of low-interest environment on the company’s profitability. The natural catastrophes have direct impact on performance and capitalisation requirements. For the said purposes, we have taken peers such as Australia and New Zealand Banking Group Ltd. (ASX: ANZ), National Australia Bank Ltd. (ASX: NAB), Westpac Banking Corp. (ASX: WBC). The stock delivered annualized dividend yield of 3.25%. 

Note: All the recommendations and the calculations are based on the closing price of 25 March 2021. The financial information has been retrieved from the respective company’s website and Refinitiv (Thomson Reuters).

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