Good afternoon,

It’s a market holiday today (even though Victoria and I didn’t realise!) so I get to tap out a weekly note in peace and quiet. As to the close on Friday, ASX200 was up 0.33% and still trading roughly around the 6000 points mark.

Lots of specific things to discuss this week so I’ll keep the general market stuff to a minimum. Resources earnings estimates are up 6% on 3 months ago, whilst sales forecasts largely remain unchanged, implying analysts feel they may have underestimated resource company cost cutting. Whilst the rest of the market has seen a 1.7% fall in earnings & sales forecasts for the next 12 months, putting those industrial names on 15.8x forward earnings.

Gage Roads Brewing (GRB) Acquire Matso’s

My favourite listed beer brewer, Gage Roads, have raised $10m and bought 100% of Matso’s Broome Brewing Pty Ltd for $13.25m (+$2.8m in performance cash and script). This is a very smart little buy for GRB as Matso’s products are non-competitive (they make mango & ginger beers… which are bloody delicious by the way!), on brand (proudly Western Australian, boutique, artisan etc.) and strategic with alcoholic ginger beer as a category growing at 13% per annum.

The buy is an immediate 20% earnings boost to GRB and offers them the opportunity to market Matso’s through the now established east coast distribution network. GRB already produce Matso’s product under contract so it’s a very low risk purchase for them from an operational perspective.

Most importantly from an investors’ perspective, this portfolio improvement only adds to the scale & value of Gage Roads and takes it a step close to being taken over by a multinational beverage company.

Last trade 9.1c

We need to have a chat about bank shares

Bank shares have been a fantastic generator of client wealth over the last 20 years, with all but NAB outperforming the ASX200 Accumulation Index when dividends have been reinvested.

However, it’s become clear to me that this 25 year run is over. I’ll try my best to explain the 4 main data points that support my perspective.

A) Loan growth is slowing

This is a function of a bunch of things but keeping it short and sweet

1. Regulation #1: banks are, as of recently, limited in how much they can lend investors, how much interest only loans they can have on their books.

2. Regulation #2: greater scrutiny on lending practices. Improved serviceability requirements means lending less money to less people.
(see below chart of decline in high LVR loan approvals recently.)

3. Economics: No wage growth = lower capacity to borrow and because of regulation #2, less likely to get a loan than before. Wage growth down sub-2% nominal, which is near enough 0% once you account for inflation.

4. Economics: Maxed out debt for current wages level already! You can’t borrow any more against existing assets base when your debt to income ratio is at all time highs, well over 120%.

5. Economics: House prices are going down. So you can’t rely on equity accumulating in your home any further (as there’s no one who can afford to buy it off you!, see points 1-4. This is both a cause and a symptom.

B) Credit Quality
High house prices, high debt and high pressure on household cash flow means house prices are likely to continue to fall. Houses are where we store the majority of our wealth, so a decline in house prices will drive softer economic conditions through reduced confidence, reduced spending which puts further pressure on wages (if you don’t quite understand this, watch the video from Ray Dalio I included in this note 2 weeks ago.)

This will negatively impact banks in 2 ways

  • Reduced demand for loans and,
  • Increased expense from bad debts.

Almost all the brokers are forecasting an increase in impairment charges as a function of total loans, below chart and forecast from Morgan Stanley.

What does it all mean?
Demand for the banks product is declining, the growth opportunities for banks are limited by the regulator (APRA) and economic conditions that historically have fuelled bank earnings growth appear unlikely to unfold in the near term.

Further to this, the cost of running a bank is likely to increase as a function of these economic conditions, the resultant competition between banks and the increased cost of regulation.

All in all I expect margins to decline, profits to stall and dividend cuts to be more likely. Profits and dividends will be more susceptible to unseen and unexpected externalities.

As an investor in the banks, you should expect nothing more than 6% dividend yield (8% grossed up) in income and below-market total returns.

I expect banks to be more susceptible to negative, external events relative to history, as steady earnings growth no longer insulates their business. Shareholders should prepare themselves for heightened volatility in their total returns (dividends + capital).

Banks Continued – Advanced Discussion
(if you’re not financially literate, this might be too much for you)

The other thing that I’ve got a huge please explain on (which Credit Suisse raised recently in a note) is the spread on interbank credit. Normally these spreads get wide when there is “risk” (think blowout in CDS spreads, high vol, yield curve steepens etc).

Credit Suisse reckons it could be a result of excessive credit growth in the economy. It’s a worry because credit quality is hard to measure, particularly given the Royal Commission found that lending standards have been pretty poor over the last few years. Essentially, the inter bank credit spread is pricing this increased risk from the high volume of poor quality credit sloshing around in our banks. The takeaways being:

  • There is an increased possibility of out of cycle interest rate hikes and without adequate wage inflation or economic growth to support it, may also further negatively impact households.
  • It also means banks are likely to be looking at how and who they lend money to very closely. Spreads have historically been an excellent forward predictor of loan approvals (all of which supports the above thesis on banks).

Movers & Shakers

Big week for everyone’s favourite aerial imaging company, Nearmap (NEA), +14% after presenting at the Macquarie conference. Appen (APX) was included in the ASX200 whilst Nanosonics (NAN) copped price target and rating upgrade from their broker Bell Potter.

Retail Food Group (RFG)… what can you say. Kogan (KGN) coming down to earth after the founders botched a share sale attempt. Ainsworth (AGI) gave an dreaded “trading update” and Inghams (ING) CEO called it a day. Blue Sky (BLA) announced the closure of a hedge fund it managed, the Australian misreported it as closing their ‘private equity business’, BLA had to correct them. Expect BLA will close its hedge fund business all together and exit that asset class. It’s small, doesn’t make much money and the strategy has struggled at staying true to label.

Fastbrick Robotics (FBR)

A quick little note, Fastbrick Robotics (who have re branded to now just be known as FBR) put out an update to the market last week,  you can read it here. Assembled the prototype, are in the final stages of testing the software, mechanical testing has commenced. All sounds like things are going to plan.

Have a good week,
The information contained in this email is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser.