It has been a wild ride in the Australian sharemarket this quarter. At one stage in early August, our benchmark S&P/ASX 300 Accumulation Index was up almost 5% above its 30 June levels. However, at the time of writing, recent weakness, primarily in the iron-ore-exposed miners, has seen much of these gains erased. Having no exposure to iron ore has been the largest source of the Allan Gray Australia Equity portfolio’s modest outperformance this quarter.
We remain optimistic about our portfolio holdings that have, in aggregate, underperformed our benchmark over the short-to-medium term. For this Quarterly Commentary, Analyst Tim Morrison details our investment thesis for Challenger Limited and the reasons we are attracted to the company.
This is an extract from our September 2021 Quarterly Commentary and you can read the full Quarterly Commentary here.
About Challenger, by Tim Morrison (CFA), Analyst
Challenger Limited is the dominant fixed annuities provider in Australia. It entered the market in 1997 and today it has around an 80% market share.
Before jumping into the company details, it is worthwhile explaining what an annuity is. Fixed annuities are agreements for the issuer (such as Challenger) to pay the purchaser a series of fixed annual payments for either a set term (typically one to five years), or for the remaining life of the purchaser. These payments are in proportion to an upfront contribution by the purchaser, for example:
Challenger might agree to pay a 1.5% per annum annuity payment on an upfront contribution of $100,000 (i.e. $1,500 p.a.), with this upfront contribution being returned at the end of year three. Alternatively, Challenger might agree to pay $6,000 per annum (representing both principal and interest) for the remainder of the purchaser’s life, on an upfront contribution of $100,000.
For the purchaser, the guaranteed fixed income stream can make annuities an important part of their retirement- planning product arsenal. For Challenger, its profit is the difference between the investment returns they achieve by investing the upfront customer contributions and the annuity rates it is contractually bound to pay (plus a significant amount of business operating costs).
Challenger is more like a bank than an insurer: it operates a spread business. The life risk it takes is a small proportion of overall profitability. Challenger also sells some annuity-like institutional index investment products. Collectively, these products make up Challenger’s Life business.
The risk that Challenger assumes is limited to investment risk and life insurance risk, by matching its investment assets with its annuity-holder liabilities. Challenger’s annuity-holder liabilities, and fixed income and property investment assets backing them, have offsetting exposures to changing interest rates. At 30 June 2021, Challenger’s Life business ecosystem is illustrated in Figure 1.
Figure 1 – Challenger’s Life business ecosystem
Source: Challenger Analyst Pack, Allan Gray, as at 30 June 2021.
Challenger has received $18.6 billion (bn) from its annuity purchasers and other lenders. This, together with Life shareholders’ funds of $3.0bn, is invested in a variety of investments. Any returns are used to pay contracted annuity amounts to purchasers, operating expenses and the balance remaining is available for shareholders.
Challenger also owns two funds management businesses: Fidante Partners and Challenger Investment Partners. Fidante Partners ($85bn of underlying assets under management (AUM)) takes a share of the economics of start-up, boutique fund managers in return for distribution, back-office services and working capital. Challenger Investment Partners ($21bn of AUM) invests a significant component of Challenger Life’s fixed income and property investment assets.
Challenger’s share price has fallen significantly in recent years and it is currently less than half of its peak levels of 2017. There are three main reasons for this weakness:
1. Challenger’s profitability on new annuity sales is currently depressed
Credit spreads (the excess corporate credit yield relative to the Government bond yield) and interest rates are well below long-term levels.
The low credit spreads on fixed income investments make it difficult for Challenger to earn a sufficient return on its investment portfolio. This is exacerbated by the low absolute level of interest rates today, which limits Challenger’s ability to offer high (attractive) retail annuity rates and also reduces the income earned on shareholders’ funds.
Challenger’s new business is being written at narrower than average spreads, as it strikes a delicate balance between attracting new annuitants, replacing expiring annuities and maintaining its profitability. This trend is indicatively represented by the size of the gap between the two lines in Graph 1. As the gap narrows, the spread between Challenger’s investment returns and annuity payments falls and profits on new sales are squeezed.
Graph 1: Challenger’s difficult balancing act
Source: Challenger, Bloomberg, as at 23 September 2021.
2. Pro-cyclical decisions in Challenger’s Life business have destroyed real value for shareholders
An inherent weakness in the Life business model exists. Challenger is regulated by APRA and must maintain sufficient levels of capital to honour obligations to annuitants. Assets owned by Challenger have different capital intensities, depending on their assumed risk profile.
When asset prices decline, capital levels fall. In order to maintain suitable regulatory capital buffers, Challenger has historically felt compelled to rotate its investment portfolio out of more risky (capital intensive) assets into less risky (less capital intensive) assets in order to shore up prescribed capital ratios. This is exactly what happened in 2020, following the onset of COVID-19, when Challenger reduced its riskier equities and credit exposures in favour of low-risk cash and equivalents. Table 1 shows the difference in Challenger’s asset allocation between the end of 2019 and the middle of 2020.
Table 1: Challenger’s switch to less risky investments
Source: Challenger Analyst Packs.
We acknowledge that we are far from perfect investors ourselves, but this buy-high, sell-low investment strategy is a recipe for certain value destruction. Total capital losses on Challenger Life’s investments from 1 January 2020 through to 30 June 2021 were $600m, despite asset prices generally rising during that time. Together with a capital raise to plug this hole, this has weighed on investor sentiment.
3. Challenger’s main annuities distribution channel is disrupted
Challenger has a range of distribution channels, namely intermediated advisers to Australian retirees, direct Australian retirees and Australian institutions such as profit-for-member funds. It also has a distribution agreement with MS&AD, a Japanese insurance company and one of Challenger’s largest shareholders. Its largest channel is the financial adviser intermediated channel.
The aftermath of the Royal Commission has seen a 30% reduction in financial advisers and headwinds for sales of new annuities. Despite Challenger having grown its annuity book in recent years, this has shifted to lower margin annuities written for Australian institutions and MS&AD and away from the higher-margin direct and intermediated retail annuities.
It is important to focus on the price you pay
Undeniably, this is all bad for Challenger, but it needs to be considered in tandem with the prevailing share price. Challenger’s market capitalisation is $4.2bn today and investors could be more than compensated in the long term for the prevailing headwinds. There are at least two ways of assessing this.
The first is to focus on earnings. Assuming the current market conditions are permanent, we estimate that Challenger would make $230m in post-tax profits without any adjustment to Challenger’s cost base, which has been built for much higher spreads. At 18.5 times those earnings at today’s share price, Challenger’s earnings multiple is in line with the broader sharemarket. Unlike the broader sharemarket however, these earnings are very depressed and are well below company-guided earnings of approximately $320m for FY22.
The second way is by reference to its asset base. Challenger has $3.2bn in net tangible assets (NTA, primarily the difference between its investment portfolio and total liabilities to annuity and debt holders). Its market capitalisation is 1.3 times this NTA. But Challenger has two significant earnings streams that have very little tangible asset backing.
The first of these is its fast-growing and scalable funds management business, which generated $70m of earnings in FY21. The second is a previously unmentioned UK Life Risk business with actuarial assessed future profits of just over $1bn. Were one to adjust for these, the 1.3 times NTA multiple would fall significantly.
Storm clouds and rainbows
There are risks to an investment in Challenger that cannot be ignored:
- A major credit cycle and/or large declines in asset prices would be very trying, given Challenger’s leverage and its exposure to the level of the market in its funds management business.
- Increased competitive intensity in Australian credit markets and/or Australian life products may eventuate, with the likes of QSuper, Allianz/Pimco and Magellan already positioning themselves accordingly.
- The recently announced retirement of Challenger’s well-respected CEO may be a cause for concern.
But there are also reasons for optimism:
- Credit spreads and interest rates are far below long-term averages and seem more likely to increase than decline from here. With this will come higher ongoing profits, comfortably outweighing any negative investment valuation impacts on this journey. We estimate spreads today are 0.9% below long-term averages, with every 0.1% credit spread increase being worth an extra $11m of ongoing post-tax profit. Ongoing investment returns on shareholders’ funds would also increase with any interest rate rises.
- Challenger should be less pro-cyclical in future. It recently announced it will hold a higher capital buffer than the past, thereby hopefully reducing the need to de-risk its investment portfolio during market This unfortunately comes at the cost of a less-than-ideal, capital-heavy balance sheet, but we believe this is the lesser of the two evils. Also, it has adopted a more conservative investment portfolio allocation currently.
- While distribution within the Australian adviser network may take a while to stabilise, considerable long-term growth potential exists. Challenger Life serves about 1.5% of Australian retirement-phase superannuation assets, which itself had been growing at 10% per annum pre-COVID. Planned regulatory change targeted to take effect on 1 July 2022 will require superannuation trustees to implement a retirement income This may well increase the demand for annuities.
On balance, Challenger appears priced for a continuation of its current operating conditions in perpetuity. We think this is unlikely. We believe conditions are more likely to improve than deteriorate over the long term and any improvement could result in significantly improved earnings. Given this asymmetric payoff profile, we have purchased Challenger to slightly over 2.5% of the Equity portfolio at the time of writing.