Intelligent Investor: Mickey Mordech

Macquarie, known as the “millionaire factory”, has consistently rewarded shareholders as well as employees, but there are challenges on the horizon

The last time Macquarie Group’s shareholders endured a recession, earnings halved and the share price fell 85%. It took six years for earnings to fully recover, and a decade for the share price to follow. The pandemic has panned out differently. Macquarie’s share price still fell 54%, but this time it has only taken a year for it to surpass its all-time high. At least for now, government support has helped borrowers, restored confidence in markets and kept asset prices afloat, which is good news if you’re in the business of packaging up funds, selling home loans and flogging initial public offerings.

In the most recent result, the strongest performer in Macquarie’s stable was its commodities and global markets division, where profit rose 50% to $2.6 billion in the year to March, as clients in the agricultural, resources and energy sectors ramped up hedging activity in response to market volatility. Oil, gas and metals clients also sought more storage solutions to combat unprecedented declines in demand.

Macquarie’s other large division – asset management – saw profits hold up well, falling just 5% to $2.1 billion. This lines up with a decline of 6% in average assets under management, itself caused by the full-year impact of 2020 withdrawals, a stronger Australian dollar (which makes its foreign assets relatively less valuable) and the realisation of profits on assets within its fund.

The banking and financial services division recorded a $770 million profit, in line with 2020, although there were encouraging signs: the loan portfolio grew by 24% and the business continues to take market share from the big four banks in home loans. Meanwhile, investment bank Macquarie Capital saw profit fall 15% to $650 million as investment-related income fell and lower merger and acquisition income was offset by more capital raisings.

The end result was a 10% rise in group profit, taking earnings per share to $8.43 and lowering the priceearnings ratio to around 18.

The company is yet to record a loss in its 52 years and while earnings have been lumpy and dependent on the economy, on average they’ve trended steadily higher (per-share earnings grew 9% annually and dividends 8% over the past 20 years).

If we assume the current 3.6% dividend yield is sustainable and that dividends will keep rising by 8% each year, at today’s prices an 11% or 12% long-run return might be achievable.

But can Macquarie keep it up?

The affirming argument might go like this. Its perceived prestige – and reputation as the “millionaire factory” – attracts a pool of talented and determined candidates from which it picks the best. Combined with savvy and well-connected directors, a wealth of global relationships and a brand that opens doors, good ideas come to fruition quickly.

The result is an entrepreneurial culture where promising new ventures are given every chance to flourish; it’s how Macquarie has established profitable niches in everything from used phones to renewable energy. As former chief executive Nicholas Moore put it in 2011: “As far as the Macquarie model is concerned, it continues to be driven not so much by a single industry focus

or a single product focus, but by a culture of always trying to find something that the market is missing and providing that on a medium- to long-term basis.”

Macquarie also has strong positions in sustainable growth markets. Asset managers tend to benefit as markets compound higher and the company is rapidly taking share in Australian home loans.

We expect these forces to continue, allowing Macquarie to diversify earnings and keep growing. Better still, the company’s head count has barely changed since 2011, so expenses aren’t growing as quickly.

On the other hand, Macquarie is much bigger now, so new ventures need to be larger to move the needle. It’s hard enough to find small profitable niches; how many global opportunities can it identify and succeed in?

Macquarie’s prospects also remain tied to the health of the global economy and financial markets. With international interests spanning asset management, home loans, investment banking and commodities trading, today’s earnings may not be as sustainable as they seem if all of this freshly issued debt comes back to bite.

In addition, parts of the business – like commodities and global markets – are opaque, which makes it difficult to quantify risks or judge the sustainability of profits. We’re not privy to all the risks stemming from entering derivatives, selling financial protection and making markets, but history shows counterparties can fail and rogue traders have wiped out big banks. Macquarie can mitigate these risks but not completely eliminate them.

Balancing these two arguments, Macquarie’s historical 8% annual growth is probably closer to a best case. Something around 5% should be achievable (which also aligns with today’s payout ratio of around two-thirds and a return on equity of 14%).

Our new buy price, therefore, settles at $110, which is a starting dividend yield of about 5% (and assumes we’d be seeking a double-digit return before upgrading). A quick sanity check shows that any time you bought the stock on a 5% yield, you made a return better than 9% (including just before the GFC in 2007, assuming you held until now). But usually it was far better than that. With the share price now square between the two, hold.

Mickey Mordech is an analyst at Intelligent Investor. Disclosure: The Intelligent Investor Equity Income fund owns Macquarie.