This article has been written by an expert contributor Tom Wegner from Marcus Today
In a slowing growth, high inflation, and turbulent macro environment it is difficult to pick stocks. One that has managed to weather those headwinds with relative grace for a few reasons is Challenger (CGF).
CGF is an Australian based investment management company with a vision to help its customers achieve financial security for their retirement. Its annuities business is well integrated into the Australian financial landscape. 91% of its revenue comes from its Life segment (annuities), which claims the title of Australia’s largest provider of annuities.
9% of its revenue is attributed to its Funds Management segment which has more than $100bn under its stewardship. It also operates a banking segment which it acquired at the end of 2020 and is expected to start ramping up lending to SMEs and certain non-retail entities in the fourth quarter of 2022.
Challenger recently upgraded profit guidance citing benefits from its diversification strategy which included a jump in institutional and retail annuity sales. Now sees FY22 normalised net profit before tax towards the upper end of its $430m to $480m guidance range. To put the upgrade into context, this time last year CGF actually downgraded guidance due to shrinking credit spreads. Exactly the opposite of what is happening now.
The major tailwind for the business at the moment is the shift in monetary policy and the outlook for higher interest rates. The attractiveness of its annuity products improves in a higher interest rate environment as the yield they can offer on their annuity products also improves. On May 5, Challenger’s three-year term annuity will earn customers 3.75% guaranteed, which compares to 1.4% a year ago.
The other slow-burn driver for the business is the aging population in Australia and Japan. Its partnership with MS Primary allows the firm to sell Australian and USD-denominated annuities in Japan. The ‘latest’ research from the ABS which is a little dated (8/05/2020) revealed 500,000 Australians intended to retire in the next five years and they all need some form of income. In Japan, which is described as having a ‘super aging’ population, that figure is much higher.
What are the risks?
Challenger makes the majority of its money by offering an income stream for retirees, talking their money, investing it, and achieving a greater rate of return than what they have to pay back as an annuity stream. The main risk is that because they guarantee a specific return, they must achieve higher investment returns or risk losing money given its liabilities are relatively fixed and fairly large. Any shortfalls have to be made by shareholders. The implication is that in times of hardship and low investment returns, there is a risk of capital raisings which can dilute shareholder equity, write-downs and capital erosion. Given its mandate and requirement for lower-risk assets, its portfolio is skewed to fixed-income investments.
What are the tailwinds?
Several long-term tailwinds are helping guide the business to greener pastures. The biggest one is the higher interest rate environment as mentioned above. Widening credit spreads will also see a positive impact on future margins over the longer term.
The super system in Australia is also set to triple over the next two decades, with $70bn moving from accumulation to retirement each year. More Australians are retiring with more money and for longer and they all need income. There is also a proposal in Australia’s new retirement legislation that would require superannuation trustees to offer a comprehensive income product for retirement by the first of July this year. Some see that as a convenient reason Challenger could see a bump in annuity sales in the near term.
Technical view
The share price is up more than 48% in the last 12 months, outperforming the ASX 200 which is down 1.9% over the same period. Challenger has responded well to recent updates which bodes well for its upcoming investor day on May 24th. The bulls were able to convincingly break through the 700c level after the well-received third-quarter update. This will continue to be a key level for the share price in the near term.
Management
Nick Hamilton was appointed MD and CEO in December last year but has been with the business since 2015. He managed the funds management business through a period of exceptional growth and performance. A proven track record of leadership and driving innovation according to the Chairman.
Conclusion
While challenger is undeniably influenced by movements in interest rates, that dynamic has now shifted into a positive for the business. A stark contrast to this time last year when credit speeds were shrinking and the yield on its products was unattractive. Upgraded guidance, higher annuity sales and progress on its diversification strategy have been supporting the share price in the near term and offer upside risk heading into its investor day on May 24. Challenger has a proven management team that has many years of experience growing annuity sales and growing the business. The banking arm the most recent offshoot of its diversification strategy which broadens its customer reach, helps lock in legacy business as well as dips its toes in the significant term deposit market. Superannuation system growth, intergenerational wealth transfer and widening credit spreads are the long-term drivers for the business that should underpin confidence and outweigh the risks of competition, and investment risk from guaranteed annuity returns. Challenger is unlikely to be attractive for investors looking for big capital growth opportunities but, it is likely to suit investors with an appetite for low volatility, income and leverage to big macro themes.
More about the author – Tom Wegner. Tom has been working at Marcus Today Stock Market Newsletter since 2016. He graduated from Monash University and is the author of the much-loved BUY HOLD SELL section of the newsletter. Tom has a natural curiosity in financial markets and is passionate about helping his peers become better investors. You can sign up for a free trial here.
Prior to making an investment decision, retail investors should seek advice from their financial adviser. This document is intended as general information only.