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MacquarieInside a Strong Buy

a compIlatIon of research on macQUarIe GroUp | PuBliShed deCeMBeR 2011

Intelligent Investor

2

Dear Intelligent Investor,

Nine years ago in a special report titled Macquarie Bank—A rare opportunity, we explained why Macquarie

Bank was our third ever Strong Buy recommendation.

From the initial upgrade at $20.39 on 18 Oct 2002, the share price eventually peaked at $98.64 in

May 2007. Had we not missed the opportunity to sell, including dividends it would have been a ‘5-bagger’.

As the GFC deepened the share price collapsed to $15.00 in March 2009 before rebounding to $58.80

in September 2009. It’s been a wild ride.

More recently, with corporate deals drying up, volatile markets producing a climate of fear, the impending

introduction of more onerous regulatory capital standards and the great deleveraging reducing demand for

debt, investment banks are amongst this year’s worst performers on global sharemarkets.

It’s an embarrassing fall from grace for a group heralded as masters of the universe during the boom.

Macquarie’s return on equity has now fallen from well over 20% to single digits and, as I write, the share

price is $22. Though profits and dividends will fall in 2012, a price-to-earnings ratio of 8, a 29% discount

to net tangible assets of $31 and an unfranked dividend yield of 7.5%, the market expects that Macquarie

is on its way out backwards.We’re not of that view. Macquarie’s balance sheet is in good shape, corporate activity will eventually

increase (though not to pre-GFC levels) and large investments in recurring revenue divisions, including funds

management and corporate leasing and lending, are starting to pay off.

With its problems mostly temporary, the low share price means Macquarie Group is only our tenth-ever

Strong Buy recommendation in 12 years.

Before deciding to act on it, please take the time to read and consider the detailed research enclosed.

It features seven full reviews, including an Investor’s College on portfolio allocation (replete with another

recommendation), a three-part series explaining Macquarie’s business and the most recent research describing

the current opportunity.There are two possible ways to read the report. From the front, with the most recent review first, or from

the back, which will give you a chronological picture of how the opportunity has unfolded.

There are no guarantees in investing, so please adhere to the portfolio limits and understand that in the

short term at least, Macquarie’s share price may fall further.

But if you’re prepared to accept the risk of owning an investment bank and want to add a high quality

blue chip to a diversified portfolio at a very attractive price, we commend Macquarie to you.

Yours sincerely,

Nathan Bell Research Director

CONTENTs pagE

Macquarie interim: Good, bad, ugly 3Macquarie Pt 3: Inside a Strong Buy 5Macquarie Pt 2: Inside a Strong Buy 7Macquarie Pt 1: Inside a Strong Buy 9Banking on Macquarie 12Weighing up Macquarie Group 14Why Strong Buy doesn’t mean load up 16

Special report | Macquarie: Inside a Strong Buy

3

Nathan Bell, CFA | First published 3 Nov 2011

Macquarie interim: Good, bad, ugly

Macquarie’s trading profits have suffered. But good results elsewhere augur well for this leading buy recommendation.

With Goldman Sachs recently reporting only its second quarterly loss since listing in 1999, the writing was on the wall for Macquarie Group shareholders. Goldman’s revenue fell by a breathtaking 60%, as the European banking crisis wreaked havoc on financial markets.

So Macquarie’s 2012 first half results were never going to impress. The company’s trading divisions were clobbered, with overall trading income falling 38% from what were already depressed levels. Compared to the same period last year, group operating income for the six months to 30 September was down 11% to $3,243m.

Operating expenses were also down 11% to $2,828m but net profit dropped 24% to $305m. Plug in the numbers and that’s an annualised return on equity (ROE) of 5.7%. This paltry figure confirms the theses outlined on 19 Oct 11 in Macquarie Pt 2: Inside a Strong Buy. Macquarie’s ROE signifies this is now a normal, rather than an exceptional, banking business.

With earnings per share falling 27% to 87 cents, the interim dividend was also cut, from 86 to 65 cents (unfranked, ex date 7 Nov). At current prices, Macquarie still yields 5.9% if the company can manage a 75—cent final dividend. That would be down from one dollar in 2011.

The bad news continued in Macquarie’s three trading businesses (see Macquarie Pt 1: Inside a Strong Buy from 12 Oct 11 (Buy—$24.89)). Macquarie Securities suffered a loss of $19m, Macquarie Capital earned $5m and Fixed Income, Currencies and Commodities $6m. All up, a net loss of $8m was incurred from these three businesses.

poor result

While phones on the equity desks ceased to ring, depressing brokerage and commissions, it was the upheaval on fixed income and currency markets, together with lower corporate activity, that sealed the poor result.

The value of Macquarie’s average advisory deals also halved, suggesting large companies are unwilling to part with their record cash piles in light of the uncertain economic outlook.

And finally, after 36 years with the company, deputy managing director and chief executive officer Richard Sheppard is retiring in December. He’ll be replaced by chief financial officer Greg Ward. Ward knows the company inside out but it’s unnerving to see such an experienced executive depart in the midst of a rapid business expansion.

That’s the bad and the ugly news. What about the good?Net profit for Macquarie Funds almost doubled to $410m, a combination of staff cuts and

the US managed fund business Delaware contributing a full year’s profit. That’s increased our confidence that the low ball valuation estimate for this division of $4.8bn, laid out in Macquarie Pt 3: Inside a Strong Buy from 25 Oct 11 (Buy—$23.34), is quite conservative.

Following several acquisitions, the Corporate and Asset Finance division produced a $358m net profit, up from $246m. As discussed on 12 Oct 11, this division, together with the Macquarie Funds business, could alone be worth more than Macquarie’s current market capitalisation.

Macquarie has also taken baby steps to cut staff numbers, by far the company’s largest expense. However, chief executive Nicholas Moore faces a difficult balancing act between protecting profit margins and maintaining an incentivised global workforce, the company’s greatest asset. It won’t be easy.

Key poInts

Return on equity falling to more normal levels, as predicted

Trading businesses struggling but funds management going well

Buyback adds shareholder value, sticking with Buy

macQUarIe GroUp | MQG

prIce at revIew $23.62

revIew date 03 Nov 2011

marKet cap. $7.9bn

12 mth prIce ranGe $20.24 —$41.78

BUsIness rIsK Med-High

share prIce rIsK Med-High

max. portfolIo weIGhtInG 5%

oUr vIew BUy

Intelligent Investor

4

Subject to regulatory approval, Macquarie will also initiate an on-market share buyback for up to 10% of shares on issue. At current prices that would add plenty of value for shareholders without compromising the company’s strong financial position or its ability to meet new regulatory capital rules.

taBle 1: mQG’s Income statement Key drIvers

1h12 $am 2h11$am 1h11 $am

net Interest Income 698 670 605

fee and commIssIon Income 1,766 1,896 1,995

tradInG Income 374 762 606

eQUIty accoUnted GaIns/(losses) 49 94 85

eQUIty Investment ImpaIrments (39) (77) (53)

loan ImpaIrments (66) (51) (77)

other Income 461 675 405

operatInG Income Before lIsted fUnd InItIatIves 3,243 3,969 3,566

GaIns from lIsted fUnd InItIatIves — 14 95

total operatInG Income 3,243 3,983 3,661

total operatInG expenses (2,828) (3,208) (3,165)

net profIt Before tax and mInorItIes 415 775 496

Income tax expense (107) (197) (85)

non-controllInG Interests (3) (25) (8)

net profIt after tax 305 553 403

Source: Table recreated from MQG Half year results, Sep 11

Still, without a rapid improvement in market sentiment, which seems some way off, Macquarie’s full year result will probably fall short of the $956m earned in 2011.

That doesn’t change our view, though. After years of investment, Macquarie’s more predictable businesses are starting to bear fruit. And when markets finally settle, an upswing in the trading businesses should see earnings and dividends increase considerably. BuY.

Note: The model Growth portfolio owns shares in Macquarie Group.

Disclosure: The author, Nathan Bell, owns shares in Macquarie Group, as do other staff members.

ntrac

Special report | Macquarie: Inside a Strong Buy

5

Nathan Bell, CFA | First published 25 Oct 2011

Part 3

Macquarie: Inside a Strong Buy

it’s a highly leveraged investment bank full of unknowns. So how on earth do you value it? Nathan Bell points the way.

Macquarie Group manages $154bn of assets, excluding $306bn of funds under management. It has 15,500 staff scattered across scores of countries. The company doesn’t split out all of its assets and even if it did, we wouldn’t be able to analyse them all.

How does one value such a beast?Discounting the company’s cashflows—a traditional method—is problematic because

these fluctuate with unpredictable markets. Historical comparisons are also unreliable. Macquarie’s 20%—plus returns on equity from the previous decade are history, literally (see Macquarie Pt 2: Inside a strong buy from 19 Oct 11).

One could value each division separately. But then some divisions would be worth less outside the Macquarie empire. Also, reported results exclude a share of Macquarie’s $1.4bn of corporate costs, which includes salaries for the risk management boffins and accountants. How would one allocate these?

There aren’t any direct comparisons with Macquarie, either. Those that have tried to copy the Macquarie model have invariably failed and it’s a model in transition anyway.

There really is no perfect way. But if we try to measure potential returns through the cycle by estimating a long-run average return on equity, we’ll get close. We can get closer still by valuing Macquarie’s ‘hard’ assets and funds management business separately and then, to build in a margin for error, take a pessimistic approach to the entire valuation.

three case scenario

Table 1 is the modest recovery case, not exactly optimistic but better than the other two. Whilst another credit crisis and large tangible asset write-offs are not part of this scenario, a modest economic recovery and a return of sorts to corporate dealmaking are.

Under these circumstances, return on equity increases steadily from the 8% expected in 2012 to 12% by 2014 and 2015. We also assume Macquarie pays out 50% of its profits as dividends (the lower end of its 50% to 60% target) and that the share price in 2015 is about 1.2 times ‘current’ net tangible assets, or ‘hard’ asset value.

Remember that using a current net asset value is conservative because higher profits would increase Macquarie’s net asset value over time, and potentially expand the multiple to around 1.4.

We’re therefore assuming Macquarie would be trading at slightly above book value, or ‘soft’ asset value, which includes intangible assets such as goodwill (which has roughly doubled since 2009 after a flurry of acquisitions).

Investment banks have historically traded for between two and three times book value. In the aftermath of the GFC, a multiple less than 1.5 is more appropriate (perhaps below one without a modest recovery). But even at $36.72 per share in 2015, Macquarie may well be underpriced if its strategy pays off and the global economy holds together.

If this scenario plays out, it would deliver a total return (capital gains plus unfranked dividends) of 88%, or about 20% per year, at the end of which investors would still own a cheap stock.

still cheap

The pessimistic case (see Table 2) assumes profits remain flat for three years, with return on equity producing higher profits in 2015. Macquarie’s share price in 2015 is equal to one times net tangible assets, meaning the stock would still be trading at a discount to book value. Total returns would be 56%, or 13% per year, a respectable result that still assumes no major disasters or regulatory surprises.

Key poInts

Macquarie is priced for a poor outcome

Even a pessimistic case undervalues the business

Returns from here could reach 20%p.a. over the next 4 years

taBle 1: modest recovery case 2012 2013 2014 2015 mUlt.

roe 8% 10% 12% 12% 1.2

net profIt 955 1,193 1,432 1,432 Share price

eps 2.75 3.44 4.13 4.13 36.72

dps 1.38 1.72 2.06 2.06 Total Return

per 8.5 6.8 5.7 5.7 88%

macQUarIe GroUp | MQG

prIce at revIew $23.34

revIew date 25 Oct 2011

marKet cap. $7.7bn

12 mth prIce ranGe $20.24 —$41.78

BUsIness rIsK Med-High

share prIce rIsK Med-High

max. portfolIo weIGhtInG 5%

oUr vIew BUy

Intelligent Investor

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In the case of a Japanese style deflation (see Table 3), return on equity, profits and Macquarie’s valuation would fall over time. A negative total return of 17% isn’t the very worst-case scenario, either. Capital raisings and other painful surprises are excluded.

If you want to investigate how bad (or good) the various cases look under different scenarios, download this spreadsheet. You could also assign a probability to each scenario to produce a weighted average return.

For example, giving scenario one, two and three a probability of 65%, 20% and 15%, respectively, would produce an average weighted return of 66%, or about 15% per year (.65*.88+.20*.56+.15*—.17).

an alternative valuation

As one last check, let’s take a different valuation methodology by adding Macquarie’s net tangible assets of $10.6bn to the value of its funds management business.

These are typically valued as a percentage of funds under management or a multiple of profit. Actively managed retail equity funds, like those of Platinum Asset Management and Perpetual, produce higher and more reliable management fees, which is why they’re more valuable.

Currently, Platinum is trading at 14% of funds under management, while Perpetual is trading at 4%. Their respective price-to-earnings ratios are around 15.

Macquarie’s funds are best valued as a multiple of profit because, following the $516m acquisition of US manager Delaware (see Chart 1), half its funds are fixed interest investments (Macquarie paid less than half of one percent of funds under management for this business), while the rest are a mixed bag including stocks and infrastructure.

Using a multiple of eight times profit before tax, a conservative assumption if fund inflows eventually increase and Macquarie’s acquisition of Delaware pays dividends, that’s $4.8bn in total.

strong recovery not required

Assuming Macquarie is successful raising more funds in Australia and the US and markets recover, at a multiple of 10 or 12 current earnings, the value of this operation rests somewhere between $6.0bn and $7.2bn. Remember, Macquarie’s entire total market value is currently only $8.1bn.

Let’s be conservative and reduce Macquarie’s hard asset value by 30% from $10.6bn to $7.4bn. Assuming the funds business is valued between $4.8bn and $6.0bn, then Macquarie is worth somewhere between $35 and $39 per share. If the funds business is valued closer to $8bn, then prices beyond $44 per share are quite possible.

This makes the point very nicely. At today’s price, we don’t need to bet on a strong recovery in order to do well. The company could be hit by another banking crisis and new regulatory capital rules may force a capital raising but this isn’t the most likely outcome. A takeover bid is perhaps easier to imagine.

Part 2 (see next page) of this series discussed how Macquarie’s three acquisitions in its Corporate Finance division totalled around $3.5bn. Combine those with even a low value for the company’s funds management division and Macquarie’s current market value is easily reached.

Whilst competitors may be eyeing Macquarie’s assets, they’re going to have to pay a princely price to get them. Company staff own a significant amount of the shares on issue. They won’t be giving it away. If a takeover does proceed, there’s a good chance it will be well above today’s price.

Macquarie boasts a price-to-earnings ratio of 8.2 and an unfranked dividend yield of 8.0%. With it trading well below hard asset value, there are several ways today’s buyer can win.

Morningstar’s US fund manager of the decade, Bruce Berkowitz, has made an all-in bet on US financials. Forced to defend the poor results so far, he said ‘The financials are priced for failure, and that’s how you want to buy them.’

We wholeheartedly agree. Macquarie offers a wide range of potential outcomes, but with the share price falling slightly since Macquarie Pt 2: Inside a strong buy from 19 Oct 11 (Buy—$24.20), it’s priced for failure when all the signs point in the other direction. BuY.

Note: The model Growth portfolio owns shares in Macquarie Group.

Disclosure: The author, Nathan Bell, owns shares in Macquarie Group and Platinum Asset Management, as do other staff members.

taBle 3: Japanese-style deflatIon 2012 2013 2014 2015 mUlt.

roe 8% 6% 5% 5% 0.5

net profIt 955 716 597 597 Share price

eps 2.75 2.06 1.72 1.72 15.30

dps 1.38 1.03 0.86 0.86 Total Return

per 8.5 11.3 13.6 13.6 —17%

Fixed income Direct infrastructure. Equities Cash Direct real estate Currency Other

Source: ASX release, Sep 2011

197

0Mar‘07

Mar‘08

Mar‘09

Mar‘10

Mar‘11

Jun‘11

50

100

150

200

250

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350

$Ab

232 243

326 310 308

chart 1: assets Under mGmt of $a308B

taBle 2: pessImIstIc case 2012 2013 2014 2015 mUlt.

roe 8% 10% 12% 12% 1.2

net profIt 955 955 955 1,193 Share price

eps 2.75 2.75 2.75 3.44 30.60

dps 1.38 1.38 1.38 1.72 Total Return

per 8.5 8.5 8.5 6.8 56%

mQG recommendatIon GUIde

stronG BUy Below $22.00

BUy Up to $26.00

hold Above $30.00

Special report | Macquarie: Inside a Strong Buy

7

Nathan Bell, CFA | First published 19 Oct 2011

Part 2

Macquarie: Inside a Strong Buy

Macquarie is radically changing its business strategy, buying new businesses and expanding offshore. But will it work? Nathan Bell investigates.

The Financial Times put it best. An article on the investment banking industry, titled A sparser future, had this to say:

“Tough new rules, coupled with tightened regulatory scrutiny and increased mistrust on the part of investors, are driving radical changes in business models and behaviour. The masters of the financial universe are scrambling to find new ways of making money against a regulatory and economic backdrop that prevents them from placing the high-risk, high-reward bets of years gone by.”

Macquarie is scrambling in its own particular way. In the first of this three part series we explained how the global financial crisis (GFC) undermined its strategy of using highly leveraged listed funds to generate huge fees. Macquarie has been compelled to adapt.

The FT article provides a graph showing return on equity (ROE) for US and Eurozone banks for the period 2000 to 2010. If one had to choose a single yardstick against which banks could be measured, ROE would be it.

The graph shows how, in the period leading up to the GFC, US banks enjoyed an extended period of ROE well over 15%. Macquarie did even better. In the seven years to 2007 it produced an average ROE of 24.3%, an incredible figure.

Future returns won’t be anything like that. Investment banking is returning to its roots, and historical returns of less than 10% ROE. Why? Because banks themselves are being forced to adapt. The only question is how they’ll reinvent themselves.

Macquarie’s approach has four planks; First, it wants to increase the amount of loans its makes to its customers; Second, it aims to expand overseas through acquisition; Third, it has a strategy of developing businesses with recurring revenues, such as funds management; And finally, it wants to use less leverage because the authorities will eventually compel it to anyway. Let’s examine each plank in turn.

While many banks have cut lending during the GFC, the interest Macquarie earns from making loans has increased 56% since 2008. In a contrarian manner, Macquarie has made acquisitions in areas it knows well.

The Ford and GMAC motor vehicle leasing businesses were purchased for around $1bn each in 2009 and 2010 respectively. Also in 2010, Macquarie acquired a fleet of 44 aircraft from International Lease Finance Corporation at a cost of US$1.6bn. With a fleet of around 170 aircraft, the company is an old hand at complex cross-border aircraft leasing transactions.

But unlike fee and commission-based businesses such as corporate advisory and stockbroking, making loans requires large licks of capital. Corporate loans are also riskier than mortgages, so capital requirements are more onerous, which in part explains why high returns on equity are now highly unlikely.

overseas acquisitions

Macquarie is also expanding overseas (see Chart 1), especially in the highly competitive US investment banking market, dominated by a handful of Wall Street titans. In fact, J.P. Morgan Chase, Bank of America, Citigroup, Goldman Sachs and HSBC account for 96% of US derivatives activity.

Macquarie isn’t aiming to compete directly with them, at least not yet. Instead, it’s taking on smaller, less well-financed investment banks. But the US isn’t Australia, where government and corporate connections are plentiful. Chart 2 (on the next page), shows how deleveraging, fewer deals and intense competition, to say nothing of poor investments, are producing lousy returns. This is far from an easy business.

Key poInts

US expansion is risky

Lower leverage means lower returns on equity

Macquarie remains a Buy

macQUarIe GroUp | MQG

prIce at revIew $24.20

revIew date 19 Oct 2011

marKet cap. $8bn

12 mth prIce ranGe $20.24 —$41.78

BUsIness rIsK Med-High

share prIce rIsK Med-High

max. portfolIo weIGhtInG 5%

oUr vIew BUy

2H09 1H10 2H101H11 2H11

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

Australia Asia Americas Europe,M.East & Africa

Operating income $Am

chart 1: dIversIfIcatIon Income

Intelligent Investor

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Expanding across Asia is no panacea, either, despite success including advising on the $22bn dual listing of the Agricultural Bank of China, the world’s largest initial public offer. The Wall Street titans are well established and better connected. And maintaining Macquarie’s risk culture abroad will be more challenging.

It’s fair to say running a bunch of highly leveraged, locally listed satellite funds that Macquarie could endlessly milk was a far easier and more profitable business than this.

recurring revenues

Macquarie is making more progress in the shift towards generating more recurring revenues. Chart 3 shows the recent change in the split between Macquarie’s annuity (read: reliable) and transactional (read: volatile) revenue.

Selling the listed fund operations removed a reliable source of fees that Macquarie is trying to recoup by acquiring funds management businesses, for example, where rivals Credit Suisse, UBS and Morgan Stanley are strong. Given current low valuations for fund managers—Platinum Asset Management and Perpetual are both on our Buy list—and the prospect of higher inflows (eventually), the timing is cute.

The problem is that Macquarie’s reputation in funds management was tarnished by poor returns during the GFC. Investors haven’t forgotten Macquarie CountryWide (now Charter hall Retail) and Macquarie Office (now Charter hall Office), for example. Again, this change in direction isn’t yet conclusively successful.

reducing leverage

With Macquarie’s net debt-to-equity ratio falling from 568% in 2008 to 263% in 2011, the company’s objectives here are within view. The risk remains significant (this is an investment bank, after all) but assets aren’t valued at boom time prices and deposits have increased from $16bn to $35bn.

Despite the deposit guarantee in Australia falling from $1m to $250,000, deposits are a reliable source of funding and reduce Macquarie’s dependence on short-term overseas wholesale funding (see Chart 4). That makes it a safer proposition.

There are three key points to understand about Macquarie’s financial position. First, lower leverage means the days of 20% plus returns on equity are gone. Returns of 10% to 12% are more likely. The issue of valuation will be discussed in Part 3.

Second, Macquarie’s $3bn of ‘surplus capital’ is a beautiful mirage. That tidy sum will be used to meet higher capital watermarks when Basel III regulations are eventually introduced. APRA, the Australian banking regulator, may also introduce tougher rules of its own, penalising Macquarie compared with offshore rivals, many of which can borrow at rock bottom interest rates.

Third, holding more capital will slow Macquarie’s growth. Whilst the company could reinvest the proceeds from selling its $5.2bn investment portfolio, which includes stakes in listed property group Charter hall, Sydney airport owner MAp Group and oil services company Miclyn express Offshore, this is unlikely.

Fixed income Direct infrastructure. Equities Cash Direct real estate Currency Other

Source: ASX release, Sep 2011

197

0Mar‘07

Mar‘08

Mar‘09

Mar‘10

Mar‘11

Jun‘11

50

100

150

200

250

300

350

$Ab

232 243

326 310 308

chart 2: retUrn of eQUIty (%)

12 mths to 31 Mar ‘10, $A7.0b

Mar ‘10 Mar ‘11

12 mths to 31 Mar ‘11, $A7.6b

Lending, leasing and 27% 27%margin-related incomeInstit. and retail cash equities 16% 16%Equity derivatives 8% 5%Fund management 17% 18%M&A and advisory income 11% 11%Asset and equity investments 8% 9%Commodities, resources and 16% 14%foreign exchange

chart 3: dIversIfIed Income

$0

20

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60

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90$Ab 31 Mar 2010 31 Mar 201130 Sep 2010

Fundingsources

Funding sources

Fundedassets

Fundingsources

Fundedassets

Fundingsources

Fundedassets

7%9%

26%

40%

16%

30%

17%10%

30%7%

31%

17%9%

28%7%

30%

17%9%

33%6%

3%8%

37%

36%

14%

6%10%

36%

31%

13%

St wholesale issued paperOther debt maturing in 12 mthsDepositsDebt maturing beyond 12 mthsEquity

Funded assets

Cash and liquid assetsTrading assetsLoan assets < 1 yearLoan assets > 1 yearEquity investments Value not represented

chart 4: fUnded Balance sheet remaIns stronG

Special report | Macquarie: Inside a Strong Buy

9

volatile profits

Under former chief executive Alan Moss, Macquarie forged a reputation for under-promising and over-delivering. After emptying its hollow logs during the GFC, that’s largely impossible now. The results from this business are now far less predictable.

Operating with less leverage is therefore entirely sensible. Although Macquarie’s financial position is sound, much capital will be tied up in lower return assets in order to meet new regulatory requirements. This is a handbrake on Macquarie’s return on equity, as it is for every other investment bank.

The company’s push into the US is also risky. It may have been sensible buying assets at lower prices after the credit bust but growth in highly competitive western economies is likely to be slow for an extended period.

Plenty of risks remain, which means the argument to buy ultimately comes down to price.With a 21% discount to net tangible assets of $30.60, the return on equity for today’s

buyer is actually a more attractive 11%, especially if we’re at or near a low point in the earnings cycle.

Even a slight hint that Macquarie’s strategy is paying off is likely to produce a much higher share price, which is the issue we’ll explore in the final part of this series. With a share price down 3% since Macquarie Pt 1: Inside a Strong Buy from 12 Oct 11 (Buy—$24.89), Macquarie remains a BuY.

Note: The model Growth portfolio owns shares in Macquarie Group.

Disclosure: The author, Nathan Bell, owns shares in Macquarie Group and Platinum Asset Management, while other staff members own shares in Macquarie Group, Platinum and MAp Group.

Nathan Bell, CFA | First published 19 Oct 2011

Part 1

Macquarie: Inside a Strong Buy

As one of only two recent strong buys, Macquarie deserves a full explanation. in the first of three parts, Nathan Bell lays out the groundwork.

In 1969 merchant bank Hill Samuel Australia, now known as Macquarie Group, opened its doors. It had just three staff. The company now employs over 15,500 people in offices around the globe.

For almost 40 years, the company’s trajectory was resolutely up. In May 2008 the company that was once a very small business produced a very big net profit of $1.9bn. Its share price had peaked at $98.64 a year earlier, valuing the investment bank at $27bn.

Everyone knows what happened next, not least the staff on Macquarie’s trading floor, visible from our new digs in Pitt St Sydney. In less than two years the widely imitated ‘Macquarie model’ was dead.

The global financial crisis made light work of the company’s suite of highly leveraged listed funds. Most were either sold off or expensive management contracts were severed. The fee factory, at least as far as the famous satellites were concerned, became a cottage business.

By 2011 net profit had fallen 50% from its peak. The share price has tumbled 75% from its all time high, including a 32% fall this year.

Despite an 19% discount to net tangible assets (NTA) of $30.60 per share, a price-to-earnings ratio of 8.9 and a 7.4% unfranked dividend yield, the crowd has moved on. After polishing a diamond, the market has found a stone.

Key poInts

Macquarie’s business has changed

Discount to NTA offers more ways to win

Downgraded to Buy

Intelligent Investor

10

different business

In Chaos amid the storm: the upgrades from 5 Aug 11 (Strong Buy—$22.97), Macquarie earned our strongest recommendation, just as it did nine years ago in a special report titled Macquarie Bank-A rare opportunity.

But whilst the share price has returned to levels reached at the time of that report, this is now a vastly different business. The $1.8bn profit in 2008 was an anomaly. Profits aren’t likely to quickly rebound, either, stuck at around $1bn as they are. But as we’ll discover, for today’s buyer to do well they don’t need to.

In this, the first of a three-part series, we’ll analyse Macquarie’s six profit centres. Part 2 explores the company’s current strategy and financial position whilst Part 3 examines the issue of valuation and lays out a road map, a series of waypoints the company needs to pass in order for this investment to work out well.

Let’s start with Macquarie’s equities business.

macquarie securities

‘Esoteric and sometimes dangerous activities are this group’s specialty’ is how we described Macquarie’s cyclical equities division in 2002. Nothing much has changed. Combining stockbroking services with risky trading strategies, this operation enables Macquarie to sell complicated products to other large investors.

Although expanding overseas has helped offset the fall in brokerage and commissions, costs have increased at a time when trading income has fallen. Low volatility (see Chart 1) and lower demand for complex leveraged products (funny, that) have reduced trading opportunities, as has an absence of investment banking deals (see Chart 3).

Around a third of the company’s profits are tied to equity markets, much of that through the equities division. No wonder group profits have tumbled from $1.2bn in 2008 to $175m in 2011. With such variable profits this division could be worth anywhere between $1bn and $3bn, or more in a bull market.

fixed income, commodities & currencies (fIcc)

This division’s name belies its purpose. FICC is a giant, legalised gambling den, financed largely with other people’s money. Allegations that traders ride on the coattails of their client’s transactions aren’t as important to this operation as the big bets on economic announcements, such as changes in official interest rates. This is a business of grand profits and great holes.

Macquarie made hay during the wild fluctuations in bond yields throughout 2009. But with staff numbers increasing from 611 in 2008 to 980 in 2011 during a time of flat profits, either trading profits need to increase or staff numbers will fall. Comparisons are difficult but Macquarie’s average profit per employee appears to lag many of its major rivals.

Helped by acquisitions, profits have been steady since 2008. The FICC division could be worth between $2bn and $4bn.

macquarie funds

Macquarie is possibly Australia’s largest fund manager with more than $300bn of funds under management (see Chart 2). The acquisition of US funds manager Delaware for $516m in 2010 added $151bn of mostly fixed income portfolios, although the average fee margin is lower than for stock portfolios.

Funds management hasn’t been Macquarie’s strong suit but it does help replace the management fees that were lost when the company’s listed funds (Macquarie Infrastructure Group, Macquarie Airports (now MAp Group) and Macquarie CountryWide (now Charter hall Retail), for example) were sold. A rough estimate suggests this division may be worth between $4bn and $6bn.

corporate and asset finance

The corporate lending division specialises in constructing complex loans and leases. Take the book of tax-driven loans for cross-border aircraft leasing for example. It’s incredibly complex, demanding and lucrative work, which is why it’s potentially worth $2bn alone.

With the GMAC and Ford motor vehicle leasing businesses each valued at $1bn when they were acquired in 2009 and 2010 respectively, a valuation of this division could easily exceed $4bn.

In fact, the Macquarie Funds and Corporate and Asset Finance divisions are potentially worth more than Macquarie’s current market value of $7bn, implying today’s buyer is getting the remaining divisions thrown in for free.

Source: Macquarie Group presentation, Sep 11

325.7

(9.6) 6.7 (6.8) 21.0 (26.7)

309.8

A. CMT/CMA conversionB. Asset acquisitionsC. Asset disposalsD. Net inflows and equity movementsE. FX (impact of strengthening AUD)

Mar 10 A B C D E Mar 11300

310

320

330

340$Ab

1

Includes the impact of net inflows/outflows and movements in AUM driven by changes in listed equity prices

1

chart 2: assets Under mGmt of $310Bn

chart 1: aUstralIan eQUIty marKet volatIlIty

S&P/ASX 200 VIX (LHS) All Ords Index - Daily change (%, RHS)

Source: ASX market announcement, Jan 11

60

50

40

30

20

10Jun‘08

Dec‘08

Jun’09

Dec’09

Jun’10

Dec’10

0

0.5

1.0

1.5

2.0

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3.0

macQUarIe GroUp | MQG

prIce at revIew $24.89

revIew date 12 Oct 2011

marKet cap. $8.3bn

12 mth prIce ranGe $20.24 —$41.78

BUsIness rIsK Med-High

share prIce rIsK Med-High

max. portfolIo weIGhtInG 5%

oUr vIew BUy

Special report | Macquarie: Inside a Strong Buy

11

Banking and financial services

This division is a mini-AMP, delivering financial services to individuals and small businesses. Last year, on revenues of $1.5bn it produced a $275m profit before tax, or 22% of Macquarie’s total profit in a year when other divisions suffered enormously.

Net interest income increased from 29% of total revenue in 2008 to 46% in 2011, as Macquarie’s former cash management trust was converted to bank deposits (and therefore brought on to the balance sheet). We’ll explain that further in Part 2 but having more deposits has helped Macquarie’s financial position at a time when it was strained.

A rough estimate of the value of this business would place it somewhere between $1.5bn and $3.0bn.

macquarie capital

During the credit boom Macquarie’s investment banking division produced vast swathes of cash advising on mergers and acquisitions, recapitalisations, rights issues, restructuring debt and raising capital for governments and companies.

Chart 3 shows how the flood has become a famine. Macquarie has also lost market share, a potential sign that there’s a ‘brain drain’ effect. The company’s smartest employees may be leaving for its competitors.

The colossal $3.3bn profit recorded in 2008 was, to a large extent, a function of the fees gouged from its former suite of listed satellite funds, all loaded to the gills with debt. Related party deals used to make up 50% of revenue. Now it’s more like 15%, a figure that contains the story of the decline of the Macquarie model.

With US rival Goldman Sachs widely tipped to report a loss for the quarter ending 30 September, Macquarie’s profits could fall further. In the event they fall to, say, $100m, a conservative valuation might suggest this business is still worth $1bn, though this is arguably the most difficult division to value. Interestingly, Macquarie’s current share price implies this division will never make another dollar of profit, an implausible scenario in our view given the relationships Macquarie has forged over four decades.

Having sold most of its listed funds and their lucrative management contracts, and with around a third of Macquarie’s profits tied to equity markets, the demise of the Macquarie model has been exacerbated by a deep cyclical downturn.

As we’ll explain in Part 2, Macquarie is now a typical investment bank. Profits will be more cyclical and, because it relies more heavily on lending its own money, it’s more risky, too.

Best opportunity

We have reduced the prices in the recommendation guide to reflect a drawn-out global economic recovery. Although two divisions alone are worth more than Macquarie’s current market value, we are downgrading a notch to BuY following an 8% increase in the share price since 9 Sep 11 (Strong Buy—$23.20).

Parts 2 and 3 of this series will tease out the case. Macquarie Group is one of the best opportunities we’ve found in years. If you haven’t yet taken advantage of it, what follows will offer you all the information you need to do so. If you have, it may well reassure you that you’ve made the right decision or perhaps convince you to buy a little more (but please note the portfolio limit).

Note: The model Growth portfolio owns shares in Macquarie Group.

Disclosure: The author, Nathan Bell, owns shares in Macquarie Group, while other staff members own shares in Macquarie Group and MAp Group.

chart 31

M&A completed 5 year quarterly average

Secondary offering IPO 5 year quarterly average

Source: Macquarie Group presentation, Sep 11

Source: Thomson Reuters, data based on completed transactions. FY data based on year ended 31 Mar

1

Global M&A completed

Global IPOs and secondary issues

0

1,000

FY08 FY09 FY10 FY11 1Q12 Jul–Aug2011

2,000

3,000

4,000

5,000

$USb

$USb

0200400600800

1,000

FY08 FY09 FY10 FY11 1Q12 Jul–Aug2011

Intelligent Investor

12

Nathan Bell, CFA | First published 28 Apr 2011

Banking on Macquarie

Trading at book value and boasting a 5.3% dividend yield, this is not the time to write off Macquarie Group, argues Nathan Bell.

Macquarie Group was once celebrated for under promising and over delivering. Now it does almost the opposite, a view recently reinforced when chief executive (CEO) Nicholas Moore revealed several profit downgrades and unveiled a risky new strategy.

Since hitting $58.80 in September 2009—Macquarie’s shares peaked at $98.64 in May 2007—the investment bank’s share price has fallen 40%. Members that haven’t yet acted on past recommendations, most recently on 13 Apr 11 (Long Term Buy—$34.62), are now getting another chance, and another advocation, to do so.

Macquarie Group, perhaps now at the low point in the earnings cycle, is an Australian success story sporting a 5.3% dividend yield.

It also happens to be highly leveraged with above-average risks. In fact, it’s a very different beast to the fee machine that won acclaim before the global financial crisis (see Good riddance to the ‘Macquarie Model’ in issue 277). If you’re to follow this recommendation, it’s vital you understand that difference.

macquarie loses its spots

Dubbed the millionaire factory, the company gained notoriety through its listed infrastructure model. It acquired assets, often using ’other people’s money’, geared them up and flipped them into a fund like Macquarie Infrastructure Group and Macquarie Airports (now MAp Group).

Every step of the way, it collected fees, some would argue rapaciously so. The profits were breathtaking (see Chart 1). Eventually, one-dimensional imitators like Babcock & Brown, Allco and Rubicon copied the model but with much less success; all collapsed during the GFC.

Macquarie survived but the halcyon days of returns on equity (ROE) above 20% are over. Last year, Macquarie’s ROE was barely 10%, and will fall in 2011. Higher capital requirements and lower sharemarket activity have shattered profitability to the point where Macquarie has become what most thought it would never be: a regular investment bank.

The death of the Macquarie model has required a new strategy, which is—drum roll please—offshore, acquisition—led expansion, primarily in the US. Of late, Macquarie has paid US$516m for fund manager Delaware Investments and US$1.2bn for an aircraft leasing portfolio from AIG. More than half of its workforce now resides overseas.

Not only do such deals require Macquarie to contribute more of its own capital than was the case in the past, they place the company up against the major global investment banks. That’s no bad thing, you might imagine, given the monumental greed and incompetence that firms like Goldman Sachs displayed before and during the GFC.

But these firms have enormous political and regulatory influence. If Macquarie ever became a threat, a few discreet phone calls could easily bring this strategy undone.

There are other problems, too. Because the company is so much larger than it was five years ago, it needs big deals to move the profit needle. But it’s not the nimble, entrepreneurial and fast-growing company it once was, which may reduce the chances of actually securing such deals.

Macquarie’s culture has also changed. The need to balance the opposing demands of staff and investors remains but it’s getting harder to attract and retain talented staff, the lynchpin of an investment banking business. Bonuses are lower, working for Macquarie abroad doesn’t carry the cache that it does in Australia, and rivals are making superior offers to senior staff. Anecdotally, there are reports of a brain drain.

Key poInts

Risky strategy

Share price compensating for risks

Portfolio limit remains 4%

0

5

10

15

20

25

30

‘10‘08‘06‘04‘02‘01 ‘03 ‘05 ‘07 ‘09

Source: Macquarie Group 2010 annual report

chart 1: averaGe retUrn on shareholders eQUIty (%)

macQUarIe GroUp lImIted | MQG

prIce at revIew $34.87

revIew date 28 Apr 2011

marKet cap. $11.6bn

12 mth prIce ranGe $20.24 —$41.78

BUsIness rIsK Med-High

share prIce rIsK Med-High

max. portfolIo weIGhtInG 5%

oUr vIew lonG term BUy

Special report | Macquarie: Inside a Strong Buy

13

Bull case

That, then, is the bear case. What of the bulls?First, Macquarie is a company that thrives and profits from activity. Yes, there’s a

chance we’re in a ‘new normal’ of permanently lower dealmaking but even Japan’s 20-year depression produced several bull markets.

Second, as discussed in Macquarie transformed by crisis (see issue 295), the bank is in a relatively strong financial position. In a downturn, that offers investors some protection. More importantly, it affords Macquarie the chance to purchase smaller players at cheap prices and pinch clients from rivals. These are no small advantages.

Third, Macquarie retains a strong risk management culture. It deserves credit for largely avoiding markets that brought much larger rivals, like AIG and Lehman Brothers, undone. It’s getting harder to maintain this culture as the company grows, but it remains a foundation stone.

Fourth, don’t underestimate Nicholas Moore. After joining in 1986, he was a major architect of Macquarie’s success and understands this business inside out. There are also a couple of seasoned internal candidates that could capably fill his shoes.

taBle 2: Key fInancIalsyear to 30 JUne 2007 2008 2009 2010 2011f

revenUe ($m) 7,181 8,248 5,526 6,638 7,670

net profIt ($m) 1,463 1,803 871 1,050 945

earnInGs per share ($) 5.92 6.71 3.10 3.20 2.70

per (x) 5.9 5.2 11.3 10.9 12.9

dIvIdend per share ($) 3.15 3.45 1.82 1.86 1.86

franKInG (%) 100 100 76 0 0

yIeld (%) 8.99 9.8 5.2 5.3 5.3

Fifth, and this is something already touched on, current return on equity (see Chart 1) needs improving. A cyclical upswing will help greatly and recent acquisitions are yet to bear fruit.

But what offers great confidence is the fact that Macquarie is sticking to markets it knows well (such as funds management and energy trading). It’s also employing a counter-cyclical approach of buying during tough times, which is what shrewd management should do. A lower Aussie dollar would help profitability, although it would also increase the price of US acquisition targets.

Finally, Macquarie’s current share price embodies very low expectations. Investors now see this company as somewhat of a yield play, which is why the company is currently valued merely at book value. That reflects the challenges that lie ahead, and the company’s much larger size.

But with a 5.3% dividend yield, investors don’t need much in the way of capital gains to do well. That Australia and Asia are currently flavour of the month with foreign investors could also make Macquarie a takeover target.

potential returns outweigh the risks

In summary, Macquarie’s ‘new’ business model will produce lower returns and be more exposed to broader financial conditions. But if its acquisitions pay off, and it can win deals considered too small for the likes of Goldman Sachs, then Macquarie will be a far more profitable enterprise. If it can regain its mojo, a share price well above $50 is within reach.

But if Macquarie fails abroad—as so many Australian companies have before it—then we’ll see the obligatory write-downs and sale of ‘non-core’ assets and the naysayers will have been proven right.

Peter Lynch said that you should ‘never invest in any idea you cannot illustrate with a crayon’. That rules out Macquarie. And, as Macquarie is highly leveraged to the global economy, conservative (and short term) investors should steer clear.

But for patient, risk-tolerant investors, Macquarie is a lONG TeRM BuY for up to 4% of a well-diversified portfolio subject to the caveats laid out in the Portfolio Point.

Disclosure: Staff have interests in Macquarie Group, but they don’t include the author, Nathan Bell.

portfolIo poInt

We recommend limiting your portfolio exposure to no more than 10% in bank stocks. And no more than 15% in other financials such as insurance companies and fund managers, for a total of 25%. The more conservative you are, the lower these numbers should be.

taBle 1: BUll vs Bear caseBUll Bear

Market activity will rebound Expanding overseas

Strong risk management culture Risky acquisitions

Strong financial position Brain drain

Experienced management Large size

Undervalued share price Culture changing

Macquarie’s ‘new’ business model will produce lower returns and be more exposed to broader financial conditions. But if its acquisitions pay off, and it can win deals considered too small for the likes of Goldman Sachs, then Macquarie will be a far more profitable enterprise.

Intelligent Investor

14

Greg Hoffman | First published 31 Jun 2009

Weighing up Macquarie Group

The group’s recent annual meeting raised a number of small red flags, but they must be weighed against the broader outlook and current share price, which is not particularly demanding.

Emotions typically run high at Macquarie Group’s annual meetings and this week’s event proved no exception. The spectrum was wide, from messages of congratulations on the company avoiding the fate of the likes of Babcock & Brown and Bear Stearns, to tough questions surrounding the disastrous BrisConnections float, the proposed internalisation of Macquarie Airports’ management and auditor PricewaterhouseCoopers.

Despite the headlines and side-issues, those with an eye for value should remain focused on the key question; is the current downturn inhibiting Macquarie’s long-term earnings power or enhancing it?

Macquarie has, in the past, turned downturns to its advantage in two main ways. Firstly, the group has made opportunistic acquisitions, such as BT’s Australian operations in 1999 and ING’s Asian assets in 2004. That’s a trend which has continued this time around with the acquisitions of Orion Securities and Constellation Energy in North America, for example.

Secondly, in previous downturns Macquarie has selectively built its staff numbers as competitors shrank or went bust. This time around things are different. As you can see in Chart 1, Macquarie has taken the knife to its own staff (indeed, Intelligent Investor is seeing resumes from former Macquarie staff flow our way).

This could be a sign of a healthy culling of underperformers, using the downturn as an excuse. Alternatively, it might indicate that Macquarie has now evolved beyond its former niche positioning and is now behaving more like its larger competitors in this regard. In any case, we note the departure from past form. And sometimes it pays to note the small things.

At the meeting, several small things irked us. Chief executive officer Nicholas Moore knows better than anyone that banking is a game of confidence (and sometimes overconfidence, as Malcolm Gladwell explained in The New Yorker recently).

In his confident—almost breezy—presentation to the annual meeting, Moore emphasised that Macquarie had some $30bn in cash ‘on board’ at 31 March. While this was a ‘truthful’ statement, it led to an inaccurate impression in the minds of some shareholders (for more on the difference between truth and accuracy, see Gareth Brown’s classic review CFS Gandel spins a web of truth, see issue 192).

For example, one shareholder asked why Macquarie wasn’t standing by with its cash hoard to take up the US$5bn worth of preferred stock Goldman Sachs issued to Warren Buffett’s Berkshire Hathaway last year.

The fact is that while Macquarie may have had $30bn in cash and liquid assets on the asset side of its balance sheet at 31 March, that money wasn’t freely available for distribution to shareholders or investment in Goldman Sachs. It was offset by liabilities of matching maturity.

It’s one thing to show that Macquarie has a well matched balance sheet (something few banks can boast); it’s another to allow an impression to take root that the company has tens of billions in idle financial capacity.

A couple of the charts used by Moore also bear examining.Slide 34 for example is, once again, truthful but not particularly accurate. At a glance,

the chart (above) seems to show Macquarie consistently outperforming the MSCI World Diversified Financials Index since April. Closer inspection reveals that the chart is not drawn with a common base; the MSCI index line begins at approximately 29.5 while the Macquarie line begins at around 36.

Although Macquarie did end up outperforming by the end of the period (returning approximately 55% against the index’s 42%), it was behind for much of the time until June; which would have made for a less impressive—less confidence-inspiring—picture.

And the chart on slide 45 was just plain laughable (and, funnily enough, reproduced by our national broadsheet). The chart (see below) plotted net profit since 1999 and included a super-imposed upward sloping ‘trend line’ replete with an arrow head jutting out,

0

3,000

6,000

9,000

12,000

15,000

Australia International

chart 1: macQUarIe staff nUmBers

macQUarIe GroUp | MQG

prIce at revIew $43.70

revIew date 31 Jul 2009

marKet cap. $12.4bn

12 mth prIce ranGe $20.24 —$41.78

BUsIness rIsK Med-High

share prIce rIsK Med-High

max. portfolIo weIGhtInG 5%

oUr vIew hold

Key poInts

Financial market recovery good for profits

Has raised enough capital

Sticking with Hold

Special report | Macquarie: Inside a Strong Buy

15

optimistically, into the future. But it’s plain to see that the ‘trend line’ chops the heads clean off the previous four years’ profit results.

Aside from the highlighted 10-year annual compound growth rate of net profit of 18% being substantially lower than last year (placing its implied predictive value into question), it is less impressive when expressed in terms of what really matters to shareholders; the 10-year annual compound growth rate in earnings per share was a more modest 11.8%. And, for completeness and accuracy, we’ve set out the compound growth rates in earnings and dividends per share over a range of periods in Table 1.

The point of this analysis is not to place a negative slant on everything, but to balance up the ledger after such a one-sided presentation by management. Macquarie has made mis-steps and shareholders deserve a frank account.

The fear for long-term shareholders is that Warren Buffett ’s admonishment (in his Owner’s Manual to Berkshire Hathaway shareholders) may prove prescient in regard to Macquarie: ‘The CEO who misleads others in public may eventually mislead himself in private.’

valuation

The reasons why book value is our preferred valuation yardstick for this business were laid out in our recommendation upgrade of 14 Mar 08 (Buy—$46.25), Throwing the book at Macquarie. We also presented two potential future scenarios in that review, which history has rendered optimistic. But the basic financial model can still provide a useful rough guide, though it doesn’t take into account the effect of any capital raisings (which are almost certain to occur over the coming years). Table 2 updates the figures for the current situation and the prospects for the next few years. For the model’s opening book value, we’ve made an estimate, taking the recent capital raising into account. We’ve then made an estimate for the coming year’s profit (which we think is likely to be hampered by further writedowns) before projecting out further on the basis of the business achieving an average return on equity of 15%.

taBle 2: what the fUtUre may hold (scenarIo 1) 2010(f) 2011(f) 2012(f) 2013(f) 2014(f)

BooK valUe ($/shr) 32.51 33.38 35.88 38.52 41.29

retUrn on eQUIty (%) 8.4 15.0 15.0 15.0 15.0

earnInGs per share ($) 2.72 5.01 5.38 5.78 6.19

payoUt ratIo (%) 68.0 49.9 51.1 51.9 53.3

dIvIdend ($/shr) 1.85 2.50 2.75 3.00 3.30

closInG BooK ($/shr) 33.38 35.88 38.52 41.29 44.19

per (x) 16.2 8.8 8.2 7.6 7.1

dIvIdend yIeld (%) 4.2 5.7 6.2 6.8 7.5

Such assumptions would have seemed overly cautious a year ago, but 2010 is likely to be Macquarie’s second year in a row of sub-10% return on equity. Yet it’s reasonable to expect that by 2011 Macquarie will be taking full advantage of its recent acquisitions and, probably, somewhat higher levels of activity in financial markets.

Table 3 shows a more sedate future, where return on equity rebounds to 12% and then flatlines at that level. Such a scenario is possible in a world of lower leverage, higher funding costs and higher bad debts.

From today’s share price, the scenario in Table 3 would likely result in lacklustre, though not disastrous returns. More attractive returns would result from the scenario painted in Table 2. Though if the world becomes mired in a broad economic malaise, there is the potential for substantially worse outcomes.

The general return of optimism and Nicholas Moore’s confident performance at the annual meeting have combined to push the share price up 20% since 2 Jun 09 (Hold—$36.65). We remain braced for further writedowns on Macquarie’s listed and unlisted investments but there now seems little doubt the group will survive following a $1.2bn capital infusion from shareholders in May.

In March, despite the protestations of a confident Nicholas Moore, we were convinced that Macquarie needed much more capital. If it had been forced into a raising when its share price was below $20, the result would have been serious dilution to intrinsic value

taBle 1: Growth In perspectIve eps dps

3-year —8.2% —4.9%

5-year 5.8% 8.7%

10-year 11.8% 10.5%

0

30

40

50

60

Macquarie GroupMSCI World Diversified Financials Index

Source: Bloomberg, data current to 27 Jul 09

Apr 09 May 09 Jun 09 Jul 09

chart 2: GloBal fInancIals contInUed to reBoUnd

200

400600800

1,0001,200

1,400

1,600

1,800

‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09Growth: 428%Ten year compound annual growth rate: 18%

chart 3: net profIt after tax attrIBUtaBle to ordInary eQUItyholders

Intelligent Investor

16

per share. But Moore’s poker face paid off and he was able to raise capital during the market recovery—and lots of it.

taBle 3: what the fUtUre may hold (scenarIo 2) 2010(f) 2011(f) 2012(f) 2013(f) 2014(f)

BooK valUe ($/shr) 32.51 33.38 35.38 37.43 39.52

retUrn on eQUIty (%) 8.4 12.0 12.0 12.0 12.0

earnInGs per share ($) 2.72 4.01 4.25 4.49 4.74

payoUt ratIo (%) 68.0 49.9 51.8 53.4 54.8

dIvIdend ($/shr) 1.85 2.00 2.20 2.40 2.60

closInG BooK ($/shr) 33.38 35.88 37.43 39.52 41.66

per (x) 16.2 11.0 10.4 9.8 9.3

dIvIdend yIeld (%) 4.2 4.5 5.0 5.4 5.9

More broadly, the continuing recovery in financial markets is good news for Macquarie as it clips the ticket when activity increases. All things considered, we view Macquarie’s current share price as somewhat on the happy side of fair value. hOld.

*You can make your own assumptions and consider the outcomes using an accompanying spreadsheet in the special reports section of the website (under the ‘Stocks’ tab).

Disclosure: The author, Greg Hoffman, owns shares in Macquarie Group, as do other staff members.

John Addis | First published 12 Sep 2011

Why Strong Buy doesn’t mean load up

QBe insurance and Macquarie Bank are incredible opportunities. So why do we recommend you allocate only a few percent of your portfolio to them?

‘Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards—so when you see one that qualifies, you should buy a meaningful amount of stock.’—Warren Buffett, 1996 letter to shareholders.

QBe insurance and Macquarie Group’s renowned brands, attractive economics and fine management make them excellent businesses. Both face short term difficulties but future earnings are likely to be substantially higher than today’s. Trading at very attractive prices, they’re both Strong Buy recommendations and two of our best investment ideas ever. If you were to follow Buffett’s advice, you’d be buying them with every skerrick of available capital—with ‘your ears pinned back’, as they say.

We’re not recommending that at all. Instead, we suggest you restrict QBE and Macquarie to just 7% and 5% of your portfolio respectively. How one reconciles our strongest recommendation with a modest portfolio limit is the subject of this Investor’s College.

Successful investors have two essential tasks. The first is to identify underpriced stocks, something in which Intelligent Investor assists you. The more positive—or stronger—our recommendation, the cheaper we believe a stock to be priced. For example, a stock with a Buy recommendation is cheaper than a stock assigned a Long Term Buy, and a Strong Buy suggests a stock is cheaper still.

Key poInts

Stock picking and portfolio allocation are distinct tasks but both are central to successful investing Share price compensating for risks

A cheaper stock doesn’t always deserve a higher weighting

Stick to recommended portfolio limits and consider recommendations in this light

Special report | Macquarie: Inside a Strong Buy

17

portfolio weightings

The second task is to assemble those stocks into a portfolio that’s appropriately structured according to your investing goals and risk profile. Our recommended maximum portfolio weightings should be central to this task.

There’s clearly a relationship between the two. Overpriced stocks shouldn’t be in your portfolio at all whilst mildly underpriced stocks might have small weightings. Everything else being equal, it makes sense for extremely underpriced stocks to have higher weightings.

But of course, everything isn’t equal. Consider Woolworths: Save a zombie apocalypse, it’s virtually certain to continue to make vast profits selling groceries. If it became sufficiently cheap we’d have little hesitation recommending it for up to 10% of your portfolio.

Insurers, on the other hand, are prone to high impact shocks; the September 11 terrorist attacks are perhaps the best example. Another such event would result in large claims and perhaps a capital raising. It’s a slim but real risk for QBE Insurance; the type of risk that Woolies simply doesn’t face.

Much the same argument applies to Macquarie Bank. It’s highly leveraged; one rogue trader could lose billions and, as a business far more complex than a simple food retailer, more can go wrong. Macquarie Group’s share price fall from its all-time high of $98.64 to its current price of $21.90 suggests as much.

Charts 1 and 2 offer a visual representation of this point. The more skewed the graph is to the right (showing a higher weighted probability of a good outcome), the cheaper the stock is and the more positive the recommendation will be. That’s why Macquarie and QBE carry Strong Buy recommendations and Woolworths only a Long Term Buy.

The wider the spread of possible outcomes, the greater the risk of a poor one, and the lower the portfolio limits should be. Macquarie and QBE’s portfolio weightings should be low while Woolies’ tighter range of potential outcomes and greater certainty permits a higher weighting, assuming the price is right.

So, whilst Macquarie and QBE are very cheap, these aren’t businesses about which one can be ‘virtually certain’ things will work out well. The portfolio limits offer an insurance policy in the event that they don’t.

conviction indication

A strong recommendation with a relatively low portfolio limit—as is the case with QBE and Macquarie Bank—indicates a very cheap stock in an inherently risky industry. A strong recommendation with a relatively high portfolio limit indicates a far higher level of conviction, implying a cheap stock in a more stable and predictable industry.

The lesson is to use the two in combination, not isolation.If you’re still not convinced, revisit our 2010 Analyst Interview videos, in particular

those with Gareth Brown, Nathan Bell and Greg Hoffman. Listen to what they consider their biggest investing mistakes.

It wasn’t that they were fully invested in 2007; It wasn’t that they didn’t buy more RhG or Flight Centre during the GFC; it was overconfidence. Each allocated too much money to what seemed like very cheap stocks that didn’t work out.

By sticking to portfolio limits and separating your stock picking and portfolio allocation decisions, you can avoid these costly mistakes.

Note: The model Growth portfolio owns shares in Macquarie Group and QBE, while the Income portfolio owns shares in QBE.

Disclosure: Staff members own shares in Flight Centre, QBE Insurance and Macquarie Bank.

portfolIo poInt

As well as portfolio limits on individual stocks, we recommend limiting your total portfolio exposure to banks to no more than 10% and no more than another 15% in other financials such as insurance companies and fund managers. Your total financial services sector portfolio limit should be no more than 25%. The more conservative you are, the lower these numbers should be.

what to Know more?

If you’re after more portfolio advice, we recommend reading our special report Building and managing a portfolio, which delves into these ideas in much greater depth.

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High

Probability

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Important InformatIon

intelligent investorPO Box Q744Queen Vic. Bldg NSW 1230T 1800 620 414 | F (02) 9387 8674info@intelligentinvestor.com.au www.intelligentinvestor.com.au

PeRFORMANCe Past performance isn’t a reliable indicator of future results. Our performance figures are hypothetical and come from the recommendations made by The Intelligent Investor. Transaction costs haven’t been included. We encourage you to think of investing as a long-term pursuit, as stocks can fall and you can lose money on the stockmarket. To read our performance report, go to www.intelligentinvestor.com.au.WARNiNG This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all people.diSClAiMeR This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation.COPYRiGhT© The Intelligent Investor Publishing Pty Ltd 2011. Intelligent Investor and associated websites and publications are published by The Intelligent Investor Publishing Pty Ltd ABN 12 108 915 233 (AFSL No. 282288). PO Box Q744 Queen Victoria Building NSW 1230. Ph: (02) 8305 6000, Fax: (02) 9387 8674.diSClOSuRe As at 1 December 2011, in-house staff of Intelligent Investor held the following listed securities or managed investment schemes: ABP, ALL, ALZ, ARP, AWC, AWE, AZZ, BBG, BCC, BER, CBA, CIF, CMIPC, CND, COH, CPU, CRC, CSL, CUE, EBT, ELDPA, FGL, FLT, HVN, IAG, IDT, IFL, IFM, IVC, KRM, KRS, LMC, MAP, MAU, MCE, MFF, MLB, MQG, MTS, NABHA, NBL, NWS, PGA, PTM, QBE, QTI, RCU, RNY, ROC, SDI, SFC, SGN, SGT, SHL, SKI, SRV, TAP, TGP, TLS, TRG, TRU, TWE, TWO, UXC, VMS, WBC, WDC, WES, WHG and WRT. This is not a recommendation.PRiCeS CORReCT AS AT 1 December 2011dATe OF PuBliCATiON 1 December 2011