There’s always high excitement about earnings season. This half-yearly beauty contest will give these long term investors the chance to over-react in the short-term and traders a chance to make money trying to guess the direction of that over-reaction. Analysts scrutinize earnings, but not for how close they are to the Street’s estimates: Notions like that aren’t grounded in thinking about long-term results and longer-term values. One quarter’s worth of earnings does not typically turn into a change in these long-term assumptions, unless a company also releases new, material information that directly alters our long-term assumptions. (For example, positive news about a drug that increases its chances for approval, or pricing gains in an important product line could impact an analyst’s long-term thinking.)
The investor’s paradox is that there is no now; we only care about what a company is going to do in the future. But all the information we have is historical. A flurry of new market participants since 2020 magnify the importance of earnings season, as many investors put outsized focus on what companies, and their investments, did. While that's cool, that's not why we invest - we shouldn't care about what happened in the past. We need to make the future our priority. After all, we don’t buy shares because of what they have done but because of what they might do.
We think the true opportunities are when the market's short-term interpretation of an earnings release fails to match the company's long-term worth. Movements in our fair value estimates for a company can help provide insight into those price movements.
An example is Bendigo and Adelaide Bank ASX BEN. Our analysts saw no change in the outlook for the underlying business and reaffirmed our fair value estimate of $10.20.
Before diving into Bendigo and Adelaide Bank, we need to know how banking works. At its most basic level, that is what banks do: They take in money and lend it out to people and businesses, and earn interest on those loans as they are repaid. There are two main sources from which they can obtain those funds, and each involves a fee. One is from customer deposits and they have to pay you interest to do that. The other is from the fact that when they go out to get it, they have to borrow it and pay interest.
The difference between those two numbers is broadly what a bank makes. This metric is known as the net interest margin and it is one of the most fundamental gauges of bank profitability.
For a more detailed explanation of net interest margins you can listen to our share deep dive of Westpac (ASX:WBC) on Investing Compass.
When rates are going up, the net interest margin will generally also go up so banks are more profitable. Banks are one of the rare groups of companies that tend to do better in a rising interest rate environment. That’s because they tend to pass along increases in interest rates to rates paid to them by customers a lot faster than they do to increases they receive from their depositors.
Well then it might just be the ideal time to buy a bank shares are clearly going up and banks are more profitable. How much banks earn from the loans is important, but so too will the volume of loans. So while higher interest rates may increase the profitability of each loan, they can also affect volume. The entire idea of a central bank raising interest rates is to cool down an overheating economy. Certainly not now: It’s to throttle back an overheating economy, even as we confront the highest inflation we’ve seen in a generation. In an expanding economy, consumers and businesses are borrowing money and spending as they feel more comfortable taking on debt in economies that are going well.
Now let’s go back to Bendigo and Adelaide Bank. ASX: BEN is among Australia’s 10 biggest banks, but is 10 times smaller than the big four. It has a higher ratio of cost to income, higher funding costs, and it’s difficult for them to produce attractive returns on shareholder capital in a highly competitive market. They have bought smaller banks to diversify, scale and compete – that includes the Adelaide Bank, Rural Bank and Delphi Bank. So it has moved from there, diversified and scaled the loan book and as yet has not delivered excess returns on equity given the bigger capital base.
And when we consider earnings, the key drivers are muted credit growth, funding costs under pressure and stiff lending competition. All of these factors impact net interest margin.
ASX:BEN delivered growth in loans that was somewhat better than what our analyst Nathan had pencilled in, 8%, but it came at the expense of margins – the net interest margin for BEN fell by 21 basis points to 1.74%.
And that was a symptom of the brutal competition in this area – without scale, it’s really hard to hold those kinds of margins and keep them going. In addition to the competition, there was greater than normal client demand for fixed rate loans, repricing of old loans and, due to regulation, higher levels of liquid assets. And all of those in combination really just outweighed the cheap customer deposits they’ve had on the back of low interest rates.
If we look at it from a NIM or net interest margin standpoint, NIM was 1.69% in the first half from January to June. But considering June, it averaged 1.73% and those are early signals of the NIM improvement from elevated rates. We believe this will continue to get better in 2023 and are forecasting 1.8% for the next fiscal year.
So, based on what Nathan thinks, the NIM looks solid and is in the process of expanding – his fair value for BEN is still 10.20. And this is not what investors got in the earnings report. The compression in NIM combined with those NIM headwinds led the market to look through the NIM decline and have a pessimistic view of BEN’s prospects.
Earnings were reported on 15 August and the market responded by selling out of BEN which pushed the stock down 15% to 30 August 2022. That is not, Nathan thinks, justified and he does not think that the announcement changed the value of the company in principle.
After all, it bears repeating that earnings season is just a snapshot into a company’s past results. It’s not thinking about the future, or future earnings…and that’s what you care about if you’re buying a company, right? In this instance, investors may simply be looking too much to NIM overst history rather how it's trending and where (with rising rates potentially continuing its trends). So, we think broadly it will be net positive against the increase in operating expenses.
Long term, it is an attractive opportunity for investors, for short term historical results to create such pessimism.
