Key points

• Anyone who didn’t take up the NAB rights issue has made a mistake. That was the closest thing to “free money” in Australian equities in a decade.
• NAB CEO Andrew Thorburn has quickly moved to get NAB’s capital position to the top of its peer group, spin off the legacy UK assets, divest Great Western Bank, and consider what to do with MLC.
• Technically, NAB has “double bottomed” and the knife is now vibrating in the deep value floor. Time to pick it up.

There should be absolutely no doubt that cross asset class volatility is rising. You can see it on your screens every minute of the global trading day. Whether it’s driven by the ongoing “Greek tragedy”, bond market volatility or simply debate about the first Fed rate rise in 9 years, there is no doubt in my mind that volatility is rising and all investors need to position themselves to take advantage of that volatility.

As I keep writing, in volatility there is opportunity but it does require conviction and contrarianism to profit from volatility. You shouldn’t be scared of volatility in risk asset classes. That is why they are risk asset classes. You should selectively take advantage of it.

A leap of faith

As I come to the end of my broking career, I have been thinking back on what have been my best and worst ideas. There’s a very clear pattern. The very best ideas were stomach churning at the time. They were the ones where I pressed the send button and had to look away from my computer screen, knowing the barrage of “you must be joking” emails that would come back at me. The single worst ideas were populist /momentum ideas that most readers cheered, yet turned out to be poorly timed and crowded.

At the end of the day, the idea is to buy low and sell high. It’s easier said than done because both buying low and selling high involve contrarian actions that are against the psychological make-up of most humans. The other lesson I’ve learnt is that “over-analysis leads to paralysis”. My best ideas were almost too simple.

You can talk yourself out of good investment and trading ideas by taking in too much outside opinion or analysis. My advice is to go with your gut. You have gut feel for a reason. Gut feel is telling you that you’ve been in a situation like this before.

After thinking about all that, I wanted to come up with one big last Australian large cap idea that had all the attributes that other successful ideas had. It had to be contrarian with a clear pathway to value release. The conclusion I came to is that the National Australia Bank (NAB) is the best risk adjusted prospective total return buy in the ASX20 Leaders index for the next 18 months. The way I approach things, the potential total reward in NAB now far outweighs the potential risk.

The case for NAB

Firstly, anyone who didn’t take up the NAB rights issue has made a mistake. That was the closest thing to “free money” I have seen in a decade in Australian equities.

So here we are today and the NAB rights issue is complete. Hopefully you all took up your rights. Today NAB is still trading below the theoretical ex-rights price of $33.79 and therein lies a further contrarian opportunity.

Obviously large equity issues lead to short-term indigestion. That in itself is an opportunity.

If I look at NAB today I don’t think I can ever remember it being stronger, better led, or more on a pathway to shareholder value release. However, when I look at NAB’s investment arithmetic, it is the cheapest since the peak of the GFC. That to me spells opportunity.

NAB CEO Andrew Thorburn will prove a winner. This really reminds me of when Ralph Norris came to CBA and embarked on a highly successful cultural change program. What I like about Thorburn is that he is man of action. He has quickly moved to get NAB’s capital position to the top of its peer group, spin-off the legacy UK assets, divest Great Western Bank, and consider what to do with MLC. Tick, tick, tick, tick on the pathway to higher sustainable ROE and higher P/E.

When you get a genuine agent of change in an underperforming and undervalued oligopoly business, you simply have to buy it.

Thankfully for contrarian investors, the market, as implied by NAB’s investment arithmetic, remains sceptical of Thorburn’s ability to “simplify” NAB. Let’s just look at the FY15 and FY16 investment arithmetic for NAB.

I look at FY16 and I see both clear value and major dividend yield support for NAB at current prices. NAB UK is removed from our FY16 estimates and this leads to 5% lower group cash NPAT. However, our dividend estimates are unchanged and these have been previously reduced to account for the impact of capital dilution (and to preserve the 75% dividend payout ratio once the UK contributions are backed out).

Next steps

What happens from here is NAB slowly gets re-rated. We firstly work through the post rights issue indigestion, remembering $5.5 billion is a massive rights issue in an Australian context (it’s the equivalent of a huge IPO), and then the market will start getting confidence in the reliability of the dividend yield and start bidding that dividend yield down and inversely the P/E up.

My view is that investors will bid NAB’s prospective FY16 dividend yield down to 5.50%, which implies a NAB share price of $36.36. That would equate to a 13.8x P/E for FY16, which is still inexpensive.

For Australian investors who can value franking credits, I think NAB is a no brainer. The stock is trading 14% below recent highs, offers a prospective grossed up dividend yield of 8.71%, and if I am right about a $36.36 price target, NAB shareholders can also look forward to an 8.5% capital gain from this morning’s opening price of $33.50 – and potential prospective total return of 18% over the next 18 months in NAB equity.

That would sure beat having your money in a NAB term deposit or CMT. Cash rates in Australia will fall further over the next 18 months.

NAB shares are the same price they were in 2006. This decade of underperformance is ending under Andrew Thorburn.

NAB has all the characteristics of industrial large cap contrarian ideas that I have had success in pushing in these notes over the years.

I rate NAB a high-conviction total return buy and encourage you to buy NAB shares while they are still on “sale”.

Technically, NAB has “double-bottomed” and the knife is now vibrating in the deep value floor. Pick it up!

Go Australia, Charlie

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.