Short Bernanke, long QBE

Chief Investment Officer and founder of Aitken Investment Management
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QBE was a recent addition to my high conviction buy list™, primarily on the view that historic correlation analysis showed QBE’s share price has the highest correlation, of any ASX top 20 stock, to US 10-year bond yields and the Australian Dollar cross rate. It’s worth remembering QBE is a significant stock, with an $18 billion market cap and represents 1.59% of the benchmark ASX200 Index. In the last month QBE underperformed the AUD fall, due to convertible bond hedging selling, and concerns about the operational update. Both those pressures have now ceased.

My initial attraction to QBE was a ‘top down’ one based on bond yield, currency, technical and open short position analysis. However, this week’s “global operational transformation program” update from new CEO John Neal confirmed an increasingly positive ‘bottom up’ story in QBE. In my experience, the biggest medium-term returns you generate in stocks are when ‘top down’ meets ‘bottom up’ and that is now happening for QBE.

Top down

Let me again start with the ‘top down’ view. Then I will look in more detail ‘bottom up’.

If I am proven right in a post ‘US Federal Reserve Quantitative Easing’ world of normalised US bond yields and a normalised Australian Dollar, then the single best large-cap Australian play on that normalisation of yields and currency is QBE.

QBE’s strong correlations to bond yields, and currency cross rates, make perfect fundamental sense. The Fed’s previously unprecedented manipulation of the risk free rate and USD has hit QBE on multiple fronts: now that reverses.

Firstly, with 70% of assets being offshore, the falling AUD increases translation profits.

Secondly, rising bond yields help investment income returns from the investment portfolio.

Thirdly, QBE has confirmed discount rate adjustments will start to benefit them. The dramatic discount rate fall in recent years, which is set off the Fed’s manipulated 10-year bond yield, has led to an extra $1 billion of claims allowances and lower profit. If the discount rate goes back to where it was after the Fed ends QE, the $1 billion will come back out through profits. At this stage you might expect 20% of it to start coming through, due to recent discount rate rises.

Bottom up

That’s a simple summary of the ‘top down’ driven earnings growth attractions of QBE, but that is now being joined by a ‘bottom-up’ cost out/business simplicity story, that will also drive earnings growth.

On the cost side, QBE confirmed $250 million of cost savings by end 2015 were on track, yet a comment on an additional $90 million of “procurement” savings, which would theoretically take the cost out total to around $340 million by 2015, appears somewhat overlooked. One thing I have learned over the years is that big corporations like to under-promise and over-deliver on cost out targets. It would seem QBE is following that trend here, with cost out likely to surprise consensus, and lead to upgrades in the years ahead.

Let’s look at a series of cost out and business efficiency slides from QBE, which confirm the effectiveness of the new management team led by John Neal.

On the balance sheet side, there are also clear signs of improvement. QBE states they are on target for debt to equity of less than 40% by December 2013. Again, that appears a conservative forecast that will be beaten.

QBE has actively strengthened its balance sheet over the last 18 months, with a combination of equity placements, convertible bond issues and sub-debt repayments. They have also lowered the dividend payout ratio and weighted it to seasonality (40% interim/60% final).

Regulatory certainty has increased with the finalisation of APRA’s LAGIC reforms, and S&P has affirmed its “A+” financial strength rating and raised the outlook to “stable” from “negative”.

While QBE doesn’t give earnings guidance as such, the slide below summarises the current earnings drivers, all of which are headed in the right direction.

The outlook

I believe QBE is entering a multi-year earnings, dividends and P/E upgrade cycle. The open short position remains 51.5 million shares, a short position that looks historic to me, and increasingly likely to be squeezed in the months and years ahead, as macro and micro influences concurrently turn positive.

On the investment arithmetic, QBE is cheap, trading on bottom of the cycle multiples, when it’s clear the bottom of the earnings cycle is behind us.

For the CY13 year, we are currently in consensus, which sees QBE grow EPS 30% to 115.8c. The P/E being applied to that is 13.2 times.

But CY14 and beyond is where the greater potential for earnings and P/E expansion lies.

Current consensus for CY14 is for QBE to increase EPS by another 15% to 133.5c in CY14. The P/E being applied to that is 11.4 times.

My view is, as the market and investors come around to my thinking on the top down and bottom up earnings growth story in QBE, they will eventually pay 15 times for what should be EPS of $1.50. That generates a medium-term QBE price target of $22.50, 42% above the current share price.

In summary, QBE is a play on

  1. Rising bond yields
  2. Rising US dollar
  3. Premium rate rises
  4. Transformational cost out
  5. Discount rate adjustments flowing back through P&L
  6. Management re-rating

QBE cleared a small sentiment hurdle this week and remains my no.1 mega cap play on Fed tapering and eventual Fed exit. Short Bernanke, long QBE – the trade of the next three years.

Charlie Aitken is the author of the daily equity market newsletter Ringing the Bell.

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.

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