An update on Just Group plc
I recently posted to Twitter that I have been torched on my Just Group plc (LON: JUST) position so far:
I recently pitched Just Group to a sophisticated investor with experience in complex financials and had the idea shot down pretty quickly (“too hard”). While that should serve as a warning to others considering investing here, this article is a reflection of the work I’ve done on Just so far and is part of my learning process. If I’m wrong I’ll just have to eat it.
So, while it is uncomfortable posting further work on a buy idea that just got shot down in front of me, here it is:
The bear case for Just Group:
The balance sheet:
Property growth assumptions and the impact of lower future growth:
Historical property price growth in the UK:
The risks are clear – you have a company forecasting solid future housing price growth in the middle of what are likely elevated housing prices fuelled by lower cost of credit. As an amateur looking from the outside, from a big picture perspective in a world of rising rates, I would guess there is something like a 70%-80% probability that this 4.25% per annum housing price growth estimate is too optimistic over the next ~3-5 years.
I have always mentally assumed the likely downturn scenario for Just Group was a property crash over a couple of years followed by a return to growth in housing values. A recent speech from April 2018 I read from the BoE showed me that was a flaw in my thinking. An alternative scenario is a Japan-like stagnation where house prices fall or stagnate over the long term. This would lead to risks to insurers as:
Importantly this is the bear case that was true before the recent selloff and I thought it was basically compensated for by the undemanding valuation Just was trading at when I bought it and the strong industry outlook. Just also has a pretty modest loan book with I think an average LVR of 31% and a borrower age of around 60 or higher. With these characteristics and a stagnant or declining UK life expectancy, it will likely be many years before a Japan scenario becomes a risk. Historically, in the past 10 years Just has only been called on to provide 13 no negative equity guarantees (NNEG) – i.e., just 13 borrowers in the past 10 years had the loan become worth more than the house valuation before the resident passed on. That was in a period of very strong housing price growth and declining interest rates, and 10 years is in my opinion also too short a period to judge NNEG risk properly anyway. Still, it will be many years before the NNEG becomes a risk. The proposed higher capital requirements (below) will also likely reduce NNEG risk, which I guess is one positive.
Now, the above BoE speech segues directly into Consultation Paper 13/18, which suggests that insurers like Just effectively need to hold more capital to offset the risks in their illiquid assets like mortgages. These proposed changes were responsible for the recent collapse in Just’s share price. I think the bear case is best summarised as some mix of:
- Housing price risks (declines or inability to sell could hurt Just’s capital position and ability to fund its liabilities, important in the context of ZIRP)
- Credit risks in the bond portfolio (same reasons as above)
- Higher capital requirements and (possible) inability to improve pricing, reducing overall ROE
In the event of higher capital requirements I originally thought it was likely that Just Group needed around another $300m in capital compared with around $2.1bn in capital currently. However the Forager International Fund stated in its July report that it thought in the worst case scenario Just could have to raise up to a quarter of new capital (~$500m). There will likely be some regulatory relief for a transitional period but even so that is a serious increase. And so the market has begun pricing in the worst case scenario.
(Just pays around $40m a year in dividends and recently deferred its interim dividend to preserve capital while waiting for the outcome of the consultation paper. I have gained respect for management following this decision, which would be nigh-unthinkable in Australia.)
A key factor in my decision to invest in Just Group originally was its target market / core products.
Betting on things that don’t change:
In terms of Just’s business I bet on three things.
- “Hedging” longevity risk will always be attractive, as people don’t want to outlive their savings (equity release mortgage with NNEG, or annuity)
- Most people will always need to liquidate/monetise their family home in one way or another, and a substantial portion of these will not be interested in (/able to) downsizing
- Corporations will continue to offload part or all of their defined benefit pension liabilities as the obligations are costly and a distraction
I’m ~90% certain those things will remain true. The DB pension book opportunity won’t last forever but it is potentially a ~10+ year phenomenon.
- Annuities (Guaranteed Income for Life, GIfL) are an effective solution for hedging longevity risk, especially for simpler customers. They can be costly and are more easily replaced than some other products however. I’m 60-70% certain that annuities will remain a viable product. They will get more attractive as interest rates rise, but then so will alternatives (like gov bonds).
- Equity release mortgage (LifeTime Mortgage, LTM) with no negative equity guarantee will remain attractive because they allow the individual to monetise their chief asset (family home) while also continuing to live in it. Also partially protects against longevity risk (no negative equity to pass to descendants). I would guess there is a 90% probability that this product will continue to exist in 10-20 years.
- Defined Benefit de-risking. I struggle to see a situation (higher bond yields, maybe) in which corporations would not want to offload their pension liabilities. I’m around 80-90% certain this product will remain viable for a decade.
The key issue is whether Just Group can survive long enough to benefit from these long term trends. With regards to higher capital requirements, it is likely that there will be a lengthy transition period. The proposed changes are retrospective (will apply to every active contract) so it appears almost guaranteed that, if implemented with no transition period, the industry will need to find billions in new capital in a hurry. This will be unpleasant for Just Group, which has a weak share price and will either have to borrow, raise capital, or reinsure away some of its responsibilities. Because of the likely impacts I think it is reasonably safe to bet on a transition period (the regulator has already stated the requirements will not be implemented before 31 December 2019), and I think there is also a >0% probability of a reduction in the proposed requirements. Industry bodies are naturally agitating for softer changes with a long transition period. That said, downside risks are still meaningful.
There is substantial uncertainty here but I do struggle to see how this company is not worth more in 5-10 years. I may be out of my depth and would be glad to hear competing theses or counter arguments.
I own shares in Just Group plc. This is a disclosure and not a recommendation.