I have been a bull on the banks this year, but with almost three months gone, am a little out of step with the market (a polite way of saying I am wrong so far). After last Friday’s sell-off, that was fuelled by President Trump’s mad idea to re-ignite trade tensions, the Financials excluding A-REIT index has underperformed relative to the market – down by 4.5% compared to the market’s overall return of -2.9%.
No one likes negative returns, and if Trump raises the stakes again, or China responds aggressively, our sharemarket will follow the US market down. Our banks won’t be spared the pain, so questions about “buy or sell” will become somewhat academic.
Rather, I take the view that “common sense” will prevail in due course and that markets will calm down and resume their upward trend. Given the impact that the Royal Commission has had on banks over its first couple of weeks, and the relative weighting that banks have in many investors’ portfolio, the question about whether to buy and increase weighting, or sell and decrease weighting, remains pertinent.
I take the view that this is the time to be moderately overweight banks. Here is why.
The case for the banks
The ‘for’ case is pretty straightforward. Firstly, each of the major banks will shortly reach the capital targets that APRA mandated to classify them as “unquestionably strong”. This was one of the key recommendations from David Murray’s Financial System Inquiry in 2014, and achieving these targets through dilutive capital raisings, non-underwritten dividend re-investment plans and sale of non- core assets, or closure of non-core businesses, has been the biggest drag on their share prices over the last few years.
Earnings look reasonably secure. While they are going to be challenged to grow income (some argue that they are “growthless”), there is no real pressure on margins or bad debts. A cooling house market could reduce the loan book, but unless interest rates rise quickly, or unemployment picks up sharply, I just can’t see this as being too much of a problem. For the record, Australia has just recorded its 17th consecutive monthly increase in employment.
And that’s not to forget about the opportunities on the cost side.
Finally, on earnings multiples and dividend yields, they look attractive. Here are the latest broker forecasts (according to FN Arena). Dividends are also fully franked, which, notwithstanding Bill Shorten’s threat, can be grossed up (at least for the next 12 months) by a factor of 1.42 times.
Forecast Multiples and Dividend Yields (Broker Consensus)
Source: FN Arena
And what about the Royal Commission, I hear some of you ask?
Royal Commission risk
There is no doubt that Commissioner Ken Hayne and his counsel assisting, Rowena Orr, have got the Commission off to a very solid start. The banks have looked ill-prepared in response to a ferocious inquisition that has highlighted some downright dodgy and shameful consumer lending practices.
Before the Commission started, I thought that the market would get “bored” with it. Sure, a negative influence for a while, but this would wane over time.
But, if the revelations over the coming months are a bad as the first few weeks, media (and market) focus could last a lot longer. While this will impact sentiment and potentially the market price, sentiment alone won’t hurt earnings. Eventually, the Commission will come to an end and the market will move on.
The key issue is not what is disclosed about the practices and the behaviour of the banks at the Commission, but rather, what happens as a result. What can the Commission recommend to Government that will materially impact long-term bank earnings?
Let’s run through some scenarios about “outcomes”.
Firstly, could the Commission recommend that the banks raise more capital? Unlikely, this is APRA’s responsibility. They are already “unquestionably strong”.
Could the Commission recommend that there needs to be more competition in financial services? Possibly, however what this would mean for the major banks when there are already more than 140 institutions that can take deposits (with a, government guarantee) and almost 100 different home lenders, is hard to tell.
Concentration is due to customer inertia, rather than lack of choice. And as I am sure that evidence to the Commission will show, behaviour of the minor banks isn’t that much better than the major banks.
Next, remuneration structures. The Government recently passed the BEAR legislation (Bank Executive Accountability and Related Measures Bill), which places tough measure on bank executive and director remuneration. A recommendation to ban sales incentives for front line bank staff is possible, as are changes to the commission structures for mortgage brokers. Whereas the former could impact bank earnings, the latter (mortgage broking commissions) could actually be a positive.
Vertical integration? Force the banks to dispose of parts of their wealth management businesses, so that they cannot fill the roles of manufacturer, distributor and client adviser. Quite likely. In terms of impact, these units haven’t proved to be that profitable, and several banks have already started to roll back their involvement in wealth management.
Tighter lending practices. While both ASIC and APRA have been raising standards here, ASIC, through its “responsible lending” provisions, and APRA from a prudential standard, it is probable that the Commission might find that more needs to be done. While a slowdown in credit growth could have an impact on long-term earnings, it is unlikely however that the Government would be keen to engender a credit crunch and stall the economy.
Finally, the banks will probably need to invest more in compliance and related systems, and possibly undertake even broader customer restitution schemes. Just how much more, and just how broad, will be up to the Commission.
This is obviously not the definitive list of possible outcomes, but I am struggling to think of those that are missing. And when I put them together, I just can’t see them being that material to the long-term earnings prospects for our major banks.
Moreover, my sense is that much of this is already priced in.
What do the brokers say?
While the major brokers are largely neutral (index-weight) on the sector as a whole, the consensus target price for all banks is higher than the last traded price. Westpac’s consensus target price of $33.01 is 14.4% higher than its closing price on Friday of $28.85.
A summary of the buy/hold/sell recommendations of the eight major brokers, and consensus target prices, is set out in the table below.
Broker Recommendations and Target Prices
Source: FN Arena
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