Banks still worth it

Co-founder of the Switzer Report
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Despite what the analysts want you to believe, there is still good value in the major banking stocks and no urgency to lighten the load.

Commonwealth Bank, ANZ and NAB have presented trading updates to the market over the last couple of weeks. As the table below shows, cash earnings have risen by between 7% and 14%, compared to the previous corresponding period.

What the analysts don’t like

The analysts warn of a number of issues. Firstly, they cite that we are right at the bottom of the cycle for bad debts and that the record low provisions that the banks are currently making will have to go up, eating into profits. Then there is the regulatory overhang of Basel III, which is driving (globally) higher capital ratios for banks. For example, Commonwealth Bank’s decision not to “neutralise” its upcoming Dividend Reinvestment Plan (by buying back the shares issued from the DRP through an on-market buyback) was called out by some analysts.

Thirdly, on a book value basis, Australian bank shares are expensive to their international counterparts. Not to forget (of course) the inevitable housing “bubble”, and that our banks are over exposed to the mortgage market.

And finally, the sector rotation argument. Last year, the ‘financials’ sector of the S&P/ASX 200 returned 28.1%, compared to 15.1% for the index as a whole – so it must be time for the rest of the market to do better – which means that the banks must underperform.

Why the bank results are so good

At the top line, there is some revenue growth due to improving credit conditions. Lending to the household sector (mainly housing loans) grew by 6.7% in the 12 months to December, and even with the business sector, the value of loans outstanding grew by 2%. Margins, that is the difference between what the bank earns on its loan book compared to what it pays for its deposits, have stabilised. For example, although down on the June half, CBA’s net interest margin increased from 2.10% in December 2012 to 2.14% for the December 2013 half.

Through a raft of productivity and other initiatives, every bank is also in minor “cost-cutting” mode. Expense growth is being held, some jobs are going, and productivity and other automation benefits are helping to drive improvements in the bottom line. To demonstrate these improvements, Commonwealth Bank released the following divisional ‘Operating Performance’ results, which is ‘Total Operating Income’ less ‘Operating Expenses’, before loan impairment expenses. These results show that all divisions of the bank are firing.

CBA operating performance by division

And finally, as the analysts point out, loan impairment expenses are at historic lows. The following table shows Commonwealth Bank’s half-year loan impairment expense (annualised) as a percentage of gross loans and acceptances, measured in basis points.

CBA Loan Impairment Expense (bpts)

Where to from here

What can go wrong with the banks? The biggest risk remains that loan impairment losses (bad debts) start to pick up. Sharply higher unemployment or a bursting of the housing “bubble” are the most likely triggers, although saying that, it is hard to see either of these factors really coming to the forefront in the next 12 to 18 months.

The Murray review into the financial system will no doubt consider some of the competition issues, however any changes here are some years away and with the major banks still writing around 85% of new loans, there really aren’t any material competitive pressures. Basel III pressures aren’t going away, however our banks claim that they are more than adequately capitalised under the new regime.

So, sector rotation? Maybe. All this means that if the market continues to rally (say hits 6,000) this year, then perhaps our banks will lag the market. Rather than gains of (say) 12%, bank shares may only go up by half that amount. And if the market stays flat or turns down, bank dividend yields will provide support and cushion any movement in price down.

There is no urgency to lighten the load.

And if you have surplus cash to invest, which bank? According to FN Arena, the broker analysts are most bullish on NAB and like CBA the least. On a sentiment scale of -1.0 (most negative) to +1.0 (most positive), CBA is currently at -0.4 and NAB mildly positive at +0.4.

Broker Consensus Forecasts

I disagree with the analysts and prefer the Commonwealth Bank. Although it is the most expensive (trading on a forecast PE of 14.5 compared to NAB’s 12.9), its multi-year track record more than substantiates a premium price and by recent standards, the pricing gap has narrowed considerably.

Bottom line – I don’t think you are going to go wrong with any of the major banks in your portfolio.

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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