The noise is becoming deafening. Reduce your exposure to banks, they scream!
Like most things in markets, the herd usually gets it wrong, and I think there is a good chance that the herd is wrong again this time. Particularly, when the “where do I re-invest” part is met with suggestions to up-weight into Telstra, property trusts (which are up over 27% this year) or Transurban, the latter as it nears a record high.
I really liked Telstra at $2.50, but up near $6.00, I am struggling to see much value. And I am not going underweight in property trusts, but after such a run, which is almost solely due to yield compression rather than rent increases, I don’t want to go that overweight. And I like Transurban – however it is yielding on a prospective basis a paltry 4.7% franked to 20% (i.e. only 5.1% grossed up).
And who is making the noise? The usual crowd. The brokers – because they need to drive transaction business, so why not drum up a bit of a scare campaign and encourage some switching business. Secondly, the fund managers. They are either underweight the banks (our four big banks alone comprise a fraction under 30% of the whole market index), or they want to be seen to be adding value. Finally, the media – because they can point to the release at the end of next week of David Murray’s Financial System Inquiry report.
And why do they say you should go underweight?
Four reasons are cited. The credit cycle has bottomed – charges for bad and doubtful debts can’t get any lower. Related to this, banks aren’t growing revenue – all the profit increase has arisen from lower bad debt charges. Secondly, an increase in interest rates will hurt bank profits. Thirdly and most importantly, the banks will need to raise a whole lot of capital arising from the report of the Financial System Inquiry.
Fact – the credit cycle may have bottomed, however, bad and doubtful debt charges are not about to blow out. There are absolutely no signs in the forward indicators to suggest that there is any looming problem. Credit growth is still in the low single figures, with business borrowing only growing by a miserable 3.8% in the year to September.
Fact – an increase in interest rates will be a positive for bank profits in the short term. Net interest margins will increase due to the zero rate on “interest free” deposits (cheque accounts, passbook accounts, transaction accounts) staying still, as lending rates rise. If interest rates keep going up, eventually the cycle turns and that’s a negative, however it is a long-term effect.
Fact – bank capital ratios may need to increase. The Financial System Inquiry is expected to recommend an increase to the ‘Domestically Systemically Important Bank’ ratio (currently 1% for the big banks), and/or re-calibrate the capital framework for all banks, leading to a higher ratio. The questions are: how big will the increase be? How long will the transition period be for banks to comply? And is this already priced into the market?
My guess is that a lot of this is already priced into the market, and I am confident enough that the transition period will be years – rather than months. For example, while the framework for Basel III was agreed in 2010/11, it won’t be until January 2016 that Australian Banks are formally required by APRA to comply.
Bottom line – I don’t think that the banks are going to need to rush out and issue ordinary shares following the report. They will be given time to make any adjustment, and hence the fear is way overdone. Besides, if you underweight banks, where else do you invest?
Actions speak louder than words, and the market (as opposed to what the media or your broker might like you to think) is voting with its hard-earned cash. This year, the market, as measured by total returns from the S&P/ASX 200, is up by 6.21%. Financial stocks (excluding property trusts) are up by 8.69%! And so far in November, despite all the noise, the market and financial stocks are down by almost the same small amount – 0.70% and 0.74% respectively!
Case made, I hope, to ignore the noise.
Let’s now turn to the four majors.
CBA continues to outperform
On 19 May, I ranked the banks in the following order: 1. CBA, 2. Westpac, 3. ANZ and 4. NAB.
I reviewed this again in August, and made one minor change, I switched ANZ and NAB around, elevating NAB to third place.
Six months have passed since my first ranking, and despite being the most expensive (and least liked by the analysts) stock, CBA is the clear outperformer (see table below). That said, the differences are fairly small.
If we reviewed the performances over calendar 2014, CBA is still the clear number one. Westpac jumps to second place, ANZ slips to third place and NAB, the perennial cheapest stock, goes back to last place with a negative total return.
So, which bank will outperform from here?
Let’s start with what the brokers think.
As a group, they are remarkably indifferent about the major banks – with target prices close to the current market price and sentiment in a very tight range. ANZ is the very marginal favourite with a sentiment rating of 0.1 (scale is -1.0 most negative, to +1.0 most positive), with Westpac the least preferred.
Commonwealth Bank is the most expensive stock on a forward multiple of 14.9, an effective premium of 25% to the cheapest stock NAB, which is on a multiple of 11.9.
Source: FN Arena as at 14/11/14. Sentiment scale (-1.0 to +1.0)
Even at a premium of 25% to the NAB and 16% to its next most expensive competitor, Westpac, it is hard not to go past the Commonwealth. Best systems, strongest franchise, stable management team and positive jaws (revenue growing at a faster rate than expenses). The last trading update revealed that cash earnings in the September quarter were $2.3 billion, an increase of 9% on the $2.1 billion for the corresponding quarter in 2013.
The new CEO at the National Bank, Andrew Thorburn, has got off to an impressive start. He has cleared the decks, changed his management team and strengthened management accountability. Importantly, he seems to be switching the focus at NAB back to its Australian domestic franchise. This has been NAB’s Achilles heel.
Execution challenges abound at the NAB as they deal with their legacy issues, technology constraints and getting the domestic business firing again, and my sense is that it is a little premature to re-rate.
ANZ, the weakest of the four big banks domestically, is able to boast of profitable growth in its Australian businesses. However, it is the most constrained of the banks in terms of capital, and in regards to its Asian strategy, it looks like one step forward and two steps backwards.
With Gail Kelly stepping down as CEO at Westpac in February in favour of Brian Hartzer, the market will be a little circumspect about Westpac. Despite a very solid full year result and seemingly smooth transition, Westpac shares have fallen and are starting to look cheap.
Like the brokers, I think the differences are at the margins – you can confidently invest in any or all of the major banks. My performance ranking remains:
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.