A yield play – buy NAB, sell CBA

Co-founder of the Switzer Report
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I am horribly overweight Commonwealth Bank (CBA) shares and horribly underweight National Australia Bank (NAB).

I say that tongue in cheek because thankfully, I never listened to the analysts and am laughing all the way to the bank! CBA has, over more than the past decade, been the best performer of all the major banks, while NAB has been the chronic underperformer. As a result, CBA has consistently been the most expensive bank (and out of favour with the analysts), and NAB the cheapest and usually, the analysts’ pick.

As the old investment saying about dog stocks goes, as dangerous as it is to change horses mid stride, the yield gap is now simply too much.

The yield and PE gap

Since NAB announced on 19 October that it would make an out of cycle increase to its collective provision of $250 million to largely cover problems with its UK banks, and then followed this up with subdued fourth quarter and annual results, NAB and CBA share prices have moved in opposite directions. NAB has fallen from $26.95 to $24.50 as at the close on Friday, a fall of 5.8% (adjusting for the 90 cent dividend). Commonwealth Bank has rallied from $57.05 to $60.88 – an increase of 6.7%. In total, an outperformance by CBA of 13.2%!

According to FN Arena, consensus earnings and dividend forecasts have changed only marginally and as the following tables show, NAB is now yielding almost 2% higher than CBA.

Some difference! That’s 5.7% versus a 7.5% yield for the NAB, which is of course pre-tax, an effective 9.12% pa after tax for a fund in accumulation and 10.7% pa for a fund in pension. And on a price/earnings (PE) basis, 13.7 for the CBA vs 10.0 for the NAB – CBA is 36% more expensive.

The ‘mean reversion’ theory

So much for the numbers, now for the theory. The ‘mean reversion’ theory goes that in a mature, highly regulated, oligopolistic market like Australian banking, it is very difficult for one of the participants to make major competitive gains over the other participants. Changes in market share are hard won and at the margin, they have the same pricing, cost bases are largely the same, they make use of similar technology, they tap the same talent pool, they share similar lending exposures etc. As a result, their profitability and return on capital will largely be the same.

As markets aren’t efficient, one bank is going to be cheaper than the others. The theory goes that over time, they will largely revert to the mean – that is, the cheapest stock today will become (on a relative basis) more expensive, and the most expensive stock will become cheaper. An uncharitable proponent might add that when sustained pricing differences are maintained, they are more likely to be caused by “own goals” rather than brilliant examples of strategic leadership, planning and execution.

NAB – what can go wrong?

NAB has scored several  “own goals” over the last decade – UK Banking, midwest USA banking, Homeside, the FX Options debacle – the list goes on. Add in under investment in technology, and legitimate questions from the market about leadership and its board.

The most obvious concerns are further troubles in the UK, and the adequacy of their provisioning for bad or doubtful debts. By one coverage ratio, their collective provision as a percentage of credit risk weighted assets, NAB comes out satisfactorily at 1.05% compared with CBA’s 1.06%. However, when residential mortgages are excluded from both sides of the equation, NAB sits at 1.40% while CBA is at 1.52%. Further, NAB’s individual provisions as a percentage of impaired assets are only 30.3%, compared with CBA’s 41.6%.

On the capital side, both banks report similar ratios, with Basel II Tier 1 capital ratios of 10.24% for CBA and 10.27% for NAB at 30 September. In part reflecting its smaller asset base, NAB is doing better in the ‘customer’ funding game, with 66% of its assets funded by deposits from customers, as compared with 63% for CBA.

CBA is the clear leader in technology – at least three to five years ahead of NAB – and now starting to translate that leadership into revenue gains. It is also dominant in housing, and while NAB is making some headway through a price-led strategy, it is coming off a relatively low base. There must be some lingering concern that the bad debts from this initiative will start to show up in a couple of years.

On the other hand, NAB is dominant in the business market, with more than double the market share of the CBA.

Looking forward, NAB is more likely to be impacted in this market by local economic conditions; an upswing would be good for immediate revenue growth and reduced bad debts, while a downswing would produce the opposite result.

While there is no doubt more risk with NAB than CBA, unless there is an “own goal” lurking in the background, the investment attributes are not that dissimilar.

The bottom line

Commonwealth Bank deserves its premium rating over National Australia Bank. However, my sense is that at present, 38% is too much and a return to a level of around 20% is on the cards. Unless NAB’s Annual General Meeting (to be held this Thursday at 9.30am Perth time) comes out with something out of the blue, I suggest to buy NAB as a yield play, and depending on your portfolio and exposure to banks, pay for it by selling CBA.

Important information: 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. Anyone should consider the appropriateness of the information in regards to their circumstances.

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