Time to unwind 22.8% profit on bank shares

Co-founder of the Switzer Report
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I like low-risk trade ideas. And even if I can’t trade (for example, because I don’t want to crystalise capital gains), it provides guidance as to where future purchases or any re-weighting decision might be directed.

On December 10, I wrote “buy NAB, sell Commonwealth Bank” (You can read the full report here).

That trade was low risk – because it maintained market exposure and sector exposure – it was just rebalancing between two very similar companies – overweight in one stock, underweight in another stock. In other words, CBA was expensive, and NAB was cheap. And low risk also due to the “mean reversion theory” (more on this later).

Profit of 22.8%!

As the table below shares, NAB shares have rallied from $24.50 to $35.98, while CBA has only moved from $60.88 to $74.17. CBA has paid an extra dividend (364 cents in total per share versus 93c for the NAB), and when this difference is added back in, the net change is 22.86%. So, if you had sold $10,000 of Commonwealth Bank shares and purchased $10,000 of NAB shares (a “low risk” trade), your portfolio would be better off by $2,280!

*Dividends expressed as a % of price on 7 Dec

The graph below shows how NAB has really outperformed CBA in the last three months (NAB in red, right hand axis).

NAB vs CBA: 3 month price performance (source ASX)

Why change?

The argument back in December was pretty simple – NAB was trading on a forecast PE of 10.0, CBA at 13.7. This meant that CBA was 37% more expensive. While CBA deserved a premium rating due, in part, to its leadership in technology, a more normal premium was around 20%. The main concern about NAB – its exposure to UK Banking – wasn’t as big a deal as the market made out because it wasn’t that material.

Now the market seems to agree. In fact, the broker analysts have gone decidedly bullish on NAB. According to FN Arena, BA-Merrill Lynch and CIMB upgraded their recommendations on NAB during September, meaning CIMB and Macquarie now rate NAB as “outperform”, Deutsche and BA-Merrill as a “buy” and Citi, UBS, Credit Suisse and JP Morgan as “neutral”. There are no “underperforms” or “sells”.

Interesting to note how many brokers cite the relative price difference between NAB and the other banks, and the easing of conditions in the UK, in their reasoning for their recommendation.

While it is true that NAB will also benefit from improving business confidence locally and, as the weakest in retail banking, has more opportunity than the other majors to grow market share, I would argue that most of the price change is due to the application of the ‘mean reversion’ theory.

The mean reversion 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 – 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.

Where to from here?

As the following broker consensus forecasts for earnings and dividend yields show, the two banks are now a lot closer. For the FY 14 year (NAB balances on 30/9, CBA on 30/6), NAB is trading on a PE of 13.4, CBA on 15.2.

Interestingly, only one broker (Citi) has a “buy” on CBA. The other seven are either “sell”, “underperform” or “neutral”.

So much for broker ratings.

My sense is that CBA still deserves a premium rating, mainly due to its very clear technology leadership, proven management team, and leading positions in most of the major markets (deposits, home loans, wealth management). The question, as always, is how much?

With NAB in the lead up to its annual result and dividend payment (result announced Thursday 31 October, ex dividend on Thursday 7 November), it is more than likely to be well bid and might tighten even further against the CBA. Also, markets tend to overdo things, so it is hard to fight the trend if NAB is “in favour” and CBA is “out of favour”.

Bottom line – time to unwind the trade. Equal weightings between CBA and NAB, leaning to an overweight position in CBA, after NAB goes ex-dividend.

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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