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Upgrading the Big Four banks

Key points

  • The yield trade is expected to support the banking sector as interest rates remain low. Prospective yield alone should support the Big Four at current share prices.
  • With benign bad debts, net interest margin (NIM) maintained, falling wholesale funding costs and quantified regulatory capital risk, the sector now looks primed for total return outperformance.
  • This means an upgrade for the sector as a whole and a buy for ANZ and Westpac.

 

The stunning moves down we have seen in global and domestic yield curves, combined with record low 10-year bond yields and collapsing commodity prices, suggests we are entering a period of low inflation, low GDP growth and ultra-low cash rates.

The only developed country in the world where cash rates will rise this year is the United States of America. However, even if I am right and the Fed raises US cash rates by 50 basis points, it only takes the US cash rate to the still ultra-low setting of 0.5%.

The rest of the developed world has downside cash rate risk and some will embark on further QE. Savers will continue to be punished for a crime they didn’t commit. Anyone requiring investment income to live will be forced up the risk curve, both globally and domestically.

Investors looking for historic fixed income like income returns will be forced into equities and buy-to-let residential property. In terms of equities, that means they need to become far more accepting of short-term capital volatility in seeking those historic fixed income style returns.

Quite simply, if the long bond yields we see in front of us today are sustained for an extended period, the price paid for any instrument that has “bond like” characteristics will rise as yields are bid down. That was the basis of my Telstra (TLS) price target upgrade to $7.00 last week.

Follow the franking

In Australia, with our ageing population and the nuances of the taxation and superannuation system, franking credits become even more valuable in an ultra-low interest rate environment. This is particularly relevant to anyone who has entered the pension phase of super (0% tax) who gets the full franking credit rebated from the ATO. The only liquid way the man in the street, who doesn’t own a private business, can accumulate franking credits is via buying listed Australian equities and certain hybrids.

I’ve tried to explain to foreign investors that to understand Australian equities you have to think like an Australian investor in the pension phase of super. You have to think grossed up yield because that is effectively exactly what certain fully franked dividend stocks physically yield to holders over 60 years of age. That is how I approached Telstra over the last five years and the big four banks via setting dividend yield based share price targets.

I get the feeling that any liquid Australian industrial equity that can demonstrate fully franked dividend growth is going to be re-rated. I strongly prefer demonstrable dividend GROWTH over basic dividend yield.

The banks

In terms of the Big Four Australian banks, I need to reassess my view to take into account these dramatic moves in bond yields and the likely direction of Australian cash rates.

In recent times being underweight the Big Four banks and overweight non-bank dividend growth stocks has worked pretty well. ANZ, NAB and Westpac have broadly gone sideways/down for a year, yet CBA has moved ahead into its record interim dividend in February.

This somewhat lacklustre performance from Australian bank equity is despite the sharp moves down we have seen in bond yields, cash management trust (CMT) rates and term deposit (TD) rates. That is why I am looking again at the sector this week.

Let’s start by looking at forecast EPS growth in FY15 over FY14.

[1]

Now let’s look at forecast dividend growth in FY15 over FY14.

[2]

Now let’s look at current FY15 forecast raw and grossed up dividend yields based off the last closing price.

[3]

In summary for FY15 (est)

[4]
With every form of Australian fixed interest having a “2 handle” (unfranked), it is now unlikely that Australian banks will prospectively yield more than four times those fixed interest yields on a pre-tax basis. I expect these bank yields to be bid down in the year ahead and this week I am reverting to setting 12 month Australian bank share price targets inverse to a 5.00% FY15 fully franked dividend yield. 5.00% fully franked is 7.14% grossed up, so still a hefty “equity risk premium” to fixed interest to compensate for the volatility and risk of equities.

5.00% fully franked FY15 dividend yield based share price targets
[5]

This fully franked dividend yield based approach to 12-month bank share price target setting worked very well over 2013 and 2014 when 5% fully franked targets were hit. I expect it to work again in 2015 as cash and bond yields plumb record lows.

Total potential total return table (projected capital gain plus estimated grossed up yield)

[6]

In the table above you can see potential FY15 total return scenarios (inc franking credits) of between +8.48% for CBA up to +32.32% for NAB.

Bet on the banks

With benign bad debts, net interest margin (NIM) maintained, falling wholesale funding costs and quantified regulatory capital risk, the sector now looks primed for total return outperformance. Prospective dividend yield alone will support the sector at current share prices if, for some reason, I am proved wrong on my prospective capital gain forecasts.

Similarly, in this yield environment, any capital raisings will be swamped. EPS growth will be better than the ASX200 in FY15 as ASX200 consensus earnings are revised down.

The Big Four banks will be volatile in the weeks and months ahead but I believe you are now being compensated in terms of yield premium to cash and fixed interest for that volatility risk. I expect bank dividend yields to be bid down inside volatile trading ranges, as money moves into equity yield from cash and fixed interest.

With the CBA interim pending, which will confirm all of the above, it is time for portfolio action.

This week I am upgrading ANZ and Westpac to buy alongside the NAB buy recommendation, remaining neutral on CBA. I am moving to mildly overweight the sector.

Go Australia, Charlie

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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