A Few Truths About Australian Banks

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By Rudi Filapek-Vandyck, Editor FNArena

It's not easy to be a banker in Australia these days. Everybody, from politicians to journalists and consumer organisations and central bankers, has an opinion about the banks, and it is seldom a positive one. In the share market, there's virtually nothing left of the popularity that made banking stocks so dominant in investment portfolios pre-2008.

These days banking stocks are being held responsible for Australia's underperformance in comparison with equities in the US (because banks represent about 20% of the S&P200 index and about double that when measured against market capitalisation). Some experts have been warning their clientele against banks "doing a Telstra" in the years ahead, implying they will continue paying out a high dividend, but potentially against the background of continuously declining share prices.

Such widespread pessimism seems justified given the banks' own admission they had been writing unprofitable mortgage loans earlier in the year. Reason why the sector hiked rates this month while the official cash rate remained unchanged. But how much of all this is mere perception rather than reality? Are investors in Australia becoming too negative at a time when investment bankers are raising ratings for banks in the US and Europe to Buy?

Let's start with a few facts that may surprise some among you.

Banks cannot be held responsible for the sheer underperformance of Australian share market indices for the simple reason that most banks, believe it or not, have outperformed the likes of BHP Billiton ((BHP)) and Rio Tinto ((RIO)) since equity markets started "normalising" in March 2009. As I explained in earlier writings, this can be partially explained by the fact that banks pay out annual dividends double as high as BHP does (Rio pays out much less).

Moreover, and surely this would have escaped most investors' attention, shareholders who have stuck with their shares in CommBank and ANZ Bank since the dizzying peak in early November 2007 have today recouped all losses endured in the credit crunch and Lehman Bros collapse sell-offs. Thanks to consistently growing fully franked banking dividends, total investment returns from peak levels in 2007 are positive today (without taking into account potential extra tax benefits from franking). Not something shareholders in most other blue chip stocks in Australia can equally boast about, including the two big miners BHP and Rio Tinto.

When we look inside the sector, performances for banking stocks today are no longer as uniform as they were pre-2008. This becomes immediately apparent when we line up total investment returns for the past three years:

– CommBank ((CBA)) 80%
– ANZ Bank ((ANZ)) 71%
– Suncorp ((SUN)) 60%
– National Australia Bank ((NAB)) 46%
– Bendigo & Adelaide Bank ((BEN)) 40%
– Westpac ((WBC)) 39%
– Bank of Queensland ((BOQ)) 18%

What the table above clearly shows is that the changing dynamics for the sector have led to pronounced divergences in investment returns, with investors clearly distinguishing the weaker players from the stronger, and the more risky banks from the safer, solid options. It is obvious Bank of Queensland stands out in terms of overall vulnerability, which today translates into the largest valuation discount built into the share price. CommBank remains the numero uno "safe-haven" when the going gets tough. Also, witness what has happened to Westpac which seemed firmly on its way to claim sector leadership in 2008, until CEO Gail Kelly and her board decided to purchase the troubled St George Bank.

As such, Westpac has provided Australian investors with yet another example of how most corporate acquisitions are to the benefit of shareholders in the target, not so much for shareholders in the acquiring company.

The rankings in the table above are remarkably similar for share price performances in 2011, when overall risk appetite was low and share market risks were being perceived as very high. I believe there's a clear message in this for shareholders in the sector. Just as investors flock to Coca-Cola Amatil ((CCL)) instead of Fortescue Metals ((FMG)) and to Telstra ((TLS)) instead of Mesoblast ((MSB)) when the world appears to be going pear-shaped, there's now a clear divergence in risk profiles inside the banking sector too.

Note how ANZ Bank's Asian expansion has catapulted the stock to the number two position in the sector, only behind the perpetually-expensive CommBank. I bet most readers will be surprised to find Suncorp on position number three. Suncorp doesn't tend to get a lot coverage in the financial press, unless when disaster strikes, but Suncorp shares finished 2011 pretty much unchanged if we include dividend pay-outs. Bank of Queensland, on the other hand, last year significantly underperformed even the big miners, including dividends.

The ranking above is again being reinforced this reporting season with National and Westpac disappointing with their market updates, while Commbank pleased and ANZ Bank surprised to the upside. Note that Bendigo and Adelaide Bank kept its interim dividend flat (hasn't happened for either of the Big Four as yet).

What about the way forward?

Australian banks are now in a low growth environment. Instead of 20%-plus growth each year (as was the case pre-2008) they are positioned for low single digit growth in years to come. This conforms with current market expectations, suggesting there's no longer a mismatch between analysts' expectations and actual industry dynamics (except, maybe, for Bank of Queensland). Note that while banks will have to again raise the interest on mortgages independently from the RBA, I believe they will do exactly that and so achieve current low growth expectations.

I believe all of the above gives investors clear guidelines about how to play the sector in 2012, and beyond. At times of risk aversion, CommBank will outperform all others. Long-term investors worried about capital preservation and still looking for a healthy dividend yield (grossed up 9.5% including full franking credits) should definitely think twice before abandoning the shares. On a risk-reward basis, however, one must conclude that ANZ shares have more upside potential given a lower valuation and more positive surprise potential from the Asian operations. Dividend yields for both stocks are the same (at closing prices on Monday).

If, however, risk appetite returns with a vengeance, or things turn out much better than currently expected in the year(s) ahead, then shares of Westpac or Bank of Queensland offer the highest return potential. As said, for this to happen both industry dynamics and overall risk appetite will have to improve noticeably. Westpac CEO Gail Kelly still has the task at hand to translate the expanded network through the added St George operations into superior leverage, but if she were to succeed, a big catch-up in share price should follow. In the absence of any concrete evidence, however, I wouldn't consider such a scenario as even remotely likely.

With central banks providing more and more extra liquidity to the global financial system (see People's Bank of China lowering reserve requirements over the weekend) it is probable that stocks in miners, energy companies and biotechs will outperform the banks in weeks and months to come. However, the past years have clearly shown what happens when risk appetite turns for the worse. Banks outperform, not in the least because of their hefty dividends, and the best of the crop, CommBank and ANZ, seem pretty good in preserving the capital of their shareholders too.

(This story was written on Monday, 20th February 2012. It was sent out on that day in the form of an email to paying subscribers at FNArena).

Note: part of the calculations used in this story were derived from Stock Doctor.

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