Are You Ready To Face The Facts ?

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, Editor FNArena

My youthfriend Eddie came home one day after work and found his house empty. His bride of less than a year had left and taken all the furniture with her. I know, this sounds like a sad story, but it gets sadder still. Eddie’s parents had paid for all the furniture. However, no matter how hard they, or Eddie, tried and no matter what avenues would be taken, there was no way they could get any of the furniture back, with or without Eddie’s bride.

After his wife left, Eddie’s friends started to open up. They’d tell him they didn’t think she was trustworthy from the beginning, they thought he was making a big mistake, she was not a good fit. Eddie understood they couldn’t signal him before as there was no telling how he would have responded. He understood, but he nevertheless wished someone would have told him something, anything!

It’s been a while since I last spoke to Eddie. I am sure he is in a better shape now. But I still remember walking into a bar, it must have been a few days only after someone had told me what had happened, and there he was, Eddie, getting drunk at the bar. No explanation needed from the moment our eyes met. After a few beers, and after Eddie had told me the story again, and again, I told him: time to face the facts, Eddie. Do you think you can do that?

Today, more than two decades and a few thousand miles later, I feel like I am back in that same bar. Instead of beer, I have a pot of herbal tea on my desk. Instead of eigthies music in the background there’s the sound of passing cars, decelerating, turning the corner and then disappearing in the dark. I have two sons now whom I have to send out of the room: daddy has to finish his story, don’t keep interrupting me! Instead of Eddie, I am communicating with many investors in Australia, but my question hasn’t changed: Are you ready to face the facts?

Ever since the “recesssion we had to have” in Australia in the early nineties was followed by a period of strong economic growth, which is still ongoing today, Australian banks have surged to the forefront of the Australian economic landscape – and of its share market. Investors have done well out of their banking stocks, and that’s more than likely a grand understatement. Double digit EPS growth, year in-year out, with relatively large and steady dividend streams have made Australian banks among the absolute favourites in the market.

The early years into the new millennium saw banking stocks, together with other financials and listed property managers, increase their relative weight in the main share market indices to above 50%. The overall mood towards banks was probably best described by one savvy market commentator who, when discussing a model portfolio for the long term investor, said: buy banks. Doesn’t matter which one, they all move into line with each other. Especially over the longer term. In fact, don’t buy one, buy ALL of them!

I have no doubt that many investors in Australia have fallen in love with their banking stocks – and rightfully so, for the love has been rewarding for more than a full decade. Equally I have little doubt that many of these investors are now looking at the likes of Commonwealth Bank ((CBA)), Suncorp-Metway ((SUN)) and ANZ ((ANZ)) while thinking: 7% dividend yields with a far superior balance sheet and growth outlook than their peers in the US, Europe and Asia. This has to be a once in a lifetime opportunity!

Before we go into more detail, let’s have a look at the following graph:

The beauty about this graph is that I could have taken each of the other major banks instead, or one of the regionals, or the complete index of financial stocks. I could have compared them with other resources, with the materials index, I could even have chosen to compare the index of financials with the generic All Ords or S&P200 index; all charts would be a little bit different and not all the gaps may be as equally pronounced as on this chart, but in essence all charts and all comparisons show the same naked truth: a widening gap.

Allow me to spell out what this chart shows: banking stocks have been underperforming the broader market since 2003. What? I hear you say, how come nobody told me this before? Sounds familiar, hey? Now you know how Eddie felt. I bet you agree that if only someone, at least someone would have told you, you now would have only yourself to blame.

Instead, it wasn’t until a few weeks ago, and only after it became clear that global sentiment towards financial stocks kept deteriorating and with the Reserve Bank determined to put the brakes on the Australian economy, that (some) stockbrokers and financial experts started to question their usual Overweight stance on Australian banking stocks. At least half of all stockbrokers would still advise today investors should pile up on banking stocks, “for the longer term”. The irony is, of course, that these same experts were giving you the same advice back in 2003, and it was the same advice in early 2006, and still in early 2007. In fact, I participated in a radio broadcast in November last year and one of the brokers in the program called CommBank shares still a Buy. They were trading at $61 at the time. (They sank below $40 on Tuesday).

But let’s not single out this one stockbroker in particular: most strategists throughout the industry advised investors should be Overweight banks until a few weeks ago. As a cynic would say: surely, what was a Buy at $61 is definitely a Buy below $40?

I believe in cycles. I believe that “things”, trends, developments, just like human beings, peak and then gradually lose their strength. The US economy was at its ultimate peak in the second half of the nineties when it reached a global dominance on a scale that had never occurred before in human history. Now US dominance is in decline, it’s only a natural process.

What if the banks peaked in 2003?

I’ll tell you what else I see when I look at the chart above: I see a change of market leadership that is still only at its early stages yet. Back in 2003, resources hardly registered on most investors’ radar, but the banks were loved by all and everyone, they were the favourite sector with the largest representation in portfolios and indices. Today, the major banks represent less than 17% of the S&P/ASX200 index compared with major resources at circa 15% (and rising). At the current trend -with the banks underperforming and mining and metals stocks relatively outperforming- we are going to witness a passing of the baton between banks and resources later this year. It will be an historic moment.

Here’s an important lesson I have learned throughout the years: when certain stocks (let alone a whole sector) stand out with an unusually high dividend yield, this is more often a warning signal than a good buying opportunity. More often than not, investors who jump on the dividend opportunity find out later the decline of the “P” (as in Price/Earnings ratio) simply preceded the decline of the “E”. In other words: investors better not get blinded by the fact that share prices already have fallen some 30% and that dividend yields have now soared to 7%, because once earnings start falling, these numbers can change in the blink of an eye.

Wait a minute, I hear you ask, aren’t Australian banks merely suffering from a guilt by association selling reflex because banks and financial institutions elsewhere are in such a bad shape? Aren’t their share prices already discounting worst case scenarios? (Because that’s what your stockbroker is probably telling you, isn’t it?)

Two weeks ago, I mentioned a report by Macquarie analysts which I felt summed up perfectly the core of today’s banking matters in Australia: the banks have experienced lower than normal levels of bad debt over the past years. One could say this has artificially pumped up their profits. But you simply cannot assume bad debts will always remain at such low levels (doing so would be like repeating the mistake by investment banks in the US who assumed that unusually low failure rates on subprime mortgages would last forever). In fact, recent acknowledgements by CommBank, ANZ and Suncorp-Metway have already indicated the tide has turned for the sector.

The key matter is that Australian banks’ profits are highly vulnerable to an increase in bad debts. On Macquarie’s calculations current bad debt provisions are at just 0.2% of the banks’ gross assets. A doubling of the provision rate will reduce average FY09 EPS growth for the sector to minus 2%. A tripling of the bad debt rate, which would imply a return to the levels last seen in 2000 and 2001, will reduce the sector EPS growth to minus 15%.

All of a sudden, buying banks may not be such a compelling investment idea after all.

The recent results season has again confirmed the overal trend in earnings for Australian companies remains negative. This trend is, for the time being, expected to continue. This means that current estimates by securities analysts remain cum further downgrades. The banks are no exception. This will have an impact on their share price performance as valuations, earnings and multiples are likely to drop over time.

As I pointed out over the past weeks, the only sectors in the market with a reasonable prospect of rising earnings estimates are resources and energy companies, because prices of their products are once again surprising to the upside.

To me, the most revealing piece of information in the chart above, is located on the left from where BHP Billiton’s ((BHP)) share price line ends: +300% it says. That has been the difference in return between owning shares of BHP Billiton and of National Australia Bank ((NAB) since early 2003.

Investors in Australia, your sweethearts have left and taken the furniture with them. No matter how much you still love them, or how hard you try, you won’t see any of it back. Time to face some facts. Are you ready to do so?

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