Rudi’s View: CommBank, The Most Consistent, Reliable Performer

This story features WESTPAC BANKING CORPORATION, and other companies. For more info SHARE ANALYSIS: WBC

By Rudi Filapek-Vandyck, Editor FNArena

Shares in CommBank ((CBA)) are back to price levels last seen in late October 2007 when the Australian share market peaked at 6,792.10, some 32% higher than where the ASX200 index is today and that is, for obvious reasons, attracting quite some attention around family BBQs and elsewhere.

Long term investors in the sector know the real news was already achieved in late 2011 because that's when CommBank shares had fully recovered all losses endured during the 2008 share market meltdown (as measured from the late 2007 peak). Two other banks, ANZ Bank ((ANZ)) and Westpac ((WBC)) -in that order of chronology- joined Commbank during the rally of 2012.

So far, National Australia Bank ((NAB)) has not managed to fully recover from its currency trading scandal at the beginning of the last decade, plus NAB is still carrying the scars from ill-advised expansions into the US and in the UK. It has made NAB over the past ten years the eternal laggard in the sector; always a smidgen cheaper than its three peers, but never been able to close the valuation gap on a sustainable basis. On the other hand, NAB has still outperformed Australia's regional lenders, Bank of Queensland ((BOQ)) and Bendigo and Adelaide Bank ((BEN)).

So there's a clear ranking order inside the Australian banking sector and the GFC has simply reinforced the differences in risk profiles and quality franchises. Bottom line: CommBank sits on top. This is why, when things get really hairy, less money flows out of CommBank shares and this is also why CommBank shareholders have been the first to see all GFC-induced losses disappear.

But the real value for long term investors is not expressed through the (relatively minor) differences between the major banks in Australia, but between the banks and the rest of the share market. Most other stocks listed on the ASX still have a fair amount of work to do before their shareholders have fully recouped the capital losses endured post-2007. The banks (three of them), as noted earlier, are now generating positive returns when measured from the peak, and CommBank shareholders have been enjoying more gains than others.

No doubt, this will come as a surprise to most investors and commentators. Wasn't the GFC at its core a cancer inside the global banking sector? Wasn't the "new normal" for banks going to be characterised by tighter controls and more regulation, leading to stringent limits on future growth? Was the global consumer not going to save more and borrow less? How about businesses finding easier funding directly through financial markets?

The real surprise, no doubt, is that Australian banks' outperformance has been achieved on the back of rather low growth. Whereas earnings for shareholders used to grow at 20% per annum during the lead up to the 2007 peak, the "New Normal" has seen rather tepid growth since. One thing hasn't changed and that is that Australian banks are very reliable, solid dividend payers. It is these continuously growing streams of dividends to shareholders that contributed to bank shares' popularity pre-2008, it is these same dividends that have turned Australian banks into shareholder champions in the post-2008 years.

The table below shows dividend payouts to CommBank shareholders over the past seven years. As anyone can see, there has only been one single, temporary interruption at the height of the GFC turmoil in the long established trend of growing dividends for shareholders:

There is one very important lesson for investors in this tale: ignore the virtue of dividends at your own peril. Share prices can slump or move sideways for an extended period of time, but dividends, once received, do not disappear regardless of what happens to the share price. Australian banks are among the highest and most reliable dividend payers in the world. When things get really tough this is all that matters to investors. And Commbank, those same investors have decided, is simply the best among the best. Or, if you allow me to show off a little knowledge of Latin I picked up at High School: the primus inter pares.

Regarding those dividends, here are a few facts long term investors might want to take into consideration:

– if one was able to purchase CommBank shares at their low point during the GFC, today's dividend yield would be no less than 13.9% (and fully franked too)
– CommBank shares have paid out approximately 32% in cash dividends over the past five years (2008-2012)
– Westpac has proved the best dividend payer post-2007 with the shares paying out 40% since 2008 (but its total return has not kept up with CBA's)

Banks' dividends might be sacred among long standing loyal shareholders, but they are by no means 100% risk free. One of the "tricks" Australian banks have used in the post-GFC era is to gradually lift their payout ratio, so that dividends have still grown relatively strongly while cash and earnings have not. Anyone can see this is not a sustainable method to keep shareholders happy. Sooner rather than later, profits will have to start growing faster or the banks risk having to disappoint shareholders expectations.

Below are consensus expectations for CommBank this year and next:

The good news is that a re-balancing in the Australian economy (as currently targeted by the RBA) should benefit the banks. Australia may be a resources intensive economy, the banks' exposure is much more skewed towards the non-resources part of the economy and that is the part that has been struggling with recession-alike circumstances in years past. This an important factor behind the rather tepid growth pace in banks lending in years past.

The flipside is that ongoing tough conditions for large parts of the Australian economy still have the potential to trigger more bad news stories for banks as companies are still calling in administrators or go bankrupt. Mortgage stress may well rise in the short term despite falling interest rates, as Australia's unemployment rate is widely expected to rise in the year ahead.

Those side-effects always arrive with a lag so don't be surprised if the banks will be confronted with more bad news from the domestic market, depending on how smoothly the economy's re-balancing process develops in the year(s) ahead. Investors should note the banks are only benefiting slightly from RBA rate cuts because of fierce competition for bank deposits and this is why they are not passing on full rate cuts to mortgage holders (they would not benefit at all otherwise). On top of this, it would appear growth drivers in key lending segments (business loans, personal loans and credit cards) are decelerating in 2012 while overall cash generation is no longer what it used to be for Australian banks.

Offsetting these threats are ongoing cost cutting programs which should assist banks in retaining the image of solid, non-spectacular but reliable dividend payers. What could possibly spoil this image is when impairment charges turn out worse than anticipated. Analysts at Macquarie recently highlighted that write-offs by Australian banks have exceeded provisions for several years now, eventually this can lead to banks being forced to top up their provisions. On Macquarie's calculations current provisions should suffice for two more years. By then this trend can no longer continue without financial consequences.

Making matters a little more tricky is that valuations for bank shares have now risen to their highest point post-2008. Arguably, this makes bank shares more sensitive to increases in loan losses should they eventuate (and they probably will).

It is here that CommBank's embedded sector premium might prove an extra burden as CommBank shares are relative to the rest of the sector by far the most expensively priced. CommBank also has more exposure to the domestic economy than peers like ANZ Bank and National Australia Bank.

But while banks share prices are far from "cheap" and short term risks for negative surprises have arguably risen (a lot), many an analyst covering the sector is predicting positive surprises for shareholders are forthcoming in the form of capital management initiatives which likely include buying in own shares and paying out special dividends. The general view is that from FY14 onwards, when Australian banks sit comfortably within limits set by international Basel III financial standards, boards will increasingly seek to use excess cash to extra-reward shareholders and create additional value.

Assuming this scenario plays out as expected, Westpac and CommBank appear best placed in the sector to offer additional rewards for shareholders through capital management initiatives.

This, I would argue, completes the circle that is banks' returns for investors. There's no realistic prospect for the resumption of rampant growth in the foreseeable future, but it is the Australian banks capability to continue rewarding shareholders through growing dividends or otherwise that will prove vital in the years ahead, even if risks for negative developments have risen in the short term.

The table below shows total returns for the Four Major Banks in Australia for each calendar year post-2007:

As the table above shows, CommBank shares are not always the best performer in the sector, but they certainly have proved to be the most consistent performer. That's why they are trading at a sector premium, and deservedly so.

Investors should always consider weaknesses and strengths when assessing investment opportunities. In the case of Australia's Big Four Banks, CommBank shares in particular, I believe these are:

Potential weaknesses: more softness in the Australian economy can lead to more bad debts and mortgage stress – growth in earnings is likely to remain lackluster and dividend payout ratios are already well above historical averages – valuations are higher than at any other time post-2008 – growth in dividends already is slowing down

Potential strengths: solid, highly reliable payers of attractive dividends – the years post 2013 are likely to see capital management initiatives (and thus extra shareholder benefits) – dividend growth is likely to decelerate, but growth should still be on the horizon

Bottom Line: Long term investors looking for a relatively low(er) risk opportunity shouldn't chase when the herd is doing exactly that. Buy at cheaper levels instead and concentrate on dividend. Keep for long term and expect positive surprises on top of income/yield.

Trivia: Macquarie analysts recently went through all kinds of impairment scenarios for the next few years. Depending on how severe this problem turns out to be, the impact on banks' profits and dividends from having to replenish provisions to cover bad loans can vary between mild and severe. However, no matter what scenario was being tested and calculated, CommBank always came out on top as the least impacted, while NAB always came fourth.

This story was published earlier in the Switzer Super Report.

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

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