Banks: More Than Meets The Eye

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

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By Rudi Filapek-Vandyck, Editor FNArena

Stating that banks are back in focus, with analysts and commentators publicly debating whether "not cheap" means "overly expensive", or not, is an understatement most of the time, in particular in Australia.

Banks in Australia not only include the largest contributor to the ASX 200 index, Commbank ((CBA)), as a group they also represent the largest index constituent. The latter should be a good thing because banks in general have proven an excellent investment in the post-2009 years, certainly better than energy stocks and miners, beyond the occasional short term rallies, and many an investor today still regards banking shares as the backbone of their long term investment portfolio.

But there's equally a large group of investors and of investment experts out there who don't like the sector, arguing investors in Australia are too complacent about the typical sector risks involved, pointing at what appears to be over-priced valuations and predicting a gloomy outlook for a sector that should have been dead and buried after the collapse of Lehman Bros and the global financial system with it.

Instead, Australian banks have re-rated to previous bull-market valuations, showing investors the underlying power of the cosy monopoly that is banking in Australia; rewarding investors with solid, growing dividends that not only beat term deposits and bonds, but the large majority of listed companies in Australia. Herein lies the dilemma for today's investor: what if those persistent doom and gloom forecasters finally prove right?

Before we try to dissect the many issues that are part of today's investor dilemma, let's have a look at a visual of the sector re-rating (thanks to analysts at Morgan Stanley) in recent years. As is clearly apparent on the chart below, the sector's Price-Earnings (PE) ratio has surged back to levels last seen in the years preceding the share market peak in late 2007.

The obvious observation is that current PE ratios are not that uncommon (and a similar observation can be made for other valuation metrics). Banks have been here in the late nineties and in the early noughties, and, as said, PEs were at present levels prior to 2008. One easy to make counter-argument is that on each of these previous occasions banks were enjoying stronger growth and lesser regulatory attention and restraints.

The other observation is that de-ratings to lower valuation metrics do happen and in fact, they are rather common if history can be our guide into the future. So what will trigger the next de-rating? Higher interest rates? This is far less likely than one might assume. Take a close look at the chart above. Then consider that the RBA ended its loosening cycle in December 2001 and started raising the cash rate again from May 2002 onwards.

For the banks, the end of monetary easing triggered a period of sharply increased volatility, but ultimately valuations ended back where they started, at today's levels of valuation. Banks are not simply a counterweight for bond yields and term deposits, they are also a reflection of overall activity in the economy and of demand for credit.

In the share market, banks compete with more than one thousand other listed entities, but in the eyes of most investors the overwhelming majority of share market alternatives are too risky, loss-making, non-consistent or simply non-investment grade. Too much emphasis in the public discourse goes to the fact that banks are reliable providers of market-beating dividends, in my view. In Australia, banks have built a long-standing legacy of solid growth, in profits, in value for shareholders and, yes, in annual dividends for investors.

It is this legacy that continues to attract SMSF operators and other investors to the sector. Against this background, banks have been benefiting from the same market dynamics as have the likes of Invocare ((IVC)), Woolworths ((WOW)), Amcor ((AMC)) and even Ramsay Healthcare ((RHC)) and REA Group ((REA)). All these stocks have in years past been rewarded by risk-adverse investors (including professional funds managers too) for offering consistency, reliability and few disappointments only.

As such, I believe two key questions that are likely to determine the outlook for bank shares are:

– what are the chances banks will disconnect from their legacy and turn ex-growth?
– what are the chances they lose their relative superiority vis-a-vis most of the rest of the share market, in particular against other large cap stocks?

Notwithstanding all the noise generated by foreign experts, including US-based hedge funds that have lost their shirt by taking short positions in the banks on expectation of either a collapse in the local property market or in the Chinese property market, none of the stockbroking analysts in Australia that cover the sector is currently toying with the idea of no growth for the sector in any one year ahead. All are united in the observation that Australian banks are enjoying a mix of tailwinds and headwinds and the end result, so these analysts believe, will be for lower growth than what we have seen in the past. Single digit instead of 10%-plus, but growth nevertheless.

Where these analysts differ in opinions and views is how, exactly, all the opposing factors are impacting on banks' ability to grow cash, profits and dividends, and it is these differences which determine sector valuations and individual preferences for the sector. Equally important, while opinions vary about margin potential/pressure, reserve requirements and further cost control, I have yet to find the first banking analyst who's willing to forecast a reduction in dividend for any of the Australian banks. Most see plenty of room for the banks to continue growing their dividends in the years ahead, just not by that much.

It's the "by how much" that is responsible for all of the debate when it comes to dividends and Australian banks.

As far as the relative performance outlook for the banks goes, with iron ore in a long term downtrend and base metals in a tepid recovery at best (with the exception of nickel), oil prices sustained by geopolitical risk, and the domestic economy possibly performing sub-par for years to come due to the unwinding of gigantic resources infrastructure building, what are the chances, really, the banks will be left behind by a growth splurge among cyclicals and other sectors of the share market?

It is my personal view the many critics of bank share prices fail to understand today's premium valuations are as much the result of low interest rates (putting emphasis on dividend yield), as they are of the banks' legacy (attractive for investors who now prefer lower risk and more steady performance), as they are in relationship to the relative performance and outlook for the rest of the share market. In this context I note many large cap players in the more volatile and more risky resources space are about to turn into dividend plays themselves, including BHP Billiton ((BHP)), Rio Tinto ((RIO)), Fortescue Metals ((FMG)), Santos ((STO)), Origin Energy ((ORG)) and Oil Search ((OSH)). Woodside Petroleum ((WPL)) already is a low growth, dividend paying energy producer.

But are these newcomers, given the nature of their sector and their core operations, as well as their past, ever going to genuinely threaten to beat the banks at their own game?

None of all of this means banks valuations cannot de-rate. As a matter of fact, it is very likely they will, at some point. History shows exactly that and investors can take another look at the chart above if they need reassurance. But for this de-rating to prove more than temporary, we would need to see a significant and sustainable change in the dynamics that support today's elevated, premium valuations.

As far as individual preferences go, recent analysis by Brian Johnson and Ed Henning at CLSA has revealed that ANZ Bank ((ANZ)) can now boast the largest percentage of international shareholders. Clearly, those international managers still interested in owning a piece of Australian banks remain uncomfortable with the outlook for Australian property and maybe even the Australian domestic economy and they have instead chosen to back the story of ANZ Bank tapping into higher growth potential in Emerging Asia. This in itself raises a few interesting observations.

Investors initially pushed ANZ Bank to a premium valuation versus its peers on the prospect of more Asia-exposure, but the relative sector premium has reversed back into a discount since as a general realisation sunk in that Asia is a little bit less straightforward than that. ANZ Bank has not been the fastest growing bank among the Big Four in Australia and only few analysts believe ANZ's pace of growth will be superior in the years ahead. Equally, ANZ Bank shares have not performed best in years past and neither does the bank offer the highest dividend yield.

Most analysts point out that spending capital in emerging countries lifts the risk profile. A fact that might be tested when US interest start rising and more weaknesses reveal themselves in corporate Asia on the back of capital fleeing the region. Others will tell you ANZ Bank will have to put more capital aside, possibly also because of its (higher risk) Asia exposure, and this puts a lid on growth, not to mention the limitation in franking credits due to more profits from Asia, which prevents lifting the payout ratio.

Already, the bank has chosen to no longer neutralise dilution from its Dividend Reinvestment Plan (DRP). This is significant in that it signals the bank is pressured on its capital requirements plus any dilution will weigh on its growth potential.

None of this separates ANZ Bank from its peers in Australia. All are facing the same challenges and restraints and all are believed to now have entered a period of slower growth and increased headwinds, but with plenty of oomph left, still.

This means there's no reason for valuations to reset and sustainably settle at much lower level.

(This story was written on Monday, 5 May 2014. It was published in the form of an email to paying subscribers on the day).

P.S. CLSA has published a detailed total return overview for the sector since 2007. It clearly shows CBA has performed best throughout the past seven years, while Westpac has outperformed in recent periods. Both National Australia Bank ((NAB)) and ANZ Bank had their moments under the sun. See top of story on the website for attached total return overview.

The Banks Indicator Strikes Again!

I used to call it my never-fail-market-indicator. It was borne out of my personal observation that whenever bank share prices in Australia moved above consensus price targets, a general market correction was never far off. Last week, I reported all share prices in the sector were trading (well) above consensus price targets, with the sole exception of National Australia Bank. Since then, a number of prominent market commentators has expressed their negative view, stockbroking analysts have further scaled back in remaining positive views and share prices have weakened, despite solid financial results being reported.

Equally important, it's not just the banks that have suffered from sellers outnumbering buyers, with the Australian share market in general suffering from vertigo.

Flexigroup Ready For A Come-Back?

Small cap credit provider Flexigroup ((FXL)) quickly built a legacy of rock solid growth in years past, turning many a shareholder into a happy chappy when, in contrast, most of the Australian share market was not performing at all. But all that changed last year when investors started to zoom in on a maturing core business and what may well become a troubled solar financing business. Momentum quickly turned negative and it has remained sharply negative since. Only recently has the share price found some support.

Yet, stockbroking analysts covering the stock continue to express the view that all shall remain OK at the financial business. Yes, underlying FlexiRent volumes are flat-lining and the Solar market is likely to have peaked, but the share market is acting as if both operations are going to be swallowed into a large black hole, suggested analysts at UBS on Monday. They are the latest to come to the conclusion that fear-stricken investors are too panicky about what may or may not transpire beyond FY15, which in itself is looking like yet another strong year for Flexigroup (projected EPS growth 13%).

On UBS' assessment, double digit growth from the years past is to be replaced by single digit growth beyond FY15, but management can still acquire businesses to maintain growth in double-digits, the analysts counter-argue. Besides, if single digit growth is still forthcoming, why is everybody jumping off the cliff?

An interesting schism has opened up between the analysts' opinion and daily price action since November last year and this may well take a while before any clarity can emerge, but Flexigroup certainly has my interest while going through this "fear-or-opportunity" process.

ClearView, A Better AMP (According to CLSA)

It is not uncommon for a stockbroking analyst to fall in love with a certain stock. Last week, CLSA's Jan van der Schalk and Swati Reddy issued an extremely positive report on small cap insurer/wealth manager ClearView Wealth ((CVW)) and subsequent daily CLSA reports have continued to highlight the fact that the analysts have commenced coverage with a Buy rating and a $1.04 price target, well above the share price. In short, CLSA sees ClearView as having everything working in its favour right now, backed up by a strong management team.

ClearView is everything that AMP is not, argues CLSA. And it'll be only a matter of time before investors start appreciating the difference, which should result in a re-rating towards higher multiples on continued strong growth for ClearView. Let's hope this scenario also includes significantly higher volumes for CVW shares. As things stand, it appears the main risk for investors considering taking both CLSA analysts up on their opinion is the fact that only few others are presently prepared to put some money in buying and selling the stock. Same problem as for container operators Royal Wolf ((RWH)).
 

(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. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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RUDI ON TOUR

I have accepted an invitation from the Australian Shareholders' Association (ASA) to present to members (and others) in Wollongong on June 10. Title of my presentation: The Share Market: Always The Same, Always Different.

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