Aussie Banks: Important Questions, Few Answers

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In this week's Weekly Insights:

– Aussie Banks: Important Questions, Few Answers
– Vale Yogi Berra
– Angst Versus Hope; China Versus USA?
– Lessons Learned, Lessons Shared
– Rudi On TV

Aussie Banks: Important Questions, Few Answers

By Rudi Filapek-Vandyck, Editor FNArena

Australian banks are the largest sector in the ASX200 with the Big Four currently weighing 27-28% of Australia's major index, depending on relative price movements on any given day.

While this is considerably less than the numbers that are often quoted elsewhere (never check a good sounding number, right?), every market observer knows as go Australian banks, so goes the index. Since share prices for the Big Four have reset since May, up to 20% lower, it won't surprise anyone the ASX200 is in negative territory for the year.

Compared with share prices in May, Australian banks looks "cheap". In fact, they look equally "cheap" when compared against historical valuations, as well as against the broader market in a relative sense.

This is the intriguing fact that is currently plaguing the minds of investors in Australia. If Australian bank shares are now genuinely "cheap", how come the sector is not overflowing with investors' money?

Solid, Though Not Immune

It's probably a fair assumption that, post multi-billion capital raisings by three of the Big Four this year, domestic investors already own plenty of bank shares. Hence the onus was on international players to step up to the plate, but internationally the ruling view is that "Australia is toast" because of the noticeable slowdown in the Chinese economy. Such was the personal observation from a NAB economist returning from an overseas trip earlier this month.

As a major exporter of commodities located in the vicinity of Asia, the impact on the Australian economy from a Chinese hard landing seems obvious and straightforward. It doesn't take too much imagination to connect the dots between a recession in Australia with rising unemployment, falling property prices and a rise in bad debts and from there onwards to banks' leverage, financial reserves and share prices.

The last time Australian banks were under threat and forced to cut their dividends was because of international developments, as everyone still remembers, back in 2009. Prior to the GFC, it was during Keating's recession Australia had to have, which, it can be argued, was also greatly inspired by international developments such as a recession in the US on the back of the American Savings & Loans crisis. Prior to that, there was the sudden stock markets crash in 1987 ("Black Monday").

It's a big testament to the solidity and the reliability of the Australian financial system that Big Four Banks have only been forced to cut their dividends three times since the eighties and on each occasion it took some serious damage to the downside to trigger such cuts. Which is why most retail investors treat banks as a no-brainer, staple component of their investment portfolio.

Share prices can move up and down in line with investor sentiment, but twice a year a steadily increasing cheque in the mail provides a lot of comfort. And as long as those dividends continue to grow, the share price will ultimately take care of itself.

Short Term Versus Medium Term

Apparently, this has become the most asked question from retirees and from so-called "mum and dad investors" to their trusted stockbroker or financial planner: are Australian banks able to maintain their dividends? What are the chances they have to cut dividends in the years ahead?

Well, history shows it takes a major crisis, not simply some operational and regulatory headwinds, to force Australian banks into lowering their dividends to shareholders. History also shows that when the banks are forced to cut, the initial impact is noticeable. Dividends were cut, on average, by 23% during the GFC. Bell Potter analyst TS Lim reports in the early nineties the cuts averaged 35%, while back in 1987 dividend reductions proved a less severe 15%.

Unless we succumb to forecasts of doom and gloom, many of the factors that could inflict a lot of damage to the banks' ability to sustain ongoing dividend increases, such as sharply higher interest rates, large numbers of company defaults or significant falls in property prices, seem at this stage rather unlikely. Probably the biggest challenge for the banks comes from the regulatory side and here it appears regulators, both domestic and international, are still far from satisfied.

Hence why the UBS banking team under stewardship of highly regarded sector analyst Jonathan Mott published the following warning last week:

"While we believe the banks now offer more attractive valuations, we think the medium term outlook remains challenging. Capital ratios are continuing to drift higher (we believe 10% CET1 is the new minimum). Basel 4 and Leverage Ratios are on the agenda. Funding costs look likely to rise as banks increase term-deposits and term wholesale mix to meet the NSFR. This may force the banks to continue to re-price their asset books to prevent further NIM erosion."

It's a battle between short-term and medium term likelihood with the mentioned Net Stable Funding Ratio (NSFR), essentially the new framework for banks' capital requirements under Basel III, scheduled for 2018. Banks re-pricing their asset books amounts to monetary tightening and might well pull the RBA out of its policy inertia next year (hints also the team at UBS).

Bear Market Valuations

Prior to the GFC I was an avid observer of bank share prices. As some of you might remember, I developed my own market indicator which essentially matched consensus price targets for the Big Four with share prices to see whether investor sentiment was overheating. It worked. Until the GFC came along. Things have since never been the same.

Valuations for banks moved above historical averages (and broker price targets) in 2012 and they pretty much stayed there until May this year. Now they have been significantly de-rated to the sector's long term Price-Earnings ratio (see Deutsche Bank chart below).

As the chart also shows, banks seldom trade on long term average PEs. Most times they hit the average on their way up or on their way down. The old adage was the long term average PE was 12.5, but banks would trade on PEs between 13-15 during good times and on PEs between 11-9 during bear market periods. The long term average between both periods became an average that almost never showed up in real time practice.

Bank shares had been de-rated once the recovery from GFC-depths had been completed (2010-2012) so that the average PE, despite elevated valuations between 2012 and May this year, has now fallen to 12.16. In broker target terms, the Big Four are now trading at a discount of between 15-22% (Monday afternoon as I am writing this story).

The relative cheapest of the four, ANZ Bank ((ANZ)), offers 6.8% in yield (ex-franking). In line with my earlier analysis about how share market investors have cramped in most dividend paying stocks on the ASX inside a yield range of 4-6%, this suggests credit troubles throughout Emerging Asia or similar scenarios are now being discounted in Australian banks share prices.

Deutsche Bank: The Benign View

Leaving any scenarios for a potential China induced Asian crisis aside for now, the question whether Australian banks represent a good buying opportunity at current prices remains linked to the outlook for Australian housing markets. On international comparison, Australian banks are relatively overweight mortgages.

Here bank analysts at Deutsche Bank issued a rather re-assuring sector analysis on Monday. The analysts acknowledge the outlook for economic growth domestically looks a tad soft, probably softer than expected, and there is likely going to be a rise in bad and doubtful debts for the industry, if only because numbers have been exceptionally low in recent years (remember: extreme low interest rates), but it'll all remain below historical averages, the analysts believe.

Deutsche Bank sees multiple factors supporting such a "benign" view, including:

– Overall, lending growth has been anaemic in recent years

– Gearing levels of large corporates are well below historical levels

– The banks' book mix has improved since the GFC

– Banks' provision coverage looks "reasonable for this point in the cycle"

Deutsche Bank suggests Australian banks are facing a steady, though gradual rise in bad and doubtful debts over the next three years, with the "normalisation" in BDDs more weighted towards businesses than to mortgages.

Incorporating such view in their modeling has led the analysts to reduce forecasts, now sitting below market consensus, and to cut price targets for Australian banks.

The good news? Deutsche Bank's revised price targets are all still above current share prices (see Stock Analysis for details), though they are lower than consensus targets.

Morgan Stanley: The Housing Downturn

Analysts at Morgan Stanley are a lot less confident about Australia's economic performance in 2016. As a matter of fact, the house view is the RBA will be forced to deliver two more 25bp rate cuts next year, so then you know the underlying view is one of disappointment, weaker-than-anticipated growth and the need for additional stimulus.

Under such a scenario, a Pandora's Box will open and release a multitude of dangers and threats to both the Australian economy and Australian banks. All of a sudden the R-word, as in "recession", makes a come-back.

Morgan Stanley's underlying premise is that residential construction essentially is the economic cycle. Australia has successfully coped with two housing downturns since the 1990s recession and in both cases the economic impact was being offset by rising houshold incomes and a Commodities Super Cycle, respectively in 2003/04 and 2008/09.

The reason the domestic housing cycle is turning is because demand for properties has to a large extent been carried by investors and now all of government, APRA and the banks have focused on limiting investors' involvement. Slowing population growth and increasing supply will do the rest, so is the underlying assumption.

Morgan Stanley is firmly of the view that house prices are too high ("bubble") and Australia's geared exposure to housing means Australian wealth is highly sensitive to house price growth. Hence a weakening of house price expectations, material or benign, will impact on consumer sentiment through "wealth effects". Hence the conclusion: "we think the risk of a recession is elevated".

Citi: Payout Ratios Too High

I mentioned Citi's latest research update on the banking sector in last week's Weekly Insights. In essence, Citi analysts conclude that, dividend payout ratios for three of the Big Four banks will be approaching 80% from fiscal 2016 onwards (ANZ Bank remains the exception) while, across the sector, the major banks will only have circa 3.5% of balance sheet core equity, the lowest capital support for future growth in 20 years.

Citi leans towards Deutsche Bank's assumption of a benign turn in the credit cycle, but the analysts predict all banks will need to set aside more cash earnings to fund growth and keep the balance sheet strong, hence rising pressure on dividends and dividend payout ratios.

Australian banks do not need to immediately respond to these challenges and pressures, and their boards may well throw everything in the mix in order to avoid lowering payout ratios or -heaven forbid- not raise the dividend, similar to supportive dividend policies adopted by BHP Billiton and by Rio Tinto, but it seems but logical, nevertheless, that share prices will reflect this increased risk, just like has happened in the case of BHP and RIO.

I think the main question for investors is whether these increased risks have now already been priced in, or whether more de-rating will be required. The answer to this question may not present itself until we've figured out what exactly 2016 has to offer and whether the overall credit environment will be closer to the assessments by Deutsche Bank, Citi and others, or whether it'll be closer to Morgan Stanley's scenario.

Until then, Australian bank shares are likely going to be "cheap" for longer, though not necessarily as "cheap" as they are today.

In the words of Citi analysts: "the uncertainty of future dividends is likely to keep a cap on share price growth in the medium term".

Vale Yogi Berra

Baseball legend Yogi Berra passed away on Tuesday last week, ninety years old and across the globe renowned for his typical Berra-isms (of which I am a big fan myself). For those not familiar: a typical Berra-ism is a rather colloquial expression that seems valid and worth repeating, until you have a think about it.

Many of such Berra-isms lend themselves for open philosophical debate about deeper meanings, and they often apply to finance and investing too. Probably the most popular Berra-expressions are "If you come across a fork in the road, take it" and "it's like deja vu all over again".

My personal favourite is one that didn't originate in Berra's brain, but it's easy to make that assumption: Prediction is very difficult, especially about the future (Nobel-scientist Niels Bohr has been accredited with that one).

A few gems from the portfolio of Berra-isms that can serve their purpose in a financial context:

– You can observe a lot, just by watching

– We made too many wrong mistakes

– You better cut the pizza in four slices, because I am not hungry enough to eat six

– The future ain't what it used to be

– You've got to be very careful if you don't know where you are going, because you might not get there

– If you ask me anything I don't know, I'm not going to answer

– If the world were perfect, it wouldn't be

Angst Versus Hope; China Versus USA?

Plenty to fret about in a world that is still coming to terms with the fact that Yellen & Co really want to get started raising interest rates while China is rebalancing away from infrastructure investments and exports. The easiest observation to make is that forecasts are still dropping; for growth in China, in Emerging Asia, and for the global economy which then translates into ever lower forecasts for commodities prices.

But are we too focused on the dangers and threats in China/Asia -which are real, no doubt about it- while forgetting what a powerhouse the US economy driven by the US consumer still is?

The question was asked by Glushkin Sheff Chief Economist & Strategist, David Rosenberg over the weekend and the answer came in the form of some interesting stats and data.

Total consumer spending in the USA, if it were a country on its own reports Rosenberg, would still be the largest economy in the world, larger than the current number two in the world, which is China. US imports, if they were a separate country on their own, would still be the world's fourth largest economy, bigger in size than the UK, France and India, and only beaten by China, Japan and Germany.

The underlying message is the US economy still represents 25% of global GDP and it should receive more recognition for its importance and its role in keeping the global economy ticking. Rosenberg advocates investors should draw more confidence from the fact the US economy is strong and its positive impact on global trade and demand may well prove of a larger -positive- contribution than China's woes on the negative side.

Another observation to make is that while forecasts and price targets for resources stocks have come tumbling down, in most cases the share price already sits significantly lower. Investors don't have to look any further than the two diversified heavyweights on the Australian share market, with the lowest target for BHP Billiton ((BHP)) shares in the FNArena database $26 (Citi) while the shares are trading below $23. The lowest target for Rio Tinto ((RIO)) to date is $54.60 (Morgans) with the shares trading close to $48. Amongst smaller cap stocks the gap between share price and broker targets can be much wider.

The same theme applies to oil and gas stocks, albeit in lesser extreme fashion. Woodside Petroleum ((WPL)) shares are trading near $29 while Morgans is the only broker with a price target below $31.

It's not difficult to see why value-seeking fund managers are again casting their eye over these beaten down stocks, or why share prices on occasion can display sharp movements higher (even without the shorts covering). Investors should note, cheap valuations are usually bad indicators for "timing" and the trend to date still remains to the downside, at least for now.

Lessons Learned, Lessons Shared

Fund manager Auscap used the September edition of its newsletter to share a few lessons with shareholders that have been "re-learnt" in recent months. I'd say, use to your own benefit:

– The golden rule: the best way to generate returns is to focus first and foremost on not losing money

– Poor management has the ability to ruin any business. If management appears not to be operating in the best interests of shareholders, or if ego and personal reward seem to be a focus, it’s best to avoid the company. If you don’t trust the team running the business, don’t invest in the business

– Companies with structural headwinds are best left alone until the headwinds subside. It is better to invest in a business after its earnings have resumed an upward march than it is to attempt to anticipate when a company’s decline in earnings will stabilise

– A company that is conducting an initial public offering needs to be incredibly compelling to warrant participation, and a justifiable reason for why the stock is being sold cheaply. A stock being sold by informed, intelligent and knowledgeable owners to uninformed, inexperienced and undemanding shareholders is rarely a recipe for success if you are part of the latter group

– If you don’t like the business, don’t buy the stock, irrespective of how cheap it looks on paper

– When you realise you’re wrong with an investment, cut it immediately (and enjoy the feeling of relief!). Holding onto bad investments can cost investors more than the money they end up losing on them, because they often cause investors to miss great buying opportunities in great companies because they are so focused on the energy-sapping mistakes that haven't been cut from the investor’s portfolio

Rudi On TV

– on Thursday, Sky Business, noon-1pm, Lunch Money

(This story was written on Monday, 28 September 2015. It was published on the day in the form of an email to paying subscribers at FNArena).

(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.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via Editor Direct 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

Odd as it may seem, but today's share market is NOT only about dividend yield. Post-2008, less risky, reliable performers among industrials have significantly outperformed and my market research over the past six years has been focused on identifying which stocks, and why, are part of the chosen few; the All-Weather Performers.

The original eBooklet was released in early 2013, followed by a more recent general update in December 2014.

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