Better Value In Smaller Banks?

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Does the ASX banking small fry offer better value than the ‘overvalued’ Big Four?

By Tim Boreham

Big or small – or none at all?

With the Big Four banks regarded as overvalued, investors are pondering whether there’s better value in their smaller counterparts that trade on more modest valuations but with similar or higher dividend yields.

Recent conditions for the small ‘uns have been problematic – notably their cost of capital disadvantage and their ability to compete for mortgage market share.

Lower credit ratings mean the banks pay more for their wholesale funding – which is like Minnie Mouse getting in the ring with Mike Tyson.

The smaller banks’ return on equity is in the single digits, compared with the Big Four’s double-digit returns.

That said, the small banks have their charms, including far superior customer satisfaction ratings, a deeper attachment to local communities and an ability to act more nimbly to enter new markets or withdraw from unprofitable ones and undertake IT initiatives.

This flexibility was starkly evidenced in the recent decision by the Bank of Queensland ((BOQ)) to taper back home lending growth. Bancassurer Suncorp Group ((SUN)) has thrown in the banking towel altogether and is selling its bank division to the ANZ Bank ((ANZ)), having finally gained approval from the competition regulator to do so.

Generally speaking, the Big Four banks have outperformed their smaller brethren since the sector rally from late October last year, when it became evident that mortgage stress was not as bad as thought.

The trends continued to be reflected in the recent half-year reports from the National Australia Bank ((NAB)), Westpac ((WBC)), the ANZ and the quarterly update from the Mohammed Ali of the sector, the Commonwealth Bank of Australia ((CBA)).

Net interest margins – or NIM, the profit on lending – generally improved, although fierce mortgage competition has meant the banks are not gaining the usual benefit of high interest rates.

(Higher rates usually mean higher margins because there’s more headroom to tweak them – but if they’re too high delinquencies start to rise).

Since December 1, 2023 the Big Four share price gains have ranged between 22% (Westpac) and 16% (ANZ Bank).

The small banks’ performance has been patchier, with Bendigo and Adelaide Bank ((BEN)) shares up 21%, while the Tasmania and northern Queensland focused MyState ((MYS)) has spurted 18%.

Bank of Queensland recently reported a half-year result that was not great, but not as bad as expected. The shares have still declined -5% over the six months.

The former Bundaberg-based Wide Bay Capricorn Building Society,  Auswide Bank ((ABA)) is struggling to land punches and its shares have declined -18%.

The Big Four rally has led to an almost universal consensus that the sector is overvalued, despite the foursome returning $5bn in capital from loan provisioning that is not required.

Broker Wilsons notes that on broker consensus numbers, the Big Four are expected to record negative earnings per share growth in the current year, as well as in 2024-25.

“In this context, the sector’s valuation premium relative to history remains excessive and unjustified at the headline level, albeit with pockets of relative value within the sector.”

Macquarie’s analysts also chime in that “current valuations are hard to justify, particularly given the backdrop of underlying earnings trends.”

Of course, experts are well known for being wrong – especially when they are all saying the same thing. Income-seeking investors addicted to (reasonably) reliable franked dividends won’t heed the warnings anyway, but they may do well to at least diversify their exposures to the small fry.

In its recent strategy update, Bendigo and Adelaide Bank chief Marnie Baker described the institution as “the only credible challenger to the major banks” – a claim likely to roil her second-tier peers.

Her evidence lies in an aggressive push into business banking and digital banking, while the bank is holding its own in the mortgage market, courtesy of fast approval procedures.

Morgan Stanley’s analysts concur that Bendigo Bank is the best bet of the bonsai banks.

“Bendigo and Adelaide Bank is our preferred smaller bank given its focus on margin management, efficiency and returns as well as the quality of its deposit franchise,” say the firm’s bank watchers.

As for MyState, one would think the bank has benefited from Tassie’s transition from a bunch of lumberjacks to boutique whisky-sipping gourmands and art afficionados. The formation of the Tassie Devils AFL – and an eventually $750m-plus stadium – adds further economic impetus.

MyState’s February half-year results showed nine basis point improvement in NIM to 1.46% and a resolve to “temporarily rebalance lending growth aspirations for the balance of 2023-24”.

The tiny $190m market cap Auswide rarely gets mentioned in despatches. This bank’s February half-year numbers were well off the pace, with underlying profit sliding -53% to $6.6m and the NIM tumbling -52bp to 150bp.

There’s no magic in the explanation: intense home loan competition and the flight to higher yielding deposits. But if the more recent Bendigo and Adelaide Bank experience reflects on Auswide, new CEO Doug Snell may have some better news early in his tenure.

Meanwhile, SME banking specialist Judo Capital Holdings ((JDO)), better known as Judo Bank) is making some deft manoeuvres of its own as it tries to chop into the big banks’ share of business lending.

Given the inevitability of higher business delinquencies relative to home lending, pundits have been sceptical of this one since it listed in early November 2021.

But Judo’s May 9 update left the doubters flailing on the mat: the bank’s loan book ticked over $10bn, with a $1.7bn pipeline of further lending.

The bank reported an average NIM of 4.4% over the bank bill swap rate: a figure of envy for the home lenders working on an average NIM of well under 2%.

Yes – Judo’s delinquencies also increased, with 90 days past due at 2.63% of the book as of the end of March, compared with 1.73% at year’s end. Management stresses the blip is mainly related to four loans that are secured as property.

Judo Bank shares have gained 27% year to date, but still have lost 44% of their value since listing. 

For those seeking something more left field, Kina Securities ((KSL)) is Papua New Guinea’s leading bank and funds manager.

Kina has interest margins (5.6%), return on equity (17%) and capital adequacy (20%) that would make a hardened Martin Place banker weep. This bank pays a dividend equating to more than a 10%, albeit unfranked.

At the bank’s AGM last Wednesday, chairman Isikeli Taureka highlighted record customer and business lending growth and a 44% surge in digital banking revenue.

That said, a financial exposure to our volatile and strife-prone near neighbour is not everyone’s cup of tea, so PNG discount in the valuation is justified.

In Taureka’s words: “law and order, security, unreliable public utility services, foreign exchange and fiscal and regulatory policy uncertainty are just some of the many challenges we continue to face in PNG.”

This column does not constitute financial product advice. You should consider obtaining independent financial advice before making any financial decisions

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