A Big Call On Bank Stocks

MP: Brian, you have been at least mildly bearish all year on banking stocks

BJ: Yes.

MP: That makes life rather hard for a banking analyst doesn’t it?

BJ: Not really. Brokers make as much money when they’re getting people to sell shares as when they buy them, and, really, what we try to do is say what it means for banks. The US seems to be getting better, which means, if you’re an Asia (ex-Japan) international fund manager, there are places that have got much better leverage to a US recovery than Australia. So that’s got to be bad for the banks. The other thing is that, at some point, bond rates have got to go up, which we know is bad for bank valuations. The final point is that this earnings risk is coming through, so there are negatives out there.

MP: The problem is that, with the banking sector being such a huge part of our market, for any portfolio to begin to weight or downgrade its exposure to banks would mean a massive change to the average fund.

BJ: Yeah, it certainly would, and that is a very big issue. With roughly 25 per cent of the market being in the Australian banks, that’s significantly higher than anywhere else in the world. And you’ve got to think that also becomes a barrier to continued outperformance. You know, there will come a point where people start liquidating their portfolio because they’re actually becoming too concentrated in Australian banks. So there is an upside and a downside . . . Basically, for international fund managers, there are other countries they can probably invest in as opposed to Australia; and, within the market, that is a real dilemma for Australian fund managers as to where they actually put their money.

MP:I suppose all investors should approach any market as if they were an international fund manager. In reality, they don’t, particularly those who have mandates, or individual investors who are heavily weighted locally. What do you think is a healthy proportion for bank stocks in a balanced fund?

BJ: It really comes down to just how big a tracking error you want to run. I’d be comfortable with progressively starting to de-weight. When a broker actually puts an underweight recommendation on a stock, it is not something a fund manager can achieve overnight. For example, we’ve got Commonwealth Bank coming out with its result next week. That will be a great result. So it’s a gradual process as you move from overweight to underweight. Domestic fund managers, I suspect, are massively overweight in ANZ and Westpac. They’re underweight in Commonwealth and they’re probably about market weight in National Australia.

MP: From the point of view of the individual investor, banks still have that security, that franked dividend. It’s pretty hard to ignore, isn’t it?
BJ: Banks have a unique characteristic for most retail investors. If they’ve owned them for a long time, and they’re selling, they’ve got a massive capital gains tax bill. That doesn’t mean retail investors should crystallise what potentially could be quite significant CGT liabilities. The sector is not broken; it’s just a little bit overvalued. There’s better value elsewhere.

MP: Where?

BJ: Commodity prices seem to be a lot higher than most analysts are using in their forecasts. If, in fact, the world is recovering, then I would argue, you’are going to see earnings per share (EPS) upgrades coming through on commodity stocks. Even though a lot of people say, “Oh, they’re fairly valued”, you start to have the EPS going up. It means that, perhaps, they’re still quite cheap. So I would rather be buying a commodity than a bank. Telstra is interesting in that it’s quite a sizeable proportion of the market in Australia and, as funds wax and wane between banks and resources, some of the residual flow is into Telstra. So Telstra is where you may see some people choose to hide.

MP: The banks have had such a brilliant, long bull run. How long do you think this period of relative weakness will last?

BJ: We’ve had 12 years of phenomenal operating conditions, and it really comes down to how serious you think the new players coming are. When you look at everything that has driven the exceptional performance over the past decade, you could reasonably argue that it is no one factor. It’s the risk of even a few factors reversing. For example, in 1990, Australian banks were doing a return on assets (ROA) of 0.65 per cent. Today, if you exclude NAB, they’re actually doing an ROA closer to 1.1 per cent. A lot of that is because loan loss charges are so low in Australia that banks are actually over-earning. How sustainable is that? I can’t put my hand on my heart and tell you that loan losses will go up, but I can tell you the balance of probability is that they will go up rather than down. Even a very small movement up, to where the historical norms should be, will crystallise the 5-10 per cent decline in the reported profitability of Australian banks.

MP: The banks have been saying for years that they really were competing very hard with each other. The figures say they have not.

BJ: Couldn’t agree more. The oligopoly in Australia has delivered a degree of pricing power among banks that you don’t see elsewhere. For example, if you go back to the last really big round of competition in Australia - when Aussie Home loans came into the banking market - the housing loan spread was about 350 basis points above the cash rate, and was over the next two years. Then, in early 1996, Commonwealth Bank repriced the spread down about 200 basis points. That is the last time we had a major erosion of housing spreads. Recently, we have been starting to see a lot of signs on buses saying “Come into the bank and we’ll give you 25 to 75 basis points off your housing loan”. We’re also starting to see banks paying very big deposit rates, so new competitors are coming into the market, such as General Electric and HBOS. At the same time, banks are changing their strategy. Historically, it has been about retaining market share; now it’s about increasing market share.

MP: There have been cries of wolf about competition several times. This time do you think it will go further than just cherry-picking a few products?

BJ: HBOS, which now owns BankWest, has said it is going to do in Australia what it has done in Britain. In Britain, HBOS was very strong in Scotland and the Midlands and didn’t have much at all in the south. It got to be the biggest mortgage lender in Britain by aggressively cutting prices. BankWest, which HBOS owns 100 per cent, is very big in Western Australia. It doesn’t have much of a presence in the east. So what has it done? When the cash rate was 5.25 per cent, it came out with a 6 per cent deposit rate. The other banks said it could not possibly sustain that rate, so they didn’t need to follow. What have the banks now done? They’ve followed with very high retail deposit accounts. Next, BankWest came out with a four-month, interest-free, fee-free-for-life credit card. What was the response to that? GE, for example, has a six-month, interest free, fee-free-for-life card. HBOS has started opening up branches on the eastern seaboard to push products. That’s not so important; what is important is that it has actually launched a 5.55 per cent business suite account, so a small business person now gets a higher rate of interest than the Government borrows at. On top of that, it has an advertised rate of 6.6 per cent. That’s a margin of 105 basis points on a business that, I think, the banks, historically, would have thought would be a 300-400 basis point type business. So the scary thing is that the banks are starting to respond.

No one knows about General Electric, a massive player in Australia. It’s big in housing loans, big in credit cards, big in commercial property, big in auto finance . . . GE, the one business it doesn’t do is take deposits, which means, theoretically, it can earn massively high returns on equity in Australia on much thinner margins. Everywhere else in the world, GE has cut prices. That will happen in Australia, so the point is that what they’re doing is very, very aggressive. But the banks are responding.

MP: HBOS looks like the broader single challenge. What sort of time frame do you think it is operating on? How long before those of us on the east coast get to see it in our faces rather than just a neat tempting deposit rate?

BJ: Well, Michael, you’re interviewing me in Grosvenor Place on George Street, Sydney. Outside, one in five buses has a BankWest credit card ad on it. On www.abetterdeal.com.au, have a look at the deposit rate and at how many people have hit it. BankWest is here right now, and people are starting to respond to it, but, more significantly, Commonwealth Bank has responded, Westpac has responded. You’re starting to see the banks respond with similar products. A good way to think of it is that banks really have two businesses. They borrow money cheaply and they lend it out expensively. That’s why we hate banks: we’re customers on both sides. The point is, the borrow-money-cheaply business at the margin is disappearing. The rates that have been paid on some of these internet accounts are greater than wholesale borrowing rates.

MP: Which bank appears to be fighting back successfully, or retreating more successfully.

BJ: It depends on the time frame. It is significant that Commonwealth Bank didn’t launch its net saver deposit product until late June. This would have had a very negligible impact on profitability in the second half of 2004-05. And the impact of rising interest rates for the Commonwealth Bank means it has actually been quite a favourable environment in the second half of the year versus the first half. So you’ve got to be very careful of the timing of these impacts. But as to who is reacting best, it’s very early to quantify whose strategic response has been the most sensible. They’ve all been doing pretty well exactly the same thing. The one thing that’s noticeable is that National Australia Bank has not yet come out and publicised a very high rate deposit product. You’ve seen CBA do it, you’ve seen ANZ do it, and you’ve seen Westpac do it. NAB will have to come out with one very shortly.

MP: Is this a game that would make sense not to play for a bank?

BJ: Not really. If you have a look at Britain, National Australia Bank’s business has decided not to play the game in a competitive environment. The end result is that you have very, very high profitability but the problem is that you’re shrinking. After four or five years of shrinkage, you disappear. So unfortunately, it’s not really a game in which you can step back and say “That’s irrational”.

MP: Is there much fat left in the banks to take out costs if they are going to have higher cost of funds?

BJ: More formation benefits have yet to come through, but the flip side is that, if you were to go back to 1996, there were 30 per cent more bank branches than there are today. And so what I flag to you is that, even though I think there are more savings to come out on the automation side, or the processes side, of the business, they have serious reinvestment back in their branch networks. Now a retailer probably refurbishes the store every four years. National Australia Bank’s historic refurbishment rate of its branches has been 19 years. So we’re talking about some fairly serious capital expenditure on the branch network. One of the great mysteries is the way people interface with banks electronically. It is absolutely fantastic. The problem is that the legacy IT systems were built four years ago. A lot of money must spent refurbishing those.

MP: And no smaller bank has tried that?

BJ: Yes, Bank of Queensland [which has overhauled its IT system]. It is now a much faster growing bank.

MP: You mentioned Bank of Queensland. That’s a good segue into other smaller banks. By implication, we’ve been talking about the big four only. How do the smaller guys fit in. They’ve been benefiting from a bit of a backlash about the big four, about lack of personal service. Can that trend last?

BJ: Potentially, the operating environment method deteriorates. They’ve been more leveraged positively on the upside. I’d suggest, perhaps, they’re more negatively leveraged if the operating environment deteriorates so . . .

MP: Which, in English, means they’re going to be in more trouble than the big four.

BJ: Yes, yes.

MP: Pick the best bank

BJ: Westpac has got excess earnings growth for several structural reasons. The great thing with Westpac is a lot of people don’t realise the great job Westpac has done in reducing its risk profile over the past few years. So when we look at Westpac, there is a stock that’s got the cheapest highest growth profile and, arguably, the lowest risk profile. So, Westpac is the one we like. Second pick would be Macquarie Bank, which I don’t buy as an investment bank. Macquarie is turning itself into basically the world’s biggest global infrastructure funds manager. On that basis, it’s still ridiculously cheap. We also like Commonwealth Bank for several reasons. We’ve always had a long term-problem with the way its capital position has been structured. We now believe that’s been rectified. Commonwealth actually has much lower capital intensity than the other banks, and it’s traded at a premium. We think it’s got the tightest share register of any of the banks, so it becomes much less vulnerable to international selling. There’s a lot more operating costs to be taken out from the automation processes. We also think Ralph Norris can probably fix up the distribution business, which has been the point of.

MP: Is there a recovery story at NAB?

BJ: No doubt about it. Earnings will recover. The problem is, the recovery is already priced into the share price.

MP: And the ANZ too? ... overweight?

BJ: Yep.

MP: Can ANZ CEO, John Macfarlane do more there?

BJ: ANZ is cheap but I can’t recall the last time I saw a good piece of news come out of New Zealand, and that’s where 30 per cent of its business is. It’s still got a weakness in funds management and proprietary branch distribution. It highlights an acquisition risk. The other thing about ANZ that worries me is that more than 40 per cent of its housing book originated through third parties. If the competitive environment does increase, and one of the banks seriously cuts housing mortgage spreads '¦ and stops using brokers, ANZ has a bit of a strategic dilemma. So there are reasons ANZ is cheap.

MP: Do the banks have to get their customers back from the mortgage brokers or are the brokers now too big a part of the market to ignore?

BJ: If the banks do not do something to reclaim the distribution business, in five years they will wish they had.

MP: Do HBOS and GE almost inevitably pick up disaffected brokers when the banks try to cut them back.

BJ: Yes, but that’s why the real strategic response to reclaiming your distribution business is - instead of originating a loan with a ridiculously wide spread and paying a broker an excessive commission - to cut home loan rates and hand the commission back to customers. Over the next five years, that will happen anyway. Your book will be priced down anyway. People say banks will never cut housing rates. Well, in 1996, Commonwealth Bank did exactly that to get into Aussie Home. We’re going to see banks re-investing back into their branch networks to get their branch distribution platforms working, instead of shrinking them; actually investing in them and getting them to grow. Once they’ve got that fixed up, that’s when the real competition will start.

MP: So retail home mortgage borrowers should remain flexible and keep an eye out for bargains?

BJ: Definitely, and a retail borrower should basically go into the bank and negotiate. You don’t need a broker to do that. You can do it yourself.

MP: Funds management. The banks have all hoped that this would be their cushion against just the sort of threat you’re talking about.

BJ: Funds management flows in Australia have been very strong. The traditional model is that you have a very big funds management manufacturing business or you have a very big platform business. We’re starting to get the rise of the boutiques. The banks with very strong platform businesses are probably in a better strategic position than those that are concentrating on manufacturing. Now, ironically, Commonwealth Bank has moved very aggressively into the platform space. St George has actually been there for quite a while. Westpac is there through Bankers Trust and Macquarie Bank is there with its wrap account. They’ve basically positioned themselves for that value shift. The real problem is that, if you have a look at this platform business in the United States, it’s a much lower margin business than it is in Australia. So, in Australia, the whole financial services industry appears to be riddled with very high margins compared with its global peers. The problem is, things like the internet are allowing a lot of global peers to come in and operate here.

END OF INTERVIEW