General investors. Shares.
For some time we have been cautious on investment in the big four banks as various influences on the banks’ profitability play out. However, our Income First model portfolio still holds positions (albeit underweight) in two of these banks: ANZ and NAB. While these positions have been significant contributors to negative performance, the underweight positon has allowed the portfolio to take strong steps to achieving its benchmark returns.
For all investors with an income focus, the banks are an enigma. On the one hand, the dividends are mouth-watering, even after expected dividend cuts are considered. Additionally, the banks are well capitalised and secure long term investments. However, on the other hand, there are a plethora of negatives impacting the banks’ share prices on a daily basis, including (but not limited to) increased provisioning, housing market concerns and regulatory pressure.
So how should income investors approach the largest sector on the ASX? With caution, and keeping risk front of mind.
Since the inception of the Income First model portfolio in August 2015, the banks have performed very poorly, pulling the large cap segment of the ASX down with them. Here is a chart of the big four and two regional banks since that date with the All Ordinaries index overlaid:
As can be seen, the banks have been a source of underperformance in the market, bucking a five-year trend. This is related to a number of factors. Firstly, profit expectations have been declining, leading to declining expectations for future dividends. Given the banks remaining a key focus for income investors (at times trading with a bond like nature), the risk to bank dividend payouts is a key driver of this underperformance.
Are the banks cheap?
Recently I was told that the banks look cheap on a price to book value basis, and was reminded that the dividend yield is also quite remarkable (even when considering the potential for dividend cuts). This is true. However, the risks dictate that the banks should trade at some sort of discount to historical levels, perhaps justifying lower share prices. Here is a table with the banks price to book ratio (we introduced some key bank metrics last year – click here for that research):
Price to book
Effectively this table tells us that banks are cheap, if you are a value investor who believes in mean reversion for these types of metrics. In fact, confirming this is the below table of P/E ratios over time:
Price to Earnings ratio
As can be seen, the banks are cheap at the moment, when compared to traditional value metrics. But the trick with value investing is that you believe that these metrics will mean revert. This can be achieved in one of two ways: The price can rise, or the fundamentals can deteriorate. At this stage the market seems to be betting on the latter.
So what is the answer? The banks are cheap according to value metrics, but the trend for analyst revisions is down, with the earnings expectations for the big four all cut substantially in recent months.
I think that the only real clear conclusion that can be drawn at the moment is that big bank investing in the current market adds more risk than might be anticipated. The key to getting the balance right is to appreciate the level of elevated risk, and take positions that correspond to risk appetite. Many investors may be blinded by the appeal of juicy dividend yield forecasts – a potential mistake from a total return perspective.
The Income First model portfolio holds ANZ and NAB
In our Income First model portfolio we have positions in ANZ and NAB. Through these positions we are overall underweight the banking sector, and have larger non-bank exposure to the financials sector through Flexigroup (FXL), Credit Corp (CCP) and Steadfast (SDF).
Our banks position plays a key role in diversifying the portfolio, but is a purposefully underweight allocation. It is important to note that many portfolios in Australia remain over exposed to the banking sector, and thus are carrying higher levels of risk than may be intended.
That said, Australia’s big four banks remain strong businesses at the core. The margins may be falling and pressure on dividends rising, but underlying this is a strong long term investment. Given this, we are comfortable holding an underweight position – we recognise that being underweight will likely assist in outperformance, but also wish to take some of the dividends paid out by banks in order to enhance portfolio yield, albeit at a lower rate than the broader market index.
The Income First model portfolio will continue to monitor the banking environment. ANZ and NAB are the lowest quality of the big four in our opinion and most likely to suffer from dividend cuts in the near term – though I suspect this is priced into the respective yield forecasts and P/E ratios. Given this, if the environment worsens significantly, there may be a case to switch or lower the exposure further seeking safety in higher quality earnings and exposure at CBA or WBC.