Bank stocks: It’s all about dividends now

Banks' stock prices will continue to face pressure, but they are excellent dividend payers and that may soon become their greatest strength.

Summary: Bank shares have fallen recently on the back of the lower Australian dollar, global instability and worries about exposure to an inflated housing market. Banks’ profitability faces the headwinds of new competitors, a possible correction in the housing market and the threat that they will be required to hold more capital. It is unlikely that banks will repeat the profit growth of recent years – they will increasingly become income-producing utilities.

Key take-out: Enjoy the banks’ dividends … but don’t look too closely at their share prices.

Key beneficiaries: General investors. Category: Shares.

In the last week or so the great driver of the Australian share market, bank shares, had a serious correction. There has been a recovery but I am taking time this week to look at some of the reasons as to why the correction took place and what it tells us about the future of Australian banking and bank shares.

And I have a note from a 73-year-old lady who is a Eureka Report reader which reminds everyone why many Australians do not sell their bank shares.

The Australian banking industry has had a wonderful run in the post-global financial crisis era. Competitors were driven out and the big four banks achieved great dominance and were able to drive that dominance into higher and higher profits. 

At the same time lower interest rates caused investors to buy bank shares for income. And the whole process became a wonderful experience for banks and their shareholders. For many it looked as if it would go on forever and the rise in bank shares has provided pretty well all the gains in the Australian share market since 2008. 

The first crack in banking shares’ invincibility came with the fall in the Australian dollar. A great many overseas investors have been borrowing at token interest rates and investing money in Australian bank shares, which has been a very rewarding practice. For the most part they took the currency risk and so in this latest correction overseas investors were suffering the dual blows of a lower dollar and lower bank shares. 

At the same time the global instability – whether it be in the Ukraine, the Middle East or Hong Kong – increased investor passion for lower risk and that fuelled selling. 

Overseas investors have been nervous about Australian banks for a long time because they believe they are too exposed to an inflated housing market.

Our banks are more highly leveraged than most overseas banks and that high leverage has helped them to achieve rates of return on capital that are much higher than their peers overseas. Low bad debts have also helped.

The high returns have contributed to the performance of Australian bank shares but there is clear nervousness among local and international bank regulators that Australian banks have taken too big a risk in the terms of their gearing and too great a portion of their lending is concentrated on dwellings. US banks are priced around their asset backing but Australian banks are priced close to twice their asset backing because earnings are higher.

The above forces came together to give us a hefty wave of selling. The ASX 200 Banks Index, which tracks the big four banks plus Bank of Queensland, Bendigo and Adelaide Bank and Genworth Mortgage Insurance, fell 8% between September 3 and yesterday, September 30.

Graph for Bank stocks: It’s all about dividends now

If the banks are required to hold more capital against their loans it will decrease their profitability on a per share basis. They are moving ahead of the game with hybrid issues and the National Australia Bank is selling its US business Great Western Bank to increase capital. Despite this it is likely there will be curbs on the Australian banks’ gearing but it will be a slow process. There is also a return to securitisation in mortgages although nothing like the level of the pre-GFC era. 

AMP, which has one of the best financial planning sales forces in the country, is now looking at using bank mortgages as a key financial planning product given that commissions on investment products have declined. AMP agents are being encouraged to market AMP bank mortgages and they receive a commission of about 0.6% plus a trail.

At the same time it is clear that new competitors are coming into the banking space via new technologies. The new iPhone will enable the banking system to be bypassed for routine transactions.

One of the reasons that banks have performed so well is that the provisions for loan losses has been at record low levels. The rise in Australian house prices has papered over lending mistakes. At some point we are going to have a correction in the housing market, particularly if unemployment rises, and if that happens banks won’t necessarily be destroyed but their profit growth will be stunted. They will be definitely about a yield game. We have just seen first home buyers priced out of the market in our two major cities. That is not sustainable longer term. But it might take a while to kick in given the increase in Chinese and investor buying of property.

Nevertheless in my view all this adds up to a likelihood that we are not going to see anything like the profit growth from banks that we have seen in recent years. They are increasingly going to become utility companies with a bias towards producing income. Banks dominate the Australian market and that dominance is being increased by the fall of mining stocks. That means if banks become more like income-producing utilities it will take a lot of growth out of the Australian market. But of course for many of those looking to retire this is exactly what they want their banks to do.

But banks, like any corporation, need excitement and drive and without it they can lose talent and market share. So investors need to be careful what they wish for. My greatest fear for banking shares is that the high share price is lowering the appetite of bank CEOs, their boards and their shareholders for risk. If that happens then banks will be sitting ducks for new competitors. But that’s all a fair way off. In the meantime enjoy the dividends but don’t look too closely at the share price. 

And I am reminded that a great many Australian retirees or self-managed super funds will not sell bank stocks because of the taxes that would need to be paid on capital gains. I received this email: 

I am too frightened to put money overseas because of the currency exchange and the tax you pay. I might be wrong. Also I have got a lot of cash – I am 73 years old. I have it in ING and UBank. I am not chasing high returns.

“Most seniors’ SMSFs have bought bank shares and they are not going to sell because of capital gains tax, and they get good dividends. And as the banks, BHP and Rio make up 40% of the market, there is very little retail trading. Seniors with SMSFs have made our own decisions – we may be wrong but it is our decision. Also Bob you are the reason I am still with Eureka Report because you have the memory. Stay healthy and happy. Cheers.”

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free

Related Articles