Banking share price bubble still has way to go
Is there a share price bubble forming in the Australian banking sector? The answer is unquestionably yes but it is reasonable to expect it to inflate for some time to come rather than pop soon. On average the share prices of the four major banks have risen a robust 34.8 per cent over the past 12 months, more than double the performance of the ASX/S&P 200 Index.
Earlier this year Commonwealth Bank eclipsed BHP as Australia's most valuable company and since has exceeded it to the tune of $14billion. Meanwhile, Westpac's market capitalisation hit $100 billion for the first time last week and is now within a good trading session of knocking BHP out of second position.
There are many ways to measure the value of a bank. The most common method is a rudimentary price to earnings multiple (PE). CBA's PE scorched through 15 times current year earnings last week, a level not seen since 2007. Similarly, Westpac's PE is approaching 15 times while NAB and ANZ are at a more reasonable 13 times.
Another popular valuation technique is comparing the market capitalisation of the banks to their book value, or the value of loans sitting on the balance sheet. Using this method, CBA's share price is at 2.7 times book value, while most of the major trading banks around the world struggle to get above 1.5 times. In 2007 valuations of the big four banks raced above 3 times.
However, in 2007 our banks were printing earnings per share (EPS) growth above 10 per cent and the return on equity (ROE) was a remarkable 20 per cent plus. In 2013 the EPS growth for the majors is struggling to get above 5 per cent while the ROE ranges from 12 to 18 per cent. Given this low growth there is not a stockbroking analyst who can justify the current valuations being paid by investors.
So why is it unlikely that bank share prices will turn on a dime and head south in the next six months? The answer lies in low global interest rates and the insatiable appetite for yield. Eventually this trade will become crowded and it will be messy, but bubbles can inflate for much longer than most people expect.
The blame for the upward march of the banks has been directed at the local self-managed superannuation funds. This is partly true, but they have been joined by northern hemisphere funds desperate to pick up yield.
The majors are paying fully franked dividends in the range of 5 to 6 per cent, attractive compared with 4 per cent term deposits that locals have to pay tax on. The yields are exceptional for American, Japanese and European investors.
To pump more air into the share price bubble, dividend expectations should be exceeded in the upcoming bank reporting season. A low-growth environment has allowed the majors to store high levels of capital, possibly excess to requirements. This should enable them to meet new global capital requirements and ratchet up their payout ratios if franking allows. Higher dividends have always been the best bang for the bank's buck.
ANZ and NAB trade at a discount to CBA and Westpac. NAB's rating suffers from its problem assets in the UK while ANZ's price labours under management's desire to expand into Asia. ANZ could easily fix this problem by increasing its dividend payout ratio from the current 63 per cent to 70 per cent and cooling its offshore expansion plans.
All these dividends will dominate investors' thoughts in the short to medium term, but a crowded trade is dangerous in the long run because when one person leaves the party others will follow. For now the party goes on.
Oil and gas group Woodside was greeted with congratulatory cheers from every corner of the investment globe last week when it decided to pay a one-off special dividend and announce an ongoing 80 per cent dividend payout ratio. This came hot on the heels of junking the $45billion Browse LNG development in Western Australia.
Chairman Michael Chaney and the board should be applauded for these decisions and promoting shareholder value above largesse. Unfortunately the same cannot be said for other big resource companies over the years including Rio Tinto and BHP.
However, investors should be wary of what this means for them in the long run. I have no concerns about the one-off dividend in light of the group's current capital position. But we should not think this is a bank and it can churn out higher and higher dividends each year. The volatility of earnings of a commodity-based company will ensure that the dividend will fluctuate dramatically.
I would go as far as to say the company should have left the payout ratio alone altogether.
Projects are highly capital intensive and it would be silly to pay out a lot of dividends and then have to raise fresh funds in a few years' time to participate in a high returning venture.
Invariably the raising will be done at an inopportune time.