Banks not cheap, but no hold-up imminent

Yesterday’s rate cut by the Reserve Bank of Australia does a number of things. And while triggering a wave of commentary is one of those things, it’s not as important as the changes it makes to valuations.

The RBA’s rate is now lower than at any time since 1960. Targeting the pressure on retail, tourism and manufacturing caused by the strong Australian dollar, the declining rates may go even lower.

Many investors understand that as rates decline, the price of a bond goes up. Think about it this way; if you buy a 10-year Treasury fixed coupon bond for $100,000 paying a 5% annual coupon, you will receive two semi-annual payments of $2,500 each. These will continue until the maturity of the bond, at which time the face value will also be returned to you. If interest rates fall during your period of ownership, the market value of the bond could rise above the face value of the bond. This is simply because the government continues to pay $2,500 semi-annually. For the $5,000 annual coupon to be equivalent to a lower than 5% rate, the price of the bond needs to be higher.

While many investors understand the inverse relationship between yield and price for bonds, what many don’t understand is that exactly the same relationship exists between rates and the value or worth of all assets. The value of property, shares and businesses all rise as interest rates fall.

That means that the RBA’s rate reductions are fundamentally supporting, if not raising, asset values – all else being equal.

Lower interest rates, however, also drive investor behavior – something central bankers around the world know only too well. As interest rates decline, investors seek higher yields elsewhere and chase shares higher. This has driven the buying of banks and Telstra for some time, and it could go on for some time yet given the yields on our banks are still not as low as they have been in prior periods.

Take the Commonwealth Bank for example, whose yield today is 5.14%. Back in 2006, 2007 and 2010, the yield was even lower than this, and so I think that talk of a bubble could be premature. Keep in mind, of course, credit growth back in 2006 and 2007 was significantly better than it is today.

But there is another relationship that doesn’t change, one that is as certain as the inverse relationship between yields and bond prices. I am referring to the relationship between price and value.

The difference is known as the margin of safety, and over long periods of time the investment strategy that has worked better than all others is the value strategy. Momentum, yield, discount to assets and earnings growth are all strategies that have their day in the sun, but value strategies have persistently outperformed. On top of that, it is simply a logical and rational way for investors to conduct themselves.

The lower the price is below the estimated intrinsic value of a company or its shares, the larger the margin of safety and the greater the value.

But confusion has emerged among investors. Valuing a company on its yield is not valuing a company at all. Zip up your wallet when an expert tells you the banks are good value because their yields are attractive. It’s not the yield that makes them good value.

The intrinsic value of our banks rises as interest rates fall. But their share prices were already above my estimate of their value in January and February. Today the value is a fraction higher. The share prices will also rise as investors run away from declining income generated by their term deposits.

The only problem is that the share prices are well above the values and, while both are rising, their attraction to value investors becomes no greater and may become less.

Now don’t get me wrong. I am not saying the banks aren’t attractive businesses. They are a cosy oligopoly, with high switching costs for customers enabling them to charge pretty much what they like. Nor am I saying that their premium above intrinsic value means they are due for an imminent correction. Valuing a business is not the same as predicting its share price. What I am saying is that they aren’t cheap, using my measures.

Roger Montgomery is the founder of The Montgomery Fund. To invest, visit www.montinvest.com