Behind this week's bank results

Since this time last year our major banks are up between 16% and 22%. And adding in grossed-up dividend yields, some of those returns are closer to 30%.

At the start of 2014, and noting already strong price growth, I thought it was worthwhile taking a fresh look at how investors should approach Australia’s banking sector.

The consensus seems to be fairly bearish, or very cautious at least. Indeed, for the nation’s largest bank, Commonwealth Bank of Australia, most analysts either have an underperform/sell, or a hold. Only a minority suggest the stock is a buy or will outperform.

Looking at the price momentum, it’s true to say that momentum for the big four has been subdued after an initial surge early last year. So, as an example, CBA stock is only about 4% higher since about May of last year when it was trading around $73. Having said that, it has travelled on a decent range ($61 to a high of $79), and buying on the dips has been very worthwhile.

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A question of value

So why the gloom? It’s not because anyone doubts that our banks are well-run companies with great prospects. Our banks give comparatively high returns on equity, and CBA in particular has consistently given the best return on equity of any of the major banks. Moreover, they are highly profitable and we had a reminder of that this week when both ANZ and CBA reported profit results. CBA’s net profit after tax was up 16%, and ANZ’s trading update showed a 13% lift in December-quarter profit.

The problem, according to the consensus view, is that our banks, and especially CBA are very expensive – some investment banks state that CBA is the most expensive bank in the world on various metrics. Ominous stuff, but thankfully for retail investors not quite right. Let’s take a couple of examples for illustrative purposes.

Looking at NAB, its current trailing price-earnings ratio is about 13.8, which compares to an average of 14.2. It doesn’t look stretched at all. ANZ and CBA in contrast look slightly more expensive – ANZ with a current trailing price-earnings ratio of 14.3 against an average of 12.8. Similarly, CBA is travelling around 15.6 times earnings. While clearly not cheap, this isn’t excessive either when you consider that average price-earnings ratio is about 14.3.

Of more importance, there are two key points that we must keep in mind when thinking about whether our bank sector is overvalued.

1. Bank stocks, which are rich, have been much more expensive.

The peak for ANZ is 18.5 and for CBA it’s about 19. Take a look at the next two charts. They shows the price earnings ratio (PER) of CBA and ANZ.

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You can see that for CBA the peak is actually around 19 – and both charts shows that CBA and ANZ spend a good deal of time above their average P/E. Don’t forget that this average includes some recessionary periods like the GFC and 2000-01 period. Obviously, Australia isn’t in a recession – we’re not even close. Consequently, it’s not appropriate to include valuations around those events. The information content contained in them is simply not relevant to our circumstances.

During a normal cyclical expansion, such as we are in now, the normal earnings multiple for CBA is closer to 15 and it’s often above 16. For ANZ, the normal average is 13.2. So, realistically, even for bank stocks which look expensive on traditional metrics, the reality is they are closer to fair value than most analysts realise.

2. When you make some reasonable earnings assumptions.

Think of it this way – current valuations are based on system credit growth of about 3.25%. This isn’t normal credit growth – it’s recessionary – and it isn’t realistic to assume the status quo.

• With that in mind, if credit growth lifts, even modestly to 4% – which is still one-third of average growth and well into recessionary territory – and earnings lift by a similar magnitude, most stocks in the sector fall to just below fair value on current prices. CBA and NAB would hold P/Es of 15.5 and 13.25. That is about fair value, and well below in what are the true normal price-earnings ratios during a cyclical expansion (about 15 for both).
• If, however, credit growth is a little stronger (driving similar growth in earnings), say at the consensus expectation of 6-7% – then, as an example, CBA’s P/E falls to 14.6 and around 14 in 2015. That’s getting into value territory just there. And credit growth of 6% is still half of what is normal.
• Final scenario: credit growth normalises, say to 12%. Earnings growth of a similar magnitude would see all our banks fall back well into value territory. CBA would be at 13.8, which is cheap.

So I ask you, which scenario is more probable? Noting that:

• Interest rates are at record lows;

• The unemployment rate gives no guide to credit growth;
• House price growth is strong and accelerating; and
• Housing affordability is the best it’s been in about a decade.

Planets aligned for robust growth

The fact is, all the planets are aligned for further robust growth in both house prices and credit – and so bank earnings. So what’s more likely over the next two years with that macro setting – 4% recessionary credit growth or a still very average 12%?

Remember what we found out this week? CBA’s earnings growth was actually 13%. And the dividend was raised by 10%. The yield banks pay isn’t going to disappear anytime soon, and sector growth (accumulation) of 10% or more this year and next is a very easy target.

There is one final issue we need to consider as well. And that is whether it’s reasonable to expect our bank sector to trade on just average earnings multiples, or whether it should trade higher. As charts 2 and 3 show, CBA and ANZ spend a good deal of time in premium territory – it’s quite a bit below that now.

From the points I’ve highlighted above, and given that current consensus earnings forecasts are based on still recessionary credit conditions for the next two years, I think there are very good reasons to expect a good deal of multiple expansion for the banking sector. That’s especially so now that international investors don’t have to worry about the RBA targeting a weaker dollar.

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Conclusion

That the risks are so skewed to the upside, that all the planets are aligned for a strong rebound in earnings, is reason enough to hold our banks.