Bursting the bank price bubble theory

The biggest problem with comparing the present to the past is that we now have a world economic environment that is nothing like anything seen in the past.

As Alan Kohler has consistently stated, the world is undertaking an unprecedented economic experiment through quantitative easing (QE) programs across three of the major four world economies (US, Europe and Japan). The other major economy (China) is holding its currency in an undervalued state as it emerges as the industrial juggernaut of the world in the 21^st century.

Quite simply, there is no historical precedent for the present. Past valuation methodologies need to be adapted to the present environment. That doesn’t mean that they may change again or change back. It just means that we live in unique times.

“As our case is new, so we must think anew, and act anew.” - Abraham Lincoln

This week the ANZ Bank delivered its result with cash earnings rising by about 8% over the previous corresponding period. Earnings growth was essentially generated by cost containment; lower provisioning and the benefits of a larger capital base.

The decision to lift the projected payout ratio was greeted warmly by the market. The stated return on equity of about 15% is still well below that achieved by ANZ in 2006-07, but it is showing a welcome positive trajectory. If anything ANZ, like the other major banks, is hampered by excess capital – but that is the new world requirement for banks following the GFC!

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Source: MyClime

It is with that background that I am writing once again about bank shares. Three of the four major banks are in either my growth or income portfolios. Bank shares have clearly been strong outperformers over the last nine months, with rises of between 30% to 40%. Thus, we are now seeing the financial press begin to question whether we are in a “bank share price bubble”. Much of the discussion focusses upon today’s high “price earnings ratios” when compared to past periods.

Readers will immediately glean that I do not think that you can compare today’s sharemarket pricing regime to that of the past. Today’s market environment is dominated by the perversion on markets of QE. This is seen most clearly in the so-called “risk-free” market of bonds. Who on Earth would buy 10-year bonds at yields below 2% in the US, Germany and UK, or at about 1% in Japan? The answer is central banks with printed money and institutions that are mandated by capital regulations to invest in those bonds.

Thus, to claim that Australian bank shares in particular are in bubble territory requires a unique ability to be oblivious to the yields in bond markets. Even as I write this commentary, the Australian 10-year bond is trading at a 3.1% yield. That is a taxable yield and marginally above its lowest yield 50 years!

The other observation that is important is that bond yields are fixed. They will not grow, and the potential capital gain for an owner is based on bond yields falling further. Shares on the other hand have the potential to deliver growing dividends. Market consensus forecasts suggest that bank earnings from 2012 (financial year) to 2015 (financial year) will grow by 20% and dividends by a similar amount.

Following the share rallies this week the yields of the major banks, based on market consensus estimates for 2013-14, show fully franked yields of 5% or more. Each bank is currently expected to pay more in dividends next year than this current year.

So much for yield – what about value?

Price earnings ratios are a shorthand method for comparing price but they have no relevance for determining value. The derivation of value is determined from the profit that is generated from the capital of a company (return on equity). Thus, value is derived as a multiple of equity rather than a multiple of earnings. Further, the returns on capital are simply not the reported profit, but include the tax credits that are created and distributed to owners as franking. This is the normalisation of the return on equity (NROE) and it will rise above the ROE for those companies that pay tax and distribute credits to its owners.

In determining value the other important input is the required return (RR) of an investor. The RR is a function of equity market risk and stock specific risk. It is often stated as a margin above risk-free rates of return. Commonly, the equity market RR is stated at 7% above the risk-free rate. So, if this is 3% (i.e. the bond yield) then the RR from the equity market is 10%. Banks are highly leveraged both in terms of their capital structure and to the economy. So I would propose a 1% premium for their unique business risk and seek an 11% RR from the major banks. The exception is NAB, whose continuing exposure to the UK and chequered history suggests a higher RR  than the other banks.

Before I disclose the forecast value for the banks in 2014 from an 11% RR I want to emphasise two things.

First, the RR of 11% is a pre-tax return and so franked dividends are important. A 5% franked yield is equivalent to a 7.1% pre-tax yield. To achieve an 11% return then, the capital gain or share price lift needs only to be 4% over a year to achieve the RR.

Second, the forecasts are based on current market consensus earnings, which in the main suggest bank earnings will lift by about 5% in 2014 from 2013 earnings. Should these earnings actually be lower than the forecasts then the projected values will fall. An investor should therefore never buy at projected value but seek to purchase at a reasonable discount. This is the “margin of safety” and I would suggest a 10% margin be sought.

2014 forecast values for major bank shares

Conclusion

While it is hard to definitively define a price bubble – it is equally hard to argue in the current environment that banks are exhibiting excessive price bubble characteristics. Referencing historic PERs in isolation, without considering the incredible monetary settings present in the world, will lead to wrong conclusions.

From the table above you can see that the best value bank is now ANZ. Both CBA and WBC are fully priced and investors need a pullback to add to positions. To consider a reduction in holdings then, a slight lift in current prices needs to occur. For active money and based on relative value, a switch into ANZ may be a strategy worth considering.

John Abernethy is the chief investment officer at Clime Investment Management.

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Clime Growth Portfolio

Return since June 30, 2012: 35.95%

Returns since Inception (April 19, 2012): 26.41%

Average Yield: 5.50%

Start Value: $111,580.24

Current Value: $151,691.98

Dividends accrued since 31 December 2012: $3,199.26