Carr's Call: Don't buy the CBA sell story

Australia’s banks have received a lot of attention of late, not all of it good. From what I can gather, the consensus is that Commonwealth Bank (CBA) is overvalued and thus ripe to sell. NAB in turn is having problems with its UK assets, and a small number of commentators still await the ‘inevitable’ domestic property crash.

Now banks have had a very hard run for sure, and the sector has outperformed the All Ords by a good margin in 2012.

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You can see from the table that CBA is the stand-out. It is up almost 160% since the 2009 trough, and is the only major bank to sit above its 2007 peak. Consequently, the current P/E of 14.6 is well above the other majors (with an average of 12.2).

At first glance, the call to sell CBA would seem quite reasonable then. It’s the most expensive bank and, as the table below shows, it pays the lowest yield. Moreover, the fact that CBA, with assets of $718 billion, has a market cap far greater than many bigger European banks also has some spooked. CBA’s market cap of $100 billion is about three times Deutsche bank’s, with assets of €2.2 trillion(it should be noted though, that the entire market capitalisation of the Frankfurt stock exchange is roughly similar to the All Ords, while Germany’s economy is about 2½ times larger).

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Taking the broader discussion on whether to sell banks as an asset class or not as done (I dealt with this last year) a strong rally isn’t by itself a reason to sell. Indeed, considering the strong arguments in support of our banking sector as an investment, any discussion to sell CBA is really a recommendation for a switch trade. So there are several issues to think about here.

For me, the analysis is heavily influenced by when and why you bought. So, for instance, if you bought six months or even a year ago for yield, the yield you’re earning on CBA shares is now between 6.6% or 6.8% – or 9.4-9.7%% grossing up. The best yield you can get now is 6.6% with NAB, or 9.4% grossing up. In that instance there isn’t a lot of pressure to sell CBA. Similarly, if you bought in the first quarter of 2009, CBA pays a grossed-up yield of 14%. Beat that if you can. The bottom line is, if you’re investing for yield and have held for longer than six months, then the answer is simply no – you should not sell CBA.

Switching for yield doesn’t make sense. It really only makes sense to switch out of CBA on a yield basis if you bought the stock over $51 (i.e in the second half of last year). That’s because if you paid over $51, the current yield on CBA shares is lower than what you can get on NAB now. Or, if NAB’s current UK woes make that stock too risky for you, then to even consider switching into ANZ or Westpac (WBC) you’ll have wanted to pay over $56 for CBA (to switch into WBC) or $61 (to switch into ANZ). If you paid less than those amounts, you get a better yield with your current CBA holding.

I’d add that I don’t think there is much risk of CBA cutting its dividend. If anything there is scope to increase it given that at around 77% the payout ratio for CBA doesn’t appear to be particularly stretched and sits broadly around average.

Otherwise, the only way a switch would make much sense is if you’re concerned about some growth surprise (downside for CBA or upside for the others). Looking back at table 2 for inspiration, the P/E suggests that NAB is Australia’s cheapest major at the moment, followed by ANZ and then WBC. NAB also pays the highest yield. That doesn’t tell us much though, as growth considerations will be driven more by one simple, fundamental question. Which bank is better placed to take part in the inevitable upswing? Or, thought of another way, is CBA disadvantaged in any way?

For me, CBA doesn’t shape up too badly. Consider that the bank has consistently offered the best return on equity over a five-year period. Similarly, in terms of CBA’s capacity to expand its loan book (growth), I’m not seeing too much in the way of constraint relative to the other majors. Take a look at table 3 below.

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It shows that CBA is in a better position to expand its book compared to WBC, with lower loans to deposits (a liquidity measure, but broadly the lower this ratio the greater the scope to lift loans) and loans to assets (a higher ratio suggests banks have more loans relative to assets and that there is less scope for growth or that default risk is higher). Compared to ANZ, CBA has more loans to deposits, but a comparable loans to assets ratio. Truth is there isn’t much in the way of difference between CBA, WBC and ANZ and I don’t think you could mount an argument to switch out of CBA into either of the other two on growth. The stand-out is NAB, which on these metrics is the bank best positioned for growth (with lower loans relative to assets and deposits).

That’s doesn’t mean I think investors should switch out of CBA and into NAB. NAB’s provisions for doubtful debts are already over two times the other majors, and while management is distracted by questions over foreign asset quality etc growth isn’t going to be a strategy they will likely pursue aggressively. Managing its UK asset problem and cutting costs will probably be a higher priority. That said, these higher doubtful debt provisions may give rise to earnings per share outperformance (as they get reduced) down the track. Similarly, given NAB’s higher cost-to-income ratio, there is greater scope for earnings upside, vis a vis the other majors, here as well.

The bottom line, and assuming you bought before the second half of last year, is I don’t think there is really a compelling argument to either sell or switch out of CBA – certainly not into WBC or ANZ. Perhaps NAB on a longer-term basis, although there is near-term execution risk regarding its UK operations and cost-cutting program. On paper, NAB’s metrics – cheaper, better yield, better medium-term loan growth prospects etc – are more a reason to overweight the sector than anything. So I wouldn’t fund any purchase of NAB by selling CBA.

For those with no allocation to banks, the decision is different and at these levels there is no strong case to buy CBA. NAB is my longer-term pick as mentioned, but investors should note these gains may take a while – at least until NAB sorts out its UK mess.

Until then, you can take the yield. Otherwise I don’t see a material difference between ANZ and WBC – ANZ is cheaper and better placed for growth (lower loans to assets and deposits) – but WBC offers a slightly higher yield.