Five reasons to hang onto the banks

It was back in November when they began bandying about the B word.

A bubble was forming, according to the bulk of analysts. Banks were overvalued, their payout ratios were unsustainable and earnings growth would be insufficient to support the incredible stock price appreciation that had begun the previous June.

Almost six months later, and the warnings have grown louder and increasingly shrill, backed up by ever-more complex calculations and comparisons to support the contention that the bank rally is an accident in waiting and that it is time to abandon the ship before it goes down.

Except for one thing. Earnings growth has occurred, and quite spectacular growth at that.

Bank shares, meanwhile, continue to forge ahead. The Commonwealth Bank is now the biggest company in the country, toppling BHP Billiton for top spot, while Westpac is hard on its heels as both now have breached the $100 billion capitalisation mark.

From 4,433 in early June last year, the ASX 200 banking index had grown to 5,400 by late October before fears of the US fiscal cliff temporarily reversed the trend. It was a spectacular performance that almost universally was considered to have been overdone. Last week it peaked at 6,809.

So much for the rear view mirror. The real question is: Where to now?

Clearly, this kind of appreciation can’t continue indefinitely but it still has a way to go while interest rates are low and falling and credit conditions remain benign.

A month ago, I wrote that Australian banks were in a sweet spot and that ANZ and NAB were the best value among the majors (see Why ANZ and NAB are most loved).

Last week, both ANZ and Westpac reported half-year results that confirmed that view and sent bank stocks soaring even further.

Following are five reasons to hang on to Australian banks, debunking the myths and fears surrounding the banking sector.

1. Australian banks are overvalued

No they aren’t. They may be more expensive than banks in other developed nations, depending on how you measure expense. But Australian banks didn’t follow their global peers into the abyss during the boom years because the Australian market is fundamentally different from those in other developed nations. So why compare them now?

On a simple price earnings ratio, Australian banks are trading at 15.1 times this year’s earnings and 14.5 times next year’s projected earnings.

That’s above the long-term average, the bubble heads claim, even nudging record levels. True. But it conveniently ignores the fact that interest rates not only are well below the long-term average but are sitting at record lows, with every indication they will trend even lower.

In addition, Citigroup research indicates that our banks were trading at 16.1 times earnings in 2011 and 15.7 times earnings in 2012. On that measure, they’ve actually become cheaper.

If you compare the price of our banks to the overall market, again they are cheaper. The banking index is priced below the ASX 200 average of 15.6 times this year’s earnings and a whisker above next year’s projected 14.4 times earnings.

The banks are much cheaper than industrials, priced at a whopping 16.5 times this year’s earnings and slightly better value than resources, which traditionally trade at a discount.

2. Credit growth has stalled

You can’t argue with that. The latest figures from the Australian Bureau of Statistics and the Australian Prudential Regulatory Authority indicate that business lending has gone backwards and that growth in residential housing is the slowest on record.

The only problem with that line of thinking is that it ignores the simple fact that, since the takeovers of BankWest and St George, just four banks dominate the domestic market, making international comparisons redundant. Unlike other jurisdictions, Australian banks are not price takers and have greater pricing power than their American and European counterparts.

They hold 83% of all household mortgages. They have the wealth management industry tied up. They have large and increasing market shares in insurance.

As a result, margin expansion is far more critical to earnings than volume growth. That explains the endless round of record profits during the past three years from each of the major banks during a period when almost every other industry outside of resources has been in crisis mode.

Both ANZ and Westpac improved their margins during the March half and judging from Westpac’s Gail Kelly’s comments last week, they plan to continue that trend.

Apart from overall market growth, the stars have aligned for our big banks on almost every other measure.

Impairments continue to improve. The domestic real estate market has stabilised and is showing nascent signs of recovery. Efficiency and cost cutting continues apace as the expansions of the immediate post-financial crisis era are integrated.

While the European debt crisis continues to flare, the acute phase of the crisis has passed and Australian banks have used periods of relative calmness to lock in lower offshore funding costs.

3. Dividends are stretched

No they are not. Payout ratios by our big banks have averaged around 75% of earnings.

Traditionally, the ANZ has paid the least at around 65% or less but last week indicated it would lift that ratio closer to its upper limit of around 70%, indicating less likelihood of a major acquisition in Asia.

Westpac’s payout ratio last week lifted to as much as 85% for this year, although that was bumped up by a special dividend.

Perversely, the slow credit growth – the biggest alarm bell for the bubbleheads – has allowed the banks to pay higher dividends.

4. The Australian economy is facing a possible recession

Global growth is weak and forecasts again have been reduced. Commodity prices are under pressure, problems are emerging in China’s economy, the resources investment pipeline is about to peak and with the Australian dollar refusing to budge, the nation faces rising unemployment and shrinking corporate earnings.

Anything is possible. But that worst-case scenario assumes the domestic currency will never fall, that lower interest rates will have no effect on non-resource industries and that the acute shortage of labour dogging our resources industry – which is capital intensive rather than labour intensive – suddenly will re-emerge as an oversupply of labour.

Even if this scenario eventuated, it is likely the banking sector would ride out the storm better than almost any other. Each of the big four banks are well capitalised and barring a complete collapse of the Australian property market, are well positioned to ride out a recession.

5. Diversify your portfolio, reduce your weighting to banks

Into what precisely? Many industrials are more expensive, with even less reliability in regards to earnings and dividends.

Resource giants are looking cheap. But a great deal of uncertainty over the direction of commodity prices has seen stock prices heading south for most of this year.

BHP is looking particularly undervalued and the time may be approaching when shifting weightings into the big miners is appropriate but not just yet.

Term deposits offer safety. But the yield is lower and there is no opportunity for capital gain.

The return on government bonds offers the greatest safety. But the yield is at record lows and the opportunity for capital gains is limited precisely by those record low yields. There is not a great deal of fat left.

Which bank?

Commonwealth Bank

It is difficult to find an analyst recommending CBA as a screaming buy. While most recognise it is well run and well capitalised, its share price performance of late has many thinking it is overvalued.

But slow volume growth has paved the way for capital management in the form of a special dividend and it could follow Westpac’s lead with the announcement of a special dividend on its full year results.

CBA leads its peers on the number of products sold to customers, its cost to income ratio has declined, deposit funding has lifted and it retains the largest market share of home mortgages at more than 25%. Further official rate cuts therefore deliver the opportunity to expand margins which flow directly to the bottom line.

As a negative, the Commonwealth is most exposed to share market volatility because of its position in wealth management and funds management operation.

Westpac

Long criticised for its multi-branding strategy, Westpac surprised investors with its improved earnings and special dividend last week. The analysts mostly rate it a hold.

Like CBA, it has worked at cost reduction, margin expansion and balance sheet strengthening through improved deposit funding. While it as reduced its impaired loans  to the best since the onset of the financial crisis, they are still well above pre GFC levels delivering the opportunity to further improve earnings.

It also has surplus franking credits creating the possibility of further special dividends in the future.

ANZ

ANZ’s much vaunted Asian expansion strategy and its proposed transformation into a regional bank has held the promise of fabulous long term rewards while simultaneously restraining its share price growth.

While the strategy has been in place for at least four years, a major acquisition has not eventuated and the bank instead has pursued its growth strategy in a far more measured manner.

Its improved payout ratio indicates that it intends to continue along this path, thus diminishing the execution risk on a multi-billion dollar takeover. Greater competition in Asian markets, however, would mean that its regional operations may not deliver the type of returns available in Australia.

With less reliance on residential mortgages and hence more exposure to business lending, ANZ is expected to benefit from any pick up on corporate lending.

National Australia Bank

The bank with the most attractive yield, NAB’s Achilles heel is its UK franchise. With the UK entering a possible “triple dip” recession, NAB appears stuck with the underperforming assets.

But that delivers the possibility of capital growth as the UK eventually improves. In addition, on the domestic front NAB is heavily geared towards business lending and is the bank considered to best benefit from a recovery in this area.

It recently, although quietly, abandoned its ambitions to be the lowest cost bank for consumers, indicating it was paying more attention to margin than volume growth.

Macquarie

The investment bank has shifted ground from entrepreneurial wheeler dealer to yield play.

Lifting its payout ratio to 80% last week, the bank enjoyed solid investor support, and has seen a 45% lift in its share price in the past six months.

Staff remuneration, however, remains exceptionally high, even for investment banks although Macquarie has reduced this and cut costs through a series of heavy staff layoffs.

Its strategy of expanding into traditional investment banking in the US and Europe in the wake of the financial crisis delivers it significant earnings improvement potential in the longer term but has left it overexposed to the worst performing areas of the global economy in the immediate future.