Is Commonwealth Bank still good value?

With the ASX lurching above 5000 points and Commonwealth Bank (CBA) hitting all-time highs following its half-year result, it is pressing that I review my position in CBA as it resides in both my growth and income portfolios.

At the outset I believe it is important that investors and shareholders take note of the environment that the banks are currently trading through. These are not normal times and I suspect in the coming years we may well question what is normal, or indeed ask, is there a “new normal”?

Specifically the world economic environment is not conducive to growth in earnings by commercial banks. There is a well-documented deleveraging cycle, whereby households continue to reduce the debt that they piled on prior to 2008. Further, there is an ageing demographic of wealth. The baby boomers are moving into retirement and they are absolutely focused on protecting their wealth by investing and reducing consumption. Meanwhile the high $A has dampened economic activity so that business credit continues to be subdued.

From a capital perspective the banks are being more tightly regulated. Following the GFC, financial regulators across the world have agreed to lift the level of capital that banks are required to hold. While this builds a reserve buffer for bad times, it does have the undesirable result that it dilutes return on equity in normal times.

On the positive side in Australia, we see continued population growth averaging 1.5% per annum and national economic growth, which is mainly driven by resource exports, continues to average around 3%. Inflation is currently under control and so the Reserve Bank continues to maintain historically low policy settings.

So, in summary, Australia is a growing economy with a mismatch of wealth and debt. Those with wealth don’t need credit and avoid it due to their age. Those with debt have too much and do not seek any more.

The result

The broad market analysis outlined above was borne out by the results of CBA. For instance, average interest assets have grown a mere 4% over the last 12 months. This represents the growth in loans on the CBA balance sheet and suggests real loan growth of only about 1% (after inflation).

The low asset growth was mirrored by group earnings growth, which lifted by 6% on a cash basis. The growth was most clearly seen in the retail banking, institutional banking, wealth management and New Zealand. The reported profit growth was mainly generated by a strong focus on costs. Operating expenses as a percentage of operating income generally improved across the board.

There was a lift in trading income as well as an improvement in the net interest margin of a few points. Provisioning for bad debts was slightly increased, suggesting a reasonable level of conservatism in the results.

Of most significance to my eye was the lift in the tier one capital ratio. This lift resulted in two key decisions. First a lift in the payout ratio was maintained at 70%, and the board has decided to offset shares issued by the dividend reinvestment program with a small buy back. These decisions confirm the board’s view that CBA is well capitalised, and so capital management is on the agenda. This is a far cry from the 2009 year when all banks were desperate to raise capital for fear of a recession.

The lift in first-half dividend of 20% over last year will not be reflected in the final dividend. Rather, the board has decided to balance the dividends and this seems sensible.

More importantly for investors and myself is the effect of the excess capital on the valuation of CBA, and this is discussed in the following valuation section.

CBA’s intrinsic value

As I write this valuation there are scores of banking analysts pouring over the CBA numbers trying to predict its level of earnings. In the end I suspect that earnings for 2013 and 2014 will be forecast to grow by about 5% in each year. For intrinsic value calculations it is not so much about earnings growth but rather the growth in profitability as measured by profits made, franking distributed and their proportion to average employed equity.

What I propose to do is derive a valuation based on the following:

1. That CBA will maintain a low ongoing growth in assets and earnings consistent with the last two years. I see no reason to expect a dramatic change;
2. I expect the “normalised return on equity’ to the owners of CBA to be maintained at current reported levels. The lift in dividend payout is factored in, and the associated franking credits act to enhance the owner returns in my normalised calculation. See the five-year performance table below; and
3. I have used a required return (RR) of 11% to derive value. This is a conservative RR as it is derived from 10-year Australian bonds, which are yielding 3.5%. Investors may choose a lower RR but they must be aware of the increased risk that they are taking in doing so.

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Despite my sober outlook for credit growth in Australia I am projecting that the normalised return on equity of 24% is sustainable for the foreseeable future. This is actually an excellent return given the massive dilution effect of the $7.3 billion of capital raised in 2009-10. CBA has managed to lift profits from the 2010 financial year by about $1.7 billion, confirming that profits will rise on increased capital and will do so at an impressive rate.

CBA is also returning cash, in the form of franked dividends, at an impressive clip. Dividends were $8.2 billion over 2009 and 2010. Over 2012 and 2013 the dividends paid will be $10.5 billion. As a side note you can see why the Government is frantically worried about a super tax black hole. As more “baby boomers” move into pension mode, pay no tax and get franked dividends from the likes of CBA, there is a massive franking cash rebate payable out of consolidated revenue.

The above table and my assumptions suggest sustainable NROE of 24% is appropriate. From this I have derived the following forward valuations, which are ex dividends, (see Figure 2) and readers will see that I am happy to hold CBA in both my portfolios.

Would I buy more at current prices? I think patience is warranted, with a buy price of around $62 appropriate ex dividend. I never want to pay for a share at a price that I think it is worth.

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To conclude, I would caution investors about aggressively chasing shares that have risen 30% in six months. Apart from the likelihood of market corrections, there is a pervasive market presumption that the current economic environment will not change. I regard this as too simplistic and dangerous.

Anyone who scans economic history knows that cycles occur. Over my 30 years in investment markets I have seen periods of euphoria followed by equity market crashes, bond crashes, hyperinflation and bank collapses. This recent period of massive and coordinated quantitative easing is unprecedented in history. Therefore, I cannot help but think that the current benign period we have in 2013 may be followed by another cyclical event. They may be difficult to predict but it is folly to ignore the risks.

John Abernethy is chairman of Clime Capital Limited, ASX:CAM (Clime’s Listed Investment Company). 

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Clime Growth Portfolio

Return since June 30, 2012: 33.34%
Returns since Inception (April 19, 2012): 23.98%
Average Yield: 5.46%
Start Value: $111,580.24
Current Value: $148,780.60