Picking a winner: bank shares or cash?

For a long time it has been one of the interesting questions: is it better to be part owner (shareholder) in a bank, or to be a depositor with a bank?

With bank shares falling sharply in value over recent weeks, and with interest rates at historical lows, the question becomes relevant again.  Over the next five years, and for an amount of $100,000 invested, which is likely to win the investment race: bank shares or bank deposits?

And while this is an enjoyable topic to think about, the big question remains how to hold bank shares in your portfolio. Where should they sit given their position as attractive dividend payers, the largest industry (by size) in the Australian markets, but with the risks that come in the banking sector.

If we are going to try to predict the outcome of a race between bank shares and bank deposits, we need to find the key drivers of returns over the period, which will be:

• Income
• Income growth
• Capital value

Income

Starting with income as a key driver of returns will see a nice win for bank shares.  At the moment a good bank account will be paying around 4.25% interest, with bank shares around 5.5%.  That seems to have bank shares winning by half a length, however franking credits add even more to that win.  Franking credits add an extra 2.4% to the income of bank shares, giving them a 7.9% income return versus a 4.25% cash rate.  For Australian investors, franking credits are as good as a cash return – they either directly offset tax owing on a dollar-for-dollar basis, or end up being received as a tax refund.

Assuming no growth in dividends or interest payments:

• Over five years the dividends from bank shares for a $100,000 investment will total $39,500.
• Over five years the interest payments from a bank deposit with a $100,000 investment will total $22,500.

Income growth

Our second driver of returns is income growth – and suddenly this takes us toward the world of forecasting.  How are we going to forecast the growth, or fall in dividends, over this period?  What is going to happen to interest rates over the same period?  The answer calls for some caution, and I certainly have no idea.

However, I want to propose a kind of ‘bad case’ scenario.  That is, that interest rates will stay low for the next five years, and GDP growth will be well below the average of recent times, at 2% a year.  (And keep in mind that 2% a year means 2% growth above inflation).

I am going to make a further conservative assumption – that the growth in the income from bank shares is less than the growth in the overall economy, and averages the rate of inflation (2.5% a year).  I think this is a conservative estimate, as it assumes that:

• Bank earnings grow at a slower rate than a conservative estimate of the overall economy.
• It does not give the banks any allowance for the ability to use retained earnings (those earning that are not paid as dividends to investors) to increase earnings and dividends in future years.

So where does that leave our race?

Adding dividend growth of 2.5% each year would take the total value of the dividends received from the bank shares to $41,525. And the bank deposits would still be sitting on $22,500.

Of course, dividend growth is certainly not guaranteed.  However, the history of bank dividend growth in Australia has been impressive, even during the period of the global financial crisis.

Capital value

The last factor is the capital value of our investment. For the $100,000 in the bank deposit, the result is easy – we get our $100,000 back and have received interest of $22,500 along the way.

How should we calculate the likely capital value of our shares?

I think a ‘bad case’ scenario calculation is appropriate. Banks are currently trading on a PE ratio of 14.  Let’s assume that in five years the environment for banks is tough, and the PE that the market is prepared to buy banks on has fallen to 12.  Given earnings growth of 2.5% a year for the next five years, and valued on a PE ratio of 12, the $100,000 investment would have fallen in value to $94,600.  However, the nearly $20,000 of income will leave bank shares ahead, even if they fall in value over the next five years.

Of course, this exercise is very hypothetical, and involves trying to predict variables that no-one can be sure of.  You can adjust the assumptions and outcomes as you see fit with your own thoughts on what the future might hold.

The bigger question

The initial glance in the direction of bank shares might see them look to be the perfect investment to build toward funding a retirement.  Generous dividends, plenty of franking credits, a generally strong history of performance over the past 15 years. So why shop elsewhere when looking for a retirement solution?

The answer would be risk. Banking in Australia would seem to be a fairly mature industry (making many billions of dollars of profit in a country of a bit over 20 million people), and we have seen the risks for banks exposed during the global financial crisis. 

Currently banks make up about 40% of the value of the Australian sharemarket. This is a reasonable starting point in thinking about the proportion of Australian share exposure that you want to hold in banks.  Taking a position with greater exposure than this to the banks requires a strong conviction that they have a capacity to provide above-average returns.

It is worth keeping in mind that the Australian sharemarket is dominated by financial service and mining-related companies. I think from an asset allocation perspective, tilting portfolios to sectors less represented in the average market might make more sense.

The dividend yield of banks is tempting – but that extra income is not a ‘free lunch’, rather a reminder that there are risks in that sector, and investors are not prepared to pay as much for each dollar of bank income compared to other sector.

Conclusion

Based on conservative assumptions, we might expect owning bank shares to be more profitable over the next five years compared to having a bank deposit – although there are a lot of assumptions behind that conclusion that might not come true.

However, bank shares, while an important part of most people’s portfolios, are not without their risks. This is something that should be clearly understood by anyone looking to take an overweight position in bank shares.

Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.