Picking a winner: bank shares or cash?
| Summary: In the hunt for yield and solid returns, are banks shares a safer bet than bank deposits? Under current economic conditions, the answer is fairly easy. Bank shares have run hard, while the cash rate has fallen away. But would the story change over five years? |
| Key take-out: Investing is always about risk versus reward. Bank shares, while a large component of the market, are not without risk. |
| Key beneficiaries: General investors. Category: Income. |
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.
Frequently Asked Questions about this Article…
Based on the article’s conservative example, bank shares are likely to be more profitable over the next five years. Using current dividend yields (about 5.5%) plus franking credits (about 2.4%), the income from $100,000 in bank shares would outpace a bank deposit paying roughly 4.25% interest. Even allowing for modest dividend growth and a weaker price-to-earnings (PE) multiple, the example showed bank shares ahead after five years, though this hinges on several assumptions.
The article notes a typical good bank account paying around 4.25% interest, while bank shares currently yield about 5.5%. Franking credits add roughly another 2.4% for Australian investors, making the effective income from bank shares about 7.9%, which is substantially higher than the cash rate mentioned.
In the article’s no-growth scenario, $100,000 invested in bank shares paid $39,500 in dividends over five years, while the same amount in a bank deposit paid $22,500 in interest. With a conservative annual dividend growth assumption of 2.5%, bank share dividends over five years rose to about $41,525.
Capital value matters because a deposit returns your original $100,000, while shares can fall in price. The article’s ‘bad case’ assumed banks’ PE ratios decline from 14 to 12 over five years and earnings grow 2.5% annually, which would reduce a $100,000 shareholding to about $94,600. Even with that capital decline, the income received left shares ahead in the example—but different PE or earnings outcomes could change the result.
Bank shares carry market and sector risks that deposits don’t. The article highlights that banks can be exposed during downturns (as seen in the global financial crisis), and the higher dividend yield partly reflects those risks. Shares can fall in value and dividend payments aren’t guaranteed, whereas deposits generally return principal and fixed interest.
The article suggests using the market as a guide: Australian banks currently make up about 40% of the value of the Australian sharemarket. Holding a similar proportion in banks is a reasonable starting point; taking an overweight position requires conviction that banks will deliver above‑average returns, because concentration raises sector risk.
The comparison assumed interest rates remain low, GDP growth at 2% a year (above inflation), dividend growth for banks at 2.5% annually, and a fall in the market PE for banks from 14 to 12 over five years. These conservative inputs produced the outcomes and highlighted how sensitive results are to assumptions.
The article warns that while bank dividends (and franking credits) are attractive and historically strong, relying solely on bank shares for retirement income carries risk. Banking is a large but cyclical sector, and high dividend yields reflect both reward and risk. The recommended approach is to understand those risks and consider diversified exposure rather than an overweight position in banks.
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