The big banks are still bankable

In January of this year I reviewed prospects for our major banks, with a focus on Commonwealth Bank (click here).

At the time, investment bank UBS had made a call that the banks, and CBA in particular, were overvalued and a sell. Ten months, and nearly 30% later, those calls are once again being made – so I thought it was maybe time to revisit my call.

I am sympathetic to concerns that our banks, especially CBA are overvalued. Clime Asset Management’s John Abernethy last week wrote that, in his view, the ‘big four’ are no longer in value (see The ‘big four’ are overvalued). Today on video, Managing Editor James Kirby and David Walker, head of equities at our joint venture partner StocksInValue, discuss Why banks are fully valued.

Table 1 below shows strong gains – 32% over the last 12 months for CBA. This by itself is impressive, but all the more impressive given it follows a gain of about 27% for the year prior to that. Indeed, since a low point in September 2011, CBA is up over 80%. Against that backdrop, and with a valuation of over 16 times earnings (trailing), some investors are perhaps understandably worried. That price-earnings (P/E) value is above what is ‘normal’ (13 on an actual basis) and system credit growth is still very weak after all – much weaker than ‘normal’.

That is why so many analysts question the quality of banks’ earnings and wonder about the sustainability of them. That P/E is way too high, they would argue, because how can we expect earnings per share (EPS) growth to remain solid when credit growth is so weak, and so far earnings have been driven by falling bad debts? And the truth is, lower doubtful debts have played a significant role in recent earnings growth.

Yet is that so unusual given where we are in the cycle? I would argue that lower bad loans and provisioning for that is a logical first step in any credit recovery. That’s what we should expect at this early point. Think about it. Policy makers around the world have been screaming at anyone who would listen that the US was at imminent risk of default. China was on the verge of a credit crunch, and in Australia we were staring down the barrel of a recession. The economic outlook was a lot more uncertain and higher provisions for bad debts made sense.

Now we find none of that was ever true. The main consequence of all this drama is that interest rates are at a record lows. That last point is important because it means, as mentioned, that debt repayments as a percentage of income is the lowest it’s been in about a decade. Against a backdrop of solid incomes growth, a very low unemployment rate and trend-like economic growth, why wouldn’t banks maintain a credible provisioning for doubtful debts – at a record low and see lower bad debts? The truth is there isn’t a lot in the way of headwinds out there, and central banks everywhere are telling us rates are going to remain at record lows for years to come. That lower provisioning accounts for such a large proportion of EPS growth is what you would expect in phase one of a bank’s cyclical earnings recovery – when the sector as a whole is on the mend and the worst is over.

Phase two will be driven by the mortgage book and actual lending growth – and we are seeing phase two pick up already with data just this week. The lending figures show a 4% monthly surge and nearly 13% annual growth! Take a look at chart 1, which shows this sharp rebound in action.

Click to enlarge

Following an initial decline when the Reserve Bank’s easing cycle began, lending growth has rebounded sharply this year and housing activity more generally has surged. People argue about consumer deleveraging and high debt levels as headwinds. Yet, the fact is consumers are not deleveraging and debt levels are not too high. Sure, the ratio of debt-to-household income is down, but that’s misleading as actual debt levels have not come down – debt isn’t being cut. It’s just not rising as fast as household incomes. More to the point, debt servicing ratios are at decade lows. So the idea that consumers have been scared off debt and are deleveraging is pure nonsense. They just had no reason to gear up. But that’s all changing given house prices are surging.

With that in mind, is it so unusual for the market to want to pay a premium for the banks? Yes, the P/E is high on an actual basis – and even on a one-year forward basis it is expected to remain at a premium compared to historical results. I’m not sure that is some oddity that should ring alarm bells though given the macro environment – interest rates are at record lows and the credit cycle is only just turning. A premium is exactly what the major banks, including CBA, demand.

In any case, the fact is even the major broking firms, many of whom have been very bearish on the banks, and CBA in particular, have a valuation on CBA not much below where it is now – at $76ish. So if the banks are overvalued, and CBA in particular, then this fact doesn’t suggest we are in store for much of a correction.

Otherwise, and even at these elevated prices, the major banks still pay – and are expected to pay over the next year or two – a grossed-up dividend yield over 7%. That’s great and still beats putting money into a term deposit – and of course anyone with any sense will keep well clear of government bonds. Ultimately, I don’t think demand for yield in an ultra-low interest rate environment is going to change much – and that will further support the premium investors are willing to pay for banks.

I guess the additional problem for CBA is that in an expensive sector it’s the most expensive – and on its current price offers the lowest yield. Wouldn’t CBA’s comparatively lower yield and higher premium at the very least warrant a period of underperformance relative to the other majors? On paper yes, but the fact still remains that CBA has consistently managed a higher return on equity than the others for many years.

More to the point, CBA’s payout ratio of 77% is fairly consistent. WBC’s at 86% is less so, which means that while WBC may have the highest dividend yield, history suggests you can’t bank that. Same with ANZ with a payout ratio well above historical norms – even at 77%. For CBA and NAB to pay out 77% of earnings is just business as usual – by and large. I guess what I’m trying to say is that the current dividend yield can be a highly misleading statistic. More to the point, I’m not seeing any reason within that or elsewhere, why investors would all of a sudden not place CBA at a premium to the other majors.

Conclusion

In sum then, analysts might be right in saying banks are expensive right now, and maybe there will be a correction. If you’re a trader, or an institutional fund who reports every three months and don’t really want to carry a stock that’s correcting on your books, considering a switch might be worthwhile – maybe.

But for my purposes, and for longer-term investors, I’m still not seeing any reason to bail out. Banks are not in the mature phase of their earnings cycle; they are very much in the early stages – lending growth is and will continue to lift earnings quality. They pay and are expected to continue to pay a high dividend, and global interest rates are expected to remain ultra-low. That suggests to me that the ‘premium’ attached to banks is indeed worth paying. Remember that ‘premium’ disappears if analysts have underestimated earnings growth as well.

Within that, CBA remains very attractive at these levels and I can’t see any compelling arguments to favour the ‘cheaper’ ‘higher yielding’ banks.