Time to sell the banks?

Look closely at the cavernous walls that enclose Sydney’s Martin Place and you’ll find a small plaque marking the last living moments of the financial advisor that told his clients to sell the big four banks.

His was a Mishima-like death, a man so traumatised by his own mistakes he could face the world no longer. It was a sad, public and bloody end to a decent and well-intentioned man.

Okay, this story is slightly exaggerated – in fact, it’s not true at all – but you get the idea. Only the brave and the foolish suggest investors sell the banks. You can work out which one I might be over the next few hundred words.

Tranche 1 of the Commonwealth Bank floated in 1991, at a price of $5.40 a share. Since then it has delivered an average annual return of 14.5% excluding franking credits. Since almost collapsing in 1992, Westpac has produced a similar compound annual return of 14.0%. No wonder the big four banks form the bedrock of most Australian portfolios and investors are reluctant to sell them.

But with Westpac’s share price increasing 27% since we upgraded it in Westpac tips the scales on 23 Jul 10 (Long Term Buy – $22.63) and Commonwealth Bank up 32% since Commonwealth back on the buy list from 12 Aug 10 (Long Term Buy – $50.73), the bulls and bears are locked in a battle over whether bank share prices are in a bubble.

Bull case

The bull case is straightforward. Despite anaemic credit growth retarding revenue (see Chart 2), by managing their profit margins, cutting staff, sending jobs offshore, employing ever-more technology (see our recent Boss Talk podcast with ANZ chief Mike Smith) and reducing bad debt provisions, the banks should be able to increase earnings and dividends.

But wait, there’s more. The Australian economy is healthy, at least by global standards, and there’s room to lower interest rates if things get tricky. The banks have also reduced their reliance on overseas wholesale funding (see Chart 3) while keeping their capital ratios in check.

The big four banks also have plenty of pricing power in a huge market. Following acquisitions made during the GFC, they now (reportedly) write 92% of all new mortgages.

And where else can you get a reliable and growing 6% fully franked dividend yield from a regulated oligopoly that would be saved by the government in a crisis? There’s no argument, right?

Bears' picnic

If only life were that simple. To overseas investors, our banking sector and the Aussie dollar is the next big short (where you profit from the price of an asset falling). Residential property prices and our exposure to a bursting Chinese credit bubble offer them plenty of encouragement.

At a colossal $355bn, the Australian banking sector is valued at nearly 25% of GDP. In the US, that figure is 4%; in the UK 18%; and 5% in Europe. With less than half the population of the UK, our banking sector is valued at about the same price.

In 2010 Jeremy Grantham, known for his accurate analysis of asset bubbles, nominated the Australian and UK housing bubbles as the only two of 32 asset bubbles yet to pop.

In All aboard the yield bubble? we discussed SC Fundamentals’ short position in Commonwealth Bank and Grant’s Interest Rate Observer’s short recommendation of Westpac and Bank of Queensland.

Jim Grant’s colleague Evan Lorenz warned that, ‘Houses in the major Australian markets are priced at an average of 6.5 times median household income, compared to 3.1 times in the United States today and 4.6 times in the zany year of 2006.’

At the recent Sohn Investment Conference in New York, Stanley Druckenmiller – the mastermind behind George Soros’s famous bet against the UK pound in 1992 – said ‘the Australian dollar will come down and will come down hard’ as the resources boom loses steam.

Our long-held concerns around the sustainability of China’s investment-driven growth has become mainstream (read some of the reasons behind the related short positions of legendary investor Jim Chanos here).

Slowing economy

The argument for selling the banks has also been recently bolstered by the resilience of bank stock prices despite a raft of negative economic data.

Eighteen months ago we were suggesting investors reduce their weightings to bank shares because of the risk of a slowdown in China and the potential consequences for the Australian economy. Today that is no longer a risk. It is a reality.

More than $150bn of resources projects were cancelled in the four months to April, causing a rout in the share prices of mining services companies. UGL, Worley Parsons and Coffey International recently announced profit downgrades, with Coffey also announcing that cost cutting would lead to 150 redundancies. Heavy machinery manufacturer and US-listed company Caterpillar also announced a further 330 job losses after announcing a 45% drop in profits due to its mining and construction divisions. Even the share price of the best operator in the industry, Monadelphous, has almost fallen 50% below its 52-week high.

The Roy Morgan unemployment survey (which counts the underemployed as unemployed) implies that the true unemployment rate was 10.9% in February, up from 9.7% a year earlier.

And BIS Shrapnel economist Adrian Hart is expecting major project work in QLD to fall by 40% over the next five years as the LNG projects in Gladstone are completed and the coal industry continues to struggle.

With Victoria, South Australia, Northern Territory and Tasmania already in recession, it’s hard to imagine the banks won’t eventually feel the impact. And yet bank share prices are up significantly over the past six months.

While valuations aren’t at record highs (see Chart 4), investment bank UBS recently published a report titled Welcome to the Great Bank Bubble of 2013, suggesting Commonwealth Bank has the highest price-to-tangible book value in the world at 3.6 times.

In summary, the economy is likely to slow (at best), the banks have a large exposure to mortgages, Australian consumer debt levels are very high by historical standards and bad debts are at or near record lows.

In our view the upside from here seems fairly limited, despite several senior bank executives recently suggesting that bank share prices are not in a bubble.

This isn’t an argument to sell out of the sector. It is, however, a call to try and dissociate from what has probably been a very pleasing experience for many members and ask yourself whether you’re over-exposed to the big banks. Here are four tips to help you answer that question with a degree of mental clarity:

1. You don’t need to own the banks

Forget the uniquely Australian notion that you need to own the banks. You don’t need to own anything. You have the flexibility and freedom to invest in anything you want.

Our Growth Portfolio has performed perfectly well over the past few years without owning bank shares. The Intelligent Investor Value Fund is up around 30% in the past year without owning one bank share, either. You don’t have to live without the banks in your portfolio; but if you think it’s the right thing to do, you can.

There are plenty of alternatives, too: companies that aren’t highly leveraged, don’t face the same risks as banks, and would benefit from a lower Aussie dollar. We’ll be publishing several special reports on 1 July full of buy ideas including stocks that should benefit from a lower Aussie dollar, just like those filling the Home and Away Portfolio that was recently discussed in Let the clouds gather and the rain fall.

2. Don’t anchor on higher prices

If you have 10% or less invested in the banking sector then you have very little to fear (remember that our recommended portfolio limit of 20% doesn’t take valuation into account).

But if the big banks form more of your portfolio than that, don’t let their current high prices and attractive dividend yields prevent you from acting.

3. Keep it simple and avoid emotional attachment

Ask yourself the same question that you should ask of all the stocks in your portfolio; at the current price, are you being compensated for the risks of holding? If not, then it’s time to sell down.

You should also avoid becoming emotionally attached to your stocks. A study by Dan Ariely, author of Predictably Irrational, found that we overvalue things we own. One way to counter this is to imagine you were building a portfolio from scratch today. Would it look the same as the one you own now?

4. Don’t let tax get in the way

Don’t let paying capital gains tax stop you from acting in your best interests. Better to pay the taxman and pat yourself on the back for a great investment than risk getting greedy and suffering unnecessary losses.

Final words

You can relax and collect your dividends if all of the following applies: you’re a genuine long-term owner of the banks and are happy
to ride out the cyclical swings; you’re not leveraged; you’re comfortable with your portfolio limits; you’re not over-exposed to home
prices through your bank shares and other property investments; and you believe the 
potential returns compensate you for the risks.

But if your portfolio is unbalanced and you’ve enjoyed a great run with the banks, now could be a great time to lock in some profits and either wait for better opportunities, or pay a cheap or fair price for some other income stocks and securities held by the model Income Portfolio, shown on our Buy list or featured in our upcoming special reports.

Although the share prices of Commonwealth and Westpac have fallen recently, we’re taking our own medicine and reducing our stake in 
Commonwealth and Westpac to 2% each in the model Income Portfolio and building up cash for future opportunities (see Note below).
Please note, though, that this is a portfolio adjustment, not a change in recommendation.

With these four tips, you’ll be in a better position to assess whether you need to reduce your exposure to Australia’s big four banks.

Note: The model Income Portfolio owns shares in Commonwealth Bank and Westpac.

Note: We’re selling 40 shares in Commonwealth Bank at $67.20 per share netting proceeds of $2,688, and selling 60 shares in Westpac at $28.60 per share netting proceeds of $1,716.