Weight watching in the banking sector

There are few sectors that elicit such strong feelings as the banking sector. If further evidence was needed, you need only look at the comments to our recent upgrade of Westpac.

One reason for this is that it's so easy to point to the dangers - tightening credit, increasing interest rates, high systemic debt, a property downturn, high leverage of the banks themselves. It can sometimes be hard to imagine how they've got by for so long; and that's often the argument on the other side - that, despite ever-present risks, they've performed well over the long term.

In this debate, we've mostly sat on the fence. This isn't particularly surprising - for some of the biggest stocks on the market you'd expect them to be priced relatively efficiently. For CBA and Westpac, we've had years of Hold recommendations with only occasional Buys and Sells; for NAB and ANZ we've been more equivocal, with a sustained string of Sells between 2009 and 2015.

Yet from the glimpses we get - at seminars and through emails, comments and Q&As - we know that many members have very large weightings in the sector. So one of the key planks of our advice over the years has been to explain the risks and encourage members to keep their weightings in check.

Risky business

Those weightings themselves have caused some trouble. At times the All Ords has had a weighting of around 30% in the big four banks, which is far too much for what is a risky sector. And there's a huge overlap between them, so you don't get much diversification by being spread between them.

So we've recommended a maximum of '20% for the sector as a whole or closer to 10% for more conservative investors or those with other significant exposures to the property market'. We've also had maximum recommended weightings of 9-10% for individual banks.

Even this left us recommending that members should be significantly underweight in an important sector of the market - and even underweight CBA on occasion.

The recent underperformance has brought the sector weighting down to around 20% (although that's still high by global standards) and the individual banks now range from a more reasonable 4% for ANZ and NAB, to 5% for Westpac and 6% for CBA.

The underperformance is understandable. The big banks have been forced to hold more capital which, as our banking analyst Rakesh Tummala explained in his banking series earlier this year, reduces their profitability.

Yet the risks are as high as ever, at least in the absence (as yet) of a financial crisis. On top of the economic risks described above, the Royal Commission is likely to cause stricter regulation, tighter lending standards (thereby restricting credit growth and perhaps exacerbating property price falls) and no doubt a slew of remediation, fines and litigation. 

Perhaps more importantly, there's the threat of technological disruption and the potential for increased competition, with several second-tier banks close to being permitted to use the same risk weights as their larger peers.

Emerging value

We think these risks are accounted for in Westpac's price, which represents a premium to its book value of about 40% - hence Friday's upgrade. However, we're nudging down our Buy prices on CBA, from $63 to $60, and on NAB, from $25 to $24.

This keeps CBA as the most highly rated of the banks - with a premium of about 60% to book value at the Buy price - and we think that's appropriate given its strong retail franchise. However, the reduction acknowledges that it probably has the most to lose from the regulatory, competitive and technological threats.

The reduction for NAB restores the slight discount we think it deserves relative to Westpac, putting its Buy price at a premium of about 27% to book value.

The adjustments leave ANZ looking a little unloved - its Buy price representing a premium of only 13% to book value - but that's not surprising given its history and we'll wait until its full-year result (due next month) before making any changes.

Even after the changes, CBA and NAB are less than 10% away from joining Westpac on our Buy list and ANZ isn't far behind. It might not be long before we have further Buy recommendations among the big four.

Risk remain

Yet the risks remain and our focus continues to be on helping you manage them. On that basis, we're reducing our recommended maximum weightings for individual banks from 10% (or 9% in the case of ANZ) to 8%. We're also raising our business risk ratings on CBA and Westpac from Low-Medium to Medium, so that all four of the majors are now rated Medium for both business risk and share price risk.

We thought hard about reducing our maximum recommended weighting for the sector overall from 20% to 15%, but have opted to keep it - instead emphasising that most members should be much closer to the 10% we recommend for 'more conservative investors or those with other significant exposures to the property market'.

We deliberately don't define what might make you 'conservative' or what might amount to 'other significant exposures to the property market'. These are grey areas but most members will fall into one of those categories, at least to some degree.

After all, the majority of our members will own a house; and most people don't realise how conservative they are until things start to go wrong. Despite their cultivated image of financial strength, banks operate on small slivers of equity. Of course their overall asset base is predictable and they manage it very carefully, but things can change quickly.

We also don't say which stocks you might include as part of the sector. You'd certainly want to include Bank of Queensland and Bendigo and Adelaide Bank, but should you also include Macquarie Group or Suncorp? Again it's a grey area, but if you have significant other exposure to other financials (such as ASX, IOOF, FSA Group or any insurers), then you'll probably want to take a tougher line on what you include and err towards the 10% overall maximum weighting.

Build positions slowly

Bear in mind also that the 10-20% range is where you should place your maximum weighting. This is the weighting you'd have when you think the sector looks very cheap, not when it's merely beginning to show some value - and certainly not as an average across the cycle. It's important to have a maximum, though, and stick to it, because banks have a knack of looking cheapest just when the risks are greatest.

And despite its position as the largest sector of the sharemarket, we don't think there's a great need to own any banks at all. To a large extent, they provide geared exposure to the overall economy, so they won't necessarily add much to a well diversified portfolio. If the banks do well, then it's likely the rest of the sharemarket will too - and vice versa.

But if you're comfortable with the risks and keep them in check, then we think it's worth thinking of adding to your holdings, starting with Westpac. As ever, though, we wouldn't be going to the maximum weighting as soon as we recommend buying a stock.

It's more a case of gradually building a position. If the margin of safety increases (either through price falls or business improvements or both), then it will make sense to increase your weighting. We'd need to see much cheaper prices, though, before we'd suggest getting close to the limits.

Generally, it's at this point that we'd say 'bring it on'. But you have to be careful what you wish for, and the banking sector is not to be trifled with.