15-11-2014, 05:48 PM
Just how good are our banks?
2017 words
12 Nov 2014
The Australian Financial Review
AFNR
English
Copyright 2014. Fairfax Media Management Pty Limited.
Stocks We ask a panel of professional investors about their predictions for banks, what their picks are and how they compare overseas.
The major Australian banks are such a staple investment that shareholders need to check their belief in the sector from time to time. The good times may not last forever – they never do – but the temptation of generous dividends has seen investors push up capital values.
The story for anyone whose portfolio is weighted towards the big banks has been a good one for the past few years, but it is not a time to be complacent.
Are our banks prone to lose value if unemployment increases and property values drop? And could there be better value in international banks?
With full-year results for three of the four major banks delivered in the past two weeks, Smart Investor asked five professional investors for their outlook on the sector. We have included a London-based analyst for perspective on the value of Australian banks relative to international peers.
Some investors are heavily exposed to the banks, but the truth is we all are. The big four make up 30 per cent of the S&P/ASX 200. It makes a difference to every one of us how they'll fare.
Many investors hold the Australian banks for income, but what are the prospects for capital appreciation and growth in earnings?
John Grace: In our view, dividend yields between 5 and 6 per cent are sustainable and we expect capital appreciation to be broadly in line with mid-single-digit earnings growth, and as such banks offer shareholders a low double-digit total shareholder return.
Dion Hershan: Beyond purely the dividend attraction, we see significant prospects for capital appreciation in Australian banks. Current earnings growth between 5 and 8 per cent per annum sets a strong foundation for future capital gains, and we'd expect earnings growth to continue as credit growth improves. Equally, we are encouraged by ongoing productivity gains, low funding costs and low rates of default. The banks offer both high yields and earnings growth upside, which we view as far more compelling than what's on offer at the majority of telcos, listed utilities or REITs.
TS Lim: We anticipate fairly healthy top line and earnings growth of 5 to 6 per cent, consistent with about 2 times expected GDP growth (and down from the pre-GFC highs of 4 to 6 times).
Add to this expected, fully franked yields of 5 to 6 per cent and investors would still attain double-digit returns.
Roger Montgomery: Returns from Australian banks will be more muted than previous years but prices will remain supported while relative yields are superior to cash. Strong credit growth and interest margins will be offset by inevitable increases in capital requirements under the Financial System Inquiry. If rates rise locally, the appeal of owning banks, at above rational estimates of intrinsic value, declines. And if rates rise globally the global "carry trade", under which investors borrow in low-interest-rate countries such as the US to invest in higher-yielding countries such as Australia, becomes less attractive.
Thus far, low interest rates locally and globally have inflated the multiples of the Australian banks. In time the pendulum always swings back.
Xavier VanHove: The dividend story in Australian banks is very strong. It's hard to argue with a 5 to 6 per cent dividend yield, particularly if it's tax-free. I'd like to see banks try to slow their growth to nearly nothing. I would be weary of a bank trying to grow in Australia today. The economy is likely to remain in the doldrums for a while, whilst property prices are not going higher, so a bank can only grow by lowering its underwriting standards, which never works.
How much of a concern are property values to the banks, and should they be a concern to their shareholders?
Grace: Given the banks have large exposures to property, it is important. However, at this stage we don't expect significant credit losses from this segment as a concern for bank shareholders given that underlying fundamentals remain supportive (unemployment, low interest rates, etc). Our expectation is house price growth will stabilise.
Hershan: Complacency around the health of the property market should always be front of mind for Australian bank shareholders, though we believe banks are well protected by prevailing low interest rates, property price resilience and a reasonable employment market. These factors lead us to conclude the risk of a housing bubble contaminating the banks is dramatically overstated. Australian banks are well capitalised, lending standards have been prudent and credit quality continues to improve.
Lim: We would not be too concerned about property values, given the very low loan-to-value for the sector of 45 to 50 per cent. Home loan loss rates have been low historically at 0.03 per cent.
Montgomery: Property values are a concern to Australian banks to the extent that rising house prices have a wealth effect that spurs consumption, in turn feeding credit card fee income and home equity drawdowns. QBE and Genworth are more directly exposed to the most leveraged homebuyers.
VanHove: It is a concern. But Australia is not the US in 2007, or Spain, or Ireland. More likely we'll see consumers deleveraging and bad loans rising.
What is the biggest risk for bank shareholders and how likely is that to play out?
Grace: The macro-economic environment is the most important driver for the outlook of bank profitability and on balance we believe this remains supportive over the forecast period. The largest area of short-term uncertainty is around potential regulatory change and potential outcomes from Financial System Inquiry.
Lim: The biggest risk would be unemployment, although this has been stable recently. As for higher capital requirements, bank capital levels are already stronger than they were pre-GFC and there should be sufficient levers to further boost current levels over time.
Hershan: In the short term, the biggest risk facing the banks is probably an adverse set of recommendations from the Financial System Inquiry.
A possible risk would be for banks to be required to hold unnecessarily high levels of capital, which could threaten earnings growth and/or increase loan pricing.
Montgomery: The key to major changes in the prospects for Australian bank business performance is job losses and interest rates, in that order. Property prices don't fall in the absence of selling; job losses are required. As was observed in many countries during the GFC, collateral values are pro-cyclical, so at the time banks need to monetise collateral the value of that collateral has likely deteriorated significantly.
VanHove: The current cost of [managing] risk in Australia is very low – for example, the cost of managing risk is 16 basis points for CBA – both by historical standards and by international standards. This is not too surprising, given the performance of the Australian economy, which has been one of the strongest in the world and where unemployment has been extremely low. Unfortunately, this is unlikely to last forever.
With commodity prices falling, GDP growth is likely to be more subdued going forward, which always translates into higher bankruptcies, and unemployment has been trending up in the past year. This hasn't impacted banks yet as there is always a lag – you don't stop paying off your debt the day you're fired, but you might a year later if you still haven't found a job – but it will very likely translate into a modest tick up in bad debt.
The good news is Australian banks seem to be aware of this and have ramped up their capital and are managing their risk-weighted assets conservatively. However, banks are a mirror on the economy, and we are therefore likely to see non-performing loans rise, meaning lower profits.
This is not a huge issue right now, but investors should be aware Australian banks are likely to see non-performing loans rise and therefore profit will struggle to grow – and there is an outside chance they even shrink – in the next couple of years.
What is your pick of the bank stocks at current prices?
Grace: NAB is our preference at current prices. We are positive on the management change and believe there is substantial upside from resolving outstanding legacy issues.
Lim: We have buys on CBA and NAB at present, although we see emerging value in ANZ.
Montgomery: That's easy, Bendigo & Adelaide Bank Limited. This is because of a unique regulatory situation under which the competitive playing field between the regional Australian banks and the majors is about to become more level. And that excludes the work they are doing with APRA to become an advanced bank.
We believe higher mortgage risk weightings and capital requirements for the majors will result in an improved competitive, market share and profitability position for Bendigo & Adelaide Bank. BEN is materially cheaper than its major peers.
VanHove: If I'd had to pick one, I'd pick CBA as it's the best capitalised and seems to be consciously moderating growth. It does seem somewhat perverse to recommend the most expensive of the lot, given I expect a de-rating, but it also seems least likely to have to do a rights issues in the unlikely case of a more severe downturn – and the probability of that, although low, is not zero.
How do our banks compare with international peers? Should we look for value in other regions?
Grace: While we don't have a mandate to invest outside Australia, We would observe Australian banks are strongly positioned compared to international peers; they are some of the highest-rated banks from a credit rating perspective globally, have high levels of profitability relative to global peers, strong balance sheets and are well capitalised.
Hershan: We see a number of developed markets banks that look attractive, particularly in the US and UK, and holding them can certainly complement Australian bank shareholdings. Globally, developed market banks are benefiting from similar trends that are playing out domestically; improving credit growth, productivity gains, strong credit quality and the prospects of higher interest rates. Australian banks have the benefit of being high yielding and paying franked dividends.
Lim: The market is quick to forget how strong the regulatory environment is in Australia. The ongoing dialogue between the regulatory authorities and domestic banks should only lower overall operating risks.
While there may be value offshore, local bank investors would still be able to look forward to returns above 10 per cent with inherently lower risks.
Montgomery: Relative to international peers, there is no doubt Australia's major banks are expensive. Given the regulatory and economic risks on the horizon, over the coming years the highest-returning banks are unlikely to be Australian.
VanHove: Banks in Australia trade somewhere between 2.25 times tangible book (for NAB) and 3.3 times tangible book (for CBA).
This is very high by international standards. Only banks in strong emerging countries with growth in the high teens trade at this price – or did until recently. By comparison, the United States' best large bank, Wells Fargo, trades just below 2 times tangible book, and most of them are about 1.3 to 1.5 times tangible book. In Europe banks are cheaper still – at or below tangible book value.
Australian banks are quite profitable, with return on assets about 0.60 per cent, which is well above their European peers but below their US peers. We're quite convinced the value is in Europe. Non-performing loans are high but falling rapidly, as a result return on assets are rising rapidly, banks are now well capitalised and yet prices are low. Also, the recent comprehensive assessment by the European Central Bank should give investor confidence that what you are buying is exactly what's on the tin . . . but, yes, it's not for the faint-hearted.
Compiled by Jeremy Chunn
Fairfax Media Management Pty Limited
Document AFNR000020141111eabc0001b
2017 words
12 Nov 2014
The Australian Financial Review
AFNR
English
Copyright 2014. Fairfax Media Management Pty Limited.
Stocks We ask a panel of professional investors about their predictions for banks, what their picks are and how they compare overseas.
The major Australian banks are such a staple investment that shareholders need to check their belief in the sector from time to time. The good times may not last forever – they never do – but the temptation of generous dividends has seen investors push up capital values.
The story for anyone whose portfolio is weighted towards the big banks has been a good one for the past few years, but it is not a time to be complacent.
Are our banks prone to lose value if unemployment increases and property values drop? And could there be better value in international banks?
With full-year results for three of the four major banks delivered in the past two weeks, Smart Investor asked five professional investors for their outlook on the sector. We have included a London-based analyst for perspective on the value of Australian banks relative to international peers.
Some investors are heavily exposed to the banks, but the truth is we all are. The big four make up 30 per cent of the S&P/ASX 200. It makes a difference to every one of us how they'll fare.
Many investors hold the Australian banks for income, but what are the prospects for capital appreciation and growth in earnings?
John Grace: In our view, dividend yields between 5 and 6 per cent are sustainable and we expect capital appreciation to be broadly in line with mid-single-digit earnings growth, and as such banks offer shareholders a low double-digit total shareholder return.
Dion Hershan: Beyond purely the dividend attraction, we see significant prospects for capital appreciation in Australian banks. Current earnings growth between 5 and 8 per cent per annum sets a strong foundation for future capital gains, and we'd expect earnings growth to continue as credit growth improves. Equally, we are encouraged by ongoing productivity gains, low funding costs and low rates of default. The banks offer both high yields and earnings growth upside, which we view as far more compelling than what's on offer at the majority of telcos, listed utilities or REITs.
TS Lim: We anticipate fairly healthy top line and earnings growth of 5 to 6 per cent, consistent with about 2 times expected GDP growth (and down from the pre-GFC highs of 4 to 6 times).
Add to this expected, fully franked yields of 5 to 6 per cent and investors would still attain double-digit returns.
Roger Montgomery: Returns from Australian banks will be more muted than previous years but prices will remain supported while relative yields are superior to cash. Strong credit growth and interest margins will be offset by inevitable increases in capital requirements under the Financial System Inquiry. If rates rise locally, the appeal of owning banks, at above rational estimates of intrinsic value, declines. And if rates rise globally the global "carry trade", under which investors borrow in low-interest-rate countries such as the US to invest in higher-yielding countries such as Australia, becomes less attractive.
Thus far, low interest rates locally and globally have inflated the multiples of the Australian banks. In time the pendulum always swings back.
Xavier VanHove: The dividend story in Australian banks is very strong. It's hard to argue with a 5 to 6 per cent dividend yield, particularly if it's tax-free. I'd like to see banks try to slow their growth to nearly nothing. I would be weary of a bank trying to grow in Australia today. The economy is likely to remain in the doldrums for a while, whilst property prices are not going higher, so a bank can only grow by lowering its underwriting standards, which never works.
How much of a concern are property values to the banks, and should they be a concern to their shareholders?
Grace: Given the banks have large exposures to property, it is important. However, at this stage we don't expect significant credit losses from this segment as a concern for bank shareholders given that underlying fundamentals remain supportive (unemployment, low interest rates, etc). Our expectation is house price growth will stabilise.
Hershan: Complacency around the health of the property market should always be front of mind for Australian bank shareholders, though we believe banks are well protected by prevailing low interest rates, property price resilience and a reasonable employment market. These factors lead us to conclude the risk of a housing bubble contaminating the banks is dramatically overstated. Australian banks are well capitalised, lending standards have been prudent and credit quality continues to improve.
Lim: We would not be too concerned about property values, given the very low loan-to-value for the sector of 45 to 50 per cent. Home loan loss rates have been low historically at 0.03 per cent.
Montgomery: Property values are a concern to Australian banks to the extent that rising house prices have a wealth effect that spurs consumption, in turn feeding credit card fee income and home equity drawdowns. QBE and Genworth are more directly exposed to the most leveraged homebuyers.
VanHove: It is a concern. But Australia is not the US in 2007, or Spain, or Ireland. More likely we'll see consumers deleveraging and bad loans rising.
What is the biggest risk for bank shareholders and how likely is that to play out?
Grace: The macro-economic environment is the most important driver for the outlook of bank profitability and on balance we believe this remains supportive over the forecast period. The largest area of short-term uncertainty is around potential regulatory change and potential outcomes from Financial System Inquiry.
Lim: The biggest risk would be unemployment, although this has been stable recently. As for higher capital requirements, bank capital levels are already stronger than they were pre-GFC and there should be sufficient levers to further boost current levels over time.
Hershan: In the short term, the biggest risk facing the banks is probably an adverse set of recommendations from the Financial System Inquiry.
A possible risk would be for banks to be required to hold unnecessarily high levels of capital, which could threaten earnings growth and/or increase loan pricing.
Montgomery: The key to major changes in the prospects for Australian bank business performance is job losses and interest rates, in that order. Property prices don't fall in the absence of selling; job losses are required. As was observed in many countries during the GFC, collateral values are pro-cyclical, so at the time banks need to monetise collateral the value of that collateral has likely deteriorated significantly.
VanHove: The current cost of [managing] risk in Australia is very low – for example, the cost of managing risk is 16 basis points for CBA – both by historical standards and by international standards. This is not too surprising, given the performance of the Australian economy, which has been one of the strongest in the world and where unemployment has been extremely low. Unfortunately, this is unlikely to last forever.
With commodity prices falling, GDP growth is likely to be more subdued going forward, which always translates into higher bankruptcies, and unemployment has been trending up in the past year. This hasn't impacted banks yet as there is always a lag – you don't stop paying off your debt the day you're fired, but you might a year later if you still haven't found a job – but it will very likely translate into a modest tick up in bad debt.
The good news is Australian banks seem to be aware of this and have ramped up their capital and are managing their risk-weighted assets conservatively. However, banks are a mirror on the economy, and we are therefore likely to see non-performing loans rise, meaning lower profits.
This is not a huge issue right now, but investors should be aware Australian banks are likely to see non-performing loans rise and therefore profit will struggle to grow – and there is an outside chance they even shrink – in the next couple of years.
What is your pick of the bank stocks at current prices?
Grace: NAB is our preference at current prices. We are positive on the management change and believe there is substantial upside from resolving outstanding legacy issues.
Lim: We have buys on CBA and NAB at present, although we see emerging value in ANZ.
Montgomery: That's easy, Bendigo & Adelaide Bank Limited. This is because of a unique regulatory situation under which the competitive playing field between the regional Australian banks and the majors is about to become more level. And that excludes the work they are doing with APRA to become an advanced bank.
We believe higher mortgage risk weightings and capital requirements for the majors will result in an improved competitive, market share and profitability position for Bendigo & Adelaide Bank. BEN is materially cheaper than its major peers.
VanHove: If I'd had to pick one, I'd pick CBA as it's the best capitalised and seems to be consciously moderating growth. It does seem somewhat perverse to recommend the most expensive of the lot, given I expect a de-rating, but it also seems least likely to have to do a rights issues in the unlikely case of a more severe downturn – and the probability of that, although low, is not zero.
How do our banks compare with international peers? Should we look for value in other regions?
Grace: While we don't have a mandate to invest outside Australia, We would observe Australian banks are strongly positioned compared to international peers; they are some of the highest-rated banks from a credit rating perspective globally, have high levels of profitability relative to global peers, strong balance sheets and are well capitalised.
Hershan: We see a number of developed markets banks that look attractive, particularly in the US and UK, and holding them can certainly complement Australian bank shareholdings. Globally, developed market banks are benefiting from similar trends that are playing out domestically; improving credit growth, productivity gains, strong credit quality and the prospects of higher interest rates. Australian banks have the benefit of being high yielding and paying franked dividends.
Lim: The market is quick to forget how strong the regulatory environment is in Australia. The ongoing dialogue between the regulatory authorities and domestic banks should only lower overall operating risks.
While there may be value offshore, local bank investors would still be able to look forward to returns above 10 per cent with inherently lower risks.
Montgomery: Relative to international peers, there is no doubt Australia's major banks are expensive. Given the regulatory and economic risks on the horizon, over the coming years the highest-returning banks are unlikely to be Australian.
VanHove: Banks in Australia trade somewhere between 2.25 times tangible book (for NAB) and 3.3 times tangible book (for CBA).
This is very high by international standards. Only banks in strong emerging countries with growth in the high teens trade at this price – or did until recently. By comparison, the United States' best large bank, Wells Fargo, trades just below 2 times tangible book, and most of them are about 1.3 to 1.5 times tangible book. In Europe banks are cheaper still – at or below tangible book value.
Australian banks are quite profitable, with return on assets about 0.60 per cent, which is well above their European peers but below their US peers. We're quite convinced the value is in Europe. Non-performing loans are high but falling rapidly, as a result return on assets are rising rapidly, banks are now well capitalised and yet prices are low. Also, the recent comprehensive assessment by the European Central Bank should give investor confidence that what you are buying is exactly what's on the tin . . . but, yes, it's not for the faint-hearted.
Compiled by Jeremy Chunn
Fairfax Media Management Pty Limited
Document AFNR000020141111eabc0001b