This article appeared in the October 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Elio D'Amato, Lincoln
The banking sector has been one of the best performers this year, as defensive high-yielding shares have generally been in favour. This and the fact that Australia's banking sector is in better financial health compared with many developed economies, means it is no surprise that the major banks have outperformed the All Ordinaries Index by more than 10 per cent on average during 2013 - even greater if dividends are factored in.
Given that banks represent more than 25 per cent of the S&P / ASX 200 index, most diversified investors will have some direct or indirect exposure to the sector. With Australian economic growth remaining below trend (average growth) and unemployment continuing to rise, many investors have become more concerned about the sector's outlook.
Although banks face challenging credit conditions, we still expect modest earnings growth over the next 12 months. Valuations do not look compelling at current levels, but banking stocks still provide an attractive and sustainable income stream.
2013 YTD Price performance - big four banks
Source: Reserve Bank of Australia
Lending growth to remain subdued
Australian GDP growth remains sluggish, with the economy growing at an annualised rate of 2.5 per cent in the June 2013 quarter. This is below the long-term average, although it is still better than much of the developed world. The Reserve Bank of Australia expects GDP growth to remain around current levels through 2014.
Overall, these conditions continue to affect lending growth, with total credit up 3.2 per cent in the year to July. Although lending conditions have improved since the start of the year, domestic activity remains subdued. Housing credit growth has been the standout, growing at 4.7 per cent over the 12 months to July, with other personal credit and business credit more disappointing at 0.5 per cent and 1.3 per cent respectively.
Credit growth - housing, other personal and business
Source: Reserve Bank of Australia
We expect lending volumes to be subdued in Australia and New Zealand, although lower interest rates should provide some stimulus and the recent decline in the Australian dollar will probably aid business activity in certain sectors.
Since the federal election there have been improvements in business and consumer sentiment, although this may take some time to flow through to lending volumes. Given signs of a pick-up in housing activity, we see this as continuing to be a key driver of growth.
Net interest margin (NIM), (the difference between interest generated by banks and interest paid to lenders) has held up reasonably well, with the benefits of recent mortgage repricing offsetting a competitive environment for business lending and deposit funding.
These trends were evident from recent full-year results reported by Commonwealth Bank of Australia (CBA), Bendigo and Adelaide Bank (BEN) and Suncorp Group (SUN). We expect deposit competition to ease, but banks are unlikely to see the same gains from asset repricing, which should cap NIM gains this financial year.
Other levers to grow earnings
Lending accounts for the majority of banks' earnings, but they have other levers for growth. Wealth management and other investment operations should benefit from better inflows and recent positive market movements. Life insurance earnings face some structural and cyclical challenges, although in the longer term we expect a recovery from current low levels.
Banks have also been able to drive solid earnings growth through good cost management, despite investment in infrastructure and IT improvements. Cost-to-income ratios have continued to decline and we expect banks to maintain this trend and deliver positive "jaws" (income growing more than expenses) this financial year. However, given low top-line growth, this will become increasingly difficult.
Impairments a risk in a slowing economy
Lower impairment charges have been another feature of recent results and this has been supported by improved asset quality. CBA recently reported that arrears for home loans and credit cards improved over last financial year and impaired assets declined as a percentage of gross lending. Although this gives some comfort that impairment charges will not rise dramatically in the near term, this remains a risk to earnings.
Historically low interest rates means that servicing debt is less onerous for households and businesses, although we still expect impairments to increase from current levels because of the soft economic backdrop and the likelihood of a further rise in unemployment. Although total provisioning (for bad debts) as a portion of lending has reduced, we believe the sector is well placed, given recent improvements in asset quality and corporate deleveraging (paying down debt) over the past couple of years.
Strong capital positions
Overall, the major banks continue to be well capitalised, with capital ratios significantly above APRA Basel III requirements and their own internal targets. To further support this, all are currently rated as being in "strong financial health", meaning they are exposed to manageable levels of financial risk.
Because of this and the lack of domestic acquisition opportunities or appetite for sizeable offshore transactions, we expect banks will continue to build their capital bases and potentially return surplus capital to shareholders. Highlighting this, Westpac Banking Corporation (WBC) and Suncorp Group have paid special dividends over the past six months.
Attractive income stream
Earnings growth is expected to be moderate, but we continue to believe that banking stocks provide an attractive income stream for investors. Consequently, Lincoln Indicators currently rates all the major banks and Suncorp Group as Lincoln-preferred income stocks because of their above-market, sustainable dividend yield.
The major and regional banks provide around a 5 to 6 per cent fully-franked prospective dividend yield. We view this as appealing in an environment of low interest rates, although if longer-dated, fixed-income yields continue to rise, this may become relatively less attractive.
All the major banks have target dividend payout ratios in the range of 70 to 80 per cent, with the exception of Australia and New Zealand Banking Group (ANZ) at 65 to 70 per cent. Given current surplus capital positions, we also expect the banks to either increase dividend payout ratios towards the top of target ranges or potentially declare special dividends over the next few years.
|Company name||ASX Code||Price $||FY14F PE Ratio (X)||FY14F Dividend Yield %||Lincoln Financial Health rating||Stock Doctor rating|
|Bank of Queensland Limited||BOQ||10.43||12.4||6.2%||Strong||n/a|
|Bendigo and Adelaide Bank Limited||BEN||10.15||12.2||5.7%||Strong||n/a|
|Suncorp Group Limited||SUN||13.07||13.2||6.1%||Strong||Preferred income stock|
|Australia and New Zealand Banking Australia Group||ANZ||30.79||12.8||5.4%||Strong||Preferred income stock|
|Commonwealth Bank of Australia||CBA||73.60||15.0||5.1%||Strong||Preferred income stock|
|National Australia Bank Limited||NAB||34.68||13.1||5.8%||Strong||Preferred income stock|
|Westpac Banking Corporation||WBC||31.88||14.0||5.7%||Strong|
Sources: ASX closing prices (17/09/13), Thomson-Reuters (consensus forecasts), Lincoln Stock Doctor
Recent full-year results in the sector have been solid and we expect companies reporting over the next few months to benefit from factors such as stable margins, lower impairment charges and improved cost-to-income ratios. Bank of Queensland (BOQ) is set to report full-year results in early October, and ANZ, NAB and Westpac will deliver results in late October or early November.
Overall, the credit environment remains tough, but banks have managed their costs well. Increased impairment charges could affect earnings but asset quality remains solid, so this does not appear a concern in the near term.
The banking sector has easily outpaced the All Ordinaries Index this year, but we believe that this will prove more difficult given stretched valuations. However, we maintain the view that banks provide an attractive income stream with a 5 to 6 per cent fully-franked dividend yield and this should support share prices. We also believe banks will be able to continue to grow dividends, given modest earnings growth and potentially higher dividend payout ratios.
About the author
Elio D'Amato is chief executive of Lincoln Indicators, a fundamental analysis research house and fund manager, and offering intelligent sharemarket solutions for the conscientious investor.
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