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Are banks stocks undervalued?

Photo of Paul Xiradis By Paul Xiradis

min read

Attractive pricing, but pressures hurt forecast earnings.

Like the curate’s egg, the Australian banking sector can best be described as attractive in parts because of its valuation metrics and dividend yield, but troubled in other areas where growing margin pressures, rising impairments (bad debts) and increasing capital requirements are making it a difficult investment proposition.

The problem facing investors was perfectly encapsulated in the recent reporting season when strong bank profits were marred by pressure on earnings forecasts.

Although credit growth is tracking at a reasonable rate, margins are being affected by rising funding costs, low interest rates and solid competition. This, however, is being tightly controlled by management at the leading banks, which have adopted loan repricing initiatives that are likely to continue for some time.

There is also an intense focus on managing costs to deliver productivity gains that can be used to help fund the necessary investment in technology and competitive positioning.

Capital levels were reported as broadly in line with Ausbil’s expectations, and while the trend is clearly rising, the quantum and timing of that outcome is less clear. Impairment charges are also moving up from a cyclically low base and this was exacerbated by the effects of several single-name, problem corporate exposures.

Banking valuations attractive

In contrast to these issues, the valuation of the banking sector relative to the 12-month forward price-earnings ratios of other industrials is at a more than 10-year low, while the 12-month net dividend yield relative to the bond yield is the highest for more than a decade.

Ausbil Investment Management has assessed this problem of appealing valuation and dividend yield in bank stocks versus earnings pressure, and moved tactically underweight (a lower exposure than the index weighting) in the sector.

Ironically, given expectations were low heading into the May reporting season, there seemed to be a small relief rally after the delivery of the results, but we suspect that had more to do with the somewhat surprising timing of the latest interest rate cut by the Reserve Bank; it highlighted the relative attractiveness of the sector’s dividend yield.

Let’s take a closer look at the underlying elements driving our decision process: valuation support, margin pressure, bad debt expense, capital requirements and dividend sustainability, as well as concerns about housing prices and potential associated bad debts, and the emergent threat of conduct risk.

Bank sector valuation is supportive on both an absolute and relative basis to the overall market when compared to long-run metrics. The dividend yield at 6.2 per cent is attractive relative to the broader market yield of 4.5 per cent, especially so when compared to the 10-year bond yield of 2.3 per cent.

We acknowledge that the high dividend yield will provide support to the sector, especially if there are further cuts to official cash rates. We also fundamentally believe the banking sector has a favourable industry structure that will ultimately be effective in managing and responding to the challenges at hand. Nevertheless, we remain cautious on the short-term outlook because of rising uncertainties and earnings risks across the sector.

Rising risks for bank earnings

Margin pressure is mounting in a number of areas, including rising funding costs and asset price competition in a relatively low-growth environment, against a background of low interest rates and ongoing regulatory pressures, such as the need to meet net stable funding ratio (NSFR) requirements. We believe banks will need to continue repricing their customer loans upwards in response to margin pressure.

Global capital standards are still evolving and the Australian Prudential Regulation Authority (APRA) is yet to finalise the capital requirements for all banks. Therefore, it is uncertain how much additional capital banks will actually be required to hold in order to meet the so-called “unquestionably strong” targets.

Ausbil has estimated that banks may need to increase capital levels by $15 billion to $20 billion across the sector in total. Importantly, our central case assumes that APRA will take a measured approach that will allow banks enough time to build up their capital levels via retained earnings growth. Further updates on the capital requirement rules are expected late this year or early next.

Elsewhere, we are likely to have seen the cyclical lows in impairment charges for the banks, while asset quality has deteriorated and is continuing to do so in some segments of the economy. As a result, we expect impairment charges, or bad debt expenses, to rise in the next year, although the profile and pace of deterioration is the key uncertainty.

Although the outlook for the Australian economy is constructive because of low interest rates and stable employment, any change in these two variables has usually been the precursor to systemic risk emerging in the credit cycle.

Risks have also risen as the economy transitions from mining to non-mining growth drivers. As stated, the lowlights of the recent reporting season were a few large, single-name, institutional exposures driving impairment expenses higher.

Are bank dividends sustainable?

Investors have also found reason to question the sustainability of the banking sector’s dividends. The prospect for dividends is naturally influenced by the outlook for ongoing rising regulatory capital requirements and rising impairment charges, despite the modest credit growth outlook which is supportive for capital generation.

We see the dividend yield as being more sustainable at the retail-orientated banks. ANZ recently reduced its dividend payout ratio target to a more sustainable level, while National Australian Bank, in our view, has the most optimistic near-term dividend target, given its temporarily elevated payout ratio.

The media and some analysts may have been focused on a housing correction because of the rising level of indebtedness and the implications a housing price collapse would have for bad debts. But our view is that the current environment of low interest rates and stable employment, both highly supportive of loan serviceability, should mean losses from mortgages will not be a material downside risk to overall bank earnings.

Ausbil has a keen focus on all environmental, social and governance (ESG) matters and how they pertain to the quality and viability of our underlying investments. We have closely monitored conduct risk in the banking industry.

The various troubles associated with the recent bank bill swap benchmark rate (BBSW) rigging, bank planner advice and life insurance practices, have more than justified our embedded ESG approach with its active ownership mentality.

Unfortunately, these issues are on the rise and are deservedly garnering widespread attention. This in turn increases reputational risk and ultimately raises questions about the need to tighten process control within the vertically integrated model, and we suspect business models may well need to adapt over time.

(Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article).

Bank stocks in Ausbil’s portfolio

Ausbil funds currently hold overweight positions in CYBG plc (CYB), the holding company that owns Clydesdale Bank and Yorkshire Bank in the UK. It was demerged from NAB in February this year and is listed on ASX.

CYB is one of our preferred bank exposures. The renewed management and board now have the autonomy and focus to improve their operations and market position. The medium-term earnings outlook is also strongly supported by a significant cost-out opportunity.

The current cost-to-income ratio is 72 per cent with a target of less than 60 per cent over the next five years, which we view as eminently achievable. CYB’s capital position is very strong, with a Core Equity Tier 1 ratio of 13.2 per cent, and its asset quality is sound, with the loan book skewed towards residential mortgages.

Valuation is also attractive, the company trading at 0.75 times book value (at May 30), and we expect the stock to continue to rerate over the medium term as earnings and returns improve.

Regulatory risks remain, however, because conduct risk has been a key issue in the UK banking sector, but we believe CYB is relatively well placed given the large level of provisions set aside for conduct-related costs. This includes a sizeable indemnity from NAB.


Our research has reinforced the view that the banking sector displays a favourable industry structure with the capacity to respond to the current challenges over time. But in the near term it is difficult to identify a catalyst that will drive a more optimistic earnings outlook.

About the author

Paul Xiradis is CEO and Head of Equities at Ausbil Investment Management. Ausbil is a foundation member of the mFund Settlement Service.

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