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See why Clime believes the Big Four are trading at a discount to intrinsic value.

Photo of Matthew Koroi By Matthew Koroi, Clime

Although banks earn revenue in many ways, their main income comes by lending money at a higher rate than they pay for money deposited with them. This is referred to as the net interest margin. Over the past 15 years, banks have placed more emphasis on non-interest income, such as fees, to increase their profits, and today non-interest income represents between 30 per cent and 40 per cent of the major banks' total revenue.

When analysing a bank, five financial metrics often referred to are:

  1. Return on equity: Clime likes to see a bank achieving a standard ROE of around 20 per cent.
  2. Return on assets: We like to see a bank achieving ROA of approximately 1 per cent.
  3. Cost-to-income ratio: A figure we would like to see declining over time and trending towards 40 per cent of net revenue.
  4. Net interest margin: The difference between average interest cost and average interest earned.
  5. Asset growth and a reduction in impaired assets (assets that have to be written down).

In determining the business risk of a bank, Clime focuses on five areas:

  1. Liability risk: The risk of depositors' requests for withdrawals being in excess of a bank's available cash. This is well regulated by the Australian Prudential Regulation Authority, which monitors banks' capital adequacy and liquidity.
  2. Credit risk: The chance that those who owe money to the bank will not repay it.
  3. Interest rate risk: "Margin squeeze", the situation where rising interest rates force a bank to pay more on its deposits than it receives on its loans.
  4. Derivative books: In the modern banking world, banks earn revenue from derivative books and proprietary trading. This is a higher-risk way to generate returns, and an example of when things can go wrong was highlighted in 2003 when National Australia Bank lost about $360 million in a foreign exchange "rogue trading" incident.
  5. Credit growth: Savings rates in Australia are the highest they have been in 15 years and credit growth across all sectors - housing, business and personal - continues to fall. The combination of this reflects growing conservatism since the GFC. Although this is a negative for banks' shareholders, when credit demand picks up it will result in more loans being written and will drive up net income. This should lead to improved profits and profitability.

Investing for yield

Given the volatility of financial markets over the past four years, many retail investors perceive a higher level of risk in the sharemarket. Reserve Bank data shows the percentage of total household assets being allocated to the sharemarket is the lowest it has been since the early 1990s, at around 4 per cent.

If you look through the current share price action of banks, with a long-term focus on wealth creation, the recent market volatility need not turn you off shares. By identifying profitable businesses that reward shareholders with consistent and sustainable dividends, you are able to ensure a steady income stream despite erratic short-term price movements.

In a general sense, when analysing companies for yield, Clime tends to find the best businesses display the following five characteristics:

  1. Dividends are consistent and sustainable
  2. Dividends are franked
  3. Dividends are paid from the business earnings and supported by real cash flows, not recent capital raisings
  4. Yield is in excess of 6 per cent
  5. The business has a record of growth in dividends per share.

In relating these characteristics to the banks, we can tick off each one of them.

Over the past two decades the average dividend yield of the Big Four banks has been roughly 5.8 per cent.

At an average of 7.5 per cent (based on prices at September 20, 2011), the yield currently available on the Big Four banks is high in a historical context. Including the benefit of franking, this figure is around 10.7 per cent.

The yield available on bank shares is also attractive in a relative sense when compared to other asset classes, such as interest-bearing bank accounts and investment property.

Using Clime data, the following tables compare a range of financial figures of the various types of banks in Australia.

The majors

Bank Market Cap* FY11 ROE FY11 ROA FY11 net interest margin Grossed up yield (for franking credits)*
ANZ^ $50.8bn 14.74% 0.95% 2.51% 10.00%
CBA $68.7bn 18.60% 1.02% 2.11% 9.70%
NAB^ $48.4bn 11.76% 0.67% 2.40% 10.30%
WBC^ $58.3bn 15.42% 0.95% 2.15% 11.00%
* Current at close Sept 20, 2011
^ FY2010

Regional banks

Bank Market Cap* FY11 ROE FY11 ROA FY11 net interest margin Grossed up yield
BEN $2.9bn 8.73% 0.63% 1.78% 10.5%
BOQ^ $1.5bn 8.56% 0.53% 1.49% 11.1%
* Current at close Sept 20, 2011
^ FY2010

Investment banks

Bank Market Cap* FY11 ROE FY11 ROA FY11 net interest margin Grossed up yield
MQG $7.4bn 8.41% 0.613% 1.15% 8.7%
* Current at close Sept 20, 2011

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

From our perspective, the majors are the safest and best performing of Australian listed banks, with each displaying stronger balance sheets, return on equity, return on assets and net interest margins. To whittle that list down further, Clime's favoured banks are CBA and ANZ.

The Asian growth strategy of ANZ is positive from an investment perspective, because Asia offers the best economic growth profile globally at present (although not without higher risk and potential capital raisings for acquisitions). The recent financial performance of CBA is excellent and its strong metrics and clear strategy suggest it is the best-performing locally focused bank.

Westpac is interesting and may surprise, with increasing synergies from the St George acquisition driving further cost reductions, a multi-branded strategy with a high-quality lending book, and potential wealth-management leverage should equity markets remain sound.

A further indication of the strength of Australian banks is that of the 10 AA-rated banks in the world, Australia's Big Four are all represented. Only one bank in the world, Rabobank, is rated AAA. This is not to say there is absolutely no chance of the big Australian banks ever failing, but it does mean the risk is somewhat lower in a relative sense.

Investing in shares always carries higher risk than investing in other asset classes such as property or interest-bearing securities. The trade-off, however, is the potential for higher returns. By investing in Australian banks at current levels with a longer-term view, not only are investors able to achieve above-average yields but they are leveraged to the future growth of the economy when favorable business conditions return.

At the time of writing this report, Clime finds each of the Big Four banks to be trading at discounts to their intrinsic value.

About the author

Matthew Koroi is a senior analyst at Clime Asset Management.

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