Banks: buy, sell or hold?
This article appeared in the June 2014 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 Nathan Bell, Intelligent Investor
On our recent visit to China, the discrepancy between major bank valuations there and here was a constant talking point. While the big four Australian banks are hitting new highs, Chinese banks are trading at huge discounts to book value (assets carried on the balance sheet) as investors prepare for an increase in bad debts from the country's unprecedented credit and housing booms.
Given Australia's dependency on China's extraordinary economic expansion and high commodity prices, it seems implausible that Australian banks will be left unscathed if China's growth slows dramatically.
Either Chinese banks are a bargain or Australian bank shareholders need to prepare for tougher times. We are definitely not banking on the former, so before we explain your options let's look at the recent round of major bank results.
(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 the ideas and themes below).
Commonwealth Bank announced a third-quarter cash profit of $2.2 billion, up almost 16 per cent from the same time last year, suggesting it is on track to deliver a $9 billion annual profit (CBA has a June 30 year-end). Competition for loans "intensified", which explains why banks have been accepting lower home-loan deposits despite swearing "never again" to drop their lending standards after the GFC.
Bad debt expenses were just $204 million, down about 20 per cent, with problem loans and impaired assets falling from $12 billion three years ago to $8 billion now - less than one year's profit. Although quarterly updates are light on detail, it looks like another great result from Australia's best bank. With the stock currently offering a 4.8 per cent fully franked dividend yield, Intelligent Investor is sticking with Hold.
Table 1: Westpac 2014 interim result
|Half-year to Dec 31||2014||2013||+/(-)%|
|Cash net profit ($bn)||3.8||3.5||8|
|Cash earnings per share ($)||1.21||1.14||7|
Westpac is our second choice behind the Commonwealth, as it generally sticks to its knitting in Australia and tops the industry for capital and cost ratios. In the half-year to March 31 (Westpac, ANZ and NAB have September 30 year-ends), revenue increased 5 per cent to $9.8 billion and underlying cash earnings increased 8 per cent to $3.8 billion.
Return on equity is an impressive 16.5 per cent and, based on a 7 per cent increase in cash earnings per share to $1.21, Westpac trades on a forecast price-earnings (PE) multiple of 14.2 times. A fully franked interim dividend of 90 cents was declared (down 6 per cent, ex date already passed), putting the company on a forecast yield of 5.2 per cent.
The most pleasing aspect of this result was the increase in lending volumes and revenue. Unlike recent results, the increase in earnings was not primarily related to cost-cutting and lower bad debts, although they still featured.
Westpac has recently been expanding in China, but so far it is just facilitating transactions rather than making a ton of loans. In contrast to taking trading positions or lending money, it should be a low risk way to nominally increase profits. However, in the medium term, we would not bet on management's assertion that "China's growth will settle comfortably above 7 per cent".
Westpac will also have no problem setting aside the new 1 per cent surcharge as a systemically important bank. While that helps preclude a potential special dividend, we would rather the banks retained more capital to offset higher bad debts in the future, given current provisions are at or near record lows. Intelligent Investor rates Westpac a Hold.
Table 2: ANZ 2014 interim result
|Half-year to Dec 31||2014||2013||+/(-)%|
|Cash net profit ($bn)||3.5||3.2||11|
|Cash earnings per share ($)||1.29||1.17||10|
ANZ produced another solid interim result, with revenue increasing 6 per cent to $9.5 billion and cash earnings increasing 11 per cent to $3.5 billion. Cash earnings per share increased 10 per cent to $1.29, putting the company on a forecast PE of 13. A fully franked dividend of 83 cents was declared (up 14 per cent, ex date already passed), for a yield of 5.3 per cent.
The heroes of the result were the non-Australian divisions. The core Australian banking franchise increased profits by 5 per cent, but profit within Australia as a whole actually fell 6 per cent. We may also be reaching a low point for (provisions for) bad debts, as Australian impairment charges increased 4 per cent to a still-low $403 million.
By contrast, profits increased 46 per cent in New Zealand to $809 million and 48 per cent across Asia Pacific, Europe and America to $681 million.
While ANZ's Asian division is "firing on all cylinders" and has compounded earnings at 37 per cent per year since 2008, total profit from Asia is still well short of the company's target of 30 per cent.
If you are a fan of ANZ's Asian strategy you should be pleased with the result. But as ANZ's valuation does not allow for any hiccups at home or abroad, and the Asian expansion offers little diversification benefits, our preferences remain Commonwealth Bank and Westpac. ANZ is Intelligent Investor's least preferred major bank.
National Australia Bank
Table 3: NAB 2014 interim result
|Half-year to Dec 31||2014||2013||+/(-)%|
|Cash net profit ($bn)||3.2||2.9||9|
|Cash earnings per share ($)||1.31||1.24||7|
Cameron Clyne recently handed down his final interim result before being replaced by Andrew Thorburn as CEO in August. National Australia Bank's revenue increased 3 per cent to $9.5 billion, with cash earnings rising 9 per cent to $3.2 billion. Diluted earnings per share increased 7 per cent to $1.31, putting the bank on a forecast PE of 12.5. A fully franked interim dividend of 99 cents was declared (up 6 per cent, ex date already passed), for a yield of 5.8 per cent.
The result was not high quality like the Commonwealth's, as the increase in profit was mainly because of a halving in bad debts to $528 million. This came mainly from the UK division, which should become less of a problem now that the economy is improving.
The cash return on equity of 14.5 per cent is the lowest of the big four banks, but this would probably increase if the company offloaded its problematic UK divisions. The UK economy is in the best shape it has been since the GFC, which makes a sale more likely sooner rather than later. While the hodge-podge of assets might limit the number of potential buyers, a sale would probably give the share price a small boost and potentially trigger a small capital return or special dividend. Hold.
Overall it was another good set of numbers from the big banks, given that demand for loans remains relatively weak in spite of low interest rates. The results also show how much fat there is in such large organisations, although the cost-cutting and falling (provisions for) bad debts cannot go on forever.
The banks are pulling every lever possible to keep increasing profits and dividends, but the contrast between the valuations of Australian banks and Chinese banks in particular cannot be ignored.
Chinese banks are reportedly priced to absorb about 10 to 15 per cent total losses from their loan books. One of China's top property developers recently confided that housing markets are oversupplied and big discounts are not tempting buyers.
Luxury sales are also stalling after the Government's crackdown on conspicuous spending. Given the thousands of half-built apartment towers we saw between Beijing and Shanghai, the actual losses could easily be higher.
There is no question there will be massive write-offs of bad property investments in China. The question is how much and how deep will the general economic malaise be when investors realise how much money they have lost.
The best that bank shareholders can hope for is that the credit bubble will deflate over a long period, like Japan, without affecting employment too much. Either way, the much slower growth will have a direct effect on Australia, likely producing higher unemployment, lower wages and a lower Australian dollar.
The message: watch your portfolio weighting in banks.
How will Australian banks fare if China slumps?
Current bank valuations in Australia make no allowance for risks in China as they are not high by historical and global standards. While we note Paul Samuelson's joke that "Wall Street indexes predicted nine out of the last five recessions", the chief action you need to take now concerns your portfolio limits.
If you are prepared to own the banks for the long term, come what may, then you can sit back and enjoy the dividends and franking credits. But if you prefer to have a margin of safety in everything you own, then now is the time to adjust your portfolio allocation to bank stocks accordingly.
Successful investing is about buying low and selling high, but one reason it is so hard is because you have to sell winning stocks when there are few alternatives and wait for opportunities that could be years away.
There is a lot to talk about regarding the banks so Intelligent Investor has decided to put together a special report, which will be available in about six weeks. We will take the pulse of the Australian banking industry before comparing it with that in the US and suggesting ways you can diversify your bank shareholdings and potentially increase your returns.
About the author
Nathan Bell is Research Director of Intelligent Investor Share Advisor (AFSL 282288). To unlock all of Share Advisor's stock research and 23 current buy recommendations, take out a 15-day free membership.
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