Australian retail shareholders have always been big fans of the major banks. According to the Australian Bankers’ Association, 1.5 million Australians are direct shareholders in the big four banks – Commonwealth Bank, ANZ, Westpac and National Australia Bank – and eight million are indirect shareholders through superannuation funds.
Retail investors have enjoyed the banks’ ability to lift profits consistently and pay attractive dividend yields that also rise consistently – giving, after a few years of owning the stocks, after-tax income yields (based on the initial purchase price, and the tax rate of the entity owning the shares) easily approaching 20-25 per cent, and even higher.
(The banks’ dividend yield and price/earnings (P/E) ratio expectations – based on market consensus earnings estimates – are set out in the accompanying tables. The yields given are for a top marginal tax-rate taxpayer, a super fund still in accumulation mode (15 per cent) and a super fund paying a pension (nil tax.))
The big four banks have been an even better prospect for investors since the global financial crisis hit. A series of government and regulatory decisions made during the GFC has enabled them to become even stronger.
Firstly, the federal government’s guarantee on saving deposits with banks (but not other financial institutions) has unintentionally caused a flight to safety: depositors have fled the non-bank institutions, which are not covered by the guarantee, to those that are covered. The deposit guarantee is in place until December 2011.
Secondly, the government allowed the banks (which are all rated AA) to ‘rent’ the Australian government’s AAA credit rating, which allowed banks to access money at a cheaper rate to stabilise the market and continue operating.
Thirdly, they have been allowed by the Australian Competition & Consumer Commission (ACCC) to become bigger by acquisition.
Commonwealth Bank, for example, was able to take over BankWest and to take stakes in Aussie Home Loans and Wizard. Westpac was approved to take over St George and RAMS Home Loans. NAB was able to buy Aviva’s life insurance arm and is now a huge player in the life insurance industry.
Also, many of the foreign banks, which had been big competitors for the local banks, have either withdrawn from the market or shelved their expansion plans, as their parents attended to a sick balance sheet.
To top it off, the non-bank lenders participating in the mortgage market through raising funds in the wholesale market virtually disappeared from the market when the credit crunch in 2008 froze the wholesale lending market. From a market share of the home loan market of 57 per cent in August 2007, the big four banks have lifted this market share to 92 per cent.
The big four also control about 77 per cent of total bank deposits. Individually, they have increased fees and have been able to increase their interest margins.
“The local banks clearly have had a good GFC,” says Tim Morris, senior equities analyst at Wise Owl. “But in particular, Commonwealth Bank and Westpac had a very good GFC, because they are more domestically focused: ANZ and NAB are the only ones with significant international operations, and they were seen as higher-risk.”
Indeed, says Morris, the big four were differentiated by the market into two tiers, with Commonwealth Bank and Westpac – particularly the former – more sought-after by investors than NAB and ANZ. The relative performances of the big four banks in generating total return (capital growth plus dividends) over the past five years (from 1 June 2005) is shown in the accompanying chart.
“In the GFC we saw that flight to the bigger two who were more domestically focused. CBA in particular has been seen as the strongest of the four. It has the largest proportion of deposits – as a group, it averages about 50 per cent of its funding coming from local deposits – and that means it is not as reliant on wholesale funding as the others. That is a very good attribute to have when there are concerns about the wholesale funding markets, as there are at the moment, with the turmoil in Europe.”
The sovereign (government) debt worries in Europe have widened to the banking sector, with banks’ overnight deposits with the European Central Bank rising on Friday to a record 320.4 billion euros ($394 billion) as banks preferred the 0.25 per cent interest on offer to lending to each other.
“If you look at NAB, its UK operations have been troublesome for many years, they’ve been trying to make them work, but they’re less profitable than their Australian operations. Recent weakness in the UK economy has created a lot of concerns about how it will fare, but operationally the Clydesdale Bank and Yorkshire Bank – while they have been performing well compared to the other UK banks, it hasn’t done much to allay investors’ concerns about the heightened risks of operating over there. Just with this latest hiccup in the market, you might see CBA and Westpac garnering a little bit more support,” says Morris.
The big four banks versus the S&P/ASX 200 Index (2005 – 2010)
David Ellis, senior equities analyst at Morningstar, says CBA has been “the clear outperformer” over the last three to five years. “It has the biggest retail deposit base, it has a market share of more than 31 per cent of household deposits, and its major strength is that its revenue base is so broad and so wide. It has the largest market share of home loans, a large market share in credit cards, its wealth management business is large and it has a growing business and institutional banking business.”
But while CBA’s high level of retail deposits gave it a cushion during the GFC, Ellis says it has grown its home loan book so aggressively over the last two to three years – along with Westpac – that the pair now have a much larger wholesale funding requirement than NAB and ANZ. “We estimate that CBA and Westpac both have an annual wholesale funding requirement of about $45 billion, compared to NAB and ANZ, which require $20 billion-$25 billion each. And the funding cost is probably the biggest headwind for the banks going forward.”
Funding is one area on which the banks must look with nostalgia for more carefree, pre-GFC days. In mid-2007, says Ellis, the big four Australian banks were paying 8 basis points above the swap rate for two-year funding, and 17 basis points above swap for five-year funds. Now, he says, two-year funds would be costing them 70-80 basis points above swap, while they would be paying about 140 basis points above swap for five-year funds.
“All the banks have been actively pursuing longer-term funding – the average of the term funding that they’re taking on board now is about five years, whereas pre-GFC it was two years. Longer-term funding is more expensive, pre- or post-GFC, so the fact that the banking sector is taking more long-term wholesale funding on board is pushing up their average cost of funds, as well as the fact that the funds are more expensive anyway,” says Ellis.
“The banks are borrowing more longer-term funding partly in response to proposed regulatory changes – having higher, more stable funding ratios – and while this reduces liquidity risk, it’s more expensive. Obviously maturing debt has to be replaced at much higher costs. Their weighted average funding cost is likely to continue rising over the next 12 to 18 months, but we think this funding cost is manageable for them going forward, provided the situation in Europe does not worsen.”
Prior to the European sovereign debt crisis, says Ellis, investors were looking at “closing the P/E gap” between NAB and ANZ, on the one hand, and CBA and Westpac. “NAB and ANZ are more weighted toward business banking than CBA and Westpac, which are more consumer-based. A lot of people are expecting a strong rebounding in business lending: all three banks that reported for the March half-year said that they have a strong pipeline of business lending. I interpreted that as being turned from a pipeline to actual advances of credit, and credit growth toward the end of the year. However the volatility and uncertainty we’ve experienced in the last six weeks, from the European sovereign debt issues, the sharp fall in equity, currency and commodity market, the government’s proposed resources super-profit tax (RSPT), increasing interest rates, the confidence that was there is starting to waver a bit.”
If that confidence does not rebound – and businesses consequently defer their borrowing activity – Ellis says it “may not be until mid-2011” that we see a strong recovery in business lending. “On the latest RBA statistics, business lending is still not growing, in fact it was still negative for the 12 months ended April. Previously that rate of decline had slowed, but it picked up in April. We’re at a delicate position now with waiting to see whether businesses pick up their demand for credit. The sooner that happens, the more it will benefit ANZ and NAB, having a higher proportion of their business in business lending. The longer it takes to happen, the more advantageous it will be for CBA and Westpac. There is an expectation that NAB and ANZ’s earnings will recover at a stronger rate than CBA or Westpac, but that is predicated on resurgent business credit growth.”
As the Australian economic recovery has gathered pace, the bad and doubtful debts cycle has been “a big positive” for the banks, says Ellis. “Bad debts peaked in the June 2009 quarter, and bad debt expenses have been coming down quarter by quarter since then. For the six months to March 2010, the three banks that reported – NAB, Westpac and ANZ – reported that their bad debts improved dramatically. That rate of decline is probably not going to continue at that rate, but assuming that the economic recovery continues at a reasonable pace, the banks’ bad debts will continue to fall – just not at the same pace as in the March half.”
Ellis has a positive view on the sector and on all four of the majors. “We have buys on ANZ, NAB and Westpac, and we rate CBA an ‘accumulate’. Credit growth is an issue, how the Australian economy continues to recover is a big issue for the banks, but medium to long term, the Australian banks will piggyback on the broader economic growth in the country. If you’ve got a reasonably positive view on economic growth in Australia for the next ten years, by default you’ve got to have a positive view on the banks – because as being the main intermediaries in the financial system, they’re going to benefit among the most.”
Morris says the banks “clearly rank” in the following order: Commonwealth Bank, Westpac, ANZ and NAB. “Just given the latest issues we’re seeing in Europe, it’s made it hard for NAB to alter that perception of its higher-risk profile. ANZ and NAB still both attract a significant valuation discount relative to CBA and Westpac – both on P/E and dividend yield – so if you’re a value investor and you think that perceptions will change, you might be looking at the bottom of the pack, but as long as these concerns in Europe persist, you might see that premium toward Commonwealth Bank and Westpac maintained, even widened.”
Morris is “taking a bit of a value approach” at the moment. “I think a lot of bad news has been factored into NAB’s offshore exposures, and that its discount provides the best opportunity for upside in that sector. Perceptions change: during the bull market, Westpac had the biggest P/E discount relative to its peers, now NAB does. Who knows where it will be in the next couple of years? We think NAB offers the best margin of safety for investors in the sector. You haven’t got much upside priced in there, but when those European fears do abate, you could see that discount that is applied to NAB start to close.”
Ben Koo, banking analyst at Goldman Sachs JBWere, has ‘buy’ ratings on NAB and ANZ, while keeping Westpac and CBA on ‘hold’. His preferences run as follows: NAB, ANZ, Westpac then CBA: his 12-month price targets are: NAB, $31.50; ANZ, $29.00; Westpac, $29.00; and CBA, $63.50.
Koo says this view is based firstly on NAB’s and ANZ’s cheap valuation versus their peers; secondly, “less demanding” debt issuance requirements; and thirdly, “better leverage to higher-growth businesses” – in NAB’s case, to business lending, and in ANZ’s, to Asia.
Lending growth is a risk to earnings, says Koo. “We believe a likely outcome of higher funding costs will be banks focusing on higher-margin products. As such, while margins are likely to remain relatively resilient, we expect credit growth to be constrained until funding availability (and price) improves. Whilst this presents a risk to sector earnings, we believe downside risk to sector earnings is priced in at current levels,” he says.
Comparing the Banks: Prospective P/Es
Comparing the Banks: Prospective 09/10 Yields
Comparing the Banks: Prospective 10/11 Yields
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