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In the last few months bank stocks have joined resources in dragging down the ASX.  All four big banks plus the two major regionals have stumbled some 7% over the past month.

Claims that the Big Four banks are overvalued has been repeatedly voiced since late 2012. During this time bad news stories have abounded – such as rating agency downgrades, slowing Chinese growth, the spectre of a housing bubble, declining profit margins, bad loans, falling interest rates in Australia, concerns over unemployment, and a slowdown in consumer spending. Despite all this, our biggest bank and the holder of the dubious accolade of the “world’s most expensive bank” – Commonwealth Bank of Australia (CBA) – has seen its share price rise 35% over the last two years.  Here is a chart comparing CBA to the ASX 200 XJO Index.

Investing in bank stocks is not for the thrill-seeking investor looking for rapid and substantial capital appreciation.  Investors the world over have flocked to Australian banks for one reason and one reason only – income through dividend payments.  

The worry here, therefore, is the threat to dividend payments posed by the RBA Financial System Review.  Increased government regulation in the form of greater capital requirements are on the cards.  In a recent report to investors, an analyst at Macquarie Group told clients increasing bank capital requirements could reduce valuations by as much as 16% and lead to further falls in share prices.

Another newly minted worry is the collapse of iron ore prices. Clearly, this has been a concern before but now the price has breached the $80 per tonne threshold with a bottom not yet in sight. The price may remain between $75 to $80 range for an extended period due to the overabundance of supply coming on line.

Another concern is the falling Aussie dollar, which now sits between roughly $0.87 and $0.90 against the US greenback. Where is it heading?  Some analysts predict $0.85, others $0.80 and US based prophet of doom Nouriel Roubini predicts as low as $0.75. 

Foreign investors flooded our markets looking for higher yields at a time the rest of the world was in economic pain. Now there’s the prospect of rising interest rates in the US in early 2015. Investors who convert holdings of ASX stocks into US dollars face greater losses the further the Aussie dollar falls.  A spread of $0.13 between the AUD and the USD means less cash for investors who sell out, especially large investors.

The banks defied the naysayers once before. Can they do it again?

The following table shows some recent share price movement and historical dividend measures for the Big Four along with regionals Bendigo and Adelaide Bank Limited (BEN) and the Bank of Queensland Limited (BOQ).

With the exception of Bendigo and Adelaide and Bank of Queensland, none of the banks have seen substantial changes in share price year over year.  The dividend yields are virtually identical with very little variance in the 5 Year Average Yield.  CBA and BEN show superior dividend growth over the period and BOQ and ANZ have the most respectable dividend growth forecasts over the coming two years.

The issue with banks comes down to dividend stability and valuation. The big question is: how will the banks generate the required earnings to maintain dividend payments?  

First, on the issue of excessive valuation, here are some numbers to keep in mind.  One of the best performers on the ASX over time has been blood plasma producer CSL Limited (CSL).  Analysts love this stock, with 3 at Strong Buy; 7 at Buy; 2 at Hold; and only 1 at Sell.  Here are some valuation and growth measures for CSL:

•    Trailing P/E     27.32

•    Forward P/E    20.98

•    P/B        11.11    

•    2 Year Earnings Growth Forecast     15.3%

Now let’s look at some numbers for the banks. 

Of course we break a cardinal rule of investing when we look at measures across companies in different sectors.  For example, the sector P/E for financials is 13.32; it’s 22.43 for the pharmaceutical sector.  However, the point to be made is not to compare CSL with any of the banks, but with what constitutes excessive valuation.  

Looking at the bank measures, you can see that four banks are trading at less than two times book value (ANZ, NAB, BEN, and BOQ) and the two smaller regionals are trading at less than one and a half times book value, a favorite standard for many value investors. Is that excessively expensive?

What’s more, ANZ, BEN, and BOQ have earnings growth forecasts over 10%. CBA, WBC, and NAB have modest growth forecasts but note that none have neither trailing nor forward P/E ratios over 15.  What’s more, the P/E for the ASX as a whole market is 15.32, although there are experts who maintain risk dictates lower P/E’s for banks.

Australia’s banks still have the reputation of being among the world’s finest, and safest.  The concerns about the future growth are not to be taken lightly, especially for CBA, WBC, and NAB.  CBA and WBC are the biggest in Australia and their massive size could allow them to maintain their status, despite the modest growth estimates.  Scale gives economic benefits the smaller banks like BEN and BOQ simply do not have.  Some analysts have already noted Commonwealth Bank could handily withstand a government requirement of greater capital reserves simply by slight reductions in interest rates and increases in fees.

National Australia Bank (NAB) has been troubled by its substantial presence in the UK and improving conditions there could help in the future.  Commonwealth and Westpac Banking Corporation (WBC) talk about expanding, but it is ANZ and the two regionals that are aggressively pursuing growth opportunities.  

The share prices of all of these six banks could well fall further, so waiting is certainly something to consider.  The Financial System Inquiry is set to release its results to Treasurer Joe Hockey sometime in November.  

That announcement could be a catalyst for share price drops in the big banks.  Conversely, Bendigo and Adelaide Bank (BEN) and the Bank of Queensland (BOQ) could see an upward catalyst if the results of the inquiry recommend lowering capital requirements for smaller lenders to further their ability to compete.  

Bendigo and Adelaide Bank is aggressively growing its deposit portfolio faster than any Australian bank, large or small, according to analysts.  The bank recently reported better than expected results with earnings growth of about 10%.  

Bank of Queensland is expanding into New South Wales and Victoria as part of an overall strategy to increase its presence in both business and retail banking with a special emphasis on targeting mortgage brokers.  This bank also has the best combination of earnings growth and dividend growth forecasts – 14% and 12%.

Over the past two years the share prices of BOQ and BEN have outperformed the Big Four, with appreciation approaching 60%.  Here is the price movement chart.

ANZ is pursuing a “Super Regional Strategy” which already appears to be bearing fruit.  The plan calls for 25% to 30% of revenues coming from its APEA markets (Asia, the Pacific, Europe and Americas) by 2017.  ANZ is already generating about 19% of its profit from APEA markets.  While the other big banks have talked about expanding into Asia, ANZ has the most aggressive strategy for diversifying outside Australia and New Zealand.  The share price is trading at less than 2 times book value with a P/B of 1.92 and has the lowest trailing and forward P/E of any of the banks at 12.28 and 11.74.

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