Value.able: Roger Montgomery
Although their shares have been sold down heavily, there are still doubts about the banks’ true value
Just over a year ago, here at Money we reviewed the banking sector and suggested Westpac and Commonwealth were our preferred holdings. From a low of $70.87 Commonwealth Bank touched a high of $87.40 and paid $4.21 in dividends since our column and a valuation of $74.73 to $84.10 a share was published. And from its low of $28.27, Westpac rose to a high of $35.06 and paid $1.88 in dividends.
Since those highs, which exceeded our valuations, bank shares have been sold down heavily in response to a number of factors, some of which we alluded to in last year’s column. Share prices returned a loss of 9.8% in May alone and were the largest contributor to the market index’s weakness.
And despite lower prices, bank share prices still only represent fair value at best, and at worst are trading at multiples well above long-term averages. Meanwhile, the risks to banks are increasingly obvious with earnings positively but temporarily, impacted by record low levels of bad debt charges.
It’s difficult to imagine a better business to own on an island than a bank, particularly one of the oligopolistic big four. Monopolies, duopolies and oligopolies tend to produce sustainable excess returns because barriers to entry are high and legislation or other conditions exist to suppress competition. In 1990, when the federal government enshrined the banking oligopoly, announcing the adoption of the “four pillars” policy and rejecting any mergers between ANZ, CBA, NAB and Westpac, it entrenched unusually high rates of returns on equity.
But even oligopolies can see returns “mean-revert” through an economic cycle, especially if they act in concert. It’s worth keeping in mind that at a very basic level banks have large asset balances (loans, particularly mortgages) and relatively little equity. A domestic systemically important bank could previously lend $100 of mortgages for every $1.60 of shareholders’ equity. Clearly, a small problem in a very large asset can cause a very large problem in a very small amount of equity.
Last year we highlighted David Murray’s financial system inquiry and associated recommendations. As a result of these changes, the big banks’ future returns on equity must necessarily be lower than in the past. That makes them less valuable, all else being equal. Asset price risk
We also highlighted the risk of asset impairments for the major banks and their exposure to significant falls in asset prices, particularly property. Any deterioration in the credit cycle (growth in borrowing by individuals and corporates is slowing), any pressure on net interest margins, higher expected funding costs, the aforementioned inadequate provisioning for bad and doubtful debts coinciding with a peak in the property market, and higher capital requirements, will put pressure on earnings in the near term.
Unsurprisingly, the 2017 half-yearly results showed negligible revenue growth due to slowing loan book growth and disap- pointing net interest margins. The results were then compounded by a significant step-up in the political risks, with the federal government announcing a surprise liabilities levy in the budget, which at the very least will require the banks to use up some of their pricing power headroom just to hold earnings and returns stable.
More recently, the market has again been put on notice that the tightening of regulatory requirements is far from over with the regulator APRA expected to provide further details regarding its definition of “unquestionably strong”. We currently expect the banks to be required to raise more capital. More importantly, an end to the construction boom and its flow-on effects to the retail sector – two of the country’s biggest employers – could lead to financial stress for many borrowers who have collectively amassed record levels of debt. At the time of writing, banking analysts have not significantly adjusted their earnings expectations. If they are unduly optimistic the downgrades could put the banks under further selling pressure.