Value.able: Roger Mont­gomery

Although their shares have been sold down heav­ily, there are still doubts about the banks’ true value

Money Magazine Australia - - CONTENTS - Roger Mont­gomery is the founder and CIO at The Mont­gomery Fund. For his book, Value.Able, see roger­mont­gomery.com.

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.

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