Rudi's View | Nov 30 2016
This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA
In this week's Weekly Insights:
– Aussie Banks And The Yield Trade
– Rudi On Tour
– Nothing Ever Changes, Or Does It?
– Rudi On TV
Aussie Banks And The Yield Trade
By Rudi Filapek-Vandyck, Editor FNArena
Australia's major banks have let Australians down too frequently in too many ways
[House of Representatives Standing Committee on Economics, review of Australian banks]
As of last Friday, the Big Four Banks in Australia accounted for 25% of the ASX200 with each of Commonwealth Bank ((CBA)), Westpac ((WBC)), ANZ Bank ((ANZ)) and National Australia Bank ((NAB)) commanding the four largest index weight positions, led by CommBank's 8.34%.
Needless to say, owning the banks -yes or no- is simply not a question asked by too many funds managers because getting it wrong can cause too much of a negative fall-out. For most index-oriented professional funds managers, which is the overwhelming majority, temporarily moving Underweight or Overweight the banking sector is as far as the investment strategy is allowed to deviate from copying the major index on a day-by-day basis.
Most retail investment portfolios too are well-stocked with banking shares, including the more than half a million self-managed super funds (SMSFs). Here the culprit is a legacy from the past. For more than two decades, Australian banks proved an excellent and reliable investment vehicle, offering shareholders double digit returns in most years and attractive dividends plus franking in every year.
If you never sell to rebalance the portfolio, you end up being heavily overweight Australian banks and this is exactly what many a retail investment portfolio looks like. Stories of 80% or even 90% exposure to the Big Four are circulating regularly. And there is absolutely no appetite to sell, reduce, re-balance or diversify. Just ask any financial advisor who deals with self-managed retail clients.
A lot of this iron-clad trust and confidence among investors stems from the past. Since Keating's "recession we had to have" in the early 1990s, the Big Four Australian banks only cut their dividends once and that was during the Global Financial Crisis. Even then their cuts were limited to 10-15% and they were one-offs. (ANZ Bank cut earlier this year, but I'll get to that further down.) Clearly, there is a lot to be said about simply buying shares in all Four and let dividends accumulate and ignore share prices running riot in the short term.
This is exactly what Mike Macrow, a former banking sector analyst, has been doing since his retirement a decade ago. Macrow's personal portfolio has been 100% invested in the Big Four since, and with no intention of making any drastic changes today.
Banks Back In Favour
All of the above belongs to the past and the future is not going to repeat it. This is what many a banking analyst has been predicting since last year. For a while, it appeared their negative outlook was proving accurate. Bank shares were pretty much in the sin bin between May and February this year, but they've made a noticeable come-back post July.
Meanwhile, the Kommentariat in the fringes of the share market remains as divided as ever: Australian banks, yes or no? The answer depends very much on which angle we choose.
The yield trade, which has dominated underlying dynamics in global assets and certainly in the Australian share market in years past, is transitioning away from typical bond proxies into more growth and economic cycle oriented stocks. Australian banks, thanks to their relative undervaluation, have been benefiting from funds flowing out of REITs, Telstra ((TLS)) and infrastructure, thanks to low Price-Earnings (PE) ratios and high yield, supported by an international revival of banking shares on the back of a steepening yield curve in bond markets.
This is merely a short term view. If banks only source of solace is that they are benefiting from other bond proxies falling out of favour, then their short-term revival can just as easily be a short-term phenomenon only; a yield-trap for those who prefer the past over the future?
Even the most ardent supporters, like Mike Macrow, are not denying the good old days are over for Australian banks, and they won't be returning in a hurry either. Objectively assessed, things already started worsening years ago, and they have simply continued to trend downwards ever since.
The chart below, from a presentation by investment manager Alphinity, argues it all started going pear-shaped post 2009. But banks still had numerous levers at work in their favour, including ever lower interest rates, potential cost-outs and reserves for bad debts that could be reversed and added back to annual growth.
Five years later, however, most of those supporting factors have been exhausted, or they are close to, while the banks are also facing increasing scrutiny from politicians and regulatory authorities. This is the current phase on Alphinity's chart when credit growth remains low, past levers are either out of puff, or reversing, competition has heated and returns from the past can no longer be treated as a benchmark. All the while, the broader community in general is fed up with the wrong sales and profit-only culture and yet another scandal. This time it's about rigging the benchmark for the Malaysian Ringit.
Analysts at Morgan Stanley dedicated a sector research report on the "growing scrutiny of conduct and competition in the banking sector" with the analysts noting the banks are all responding by improving selling practices, addressing customer complaints, changing remuneration structures as well as protecting whistle blowers as they feel the need to placate broader communal unrest towards their cosy oligopoly in Australia. This could be beneficial to their customers (we'll have to wait and see) but for shareholders this translates into "higher costs".
Not exactly what the doctor would order at this vulnerable point in the cycle.
Admirable Dividend Track Record
One of the key features of Australian banks, and the reason as to why investors like Macrow are happy to put all their eggs in the sector basket, is that unlike banks overseas, Australian banks rarely ever cut their dividend. National Australia Bank, for example, which has consistently lagged the other three in terms of operational performance and shareholder returns since 2004, has kept its dividend at 198c per annum over the past three years.
Despite rumours, speculation and predictions to the contrary, NAB again paid out 198c over the financial year to September 30, 2016. As far as early indications go, NAB board members don't seem to show any intention of paying out less in the current year.
No doubt, it is this determination, shared by all boards across the sector in Australia, that allows the many Australian investors on bank shareholder registries to sleep soundly at night, knowing their investment is in good hands, with reliable income streams and tax franking offsets continuing to flow.
Of course, this is where the devil's advocate points out it wasn't that long ago when dividends at companies such as BHP Billiton, Woolworths, Fleetwood and Metcash equally looked sacrosanct, yet they have been cut, if not fully wiped out. Investors worried about their dividends from the Big Four banks should note BHP Billiton has no moat or pricing power and it took the worst commodities downturn in modern history to pull the board off what was an untenable promise to increase annual dividends no matter what.
Fleetwood fell victim to that same downturn, while Metcash is being squeezed by more powerful competitors, among them Woolworths, which has too many business units not performing, a structurally under-invested network, a vulnerable balance sheet and foreign competitors demanding their piece of the pie. None of these characteristics would apply to Australian banks, yet, it has to be noted, ANZ Bank did cut its dividend earlier this year by lowering the pay-out ratio.
So what does the ANZ cut tell us?
Stress Points And Capital Requirements
ANZ Bank reducing its payout ratio tells us that even when faced with extreme determination at Australian bank boards to not disappoint shareholders who became accustomed to annual growing dividends, it is still impossible to avoid the inevitable when the downturn persists and payout ratio and cash flow simply prove insufficient.
Australian banks have all pushed out their payout ratios to circa 80%. This is extreme by anyone's standard and makes their dividends vulnerable in case more bad news hits the sector. One area of concern is the pending downturn in apartment markets due to rising over-supply, another could be housing market deflation in Western Australia.
All Australian banks have significantly increased their exposure to mortgages since the GFC, yet it would require something out of the ordinary, like a global freezing of credit markets, as happened in 2008, or an economic recession, or a significant downturn for domestic property markets to force them all into a repeat of 2008 and cut their dividends through lowering payout ratios. Virtually no one with a credible voice on this subject is even remotely contemplating such a scenario, which doesn't mean it is 100% impossible, just a tad unlikely.
Yields on mortgage loans are rising and there certainly are indications stress on household finances is higher than what statistics suggest. Also, investors should not forget banks yet have to find out whether they'll need a lot more capital than can be raised through dividend reinvestment plans (DRP) and small sized asset sales. This question might remain unanswered for yet another year.
My suspicion is bank boards are hoping they can combine any bad news about shareholder dividends with potential bad news from the Basel committee internationally and APRA locally, so that the blame can be shifted onto the faceless regulators. Contrary to the capital raisings in 2015, any further raisings are likely to prove attractive buying opportunities.
Despite all these risks and headwinds, and the high payout ratios (except ANZ Bank), analysts researching the sector remain deeply divided whether or when any of ANZ Bank's peers will/should/might follow suit. Were the question being asked in any other country, there would likely be no room for a long-winded, undecided public discussion. However, given the unique characteristics of the Australian banking sector, including a high degree of pricing power and customer loyalty, the banks might, just might sail through all of the above without any damage to their dividend trajectory.
But shareholders should be aware "stable" and "unchanged" are now the new "growth". Plus, as far as I see it, all the effort and energy that is being spent on maintaining dividends at current levels at all cost virtually guarantees growth in profits will be tepid at best in the years ahead, if there will be any growth at all. Surely the banks could use any positive rub-off from China stimulus or Trump tax cuts.
Brian Johnson's Assessment
Last week, one of the veterans in the local bank analysts community, Brian Johnsonof CLSA, released his latest in-depth insights on the sector with colleague Ed Henning. In the report, titled "Sloth or Rat?", the CLSA banking team advocates funds managers should be sector Underweight. On an individual basis, only three companies in the sector deserve a positive rating, according to the report; Macquarie Group ((MQG)), CYBG ((CYB)) and National Australia Bank.
All others, including Bank of Queensland ((BOQ)) and Bendigo and Adelaide Bank ((BEN)) are either rated Underperform or Sell. CLSA analysts have long stuck to their view Australian banks require $27bn more capital in order to meet increased regulatory requirement (but this is at this stage no more than educated guesswork). In 2015 the banks raised $18bn in new capital.
In the report, Johnson and Henning line up eight crucial themes for investors in Australian banks:
1.) Notwithstanding the favourable impact of rising bond rates for US banks, the macro outlook for financial stocks globally remains challenging, in particular outside the USA. In Australia the banks have benefited from the initial phases of US quantitative easing but they have emerged as over-earning, over-distributing and their shares have been over-bought in extension of the AUD dividend trade.
2.) The Australian Prudential Regulation Authority (APRA) is not going to be soft on the banks. By late 2017 we will probably hear they need another $27bn in capital.
3.) Recent FY16 results failed to surprise. The forward EPS growth rate looks set to slow markedly.
4.) Warning: Sustainable bank dividend payout ratios are not linear; should earnings fall and capital intensity rise the sustainable payout ratio would fall. Any normalisation of earnings to mid-cycle and recapitalisation would seriously erode the dividend yields of the Australian banks. Under such scenario the report suggests dividend cuts of between 12%-24%.
5.) In the present context, Australian banks are likely less confident in pushing up lending rates, which will further increase pressure on Net Interest Margins (NIMs).
6.) Assuming we are approaching the end of the Australian interest rate cutting cycle, and longer term global bond rates are already rising, then the prospect of even a stabilisation in real asset values (let alone a decline) suggests Australian system credit growth could slow.
7.) Given the concentration of housing in Australian bank loan portfolios (ANZ: 43%, CBA: 58%, NAB: 51%, WBC: 61%) any bad news from local housing markets are poised to open up stress points across the sector.
8.) Australian banks seem reasonably priced, but not against a context of slowing earnings and stress points opening up. Rhetorical question from the report: Given that the EPS growth rate is set to slow and dividend cuts are likely the question must be asked what are the Australian banks actually worth? Also: History tells us that when it comes to banking you make the serious money on the last recapitalisation raising.
Special comment: Brian Johnson is one of the brightest amongst his peers, but this does not by definition extend to his stock picking abilities. He has been a long term fan of Macquarie Group, for which he was painfully off the mark when the shares approached the $100 mark back in 2007. He has been on the mark so far with his prediction CBA remains poised to lose its large sector premium.
Yield Trade Under Pressure
Australian banks have for a long while been the lazy man's option for investors in the Australian share market. There always have been more lucrative options elsewhere but pitted against the sector's solid track record, and the potential for making errors when switching to alternatives outside the sector, many investors felt safest to stay the course and simply ride out the bumps and troughs along the journey.
With many looking over their shoulder towards a rather rewarding investment strategy (even if it was in the past), it seems likely many are going to stay the course in the years ahead. This may well lead to an equally satisfying outcome, in particular with so many question marks about sustainable growth for corporate Australia.
Then again, it may not. Risks have risen. Market sentiment is like a one-eyed cyclops: only one focus at any given time.
For yield seekers, the dilemma stretches to high yielders whose share prices are under pressure every time bonds feel the jitters. And it's not like alternatives such as Kathmandu Holdings and FlexiGroup, both offering yields of 6%+, don't have their own challenges and risks.
From a risk-reward balance point of view, it is likely the better total return opportunities are with industrials offering 4%+ yield, but for many investors the risk for making an error is probably too high to contemplate making a switch. After all, Flight Centre looked like one such attractive option a year ago (and the year before that), and it's not like FlexiGroup doesn't know how to spell "disappointment". What happened to Telstra of late?
Maybe the conclusion from all of the above is that turning to equities solely for yield/income is now a less straightforward and riskier proposition. Contrary to recent price action, this also includes the banks.
Rudi On Tour
I will be presenting:
– Christmas Special for Chatswood members of Australian Investors' Association (AIA), December 14, 7pm
– To Sydney chapter of Australian Shareholders' Association (ASA), December 15, noon-1pm, Sydney Mechanics School of Arts, 280 Pitt Street
– To Perth chapters of Australian Investors' Association (AIA) and Australian Shareholders' Association (ASA) on 7 February 2017
– At the ASA Conference 2017, Grand Hyatt Melbourne, 15-17 May 2017
Nothing Ever Changes, Or Does It?
Yes, of course, investing in the share market is never really different and best working strategies today are the same that worked pre-GFC. Seriously. I tell you, seriously.
Now that we had a good laugh about it, let's get straight to business. This is a low growth environment. Has been since 2010 (it was masked at the time because of the V-shaped recovery from the global recession) and it is not likely to change fundamentally in the near term. I wrote a book about this (see below). This means investment strategies must adapt. You'll be turning your portfolio into a wish list for dinosaurs otherwise (and your returns will be a reflection of it).
Those not afraid to contemplate "this time is different" can subscribe to FNArena and read all about it in our bonus eBooklets 'Make Risk Your Friend' (free with a paid 6 or 12 months subscription) plus the freshly published eBook 'Change. Investing in a low growth world' (equally free with subscription, or available through Amazon and other online distributors).
Here's the link to Amazon: https://goo.gl/XVMzmP
See also further below.
Rudi On TV
– On Tuesday, around 11.15am, on Sky Business, I shall make a brief appearance through Skype-link to discuss broker ratings for less than ten minutes
– On Thursday, I shall appear on Sky Business, 12.30-2.30pm
– On Friday, around 11.05am, on Sky Business, I shall make a brief appearance through Skype-link to discuss broker ratings for less than ten minutes
(This story was written on Monday 28th November 2016. It was published on the day in the form of an email to paying subscribers at FNArena).
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.
In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: firstname.lastname@example.org or via Editor Direct on the website).
BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS
Paid subscribers to FNArena receive several bonus publications, at no extra cost, including:
– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow. This book should transform your views and your investment strategies. Can you afford not to read it?
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FNArena has reformatted its monthly price tracker file for All-Weather Performers. Last updated until October 31st. (New update later this week). Paying subscribers can request a copy at email@example.com
For more info SHARE ANALYSIS: ANZ - AUSTRALIA AND NEW ZEALAND BANKING GROUP LIMITED
For more info SHARE ANALYSIS: BEN - BENDIGO & ADELAIDE BANK LIMITED
For more info SHARE ANALYSIS: BOQ - BANK OF QUEENSLAND LIMITED
For more info SHARE ANALYSIS: CBA - COMMONWEALTH BANK OF AUSTRALIA
For more info SHARE ANALYSIS: MQG - MACQUARIE GROUP LIMITED
For more info SHARE ANALYSIS: NAB - NATIONAL AUSTRALIA BANK LIMITED
For more info SHARE ANALYSIS: TLS - TELSTRA CORPORATION LIMITED
For more info SHARE ANALYSIS: WBC - WESTPAC BANKING CORPORATION