Big Four Banks: Risks & Low Growth, But Value?

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Should investors' portfolios be overweight or underweight local banks? The question dominates public opinion in Australia on regular basis. This time around Australian banks have consistently underperformed the broader market throughout 2017 and during the opening weeks of 2018. As a matter of fact, Australian bank shares have underperformed since late 2012, the occasional brief sector rally not included. That's five long years!

The discussion below between various sector analysts at local stock brokerages took place before Wall Street went into sudden correction mode, also forcing share prices lower in Australia, but we don't think this sudden bout of share market volatility has fundamentally altered the discussion at hand: Australian bank shares; a buying opportunity or not?

-Market consensus forecasts sector earnings growth of 2-3% in years ahead
-Slowing housing market and narrower margins to weigh on profitability
-Capital adequacy measures under control
-Excess risk from Royal Commission may have already been priced in

By Nicki Bourlioufas

How are the banks doing?

While sector analysts agree earnings growth for the big banks will be modest at between 2% to 3% a year, the sell-off in share prices (even before this latest risk off event) may be overdone and banks could potentially represent good value for longer term oriented investors. At least, that's the suggestion made by some.

Stockbroker Morgans is one of them: “We believe the major banks sector as a whole presents good value at current share prices and for this reason we have an Add recommendation on all four majors. Some of the value in the major banks is attributable to a heightened regulatory risk premium in our view.”

 JP Morgan is happily singing from the same hymn sheet: “Regulatory risks remain (not least of which is the Royal Commission this year), however the sector looks inexpensive versus the market and the bulk of regulatory headwinds have already been weathered.”

 Deutsche Bank, on the other hand, is less upbeat but it does opine that cost controls should benefit the banks.“Cost control remains a key lever for the banks in a challenging environment, and we expect this to provide some support for profitability in FY18.”

On Deutsche Bank's forecasts the Big Four, excluding National Australia Bank ((NAB)), are facing average cost growth at just around 1% year-on-year. NAB is an outlier given its increased investment spending program, with management guidance for 5% to 8% growth this year, reminds Deutsche.

Outside of cost control, and of underperforming share prices, views on the banks' profitability outlook remain mixed. A slowing housing market will hang over the sector as well as narrower interest rate margins, while the Royal Commission will maintain uncertainty over the banks' reputations and potentially their operations.

Sector earnings under pressure

For Morgan Stanley, who's not on the same support ticket as are Morgans and JP Morgan, big risks remain for the big banks and they are best avoided, still. The housing market is slowing and the big banks' earnings growth will remain subdued. Fintech innovation too will threaten existing profit pools and political and regulatory scrutiny is rising with the Royal Commission.

Morgan Stanley: “Banks have been major beneficiaries of the housing super cycle and growing oligopoly pricing power. However, ongoing efforts by authorities to enhance financial stability and address the community's conduct and competition concerns change the investment case for major banks. Against this backdrop, we believe investors should expect declining returns, more modest growth prospects, weaker capital generation and a further de-rating.”

Citi too is sticking with a less upbeat view: “The bank sector is under pronounced revenue pressure with political blowback exacerbating the situation. Banks are entrenched in a lower growth cycle with high dividend yields being the primary attraction. With valuations at fair value, most stocks screen as Neutrals." If one has to add exposure to the sector, Citi's preferred options are NAB and ANZ Bank ((ANZ)).

Royal Commission may not change financials

Morgans believes too much risk resulting from the Royal Commission has been priced into banks. “The announcement is clearly not a positive development as it increases the regulatory risk for the sector. However, we believe there was enough regulatory risk priced into major bank share prices prior to the Royal Commission announcement.”

"Our base case is that the Royal Commission will not ultimately result in capital raisings or dividend cuts. We are therefore of the view that Royal Commission -related share price weakness presents good opportunity to buy yield,” says Morgans.

The view resonates with the peers at JP Morgan: “We obviously cannot rule out further examples of misconduct being unearthed, but given how much has transpired in recent years we do think some of the Royal Commission's thunder has already been stolen in a sense.”

As one would expect, Morgan Stanley disagrees, suggesting there may be additional negatives forthcoming still. On top of this, points out Morgan Stanley, CBA faces extra scrutiny with the AUSTRAC case pending for serious and systemic non-compliance with the anti-money laundering laws.

Capital adequacy under control

Some brokers are favouring ANZ Bank and Westpac ((WBC)) given capital management progress.

 In JP Morgan's view: “Capital management is also an emerging theme, which should assist our preferred picks – ANZ (Overweight) and WBC (upgraded to Overweight) – this year. Given valuation support we also raise CBA to Neutral while NAB is maintained at Neutral.”

Deutsche Bank thinks the major capital reform challenges are behind the big banks following several years of uncertainty. ”The Basel Committee on Banking Supervision (BCBS) finally came to an agreement and finalised its so-called Basel IV reform package in December 2017. The impact of these reforms is manageable, and we estimate that the final watered-down version of these reforms would impact the majors’ CET1 ratios by ~35bps, which is a benign outcome.”

In addition, any additional requirements from APRA will be well accommodated by the banks. APRA is expected to issue a discussion paper early this year with proposed changes to the banks' capital framework, including strengthened capital requirements for mortgages, as well as possible changes to improve transparency and comparability of capital ratios (against global peers). Deutsche Bank believes the banks will easily meet these requirements.

Again, Morgan Stanley warns the majors' common equity Tier 1 (CET1) ratios are diverging again, and dividend payout ratios may be elevated.  ANZ should be able to undertake around $3bn of buybacks this year, “but we think it's too early for the others. At the same time, lower returns and higher capital ratios have adversely affected the banks' capital generation, leading us to believe that payout ratios remain elevated and dividend growth is hard to justify.”

Below is a broad sector overview, including the three largest regional lenders, in terms of broker ratings and forecasts as at Friday, 9th February 2018.

FNArena Major Bank Data					FY1 Forecasts				FY2 Forecasts
Bank	B/H/S Ratio	Previous Close $	Average Target $	% Upside to Target	% EPS Growth	% DPS Growth	% Payout Ratio	% Div Yield	% EPS Growth	% DPS Growth	% Payout Ratio	% Div Yield
ANZ	3/5/0	27.99	30.34	8.78	6.8	0.3	68.3	5.8	1.7	1.1	67.9	5.8
CBA	1/5/2	76.51	77.75	1.97	– 3.6	1.1	77.9	5.7	3.3	3.3	77.9	5.9
NAB	6/0/2	28.90	31.81	10.02	– 0.3	0.0	87.0	6.8	6.8	– 1.9	79.9	6.7
WBC	5/3/0	30.40	33.46	10.26	1.8	2.6	79.6	6.4	1.9	1.5	79.2	6.4
BEN	0/4/3	11.28	11.25	0.18	0.2	2.0	78.2	6.2	– 0.7	0.5	79.1	6.2
SUN	4/3/1	13.24	14.34	8.39	5.8	1.9	83.9	5.6	10.7	2.3	77.5	5.8
BOQ	0/5/3	12.05	12.08	1.35	– 2.2	3.4	82.3	6.6	0.7	– 1.3	80.7	6.5

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