Hugh Dive, Head of Listed Securities

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Tales from the Trenches - Banks 2014 Report Card

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Over the last eight days we have been digesting multi-billion dollar profit results for the major trading banks and listening to bank CEOs and CFOs commenting on their profit results. In aggregate the four major banks generated $28.6 billion in cash profits over the 2014 financial year, which represented an increase of 5% on the previous year. In this piece we are going to look at the common themes arising out of the results, differentiate between the banks and hand out our reporting season awards to the stocks that comprise a large weighting in most investors' Australian equity portfolios. The large overall size of bank profits reflects that their core business of transforming savings into lending as loans to borrowers remains a very profitable task. Indeed over the past decade (inclusive of the GFC) the big four banks have generated approximately $200 billion in profits after tax.

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Gold Star

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Profit growth still strong but momentum slowing: Emerging from the GFC, the banks have boosted their earnings handsomely. A primary driver of this has been declining bad debt charges, as the banks have faced an environment of anemic loan growth and increased competition for deposits. Over the last 12 months CBA has been the star performer increasing cash earnings by 12% to $8.7B. NAB had another tough year with declining revenues and another large write-down on their UK business.

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Gold Star
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Bad debt charges continue to decline: One of the key themes across the 4 major banks and indeed one of the biggest drivers of earnings growth over the last few years has been the significant decline in provisioning for bad debts. Declining bad debts boost bank profitability, as loans are priced assuming that a certain percentage of debtors will be unable to repay and that the outstanding loan amount is greater than the collateral recovered. The buoyant property market continues to result in loans formerly classed as "impaired" (i.e. where borrowers are behind on payments), returning to performing or being repaid.

Westpac presented the lowest bad debt charge, with their percentage of impaired loans now at pre-GFC levels, though this is unsustainable in the medium term.

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Gold Star on increasing lending in Asia
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Loan growth improving: Whilst loan growth is improving particularly in housing, overall de-leveraging by businesses continues to have an impact on the net demand for new loans. The upside to lower loan growth is that it has enabled the banks to rebuild their capital bases quickly in the lead up to the Basel III regulatory reforms.

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Gold Star
b2ap3_thumbnail_CBA-logo.JPG Dividend growth slowing: The banks all reported higher dividends in 2014, though for this period dividend growth lagged behind earnings growth. The reason for this has been to build capital reserves ahead of the upcoming Murray Financial system inquiry. Higher capital requirements will put a brake on the banks ability to deliver higher dividends to shareholders

 

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Gold Stars

 

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Capital position a big focus: Whilst a stronger capital position is not as exciting as higher profits or dividend growth, it is currently the main item that investors are focusing on. A bank's capital position measures its ability to absorb unexpected losses and is the difference between all of a firm's assets (loans) and its liabilities (deposits and bonds). Obviously to remain a solvent entity, the value of a bank's assets must exceed its liabilities. We view that the impact of higher capital requirements won't be as dire as many in the market believe. Over the last 30 years the banks have proven to be effective at passing on similar headwinds to customers. We expect that profits will be maintained through a combination of reduced discounts for new mortgages, lower term deposit rates and wider spreads on some business loans. However the banks are in a situation where they are wringing their hands about potentially being ordered to hold more capital (as Westpac did on Monday), whilst simultaneously reporting record profits. At the recent results season CBA and Westpac reported the highest capital positions, with NAB having the lowest.

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Gold Star - Australian banking oligopoly
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Net interest margins steady: The banks generally maintained flat margins and the strong deposit competition that has been a feature of recent years appears to be waning. Also contributing to the banks being able to hold their margins relatively flat has been the reduction in competition from the non-bank financial lenders although this may prove short lived.

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Gold Stars

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Total Returns: In 2014 Westpac, CBA and ANZ have all outperformed the ASX200, which has returned +6.6%. CBA and Westpac have been the top performers amongst the banks giving investors a total return (capital gain plus dividends) of 9.5% and 9% respectively. As you can see from the above scorecard, the two Sydney-based banks have garnered the bulk of the gold stars on offer; this is primarily due to their greater exposure to home rather than business lending.


Core Equity Portfolio Strategy: The Core Equity Portfolio's banking exposure is weighted to the more domestically-focused banks (CBA & Westpac), with the off-shore exposure being held in ANZ (Asia) rather than NAB (United Kingdom).

Whilst NAB's share price performed well in 2013, it has been the worst performing bank in 2014. We don't own NAB, as we view that the company's culture of being more adventurous with shareholder's capital has tended to result in higher bad debts through the cycle and occasional results in left field disasters such as Homeside in the US and the 2004 foreign exchange trading scandal. Overall we are underweight the banking sector and are overweight towards the 'quality' domestic franchises.


Disclaimer

This article has been prepared by Philo Capital Advisers Pty Ltd ABN 70 119 185 974 AFSL 301808 (Philo) and contains general investment advice only. The information in this article does not take account of your objectives, financial situation or needs or those of your client. Before acting on this information readers should consider whether it is appropriate to their situation. We recommend obtaining financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, neither Philo nor any of its related entities accepts any responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this article. The information in this article is based on information obtained from sources believed to be reliable and accurate at the time of publication but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. Past performance is not a reliable indicator of future performance. Any forecasts included in this article are predictive in character and may be affected by incorrect assumptions or by known or unknown risks and uncertainties. Nothing in this article shall be construed as a solicitation to make a financial investment.

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Hugh Dive, Head of Listed Securities


Prior to joining Philo, Hugh was Head of Basic Materials Group Investment Research; covering the chemicals, building materials and steel sectors. In the 2011 Reuters StarMine Equity Analyst Awards, he was rated 5th overall in Australia for stock picking and first in the Diversified Industrials and Chemicals sectors. Hugh has extensive portfolio management experience gained at Investors Mutual, with a successful track record managing both small and large cap value funds. In 2009, one of the funds he helped manage, the IML Future Leaders Fund, won the AFR Smart Investor Award for the best Australian small cap fund.


Hugh started in funds management with CC&L Investment Management in Vancouver; Canada’s largest independent fund manager with C$37B under management. At CC&L he focused on asset allocation and then Canadian equity analysis. Hugh holds bachelor’s degrees in both Economics and Law from Sydney University and the University of British Columbia, Canadian Securities Course (Honours) and is a CFA charter holder.

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