Hugh Dive, Head of Listed Securities

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Tales from the Trenches - what to do with the Australian banks?

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Assessing future prospects for the major banks is currently one of the biggest issues facing all Australian equity fund managers. Aside from employing over 200,000 Australians and touching every sector of the Australian economy, the four major banks plus the two regionals comprise 32% of the ASX100 and four of the five largest stocks listed on the ASX with a combined market value of A$400 billion. After several years of delivering strong profit and dividend growth, primarily due to the tailwind of declining bad debt charges, all bank share prices have been sold off aggressively (down -6%) over the past month. This fall can be attributed to investor concerns that the banks will face higher capital requirements post the upcoming Murray Financial System Inquiry, as well selling from foreign investors due to a sharp fall in the AUD. In this piece we are going to look at the causes of this correction and some thoughts for the future.

Banks.JPG

Unravelling of the Carry Trade

Over the last month there has significant offshore selling of stocks in the higher yielding sectors of the market, namely banks, listed property trusts and utilities. A factor contributing to the fall in these companies' share prices has been the unravelling of the AUD "carry trade" caused by rising bond yields in the US and a sharp fall in AUD. The carry trade is an investment strategy, where an investor borrows in a country with a low interest rate like the US at 0.5% then uses these funds to buy an asset in a different currency yielding a higher return such as Westpac shares at 5.5% or Australian government 3 year bonds yielding 3%. This strategy could give a profit of 5%, provided the AUD/USD does not change significantly and these profits are often magnified by the use of leverage.

The risk inherent in this strategy are sharp downward moves in the higher yielding currency, such as what we have seen since the 3rd September where the AUD has fallen -6.4% vs the USD. Obviously moves of this magnitude can wipe out all the returns being generated from the differences in interest rates.

Increasing Capital Requirements

Another factor weighing on the share prices of bank stocks has been the uncertainty around the potential outcomes of the upcoming Murray Financial System Inquiry. This inquiry is being headed up by the former long-serving CEO of Commonwealth Bank and is investigating whether to recommend that the Australian banks will need to hold more capital to back their lending. During the GFC, many banks globally were forced to seek direct financial support from governments (and ultimately taxpayers). For example, the US government injected US$45 billion into Citigroup at the height of the GFC. This proved to be quite profitable for US taxpayers with the government selling their Citigroup shares in 2011 for US$57 billion. Whilst the Australian banks did not require similar levels of government support, additional banking capital is designed to reduce the probability of Australian banks needing direct assistance from taxpayers during future crises.

Our View

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 similar costs onto customers and 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. Effectively the consumer will bear most of the cost for this "gold plating" of the banking system.

During 2012 Sweden introduced higher capital requirements on banks writing mortgages to rein in a very buoyant housing sector and provide greater bank capital requirements. These moves cooled down the Swedish housing sector, slowing housing credit growth from 10% to 5%. However this ended up being a positive development for shareholders in the Swedish banks (Svenska Handelsbanken and Swedbank); as the banks repriced their mortgage book upward to account for this additional capital and saw margins expand and earnings per share rise by approximately 15%!

Currently the banks trade at a 15% discount to the ASX 200, the biggest discount since 2007. Moreover the banking sector dividend yield is currently at 5% margin over the 1 year term deposit (TD) rate (below table). As the banks report positive results in late October/early November, we can see strong catalysts for buying support in these stocks, especially from retail investors dismayed at the deposit rates on offer.

Banks-2.PNG

Bank reporting season kicks off in the next two weeks and the reporting banks (ANZ, NAB & Westpac) should reveal strong results with improving momentum for future earnings growth. Whilst we see that the banks may be required to hold more capital backing the loans that they write, we believe this will be accomplished in a less dramatic form and more gradually than is currently being presented in the press.

Whilst we are underweight the banks in the Core Equity Portfolio, we view that the sector is looking attractive at the moment. The four major banks (including NAB's A$1.3 billion downgrade put through last week) are expected to generate approximately A$29 billion in cash profits for 2014. The level of profits combined with average lending growth gives the banking sector a few levers to bolster capital through underwritten dividend reinvestment plans without resorting to massive direct equity issues.

 

 

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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