Are banks creeping back into compelling value territory?
Stresses in the commodity space have contributed to the massive sell-down experienced by the global banking sector since April last year, with Australian banks down around 30% from their peaks in 2015, with European banks down around 45%, while the US counterparts are down by almost 30%.
What’s arguably spooked global investors into exiting banks was the impact of stresses in commodities on the bad debt cycle, and deleveraging from the global growth story.
With crude oil prices down 54%, LNG prices down 32%, and iron ore prices down around 30% in the last year, many of the projects may never be profitable – and some debt may struggle to be repaid. As a result, credit ratings agency Moody’s suggests much of the debt issued by US energy companies will be downgraded to junk in the near future.
Equally concerning for investors is the difficulty all banks have growing profitability within a low or negative interest rate environment, with Sweden cutting rates just last week to a -0.5%.
With a number of Australian banks reporting during the week, there will be no shortage of data with which to gauge the domestic environment, and its impact on local bank performance.
In addition to the effects of residential sales on banks, the market is also going to be watching closely dividend policy announcements with National Australia Bank (ASX: NAB) and Australia New Zealand Banking Group (ASX: ANZ) regarded as most at risk of changing their dividend polices.
But if the Commonwealth Bank of Australia’s (ASX: CBA) interim profit last week – up 4% and no blowout in bad debts – is any proxy for banks, Australia’s ‘big-four’ and the Bank of Queensland (ASX: BOQ), (down between 15% and 20% since the beginning of the year), are in pretty good share with low levels of problem loans, especially when compared with their overseas counterparts.
Much of CBA’s improved first half profitability, and rise in earnings to A$4.8 billion is down to its increasing net interest margins (NIM) – a high ratio indicates bank efficiency – which are now at 1.92%, compared with the next best of the big-four on the NIM-front, Westpac banking (ASX: WBC) which has net interest margin of 1.80%.
The single biggest boggy-man that’s been vastly overstated is the notion that Australia’s major banks are literally sitting on massive China-fuelled resources impairments.
While Australian banks are by no means immune to the impact of falling commodity prices, even CBA which is more exposed to a slowdown – in Western Australia through its Bank West – appears to have relatively minimal exposure.
As a case in point, CBA’s total exposure to mining, oil and gas is only $18.9 billion, which equates to 1.8% of its committed exposures, and only 1.9% of the value of these loans is actually impaired.
Based on Reserve Bank of Australia (RBA) data, at less than 1%, Australian banks’ non-performing loans pale when compared with their of their global peers which are 2%, 4% and 6% for the US, the UK and the EU respectively.
Underscoring the potential for good earnings growth by Australian banks is the prospect of credit growth of up to 7%, which based on expectations for GDP growth appear relatively healthy.
Then there’s the underlying resilience within Australia’s housing market, relative to banks offshore. It’s true, local banks have around 60% of their loan portfolios directly wired to housing. But with a high proportion of borrowers well ahead of their mortgage repayments, a sharp jump in problem loans and write-offs appears unlikely.
Equally important, and contrary to popular opinion, it’s unlikely that local banks will need to retain larger amounts of their earnings to satisfy higher thresholds by regulators. The net effect is that the need for banks to have to reduce their payout ratios from current levels may have been significantly overstated.
Meantime, what’s also been understated is the potential for local banks to use new technology to not only improve productivity, but to also drive down their cost-to-income ratios.
The lower the ratio, the better the bank is at controlling costs, and at 42.54% CBA is the best performing of the big-four on this measure, compared with NAB the worst performing on 53.43%.
Before writing-off Australia’s banks, it’s important to remember that they’re performed exceptionally well over the past five years.
Helping to push local banks share prices to all-time highs in 2015 were record levels of profitability, which have in turn supported large dividend payments to shareholders.
Since the major sell-off in Australian banks, they’re representing significantly better value than they did a year ago, with the big-four all trading at significant discounts of between 10% and 40% to their intrinsic value.
Given that banks (along with miners) dominate the ASX by market cap, they’re hard to ignore. Rather abandoning the sector completely, you need to watch reporting season very closely.
Look beyond the numbers to the underlying commentary, it’s the source of future growth that should dominate your attention.
We may not be at the point where banks make for extremely attractive entry levels – especially given the risk being ascribed to future earnings, and the valuations placed to their global counterparts – but it may not be too far away.