A few years ago, a suburb near me had five bank branches on its main street. Now it has two after the closure of Bank of Melbourne, ANZ and National Australia Bank branches.
The closures are yet another sign of banks quickening their cost-cutting programs – and a reason why bank shares will deliver solid returns in the next few years.
To recap, after years of avoiding bank stocks, I presented a bullish view on them for the Switzer Report in April 2020, just after the COVID-19 share market crash.
I wrote a year ago: “It is time to buy the banks. If you already own them, add more if possible. If you do not, take advantage of the best buying opportunity in banks in a decade.”
That idea attracted some puzzled looks from friends and a few concerned emails from long-time readers. At the time, newspaper headlines screamed recession and there were fears of skyrocketing unemployment, falling house prices and a spike in bad debts. A bullish contrarian view on banks seemed bonkers at the peak of COVID-19.
In my April 2020 column, I outlined six reasons for my positive view on the banks. All those reasons remain today. The main one was that I was “less bearish on the economy over the next 12 months than some forecasters”, and did not believe banks at the time were underestimating loan impairments or that household bad debts would soar.
So far, so good.
The VanEck Vectors Bank ETF (MVB) was my preferred instrument. This Exchange Traded Fund provides exposure to big-four bank stocks, Macquarie Group, Bendigo & Adelaide Bank, and Bank of Queensland. MVB is a simple way to “buy the Australian banking sector”.
Long-time readers know I prefer using ETFs when sectors are irrationally oversold. Rather than try to pick stocks and take on company risk, it’s better to buy the sector through one ETF.
MVB has returned 61% over 12 months to end-March 2021, from a diversified, quality portfolio of bank stocks.
Chart 1: VanEck Vectors Bank ETF
Source: ASX
It’s great when a strong, contrarian idea works. But “buy” ideas are only half the story; as important is knowing when to take profits on high-performing ideas. The only “paper” profits that count are the ones you can fold in your pocket or use to swell your bank account.
Is it time to take profits on bank stocks?
Yes and no. Yes, if you are an active investor who bought banks last year to benefit from a rebound in their share prices. Taking a few profits makes sense.
Banks shares will deliver solid returns over 12 months, but share-price gains will be slower from here. More of the total return (capital growth and income) will come from dividends.
Fiscal and monetary responses to COVID-19 have given the banks a big, temporary free kick. Billions of dollars poured into term deposit accounts as Australia’s savings rate jumped. The JobKeeper and JobSeeker programs sensibly put more money into people’s pockets.
In turn, that helped Net Interest Margins as banks used more of that cash (which paid almost zero interest) to fund home loans. However, the average bank NIM has peaked and will come down gradually from here as bank funding costs edge slightly higher, as deposit rates are eventually repriced higher.
Strong credit growth is another tailwind for banks. Higher property prices mean more money is borrowed to fund a home purchase, or spend on furniture and other home-related goods. Sharply higher business confidence also bodes well for bank credit growth.
The market is well aware of the credit-growth story and has already priced that into bank valuations, in my view. If anything, credit growth could cool a little over the next few months as the housing market catches its breath and business grapples with the COVID-19 recovery.
Better times ahead for income investors
As to the “no” argument, long-term income investors should hold rather than sell their bank shares. Clearly, banks were too pessimistic at the peak of the COVID-19 crisis last year, judging by their provisioning for impaired loans. At the time, several banks tipped double-digit house-price declines. Now, the banks mostly expect double-digit price gains this year.
A chunk of provisions for impaired loans will continue to be written back to bank profits over the next year or two, driving higher cash earnings. That, in turn, will allow the banks to pay bigger dividends over at least the next 18 months, and even buyback their shares.
Although I expect share-price gains to moderate, higher bank dividends will be a great result for income-starved investors. And a reason to keep those bank shares.
Another medium-term tailwind is faster cost cutting than the market expects. I’m surprised analysts haven’t made more of the prospect of more aggressive bank rationalisation programs. Most discussion has focussed on the reversal of bank provisions and net interest margins.
I believe the market has underestimated the potential for big banks to downsize aspects of their operations. If three of five banks can close branches (all of which had plenty of floor space) near me in a year or so, imagine the cost savings of closing many more outlets.
Previously, closing bank branches was fraught with risk. The community backlash from closed branches, particularly in the regions, was a terrible look for the out-of-favour banking sector. But COVID-19 forced more people to bank online, especially older customers who had no choice.
The argument to keep more bank branches open, when fewer people visit them, is getting harder by the day. For banks, that means more opportunity to rationalise their branch networks, cut staff numbers, save costs and digitise more of their operations.
The upshot is banks will have solid earnings and dividend growth ahead over at least the medium term (1-3 years), provided COVID-19 is contained over this year or next.
Which bank?
I can’t go past Westpac after it reported a cracking first-half result. Reported net profit rose 189% to $3.4 billion for the first half of FY21, compared to the same period a year earlier.
After $3.16 billion of impairment charges in FY20, Westpac wrote back $372 million in the first half of FY21. The bank said Australia’s economy was performing significantly better than expected.
Importantly, Westpac’s Return on Equity (ROE) jumped to 10.2% in the first half, from 2.9% a year earlier when COVID-19 led to $2.2 billion in loan-impairment charges.
Best of all, Westpac’s interim dividend was 58 cents a share (from 31 cents a share in the second half of FY20). Like many corporates, Westpac suspended its dividend in the first half of FY20.
For me, the big surprise was Westpac putting a target on its cost base. The bank wants to slash expenses from $12.7 billion in FY20 to $8 billion in FY24. Seldom do large corporates, particularly banks, put such a definitive target and timetable on cost cuts.
Put another way, Westpac will be shrinking its cost base by just over a third within four years, while investing in the business and sustaining a higher return on equity. That will be a remarkable feat if CEO Peter King pulls it off.
Therein lies the big upside to Westpac and the other big-four banks: the potential to slash more costs in their operations, faster than the market expects. Digitisation is creating incredible opportunities for banks to deliver their services with far fewer people.
I’d hold Westpac shares after its result or buy more. After a few years of scandals and disappointments, the bank is turning a corner under its new leadership team.
Chart 2: Westpac Banking Corporation
Source: ASX
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 5 May 2021
