Australian banks – downgrading sector to neutral

Chief Investment Officer and founder of Aitken Investment Management
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Firstly, I have to say I totally agree with Peter Switzer that this so called “debt levy” is not the way forward. From my perspective of writing investment strategy, the biggest risk from introducing unexpected new taxes is actually what foreign investors think. In my view, there is nothing surer than foreign investors applying a higher risk premium to Australian equities to reflect the uncertainty new taxes create. This is EXACTLY what happened when the MRRT and carbon taxes were introduced.

Tax risk premium

This is relevant to what I am writing below on the Australian banking sector, which would see short-term foreign asset allocation selling pressure if any new unexpected tax was introduced. Nobody likes political or regulatory risk, but it seems there is some growing risk in Australia ahead of this Federal Budget.

Interestingly, both the banks, as GDP proxies, and listed discretionary retailers have fallen in price over the last two days since the speculation of the “debt levy” increased.

With the ASX200 trading near a six-year high, I am going to continue to look top down at our Australian equity strategy and consider where we do, and don’t, want more exposure, as pure absolute value becomes significantly harder to find.

Ahead of schedule

With three of the big four Australian banks hitting our top down driven FY14 price targets of 5.00% fully franked (yield inverted to create share price targets), I thought it was worth broadening out that sector discussion today.

At the top down macro level, I set those FY14 5.00% fully-franked yield-based share price targets on the view they would be hit in the lead up to the full-year bank reporting/dividend season in August through November. As it turns out, they have been hit six months ahead of that estimated timing, as we approach the FY14 interim reporting/dividend season.

No doubt, as we have written in these notes regularly, some of the demand for reliable/growing/fully-franked Australian dividend streams is structural (ageing population, legislated increases in compulsory super contributions, taxation system etc.) and some is cyclical (ultra-low cash rates). Below is a 2.5-year chart of the RBA cash rate target versus the ASX Banks Index to illustrate the cyclical dividend demand element. The cash rate basically halved and the bank sector doubled.

Those structural and cyclical dividend demand forces, when combined with benign bad and doubtful debts (BDD) in the banking sector (EPS/DPS upgrades), have driven pretty much the perfect upside/re-rating storm for Australian banks. Banks have added P/E, PEG and price to book ahead of those EPS growth rates, with the share price re-rating really being an inverse one to prospective fully-franked dividend streams.

The chart below illustrates that P/E versus yield inverse relationship by graphing the AS51 Bank Index P/E versus the index dividend yield. P/E is up by 45%, dividend yield down by 33% over that period.

To my way of observing Australian banks, it seems the trading range in major banks is basically a 6.00% to 5.00% fully franked prospective dividend yield range, assuming cash rates are steady at 2.50%. That 6.00% to 5.00% trading range has worked well in recent times and obviously we are now at the top end of the yield-based trading range. We are also at the bottom of the cash rate setting range.

That is understandable as the sector is about to confirm record earnings and dividends, while at the same time, recent CPI data pushed back the timing of domestic rate rise expectations.

Not bearish on banks

But my point today is, I don’t expect the 5.00% fully franked prospective yield to be bid down any further. Cash rates at 2.50% (with upside risks) and grossed up major bank yields at 7.14% (5.00%ff) suggests an equity yield risk premium of under 5.00% versus cash and I would be very surprised if that got bid down any further from here.

Now I don’t want anyone reading these notes to think “Aitken has gone bearish on banks”. Far from it: what I am doing today is toning down our top down 2.5-year sector bullishness to a more neutral stance. I broadly think, in the true sense, the Australian banking sector is now a “hold” rather than the outright “buy” we have recommended for that entire period. I expect banks to track their physical dividend growth from here, not outpace it. This is particularly so as cash rates eventually rise.

At these share price levels and considering what large parts of portfolios banks have become, I simply believe I don’t need to commit more fresh money to the sector or even reinvest dividends.

I don’t want to sell the banks. I just don’t think we need more of them up here. I am happy to collect the dividend streams, but I tend to want to reinvest those dividend streams elsewhere in multi-year financial laggards (IAG, AMP, CPU, CGF etc.), Telstra (5.65% fully franked), Woolworths (WOW) or even park a bit of it back in the bank in the form of cash and wait for better value to emerge over the next few months.

No doubt, however, for faster tactical money, there might be a quick downside trade in Australian banks once they are ex-dividend. This is particularly so if that ex-dividend period coincides with a broader period of weakness in global equity indices. Australian banks do tend to be a little friendless ex-dividend/ex-franking credits and particularly so if they are not neutralising their DRPs on market. Note the Bank of Queensland (BOQ) example recently ex-dividend.

Nobody has been more consistently bullish Australian banks over the last few years than us, both top down and bottom up. What I am doing today, top down, is simply “stepping off the gas” in the sector a notch to reflect the P/E, PEG price to book and dividend yield re-rating we have been on the right side of. That has all played out how we forecast, but as I mention above, about six months AHEAD of when we forecast.

To me, the major Australian banks are now more accurately described as “fair value” for what we know today and on that basis I am downgrading our top down view of the sector to neutral for the first time in 2.5 years.

Below is the ASX Bank Accumulation Index (XFJ) just to remind you where we have come from/ to over the last 2.5 years.

Go Australia, Charlie

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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