I get plenty of questions about what I think about the big four Australian banks from here and my simple answer is I am still bullish.
Total absolute returns from the sector will not be as spectacular as last year, but in real after-tax terms to an Australian taxpayer, they will destroy what is available in a 12-month bank term deposit, even if we only collected fully-franked dividends and didn’t get any capital appreciation.
However, I think we will collect record fully-franked dividends and get capital appreciation. I am targeting a 15% total return (including franking credits) from the Australian banking sector this year.
Long live the yield trade
Where I differ from other commentators who say “the yield trade is dead” is that I believe, in Australia, we are witnessing a structural change in demand for relatively assured/growing fully-franked dividend streams, due to our ageing population, compulsory superannuation contributions rising to 12% by 2020, and the taxation advantages of franking, particularly in the latter stages of the superannuation cycle. I can see structurally increasing demand for tax effective yield streams, which are exacerbated in periods of ultra-low cash rates.
While cash rates in Australia have almost certainly bottomed, we are potentially many years away from cash rates being raised to levels that can make grossed-up bank dividend yields look relatively unattractive (let alone paying CGT on the sale of the stock). In fact, if you consider why the cash rate cycle has bottomed, it’s because monetary policy is stimulating cyclical economic activity and asset price rises, which are good for banks, particularly mortgage banks in terms of bad and doubtful debts (BDD)/ average LVRs and credit growth.
Banks are GDP proxies. The East Coast recovery is good for bank earnings. They are, in effect, leveraged financial cyclicals. Their own activity in lowering term deposit rates and fixed mortgage rates (while maintaining NIM) is driving both investors out of cash and cyclical growth activity. Competition for deposits has clearly peaked, with all banks holding excess regulatory capital.
Last year I created “the self-fulfilling virtuous circle of bank equity demand in an ultra-low interest rate environment”. The conclusion was that the ultimate winners of ultra-low interest rates in Australia are the oligopoly mortgage banks. I am going to attempt to illustrate my concept of a self-fulfilling virtuous circle that I believe Australian mortgage banks are in an ultra-low interest rate, rising domestic risk asset price environment.
Ultra-low cash rates → refinancing → credit growth→ rising asset prices→ low BDD→ net interest margin→ ROE→ NPAT→ dividend→ super system→ demand for dividends→ demand for bank equity→ bank share prices→..
The focus
The way I attempt to approach the Australian mortgage banks top-down is simply a view on interest rates, employment, economic growth and residential property prices. I see them as basic proxies, leveraged proxies, for East Coast GDP growth. I then try to work out what the SMSF retail army will pay for the fully-franked dividend growth (income streams) the banks spit out. I pay absolutely zero attention to Australian bank pricing relative to global peers. In my view, that remains irrelevant and misleading, particularly given the registers of Australian banks are dominated by domestic investors with domestic specific drivers of the investment decision.
I will write at a bank specific level over the next few weeks as we approach the FY14 interim reporting season for ANZ, NAB and Westpac (WBC), but at the macro sector level it’s blatantly obvious that the trends CBA (No.1 pick) reported in Feb (positive JAWS, falling cost to income ratio, low BDD, high ROE, high TIER 1), which led to consensus upgrades, will be evident in the broader sector.
On the way up
Similarly, since Feb, pretty much ALL Australian economic data has surprised on the upside and I personally think bank EPS and DPS consensus estimates are too low for FY14 and FY15 and need positive revision. Bank analysts have been too bearish on EPS and DPS for years now and it continues to this day.
This positive EPS and DPS revision cycle has been underpinning the bank sector move for three years now and it will continue. For example, below is the consensus FY14 EPS forecast for CBA over the last 12 months and the consensus FY14 DPS forecast for CBA over the last 12 months. Note how consensus responds to results confirmation. Four buys, seven holds, seven sells currently on CBA…hmmmm, but that’s been the case since $60.00.
CBA EPS FY14
Source: Bloomberg
CBA DPS FY14
Source: Bloomberg
For a large version of these charts, click here [1].
We are going to see all-time record interim dividends from the sector in May and the domestic SMSF army will cheer. It’s that simple in my view and it is interesting that the ASX Bank Accumulation Index (XFJAI) (in blue) continues to lead the ASX Bank Index (XFJ) (in green). To me, this confirms we are seeing structural demand for these tax-effective and growing-in-absolute-terms dividend streams, which in turn are driving capital appreciation in bank equities. I expect absolute dividend growth to continue to drive bank share prices higher.
I continue to recommend being overweight the big four Australian banks (+SUN/BOQ/MQG) at the Australian equity strategy level, with the two highest conviction ideas remaining the two big East Coast banks in CBA and Westpac. Yes, those two are more expensive that NAB/ANZ, but there are many valid reasons for that premium rating.
The strategy
In terms of individual investor bank strategy, I wouldn’t be committing new money to the sector, simply reinvesting dividends and effectively playing the compounding/accumulation game, which has worked so well in recent times and will continue to do so in my opinion.
Record profits and record dividends are coming in May, followed by consensus EPS/DPS upgrades. That is the simple summary of my still bullish view on the sector – bullish view that has been unchanged for three years.
Ignoring doomsayers on Australian banks has worked well for three years now. I expect that trend to continue, albeit as I say, at a lower total return rate than the last few years.
100% of Charlie Aitken’s fees for writing for the Switzer Super Report are donated to The Sydney Children’s Hospital Foundation
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.
Also in the Switzer Super Report:
- Margaret Lomas – My SMSF – Property guru Margaret Lomas [2]
- Penny Pryor – ASIC promises equal scrutiny [3]
- Staff Reporter – Buy, Sell, Hold – what the brokers say [4]
- Ron Bewley – What not to buy [5]
- Tony Negline – Changes to superannuation assessment and you [6]
- Questions of the week – Monadelphous and SMSF estate planning [7]