Which bank now?

 

Just a little less than three months ago, I argued that it was time to lighten your bank holdings ^[1]. If you were overweight (as many trustees were), I said to get back to index weight.

I said that the banks would, over time, start to raise capital (which would be dilutive) and that in a bull market helped by a lower Australian dollar, they would lag the rest of the market. As yields were still attractive and interest rates were staying low, it wasn’t a case of being underweight, yet.

I didn’t, however, foresee the severity of the correction in bank share prices, particularly as it has occurred in a down market. This calendar quarter to date, financial stocks (excluding A-REITs) have lost 8.64% compared to the index’s 4.18%.

So the obvious question is, with this correction underway, how do you play bank stocks going forward?

Why the correction

There are three main causes. The most difficult to rationalize is that globally (and in Australia), yield curves have steepened sharply. In the US, the 10-year Government Bond has risen over the last month by 20 basis points to 2.15%. The German Bund has risen by 39bp to 0.54%, and in Australia, our 10-year bond has risen by 47bp to 2.84%.

Higher bond rates means that bank shares are less attractive – and potentially, an end to the yield trade!

Bond markets (like equity markets) sometimes get it very wrong. This may just be a long overdue correction (caused by a weakening US dollar) to a massively overbought bond market (I forget how long I have been short duration – and wrong), however on face value, the bond market is saying that short-term cash rates are going up. This seems to fly in the face of the recent economic data.

Next, we can’t seem to get away from the chatter about the obvious reality that the banks will need to find some more capital. The Government has said that it will respond to the recommendations of the Financial Systems Inquiry in July, while APRA has hinted that it may take earlier steps to change the effective weightings that the major banks (and Macquarie) use to risk weight their mortgage portfolios, which will bring them closer to the standard weightings used by smaller financial institutions.

The banks are already taking steps to boost capital. Dividend re-investment plans (not being neutralized and in some cases, partially underwritten), selling non-core assets (ANZ with Esanda Finance, NAB with Great Western Bank), and finally, issues of ordinary shares (a 2 for 25 rights issue by NAB to get ahead of the game).

The critical issue is the timing – how long banks have to make the transition to any new higher capital standard. If the timespan is multi-year, banks will get ahead of the game and this issue will fade away.

Finally, last week’s profit results were ordinary. All banks had negative jaws – expenses growing at a faster rate than income. Earnings growth has stalled. This was the big message.

How to play

I think this really depends on your portfolio’s starting position. While I am not convinced that the yield trade is over, if the banks can’t grow their earnings, then comparisons to the bond market are going to become more relevant – and higher bond yields will mean lower bank share prices. Watch the bond market for a lead.

Also, all banks will raise more capital – which ultimately, has to be dilutive on earnings.

What’s a normal position? Well, if you are an index hugger, this means that your exposure to stocks in the financial sector would be 41% of your total share portfolio. Of this 41%, the four major banks make up 31% – with AMP, Macquarie, Challenger and the regional banks accounting for the remaining 10%. So, if your exposure to the four major banks is around 30% to 40% of your share portfolio, then you are around index weight.

If you are overweight banks, use any meaningful market rally to pare back your exposure (or don’t participate in DRPs or take up rights). If you are underweight or index-weight, you can afford to dip your toe in the water, but do so with care.

Which bank?

In the Switzer Super Report edition of 16 February, I revised my bank ratings as 1) CBA, 2) NAB, 3) Westpac and 4) ANZ. Over the 12-week period, NAB has been the best performer (prior to Thursday’s capital announcement), and Westpac the worst. ANZ is in second place, and CBA comes in third. That said, the differences are pretty small.

Over the last 12 months, CBA has been the best performer, with NAB a close second. ANZ and Westpac make up the rear. ^[2]¹ Does not include NAB or Westpac interim dividends. NAB ex div 99c on May 15, Westpac 93c on May 13

Of the results last week, Westpac’s was the most disappointing.

Cash earnings in the first half 2015 were flat, compared to the second half 2014, and down 2% of first half 2014. While cash earnings were impacted by lower treasury earnings and an adjustment to the valuation of derivatives, taking these changes into account only resulted in very marginal jaws.

Compared to the first half 2014, adjusted income grew at 4.8% and expenses grew at 4.6%.

For a bank priced at the second highest forward multiple, Westpac’s result was just not good enough. “Must do better, Mr Hartzer” would be how the market saw it, and accordingly, savaged the share price.

On the other hand, expectations for ANZ were very low – it has been at the bottom of the performance table, and was priced at the lowest multiple. It delivered an “ok” result, with cash earnings up 4.6% compared to 1H 2014.

While earnings in Australian banking improved, the group still had negative jaws – foreign exchange adjusted income grew at 5.3%, while foreign exchange adjusted expenses grew at 7.2%. Strategy in Asia remains confused, with ANZ signalling that it might sell (to improve its capital position) minority stakes in several Asian banks.

Commonwealth Bank shocked the market with its quarterly report – about 600 words in total. Cash earnings for the quarter were $2.2 billion (the same as the corresponding quarter in 2014), whereas the market had been expecting $2.3 or $2.4 billion. Revenue growth was about 5%, benefitting from higher trading income, but impacted by competitive pressures affecting margin.

Expense growth was higher (implying neutral or negative jaws), impacted by growing regulatory, compliance and remediation costs.

It can be really dangerous extrapolating this report (numbers are only provided to the nearest $100 million and there is absolutely no detail or analysis). However, the tone was unquestionably downbeat.

NAB’s package of UK banking exit via a demerger and IPO, sale of the remainder of Great Western Bank, reinsurance arrangement for 21% of its retail advised insurance book, and capital raised through a 2 for 25 rights issue at $28.50 to raise $5.5bn, was well received. Upon completion, NAB’s capital ratio (CET1) will be 10.0% – a full 1.00% above the midpoint of its target range of 8.75% to 9.25% – providing it with a buffer for regulatory changes and developments.

NAB’s half-year result was largely as expected – adequate, not startling. Cash earnings rose 5.4% compared with the March 14 half year, or 3.7% on an earnings per share basis. Adjusting for a one off UK fine and foreign exchange impacts, NAB’s underlying costs were well contained, only growing by 2.3% over the year. Market share gains in home loans and deposits were highlights.

The brokers

While I have little confidence in the brokers’ collective insights, it is another data point. Listed below are the consensus broker ratings from FN Arena. With sentiment measured on a scale of -1.0 (most negative) to +1.0 (most positive), NAB is the most favoured and Westpac is the least favoured. On forward multiples, CBA is trading at multiple of 14.9 times earnings – an effective premium of almost 22% to the ANZ.

^[3]Source: FN Arena as at 08/05/15. Sentiment scale (-1.0 to +1.0)

My view

I am very wary about writing the CBA off after just one quarterly report. There is no doubt that it deserves to be priced at a premium to its peers – it is just a question of what margin that should be.

I like NAB’s comprehensive capital package and it looks like CEO Andrew Thorburn has the organisation focused on a “back to basics” approach, centred on Australian and New Zealand banking. They have drawn a line under their legacy businesses.

On the other hand, Westpac has real technology pain points and potential capital issues, and ANZ’s strategy seems as confused as ever. Does it really think it is on track to be a “super regional bank”?

Bottom line – as the performances over the last 12 months have shown, the differences are at the edges. In a tight market, if you are looking to add to your bank holdings, my rating is:

1. NAB
2. Commonwealth
3. Westpac
4. ANZ

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.