A newspaper recently described being underweight banks in FY24 as a “widow-maker” trade, such was the outstanding performance of local bank stocks in the previous financial year.
Led by a 20% weighting in the Commonwealth Bank, the VanEck Australian Banks ETF (ASX: MVB) returned 29% (including dividends) over one year to end-May 2024. MVB tracks an index of the seven largest banks and financial institutions on ASX. The big-four banks and Macquarie Group comprise 97% of that index.
Chart 1: VanEck Australian Banks ETF
Source: Google Finance
Retail investors who were overweight Australian bank stocks did well. But after strong gains in bank stocks, is it time to take profits and re-allocate capital?
Yes and no. For context, I have favoured bank stocks since 2020 and still do. During COVID-19, I thought Australian bank stocks offered exceptional value after heavy share-price falls in the early phase of the pandemic.
My positive view on banks was later informed by expectations of rising inflation and interest rates. As readers know, I thought inflation would remain higher and stickier than markets expected, requiring sharply higher interest rates.
Higher rates, in turn, would boost bank Net Interest Margins (the difference between interest received and paid) and thus bank earnings. That happened. I still expect inflation to remain higher for longer, and for the first rate cut to be up to 12 months away. Initially, I thought the RBA would cut rates in first-quarter 2025. After last week’s poor inflation data, the second quarter is more likely.
Higher-for-longer rates is good for bank earnings, provided the benefits to bank NIMs are not outweighed by a sharp deterioration in loan impairments and a contraction in credit demand. My base case is still for recession to be narrowly avoided, although the odds of economic contraction are shortening.
If this macro view is correct, the backdrop for Australian banks is okay. Granted, there are growing economic headwinds and risks, but the market position of big banks and their defensive earnings are attractions in this market.
Weight-of-money is another factor. Self-Managed Superannuation Funds (SMSF) and other retail investors continue to favour banks stocks for franked dividend yield, helping drive demand for them. It’s hard to see that dynamic changing. The problem is valuation. After strong gains in FY24, some Australian banks look significantly overvalued.
On Morningstar’s numbers, CBA is about 39% overvalued (fair value $90), NAB is 14% overvalued (fair value $31) and Macquarie Group is 10% overvalued (fair value $185). Westpac and ANZ and trading slightly below fair value.
Chart 2: Commonwealth Bank
Source: Google Finance
CBA, NAB and Macquarie Group comprise 58% of the MVB ETF. Simply, a big chunk of that index is significantly overvalued, and the rest is trading a touch below fair value at best. Valuation dynamics for bank stocks are hardly compelling.
That doesn’t mean retail investors should dump their bank stocks or that the sector cannot rally further. Paradoxically, as economic risks rise this year, so too could demand for bank stocks given their market position – to a point. Some analysts and fund managers who are bearish on Australian bank stocks today were also bearish six months ago when they expected rate cuts this year. They were wrong then and could be wrong again in FY25.
Global banks offer better value
My argument over the past year has not been to slash bank exposure. Rather, to reduce exposure to Australian banks and gradually increase exposure to global bank stocks, principally in the United States and Europe. My preferred exposure to global banks – the BetaShares Global Banks ETF currency hedged (ASX: BNKS) is up almost 37% over one year to end-May 2024. As mentioned, Australian banks stocks (through MVB) rose 29%.
Chart 3: BetaShares Global Banks ETF currency hedged
Source: Google Finance
The main difference is valuation risk. Remarkably, BNKS was on a forward Price Earnings (PE) multiple of 8.86 times at end May 2024, as shown by BetaShares data. In contrast, Australian banks (MVB) were on a trailing PE of 15.65 times, VanEck data shows.
The valuation gap between global and Australian banks stocks is even more stark at a company level. MVB’s top two stocks holdings – CBA and NAB – respectively trade on PEs of about 22 and 16 times. BNKS’s top two holdings – Bank of America and JPMorgan Chase – trade on PEs of 14 times and 12 times.
An examination of the top 10 holdings in BNKS shows several US and Japanese banks trading on PEs in the low teens. And that’s before you get to European banks, many of which are on single-digit PEs, despite serving markets several times large than Australia’s in many cases.
Yes, income investors are prepared to pay a valuation premium for Australian banks stocks over their global peers due to dividend franking. But it’s hard to justify paying a PE of 22 for CBA when Bank of America, one of the world’s great banks, in on a PE of 14 or Wells Fargo trades on a PE of 12.
In the UK, Lloyds Banking Group is on a trailing PE of about 8 times on Morningstar numbers. HSBC Holdings in on 7.3 times and ING on 8.7 times.
Prospective investors are buying UK and European bank stocks on single-digit PEs and dividend yields well above 5% in many cases. That’s a far greater margin of safety compared to buying Australian banks on PEs in the high teens or above 20 in CBA’s case. Key Australian banks are priced for perfection.
The counter argument is that the US, UK and Europe will cut rates before Australia, leading to margin compression for offshore banks. Australia is lagging those economies in the interest-rate cycle, given that we raised rates less aggressively and will need to keep them elevated for longer.
That risk, however, is more than factored into bank current bank valuations. Also true is that falling rates in the US and other offshore economies in the next 6-12 months should reduce the number of insolvencies and support credit demand.
Gaining exposure
The easiest way to gain exposure to global banks stocks is through an ETF. In a single trade via ASX, the, BetaShares Global Banks ETF provides exposure to a portfolio of 60 of the world’s largest bank stocks (excluding Australia).
About 35% of the BNKS is invested in US banks, followed by Canada, and Japan. UK and European banks comprise at last 20% of that index. BNKS’s annual management fee is a reasonable 0.57%, given currency hedging.
Although BNKS is a useful tool, caveats apply. Before investing in BNKS, consider how much exposure to banks is already in your portfolio. Some retail investors are badly overweight Australian bank stocks, given that sector’s high weighting in the S&P/ASX 200 index. Others are overweight bank stocks due to years of dividend investment and reluctance to sell and trigger a capital gains tax bill.
With some local bank stocks trading at full valuations, a cautious lightening of Australian banks and an increase in global banks makes sense. It’s not about moving completely from local to global bank stocks but taking some profits on highly valued local banks and buying undervalued global ones.
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 3 July 2024.
