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CBA – a contrarian’s play?

Posted By Charlie Aitken On In Markets,Shares | No Comments

The Commonwealth Bank of Australia (CBA) remains a core long-term member of my high conviction buy list ™. This is another example of a high barrier to entry Australian company, where my top-down macro views are meeting our bottom-up fundamental view. In fact, in the case of CBA, the top-down support and bottom-up support is concurrently getting stronger, almost ensuring that a new all-time high ($74.18) will be seen for CBA equity once the consensus view comes around to ours.

I think that day is sooner rather than later, most likely delivered by under-rated and under-stated CEO, Ian Narev, at CBA’s full year results and dividend in mid-August.

Interestingly, WFC.NYS and CBA.ASX have a very close correlation, with the near-term picture suggesting CBA will play catch up to WFC.

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I want to focus bottom up on the CBA investment case after Bell Potter updated our CBA view. I wanted to get our view to you before the bank analyst masses start focusing on the CBA result and previewing it in a few weeks’ time. We feel they will come to the same positive conclusion as us.

There is a lot of noise in the coverage of CBA. According to some, it’s the most expensive bank in the world. In reality, the truth could well be CBA is the best bank in the world. On that basis, it remains undervalued versus its global and local peers (I think I got canned in the global press for writing that at $54, now I am writing it again at $70).

While the bear case on Australian banks focuses on their downside leverage to rising unemployment and BDD (bad and doubtful debts), my positive strategy, however, focuses on them as cyclical financials, as we come out of a five-year “feels like” East Coast recession. If they came through the five-year “feels like” recession unscathed, imagine how they will go with a bit of a tailwind.

60% of CBA’s entire lending book is basic Australian mortgage lending at a dynamic LVR of less than 50%. 75% of those mortgages are in NSW, VIC and QLD combined. The bank also owns Australia’s biggest fund manager, in Colonial First State, just as risk asset markets rise and compulsory superannuation contributions increase. It also owns the largest online stockbroker in CommSec. When you think about it, CBA is a mums and dads product bank, owned predominately by mums and dads, who simply won’t sell the stock if the fully franked dividends are growing.

On that basis, CBA is a not a “defensive”. It is a consumer and household cyclical confidence stock on every front. It is the ultimate self-fulfilling virtuous circle stock, where its own success leads to exponential demand for its own fully franked dividends.

In the Bell Potter forecast table below, simply focus yourself on the dividend line. For FY13 we see it rising to 361c in total (confirmed mid-August), this year FY14 it jumps again to 381c, then in FY15 we see CBA paying 404c in annual dividends. 404c grossed up is 577c, which is monumentally valuable inside a super fund in pension mode.

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Also consider this, an Australian Government 3-year bond currently yields 2.77% per annum. CBA trades on a prospective 14.1 times FY14, inverting to an earnings yield of 7.1%. Similarly, CBA’s grossed up prospective FY14 dividend yield is 7.75%, nearly 500 basis points higher than the current 3-year bond yield.

If the dividend forecasts above prove to be right over the next 25 months, you will receive the 197c FY13 final dividend, a FY14 full year div of 381c and a FY15 full year div of 404c. That adds up to $9.82 of fully franked dividends from CBA, paid semi-annually, grossing up to a value of $14.02. That equates to a grossed-up 25 month yield of 20% on the current CBA share price, versus 5.77% from a 3-year AGB over the same period.

And before all the bond people scream “there is equity risk in equities”, I am of the view the much bigger risk of losing your capital is currently in any form of bond. The much bigger capital risk and greater near-term volatility will be in bonds, not large cap equities. If anything, the great rotation from bonds to equities will continue, and on the forecasts above it should – every day of the week.

I strongly encourage you to read the snippet of Bell Potter research below. The $111 billion market cap of CBA is 9.46% of the benchmark ASX200 Index and a stock that is critical to get right for professional and amateur equity investors.

We remain outspoken and somewhat lonely bulls on CBA. That continues to mean recommending buying CBA is contrarian. That in itself is amazing, considering CBA has been such a wonderful total return performer year in year out for two decades. Currently there are seven sells, six holds and five buy recommendations on CBA.

As a school cricket coach once told me as he dropped me after getting a century, “form is temporary, class is permanent”. CBA is pure class and that will be reinforced at the full year result in mid-August.

The Bell Potter view

In addition to having a history of not overpaying for acquisitions and management that is generally risk averse, CBA is now also well placed to capitalise on inevitable East Coast economic recovery.  Further reasons for being bullish on CBA are as follows:

Maintain $78.00 price target and Buy rating 

In line with recent sector experience, we have normalised CBA’s long run prospective BDD charge to the high end of the 25-30 basis point range within its domestic retail and business banks.  The impact on earnings is immaterial, being a less than -1% change to outer year earnings, and the $78.00 price target is thus left unchanged.  We have further revised dividends to reflect a 70% payout in the interim period and a higher 2H payout leading to a sustainable 77% payout (i.e. bringing forward higher dividends while maintaining cumulative payments across the forecast horizon).  We again point to the close historical correlation between CBA’s dividends and share price, with likely convergence towards the upper end of the $70-80 range in the next 12 months. Finally, our Buy rating is supported by better underlying fundamentals, a lower risk profile relative to the other majors and management’s consistent record in generating high ROE and positive reporting surprises (i.e. ~40% more positive occurrences).

Charlie Aitken is the author of the daily equity market newsletter Ringing the Bell.

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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