Commonwealth still the top bank

Co-founder of the Switzer Report
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Sometimes there are good reasons why stocks are expensive – and it pays to invest in those stocks rather than their cheaper cousins. Commonwealth Bank (CBA) is one such case. It remains the most expensive of the major bank stocks, and my number one bank pick.

Last Wednesday’s March Quarter trading update from the CBA showed a better than expected increase in underlying cash profit of approximately 15% ($2.2 billion for Mar Qtr 2014 versus $1.9 billion Mar Qtr 2013), and importantly, positive “jaws” (revenue increased at a faster rate than costs). This reconfirmed their leadership in the banking stakes and why they deserve their premium pricing. And don’t be too scared by their elevated price of almost $80.00 – if you believe (like we do) that the ASX 200 is headed for 6,000, Commonwealth Bank will hit the $88.00 mark.

Comparing the banks

In the oligopoly of Australian banking, there really isn’t that much difference between the four major banks. The differences are more nuances around strategy, positioning and investment, and of course, the impact of leadership. Here is the qualitative summary.

Commonwealth: Arguably has the strongest leadership team. Market leading shares in all major banking markets in Australia, with the exception (and possibly a strength) of business banking. The leader in technology, with its investment in a new core banking platform/customer management system giving it a key competitive advantage.

Westpac: Has the strongest Australian franchise of any of the four MTBs. Slightly differentiated strategy through its multiple customer brands (Westpac, St George, Bank of Melbourne, Bank SA) and “one kitchen, many dining rooms” approach.

ANZ: Differentiated strategy with its investments in Asia/Pacific, which now account for 24% of group revenue. Domestically, lags in the retail market, with only 15% market share of the mortgage market.

NAB: Still paying the price for past investments, particularly in the UK. Has been trying to grow market share in retail banking in Australia through price leadership – the jury is very much out on how successful this strategy will prove to be. Strongest in business banking, although not where the growth is at the moment. New CEO takes over shortly.

Looking at the numbers below, Commonwealth Bank stands out with the highest Return on Equity (ROE), second lowest expense to income ratio, and the standout increase in cash earnings. Westpac is the best-capitalised bank, has the best expense to income ratio and its ROE, although some distance from CBA, is higher than the other banks.

While NAB’s expense to income ratio has deteriorated, in part, due to some one-off penalty costs in the UK, the reported increase in cash earnings was entirely due to a reduction in bad and doubtful debts and the benefit of foreign exchange movements. Underlying operating income actually fell by 1.2%, while costs increased by 2.9%. When the benefits of foreign exchange gains are excluded, ANZ increased revenue by 3.6%, whilst holding the cost increase to only 1.7%.

ANZ has the lowest Tier 1 Capital ratio and may find this inhibits some of its growth plans or is pressured by the market to consider boosting its capital position.

 

 

¹ Increase in cash earnings compared to prior corresponding period (ANZ, NAB, Westpac: 1H14 vs 1H13; CBA Mar Qtr 14 vs Mar Qtr 13)
² Group Operating Expense to Group Operating Income (ANZ, NAB, Westpac: HY ending 31/3/14; CBA: HY ending 31/12/13)
³ Return on Equity (ANZ, NAB, Westpac: HY ending 31/3/14; CBA: HY ending 31/12/13)
⁴ Common Equity Tier 1 Capital Ratio (all banks as at 31/3/14)

Brokers and pricing

Commonwealth Bank is priced at a material premium to the other banks, trading on a forward PE multiple of 15.3. This compares to the NAB, which is only trading at a multiple of 12.5. On one measure, CBA is trading at a 23% premium to the NAB.

In terms of “broker sentiment” and target prices, the brokers are pretty neutral. On a scale of -1.0 to +1.0 (where -1.0 is most negative, +1.0 is most positive), all the banks are rated between 0 and 0.1.

Source: FN Arena, using closing prices on 16 May 2014

My ranking

I don’t subscribe to the “banks are overpriced” theory, simply because there are no signs of the forces that could really threaten earnings or make bank shares less attractive. These would most likely be a pick up in bad debts due to higher unemployment, or too rapid business credit growth; higher interest rates leading over the medium term to higher bad debts and in the short term, making bank shares less attractive to yield investors; or material competitive threats to the oligopoly from other players or disruptive new technologies.

At some stage, the cycle will turn – however it is hard to see this in the next 12 months.

So the question is – “which bank”?

Despite the pricing premium, my order matches the market pricing:

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

Is the Commonwealth Bank too expensive? Well, in recent times on a ratio of PE multiples, it has been 38% more expensive than the NAB, so on this count probably not. It is now yielding only 5.0%, which means that it will need to continue to exceed forecasts to sustain its premium pricing. Westpac is a slightly cheaper option, and possibly more attractive on a pure yield basis.

Finally, if you are looking for a reason to consider the most expensive banks, the following chart from Westpac’s profit announcement makes for interesting reading. Over the last 10 years, Westpac’s dividend has grown at a compound annual growth rate of 9.5% compared to its major bank peers of only 5.3%. When you consider that one of these three peers is the Commonwealth (I am guessing it will at least have matched Westpac), it does put into perspective the performance of the ‘A’ banks (Commonwealth and Westpac) compared to the ‘B’ banks (ANZ and NAB).

Dividend CAGR to FY13^2 (%)

 

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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