No doubt, global and domestic equity markets remain volatile. A nice relief rally on the back of Greece can being kicked down the road again, followed by another pullback driven by US quarterly earnings disappointment.
As I look around global markets for contrarian value, there are two sectors I think look good value and have bottomed. I hope you’re sitting down: China H shares and Australian banks.
In a world where value is hard to find and many, many stocks are priced for perfection, I think the deep correction in China H shares and Australian banks is offering a clear contrarian medium-term value opportunity now that the trading knife has stuck.
My fund has started building positions in both China H shares and selected Australian banks, feeling both offer the right risk adjusted value proposition right now. Of course, these sectors won’t be without short-term volatility, but we think the very worst of that volatility is behind us in both these sectors.
Today I want to focus on the Australian banks because I suspect they are near and dear to all Switzer Super Report subscribers’ hearts.
With the big four banks dominating the ASX200 index, they do attract a disproportional amount of broker and financial press commentary. Fair enough, so go the banks so goes the ASX.
This week there was a regulatory development that was genuinely “non-negative” for the Australian banking sector. In fact I believe it was a classic “short-cover the fact” or “buy the fact” event and that is exactly what I did in my fund.
No doubt the key reason for the -20% Australian bank correction was regulatory risk. Markets hate uncertainty and the “certainty” on regulatory capital this week confirmed by APRA was in my view the end of “uncertainty” for the sector. The fact the outcome was “less worse” than every analyst had forecast was an added bonus.
I think it’s important I explain exactly what did happen this week.
The Australian Prudential Regulatory Authority (APRA), the bank regulator, confirmed an increase in the capital requirements only for residential mortgages under the IRB approach. However, APRA’s announcement of a 25% mortgage risk weight was below analyst expectations of 30% and at the low end of the range recommended by the Financial Services Inquiry (FSI) of 25% to 30%. The outcome appears in line with the Basel Committee’s current thinking on global capital adequacy.
The higher risk weight will apply to all residential mortgages other than SME lending secured by a residential mortgage and will come into effect on July 1 2016 to ensure an orderly transition.
The good news for bank shareholders is that, in my opinion, bank share prices were already discounting the 30% increase scenario. That was consensus and fears about capital raisings were weighing on bank share prices. My view remains that Australian banks will not need to raise external capital but will simply fund the extra capital requirements via dividend reinvestment plans (DRP).
NAB post their recent capital raising should NOT require any DRP. We feel ANZ will need just one underwritten DRP to raise $2b (give or take Esanda sale receipts), while WBC recently raised $2b and will most likely raise another $2b via DRP. CBA will confirm at its August result its intentions but again we feel an underwritten DRP (or maximum 2) will see it raise $4b. All in all, it’s a very manageable position for the banks to handle in the medium-term.
For Australian investors who can value franking credits, I believe grossed up yields above 8.00% more than compensate you for taking the risk of owning bank equity. Cash rates are certainly not going up in Australia, in fact I forecast further cuts, which would make these bank dividend yields even more attractive relatively and absolutely.
Below is a summary of current major and regional bank investment arithmetic.
Click here for larger image
FY16 price to book ratios and dividend yields appear attractive to me and the greatest share price upside lies in ANZ and NAB in my opinion.
Not many people have noticed, or perhaps they have, but industry leader CBA has bounced $7.00 (+9%) off recent capitulation lows. CBA will pay their final dividend in August, while the other three banks will pay dividends in October/November.
Personally I think the chart below tells you that ANZ and NAB will now start playing performance catch up to CBA.
The last few months have been a tough ride for Australian banks and Australian bank shareholders. My view is now the worst of that is over and it’s time to pick up the vibrating knife, which has stuck in the value and yield support floor.
My final point is the hedge fund community has been short the major Australian banks and the Australian dollar. For the first time in many, many years that short Australian bank trade worked in Australian dollar terms. I believe that this successful short has now run its course in Australian banks and I expect to see some short-covering over the next few weeks as it becomes a more consensus view that the worst is over for the sector due to regulatory certainty arriving.
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