Australian banks are not what they used to be

Chief Investment Officer and founder of Aitken Investment Management
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The Reserve Bank of Australia (RBA) board’s decision to hold cash rates on Tuesday is a ‘triple-edged’ sword.

Firstly, it will ensure the Australian dollar moves to record highs versus every major currency over the next few months. Secondly, it ensures domestic manufacturing, domestic discretionary retail, industrial export industries, inbound tourism and education remain under the pump.

Yet, the one positive is the RBA is clearly seeing tangible signs that the world is getting better, not worse. Another resilient performance by global markets and risk assets early this week suggests they are on the right track. The Aussie dollar Trade Weighted Index (TWI), which is up at 78.8, is about to break to a new high in my opinion.

So the world is getting better as we have been saying and the currency is going to stay high as we have been saying, yet many Australian domestic industries remain under heavy structural pressure from the currency.

Why our market is underperforming

Today I want to explore where I think the domestic banks fit into all this, remembering they are “bankers to the domestic industrial economy”.

The key feature of 2012 for me is the underperformance of Australian banks; the key reason the ASX 200 continues to underperform global equity indices is the heavy weighting of the big four banks (25%).

Even on Monday, trading updates from National Australia Bank (NAB) and Macquarie Bank (MQG) saw both stocks underperform. While Macquarie’s weak trading update should have come as no surprise to anyone who works in financial markets, I have to say the sanguine NAB trading update was disappointing because it lead to small consensus earnings per share (EPS) downgrades again.

The problem is that every time a major Australian bank speaks, we tend to lower our EPS forecasts fractionally, which is important because our EPS growth forecasts are modest already. The more we chip away at our growth forecasts, the more ‘utility-like’ the bank sector looks.

The underlying problem remains a broad lack of credit growth in Australia. Australian households continue to deleverage, with the household savings rate remaining at a generational high. This savings rate, despite last years’ interest rate cuts, is negatively affecting discretionary retail sales (excluding Western Australia).

No near-term earnings growth

While the major Australian banks offer compelling grossed-up dividend yields versus term deposits and fixed-interest alternatives, the problem is they don’t offer any near-term earnings growth. Don’t get me wrong, the yield is attractive in itself, but at a strategy-writing level, I like to see growth plus a sustainable yield.

To prove markets are efficient, Australian banks have already been de-rated to utility multiples. They are being rated simply as growthless reliable dividend streams in a world of low demand for new credit.

There is a very big difference in the way Australian banks were rated before the global financial crisis (GFC) and how they are rated today. This change has been driven by reduced leverage, reduced demand for credit, higher capital requirements and therefore lower return on equity (ROE). Price to earnings ratios (P/Es) were once triple dividend yields, but now yields and P/Es are converging. When the dividend yield and P/E are the same, you are a growthless utility in the market’s view.

Comparison of the Big Four pre-GFC and in 2011

Over this period, the XXJ, which is the ASX200 Financials Index (ex-property trusts), basically halved then traded sideways for four years. The Big Four banks and Macquarie represent over 70% of this index, so it’s the closest we have to a major Australian bank sub-index.

One of the other issues with bank equity at the moment is that the banks themselves are issuing more and more term funding products that are taking demand away from their own equity. This will be an ongoing issue as the major banks line up to issue covered bonds to the yield-hungry SMSFs of Australia.

To me, this reduces the traditional retail demand for high-yield bank equity, which is another reason this de-rating to utility like multiples may prove structural.

Telstra is the new black

What seems clear to me is that Telstra (TLS) has become the high-yield plus growth stock of choice for retail investors. Comparing Telstra and the XXJ Index suggests to me that Telstra is about to break out into a new higher relative outperformance range after already strongly outperforming. The catalyst would be the NBN deal being finalised.

The point I’m getting to is that I’m truly wondering whether Australian banks will EVER be the investment they once were. I know that’s a big statement, and I don’t want anyone to think that I believe Australian banks are a bad investment, I just struggle to see how in the global and local credit and capital conditions (and regulation) they can ever deliver pre-GFC-style total shareholder returns again.

I’m very happy to collect bank dividends, but I’m starting to think expecting strong capital gains on top of those dividend yields is delusional in the world we operate in today. This may well be the classic sector where historic share price performance is NOT a guide to future performance. It is worth all of us considering whether Australian banks are not ‘cheap versus historic valuations’, but more accurately ‘appropriately priced as utilities’. I tend to favour the latter and feel much, much stronger total returns will be available in other global facing sectors in 2012 as has been the case so far.

Anyhow, just thinking aloud today, mostly about the Australian banks. Their best years as a total return investment are most likely behind them.

Important information: 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. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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