NAB moves to my No.1 bank recommendation

Chief Investment Officer and founder of Aitken Investment Management
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It doesn’t get much coverage but one of the clearest themes in the last three months has been a rotation from momentum stocks to multi-year laggards. The dogs are certainly barking and the pretty girls are looking a little tired.

The scenario

What I suspect is happening is the 130/30 funds and long/short equity funds have been crystallising multi-year large gains in pairs trades that favoured “good” stocks over “bad” stocks. The hedge funds and 130/30 funds short bad stocks to fund further investment in good stocks, but what happened is the valuation and performance spread between the good and bad simply got too wide and is now narrowing, as the bad deliver less incrementally bad news (if any) and the good struggle to justify their premium valuations. Similarly, merger and acquisitions aimed at multi-year laggards (as it always is), has played a role in making shorts/underweights nervous.

I have been warning for months that momentum stocks were losing momentum. The vulnerable MO list I published three months ago has handsomely underperformed the broader market and handsomely underperformed a basket of multi-year laggards.

My view is this will continue and the outperformance of multi-year laggards like AMP, Aristocrat Leisure, Qantas, Sims Metal, CSR, Echo, Fairfax, Incitec Pivot, Primary Health Care, Whitehaven Coal, Western Areas, Alumina, Iluka, JB Hi-Fi, Leightons, Lend Lease, Treasury Wines, Tatts Group etc. will broaden as all investors start focusing on relative value and recovery EPS/DPS growth.

Of course, QBE’s 987th profit warning this week will bring out the doubters of my dogs’ strategy, but that is very QBE specific and QBE was NOT part of our recovery list. I dumped enough money last year backing that thing and learned my lesson. Our recovery insurance bets remain AMP, IAG and Suncorp.

In the ASX top 20, there are very few stocks that you could truly describe as “multi-year laggards” that offer solid absolute and relative value. AMP is one, and NAB is another.

The best bank

Today I want to look at NAB because despite being neutral the banking sector, I think NAB is now the number one pick in the sector for potential total returns and relative sector outperformance.

Believe it or not, NAB now stacks up on all forward investment arithmetic better than its peers. I realise it sounds like an oxymoron, but NAB has every chance of being the best performing bank over the next 12 months, delivering the strongest relative and absolute total returns.

While the Australian banking sector has done extremely well since the peak of the GFC lows, not all bank share prices have been equal, despite the cozy domestic oligopoly. Pure domestic plays CBA and Westpac have dramatically outperformed the “diluted” domestic plays in NAB and ANZ. The chart below graphs ANZ (Blue), CBA (Red), Westpac (Brown) and NAB (Green) on a common share price performance base (not including dividends) over the last five years.

What happens from here is NAB plays relative and absolute catch up to its peers as the UK noose around its neck lessens.

This is a situation NOT to overcomplicate. NAB’s PE and price to book discount to its peers will narrow as the market becomes more accepting that its exit from problem UK commercial real estate loans is a reality. Even if this occurs by NAB shares standing still and its peers falling, I can only see scenarios where NAB is the sector outperformer from this point.

NAB is currently trading on the lowest FY15 P/E and P/B ratio in the sector, yet offers the highest EPS growth in the sector, highest dividend yield and highest ROE growth. What needs to be emphasised is, as NAB exits the UK problem loan book, capital is released and ROE improves. I strongly believe that ROE and price to book ratios are linked in the bank sector. That makes fundamental sense, and as NAB’s ROE improves on UK problem loan exposure reductions, you will see PB and PE expansion, both relative and absolute.

The Suncorp playbook

If you made any money backing my view on Suncorp Group (SUN) as problem loans were exited, you should listen to me on NAB. The playbook is the same as SUN and also the same as UK examples RBS and Lloyds. In simple terms, investors pay a higher multiple for reduced risk. That is how it works in financials, both globally and locally.

The other attraction of NAB is a change of CEO just as the problems in the UK are becoming less of an issue. Incoming CEO Andrew Thorburn will have far less distraction from the UK than Cameron Clyne had to deal with and Thorburn will be able to focus his attention on the high ROE domestic business. This will be good for NAB shareholders.

On the topic of Thorburn, I recently had lunch with a former Australian bank CEO (a very successful and well regarded one), who thought Thorburn would be fantastic for NAB. Thorburn had once worked for this person and he said he was a first class operator. It was high praise from someone very well placed to make the observation.

In my view, NAB shares potentially offer a +13.4% total return over the next 12 months, comprised of a +7.2% capital gain (ROE, PB driven) and 6.2% fully franked yield. The investment metrics are below and I encourage you to focus on the FY15 forecasts.

Move to overweight

NAB represents 5.96% of the ASX200 and is easy to overweight relatively inside a balanced portfolio. Unlike CBA, you don’t need 10% of your capital in it to be market weight.

NAB, to my way of thinking, should be overweighted by relative investors and a clear long for long/short or 130/30 funds versus an underweight in one of the higher rated domestic banks. I suspect the funding vehicle should be Westpac for people who need a funding vehicle. I must stress the reaffirmation of a positive view on NAB doesn’t mean I want to commit more capital to the Australian bank sector. Quite the opposite: I think anyone who increases their NAB exposure should fund it by selling another bank.

The main point is “NAB is running off UK CRE (commercial real estate) loans at a faster rate than forecast”. That’s the crux of the matter and the basis for my NAB investment thesis.

NAB moves to my number one relative and absolute recommendation in the Australian banking sector. The sector weighting remains neutral/hold.

Go Australia, Charlie

100% of Charlie Aitken’s fees for writing for the Switzer Super Report are donated to The Sydney Children’s Hospital Foundation.

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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