The Treasurer’s announcement that the major banks and Macquarie will pay a levy on their liabilities was the catalyst for a material sell off in bank shares last week. The tax, which is set to raise $1.5bn pa or just under 5% of total bank profits, will apply from 1 July.

Although the fine details are still being developed, retail deposits and tier 2 capital will be exempt from the tax. Hence, it will impact the banks differently, with Deutsche estimating that it would cause a 5.9% hit to earnings for ANZ, 4.9% for NAB, 3.4% for Macquarie and 3.9% for both CBA and Westpac.

This is the worst-case scenario and assumes that the banks won’t pass the cost on to customers. While they will be under pressure not to do so in the short term and their smaller competitors will act as a competitive break, the likelihood is that over time, customers will end up sharing some of the pain.

Adding to the negativity last week were underwhelming half year and quarterly earnings reports from Westpac and Commonwealth.  As a result, CBA shed 3.23% over the week, Westpac lost 3.81% and ANZ 4.67%.  The fall in ANZ included going ex an 80c dividend, which brought its “real” loss down to 2.05%, while NAB was the “star” losing just 0.58%.

So, with bank reporting season out of the way, and the banks having to deal with a new tax, do bank stocks still represent good value? And, let’s pose that perennial question – which bank?

Banks look close to fully valued

Since I reviewed the banking sector last November (see here), the four major banks have returned on average just over 10%. NAB leads the way with a return of 16.3%, while Westpac is the laggard with 5.0% (see table at the end of this article). Earnings multiples have expanded, with the banks moving from an average of 12.9 times to 13.8 times forecast earnings.

In 2017, the Australian sharemarket market has returned 4.51%. The financials sector (which comprises the major banks, regional banks and the insurers) is still up 2.95%, notwithstanding that it has given up 4.65% so far in May.

Local banks have followed the lead of financial stocks in the USA and Europe, which have risen strongly as the prospect of higher interest rates should allow banks to increase profitability from higher margins. However, local banks are seeing ongoing margin pressure as offshore funding becomes a little more expensive and the RBA keeps interest rates on hold. Further, APRA is making noise about the banks having “unquestionably strong” capital ratios, the Government is imposing a new tax on liabilities, business credit growth remains tepid and the banks are under pressure to restrict investor home lending. Revenue growth is anaemic.

With the four major banks making up 27.4% of the S&P/ASX 200 index, it is hard, but not impossible, for the index to advance through 6000 unless the banks do their share of the heavy lifting. So, given a positive disposition on the market, I don’t think it is time to go materially underweight the banks. However, they have had a good run and there are enough negatives to warrant a more cautious approach: indexweight.

Earnings season

Looking at the bank results, they showed:

• Cash earnings up marginally, but this half largely flat when compared with the second half of 2016. Earnings were boosted by trading and markets income their institutional business;
• The “growth challenge” is best illustrated by the cash profit in their Australian retail banking operations. Apart from the CBA, each of the other three majors saw profit decline by between 1% and 2% in the latest half compared to the preceding six months;
• Bad debt expense remains low by historic standards. Forward indicators are satisfactory, although there has been a slight tick up in housing and personal loans in arrears;
• Risk weighted asset growth is negligible, and in the case of ANZ and NAB, declined in the half year;
• The net interest margin (NIM) remains under pressure. Most banks saw NIM decline in the current half compared to the preceding half;
• Return on equity has dropped – the new norm seems to fit in the 13% to 15% range;
• All Banks have capital ratios in excess of their (current) target range. ANZ, NAB and Westpac each have common equity tier 1 (CET1 ) ratios of 10.0% (prior to the payment of their dividend);
• Expense discipline was strong, with ANZ reducing operating expenses by 1.5% compared to the preceding half, while Westpac kept growth flat; and
• Banks maintained their dividends. Commonwealth Bank increased its dividend by 1c to 199c.

Bank results

* Versus 2H16. NIM excludes treasury & markets

** ANZ is with pro-forma adjustments

Australian Retail Profits

The Brokers

The table below shows each major broker’s recommendation and target price for the four major banks (source: FN Arena).The bank(s) with their highest recommendation is highlighted in yellow. For example, Citi has a neutral on ANZ, but a sell on CBA, NAB and Westpac.

Most banks are trading close to their consensus target price. For example, the consensus target price for Commonwealth Bank is $80.85, which was 1.0% lower than its closing price on Friday of $81.67. On this metric alone, ANZ represents the best value.

Broker Recommendations and Target Prices as at 12 May 17

From this table, it is clear that the major brokers see little difference in value or price potential for the major banks. There is no standout.

The table below shows the consensus broker FY 17 and FY18 forecast earnings multiples and forecast dividend yields. It also shows earnings per share growth between FY18 and FY17. On pricing multiples, the gaps are narrow. CBA is the most expensive, trading at 14.7 times FY17 earnings, while ANZ, having gone ex-dividend, is now the cheapest at 12.7 times (13.1 times adjusted for the dividend).

Forecast Earnings Multiples and Dividend Yields

Two other points to note. Earnings per share growth is very low, with CBA the highest at 3.6% forecast between FY18 and FY17, while virtually no growth is forecast for the NAB. Also, most brokers now see dividends as stable, although a couple of brokers still forecast a small cut to NAB’s dividend.

My view

Last November, I commented:

“In a very tight race, my order is:

1. Commonwealth Bank
2. National Australia
3. Westpac
4. ANZ”

This is largely as it has turned out (see table below), although NAB has been the clear outperformer, and Westpac the laggard.

It remains a very tight race, with almost no difference in strategy between the major banks, only minor differences in pricing metrics, and as the brokers observe, very little difference in growth prospects. Commonwealth Bank, however, does still enjoy a leadership position in technology, market shares in key retail markets, funding base and return on equity. Historically, CBA has traded at a material premium to the other banks, however the gap from it to the cheapest bank, the ANZ, is now down to 16%. Against the NAB, it is into an adjusted 14%.

I expect CBA to retain a premium, and for this reason, continue to rate it as my preferred pick.

ANZ seems to have been harshly punished by the market following its result, possibly because expectations from some analysts were too high. While it is hard to “shrink to greatness”, ANZ is doing the most to cut costs. Its lack of investment in technology during the “Asian years” might ultimately be its undoing, but it is now the cheapest bank. Meanwhile, Westpac is now investing in technology, but with its multi-branding strategy, the benefits may still be some years away. It is also likely to face some challenges with growing its home loan book, as the proportion of interest only loans at 50% is well above APRA’s new cap of 30%.

In a very, very tight race, my order is:

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

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.