Brokers think this ASX bank stock is a screaming buy and I'm inclined to agree

The ASX has the world's most expensive bank stock in Commonwealth Bank (ASX: CBA) and bizarrely it might have one of the cheapest as well. But only if you know where to look. 

Last week, I had lunch with Chris Bayliss, the ebullient chief executive of Judo Bank (ASX: JDO) and the logical conclusion from our laid back chat is he thinks the stock is undervalued. 

Broker Macquarie agrees. It says at $1.47 per share, Judo Bank trades on just 12 times its forecast for earnings per share of 12.1 cents in financial year 2026. 

Macquarie also forecasts Judo to grow earnings per share (EPS) at a compound growth rate of 34% over the next three years. 

So you don't need to be Warren Buffett to see you could make spectacular money on this stock if Macquarie is correct. Below, we'll look at the investment case and downside risks. 

What does Judo Bank do?

Unlike its big-four rivals, Judo focuses almost exclusively on lending to small-to-medium-sized (SMEs) businesses, rather than the home loans that are the core business of CBA, National Australia Bank, Westpac, and ANZ. 

At the lunch, Bayliss said a typical loan offered to a business borrower would be at a rate 4% above the 30-day bank bill swap rate (BBSW), which currently sits at 3.7%, just below the cash rate of 3.85%. 

So at Judo, a typical borrower would pay 7.7% interest on any loan, although Bayliss said a loan's rate could vary between 2% and 7% over BBSW, depending on factors like collateral such as equipment or property a borrower can put up in return. 

Home loans typically attract lower rates as the collateral is the home itself and if the bank needs to call in the debt, it's secured against the property. 

This means business lending is generally riskier, but potentially higher return. 

This logic also explains Judo's guidance for a net interest margin (NIM) between 2.9% and 3% over the second half of financial 2025. This is far higher than the NIMs of the big four including for example CBA's at 2.08% for the six months ending December 31 2024.

For the uninitiated, the NIM shows the difference between what the bank earns on what it lends, versus what is pays on what it borrows in term deposits and wholesale funding sources. 

So the high NIM is a positive for Judo investors, as it shows it can make more profit on invested capital in the form of loans as assets and also boosts its return on equity. 

However, it's important to note the NIM is reported before adjusting for bad and doubtful debts (BDDs) to mean it's a gross metric. 

Banks generally don't report NIM's net of BDDs, but smart investors should adjust for this as it's no use having a huge NIM if it's because you've mis-priced risk and are accumulating too many loan impairments. 

Loan loss rates can be calculated in different ways, but Judo disclosed an impairment expense of 51 basis points, or $28.8 million, as a percentage of gross loan assets for the first half of FY2025. By comparison, CBA's was just 7 basis points or $320 million of impairments, which reflects that it's taking less risk in the humdrum home loan market. 

The BDDs may also go some way to explaining why the market values Judo Bank cheaply, versus its peers. 

Bayliss argued this cheaper valuation is likely to reverse as the bank grows in what could prove a twin tailwind of earnings growth and multiple expansion. 

In particular, he suggested the bank could trade on a sporty price to book multiple of 2.5 to 3 times as analysts adjust their discount rates and its return on equity climbs. This compares to a price book of 0.9 times today. 

Judo is also growing its loan book quickly and assuming its bankers can price risk correctly, it seems a decent bet it can grow profits quickly at the same time as its valuation expands.

Downside risks 

In terms of downside risks to buying shares, you should understand how banks like Judo are basically in the business of maturity and risk transformation. 

Maturity transformation exists as short-term deposits are transformed into long-term loans and risk transformation exists as the deposit is risk-free, but the loan is subject to serious risk. 

Another general principle of risk in banking is that if you diversify lending across a large number of loans or sectors, the risks are uncorrelated, so if one loan turns bad it's not under circumstances where too many others do. 

This means the profits from most loans can easily offset the cost of the bad loans and Judo has a range of borrowers in agriculture, retail, healthcare and industrial services, among others. 

However, as a word of caution, this principle works well in text book theory but in practice history shows a general downturn, such as a horror recession, tends to drag down all businesses together. 

As banks, including Judo, fund themselves with term deposits, even minor concerns about the value of their assets can undermine confidence and potentially put those deposits at risk.

To be clear, I'm not suggesting this is a likely outcome for Judo Bank. It's more to explain the risk in banking generally and how it can quickly go wrong. 

Take for example, the run on deposits that occurred at Silicon Valley Bank (SVB) in March 2023, which came about as it flagged huge losses in its asset base of bonds. 

In terms of human psychology, runs on banks or investment funds also occur as people decide it's irrational to leave money at a bank simply because they believe others think this way.

This fuels the run even if the bank's asset base is relatively sound and this phenomenon occurred during the GFC and across US regional banks in 2023. 

At the lunch, Bayliss even said that the collapse of SVB saw a surge in demand for deposits at Judo up to the government guaranteed limit of $250,000. This was because depositors were spooked into not having more than the guaranteed $250,000 at any one bank. 

Note that the deposit insurance offered by the government is a subsidy for banks and incentive for risk taking. It's also another example of risk transformation as the risk is not eliminated, it's just transferred to the tax payer. 

If things go south, the legal system of limited liability incorporation also means a bank is only on the hook for the loss in shareholders' equity, rather than all the losses owed to creditors as well. 

This is good for bankers' risk appetite and since the GFC bailouts in response to the banking crisis the system has been flooded with liquidity. We saw this in the US with the Bank Term Funding Programme (BTFP) from the US Fed in response to its regional bank's problems. 

I'm not suggesting Judo Bank runs into problems, but it would be foolish to assume it gets bailed out in the event of a downturn. It's also possible it runs into trouble even though the banks must keep significant capital in reserve to make sure they're "unquestionably strong".

So, I'd keep keep an eye on its loan book and consider that investors may flee the stock if Australia's feeble gross domestic product growth for the March quarter is a harbinger of bigger problems ahead. 

Bull case

Now we have those caveats out the way, it's also not hard to make the bull case for this stock. 

Judo Bank is playing in a profitable market with limited competition and is growing its loan book quickly.

Bayliss also argued that the advantage of being a start-up type bank is that it can hire or hand-pick the best bankers and staff. He hinted that older banks have a lot of staff that are passengers in management and this isn't his vision for Judo as it's bad for culture. 

The nimbleness also means it can move faster in providing credit to businesses and offer a more personalised service, which explains its strong growth rates.  

Fierce competition for the deposits it needs to fund itself is also easing, according to Bayliss. It should be noted deposits are a key funding source for his bank and this is positive as the higher the rates it has to pay savers, the more profitability erodes.  

Another interesting takeaway is that the CEO also basically acknowledged that the term deposit market is competitive as anyone can quickly compare rates online and work out the best deal for them. 

That's why a lesser-known bank like Judo needs to offer the best rates to attract depositors. These higher costs are also what has generally hurt the stock and made the market cautious.

Non-legacy advantages

More generally, the banker also pitched the start-up bank as "non-legacy" in that it can operate on a lower cost base as it has no legacy products, sales culture, technology, compliance or staffing problems to deal with. 

By comparison, three of Australia's other big lenders in Westpac, NAB and ANZ Bank arguably haven't invested enough in digital user experiences to engage and attract customers, with CBA streets ahead. 

Broker views

Apart from Macquarie, other brokers are also positive. Jarden's banking team for example values the stock at $2.40, versus Tuesday's price of $1.52. 

The broker has pencilled in EPS as high as 17 cents per share in 2027, which would be nearly two-and-a-half times the 7 cents per share expected for the 12 months to June 30. 

UBS rates the stock a buy with a $2.20 price target and labels it a "high growth bank offering sizeable upside." The analysts led by John Storey reckon Judo can grow EPS at a three-year compound growth rate of 30%. 

Finally, you'll often hear fund managers and analysts go on about how important "good management" is to them as investors, and my impression of Bayliss was very positive. 

As such I'm inclined to agree with the investment community and rate this ASX bank stock a buy on valuation and outlook grounds, just be cognisant of the risks. 

Please also note, it's possible my view of the bank is rose tinted by the lunch, so this is not advice and everyone must take responsibility for their own investment decisions. 

If you have a view on Judo Bank or banks generally please leave a comment below. Good luck.