Golden age of banking is over: A response to feedback
In the last couple of days, I have received a number of responses from clients and readers regarding our article ‘The golden age of banking is over’. Given the connection some investors have with banks shares this was to be expected and I’ll take some time in an attempt to address some of the valid points being raised.
Firstly, I'm not suggesting banks shareholders should go out today and sell all their bank holdings. It's never a case of being all in, or all out. Banks could indeed rally from here, but we feel it is going to be difficult for bank share prices to perform as many have become used to with a number of headwinds, and business models now changing to more closely resemble building societies.
We acknowledge that long-term investors have tax implications to consider and should therefore speak to their adviser about those implications. Instead, my general advice and suggestion would be that now is a good time to think about portfolio exposure and weighting towards the banks, and review what their expectations are from those positions.
Long term, with the exception of the NAB, the banks have delivered sustained capital and income growth. Over the very long term some would argue that one can expect banks to continue to grow simply because of GDP growth and population growth. But I'd caution against assuming bank share prices will only increase over time. You only have to look abroad at European banks, or US banks, for evidence that is simply not the case. The question is: will the rate of growth over the long term remain at a consistently high rate? And we don't think so.
People have alluded to the fact that the banks have consistently provided dividends and are drawn to those sustainable dividends. Dividends per share is ultimately a function of earnings. Over the last 30 years earnings have grown rapidly enabling dividends p/sh to increase rapidly as well. We are now at a point where the earnings aren't growing as quickly, therefore dividends haven't been growing as quickly either. I don't foresee bank dividends being cut in the near future, but it’s certainly a possibility (for some of the banks more than others) in the coming years if the recent trends in bank balance sheets continue and bad debts increase off a low base.
Also, worth pointing out is that the business models have changed. During the 90's and 00's banks vertically integrated and moved into higher ROE businesses. Generally speaking, the media now views this as a bad thing, but at the time the economics and risk of those decisions made sense and the banks profited immensely from many of those decisions. Given the evolving business models and greater profitability (and higher ROE) the market rewarded the Australian banks by re-rating them higher to trade on some of the highest P/E's in the world for banks.
Due to the royal commission and APRA’s higher capital requirements, among other things, the times have now changed. Banks are now returning to their roots which are inherently less risky but lower returning businesses. Therefore, Australian banks should arguably loose some of their P/E premium and trade on multiples closer to their global peers.
Other questions raised related to bank return on equity (ROE) and its impact on dividends and share price. In short dividend growth rates and ROE are linked. In simplistic terms dividend growth can be estimated as follows:
DivG = ROE x Payout Ratio
In recent years some of the banks have been maintaining dividends essentially by increasing payout ratios to offset the falls in ROE. Naturally management can’t keep raising payout ratios indefinitely and at some stage will need ROE to stabilise or rise to support dividends p/sh.
There is also a relationship between ROE and share price. ROE is an indication of business profitability and capital efficiency. Definitions suggest that a company cannot grow earnings faster than ROE, without raising additional debt or capital. Therefore, a lower ROE constrains earnings growth, arguably placing downward pressures on share prices, sentiment aside.
Other questions from readers and clients have centred on bank dividends and the need for income. For those income-focused investors there are diversified alternatives such some LIC's with lower price volatility then bank shares, and growing dividends that have a yield equal to, if not higher than the banks. These don’t have to be used exclusively in place of bank shares, but can certainly be used in conjunction with bank holdings.
You can read my original article here: (VIEW LINK)
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Michael is Managing Director of Medallion Financial Group with a number of years experience in financial markets, specialising in financial strategies and investment management.