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)
Thank you for this. I wonder how different the US banks are, given Warren Buffett has just bought heavily into banks.
Hi Elizabeth, you make a good observation. I feel the landscape for US banks and Australian banks differs at the moment. Although the US banks haven't shot the lights out over the last 12 mths the argument is they stand to benefit from rising US interest rates in that they will be able to use the change in rate cycle to increase margins. Given the small Aust. population and smaller deposit pool Aust. banks need to raise funds overseas. As such as rates increase in the US, the cost of funding moves higher and actually places downwards pressure on Aust. bank margins.
Banks write their own interest rates - banks reducing staff - banks closing out branches - banks retreating to major centres - banks disposing of low-performing assets - banks re-orienting to, and developing, new concepts - banks concentrating on high performing ideas - etc etc etc. I can't see why you are writing off banks. Pre-supposing that they will continue generally doing what they are/were doing is short-sighted. They certainly have inherent issues - but consolidating their forces by trimming the crap with which they got involved without any particular planning concepts means that they can come back as different animals. And don't forget that they are very large animals with very large reserves. The big problem is that they did not change too much within a changing world - just grew larger. I'm sure they realise that and ditch the old ideas and systems. There are many examples of new age operations and you could see investment type concepts such as Macquarie and Magellan and Mortgage Choice being implemented - probably sweeping up many of the smaller ones in the process. Apart from which the four pillars are the basis of the Australian financial system - if they droop then Australia is in real trouble.
Thanks Jack. I'm not writing off the banks or pointing to their demise. As with all businesses it is possible to go on operating large and systemically important businesses without the share price necessarily going up. I'm just asserting that the conditions have changed and the likely outcome in my opinion is that it will be more challenging for the banks to thrive as they have in the past. If, and as they evolved into "different animals" our view might well change, but assuming they'll "work it out" because they're big and well resourced is fraught with danger.
Great set of articles Michael, I can see you've got the people thinking.
Banks aren't a bad investment, just not the best, at this point in time. Always look for a sign. For me, about three years ago, it was Genworth, the mortgage lender insurer, who were making greater provisions for bad and doubtful debts - all at a time of record low interest rates! I exited CBA in the mid $80s, and they haven't been there since. This was all before the Royal Commission and the regulated necessity for banks to now start rolling Interest Only loans into P&I reducing.
Thanks for the thoughtful response Michael. All very interesting.