Own the bank not a bank deposit

Roger Montgomery

Montgomery Investment Management

After 37 years of declining interest rates that have fuelled asset price increases but laid waste to lower-risk income streams, it is perhaps surprising that now should be the time to be discussing dividends. But dividends are back in the spotlight, in no small part due to pronouncements by central bankers including the US Federal Reserve’s Jerome Powell and the Reserve Bank of Australia’s Phillip Lowe that low short-term rates are here to stay, perhaps for years.

The search for higher income and yields

The desire to deliver income in a low yield and low growth world is, we believe, driving a surge in corporate merger and acquisition activity. And the buyers aren’t just trade operators but also large pension and superannuation funds looking to enhance income returns to their clients, investors and members.

Evidence of this demand is reflected in mutterings by the NSW Government that they are considering selling the revenue stream from gambling taxes (to also plug the hole left by changes to stamp duty), and in Telstra’s idea to spin off its cell towers.

We recently wrote about this thesis, translating the search for income and higher yields by pension and super funds into the purchase of securities in companies with boring but stable annuity-style income streams. Included in the list of small cap candidates are REITS such as National Storage REIT and retirement and caravan park owner Ingenia Communities Group, as well as companies where we believe reliable annuity income streams are being developed such as Macquarie Telecom and Uniti Group.

Will the banks return higher dividends?

The banks are also back in the spotlight with a meaningful rebound possibly underway in the prospects of higher dividends. Prior to the global pandemic, bank dividends amounted to A$24 billion in 2019, representing almost a third of all of the dividends and franking credits paid by companies listed on the Australian share market.

While vaccination programs are still underway and COVID mutations may yet keep company boards on edge, stronger balance sheets, a recovery in the economy and particularly real estate prices should give the banks leeway to increase their payout ratios.

Any upside from the 0.1 per cent cash rate?

One upside from the decline in cash rates by the RBA to 0.1 per cent at the same time consumers cannot travel overseas, is that they are reassessing the suitability of their homes and borrowing to renovate or upgrade.

The pile of non-performing home loans is defrosting, repayments have recommenced, and home loan credit growth is being fuelled by refinancing and house upgraders and sea and tree changers thanks to technology and the work from home trend COVID spurred. ANZ CEO Shayne Elliott recently noted 92 per cent of customers who had deferred mortgage repayments had returned to repayments.

Changes to lending and borrowing

At the same time, the government’s management of the economy has meant job losses have been less acute than expected and consequently, the number of frozen home loans is thawing. Fewer underperforming loans will also help bank confidence in the future.

A change in posture by legislators and regulators will also favour a more generous dividend payment policy for the banks. Late last year, the Australian Prudential Regulation Authority (APRA) cancelled its previous ruling that prevented banks from paying dividends in excess of fifty per cent of profits. Bank boards now have control of the payout ratio.

And around the same time, the Federal Government indicated it would relax the rules surrounding responsible lending.

These changes are occurring at the same time consumers, having been banned from travelling overseas, and therefore from spending A$42 billion per year there, now have more firepower to spend locally or accumulate savings. Indeed according to the banks, bank customers have been building cash deposits at a record rate despite returns falling to close to zero.

With more of the onus around the risk of borrowing being born by the consumer/borrower, and with consumers flush with cash, the endemic fear of lending hitherto held by the banks is lifting and that means a return to credit growth along with confidence in paying higher dividends.

The shift in confidence should not be underestimated. It was only six or nine months ago that some of the major banks’ economists were predicting economic Armageddon and property price falls of up to a third.

Commonwealth Bank results

Earlier this week, the Commonwealth Bank of Australia announced its half-year results. After delivering a cash net profit that fell 10.8 per cent to $3.9 billion in the six months ended December 31, the bank announced a fully franked $1.50 dividend to be paid on March 30. The dividend exceeded expectations $1.45 a share and while it was 25 per cent down on the first-half dividend last year of $2 per share, this interim dividend was 53 per cent higher than the second half’s 98¢ a share.

As an aside, the bank pointed to the economy returning to good health. It recorded strong growth in residential housing and business lending, along with deposits.

For years bank dividends were sacrosanct and surveys of retiree self-managed superannuation portfolios revealed heavy weightings to the banks. In an environment of plunging yields elsewhere, bank dividends became indispensable. With the threat of the COVID-19 pandemic now dissipating, with bank forecasts for a property calamity turning 180 degrees and with business confidence returning tentatively, bank credit growth should cease slowing at the same time Net Interest margins could cease narrowing. Consequently, we believe bank dividends may once again be the lure that sees bank share prices improve.

And sturdier bank share prices are both, directly and indirectly, good for shareholders. Keep in mind, they make more attractive and less dilutive future capital raisings, improving bank capital management flexibility.

At Montgomery, we don’t expect the banks will immediately return to the payout ratios of old, but the main obstacles to increasing payout ratios have been removed and that makes banks prospects and shares a vastly more attractive proposition compared to term deposits than they were before.

Macquarie Bank’s result

Elsewhere Macquarie Bank, this week, delivered a surprise profit upgrade at its operational briefing, highlighting very strong trading conditions in 3Q21.

While the trading businesses benefitted from market volatility, the bank also highlighted ongoing growth opportunities (infrastructure, commodities, renewables and retail banking) and a focus on Asset Management and Macquarie Capital.

Importantly, management flagged the FY21 result is expected to be only slightly down on FY20’s NPAT of A$2,731 million. If “slightly down” means circa 2.5 per cent below FY20, it implies A$2,660 million for FY21), which is 22 per cent above the previous consensus estimates of circa A$2,180 million. This resulting in big upgrades by analysts for FY21 and FY22 and possibly puts the stock on a PE of less than 18x FY22 estimated NPAT.

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Chief Investment Officer
Montgomery Investment Management

Roger Montgomery founded Montgomery Investment Management, www.montinvest.com in 2010. Roger brings more than two decades of investment, financial market experience and knowledge. Roger also authored the best-selling investment book, Value.able.

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