Beyond the Royal Commission headlines

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Financial services have been making headlines for all the wrong reasons in recent weeks. Following Rowena “Shock and” Orr’s public shellacking of the wealth management industry, AMP Limited has since lost almost its entire board of directors, as well as a big part of the executive team. The banks were sold off in the immediate wake, and while they have recovered some ground already, they remain steeply discounted relative to levels seen in 2015. But changes this large inevitably throw up opportunities, so we asked four distinctly different fund managers for their view on the issue.

The contributors:

  • Todd Guyot, Portfolio Manager at the Regal Australian Small Companies Fund, gives the small caps perspective
  • David Poppenbeek, Chief Investment Officer at K2 Asset Management, gives the large caps perspective
  • Christopher Joye, Co-Chief Investment Officer at Coolabah Capital Management, gives the debt and hybrids perspective, and 
  • Jason Teh , Chief Investment Officer at Vertium Asset Management, gives the income investor's perspective. 

The questions:

  1. How do you expect the Royal Commission to affect the banks in the long term?
  2. How material is the impact?
  3. Is there value emerging in any of the banks?
  4. Do you have a preferred exposure?

The Royal Commission changes everything

Australia’s banks have had it easy for the past 25 years, but that’s all changing, according to Todd Guyot, Portfolio Manager at the Regal Australian Small Companies Fund

“There's no question that the landscape for financial services has changed.”

One of the biggest shifts occurring is in the wealth management sector, which has traditionally been dominated by the vertically integrated operations of the big four banks and AMP. But the big players’ gains could benefit smaller players in this industry.

Regional banks set to challenge the majors

David Poppenbeek, Chief Investment Officer, K2 Asset Management

The Financial Services Royal Commission has undergone two rounds of public hearings and it’s clear that good corporate governance and culture within the industry has not been of the highest standard. Unfortunately, Australia’s four largest banks have been consistently sighted for improper conduct.

As a result, we believe that the major banks will be subjected to ongoing bureaucratic overlays as laws and policy settings are again re-adjusted. Prospective returns from the major banks will taper over the long term. Board members and executive management teams of the major banks will be under heavy scrutiny and will most likely have less capacity to embrace risk.

We feel that regional banks will be afforded more latitude to compete directly with the majors. The amount of capital to support low-risk housing loans should converge in favour of regional banks, thus allowing them to selectively grow into attractive markets. Ultimately, we feel that Australia’s major banks will have far less leverage to economic activity over the coming years.

No major impact for the big four

Operationally, the banks will be impacted by the Royal Commission, however, we do not believe it will be material. The banks have already participated in more than 50 inquiries, reviews and investigations since the GFC.

Last year the major banks were also subjected to a $6 billion levy. In response, the major banks have already selectively sold, or plan to divest, non-banking product and advice operations. Hence, we believe that the major banks are suitably conditioned for an adverse interim report from the Royal Commission which is due later this year.

We believe that Australian banks will continue to reduce the complexity of their operations. We anticipate that deposit funding will be prioritised, experienced borrowers will continue to be favoured, productivity solutions will be sought, and loan arrears will be actively recovered. All up we believe that banking ROE’s will gravitate between 12% and 13% for several years and dividend growth will be capped at 5%pa.

Value is gradually emerging in the banks

Since the major bank levy was announced this time last year the banks have underperformed the ASX 200 by more than 15%. The average PE of the major banks is now below 12x next year’s EPS and is at a 25% discount to the ASX 200. Importantly, the major banks are offering investors a dividend yield of more than 6% based on next year’s DPS. We are confident that this level of DPS can be viewed as a base and income will subsequently grow by about 4% p.a. over the medium term. As a result, we believe that investors can increasingly transition from being a customer of the major banks to becoming an owner.

We are more optimistic about the investment opportunities amongst the regional banks. The regional banks are trading on similar PE’s to the majors but offer superior dividend yields. This is despite the current regulatory framework that forces the regional banks to carry 50% more capital per residential mortgage than their major bank peers. We believe that the Royal Commission is demonstrating that this uncompetitive burden is unjustified.

Our preferred exposures

For the past five years, the K2 Australian Fund has been underweight the major banks.

We remain underweight; however, we have recently added Westpac to our top 10 positions. Westpac has a dominant share in all its business lines and has continued to invest actively in sustaining these market positions. Westpac currently trades on a PE that is in-line with its global peers, despite generating an ROE that is nearly 200 basis points higher. Westpac’s dividend yield is pushing 7% and we believe that these dividends can grow from here.

We have also recently added to our Bank of Queensland (BOQ) position. The Queensland economy has been subjected to a number of adverse events since 2010. Natural disasters and a sharp contraction in commodity prices had a meaningful impact on economic activity and led to BOQ delivering zero income growth. Queensland is now well positioned for better economic fortunes; population growth is recovering, commodity prices are rising, and the unemployment rate is falling. BOQ’s revenue opportunities are looking more prospective and we believe there are also meaningful cost savings available. BOQ is attractively priced at 11.2x next year’s earnings and offers a dividend yield of 7.4%.

What’s bad for equity is good for debt & hybrids

Christopher Joye, Co-Chief Investment Officer & Portfolio Manager, Coolabah Capital Investments

Our position on this has been consistent from the outset: the RC is bad for bank equity and positive for bank credit sitting higher up the capital structure. You will get materially more risk-averse and narrowly focussed banks with significantly less growth potential. Combined with ongoing deleveraging, this will cut revenue growth and shareholder returns.

The flip-side is that these much more conservative institutions will have materially lower risks and probabilities of loss. You are, therefore, seeing a direct transfer of wealth from equity to debt, which is long overdue (returns on equity were too high for too long).

Before the RC these were some of the best capitalised and strongest banks in the world, but they were too complex. From a creditor perspective they will be materially stronger as they sell-off non-core businesses and focus on their essential savings and loan activities buttressed by even more robust credit standards. 

The impact will be material

Since 2013, we have argued that the major banks' 16%-18% returns on equity were way too high and an artefact of excessive, circa 25 times leverage. We forecast substantial deleveraging and reduction in returns on equity towards their 11% cost of equity. This meant that the major banks’ valuation premiums to their book values, which in 2015 were 2 to 3 times, had to fall, in our view, to 1.0 to 1.5 times.

Since that time the major banks have raised more than $50 billion in tier one equity capital and reduced leverage to sub 19 times. ROEs have also fallen to 12-14% and they now trade at 1.5 to 2.0 times book value.

These reduced risks should in turn lower the cost of the debt and hybrid capital, although this has yet to materialise as the RC noise creates some confusion in capital markets.

Where the value lies

Our view is that when the big banks are trading at 1 to 1.5 times book value, there might be value in the equity part of the capital structure.

If we move up the stack, we have fair value for 5-year major bank hybrids at about 250 basis points above the bank bill swap rate compared to current ASX spreads of around 370 basis points using bottom-up valuation models. This is above 130 basis points wider than where these securities traded in mid-2014 when the banks were carrying 20-30% less equity capital. So, hybrids are cheap.

In contrast, our analysis suggests the majors’ tier 2 subordinated bonds are expensive at circa 158 basis points at the 5-year tenor, given they have similar non-viability risks to hybrids.

Higher up we find the major banks’ senior bonds, which are trading at 90 basis points above bank bills, cheap relative to our bottom-up fair value estimates at around 50-60 basis points and the post-GFC tights at circa 60 basis points.

Our preferred exposures

Since 2013, we have argued that investors should sell major bank equity and buy their debt, although the precise parts of the capital structure that appeal on a quantitative basis vary from time to time.

In 2014, major bank 5-year hybrids were only paying 240 basis points above bank bills, which is why we avoided the sector. In 2015 and early 2016, the major banks’ hybrids, subordinated bonds and senior bonds all became extremely cheap, which is when we loaded up. In 2017, subordinated bonds got too expensive, and we exited that sector. But there have been ongoing opportunities in the senior bonds and hybrids.

Excluding franking credits, the circa 4.5-5.0% cash yield you can get on major bank hybrids is better than the dividend yield on the ASX200 index (as is the 6%-7% franked yield), yet since 2003 the ASX hybrid sector has carried about 1/3 the volatility of the ASX 200 Index. They also suffered about half the losses the equity market incurred during the GFC. So, we think moving up the capital structure in senior bonds and hybrids makes sense right now, while avoiding the subordinated bonds unless they happen to trade cheap, which they can do on the ASX.

Credit growth set to slow down

Jason Teh, Chief Investment Officer, Vertium Asset Management

The Royal Commission has introduced several known unknowns into the banking industry. The key long-term issue coming out from the Royal Commission affecting the banks is responsible lending. Going forward, stricter compliance standards imposed by the banks will make it harder for households to borrow money. This in turn will constrain credit growth, which has been the key driver of bank profits over the last few decades.

Another important issue revolves around the death of the ‘bancassurance’ model in Australia. While not as material to profits as household lending, wealth management has come under the microscope at the Royal Commission.

The two areas to watch

It is too early to work out the exact profit impact on banks but there will be two effects. First, there would be higher compliance costs associated with stricter lending standards. Second, household lending growth is likely to be slower.

How much slower? That’s hard to determine, but one could assume that the days of high single digit housing credit growth are likely over.

The banks appear to have anticipated some of the potential impact of the Royal Commission. Anecdotally, banks have begun to tighten lending standards for housing loans. And in recent months some banks have been scrambling to divest parts of their wealth management divisions. While sale proceeds might strengthen their balance sheets, it will also create an earnings hole in an industry where meaningful growth will be hard to come by over the medium term.

Relative value beginning to emerge

The current momentum driven market has sold off any stock with negative news whether its due to regulatory pressures or operational issues. And banks certainly fit into this basket of negative news. Hence, there is some value emerging relative to an expensive market.

However, banks should never be valued like they were five years ago. Back then, banks had higher ROEs and faster profit growth. Going forward, banks will have lower ROEs and slower profit growth. This means that they should trade on lower multiples than was historically the case.

However, there is an upside to slower lending growth. It means that there is less need to redeploy retained earnings in the business. Hence, the banks are likely to build up excess capital over time which will be returned to shareholders.

Our preferred exposure (and one to avoid)

Our preferred exposure is ANZ Bank because of its enviable excess capital position. The bank has $6 billion excess capital which represents about 7% of its market capitalisation. Excess capital helps protect the business from uncertainties in the banking world.

ANZ has begun to return the excess capital back to shareholders. Over the long term we expect its ROE to improve and become closer to its peers as it focusses more on its domestic operations. When ANZ’s ROE improves the valuation of the bank should also rise.

On the flipside, we are avoiding National Australia Bank because of its tight capital position. We believe its high dividend is not sustainable and is likely to be cut over the next couple of years as it scrambles to meet APRAs ‘unquestionably strong’ benchmark by 2020. More importantly, it is the most expensive bank relative to the quality of its business.

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