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Banks – Yield and safety outweighs overvaluation

It is nigh on impossible to mention a bank stock these days without being distracted by the dividend yield story, as good as it is. But ANZ’s interim result this week showed revenue growth is being stymied by weak demand for credit leaving cost cutting and efficiency focus as the main means by which the bank delivered an 8% increase in cash profit for the half year. The bank sector is facing similar dynamics.

The dilemma for the market generally is the increasingly stretched valuation metrics (Price to book values now well above 2x for the bank sector) versus the weight of money chasing the apparently low risk but extremely generous dividend yields on offer in the sector.

We are now in a situation where fundamental valuations are imploring investors to sell the banks (or at least not buy more) but the relentless pursuit of income is overriding the warning signs.

Yield compression (where higher share prices mean lower dividend yields) has driven the bank sector to a net yield of around 5.0% with just NAB remaining a slight laggard.

Investors should be questioning the sustainability of higher dividend payouts amidst the current low earnings growth environment but do not appear fazed by the potential squeeze.

Instead, bank shareholders are looking at the broad range of factors that say these stocks are relatively safe investments, including:

  • the excellent capital ratios
  • the very high credit ratings
  • the already low and declining impairment expenses
  • the high level of exposure to a housing market that itself is not highly geared
  • the high level of customer funding
  • the high level of barriers to entry in the market giving strong pricing power

The contrary argument about what is not a safe investment is also at play. In this sense, many investors are shunning resource companies as demand for commodities eases and price volatility raises the risk profile. Factors contributing to this scenario include:

  • Data from China is signalling a softening in its rate of economic growth
  • Progress of recovery in the US remains tepid
  • Europe remains an economic basket case in peripheral countries
  • Rising development costs and the high A$ are delaying new projects and hurting existing expansions

This theme continues to dominate the Australian market as it has done for most of the last year and a bit. The following chart shows the performance of the index by sector so far this year.

ANZ profit result

A brief look at ANZ’s interim result shows profit growth was driven mostly by efficiency gains and cost cuts rather than revenue growth.

ANZ has upped its dividend payout ratio and expects it to be toward the top end of its 65-70% target range this year. The increased interim dividend will reflect a more even spread of the annual dividend between halves.

Expenses were down by 8% clawing the cost-to-income ratio down from 48% to 44.4%.

 But retail lending growth of 1% and commercial lending of 2% says much about the lack of demand for credit almost anywhere in the economy. This is not a peculiarity of the ANZ result and we expect to see it repeated in Westpac’s result tomorrow and the other banks when they report.

Like all major banks, ANZ’s exposure to the residential mortgage market is large with loans of $188bn at 60% of group lending. But the quality of the housing loan book is exemplary with 49% of loans at least 1 month ahead on repayments. The loan loss provision is miniscule at 0.01% and the average loan to value ratio is 52%.

There is a huge safety buffer in the mortgage book.

It’s worth remembering that the RBA has cut interest rates by 175 basis points since November 2011, allowing mortgage interest rates to fall by an average 138 basis points. But, as the RBA regularly points out, the savings rate has barely dipped from historically high levels around 10%. Despite the lower rates, consumer confidence remains very subdued.

The inference is that consumers are not willing to spend even though they appear to be financially more comfortable. Why not?

What ANZ and the other banks lack is corporate demand (large and SME) for loans.

Easy monetary policy from the RBA has allowed the banks to fortify their balance sheets but, like a horse to water, you can’t make businesses borrow money if they do not feel confident about hiring and investing.

Corporate balance sheets are generally under-geared as well suggesting that if and when Australian corporates regain their mojo, then the banks will have significant operating leverage to an increase in business demand for credit.

ANZ’s point of difference with its three main peers is its Asian growth strategy (currently 20% of group revenue heading for 30%) and in the long run this looks an entirely valid growth option. But its Australian competitors are not devoid of exposure to this option – they just don’t trumpet it as loudly.

ANZ remains the largest bank in New Zealand, a market dominated by Australian banks, but a market in which growth is tempered by the perennially weak earnings growth.

Summary

Investors are looking past the stretched valuation levels of the bank stocks in search of the generous dividend yields available. The relative safety of the bank stocks compared to the volatility of the resource stocks is providing comfort in that decision.

Despite low revenue growth due to low credit demand, the banks are finding efficiency gains through technology improvements are providing the catalyst for earnings growth.

One Response to Banks – Yield and safety outweighs overvaluation

  1. Ben Dehlsen says:

    Hi Kim and Greg,
    Have you got a reduce, hold or accumulate recommendation on the big 4 and what is your order of preference of the big 4 banks?

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