Income Report / Income Note: Banks, the sector in 7 charts (CBA)

By Market Matters 24 June 20

Income Note: Banks, the sector in 7 charts (CBA)

Market Matters Income Report 24th June 2020

The ASX has opened marginally higher this morning led by IT stocks that are keying off a positive lead from the US, the Nasdaq again hitting a new all-time high. Stocks catching my eye this morning include Wisr (WZR) in the smaller companies space up +10%,  we’ve spoken about this finance business in the past while nickel miner Western Area (WSA) is building on yesterday’s solid gains trading 3% higher - smaller rival Mincor (MCR) has gone into a trading halt to raise capital. Gold is also in focus early with gold stocks finding some form thanks to a weaker $US overnight, Gold company EVN and NST 4% & 3% respectively.

In today’s note we provide 7 interesting charts on the banks with the intention of highlighting how we view the sector. At MM we typically like to keep things brief and to the point, however at times we think it’s useful to give some more ‘meat on the bones’ around our thought process towards a particular stock / sector.

The ASX 200 is currently trading up +26pts/0.44% to 5980.

ASX 200 Chart

The Income Portfolio ticked marginally lower over the last week with a fall of -0.23%. There was little movement under the hood in either direction, with IGL the only notable fall of 7.65%. there were no dividends paid for the week. With just 1 week left in the financial year, the portfolio has declined by -5.44% versus its absolute benchmark (RBA cash +4%) of +4.58%.  Since inception, the portfolio has added +9.27% vs. the benchmark of +15.50%. 

Banks – the sector in 7 charts

Dumbing it down, do banks simply trade on dividend yields?

The first chart looks at CBA share price versus yield over the last 30 years. Two points worth making about CBA. 1. This is the most consistent of all banks in terms of dividends with the GFC the only time that saw a cut to the dividend, in that instance, they cut from an FY08 dividend of $2.67 to $2.27 in FY09, bouncing back to $2.88 in FY10. 2. The share price bounced back in line with the dividend.  

Chart 1 – CBA dividend yield v share price since the early 90’s

The second chart looks at Westpac, which has a more checkered history, the cut to dividends now is extreme and the share price decline seems warranted based on this metric.  

Chart 2 – WBC dividend yield v share price since the late 80’s

Chart 3 looks at earnings and dividends at a sector level. Again, 2 obvious points here. 1. The decline in earnings and dividends has this time been sharp & deep. 2. Earnings, and as a result dividend, regularly see hits. The setbacks do get overcome, and earnings and dividends rebound strongly. This is a function of bad debts, they spike, then normalise. We expect the current spike / provisioning for bad debts will normalise.  Profitability returns and so do dividends.

Chart 3 – Bank sector profits v bank sector dividends

Chart 4 looks at current payout ratios which sit around 80% which include a very hefty current bad debt charge plus regulatory provision. At MM we think payouts will settle more towards the mid to high 70’s with banks retaining more of their earnings over time. That’s not a big call, however when bad debts normalise (assuming that’s FY22), we expect dividends to be in the range of 5.5% to 8.5% plus franking, which is clearly attractive. CBA lowest, NAB highest.

Chart 4 – Current bank payout ratio

Our view is that a reduction in bad debt provisioning will drive earnings and therefore dividends, but what about top line growth for the sector? If we multiply one minus the payout ratio (percentage of earnings that are retained) by the return on equity, we get the implied growth in earnings for the sector. Chart 5 articulates this.

Chart 5 – Expected growth – not great

So, what are valuations saying? Chart 6 looks at the price to book value (P/BV) at a sector level. Price to book compares the stock / sectors market capitalization to the value of net assets on its balance sheet (assets minus liabilities). Or in other words, if a company liquidated everything it owned, what would it realise? Currently, the banking sector is trading at a discount to the value of its assets. That generally happens when the assets are expected to lose money, yet our banks are still very profitable.   

Looking at this in the context of time, banks trading sub 1x book are cheap.

Current P/BV (ex CBA) looks very attractive: CBA 1.72x, ANZ 0.86x, NAB 0.98x, WBC 0.86x, BEN 0.63x, BOQ 0.68x, however, to put this number into context we need to look at return on equity (ROE), which is also low at this point 

Chart 6 – bank valuations – price / book value

Return on equity is low right now. Chart 7 reviews this over time highlighting the current issues banks are facing, however it’s not all bad news. Pre-GFC, banks were more leveraged, holding tier 1 equity of around 5%, or in other words, they were leveraged around 20x. Since the GFC you may have heard terms like ‘unquestionably strong’, increasing capital requirements, tier 1 hybrids. In short, the regulator has forced banks to increase the level of equity on their balance sheets, with tier equity capital now above 10%, or in other words, banks are now leveraged 10x, or about half as much.

While lower ROE generally = lower share prices which is the right response (assets yielding lower returns should be valued at less), the counter argument to this is that banks have become safer. It’s the reason we also like bank hybrids at current levels.

Our feeling is that ROE has overshot to the downside, BUT, the heady years of the early 2000’s are long gone. Low double-digit ROE’s the more likely scenario moving forward.    

Chart 7 – Sector (ROE) return on equity.

Charts sourced from Shaw and Partners Research

MM remains bullish the banks at current levels with a preference for CBA

Commonwealth Bank (CBA) Chart

Conclusion (s)

We remain bullish the market underpinned by stimulus

Banks are oversold and we remain bullish

Have a great day!

James & the Market Matters Team


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