Income Report / Income Report; Bank valuations

By Market Matters 19 December 18

Income Report; Bank valuations

Market Matters Income Report 19th December 2018

The ASX is trading marginally lower at time of writing (- 18points) weighed down mostly by the energy sector following Oil’s big decline overnight while the financial stocks, led by the banks are trying hard to fend off the sellers. A lot of stock specific news about today with the NAB, ANZ and Orica (ASX:ORI)  AGM’s being held – Bega (ASX:BGA) putting through an earnings downgrade and Medibank (ASX: MPL) announcing average premium increases of +3.3%, its lowest average increase in 18 years, obviously good news for consumers!   

For the week, the MM Income Portfolio fell -0.30%, mostly as a result of weakness seen in Fortescue (ASX: FMG) & Genworth (ASX: GMA). In the current financial year the portfolio is down -2.47% versus its benchmark of RBA cash rate +4% which sits at +2.56%  while the ASX 200 accumulation (including dividends) is down by -7.98%.  Since inception the portfolio has added 3.72%, equating to 2.56% per annum.

Another hit for the banks from across the ditch

2018 has been a year when banks have looked to bottom on numerous occasions but have gone on to make lower lows, the latest hit to the sector coming from New Zealand last Friday. While we generally have a good relationship with the Kiwis, the outperformance of their stock market in 2018 versus our own, the dominance of the All Blacks and now the RBNZ’s plans to change the regulatory capital required for banks is testing that bond.  

The 4 major Australian banks dominate the New Zealand market accounting for 88% of NZ assets. Without getting bogged down in detail, the proposed plan is to increase the tier 1 capital requirement for banks to 16% from 8% currently (although the major banks are currently at 13.4%) plus tweak how they risk weight  assets on bank balance sheets which could impact the amount of capital they need to hold to absorb shocks – both moves are a net-negative for Australian banks. If the proposed changes are implemented (decision due in June 2019),  ANZ would see the most impact, followed by NAB, CBA and Westpac.

Increased capital is not necessarily a bad thing in the longer term given it makes the financial system safer - which is what the regulator ultimately wants, however it impacts near term profitability. Essentially it’s just another headwind for a sector that has had the proverbial kitchen sink thrown at it in 2018 leading to a significant drop in share prices as shown below.

Banks have mainly faced earnings downgrades from the Royal Commission but there has also been an expectation of lower loan growth. This latter issue is largely due to tightening credit standards which licked off in 2015 and has been felt in falling house prices from the middle of 2017 onwards. Other measures were put in place to cool housing and improve housing affordability for first home buyers, such as a cap on investor and interest only lending which has had the desired effect. Looking at credit growth, particularly investor credit growth the cap has essentially put the kibosh on that market. From experience, I don’t want to pay principle and interest on my investment loans while the alternative, which is to pay additional interest of more than 1%  is also not that attractive. Effectively banks have been aggressively discouraging investor and interest only lending given the APRA cap that was  in place.  This morning, APRA have announced the removal of that cap (as of January 1) so investor lending should start to recover from depressed levels.  

The main issue from an income perspective flowing from the proposal in NZ to increase capital requirements, is the potential impact on dividends. NAB for instance has a payout ratio above 90 at a time when earnings are under pressure, asset quality is fine however the media is doing their best to undermine that and the local regulator is yet to make its formal ruling on what it will do (although we have a fair idea). The added impost from NZ is clearly another ball in the air for the banks that will feed more uncertainty.

The question now is, what is priced in?  

The banks trade on a forecast P/E of 10.9x versus the ASX 200 which trades on 14.36x, a ~24% discount relative to its usual ~20% discount.

In terms of the banks relative to one another, NAB screens cheapest as you’d expect given they’re the mostly likely to cut their dividend, ANZ is a close second given they have most exposure to changes in New Zealand plus there are some rumours circulating about asset quality in some of their legacy holdings in Asia, while CBA has once again reclaimed its rightful premium against its peers. Relative to the group and 5 year average, Westpac screens cheapest while Bendigo screens most expensive

Peer Group Comparison

ANZ Bank (ASX: ANZ) $24.06

While we don’t own ANZ across either portfolio, its clearly catching attention given its relative value plus its sector leading capital position. The expectation was that ANZ would increase its current $3bn share buy-back program to $7bn which would have been supportive of the stock going forward, however the potential change to capital requirements in NZ may put that on ice.   


In June 2016, ANZ was trading on a similar P/E multiple to today dragged down by a big decline in the market which saw the ASX 200 fall from ~6000 points in May of 2015 to a 4700 low in January of 2016, a ~20% pullback,  BREXIT being one of the major reasons. As shown above, the ANZ share price bottomed out at $21.87, or ~9% below where its trading today.    

ANZ P/E Trends

Commonwealth Bank (ASX: CBA) $69.55

We have CBA in the Income Portfolio from higher levels however we remain comfortable with the holding. CBA has agreed to sell its Colonial First State Global Asset Management (CFSGAM) business for $4.1bn and as a result, should be in a position to return around $3bn back to shareholders through share buy-backs.

Commonwealth Bank (ASX:CBA) Chart

CBA has experienced a P/E re-rate back up in this most recent market sell-off, and now trades at a premium to the sector, however it’s warranted in our view. Put simply it has better metrics relative to the other majors in terms of deposit funding, home loan distribution while it also  has the best cost to income ratio.

CBA P/E Trends

National Australian Bank (ASX:NAB)  $23.42

As is the case with CBA, we have NAB in the Income Portfolio from higher levels however we remain comfortable with the holding although there is room for improvement on the price we paid! The bullish case for NAB centres on its skew between commercial and residential loans. NAB is a business bank and therefore has lower exposure to a weakening domestic property market. In recent results, they showed the lowest level of new impairments, the lowest level of total impairments, the lowest net write-offs, the lowest 90-day past due number while they are carrying the highest bad debt charge – all in all, asset quality is good relative to peers. The downside is clearly the current payout ratio and the lack of room to move, plus they have the highest cost to income ratio and the weakest capital position in the sector.  

NAB (ASX: NAB) Chart

NAB is the cheapest it’s been in the past 5 years and now trades in a single digit P/E.

NAB P/E Trends

Westpac (ASX:WBC)  $24.53

WBC is rarely the best in its peer group and rarely the worst – it’s this stability that’s been at the cornerstone of WBC for decades. One area that has been an issue for it in recent times is the cap on interest only loans where the regulator (up until today) put a cap on the proportion of new loans that could be interest only.  WBC still had 40% of its Australian home loans represented by interest only loans as at the end of 2H18, compared to 22%, 30% and 25% for ANZ, CBA and NAB, respectively. The cap removal we’ve seen today is a positive for the sector, however its less of a positive for Westpac given they still have less room to grow their interest only loan book relative to peers.

Westpac (ASX: WBC) Chart

Westpac is trading at its cheapest level in the last 5 years from a P/E perspective while on a price to book its trading on just 1.3x versus its historical 1.9x, making it 32% ‘cheap’ on that metric.

WBC P/E Trends

Clearly, the banks are cheap and are pricing in a significant amount of bad news. They obviously face further risks around large house price falls, more significant fines, penalties and customer remediation that occurred in FY18 and importantly a reduction in Australian economic growth which would produce an increase in bad debts, however it seems to us that share prices are currently factoring in these threats and the banks are susceptible to ‘less bad’ news.


We hold the banks and believe they’ll reverse their underperformance in 2018, with outperformance in 2019, especially if the market remains volatile

As this stage, dividends are sustainable while capital returns through share-buys backs remain on the table.  

Have a great day!

James & the Market Matters Team


Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday, or after the session when positions are traded.


All figures contained from sources believed to be accurate.  Market Matters does not make any representation of warranty as to the accuracy of the figures and disclaims any liability resulting from any inaccuracy.  Prices as at 19/12/2018

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