Australian investors (who have been around for a while) can be prone to an emotional attachment to Australian bank stocks. This is understandable.
Commonwealth Bank of Australia (CBA) commenced its privatisation process in 1991 with investors paying $6 per share (with a $4.45 second instalment paid in 1997). The share price peaked at over $95 in March 2015. This was a stellar 24-year performance, with around 5% dividends also received along the way.
As a result, bank stocks occupied an increasing portion of many portfolios, particularly for investors that ploughed their dividends into more shares via dividend reinvestment programmes. In 2015, the four major banks accounted for roughly 30% of the market capitalisation of the Top 200 companies listed on the Australian Stock Exchange.
Since 2015, things have not been the same with the current CBA share price around $70. So what changed?
Simply put, the banks’ ability to grow earnings and dividends for shareholders changed. In 1992, CBA paid total dividends of 40c. Total dividends for 2014 were $4.01. This represented an incredible 11.0% compound annual growth rate over 22 years. In 2018, the bank paid total dividends of $4.31. The compound annual growth rate fell to 1.8% per annum from 2014 to 2018.
The sharp decline in the major bank’s capacity to grow earnings and dividends reshaped investor perceptions of the worth of these businesses. As a general point, businesses with stronger growth profiles command higher PE multiples. In 2015, the CBA stock price equated to close to 16x that year’s earnings. Now, it is trading to close to 13x earnings representing close to a 20% derating.
Explaining all the factors behind the growth slowdown would require a lengthy (and somewhat dry) dissertation. But two factors stand out:
- A slowdown in the rate of lending growth.
Latest data shows total credit growth running at a rate that is a little shy of five percent. Through most of the nineties and the early 2000’s, credit grew at a double-digit rate.
- Regulatory requirements to raise capital ratios.
Those with long enough memories will remember that Australian banks engaged in rolling programmes of share buybacks during the second half of the nineties and after the turn of the century. Reductions in the number of shares on issue added to the banks’ capacity to grow earnings and dividends on a per share basis (in a world of double-digit credit growth). Then, in 2014, David Murray’s Financial System Inquiry called for the nation’s banks to become “unquestionably strong”. This meant increasing capital bases (and the number of shares on issue) by roughly 20%.
Going forward, we do not expect credit growth to pick up for several years. In fact, housing market weakness could see growth slip into the 3 – 4% range. However, the good news is that the banks have now achieved (or are very close) their new, upwardly-revised target capital targets. In ANZ’s case, this will allow the bank to return proceeds from sold businesses to shareholders via buybacks.
Recent 2018 results from ANZ, National Australia Bank and Westpac supported the view that underlying growth rates for the banks will continue to be ‘low single digit’. The banks continue to be very adept at reducing costs to offset weaker revenue growth rates. Commentary provided with the results suggest that cost lines are unlikely to grow, and may fall, in 2019.
It appears to us, that after a material derating since 2015, Australian major bank valuations are now in line with these reduced growth expectations. This means that the share price outlook is more stable. Dividend yields of 6-7% (fully franked) are also healthy but dividends are growing far more slowly than in the old days when bank stocks were star long-term performers in client portfolios.
The final point to be made is that our banks tend to be low-risk plays outside of recessions. However, during recessions, a rapid rise in bad debts mean that banks can become high-risk investments overnight. Recall that Australia hasn’t seen a recession since 1991.
In summary, there remains a place for bank stocks in Australian equity portfolios. However, a much weaker growth outlook means that the risk/return equation no longer warrants the inherit risk of large allocations of Australian equity portfolios to the sector.