Wednesday, December 5th, 2018
The market prices banks within a range of price-earnings ratios (PERs); our view is this range should be lower than post-GFC when the four majors emerged with 90% of the mortgage market and a home lending boom ahead.
Banks have derated for three years in response to negatives well-understood by the market. Banks are not yet dirt-cheap but are now cheap. The following graphs show PERs for the four majors over the last 10 years:
Figure 1. Bank price-earnings ratios, last 10 years, as of 21/11/18
As well as trading on historically subdued earnings multiples, banks recently traded below the most bearish sell-side share price targets quoted in Bloomberg in all cases except for CBA. This means influential sell-side analysts are less likely to recommend institutional clients sell.
Figure 2. Major bank share price targets on 21/11/18
The major banks remain undervalued against the valuations in StocksInValue and the total shareholder returns available after dividends are sufficient to justify holding our existing positions in ANZ, CBA and NAB within the StocksInValue Model Portfolio.
Bank stocks have entered a near-term re-rating driven by expectations of consensus earnings upgrades in coming months. We think there will be:
- No material normalisation of bad debts expense given low unemployment
- No widespread defaults on mortgages or property settlements
- No recession
- No Chinese hard landing
- Subdued growth in consumer spending, but no contraction
- Another year of house price falls in Sydney and Melbourne for a peak-to-trough fall of ~15%, but flat to slightly higher prices elsewhere
- Support to 1H19 interest margins from the current moderation in global interest rates and mortgage repricing
- A deceleration in banking system home lending growth to 4% pa from 5-6% currently as banks scrutinise the expenses of mortgage applicants in more detail and this slows the approval of new loans. Owner-occupier and particularly first-home buyer demand are supportive and we do not expect the Royal Commission to recommend any tightening of lending standards that might further constrict lending and weigh on economic activity
- An acceleration in business lending to mid-single digit annual growth
- No cuts to dividends
- FY19 legal, regulatory, compliance and remediation costs no worse than FY18 and possibly lower. The majority of elevated remediation charges were probably taken in 2H18
- Few further consensus downgrades to earnings forecasts. Our base case is for flat consensus EPS forecasts until 1H19 results, after which consensus forecasts will be upgraded slightly as further cost savings and productivity gains are targeted. Already CBA managed to reduce underlying (before one-off regulatory costs) operating expenses by 1% in the September quarter
- Ongoing buybacks by ANZ and a new buyback program by CBA in 2H19
- A partial unwind of the current 39% discount to industrials back towards the 30% four-year average.
The rally in all four majors on 21 November, when the ASX had a bad overnight lead from Wall Street, was telling because it signalled rotation into banks even on a down day for the broader market. Most likely the market thinks the bad news is largely priced in for now – as do we – and the current rally in bank stocks reflects this forming consensus view.
However, we have less conviction beyond the short term given federal Labor stands to win majority government at next year’s election based on current polling trends. While majority government is better for consumer and business confidence than minority government and banks are plays on consumer and business confidence in the economy, there are three Labor policies which would reduce the performance of bank shares:
- The end of rebates of surplus franking credits given bank shares is widely held for franked dividends.
- The restriction of negative gearing to newly constructed properties (and properties purchased before the policy’s implementation). We have seen estimates this would reduce mortgage lending growth by one percentage point per annum compound.
- An increase in the bank levy to charge bank shareholders for the costs of the government guarantee of deposits. While there is an argument depositors, not shareholders, should pay for their own protection, if the policy is introduced there would be substantial consensus earnings downgrades and also a derating of the sector.
Our current lack of conviction on the medium-term prospects for bank shares means we are likely to trim our current positions if banks keep rallying towards value.
Clime Group owns shares in CBA, ANZ, WBC & NAB.