This week’s Investing Report will sweep across the Australian equity market and review a number of banks, and seek to determine what shareholders can expect in the next few years.
Our first chart covers the last twenty years of the Australian market and covers the absolute and relative performances of the key parts of our equity market. This chart gives the reader a long term perspective of financial sector performance mapped against the resources sector and other service sectors.
Australian Share Price Indices
Figure 1. Australian Share Price Indices* (Log scale, end December 1994 = 100)
Source. Bloomberg, RBA
The financials sector is largely dominated by our major banks. History shows that the fifteen year rally that commenced after the 1992/93 recession mirrored the growth in the Australian economy. The banks recovered quickly from the ravages of the recession and they prudently managed growth for the next decade.
Bank Profitability* (Institutions Operating in Australia)
Figure 2. Bank Profitability* (Institutions Operating in Australia)
Source. Banks’ annual and interim reports; RBA
Clearly (and in retrospect) bank prices were running ahead of themselves just prior to the GFC, and the risk of recession and bad debts dragged share prices lower. Massive capital raisings were undertaken in 2008/09 in anticipation of an Australian recession that did not eventuate. From this point, the combination of a resources price boom, rising national income and historic low interest rates plus benign regulation saw a housing credit boom develop. The household sector, funded by the banks, grew debt to historic high levels. The banks grew their assets at an exceptional rate to utilise their capital; profits grew strongly and so did their share prices. By 2013 the four majors, adjusted for rights issues, had virtually regained their previous share price highs of 2007. However, since then the party has stalled with the regulators awakening to the fact that the banks had actually grown too quickly, were undercapitalised on international metrics, had excessive payout ratios (i.e. did not retain sufficient capital in reserve) and were excessively exposed to residential property. What has followed (and is still occurring) has been a succession of capital raisings (under regulatory direction) that has diluted earnings and share prices have languished for the last few years. At present, the excessive payout ratios continue even as the banks battle with declining margins caused by historic low cash rates. Based on recent history and observations across the financial world, our banks are in for a tough few years. However, there is evidence to suggest that the current market has fairly priced this in to bank shares.
A non recessionary cycle
The next chart shows the extent of Australia’s current era of a non-recession cycle. Twenty four years of continuous growth has made this a great era to invest in financials, and particularly if an investor had the courage to buy bank shares at the height of the 1992 recession.
GDP Growth
Figure 3. GDP Growth
Source. ABS
The banks have benefited from continuous economic growth and the extended benign bad debt cycle shown in our second chart above.
In our view, it has only been bad bank management decisions that have checked individual bank performance. We recall NAB’s drift into non-conforming assets (prior to the GFC) and a senseless acquisition in the Midwest of the US. The ANZ also flirted with strange trading assets prior to the GFC and embarked on an Asian growth strategy which has now been largely junked.  Westpac had its impressive growth checked when its board agreed to acquire St. George Bank over the weekend leading into the GFC. At the time Westpac was Australia’s best credit bank and had it waited a few months, it would have picked up St.George at a discount to book value once its excessive wholesale funding model came home to roost. Meanwhile, the Commonwealth Bank displayed a level of patience that has rewarded shareholders with its premier status. The acquisition of Bankwest has had its issues but no one can dispute the timing and the price. Possibly Commonwealth’s major misdemeanour has been its troubled diversification into financial wealth management advice. A poor corporate culture has certainly stalled a logical diversification strategy.
This remarkably good and long period for banks that would have been even better if their management and boards had focused on steady growth with no grand ambitions to grow much faster than the economy or through international diversification. While the major banks have posted either record or near record profits in the recent year, the truth is that bank boards, their management and their shareholders have become intoxicated by franked dividends. Excessive payout ratios have repercussions; earnings per share have been diluted, return on equity has peaked and share prices have fallen without the impact of a recession.
Our final chart shows that the key sector for bank asset growth would appear to be close to a peak. The residential building market has experienced a massive surge in high density residential development over recent years. There are now market commentators forecasting that oversupply is appearing and that  residential apartment property prices will soon be severely tested in Brisbane, Melbourne and Sydney.
Private Residential Building Approvals (Monthly)
Figure 4. Private Residential Building Approvals (Monthly)
Source. ABS
Investors should question whether bank credit managers and analysts have properly managed the risk associated with excessive property development and pricing. Indeed the many recent statements by the RBA concerning residential property prices suggests that the RBA has not sufficiently regulated house credit risk and nor have the banks properly assessed the risk of excessive residential property prices. One wonders who should be managing the heightened risks in the economy as our politicians seem oblivious to their responsibilities.
The Outlook for Banks
As we noted earlier, it appears that the major banks are currently priced for low profit growth and declining returns on equity (profitability). The recent Westpac update disclosed a lift in nonperforming loans or loans in arrears in states where the slowing resource cycle is taking hold.
At this point, the East Coast residential loan books of major banks are not showing any distress. Steady employment growth and interest rate cuts by the RBA is keeping the residential property market steady, and some segments -particularly detached dwellings – buoyant.
The key issue for bank share price returns is the maintenance of dividends without the need to dilute earnings through more ordinary share capital raisings. As we noted, the banks have not managed their capital or their growth particularly well and today’s prices reflect past mistakes that took some time to become apparent.
We position banks in the large capitalisation and income portfolios based on our projection that they can produce an adequate return against inflation. As the bulk of this return will come from franked dividends, we believe that portfolios can be managed in and out of individual banks to capture dividends at different points. For instance, CBA and some regionals can be held for dividends before switching to, say, ANZ and NAB to capture their dividends at different points in time.
Australian banks are now well capitalised and finally appear to be better regulated. A better focus on steady risk-adjusted growth and a renewed focus on the customer will see them produce adequate returns.
While the risk of an Australian recession is always present, our view remains that this risk only becomes heightened if the $A were to lurch higher (above US80 cents). Therefore the battle over currencies, covered last week, remains the single most important determinant for confidence in the Australian banking sector.