This week we’ve put the spotlight on CBA, which we’ve had recent success trading between $70 and $80. As Model Portfolio readers would be aware, we sold down and subsequently out of CBA late last year as the stock rallied above $80. With the stock price now trading around $82.00 we see price risk developing and despite the near-term dividend appeal, are happy sitting it out for now.
The last two years has been particularly volatile for the banks. Conditions are historically poor due to the incredible debt expansion in Australia and other developed countries over the last 25 years. This causes nervousness.
We are grappling with a range of headwinds, key among them being: increased regulatory capital, slow economic growth, falling loan growth, low cash rates, margin pressure from competition, bad debts remaining near historical lows, and an accumulating risk in the housing market.
However value emerged in Q3 of 2016 on these fears, which were probably overplayed.
The current view from institutional analysts, which drive consensus NROE forecasts in StocksInValue, is that bad debts – the key swing factor for bank earnings – should remain subdued through benign conditions for the next two fiscal years.
As illustrated in Figure 1 below, the current share price matches our Future Value Y2 valuation, so there is a little too much growth baked in (in our view). CBA offers a reasonable 5.0% dividend yield, or 7.1% including franking credits, but this is unfortunately not accompanied by strong prospects of capital growth.
In December we recalibrated our risk model and adjusted required returns for several companies in StocksInValue. CBA’s required return remained the same at 10.8% so there was no corresponding change to its valuation.
Observant readers will see equity growth of 8.7% has exceeded earnings growth of 5%. This implies profitability as measured by Normalised Return on Equity (NROE) is falling, which we discuss next.

Figure 1 – CBA Valuation Summary (Dashboard Summary Tab)
Source: Clime and StocksInValue
CBA’s five year capital history provides a clear picture profitability trends. Our forecast NROE, which encompasses our assumptions for earnings growth and changes to equity, is 19%. This is well below the average of the last five years of 29%. Although earnings are expected to continue growing at 5%, consistent with the trajectory of the previous five years, the main driver of lower NROE is higher equity from external sources due to capital requirements imposed by APRA.
Although CBA’s common equity Tier 1 capital as a ratio of is Risk-Weighted assets – the CET1 ratio – is 9.4%, and comfortably above APRA’s 8% minimum, higher risk weights for mortgages could potentially lower CBA’s ratio and require more external capital. We account for this and assume close to 20% of CBA’s near term earnings will be put to further building CET1 capital.
 

Figure 2 – CBA 5 Year Financial Summary (Dashboard Key Stats Tab)
Source: Clime and StocksInValue
Our banks have been among the best performers in the world over the last couple of decades, which can perhaps lead to complacency and potentially over-exposure to banks. But with banks some risks are hidden, and they build up over time. They are difficult to quantify in risk models but are present nonetheless. Banks, after all, drive profits from returns on assets and financial leverage.
Occasionally, bad debts rear their head and causes significant falls in earnings and sometimes significant losses. This occurred around the world during the GFC however Australia escaped much of the pain. However, risk continues to build in mortgages, as everyone trying to buy property in Sydney or Melbourne would be aware. Our approach is to continue actively managing our banks positions with a clear focus on our valuation framework and remaining appropriately diversified across portfolios.
 

Figure 3 – Banking Sector Profits and Bad & Doubtful Debts (Australia)
Source: Clime and RBA Chart Pack (January 2017)