Is there still value in bank stocks?

There is only one share price, just as there is only one official interest rate. But these truisms are easily forgotten when economists pore over data entrails to foretell the next central bank move.

"Since its trough in 2009, the bank index has more than doubled. Now, following the recent sell off, the index is approaching the ‘correction’ level of 10 per cent down."
Andrew Cornell, Managing Editor, BlueNotes

It’s the same for share prices, and the latest sell-off in Australian major bank shares has generated heated coverage.

For Australian shareholders, that’s understandable: banks make up around a third of ASX market capitalisation and even more of retail investors’ portfolios. For many Australian investors fully franked bank dividends are a major income source.

And since its trough in 2009 the bank index has more than doubled, indeed it has been up more than 160 per cent. Now, following the recent sell off, the index is approaching the “correction” level of 10 per cent down.

But those single share prices are bringing together myriad pieces of data and it is wrong to attribute the move to industry fundamentals, macro-economic conditions, market dynamics or “animal spirits”. Because it is all of those things.

Just consider: banks are a leveraged play on economies, so when economies improve, so too, eventually, do bank earnings. But there is currently a major financial system inquiry underway in Australia, and it is possible that inquiry will recommend – and the government accept – that banks should hold more capital.

This would (all else being equal) dilute the return on shareholders’ funds. However, the world’s largest economy appears to be on the improve, so the greenback is the most rapidly appreciating major asset class this year – which bad for equities in other market,s because their $US value will decline.

Conversely, companies which derive some earnings in $US will do better. Meanwhile, US interest rates will rise so the relative attraction of other yields, such as dividends, will fall (as the spread between official “risk free” US rates and riskier dividend yields falls.)

But there is just one share price…

Two broad concerns, though, underpin the analysis of the latest bank stock moves. One is bank fundamentals: are earnings stable, bad debts under control, dividends intact, costs contained?

The other is market dynamics – for a given state of health for the banks, are investors prepared to put their money in bank stocks or somewhere else?

One is a question of fundamental value, the price an investor is prepared to pay for a total return. The other is a question of relative value - can that return in the future be obtained more cheaply somewhere else?

There is no doubt that Australian bank shares have had an extraordinary run since 2011. That’s because earnings have been very stable, bad debts have been falling and dividend yields are high – at a time when other interest rates have been historically low.

This is critical for Australian investors, in particular, who have enjoyed both high relative yields and the benefits of franking credits on dividends.

But the yield has also been important for offshore investors who don’t benefit from the franking credits. In their case the unfeasible rise in the Australian dollar, despite insipid economic growth and falling prices for Australian exports, has amplified returns.

For large international investors, particular so-called “quant funds” which are asset agnostic and shift large amounts of money at a time, a shift in relative yields – say towards US treasury bonds in response to a higher greenback and potentially higher interest rates – is enough to trigger selling in other yield classes like bank shares.

For Australian retail investors, however, relative yields are far less significant than actual returns, money in the bank. For these investors, the cash that hits their bank accounts twice a year is far and away the most important consideration.

These investors, who make up between 40 and 60 per cent of major bank shareholders, basically don’t buy bonds (although many would argue they should).

Retail investors, then, don’t worry about market dynamics as much as the danger banks will cut dividends. That’s why the likely impact of regulatory and prudential change at the international and national level is significant.

The G20 and Financial Stability Board in Basel are committed to improving the stability of the global financial system and lessening the danger taxpayers will have to pay for bank failures.

High on the agenda of these bodies – and on the mind of David Murray’s Financial System Inquiry in Australia – is the question of whether banks should carry more capital (capital levels have already been lifted since the financial crisis).

The impact of that would depend on how much capital. Australia’s banks are generating capital at a healthy rate and have strong retained earnings. Nevertheless, capital going into reserves is not available to be paid out in dividends.

Further contributing to anxiety about the ability to pay dividends is the raft of other potential threats to the banks such as bad debts or continuing weakness in the global economy, whether due to geopolitical threats or high levels of indebtedness or asset bubbles.

All these tamp down the “animal spirits” of investors or at least cause them to look elsewhere.

Professional funds with Global Benchmarks (a relatively small group as most are referenced to either the MSCI Asia Ex-Japan, MSCI EAFE or the ASX200 indices) would be looking at exiting the safe haven of the Aussie banks in anticipation of increases in US rates. US banks look comparatively cheap and benefit from higher US interest rates.

For all investors however, the Australian banks have been fantastic investments for nigh on three years and inevitably are vulnerable to profit taking.

For different investors, though, there are different signals: for the global quant funds, a shift in relative yields is enough.

Australian equity funds might see the looming FSI recommendations and publicity about debt levels as a trigger. Retail investors will still like the cash of bank dividends. But for all, there’s only one share price.