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Bank investment with Clint Eastwood

No doubt it’s familiar to all but in the climactic showdown in Sergio Leone’s epic Western The Good, The Bad and The Ugly the three protagonists confront one another. A classic stand-off, in a cemetery no less, beloved of game theorists, the winner getting the money and the losers ending up, well, six-feetunder.

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Okay, maybe not everyone is a fan of the Leone oeuvre but the scenario, where there are multiple players with none having an obvious advantage over the others and no clear answer to the question of when to act is a common one.

" The first to buy back in may be too early and get killed by the other two selling."
Andrew Cornell, Managing editor, BlueNotes

It’s currently playing out between international investors, Australian investors and hedge funds with the ‘prize’ being the return on Australian shares. For some time the asset class, and particularly financial institutions, have been underweight in investor portfolios.

Indeed, so convinced have investors been by the negative story around the Australian system, and in particular consumer gearing (mortgage lending) and the business environment (the transition from commodity related industries) the level of “shorts” – where investors borrow and sell shares they don’t actually own in the expectation prices will fall further and they’ll be able to buy them more cheaply later – on bank stocks in Australia remain elevated.

But in recent times one prevailing theme from global investors and international sales desks is interest in Australian stocks is increasing; whether it be from top-down analysis of the region, the outcome of quantitiative screening or bottom up fundamental stock research.

Stand-off

The stand-off exists because the first to buy back in may be too early and get killed by the other two selling. But if two buy in, sentiment mayshift and the investor group (especially the shorts) left underweight may well miss the rally. Indeed, one may get it right and make a killing.

In The Good, The Bad and The Ugly, Clint Eastwood has an edge because he’s secretly taken the bullets out of Eli Wallach’s gun and so can safely shoot Lee Van Cleef knowing Wallach can’t shoot him. In an astute piece of investment advice he tells Wallach “in this world there's two kinds of people, my friend: those with loaded guns and those who dig. You dig.”

The real world though is not an Italian spaghetti Western shot in Spain. Nor indeed a farce set in Birmingham.

The Australian market is certainly cheaper – over the last two years, the Australian currency has lost around 20 cents, more than 20 per cent against the US$, and is now off lows set January which may indicate the currency has found a floor.

If the returns from and outlook for Australian companies have remained similar, shares are much cheaper. Even if things have deteriorated – and for Australian banks the bad-debt cycle has bottomed, revenue is hard to come by and higher levels of capital are likely – for investors that may well be offset by the cheaper price.

All things are relative Eastwood is hardly ‘good’ in Leone’s film, Van Cleef is motivated by the same desire for loot and Wallach…. Well, actually he is pretty ugly.

Investors are weighing up relative risk and return, not absolute. Japan’s economy has not rapidly improved since Brexit but investors are happier to be in yen denominated assets than pounds or euros. The feedback from sales desks is their European clients are looking for a more global exposure.

As JP Morgan noted in a recent presentation, Australia is more attractive because of the lower dollar, lower interest rates and robust consumer sentiment.

“Growing regional concerns (particularly China volatility and growth, Japan’s higher yen, its credit cycle and scepticism around “Abenomics) are making Australia relatively attractive,” the bank says.

“Investors are still generally underweight Australia, especially the banks and resources.” However, selected Australian holdings are being trimmed on valuation grounds.

Significantly, Australian banks are trading on price-to-earnings ratios around 12.2 times compared with a long term average of 10.7 times but that’s not as high as other sectors – the market ex-financials is around 19.6 times compared with an average of 14.8.

So there is an argument being put Australian banks are due a catch-up.

NO GOOD

Opposing that argument however is the view that while global, domestic and hedge fund investors are underweight, and the Australian dollar is cheaper, banks are still not good value.

From this angle, more than offsetting cheaper prices is the credit cycle, Asian uncertainty and likelihood of more capital raisings to satisfy regulators.

CLSA’s Brian Johnson is a prominent proponent of this view. In a recent note he accepted “ostensibly the Australian banks are trading reasonably on FY16E PEs of 12.1x, Price to Books of 1.7x and dividend yields of 6.3 per cent”.

But he went on to argue on other measures, and looking at the sustainability of dividend yields, the case to buy was not compelling.

“Given that earnings per share growth rate is set to slow and dividend cuts are likely the question must be asked what are the Australian banks actually worth?” he asked. Not enough, he answered. 

“With the prospect of more disruptive capital raisings, we recommend staying tactically underweight.”

Johnson reckons don’t shoot first. Yet the message from global sales desks is the music is getting louder, the camera is swinging faster, Tuco is starting to twitch, Angel Eyes is focussed, Blondie is squinting even more than usual.

Like all stand-offs, there needs to be tension. For international investors, domestic investors and hedge funds, tension appears to be rising around established underweight positions. 

Brexit, while it has roiled markets and stirred up volatility, has increased the relatively attractiveness of markets like Australia – particularly as it has also pushed down the dollar.

Sell-side banking analysts in Australia look to differentiate between the four (sometimes five, including Macquarie Group) major banks based no their business mix and credit exposures.

Recent notes have alerted investors to a post-Brexit rise in funding costs and narrowing margins but they have been sanguine about bad debts and positive on restructuring.

International investors however don’t differentiate to the same degree. A decision by one investor sector to move to less underweight Australia (or Australian banks) means a shift in underlying demand.

Fingers are twitching but no one has pulled the trigger yet.

Andrew Cornell is managing editor at BlueNotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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