Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 528

Can Aussie banks rediscover their glory days?

We could have opened with a quote from a famous value investor like Benjamin Graham, Warren Buffet, or Charlie Munger. But let’s take a more modern approach: Let’s use Chat GPT.

According to this AI tool, “Value investing is an investment strategy based on the fundamental analysis of stocks or other assets to determine their intrinsic value. The core principle of value investing is to identify and purchase assets trading below their intrinsic value, in the expectation the market will recognise and correct this undervaluation, leading to price appreciation.

It is an approach we believe in at Morningstar. Figure out what something is worth, then invest with a margin of safety. Keep this front of mind.

Two things we hear from clients:

  1. Bank share prices are below where they were 10 years ago, why would I buy bank shares?
  2. People have said Commonwealth Bank is expensive for years, but it just keeps going up!

Exhibit 1: Only CBA share price is up in last 10 years

Source: Pitchbook data

Shares have gone nowhere, why invest?

Westpac and ANZ shares are down 33% and 17% respectively, in the last 10 years. With dividends, the returns are more respectable but still not great. Since August 2013, Westpac has paid fully franked dividends totaling $15.49 per share, ANZ not far behind at $15.19. This lifts 10-year total shareholder CAGR to 1.4% for Westpac and 3.6% for ANZ. National Australia Bank has done a little better with total shareholder CAGR of 4.3%. The S&P/ASX 200 total return index has returned around 8% per year for the period.

We forecast Westpac’s ROE to be 9.5% in FY24, down from 15% ten years ago. The financial services royal commission, anti-money-laundering breaches, asset divestments, and lower interest rates have driven the earnings decline. Net interest margins, or NIM, has weakened, asset divestments have halved non-interest income, and operating expenses have risen on risk, compliance and technology spend. Meanwhile, Westpac now holds an additional $24 billion in shareholder equity, a more than 50% increase. Not a pretty story and explains the share price weakness.

But we think the next five years will look different. Margins are recovering from FY22 lows and smaller banks and nonbank lenders are struggling to compete as funding costs rise. Cost savings look achievable given the bloated cost base while recent changes make it unlikely APRA will again lift capital requirements. 

Market expectations are now low, which we think is an opportunity. At the current share price, the FY24 PE of 11x and price/book of 1.0x seem to imply no operational and profit improvement. By contrast, Westpac traded on a P/E of 13x and price/book value of 2.2x in 2012 and an average price/book of 1.6x for the 10 years to 2022.

Exhibit 2: Higher multiple expected on improved profitability

Source: Company Reports, Morningstar

Our fair value estimate of $28 for Westpac, which is 30% above the current share price, implies a FY25 PE of 12.7x and price to book value of 1.3x. National Australia Bank, for comparison, trades on a price to book of 1.5x, showing that if Westpac can improve profitability as we expect, a modest multiple rerate is likely and can deliver attractive shareholder returns. We only expect Westpac’s ROE to improve to 10.5% in FY25, still much lower from 15% in FY13.

Price matters and Commonwealth Bank looks expensive

Past performance does not equal future performance. Yes, Commonwealth Bank shares have outperformed peers, and materially since 2019, but there is no guarantee history will repeat. Commonwealth Bank has delivered an annual total shareholder return of 8.8% over the last 10 years. ROE is down from over 18%, but still at a respectable 14%. But current share price implies a FY24 price to book of 2.3x, above the 10-year average of 2.2x.

Commonwealth Bank shares trade on a forward PE of 17.5x and Westpac 11x. It seems valuation is being ignored by many investors. Index aware investors likely gravitate to the largest lender for bank exposure. It’s an easy argument to make—digital leader, most efficient, cheapest funding sources, strongest loan growth from direct channels (branches and mobile lenders), a sound balance sheet, conservative provision levels, and market share gains in home loans.

The 4.5% dividend yield for Commonwealth Bank is not overly attractive either, you can get 4.8% in a Commonwealth Bank term deposit. Granted, it is not like-for-like comparison, given the dividend yield grossed up is 6.9%, and income of term deposits has no franking credits. But the equity risk premium in Commonwealth Bank shares looks slim.

Total return is ultimately what investors should focus on. Our fair value estimate of $90 per share for Commonwealth Bank implies a FY24 dividend yield of 5.1% and price/book ratio of 2.1x. The capital loss if the share price falls back to our fair value estimate, would essentially offset two and a half years of dividends.

What’s in the price?

A simple answer is what’s the implied cost of equity based on the current stock price. We use a 9% cost of equity in our valuation for all the major banks, given their similar exposures, business models and the common regulatory environment. If we lower the discount rate on Commonwealth Bank to 8%, our fair value estimate increases around 15% to the current share price. All else equal, lifting the discount rate to 10.5% gets our Westpac fair value close to the current Westpac share price. We don’t think such a large difference is warranted though.

Alternatively, to justify the current stock price, we need to assume Westpac loses more market share, its cost base blows out further, and profitability remains sub-par with a return on equity of just 8% in five years. For Commonwealth Bank, we’d need to assume significantly stronger loan growth, further substantial cost efficiencies and the return on equity grows back up to 17% from 14% now. This seems unrealistic longer-term given the competitive landscape and similarities in the big four banks’ business models.

What about regulation?

Politicians and media talking heads love to pop up when Commonwealth Bank hands down earnings. They like to express outrage at such large profits from a single company. This populist view is shared by many. I for one prefer profitable and well-funded banks with low risk of failure, unlike Silicon Valley Bank, First Republic Bank, and Credit Suisse which all recently imploded.

However, government may see record profits as a green light for levies and taxes. This seems unfair given profitability has fallen materially over the past decade. Commonwealth Bank’s return on equity of 14% compares to 18.5% ten years ago, and it is expected to fall more in the short-term on weaker margins and bad debts. We forecast the other major banks to make returns on equity of 10.5-11.5% in FY23, solid but not spectacular. When the bank levy was introduced in 2017, the average major bank return on equity was at least 13.5%.

Australia’s biggest retailers, Wesfarmers, Woolworths and Coles delivered ROE’s of 30%, 26%, and 34% respectively, in FY23. There are a host of other big corporates across many sectors making very large profits and attractive returns—generally a good thing and a sign those businesses are performing well. Against that backdrop, we think any additional bank specific regulations and tax are hard to justify. That is the base case assumption for our bank sector fair value estimates.

Exhibit 3: Banks slipping down the ranks of the highest ROE firms

Source: Morningstar

 

Nathan Zaia is a Morningstar equity analyst, covering the banking and insurance sectors. This article is general information and does not consider the circumstances of any investor. Please consult a financial adviser before making investment decisions. This article was originally published by Morningstar.

Access data and research on over 40,000 securities through Morningstar Investor, as well as a portfolio manager integrated with Australia’s leading portfolio tracking service, Sharesight. Sign up to a free trial below:


Try Morningstar Investor for free


 


 

Leave a Comment:

     

RELATED ARTICLES

Who gets the gold stars this bank reporting season?

The case against owning Aussie banks

The best income-generating assets for your portfolio

banner

Most viewed in recent weeks

Where Baby Boomer wealth will end up

By 2028, all Baby Boomers will be eligible for retirement and the Baby Boomer bubble will have all but deflated. Where will this generation's money end up, and what are the implications for the wealth management industry?

Meg on SMSFs: $3 million super tax coming whether we’re ready or not

A Senate Committee reported back last week with a majority recommendation to pass the $3 million super tax unaltered. It seems that the tax is coming, and this is what those affected should be doing now to prepare for it.

How much do you need to retire comfortably?

Two commonly asked questions are: 'How much do I need to retire' and 'How much can I afford to spend in retirement'? This is a guide to help you come up with your own numbers to suit your goals and needs.

The secrets of Australia’s Berkshire Hathaway

Washington H. Soul Pattinson is an ASX top 50 stock with one of the best investment track records this country has seen. Yet, most Australians haven’t heard of it, and the company seems to prefer it that way.

Meg on SMSFs: Clearing up confusion on the $3 million super tax

There seems to be more confusion than clarity about the mechanics of how the new $3 million super tax is supposed to work. Here is an attempt to answer some of the questions from my previous work on the issue. 

How long will you live?

We are often quoted life expectancy at birth but what matters most is how long we should live as we grow older. It is surprising how short this can be for people born last century, so make the most of it.

Latest Updates

Property

Australian housing is twice as expensive as the US

A new report suggests Australian housing is twice as expensive as that of the US and UK on a price-to-income basis. It also reveals that it’s cheaper to live in New York than most of our capital cities.

Exchange traded products

The catalyst for a LICs rebound

The discounts on listed investment vehicles are at historically wide levels. There are lots of reasons given, including size and liquidity, yet there's a better explanation for the discounts, and why a rebound may be near.

Retirement

The new retirement challenges facing Australians

A new report from Vanguard has found an increasing number of Australians expect to be paying off a mortgage in retirement, or forced to rent. A financially secure retirement is no longer considered a given.

Strategy

Why aren’t there more Warren Buffetts?

Warren Buffett is widely regarded as the most successful investor ever. Rather than keep his secret sauce hidden, he's shared his knowledge for decades, so why aren't more investors able to replicate his methods and success?

Retirement

Finding joy in retirement

Retirement can last more than 30 years, necessitating thoughtful planning. Many miss workplace friendships, identity, status, expertise, and routine, but these can be replaced with renewed activities and purpose.

Shares

Bull and bear case for Australian equities for FY25

ASX market bulls point to corporate balance sheets and earnings, while bears highlight company valuations and persistently higher inflation. It's best to ignore short-term noise and focus on investing in quality companies.

Gold

How gold can help diversify your portfolio

As inflation is likely to remain stubbornly elevated, the correlation between bonds and equities could remain high, reducing diversification within portfolios. A gold allocation may help to better protect your investments.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.