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Second-level thinking on Australian banks

In September 2015, Howard Marks wrote a memo entitled, 'It’s Not Easy', a reflection on Charlie Munger’s famous aphorism about investing, “It’s not supposed to be easy. Anyone who finds it easy is stupid.” The memo reflected upon the requirement for second level thinking in order to be a successful investor.

“The first-level thinker simply looks for the highest-quality company, the best product, the fastest earnings growth, or the lowest p/e ratio. He’s ignorant of the very existence of a second level at which to think, and of the need to pursue it.”

Given the substantial aggregate IQ devoted to identifying value in the market, most opportunities are seized upon quickly and priced such that the prospect is eliminated. Anyone who believes investing with consistent success is easy can miss “substantial nuance and complexity”.

Good investing is not only about good IQs

However, I believe successful investing is not merely a race to the prize between the highest IQ’s. Indeed Charlie Munger’s business partner, Warren Buffett, stated investing is not a game where the highest IQ wins.

Many extremely bright people require hard evidence, quantitative proof if you will, before making a decision. They argue that anything less is a guess. Sadly for this line of reasoning, the speed of repricing is so rapid in financial markets that waiting for the robin to sing renders spring over.

This is where second level thinking comes in. As Howard Marks wrote: “You must think of something they haven’t thought of, see things they miss, or bring insight they don’t possess. You have to react differently and behave differently.”

This article is about how Howard Marks's memo topic might be applied to today’s equity markets.

Second level thinking in today's market

Consider for a moment the widely-held view that banks are the place to invest. Since 29 February 2016 to the time of writing, CBA has risen 17%, NAB 26%, ANZ 34% and Westpac 12%, driving much of the gains in the S&P/ASX200 over the last year.

Late 2016 one analyst wrote: “The last Aussie banks results season once again confirmed no collapse in the housing market, no rampant rise of bad debts, resilient NIM’s and no cuts in dividends or imminent capital raises to rebut the bear thesis coupled with attractive valuations and double digit ROE’s.”

What about that second level thinking? Does a rear view mirror – that which has already occurred – aid in the navigation of what lies ahead?

Knowing that humans suffer from representativeness – a belief that the past is a good sample to use to identify what the future holds – is it any surprise that we are notoriously bad at predicting turning points?

Given that bank updates are at best a distillation of the last three months, what can they offer about turning points other than that they have passed?

As Howard Marks observed, first level thinking says, “It’s a good company; let’s buy the stock.” Second level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”

Bank share pricing is factoring in a scenario that does not have a high chance of transpiring, and while there is little hard evidence today that the banks are suffering from any headwinds, any sailor knows the ripples and wind lines on the water are a better sign of what’s to come.

Australia’s mortgage debt and household debt-to-GDP ratios are the highest in the world, and with credit card debt also at a record, consumers – who are also leveraged apartment investors - can least afford increases in their mortgage interest rates now.

And yet the prospect of imminently higher mortgage rates is real. The correlation between 3 year bonds and mortgage rates is high and while Australian 3 year AA-rated corporate bond yields have been declining since 2012, they have been rising recently. Mortgage rates are showing early signs of rising.

Of course, as long as highly-geared investors keep their jobs, they can attempt to raise rents and offset any increase in interest rates on their mortgages. Sadly, rents are unlikely to go anywhere but down. Last year in Cuffelinks, I described the situation for landlords in Brisbane:

"For the nine months to September 2016, just over 5200 apartments were completed within 5 kilometres of the Brisbane CBD. During the same period of time, owners of apartments 5 to 15 kilometres from the CBD experienced a doubling of vacancy rates from 2.3% to 4.7%. So think about that: just 5200 apartments caused a doubling of vacancy rates. What might happen when the 13,000 apartments currently under construction and due for completion in the next 14 months hit the market?"

The yield on an apartment with no tenant is zero so landlords will compete by offering lower rents. Any landlord that doesn’t follow suit will lose their yield too. The outlook for many leveraged apartment investors will be lower yields. Investor appetite for apartments will be turned on its head in due course, putting further pressure on credit growth for banks.

Short-term problems will hit banks

Bank earnings over recent years have also been aided by the writing back of provisions for bad and doubtful debts. These provisions will need to be rebuilt and just in time for a peak in the property market. The October 2016 apartment approvals dropped by 23% and given approvals lead to commencements, commencements to construction and construction to completion, a drop in approvals today will mean lower construction activity and associated employment soon.

Much of the above, along with record credit card debt, and APRA’s requirement that the banks increase their Common Tier 1 equity and reduce their mortgage risk weighting ratios, will conspire to render the banks’ collective prospects less attractive than in the past.

I am not talking about the prospects for the next two decades, which are terrific given the Australian population will almost double, ensuring the banks will be much more valuable. I am looking at the next few years.

Using consensus forecast numbers for 2016, we believe current bank share prices are factoring in 4.5-5.5% EPS growth into perpetuity from FY18 assuming the marginal ROE is in line with the ROTE generated in FY16 (with adjustments for ANZ and NAB to reflect a shift in mix away from Asia and divestments respectively). So even if we adopt a benign regulatory outlook and no need to increase capital intensity from current levels, the banks need to grow earnings in line with nominal GDP growth into perpetuity to be fair value.

The recent share price performance of banks reflects first level thinking about their aggregate business performance to date. Second level thinking considers the cyclical headwinds to the loan book growth, non-interest income growth, the lower than mid-cycle level of bad and doubtful debt provisions that need to be extrapolated into perpetuity.

If successful investing requires second level thinking, then successful investing may also require caution towards the dominant position of banks in an investor’s portfolio.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is general information and does not consider the circumstances of any individual.

12 Comments
SP
February 01, 2017

You should ask him how is his second level thinking performing in sirtex, hso, vtg, rea etc. Was simple when something is priced for perfection there is little room for error

Umberto Mancinelli
January 31, 2017

Thank you for your analysis.

Given that it is framed for the next few years, I'm having difficulty agreeing with your outcomes. Firstly, you say that the large boost to supply of units in Brisbane (occurring mid-to-late 2017?) will have a negative effect on rents but you don't provide any supporting evidence from the demand side. Family formation and immigration tend to soak up a lot of excess supply.

Secondly, you propose that the 23% fall in apartment approvals (Nationally?) will have negative consequences for employment implying poorer prospects for all the banks. Surely the drop in supply will also mitigate any large aberration in rents and capital returns for property, leading to not much change for the banks' residential lending portfolios.

...but, I still reckon you're right overall in that second level thinking is important in driving investment decisions. May I offer the following story recounted by a property developer in the 1980's: "...property investment is easy. If you can hold onto it, you'll never go wrong".

Kevin
January 29, 2017

I should add a comment I really like from the master, good old Warren.


In spite of 2 world wars,numerous minor wars and a lot of noise the dow went from13 to 13,000 in 100 yrs.

So in spite of crashes,loads of loud noise and everything else, CBA went from $5.40 to $83, in just over 25 yrs.Dividends went from 40 cts per share to $4.20 per share.

In 10 yrs time in spite of all the above CBA will go from $5.40 to whatever it is in 10 yrs time.

Every day of those 35 yrs events will/did occur,we cannot predict them,and there is a chance that CBA can go bust.

The annual report tells us that very few people are prepared to take that chance.From memory around 0.5% of the population own between 1001 and 5,000 shares in CBA.So much for opinion polls.

I think that is shocking.

Graham Wright
January 29, 2017

Writee

All of the possibilities and probabilities in the past have been superceded by the certainties of the present. But there are no certainties in the future, only possibilities and perhaps probabilities. The Lehmann Bros moments of the past prove we cannot know the future with certainty.
Roger has highlighted the need to assess the possibilities of the future and to not project yesterday's certainties as tomorrow's certainties.
If you cannot see Roger's message, you will be fearlessly buying when he is fearfully capitalising his profits and later he will be fearlessly buying when you are fearfully selling after a Lehmann Bros moment.

Writee

Kevin
January 29, 2017

While what you say is correct,the past does not predict the future and we cannot predict the future.

Where does that leave me,is it not just all noise.CBA funds my retirement (mostly).For 25 yrs I have ignored the noise,reinvested the dividends and now live comfortably indeed.

When the price has dropped I have bought more.The last rights issue at $71.50 and a few on market at around that price.I have no intention of buying any at $83 today.

The last 25 yrs has been great listening to everybody tell me how wrong I am/was.Luckily time judges all men.

Will what is left of my life prove to be all noise,I think so.If I am wrong it will be very easy to see.

In the short term Roger may be right,we don't know.We cannot predict the future.In the long term we are all dead and still cannot predict the future.

So it is a case of in a few weeks they declare their dividend,some of it will go to the DRP,most of it will fund my retirement,same in August of this year.Same every year.

I expect the rest of my life I will be told I was/am wrong.Time will tell

Kevin

Brett Edgerton
January 27, 2017

First order thinking is easier to market than second...

Add in policy asymmetry - and that it's almost unAustralian to say that house prices could actually fall substantially - it's hardly surprising that few are willing to talk negatively about housing and banks... (Shane Oliver, for one, is someone who spoke up a few years back about the dangers of a housing bubble and everything he has said and written since seems to suggest he regretted taking that risk to his reputation)...

Good on Roger for having the guts and the integrity to fearlessly express his view... for the benefit of those that wish to ponder second order considerations...

For others, get on the Trump trade before you miss out! (What ever the hell that means!!!)

Justin
January 26, 2017

Roger holds both CBA and WBC in The Montgomery Fund! They can't be that bad.

Manny
January 26, 2017

Roger, stop being the glass half empty commentator. Be a pragmatist and embrace their good dividend payments to their shareholders.

Future problems?......cross that bridge when the time arrives. Be assured each bank board is in the hands and power of their respective selected directors (12 or more) who would be suitably qualified.

Andrew Brown
January 25, 2017

If we delve a bit further into Roger's assumptions, using CBA only as an example (because its the best of the bunch and highest rated) and see if the slightly broad brush conclusions stack up. Their profits before doubtful debts and tax PER SHARE have grown at a compound 7.4% per annum over the past 23 years. That's ahead of the assumptions. For CBA, charge offs have been remarkably stable over the years averaging 31bp of RWA or about 20bp of interest earning assets - they are around 15bp at present. What might unhinge this? It's very hard extrapolating housing downturns into doubtful debts because of lack of experience with the phenomenon - it's commercial property loans and other "excursions" that ramp up bad debt charges for the majors, and they have mainly avoided these in recent years. A big downturn in the economy would be needed to increase unemployment and raise small business/property bad debts. The biggest headwind to me, apart from technology changes making them uncompetitive is that the ability to gear the balance sheet much more is diminishing. The CBA figures have arisen during a period when interest earning assets are now 2.1x risk weighted assets, versus about 1.1x at the start of these figures. HOWEVER, over the past 7 years, PBTDD/share has only grown at about 4.2%pa as the ability to gear up has been diminished by slow lending markets and the regulator (peak gearing was 2011). On the basis of this long term analysis, I don't hold CBA but don't find them so expensive that I'd be shorting them either. My conclusion on the "second level thinking" is that the penultimate paragraph is probably correct but not so sure about the one above it - bear in mind, I don't use Roger's valuation models.

David
January 25, 2017

Interesting article. I wonder if Roger's assumption around 3yr bond rates and bank lending rates should be based on an understanding of funding rather than a simple correlation.

PM 1957
January 25, 2017

It must be early in the calendar year - an amusing piece of financial literacy. Would you really leaving banks out of your long term portfolio!

Warren Bird
January 25, 2017

I can readily make a case to do so. On top of the issues Roger has raised, there is also the ever growing threat from competition from other providers of services expanding into financial services (Google, Alibaba, even Facebook). Just because financial service income is probably going to grow with nominal GDP growth, that doesn't mean that the incumbent service providers are guaranteed to share in that growth.

Of course, the banks know about these things and are working on countering strategies. One potential area I see is that they become intermediaries of other things - eg energy. If Wesfarmers can become an insurance policy provider (the "little red quote") then why can't banks become energy retailers?

So, I'm not seriously arguing to leave banks out of a long term portfolio. (I haven't personally, for what that's worth. ) But I don't agree with PM 1957's sentiment that Roger's argument is just amusing holiday reading. Instead, it challenges lazy investment thinking in a helpful way, even if you come to a different conclusion.

 

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