Stock Review

Big banks at the crossroads

23/11/2004

  • Company: ANZ Bank (ANZ)
  • Recommendation: Hold
  • Price at Review: $19.66
  • Current Price: $30.13
  • Fundamental risk: 2
  • Share price risk: 3
  • Category: BLUE CHIP INDUSTRIAL
  • Category: Financial Analysis

It may pay big bank shareholders to ponder what the next few years might hold rather than focus on recent good results.

Big bank investors have grown used to rising profits, dividends and, consequently, share prices. With the notable exception of National Australia Bank, this theme continued in the recent round of financial reporting. This, though, should not overshadow the two critical questions every bank shareholder should ask: ‘How reliable is the income (dividend) from my bank shares?’ and ‘How safe is the money I have tied up in these financial elephants?’.

The elephant analogy isn’t quite as silly as it sounds. If you have purchased bank shares over the past decade or so, they might now seem akin to rare African elephants—large, strong and valuable. If you’ve been around a little longer and experienced the convulsions of the early 1990s you will realise that, at times, a bank can resemble another kind of elephant—a white one.

Comparative Share price

Having iterated these concerns in our cover story of issue 155/Jul 04,  titled ‘Do you own too many banks?’—an article you may like to re-read—here we’re going to zoom in on the key issues of income and capital safety.

Let’s consider the income side of the equation first. Logic dictates that to increase dividends consistently by, say, 10% each year over a long period, earnings must increase by a similar amount. Sadly, banks have adopted a flat-earth philosophy in this regard and have been increasing dividends at a faster rate than they have grown earnings.

Take a look at the table below. It features the percentage of profits paid out as dividends in 1999 and 2004, known in the jargon as the ‘payout ratio’. As you can see, each of the big banks has increased its payout ratio over the past five years, as they must if they are to continue to increase dividends at a rate faster than the growth in their earnings. Commonwealth Bank, last reviewed in issue 158/Aug 04 (Hold for the Upside—$29.18) and National Australia Bank, last reviewed in issue 161/Sep 04 (Long Term Buy—$26.95), are the worst culprits. This financial year, the Commonwealth paid out 93.5% of its profits as dividends—a very high figure.

It is a fact that payout ratios cannot rise forever. Thus, the current trend must either tail off or reverse: it cannot continue. The consequences of this fact could be amplified, as we pointed out in issue 155/Jul 04, if profits fall at a time when payout ratios are at or near their maximum levels. Currently, with the exception of the Commonwealth, the banks have a little room to move—but this safety valve is nearing the end of its useful life. Banks must either increase earnings at a rate commensurate with their rates of dividend growth or reduce the rate of growth in their dividends.

Bank Financials

Increasing competition

What, then, are the chances of banks increasing their earnings at a more rapid pace? Industry competition has been increasing in recent years. Regionals such as Bendigo Bank and Bank of Queensland have been growing very quickly, creating risks not just for their own shareholders, but for other banks’ too. A smaller bank, hungry for market share, may slash its margins in order to attract customers and, in this industry, it’s difficult to behave sensibly when faced with an irrational competitor. Homebuyers tend not to worry about who provides their mortgage, as long as the money is available on settlement day at the cheapest possible rate.

In the business sector, our little publishing enterprise has recently witnessed first-hand some savage competition between three banks eager for our business. The happy result has been lower fees and better service. With GE Money, a subsidiary of giant US conglomerate General Electric, making an aggressive push into the Australian finance industry, the cosy nature of the banking cartel, if not breaking down, is being chipped away at its edges. These factors suggest lower, not higher, margins for the industry. And that implies a bleaker outlook for big bank profit and dividend growth.

This in itself should have an impact on big bank share prices, but it’s compounded by another issue about which we’ve repeatedly warned subscribers: a complete property meltdown. Westpac, last reviewed in issue 154/Jun 04 (Hold for the Upside—$17.70), offered a great deal of detail relating to the impact of a property collapse in its results presentation. Volatile cocktail The figures were comforting, as they were designed to be, but are only a guess of what could happen. History suggests that high levels of debt (in evidence in the residential property market, and just about everywhere else), when added to fears that prices may be about to fall, are a volatile and unpredictable cocktail.

Another topic that we touched on in our cover story of issue 155/Jul 04 is the banks’ use of derivatives and other exotic financial instruments. You might think it unlikely that a bank will lose large sums on derivatives, and perhaps it is. But just one large, poorly-hedged transaction, or the actions of a devious rogue trader, can cause massive losses. Our two-part Investor’s College on this topic (which concludes on page 15), highlights the dangers presented by derivatives. And when you’re talking about highly leveraged financial institutions like banks, the risks are heightened. When one rogue trader brought about the collapse of Barings Bank, the UK’s oldest merchant bank, shareholders learnt this the hard way. The $360m ‘lost’ by a group of collusive traders at the National is a smaller, but more relevant, example for Australian investors.

These, then, are the risks. The big banks have enjoyed a great run over the past decade and, if they’re well managed, there’s a reasonable chance they will continue to deliver acceptable returns. But increasing competition and heightened business threats lead us to believe that subscribers should limit their exposure to this sector to no more than 15% of their portfolios.

Individually, though, each of the banks looks to be in a reasonable position. ANZ, last reviewed in issue 164/Nov 04 (Hold for the Upside—$20.07), and Westpac lead the bunch with their top management and consistent returns. Commonwealth and National, as discussed above, may struggle to increase their dividends over the medium term at the same pace as their peers. That fact, in conjunction with National’s recent disappointing result, has caused us to downgrade our recommendation a notch. Whilst this industry remains incredibly profitable, there’s mounting evidence to suggest that the future will not be a carbon copy of the recent past. That’s why we now recommend each of the big four banks as a HOLD.

Disclosure: Interests associated with The Intelligent Investor, somewhat nervously, own big bank shares.


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