Income Note: Will bank dividends move higher & what’s wrong with Westpac?
Market Matters Income Report 16th December 2020
The ASX has followed overnight markets higher this morning with a bounce back in technology, materials and financials supporting a 1% gain at the index level. Just looking at the buying around this morning, the flow through the desk shows clearly that buyers are a lot more energetic than sellers in this market, yesterday we trickled lower, today we’ve stormed higher, hence we retain our bullish stance.
Overall, the ASX 200 is currently trading up +78pts / 1.18% to 6709
ASX 200 Chart
The Income portfolio fell by -0.26% in the week as the market cooled after a strong run. Ive Group (IGL) was the weakest link down nearly 9% proving that this stock will remain volatile, while Wesfarmers (WES) rallied +3% to new all-time highs above $50. No dividends were paid during the week. The portfolio remains well ahead of its benchmark for the current financial year, up 14.07% vs the RBA + 4% target of 1.93%.
At MM we also run a Separately Managed Account (SMA) allowing investors to easily invest in the income portfolio. While the holdings will deviate very slightly, for example, the SMA cannot hold international securities and the NBI fund is deemed that given overseas bonds, the process and structure is aligned.
The performance up until yesterday is outlined here over varying time frames, including the large sell-off experienced in March. Consistency of returns is a key target of this portfolio. If you would like to discuss this further, please visit: https://www.marketmatters.com.au/news/sma/ or reach out to Edward McKenzie on [email protected] or call 02 9158 6524
The current portfolio
Will bank dividends move higher & what’s wrong with Westpac?
In another very strong sign of the broader economic recovery playing out in Australia, yesterday we saw APRA, the prudential regulator of the banks, remove the requirement for lenders to retain a minimum level of earnings (50%) which had effectively reduced bank dividends by around 40%. The changes come into effect from the start of 2021 and were a direct result of banks withstanding ‘extensive’ stress testing. “While APRA will no longer hold banks to a minimum level of earnings retention, the onus will be on boards to carefully consider the sustainable rate for dividends, taking into account the outlook for profitability, capital and the economic environment.”
Using CBA as a guide, in FY20 they had earnings per share (eps) of $4.22 and paid out $2.98 in dividends equating to a payout ratio of 70%, however that was obviously skewed heavily to the first half ($2) v the second half (98c). Second half earnings were hit by large pandemic provisioning while the APRA cap put the kibosh on dividends. As we suggested at the time, we felt the provisioning was overdone for the economic outcomes in Australia and level of Government assistance. I think it’s very clear that most banks are now in a strong position from a capital standpoint, plus of course they’re heavily exposed to the prevailing economic recovery.
So, can we expect dividends to snap back to normal? In short, no.
Like many sectors / industries the banks will likely use this circuit breaker to right size dividends going forward, or in other words, they were paying too much out and not retaining enough for growth. This will be good for total returns but expect lower dividends as a percentage of earnings – something around a 60-70% payout of earnings is more likely.
This sort of trend where many companies are improving their businesses, whether it be through reducing costs, realigning dividend payouts, streamlining operations, cutting weak legacy divisions and the like, will be a silver lining to what’s been a very tough year.
In terms of dividend forecasts for the banks, based on a conservative 65% payout ratio, expect the following yields, although at MM we think there is some upside potential here on better than expected earnings:
– ANZ will yield 3.73% in FY21 rising to 4.64% in FY22
– CBA will yield 3.34% in FY21 rising to 3.56% in FY22
– NAB will yield 4.05% in FY21 rising to 4.64% in FY22
– WBC will yield 4.53% in FY21 rising to 5.02% in FY22
All fully franked.
Clearly Westpac screens well from a forecast yield perspective while CBA is relatively low.
Looking at the relative performance of banks over the past 3 years we see huge outperformance by the sectors No1 player, CBA while WBC underperformed significantly. It’s been a common trend for CBA to outperform, however not by this magnitude. If we break up the sector rather crudely, we think of ANZ & NAB as business banks, and CBA & WBC as housing banks, today we’re focussing on the housing banks.
Westpac have had a number of issues headlined by the $1.3bn AUSTRAC fine relating to anti-money laundering breaches, however more recently (start of December) they were hit with an enforceable undertaking after APRA was not satisfied with the progress they had made on risk governance remediation. An enforceable undertaking put’s in conditions around how they operate and ultimately increases costs, it’s also a poor reflection on WBC’s internal abilities to react to regulatory scrutiny, but has this gap simply become too wide remembering that CBA also copped a $700m AUSTRAC penalty?
Bank Price Performance Chart
Making a longer term comparison of the weakest bank (WBC) with the strongest (CBA) shows the recent trend is more of an anomaly.
Westpac (WBC) White v Commonwealth Bank (CBA) Blue Chart
From an earnings perspective, CBA now trades on 19.2x versus the sector on 15.3x which represents a 26% premium. Overtime, this premium sits at an average of 15%.
Commonwealth Bank (CBA) P/E versus Sector
Westpac on the other hand generally trades on the sector average P/E, however is currently trading at an 8% discount, more than 1 standard deviation below the norm.
Westpac Bank (WBC) P/E versus Sector
If CBA is 9% expensive and WBC is 8% cheap, all things being equal there’s a 17% performance gap to close. I have to admit, I’m gun shy in selling the top performer to buy the weakest stock in a sector, there are many examples currently where the cream is rising to the top, however banks are different and history shows they generally mean-revert after periods of excessive out/underperformance.
Westpac (WBC) Chart
Commonwealth Bank (CBA) Chart
MM is now watching closely for signs that WBC’s underperformance is turning, with the view of switching out of CBA into Westpac as the elastic band stretches too far.
Conclusion
Bank dividends will rise, however it’s unlikely that past payouts will resume at the same level, expect a more balanced approach
Westpac screens ‘very cheap’ in the banking sector.
Have a great day!
James, Harry & the Market Matters Team
Disclosure
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