We met with UBS banking analyst John Story yesterday to discuss the environment for banks, and his specific calls in the sector. John is a very good analyst and income investors (MM’s Income Portfolio included) generally have a large exposure to banks either through bank equity or bank hybrid securities or bonds. The Income Portfolio holds a 13% weighting to bank equity via Commonwealth Bank (CBA) and National Bank (NAB) along with a 26% weighting to major bank hybrids, implying we are underweight bank equity offset by exposure to their floating rate debt. Our Growth Portfolio holds a 12% weighting split across ANZ and NAB against the ASX 200, which has a 19.8% weighting to the majors and a 24% weighting to banks when the regionals are included (ex SUN & MQG).
- John (UBS) has a buy call on ANZ, hold calls on the CBA & WBC, and sell calls on NAB, BOQ and BEN.
Banks have underperformed the broader market YTD, down 3.5% vs. a flat market. WBC has been the poorest of the majors with the regionals (BEN & BOQ) seeing the most selling. ANZ has been the top performer.
- At a high level, CBA and NAB are expensive relative to history, ANZ and WBC are cheap, while the regionals are particularly inexpensive, however, they do have some specific challenges that are playing out, leaving us more negative despite the valuation support.
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Bank valuations vs 5-year average – Source Bloomberg
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Bank valuations vs 5-year average – Source Bloomberg
From a sector perspective, the positives are better economic conditions are driving what we call a better credit cycle. In other words, bad debts are still very low even with the significant increase in interest rates. Capital levels are incredibly strong across the sector, well in excess of regulatory hurdles and this does open the door for higher dividend payouts and other forms of supportive capital management. Put simply, banks are in incredible shape from a capital position which makes them safer, a clear positive for Hybrids.
On the flipside, there is some pressure persisting on margins as a result of some irrational pricing on mortgages (to win market share), and pressure to attract deposits (both are good for the consumer), although there is evidence that this has subsided more recently. Funding costs are also going up while cost pressures have been obvious, although this is more sporadic across the sector with WBC experiencing the most pain in terms of costs.
Overall, consensus expectations have major bank earnings contracting ~6.5% in FY24 and only returning to the levels seen in FY23 by FY27, which is a fairly pessimistic outlook. While we don’t expect significant capital growth in the banks, which is why we’re underweight the sector, their strong capital positions will support yields, which currently equate to: CBA 5.22%, ANZ 5.86%, NAB 6.11% and WBC 6.65%, all fully franked which puts the sector on an average 8.5% grossed yield (including franking credits).
- We see most upside in ANZ, the highest safety in CBA, while NAB & WBC offer the most attractive yields. We remain negative on the regionals given scale issues.
MM will likely increase our exposure to banks into weakness
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