Are the big banks finally cheap?

The following article appeared in the Australian Financial Review on October 08, 2018.

Australia’s big four banks are so out of favour that they’re considered a contrarian bet. Long loved for their rich dividends and history of capital appreciation, each of the big four banks has underperformed the ASX 200 on a total return basis over the past five years. Each has seen its share price fall in absolute terms over that stretch and the best performer of the bunch, CBA, sits 25 per cent below its March 2015 peak.

The shares don’t look conventionally expensive either on an earnings multiple basis. CBA sells for 12.4 forward earnings, according to S&P Capital IQ, which looks reasonable in an historical context (the five-year average is 14.1) and against the broader ASX 200 (selling on 15.7 times forward earnings).

But is that cheap?

It’s tempting to view the banks as good value. In my experience, though, investors have short memories when it comes to bank valuations, valuing them on income statements in good times and their balance sheets in tough times.

And how do valuations look in the context of balance sheets? They’ve certainly come off a great deal: CBA sells for 2.1 times tangible book value today, which is far below a borderline farcical peak of 3.9.

Still, it is hard to argue that a multiple of 2.1 times tangible book value – which is another way of saying a 110 per cent premium to tangible book – is conventionally cheap for a bank. It’s worth remembering that CBA spent most of its time as a listed business in the 1990s selling south of two times tangible book.

Further, turning to a decent global comparison, Wells Fargo (which is facing its own cultural crisis but has a strong core franchise) sells for only 1.6 times tangible book despite a directionally stronger and deleveraged domestic economy.

What’s ahead

Investors hoping that the big banks will recapture their valuations of yesteryear could be waiting a long time. In a structural sense, the banks have seen their capital requirements increase, which reduces returns on equity, and it’s hard to imagine the royal commission not resulting in increased compliance burdens.

In a cyclical sense, it’s hard to overlook that wage growth remains stagnant with no obvious catalyst for improvement and that household balance sheets are stretched.

Bank investors should also mind that home prices have begun sliding backwards, which could pressure consumption, mortgage demand and mortgage repayments.

The big and rich dividends paid out by the banks could also be at risk given the confluence of these headwinds and risks, inherent leverage to the business model and the already-high payout ratios of the banks that don’t leave much wriggle room.

As an aside, I have no axe to grind with the banks. We have no position in them, long or short, and as someone who lives, works, and plays in Australia I wish the Australian financial system continued health and success.

That said, given how widely-held the shares are and their immense weighting in the domestic share market – the combined value of the big four banks makes up 22.5 per cent of the ASX 200 – I’m obliged to follow them and feel some duty to provide my $0.03 on the subject.

Joe Magyer is the chief investment officer of Lakehouse Capital. This article contains general investment advice only (under AFSL 400691).