A new era for banks?
Banks have been relatively poor investments over the past few years, having faced several headwinds.
However, during the selloff in February they become cheap – too cheap for us to ignore.
This provided an opportunity to build a position over March/April - at prices that have only been seen a handful of times over the past four decades. We have been pleased with the performance of these positions (ANZ and NAB) so far.
Overall, we continue to see merit in banks as an investment: they are inexpensive on both a relative (to the broader market) and an absolute basis, but our position remains conservative.
Your equity portfolio currently has approximately 6 per cent invested in banks – which is a modest exposure relative to the index (19 per cent).
And while the selloff in banks was rooted in concerns around the resilience of the broader economy during and post COVID-19, the regulatory and economic landscape has shifted considerably since then, with a large volume of support provided to the economy.
There are three key changes to the landscape that will shape the outlook for banks over the coming period. These are:
- A dramatic increase in levels of liquidity in the economy
- A movement towards explicit government support for households, business and investment going forward, which will benefit those parts of the banking sector with exposure to small and large business.
- Regulatory policy that is supportive of maintaining a viable banking system and minimising financial shockwaves.
These changes have altered the nature of banking during COVID-19 and could prove to shape the nature of banking in the future.
To understand why we look at banking fundamentals and how they may be impacted.
Banking basics and COVID-19: borrowing short, lending long
Bank profits primarily come from the arbitrage between the short-term cost of money and longer-term lending rates.
Banks tend to borrow money using short-term funding (deposits and wholesale funding) and lend out that money in the form of either longer-term loans or into products with structural higher profit margins (especially home-loans in Australia).
As a result, in general, banks tend to make higher profits when medium-term interest rates are higher than short-term rates.
So how have changes as a result of COVID-19 impacted this?
Long terms rates have fallen sharply. However, short-term funding, either in overnight accounts or in term-deposits, which previously cost Australian banks little in general, costs them even less today. This is as official rates are low (the RBA’s official cash rate is now at 0.25%) and the supply of cash from the economy very high (see the charts below).
In addition, the remainder of a bank funding tends to come from global wholesale markets - which are also flush with money looking for a relatively safe place to hide.
We have seen the consequences of this in the home loan market: with cheaper funding the banks have been competing for loans and discounting strongly, as evidenced by the Lendi Mortgage Pricing Index – which tracks home loan rates charged by a majority of Australian lenders.
Banking basics and COVID-19: credit risk
Banks make strong margins in general on the money they lend out. But this is no free lunch: in return for this they face credit risk. Banks are therefore required to assess the creditworthiness of borrowers and ensure that the loans being made will be paid back.
Given the size of loans being made in comparison to profits, a relatively small number of non-performing loans can ruin a year’s profit from the rest of the loan book and its equity value.
Due to this (and other inherent risks involved in banking), banks are required by regulators to keep aside a prescribed amount of high-quality assets (regulatory capital or “buffer”), to ensure they can remain solvent and resilient during periods of stress.
Naturally, you could again ask the question: how have changes as a result of COVID-19 impacted the credit risks that banks face?
The unprecedented impact of COVID, where otherwise successful businesses are facing major disruptions, and where “normal” activities of the economy are curtailed - the outlook for loans is much less certain.
Therefore, government and regulatory support during this period is crucial.
Government support key to mitigating risks
Bank prices currently reflect a view that their loan books will be significantly impacted by the crisis.
If there was no intervention, we could expect a significant spike in bad loans, as well as higher funding costs.
However, should support continue and the recovery from COVID be faster than expected, then losses will be minimized.
This intervention is crucial to avoid major long-term economic impacts, and significant deleveraging.
There has already been intervention in many forms. This has been through cash (which could be seen in the chart of deposits above) and back-stopping loans which both provide a potentially significant stimulus to the economy through recovery.
Some specific interventions to date include:
- The deferral of loan payments by banks
- Government support for loans, through wage support programs such as JobKeeper, concessions for landlords, and JobSeeker.
- The provision of cheap funding facilities by the government, which supports funding costs
- Regulatory support for banks
- Regulatory support for renters
This has effectively put the economy into “stasis” during the pandemic, providing the support required until an eventual reopening and resumption of normal economic activity. These actions have reduced the risk of a significant deterioration in their loan books and blunted the impact of COVID-19.
So how will this intervention translate to banks’ reported earnings over the coming year?
Accounting earnings could look uglier than underlying performance
Currently, loans are not being repaid as quickly, as payments are deferred. In most cases deferral means the interest is accrued and either add to the final repayments or repayments are restructured at a future point.
However, banks are required to report both realised defaults and expected default. Accounting for expected credit losses is part of provisioning, which impacts accounting earnings, but is not necessarily reflective of underlying performance.
If a bank wasn't required to tell the market about a bad loan (one that isn't being repaid or indeed written off) until it was certain that the money was lost, it would be too late for the banks, stakeholders and regulators to take corrective or supportive actions.
So, bank company accountants, and the government regulators that oversee them, ask banks to continually estimate the expected level of losses from their loan books.
It is this estimate of losses, not actual losses, that determines the level of profits reported by banks.
The differences are important - when banks report their performance in the coming months, they will tend to highlight these accounting earnings, which could look ugly, despite realized losses being smaller.
And what about dividends?
Under normal circumstances the regulator would consider these expected losses when determining how much capital (buffers) are required for the bank to keep aside.
This is crucial as the amount of capital a bank is required to hold determines the dividends it can pay. Generally, the determination of dividend levels is a mix of “profitability” (as measured by accountants) and capital requirements (as measured by the regulator). Recently however, the regulator has softened this requirement – meaning while banks still need to report their expected losses for accounting purposes, they have less of an impact on the actual capital they are required to hold. This has supported banks.
However, in the coming years capital will be scarcer than it has been over the past 15 years. For this reason, banks are not likely to provide the same dividend yield, or trade at the same price premium. We expect dividend yields on current levels of 3-4% in 2021 for our positions in ANZ and NAB.
What does this all tell us? Near-term dividends alone aren’t a good reason to own the banks (at current price levels). However lower dividends will mean their long-term solvency is supported, and these features are more than discounted at current levels.
Banks and positioning in your portfolio
We see merit in an exposure to banks, but given this changing landscape, we remain cautious. As mentioned, your equity portfolio has approximately 6 per cent invested in banks. Relatively speaking, this is a lower exposure than the market’s (ASX300) exposure of 19 per cent.
While the dividends from banks moving forward are likely to be lower, we see that they still have merit as an investment exposure due to the potential for capital growth. Put another way: both ANZ and NAB are currently trading at prices we have not seen for over 20 years. A reversion to prices closer to their historical values would create significant returns.
The charts below look at a metric which we have introduced before – price to book value.
In Australia, banks trend to be worth around book value, plus their permanent value of deposits, and the franchise advantages they enjoy in Australia.
The chart below shows that over the past 40 years, ANZ has traded on average at a price of 1.48x its book value. We purchased ANZ at a price of 0.75x its book value. Despite good returns, it is currently trading at a price of 0.86x its book value, a price we have not seen for over 20 years:
We have lightened our position in recent weeks as ANZ share price returned towards book value.
Likewise, over the past 40 years NAB traded on average at a price of 1.5x its book value. We purchased NAB at an average price of under its book value. It is currently trading at a price of 0.97x its book value, which again is a price we have not seen for over 20 years:
Overall, we remain cautiously positioned, with an exposure that is below that of the broader market.
However, with an improvement in the management of the pandemic, continued support from government and institutions, we should see both ANZ and NAB trade closer to their book value and good returns for clients.