Investment Matters

The Bank Squid Game

Netflix’s breakthrough series Squid Games has provided some iconic scenes.

In one scene contestants are forced to cross a bridge made of two columns of seemingly identical glass tiles.

However, only one tile in each row can support contestants’ weight.

They are left to choose their path – knowing a single misstep could lead to their demise.

This image comes to mind when reflecting on how investors have had to traverse the banking sector over the past few decades.

Big 4 Squid Games

On the surface, the big four are the same.

They exist in an oligopoly, with more or less similar business lines, operating under the same laws and regulations, in the same markets underpinned by activity in the same economy.

However, often it is only when they are put under pressure that cracks begin to appear. In these circumstances investors very quickly learn that they are not as comparable as they thought.

We look at the performance of bank shares over the past few weeks and the importance of not owning the ‘wrong bank’.

Owning the wrong bank

There has been one clear candidate for the ‘wrong bank’ to own over the past year: Westpac.

This is shown in the chart below, which compares the relative price performance of bank shares since the COViD sell off.

It is clearly the glass tile that shattered.

Westpac tile shatters

Source: IRESS, First Samuel

We’ve avoided owning Westpac, due to our concerns about its under-investment in technology, elevated costs and the weighting of its loan book towards residential mortgages.

Its share price tumbled after its FY-21 result. The bank revealed a loss in home loan market share, an attempt to regain share by writing ‘cheaper’ loans at perhaps the wrong time and trouble meeting its cost targets.

Over this period clients have owned NAB and ANZ – which as the chart above shows, have been amongst the three “right banks” to own.

How important has not owning the ‘wrong bank’ been with respect to returns?

Banks form a huge part of the Australian market (approximately 19% of the S&P/ASX 300 Index).

In FY-22 to date, the market (S&P/ASX 300 Accumulation Index) has returned 2.9%.

A seemingly innocuous decision to avoid owning Westpac would have added 0.75% to this return.

This highlights not only the importance of not owning ‘the wrong bank’ but also the value of stock picking, even at the level of a single stock.

Furthermore, this is not the first time we have seen this sort of divergence in performance between the banks.

Over the past decades not owning the wrong banks has been an important part of constructing portfolios.

This is illustrated below:

Period

Share price performance

What happened?

 ANZ logo  Commbank logo  NAB logo  Westpac logo

Jun 2021 - Present: Rebound in housing and the post COViD pivot

+2.9%

+9.9%

+14.3%

-9.4%

Cost control post Royal Commission, IT investment, pivot away from home loans

Dec 2017- Feb 2020: Royal Commission

+1.2%

+18.6%

-0.4%

-8.9%

Royal Commission: best and worst of a bad bunch

Jan 2016- Jan 2018: APRA and Macroprudential Policy

+14.4%

+3.9%

+15.2%

+4.6%

APRA put macroprudential limits on investor lending and riskier loans. The market correctly thought WBC and CBA over exposed

Jan 2014- Jan 2016: The hunt for yield – failed overseas adventures

-7.8%

+17.5%

-3.2%

+12.5%

End of the Asian strategy at ANZ, and NAB final stages of exit (Brexit, PPP insurance claims – warranty)

Jan 2006-Jan 2010: Offshore misadventures

+16.4%

+51.1%

+6.6%

+33.5%

NAB caught out with exposure to CDO's, disastrous growth of Clydesdale bank (UK)

Source: First Samuel, IRESS

Why the game is likely to continue…

It is relatively easy for banks to grow. However, it is much more difficult to grow profitably.

The structure of Australia’s banking industry and economy, while resulting in industry leading returns on equity, has also led to intense competition for market share.

This has manifested in a variety of corporate strategies over the years. Small differences in strategy mixed with a large amount of leverage can have a significant impact on returns.

Much like insurers, bank accounting can mean there is a lag between “growth” and the realisation of whether this growth has been profitable.

This depends on the quality of loans written, the underlying exposures taken on, the adequacy of compliance and risk management frameworks, amongst other factors. And of course, profitability has to be achieved while continuing to invest in core banking systems and technology.

In some instances, as Buffet preaches, “it is only when the tide goes out that we see who has been swimming naked”.

At these points the cumulative impact of past decisions come home to roost (for example, bad loans during the GFC and remediation costs post Royal Commission).

You can, however, avoid owning the ‘wrong bank’.

This involves a careful analysis of corporate strategy and indicators of bank health.

This includes book mix, capital ratios, net promoter scores, net interest margins (NIM), broker channel support and technology investment.