Investment Background Briefing – 29th March 2016
What’s happened recently?
- The ANZ and Westpac announced an increase in their corporate lending provisions for bad debts- mainly on loans to the resources sector- which surprised many in the market.
- This should not have come as a surprise to the equity market given the impact of falling commodity prices on many resource companies, but it did.
- Both ANZ and WBC sold off sharply and CBA and NAB were also sold down in sympathy. It appears to be an overreaction and maybe an opportunity for more agile investors.
- Meanwhile Australia’s big four banks continued to make huge profits from their housing mortgage books. At around 55% of their assets, mortgages very predictably underpin the profitability of the banks allowing them to pay out a high proportion of their after tax profits as dividends.
- The big four – CBA Westpac ANZ and NAB- are more alike than they are different. They all have a preponderance of relatively low risk home loans as the major component of their assets, most have financial services businesses that cause them bad PR but really have little impact on profits and they all pay high rates of fully franked dividend. Their gross dividend yields range from 7.7% p.a. from CBA to 9.9% p.a. from ANZ, averaging 8.5% p.a.
- This is a long way above the yield on the ten-year government bond rate, which is around 2.5% p.a.
- The banks are important in many investors’ portfolios- both individuals and fund managers. The former like the dividends and the familiar names, the latter are often too timid to bet against the share market index in spite of being paid handsomely to do so.
- The big four banks make up 26% of the ASX 200 market capitalisation. Holding a large share of a portfolio in them has great attraction, partly for their dividend yields and partly for their blue-chippedness, which translates into some sort of feeling that it is hard to lose money on such stocks.
- In the long run this is probably true, not least because the big four have real market power and operate as an oligopoly run by managers who are paid well for running what amounts to a set of quasi public utilities subject to a lot of regulatory supervision.
- Their return on equity is to some extent assured by the care and attention they receive from the Australian government “Official Family” comprising the RBA, APRA and the Commonwealth Treasury.
- While their return on equity (ROE) or return on shareholder funds may come under some pressure from time to time from various sources, in the long run their role in financing the economy in general and the current account deficit in particular means that their ROE is unlikely to fall below 12% p.a.
- Below this level they would struggle to retain their AA rating from credit agencies. This rating is vital to keep their borrowing costs in the global wholesale markets at a level low enough for them to continue with the scale of their borrowings in this market, thereby relieving the government of the need to do so.
- In the long run, their profit and dividend growth will be governed more by the rate of overall credit growth in the Australian economy than anything else, such as corporate bad debt write offs.
- In the shorter run however, markets will react to bad news of all sorts. The falls in the bank stock prices in the past week ranged from 7.6% for ANZ and 7.1% for NAB to 5.25 for WBC and 3.9% for CBA. Each of these makes a fair size dent in the annual return from dividends on these stocks.
- There is an implicit cost that has to be borne when seeking returns from high dividends and gradual capital growth in the long term. It is the need to put up with the drama of wide week-to-week swings in the capital values. These may be powerful companies operating in a protected environment but they are nonetheless very highly geared or leveraged and they pay out a very high proportion of their earnings as dividends.
Key takeouts and implications for investment portfolios
- Keep investing in the big Australian banks but limit the exposure of portfolios to the big four banks to less than their index weight of 26%.
- This can be done directly in portfolios that invest directly in stocks.
- When using funds or fund managers to execute portfolio strategy, seek out funds which are more broadly diversified into the mid cap or even small cap segments of the ASX.
- Low cash and fixed interest returns will persist for some time, putting more emphasis on the need to have substantial but risk controlled holdings in growth assets such as equities or property securities. Do not chase high yields on so called blue chip stocks without keeping in mind the potential for short-term volatility as well as longer term constraints that lead to slow growth.
Planning Perspective Gold Coast Pty Ltd is a Corporate Authorised Representative of Madison Financial Group Pty Ltd | AFSL No. 246679 |
ABN 36 002 459 001 http://www.madisonfg.com.au
This information is of general nature only and neither represents nor is intended to be specific advice on any particular matter. We strongly suggest that you seek professional financial advice before acting.