The rise and rise of Australian banks
Australia is renowned for having highly-rated government bonds and market-leading resource companies including BHP Billiton and Rio Tinto. However, resource stocks (down 9% since October 2011) are not the only Australian companies that have been at the forefront of investors thinking over the past 12 months, with Australia’s high-yielding banks (up 23% over the corresponding period) rising during a period of elevated financial system stress.
Australia was the ninth largest banking sector in 2007
The recent strong relative performance of Australian banks has been the latest chapter of a five-year story. Indeed in October 2007, Australia had the world’s ninth largest banking sector by market capitalisation (after China, US, UK, Japan, Italy, Spain, France and Canada). However, the resilience of Australian banks impressed many global investors, coming through the GFC relatively unscathed while many of their global peers failed or else were nationalised.
… but they are the third largest now
Today, Australia has a banking sector that is the world’s third largest; larger than every single European country smaller in size only to the US and China (see Table 1). That places Australian banks ten places higher than the country’s position in terms of annual economic output (ranked 13th at the end of 2011, but it should overtake Spain in 2012) and 48 places above its status in the global population stakes. More importantly, Australia is one out of only two countries in the table below, where the banks’ market capitalisation has actually increased in dollar terms since 2007 (the other is Canada); Australia’s big four banks are now all in the world’s top 20, whereas in 2007 none of them were.
Table 1: Capitalisation of global banks by country ($US billions)
Source: UBS Australia Limited as at 10 August 2012.
The elevation has had many drivers
With Australian banks collectively having higher capitalisation than traditional financial hubs such as London, Spain, Hong Kong and Tokyo, investors may question what underpinned their rise. The result partly reflects the woes in other financial regions, the relative strength of the Australian financial system and the Australian economy (with no recession in 22 years), along with the more conservative lending standards of Australian banks and their different operating models. Although traditional credit growth is at historically low levels, the banks have a dominant position in Australia’s large pension fund market, which is the fourth largest in the world by assets under management. They have also diversified their global funding risk, by raising their funding from local deposits.
Another reason for the outperformance might be the Australian dollar’s rise against other global currencies since 2008, but Australian banks are also highly capitalised and as such, possess higher payout ratios than many of their global peers and have a strong track record of dividend increases. For example, the Commonwealth Bank of Australia, the largest of the Australian banks, just announced a dividend increase – it’s 19th out of the past 20 years.
Earnings and valuation risks are never far away
All investments attract risk, but with a dividend yield of around 6%, Australian banks appear to be a low-risk high-yielding investment relative to their global peers. The key risks to earnings remains to have continued pressure on interest rate margins, low credit growth and a cyclically low ‘bad and doubtful debts’ charge. If the Australian unemployment rate (currently 5.2%) began to rise, this charge could place some pressure on Australian banks $US1 trillion lending book. However, Australia has significant traditional policy ammunition left to fight higher unemployment, with low government debt and relatively high official domestic interest rates (currently 3.5%) that can be utilised. With Australian bank’s modest earnings growth at this stage of the economic cycle, their fast run-up in share prices over the past year could culminate in valuation risk. Indeed, valuations appear stretched relative to their peers, history and the book value of assets.
… but global risks are more prominent and all banks are exposed
With the Australian economy growing at a pace above trend (at around 4% in in the first half of 2012), it is more likely that risks to bank share prices would emanate from global sources such as Europe, China and the US. In that sense, all banks are ultimately exposed, not just the ones with stretched valuations. At Perpetual, we continue to search for companies with strong balance sheets, which have good operating models that generate surplus cash-flow and that have boards and management that know how to invest capital wisely. These types of companies create wealth for shareholders over the long-term and the current environment is no exception to this rule.
Article courtesy of Perpetual – September 2012