Australian property has been an exceptional investment over the last 3 decades, increasing steadily in value by over 400%1. There are several reasons for this, and this list is by no means exhaustive: an explosion in cheap (relative to history) household debt, a high migrant intake, limited new supply, a tax system that heavily favours property investment and city councils that are reluctant to approve new developments.
1Source: Corelogic
Against this backdrop, Australian banks have had a strong wind at their backs for several decades. In this sweet spot era for the housing market bad debts have been minimal as people could almost always sell their house for a higher price if they couldn’t afford their mortgage and the constant supply of easy money greased the wheels to higher levels of household debt and expanding bank mortgage books.
It is also worthwhile to note that the earnings profile of domestic banks has changed dramatically over the years, especially after the shock of the 2008 Global Financial crisis (GFC). Post the GFC the banking regulator placed a much greater emphasis on risk-weighting bank assets to ensure that the domestic banking system would be better prepared to face a financial shock in the future. Due to the lower-risk nature of funding residential mortgages, housing loans require less regulatory capital than other categories such as corporate and small business loans and are therefore significantly return-enhancing for shareholders. Coupled with a structurally supportive domestic housing market, the banks started concentrating their exposure in this category – historically household lending accounted for about 30-40% of their outstanding loans, this ratio is now closer to 70%. This opened the door for more non-bank lenders to enter the arena, along with their funding partners in lending to the corporate world. Wentworth Williamson customers benefit from this trend in our Stable Income Fund, but we will leave this story for another day. Finally, the major banks also slimmed down and shed some of their non-core operations such as wealth management.
If you refer to the history of the Australian banking system and the immaculate credit loss history relating to domestic housing loans you can understand why our bank shares are considered by many as safe ‘blue chip’ investments. Residential mortgages are a lower-risk lending category and are significantly return-enhancing for the banks and the government-supported deposits are a cheap source of funding – the combination is a winner.
The obvious elephant in the room is Australian house prices are already amongst the highest in the world and the median Australian accumulated debt pile is so large it would frighten the pants off almost any other consumer across the globe. What could possibly go wrong! According to the shareholders of the Commonwealth Bank of Australia (ASX:CBA), apparently very little can go wrong. Investors will pay an enormous price for CBA shares – significantly more than its fair value if we compare it to a basket of global banks. See chart below comparing the price to book ratio with the expected return on equity (ROE) of some other major banks domestically and overseas.
To align with ‘fair value’ in comparison to overseas counterparts CBA’s share price would need to drop by 50%. This adjustment would take off over 4% of the ASX300 according to our estimates. Even if we only include Canadian banks and US banks who generally trade at a premium to their overseas counterparts then CBA is still overvalued by 40%.
As further sense check if we only considered the big 4 in Australia then CBA is still trading a huge premium to its competitors. CBA is projected to make roughly $9.6bn in net profit next year on a market capitalisation of about $178bn although this moves around day to day. If we take the next 2 biggest banks of NAB and Westpac (ANZ has similar earnings but a slightly smaller market capitalisation) we could theoretically buy both for $168bn but get about $13.3bn in net profit after tax. You pay less and get almost 40% more earnings!
The reason we highlight this is that almost all working-class Australians own bank shares via their super funds and CBA, is widely owned as Australia’s largest domestic bank. Additionally, investors who are investing in the index or index like funds may not be aware that around 25% of their investment is in bank shares at time they are flagging as expensive relative to their overseas counterparts. Furthermore, in the current uncertain environment earnings for banks are barely growing if not going backwards according to consensus. Finally, and just as importantly, most of the value of people’s assets is in their house – you get little diversification by investing your hard-earned savings in banks if most of your net worth is already in property. This doubling-up trade has worked for several decades but for the reasons cited in this note, it may make sense to think about further diversification.
To be fair Australia does have a very solid banking sector that is world renowned, and it operates in a stable geopolitical environment, but to pay such a high price for a company that is not growing is a trade that has an unfavourable risk/reward profile in our opinion. That is why in our fund we are actively avoiding this sector and looking at the smaller end of the market that offers greater diversification and is less exposed to the whims of the property market. Today in this segment of the market there are opportunities for the discerning investor to buy high-quality smaller companies with solid growth profiles all the while paying inexpensive multiples relative to history. At the very least, hopefully, this little article is food for thought that there is a place for smaller listed companies in a portfolio, especially considering the sector has been so out of favour with investors in recent years.
Appendices
Return on Equity: An improvement from the COVID impacted recent past but well down on historic averages. Unclear where normalised ROE will settle. We consider normal ROE at around 8%.
