THE CURIOUS CASE OF THE BANKS
Welcome to our first aMail for 2009, a year in which your mettle as a financial adviser will be truly tested. Will you (as the “Sage of Omaha” encouraged) advise your clients to re-seek exposure to Australian equities – to ensure that they avoid “waiting for the robins (lest) the Spring be over”?
Or, will you settle for second best and allow your clients to succumb to the stagnation of the “average” financial planner whose views were summarised in last month’s IFA Magazine – which predicted that “the events of 2008 are likely to make the average investor content to select a lower strategic allocation to growth assets.” (IFA Issue 441, page 22)
As far as I can see the better planners are rejecting the “wait and see” approach and in this aMail we cover some of the rational analytics which good planners are using to help with this proactive approach. Let’s turn to the reality of valuations of shares in the Australian banking sector – one of the key “defensive” sectors.
Why haven’t the banks kept falling (like the brokers were telling us)?
Supposed victims of our ravaged economy, the best two performing Australian banks’ (CBA and WBC), current crop of earnings announcements have surpassed the pessimists, triggering share price recoveries in their share prices. The cynics were almost belligerent in their recent predictions of the demise of the whole sector’s long history of growth, and many investors have shunned the banks on the strength of this. These two bank’s resilience may be a presage of things to come across the broader market or it may just show the relative impregnability of the “Four Pillars” – but either way this is a central issue to understand for any investor working through the highly conflicting signals coming from analysts and brokers right now.
At Alpha, we believe that it’s vital to avoid being exposed to short-term share price volatility. Personal investors should build share portfolios to suit their longer term needs and aspirations – SMSF is increasingly being used to facilitate this in the context of retirement savings. History shows us, that moving in and out of shares in a time frame less than 12 months is unwise. Investing in shares for one year could see your returns vary between a loss of 40 percent and a gain of nearly 90 percent. Historically, investing for 20 years has resulted in the range of annualised return narrowing to between a gain of 9 percent at worst and 20 percent at best.
Why then invest in traditional Australian managed funds, which turnover their portfolio by as much as 60% or more per annum – or rely on broking analysts which endorse the high levels of trading which their main customers (the managed funds) rely on?
Brian Johnson, (newly) of Credit Lyonnaise, has recently been the leading advocate of selling the Aussie banks. Brian is the doyen of Australian banking analysts, and notably was previously the head of research at JP Morgan, where he was routinely rated the top institutional banking analyst. In a recent report for institutional clients, Credit Lyonnaise predicted banking share price falls of between 26% to 41% resulting from weaker earnings.
By any measure the CLSA report spooked the market and many of my clients quickly worried whether they should feed the research into a more pessimistic view of Aussie shares for this year...
This report was issued on 19 January 2009, just days prior to the release of earnings guidance by CBA on 2 February, and the ANZ and WBC results which were released on 6 February.
The CL approach seems largely to be driven by their “top down” view of the sector, namely that:
- provisions for bad debts would rise in first half earnings well beyond 1990 levels;
- loan margins and earnings would fall;
- ANZ and NAB would cancel their dividends next year; and
- that as a result investors should sell their bank stocks.
On 2 February, CBA announced that it’s first half 2009 cash NPAT would be around $2 billion, an astoundingly good number, although 16% lower than for last years comparable period, it is more than 20% above market expectations. The result shows strong revenue growth, particularly from the banking division which has seen revenue growth of around 20%. However, funds management revenue is lower due to the weaker equity markets. Expenses have also been kept down which assists the earnings number. Significantly, although provisions for bad debts are much higher, they are massively lower than predicted by CL. In fact, other banking analysts viewed the announcement positively. as it demonstrates the strength of the CBA's underlying franchise, eg. a flight to quality by depositors, the demise of non-bank mortgage lenders and the retreat of overseas banks.
A key mistake in the CLSA approach was to assume that bad debts would rise to the same levels as in the early 1990s. Maybe they will surprise on the upside, but gauging them by reference to the 1990s experience is not based on any empirical evidence... the early 1990s had interest rates of nearly 20%, whereas in Australia rates are now at their lowest levels in decades. It’s important when using top down analytics to get their selection right.
Has the market bottomed?
One often cited measure of the bottom of the market is when shares don’t fall, even when bad news emerges. CBA’s profit guidance triggered a sharp rise in its share price, even though its results will be worse than last year. Watcher’s of the market will find solace in this, and should keep a keen eye for further examples of shares rising after bad news emerges.
Its too early to call the market bottoming – although as we previously have noted, the structural damage done to the global financial system is now being repaired and this has taken the heat out of the free fall experienced last year. But what other indicators are there for us to examine?
The three charts set out below show us how we are now faring compared to previous crashes. Chart 1 shows how far global earnings per share have fallen compared to previous cycles. We are well on the way to the bottom of the eps decline when compared to previous cycles:
Source: UBS Global Strategy January 2009
It’s even more interesting to consider that markets are leading indicators of economic recovery. As Chart 2 shows, it’s expected by most analysts that global GDP growth will resume in the latter part of 2009 and into 2010:
Source: UBS Global Strategy January 2009
These indicators have in all previous cycles in the modern economy coincided with share price recoveries, with often steep appreciations following massive GDP and eps declines. Chart 3 below shows share price peaks and troughs for the last four decades.
Source: UBS Global Strategy January 2009
Its vital when building share portfolios for long term wealth creation, to avoid the spruikers of short term trading (rapid buy and sell orders feed stockbrokers commission pools), and instead to focus on the fundamentals.
So what about the bevy of doomsayers that are pointing to our market heading a lot lower. It may do that if circumstances change, or if we get a big exogenous shock – but on the basis of what we currently know, the signs are definitely more positive than many think.
Its a telling indictment of the sceptics, that no less an authority than the Governor of the RBA Glenn Stevens has indicated as recently as Friday, 20 February that, in his professional view, the Australian economy will recover and that it will do so ahead of other major economies. The RBA’s mettle as a well managed, accurate and professional central bank has been tested and proven in the global financial crisis – and so we will do well to heed their analysis.
A senior financial planner sent me a succinct summary of the contrary view, which is being put about by fund managers. At the recent Portfolio Construction Forum in Sydney, a bevy of large fund managers tried their best to tilt the field away from the likes of Warren Buffett, who is on the record as saying that now is a great time to buy shares. The bias inherent in this anti-view is a key underminer of its validity – after all, since most fund managers’ investment mandates are structured to force them to sell shares into a falling market, (thus crystallising losses and typically underperforming the market itself) – its not surprising that they are looking for excuses to explain their poor performance in the last 12 months. The loudest complaints of “blame the market – don’t blame us” come from the hedge fund industry. So it’s no wonder in that context that investors and financial advisers may be thinking, like my correspondent wrote...
“What concerns me, really concerns me, is that it is massively different this time. I attended Graham Rich's Portfolio Construction one dayer on Tuesday and the mood was far from sanguine. What I find difficult at this time, and as was espoused on Tuesday, is that the outlook is just soooo uncertain. The economic picture is decaying (the latest rumours from Europe could be another downer...) and hence the 'not missing the upswing' is debatable because the upswing may only be another bear market rally. It was also said that after a massive financial crisis equity markets could take four years to recover.”
These comments are well made and have to be seriously addressed. Which is why it’s sensible to prefer the views of our independent central bank, rather than the views of fund managers who are “talking their own book.” In his speech to the House of Representatives Standing Committee on Economics, Stevens said that...
“Australia was better positioned than many countries to ride out the international difficulties... banks are seeing the inevitable increase in bad debts as the economy slows. But our major financial institutions are still in a strong condition, have access to debt and equity markets, are still earning good profits, and are in a position to lend for sound proposals. Our housing sector is not overbuilt – instead there is considerable pent-up demand, and affordability is improving quickly. Most of the corporate sector is not over-geared.”
And for good measure he confirmed what serious market watchers have expected all along...
“The long-run prospects for Australia have not deteriorated by as much as we may all be feeling just now. China’s emergence, for example, has not finished. It has years to run and Australia will benefit from it. We should not lose sight of that or other positives.” http://www.rba.gov.au/Speeches/2009/sp_gov_200209.html.
Stevens is right and investors that can buy Australian shares now at bargain prices will profit from doing so. In fact, look at the prices of key stocks over the last few months and you will see that the best have already started to rise off their lows of last November. So it’s important to understand the subtlety of the anti-message being spread by fund managers. They benefit in the eyes of disappointed investors if they can divert the blame away from themselves. But at a deeper level, the anti-message is about keeping investors from withdrawing funds from them. The idea that the market will recover, but that this will take far longer than people think, seeks to reinforce the traditional mantra that fund investors should not sell out at the bottom of the market, instead that they should patiently wait – and do nothing! The opposite is in fact true right now – judicious redeployment of funds into better performing opportunities (like exiting international share funds and buying more Australian shares at deep value prices) is a far better alternative than staying on the sidelines. The world’s best investor may know better than the doomsayers.
Alpha Structured Investments
